Sometimes staying in the game takes deep pockets, and as the saying goes, “The market can stay irrational longer than you can stay solvent”. XLE’s 3% drop today has crushed our May Supplemental Trades portfolio…but we have an opportunity to make back a good portion of this month’s unrealized loss—at the cost of taking on additional risk.
Make no mistake: Any member who has real cash on the line and who doesn’t have the means and/or desire to accept the additional risk would be best advised to stop out this afternoon. But simulations show that we can create a reasonable risk curve going forward if we sell IV here with another butterfly, as follows:
Day limit order
Buy to open 2 XLE May 74 puts
Sell to open 4 XLE May 70 puts
Buy to open 2 XLE May 66 puts
for a net debit of $0.74† or better.
Note that the 2 contracts specified above for the wings represent approximately *double* our base calendar-spread allocation in dollar terms. To be more precise, we want to hedge about 88% of our delta, so for a current portfolio risk of $10,000, we would allocate about $1500 to this hedge position.
Also note, as usual, that as a Supplemental Trade, this order will not be autotraded.
Analysis: This trade neutralizes our portfolio delta and vega, and gives us a $5 range over which no adjustment would be triggered. The price of reducing risk to such an extent (besides the cash required) is that we’re guaranteed to take a loss—but odds are we’ll be able to cut the final loss by about one-third compared to our current unrealized loss.
Our XLE portfolio delta bias has gone from nearly +3% of total capital at risk to virtually zero. Because this butterfly is positioned below the current share price, portfolio vega has actually increased marginally…but was and still is essentially neutral. Our new risk-management thresholds are approximately XLE $71.60 (which is well below technical support at the March 15 low) and $76.60 (where there’s resistance from last week’s high)—and because our positions are spread out as widely as they are, those adjustment points will move further apart as we get into expiration week.
I expect that newer members have found this month’s Supplemental Trades rather overwhelming…so I’ll close with a few key points everyone should understand about this feature of the newsletter:
- As the disclaimer reads, these trades aren’t for members who have yet to gain a somewhat thorough understanding of the core strategy and/or don’t have the capital to tolerate a drawdown of as much as 25% to, under the very worst circumstances, 100% of capital risked on this part of their total investment portfolio. Read the posts, and paper-trade if you wish, but never, ever risk more than you can afford to lose, especially when it comes to Supplemental Trades.
- If there’s a very good chance that an adjustment will recover a significant portion of an unrealized loss, we usually don’t stop out of Supplemental Trades, even if we hit our target maximum loss of 25%. That’s because this newsletter, and the Supplemental Trades feature in particular, are intended to teach members how we use option-selling strategies to manage risk, even under the most adverse conditions.
- Nevertheless, if you’re trading real funds, don’t hesitate to close your positions the minute you become uncomfortable with the prospect of a 20% to 30% loss. Our trades are published first and foremost for educational purposes, not as a capital-management advisory service.
- For advanced members who choose to follow our trades with real money, keep positions small. Personally, I never risk more than about 15% of my total investment capital on any one strategy; and Supplemental Trades, for those who risk real cash on them, should be considered part of the total Calendar Options portfolio for allocation purposes.
As always, please feel free to send any questions or concerns to firstname.lastname@example.org. And on that note, the Supplemental Trades disclaimer…
NOTE: Supplemental Trades are optional and primarily intended for more experienced/risk-tolerant subscribers. They are not autotraded, and have no bearing on our core newsletter portfolio; however, we follow up by posting any additional entry or adjustment trades that the Calendar Options risk-management approach may call for. Also note that it’s important for anyone who chooses to participate in Supplemental Trades for a given cycle to follow all Supplemental Trades in that cycle if they wish to match our risk-management profile.†Average fill price.