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April 9 Readout, VIX, "Poor Man's Covered Call", and Our ETF Trading Systems

Greetings NGTers! We have four topics for today!

(1) The April 9 weekly options read-out

(2) A small discussion about VIX

(3) Why we don't like Poor Man's Covered Calls

(4) Our fantastic ETF systems

April 9 Options Readout

49 trades closed out last week, all winners.

Average gain: 1.95%

Average duration: 6.38 trading days

Average P/L per day: 0.45%

Average annualized return per trade: 112.5%

Below is a table of the trades we closed during A9 week:

We currently have 112 signals open, only 18 of which show a negative cushion as of the close on April 9.

Oh How The VIX-y Have Fallen!

As many of you know, the CBOE's VIX index provides a measure of the volatility of the S&P 500. Because time premium is correlated to volatility, and because we sell time premium, the VIX levels tend to correlate to our overall options trading returns. Thus, we regularly look at VIX to see what's going on in our trading sphere.

Looking back at the last 15000 days of VIX data (since May 2004), we found (roughly):

25% of the time, VIX was below 13

25% of the time, VIX was between 13 and 16

25% of the time, VIX was between 16 and 22

25% of the time, VIX was above 22

The historic mean VIX level is about 19.

VIX tends to be mean-reverting, i.e., it tends to return to 19 when it has fallen above or below that level. The chart below shows this pretty clearly:

So what does all this mean? We can use this information to get a rough idea of where our trading is relative to its historical curve and where it may be headed.

VIX was super high earlier this year -- up over 23 in January, above the highest quartile of VIX prices. There was a bump or two, and then VIX settled down below its historical mean of 19 to close on Friday just under 17:

Our returns correlate with VIX, and you can see that the NGT Options Trading System's average profit-loss per day has fallen along with the VIX:

The correlation is super tight, which we think is pretty cool.

VIX seems to be trending lower, but it's hard to take trends from VIX, which is fickle and mercurial -- it can change in a moment. Suffice to say, we can expect our overall returns to be a bit lower than they have been, given the lower volatility generally.

However, we note that "lower" returns are not "low." For trades closed last week we averaged 0.45% profit per day per trade. As we have said, our algorithm is designed to look for setups showing 25% to 50% annualized returns per trade, but it will take more if the market is giving this, which it has been. If you consider the 25% level, that is 0.1% gain per day (250 trading days in the year). Thus, on average, we are more than four times above the normal level. Let's be quite happy with that.

The Poor Man's Covered Call: A Rich Person's Plaything

We get asked a lot about the "Poor Man's Covered Call" and whether we can provide signals for those kinds of trades. This trade seems easy on the surface, but when you look beneath the waves, there's a lot more to it.

As you know, a "covered call" is when you sell a call option and also buy 100 shares of stock to "cover" the option should the stock price rise. This gives the familiar profit curve below:

A "Poor Man's Covered Call" is where you buy an in-the-money long term option (known as LEAPS), rather than buying the underlying stock to cover the short call option. The result is that the position is cheaper, because the LEAPS option is cheaper than the stock. Hence the name: "Poor Man's" covered call or "PMCC" for short.

Example: say you can buy 100 shares of XYZ at $100 per share and then sell a covered call on that. That's a true covered call. By contrast, with a PMCC, instead of buying the stock, you buy 1 LEAPS option with a strike that is deep in the money. In this example, let's assume you buy an XYZ LEAPS with an $80 strike. That would probably cost you around $30, i.e., $20 of intrinsic value and $10 of time value. You can see that the PMCC only costs about 1/3 as much as the regular covered call. You can thus buy 3x as many.

But watch out: there is a lot more risk! If XYZ drops to $70, then the true covered call would lose about 30% (about $70/$100). But the PMCC will move from being $20 in the money to being $10 out of the money. That's a big difference. That LEAPS option may have gone from $30 to $5. So you may now be looking at a 70% to 80% paper LOSS.


We re-iterate again and again: we never use leverage when it comes to options selling. That's our view and our risk tolerance. We use cash-secured puts and stock-covered calls. This means we have zero leverage and that's how we want it. It means we have limited downside and no margin calls.

Now, you might be saying: well, what if I only use one-third of my capital to buy the PMCC and leave the rest in cash. That way if the stock goes to zero, I still keep 66% of my money.

True, but there are problems with that. For example, the LEAPS leg has time premium on it. In our example above, the $80 strike had $10 of premium, which is why you paid $30 for it when XYZ was at $100. That $10 will decay, and you will have a 33% headwind against you.

Yeesh again.

There is also a delta and gamma differential that can arise if the stock quickly shoots up above the strike of the short call. In that case, the near-term short option can have much higher delta/lower gamma than the LEAPS option, which means the LEAPS won't rise dollar-for-dollar with the short option. The intrinsic value of the short call is thus only mostly covered, not fully covered, by the LEAPS, and you could face a paper loss. This could become a real loss without your consent if the short call (which is now deep ITM) is exercised! Triple yeesh! Your broker will deliver that stock to the options holder, and you will have the stock short in your account. If you act fast, maybe you can buy and cover without suffering more loss (watch out for that bid/ask spread...), but you'll need cash money to do that, which you might not have on hand, further requiring liquidation of other assets and/or a margin call.... You see the trouble. This is where PMCC's (or any calendar spread for that matter) can get really nasty. By contrast, the stock leg of a true covered call will always cover 100% of the intrinsic value of the short calls, so those short calls are always 100% covered. If the stock shoots up and the call is exercised, your stock is called away and you're left with cash. Easy peasy.

We have heard that one benefit of PMCC's is that the premium on the LEAPS option can reduce the impact of short-term, small dips in the stock price. That is, when the stock dips a little, volatility tends to rise, and the LEAPS option will not dip as much. True in theory. But don't forget that the option premium will decay over time. The effect of a "smaller dip" from the LEAPS is short term and only helps emotionally. From a financial perspective, it's not all that relevant, and is eventually overcome by the decay of the premium in the long term. Moreover, don't forget that PMCC's are leveraged anyway. If XYZ stock dips 1% ($1 in the example above) but the LEAPS dips only $0.50, that is still a much larger 1.6% dip on the LEAPS because the LEAPS is worth only $30.

And all of this can arise from just one PMCC position. Imagine trying to manage 20 of these puppies. Fugeddabaddit.

The bottom line is that PMCCs are really complex and involve lots of hidden risks that, in our view, are nearly impossible to manage.

You might not guess it from our trading style, but we are really risk-averse. Our number one goal in setting up our trades is to avoid significant loss. Do those losses still happen sometimes? Of course, they do, especially when we are out there bringing in trades with well more than 100% annualized returns on average. We try really hard to minimize the frequency and magnitude of any such losses through our algorithm, which places greater weight on the cushion and other risk factors than on the level of returns being offered by a trade. When most people filter trades by dividing returns by risk, metaphorically speaking we divide returns by risk squared. It's more complicated than that, and it's part of our secret sauce, but we hope you get the idea there.

Our ETF Trading Systems: Stock-Like Returns With Bond-Like Risk

Speaking of risk-aversion, our ETF systems are dynamite at reducing risk, and they don't skimp on returns. For those new to this, ETF's are like mutual funds except they can be traded like stocks, i.e., bought and sold during the day with no fees. We have developed two systems that allocate funds between ETFs in an effort to match the returns of the stock market but with much less risk. We have backtested these for many years, and you can read about them on SeekingAlpha in our "Return Like A Stock, Risk Like A Bond" series.

Since 1926, according to Wikipedia, the average historical returns of the S&P500 has been 9.8%. Some years, however, the S&P fell more than 30%. Since mid-2008, the SPY ETF, which tracks the S&P500, has grown at 10.7% per year with an annual standard deviation of returns of about 15.8%.

The S&P 500 is volatile. At times, it was more than 46% off its highs. This is called "drawdown," and 46% is big. Imagine sitting with less than 60% of what you once had? Wondering how long it would take to make that back? That would suck. In our sample from mid-2008, it took SPY about 2.5 years to come back.

There's a lot you can do to try to reduce the volatility of investing in the stock market via the S&P500. The most popular is to mix your stocks with bonds and rebalance. If you do 2/3 SPY and 1/3 long bonds (via the TLT ETF) and rebalance monthly, you get 9.7% returns (about the same as the S&P) but with only 10.4% standard deviation in annual returns, i.e., less volatility. The maximum drawdown since mid-2008 for this 2/3 - 1/3 system was 27.6%. This is much better than holding S&P alone.

We developed two systems that take this a few steps further, using our mathematical tools. In one system, we swap IWM (small cap stock ETF) with TLT (long bonds) depending on which one has performed better in the recent past, among other factors. We call this the "IWM-TLT Swap." Using this system, we gain 13.5% per year on average with a maximum drawdown of less than 25%. In another system that trades a more diversified basket of five ETFs, called "Simplified Diversification," we saw 9.25% returns with a maximum drawdown of less than 12%.

You can receive signals for these systems with our separate ETF subscription or you can subscribe to both the options and the ETF systems with a combined subscription. We invite you to check it all out on our website! The ETF performance charts for the last five years are here.

Have a great weekend, everyone!


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