Why This Strategy is Imperative to Overall Portfolio Success (SLV, IWM)

SmallCapInvestor.com


On behalf of Wyatt Investment Research, I'm writing to let you know that all of our East Coast employees from Northern Virginia to Vermont have weathered Hurricane Irene.

Our offices in Washington, DC and Richmond, Vermont have been undamaged by the storm, and other than a few power outages, trees down, and road closures, we were lucky to be largely unaffected. We hope our many loyal customers were similarly unscathed by the storm.

Our thoughts are with those who bore the brunt of this hurricane as it made its way up the East Coast. Many of our neighbors here in Vermont have suffered far worse as a result of the massive flooding.

Wishing you and yours all the best as we recover from the storm.

This is Andy Crowder writing now from my house in Vermont.

As an options trader I am often asked about my favorite options strategy for producing income. And recently, after working with Ian Wyatt on an issue for SmallCap Investor Daily titled "What You Need to Know Before Using Options on Small Cap Stocks," I have been bombarded with questions from small cap investors about how to trade small cap stocks for income using options.

In my opinion, the best way to bring in income from options on a regular basis is by selling vertical spreads, otherwise known as credit spreads.

In late July I started publishing credit spread trades for Small Cap Daily readers. So far, I have four successful trades with a win ratio of 100 percent. But, I am a realist and know this perfect streak won't last forever. I realize there is no holy grail in trading.

Losing trades are a definite. It is how they are managed over the long-term that proves the success of a strategy, and I think I have shown over the past few years that I have managed my strategies appropriately to both capture gains and limit losses. My performance speaks for itself.

Now I want to bring to my strategies bring them to Wyatt Investment Research. Capital preservation is one of the key elements of my strategies and I insist on a disciplined, risk-management approach so that my strategies will have the best chance at long-term success.

Here is a simple example using my most recent trade.

Recently, I suggested a trade for our TradeMaster publication. I placed an options trade using the highly liquid iShares Silver Trust (NYSE:SLV) as my underlying. Similar strategies can work with small cap stocks too, you just need to make sure that there are liquid (, i.e. frequently traded), options on the stock in question.

At the time we entered this trade silver was trading at new lows and consolidating, so I decided to place the following trade:

  • Sell to open Aug11 SLV 28 puts
  • Buy to open Aug11 SLV 26 puts
This spread created a total credit of $0.24 (or higher) for a return of 12 percent.

At the time silver was trading for roughly $33.00. While I was bullish on silver, I still wanted some downside protection, which is why I sold the Aug11 SLV 28/26 vertical put spread.

The SLV credit spread allowed for a 15 percent decline in the underlying (in this case SLV) before the trade was in jeopardy of becoming a loser.

As long as SLV closed above $28.00 at August expiration, I would make 12 percent on the trade.

Amazing, right? Nice upside, with limited downside. This is why my options strategies are a necessity in any portfolio. If used correctly, they can be a powerful tool to enhance returns in your overall portfolio - even if the market slips significantly lower, moves higher or trades sideways.

With August expiration 32 days away, the credit spread that I placed was only worth $0.03. Given the limited upside remaining, I decided to take all risk off the table and buy back the spread. Here is the trade to do this:
  • Buy to close Aug11 SLV 28 puts
  • Sell to close Aug11 SLV 26 puts for $0.03
Some of you might be asking why would I not just let the spread expire worthless, which would allow us to reap the entire $0.24?

The answer is that upside was limited. While I did not think SLV will move 28 percent lower over the next 32 days, I was not willing to take a chance of silver breaking to new lows just to make an additional $0.03.

Trading - particularly options trading - is about taking profits when it makes sense; and being prudent, staying disciplined and most importantly, looking at the long-term picture.

As I always say, opportunities are made up easier than losses. Trying to squeeze $0.03 out of a trade just isn't worth the risk. The trade was successful, making 11 percent in just over three weeks. Now it isSo it was time to move on to the next opportunity.

On Thursday I will bring you my next credit spread trade on SLV and another trade in the small cap index iShares Russell 2000 (NYSE:IWM).

If you have any questions about the strategy, or any options related questions for that matter, please do not hesitate to email me at andy.crowder@wyattresearch.com.

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