2018 Tuesday – How we will be Building our New $100,000 Portfolios

I hope everyone had a nice holiday.

Happy new year!

I hope everyone had a nice holiday. Over at PSW, we've been in CASH!!! since early December so we'll be starting fresh this year and setting up 4 new virtual portfolios so we can get a bit more educational and teach our Members both basic and advanced techniques for wealth building. Our 4 Portfolios for 2018 will be:

  • Options Opportunity Portfolio (OOP) – This was orignally called the 5% Portfolio, as the goal was to use $100,000 to make $5,000 a month but, at Seeking Alpha, where we have a version of this portfolio, they felt is was confusing people to call it a 5% Portfolio, so we changed the name to what we do – look for opportunistic option plays. Originally, we were more short-term but I realized not that many people have time to trade so actively so we went with more long-term trades, which still make plenty of money in the short-term. While 5% a month may seem like a high goal, we were up over 100% in each of the two years we ran the portfolio.
  • Butterfly Portfolio – "Butterfly" refers to the type of spreads we use, though they are not typical butterflies as we use extended time spreads as well. Since we began our first butterfly portfolio in 2006, it has been our most consistent player, easily averaging 40% annual returns with much lower volatility than the other portfolios. Though the spreads are complicated, ofen with 4 or more legs, they are generally low-touch and their self-hedging nature means they have much lower volatility than our more directional bets we take in the other portfolios.
  • Short-Term Portfolio (STP) – Our STP is part one of our larger, paired portfolio and the purpose of the STP is to protect the Long-Term Portfolio (LTP), which is generally 100% bullish. So the STP tends to have shorter-term bearish bets and index hedges but we do take the occasional short-term plays if something interesting comes up. We'll also use this portfolio for short-term speculation for trades which do not fit into our LTP.
  • Long-Term Portfolio (LTP) – Our LTP is our bread and butter portfolio and is much larger ($500,000) than the other 3. The STP/LTP strategy is all about balancing risk and we use the STP to quickly tilt the combined portfolios more bullish or bearish by simply adjusting the hedges without messing around with our long-term positions. In general, the LTP is a very low-touch porfolio and we ofen go two months without a single change. Our core strategy in the LTP is to plant "trees" – stocks which will pay us steady incomes over long periods of time through either dividends or option sales.

Now that we have our portfolios in place, each with a fresh $100,000 (and $500,000 for the LTP), let's talk about how we allocate that money and begin to deploy it for the new year. The first step in trading any portfolio is to identify what your target goal is. There is little sense targeting a 300% return if your historical average is 8%! While it’s possible and I’ve certainly seen some phenomenal traders achieve those lofty goals, it usually encourages you to force trades which can be particularly detrimental to your results.

In fact, one of the greatest challenges money managers must overcome is the pressure to force trades to generate quick results in order to keep clients happy. This is one of the reasons you hear about the ‘window-dressing’ phenomenon so much as the close of a quarter’s trading approaches; suspicion is rife that money managers conspire to artificially inflate prices to cloak an otherwise mediocre performance.

I default to the general standard of 20% returns as a reasonable target when you start trading. Of course, it’s feasible to do much better and following a well-informed, active trader enhances your chances of excelling beyond such a target. At PSW, in this bull market, we've been running closer to 40% since 2013 (our last set of new porfolios) but we expect a more challenging environment ahead and feel sticking with a 20% annual target is more realistic – though we leave room to be pleasantly surprised, of course.

Sometimes 20% can be dismissed as being inadequate in the context of options trading where 50%+ returns can be generated on any given day. But you will never (or certainly you should never) have all your money in a single trade that might make 50%+ or go bust on any given day! We generally targets a 20% annual return, which is why we constantly take our winners off the table when they get too far ahead of "normal" returns. Once we take off 100% the starting balances on trades on both bull and bear sides, the rest of the year becomes playing with profits and we can get more risky but, intitially, let's make sure we lock in 20% as a good rule of thumb (see: "The Secret to Consistent 20-40% Annual Returns on Stocks").

If you are struggling to accept 20% returns as being a reasonable number, factor in the impact of compounding and you can quickly see that you will be very rich indeed if you simply target 20% per year no matter what trading capital you begin with. In fact, generating 20% per year for 20 years would yield a 38x multiple in a qualified account on your starting cash – which I think most of us would be quite content to have (see: "How to Get Rich Slowly")! With $100,000 starting capital, that’s over $3,750,000, which should still be nice chunk of change in spite of inflation.

I know, for a lot of traders who are not familiar with our systems and strategies, 20% annual returns might seem like a lot to expect but let's give you a couple of simple examples of trades we like and see how much they will make for us.

Apple (AAPL) is always a favorite stock of ours and not cheap at $169 but, at PSW, we teach our Members never to pay retail for a stock anyway. Our favorite way to accomplish that is by selling a put option, where we are paid for accepting a contract that allows the seller to force us to buy his AAPL stock at a certain price. The reason an AAPL stockholder is willing to do this is likely because they want to lock in gains or prevent a nasty market shock from damaging their position too severely. For instance, we can sell the AAPL 2020 $140 put for $9.50 so we would be paid $9.50 per option (100 per contract) to promise to buy 100 shares of AAPL for $140 between now and 2020.

Mechanically, the seller of the put contract can order us, at any time, to give them $140 for their AAPL stock but, realistically, they won't do that if AAPL is over $140 – as they would get more money selling the stock on the open market. By paying $9.50 to us, they guarantee they won't lose more than 20% on the position and AAPL will pay $5 in dividends over 2 years (and maybe a special dividend if they bring money back from overseas) so the cost of insurance is very low and the AAPL holder still gets all the potential upside of the position.

From our perspective, we are getting paid $950 per contract to promise to buy 100 shares of AAPL stock for $140 – a 20% discount to the current price. If AAPL never goes below $140, the contract expires worthless and we keep the $950 – free and clear! We then use this as the basis to construct an option spread on AAPL as follows:

  • Sell 10 AAPL 2020 $140 puts for $9.50 ($9,500)
  • Buy 10 AAPL 2020 $150 calls for $35 ($35,000)
  • Sell 10 AAPL 2020 $180 calls for $20.50 ($20,500)

Buying the calls gives us the right to pay $150 for AAPL through the same Jan, 2020 expiration date as the puts and selling the calls gives us the obligation to sell the stock for $180. Since we have the right to buy for $150, if someone "makes" us sell them the stock for $180 (AAPL would be over that level, of course), we would make net $30 on the spread. The net cost of this spread is $5,000 so the upside profit potential is $25,000 in two years.

Though the obligation is to buy 1,000 shares of AAPL stock for $140 ($140,000) the margin requirement is only $10,055 because $140 is already 20% below the current price. Still, it's a bit too risky in a $100,000 portfolio – as we simply can't afford the assignment if the market crashes, but this would be perfect for our $500,000 Long-Term Portfolio, which has $1M in ordinary buying power and can easily risk the assignment.

So here's a single play that will return, at $180 or better, a 500% profit on $5,000 cash in just two years. If we allocate our firepower to have 10 trades like that in the LTP, we could make $250,000 on a $500,000 porfolio in two years, which is 50% or 25% per year – right where we want to be when we begin building a portfolio!

Now, I know a lot of our PSW Members are yawning at 25% annual returns but, when we begin building our portfolios from scratch, that is how we do it BUT, as these position go into the money and look safely on their way to hitting our goals, THEN we can either add to the position and get more aggressive or we can add new positions as the risk of assignment fades away. But these things take time. When we begin a new portfolio, we like to error on the side of caution (see our article on scaling in and out of positions: "Stupid Option Tricks – The Salvage Play" as well as the general notes from our Strategy Section).

Allocation strategies are very important as you don't want too much risk in one position or sector, for that matter. As a rule of thumb, with a $100,000 portfolio, we expect to have $200,000 of buying power so we set up 10 allocation blocks of $20,000 and we look for diversified positions that will give us the best returns for our money.

With portfolio over $200,000, we would rather have 20 blocks – so no single position risks more than 5% of our portfolio. Now, it's important to consider what we mean by risk. With AAPL, we do think they could correct 20% (easily) and, in a crash, 40% would not be too surprising. From $169, a 40% drop would take us to $101 so say $100 and that means our $140 puts would be down $40 each of $40,000 – that is our realistic risk on the trade so, in a $500,000 portfolio with $1M in buying power and 20, $50,000 allocation blocks – we're not terribly worried abotu the risk on this trade – so it fits and we can pull the trigger.

For the OOP, I would also love to own AAPL but I would only buy them AFTER they have a 20% correction – which then hopefully cuts down the additional downside. Now, let's turn our attention to a divided-paying stock and we'll use Ford (F) at $12.49, which pays a reliable 0.60 (4.77%) dividend. In this case, we can set up the following trade:

  • Buy 1,000 shares of F for $12.49 ($12,490)
  • Sell 10 2020 F $12 calls for $1.50 ($1,500)
  • Sell 10 2020 F $12 puts for $1.50 ($1,500)

So here we are buying the stock for $12,490 and promising to sell it for $12,000 in exchange for $1,500 while promising to buy 1,000 more share for $12 in exchange for another $1,500. So the net cash outlay for the trade is $9,490 and, if called away at $12,000 we will make $2,510 (26.4%) plus another $600 x 2 in dividends brings our total profit up to $3,710 (39%) – right on that line where we want to be with our trades (20% per year).

Remember, in our $100,000 portfolios, we have 10, $20,000 allocation blocks so this is really a half position to start though the risk of being assigned another 1,000 shares at $12 could fill us up. Still, it's not about the maximum risk but the REALISTIC risk and we certainly don't think F will fall more than 50% in which case we'd have 2,000 shares (assuming assignment) for $9,490 + $12,000 = $21,490 or $10.75/share. So our worst-case scenario is owning 2,000 shares of Ford at a 20% discount to the current price – not even including the dividends to be collected.

Even if F felll to $5.75, our loss would be $10,000 so, at best, this is half of an allocation block that will make us $3,710.

Not to get too confusing but, if Ford were to motor up to $15 the trade would be so in the money that we'd no longer consider it a serious risk and we would then release that allocation block for a new trade. That kind of layering is how the portfolios tend to accelerate their performance over time – especially in a nice, bull market.

This is how we start to build portfolios that will generate consistent 20-40% annual returns and this week we'll be spending a lot of time talking about the basics and, of course, building our Watch List – stocks we'd love to buy if they get cheaper. Earnings will give us a great opportunity to pick up stocks for a discount as there are always ones that disappoint and sell off – even though their long-term prospects remain strong.

We're going to be cautious through January as we're still expecting a market correction but, if we don't get one – then we'll have to run with the bulls until we finally get to the edge of that cliff – and, hopefully, we'll be nimble enough to avoid going over the edge.