The One Percent Rule (QQQ)

Ladies and Gentles –

The major indexes just cracked through their former highs to post all-time best reads, but we’re going to take a detour for a moment to discuss what we feel is an equally important issue.

We’ve discussed the matter of cash management several times in the past and endeavored to stress its singular importance to the trader – particularly the trader of options.

And we repeat here again– there may be no more important aspect to the trading game than cash management.


A Quick Lesson

awake

Our repeat performance is not without proximate cause – it comes in light of a very friendly note we received from kind reader Jim Rodgers, whose fame in the investment arena appears equal only to his humility, for he describes himself in his comments as a ‘beginner’ to trading and to options.

Indeed!

Yes, yes, Jimmy boy, we get it… Nudge, nudge, wink, wink…we’re all newbies in the trading game, aren’t we? Important to keep our feet on the ground, right? Even after all those investment biker miles logged and all those millions made again and again?

Fair enough. We’ll take your question on face, old boy. We’ll play the game.

Let’s recap.

Reader Jim was referring to a trade we posted last week in our Options Trader Elite letter, which invited you to go long the oil companies and short oil, the commodity.

First, he asked –

What would be a realistic amount to dedicate to the above trade on a 100k account?

And we responded that, in general, we see fit to dedicate between 1% and 2% of our trading portfolio to any given trade. There will be times when we deem a trade an essential component of the portfolio, and we’ll therefore raise the percentage involved. But generally speaking, we hold to the 1-2% rule.

milk

Second, he asked a series of related questions –

1. Am I correct that there is no risk on the USO/XLE trade?
2. Would 25 per side be a reasonable position?
3. Is the trade still viable to take?

Whoa, whoa! Jimmy Boy! Slow down, brother. Did we hear someone say, NO RISK?

The only thing that’s no risk these days is a condom dispensary in Rio!

There is risk in every options trade, friends. Sometimes it’s definable, sometimes not. We do our best to hedge our trades, but sometimes we don’t, and sometimes we can’t. And sometimes we leave ourselves open to theoretically ‘unlimited’ losses.

But that’s exceptionally rare.

Most of our initiatives are limited in risk to the money we spend at the outset.

Last week’s Risk/Reward Profile

 

Now let’s revisit last week’s excursion a little more closely to see how it breaks down, and state, even before we get into the nitty-gritty, that, yes, the trade is STILL VIABLE.

Remember: we recommended you consider –

“…purchasing the XLE December 31st 100 CALL for $0.91 and selling the USO January 15th 26 CALL for $1.00. Your credit on the trade was $0.09 per pair traded.”

[As of today the XLE CALL goes for $0.76 and the USO CALL for $0.84, so the spread is $0.08 per pair traded.]

Now let’s talk about risk.

Theoretically, your long CALL could decline to $0, and your short CALL could climb to infinity, leaving you one very poor sonuvabatch.

It’s not likely, but it’s possible to lose everything you ever worked for and then some with this trade. Remember that. And as they say in the business, trade only ‘Risk Capital.’

Risk Capital, by the way, is the term some wise guy over in compliance came up with to stand for money you literally wouldn’t miss flushing down the toilet.

taxes

Back to the trade.

Jim’s second question was whether 25 options per side was reasonable for the trade. And the answer is yes and no. It depends on who you are.

Consider – the credit you’d pocket at the outset would be $200 (25 x 8), which is a nice bit of spending cash. But let’s consider what might happen should the trade go sour.

Let’s imagine USO runs higher, faster than XLE, and the USO CALL begins trading for a hypothetical $2.00, while your XLE CALL climbs to just $1.05.

In that case, you’re looking at a $0.95 loss per pair – or $2375 (25 x 95 – less your initial $200 puts your actual net loss at $2175).

That ain’t risk-free.

The whole trade is predicated on XLE outperforming USO – whether on the upside, or down. But if the opposite occurs, you have to decide how much pain you’re willing to bear. If you can set stops on your trading account, then you do it. If you can’t, but you have time to watch your options all day long, then that’s precisely what you have to do. Twenty-five pairs in a fast moving, leveraged market like the one we’re trading could mean a deep wound in fifteen minutes, and financial suicide in a few hours.

Bottom line on the trade is like this – if you have a portfolio of $100,000, you have to find a way to limit your loss to $2000 on the trade. If you can’t do that ABSOLUTELY, then DO NOT POST THE TRADE.


Cash Management

 

In short, you never want to suffer a cataclysmic loss. It’s depressing and it saps all your vital energy. You absolutely must manage your cash properly, committing just the right quantity to each trade and never allow yourself to watch all your capital go to hell over the course of a day or two.

consolation

Dow, S&P strike it Rich! NASDAQ just
a few days away…

 

Both the Dow and S&P 500 hit all-time highs last week, while the NASDAQ at 4955 is a mere 93-points away from its all-time high close of March, 2000 (5048).

djia223

The NASDAQ hitting new highs is just a matter of when, not if. Moreover, we believe that it’s just around the corner, and that the run is beginning now.

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We’re therefore recommend you consider purchasing deep-in-the-money CALLs on the PowerShares QQQ Trust (NASDAQ:QQQ). We like the September 70 CALL, now trading at $39.87.

 

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We’re therefore recommend you consider purchasing deep-in-the-money CALLs on the PowerShares QQQ Trust (NASDAQ:QQQ). We like the September 70 CALL, now trading at $39.87.

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And feel free to dedicate up to 8% of your portfolio to this one.

With kind regards,

Hugh L. O’Haynew, Senior Analyst, Normandy Research

See what people are saying...

  1. Jesper Markenstam

    If we MUST place a stop to save our life, perhaps we’re simply trading too many contracts – no?

  2. Hugh L. O'Haynew

    Jesper, you said it. That’s precisely what we were implying.
    As always, take care,
    Huey

  3. William McMahon

    Hello Hugh,
    I’m a bit confused. Your pitching a larger position in the QQQ in this release which I committed to hook, line and sinker. As of today’s review of your OTE, however, it appears you are betting on a downside move in Apple. Isn’t Apple a sizeable chunk of the QQQ?

  4. Hugh L. O'Haynew

    Hi William,
    Thanks for writing, and your question is a good one.
    Let’s start by saying that Apple does, indeed, make up a disproportionate amount of the NASDAQ, so on face it looks like we contradicted ourselves.
    A deeper look, however, shows otherwise.
    Our long QQQ bet goes out seven months and is deep-in-the-money, revealing our commitment to a higher NASDAQ through the spring and summer.
    Our pairs trade with Apple goes out seven WEEKS, and is constructed to win on any RELATIVE outperformance of Tesla over Apple during that time frame.
    Apple can move up, down or sidewise before April expiration and we won’t care, so long as Tesla moves slightly MORE up, or slightly LESS down, and the technicals for both stocks indicate that Tesla should outperform.
    Thanks for writing, bro. Both trades should work out fine.
    All the best,
    Huey

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