After finishing my long series of UCO trades with a profit last week, I’ve been trying to re-enter my exposure to oil. The price got a little ahead of itself and there was no way I was going to make this mistake of chasing it with high strike naked puts while WTI Crude is trading above $100/barrel. I like working UCO while WTI is between $80-100/barrel. I chose to get back in with UCO by using a ratio spread built with two legs of puts this time. I have the opportunity to make a profit on oil’s fall. If it falls enough, I could end up buying UCO again at a much-reduced price.
To ease back into UCO, I sold 10 put ratio spreads using a combination of one long UCO October $30 put for every two UCO October $28 puts I sold. While UCO was trading at $35.31, I bought 10 UCO October $30 puts for $1.141 each and sold 20 UCO October $28 puts for $0.7215 each. I received a $291.62 credit for the spread after paying $10.38 ($0.346 per contract) in commission. I went 12 weeks out on the calendar to give the position more time to work out for me. Oil tends to make occasional runs above $100 and has even made it above $150, but the reversal can be swift and steep. The sweet spot seems to be between $80 and $100 a barrel lately and I’m banking on it returning to those levels over the next three months. If I’m wrong, I make $291.62 and try it again.
Ideally, UCO will fall below my $30 long puts and increase my profit. If it magically lands on $28.00 at expiration, I’ll make a total profit of $2,291.62. That’s $291.62 for entering the spread and $2,000.00 ($2.00 x 10 contracts x 100 shares per contract) for the potential profit on the spread. My profits get cut dollar for dollar below the short strike at $28.00 until UCO hits my breakeven point of $25.71/share. I found my breakeven point by dividing my profit if UCO hits $28.00 by the number of shares I’ll have at risk ($2,291.62/1000 = $2.29). Then I subtract the profit per share from the price I’ll be buying shares after my hedge is out of the way ($28.00 – 2.29 = $25.71). That might sound complicated, but it isn’t. I took a few minutes to enter these formulas into a basic Excel spreadsheet and can simply enter the variables with whatever ratio spread I’m considering.
I took another minute to have my spreadsheet calculate what my returns could be in different scenarios. I don’t plan on keeping $28,000 available to cover this spread’s assignment, but if I did, I would only make 1.04% if UCO stays above $30. That’s only 4.37% annualized. If the stars align and I make a full profit, it’s a gain of 8.91% or 37.38% annualized. I expect something in the middle to be the final outcome. If UCO falls below $28.00, my profits drop as I illustrated above, but my returns can still be good. I might even close the position early if I can gain a quick $1,000-$1,500. If I take the assignment of 1,000 shares at $28 and my cost per share is $25.71 including premiums, I’ll start writing covered calls and might add in 10 more naked puts at a lower strike. That’s what I like about this low cost per share entry point. I won’t mind adding 1,000 more shares at a low $20s strike. My gains if assigned have too many variables to give estimates on, but figure I should be able to eke out 15-20% annualized without too much trouble.
I chose these strikes because I wanted the low cost per share if assigned. The $31/29 combination offered a cost per share of $26.67, which is reasonable, but I’d only gain ~$48 more in premiums for the extra $950 in risk. That’s not a good ratio. I didn’t bother to check any lower strikes because I think $25.71 is not a risky entry point if I’m assigned shares.
I’m still far too underinvested if the market is going to continue to push higher, but it’s starting to look shaky. Yesterday, the S&P 500 hit an all time high and then closed lower, right on its 10-day moving average after dipping below it intraday. Today, the same index opened below its 10-day moving average, nudged above it barely and then sank below it again in the morning before recovering some by the time I wrote this. This isn’t a sell signal for me yet, but it certainly makes me not want to invest fully quite yet. If we can see a 20-point drop in the $SPX, it’ll be close to its 20-day moving average and opening new out-of-the-money naked puts from there won’t be as risky due to the tiny (2.35%) correction already in the bag and the slight increase in volatility by then.
Barron’s had a cover story on the theory that the EU is recovering. If this idea is correct and they start to get the earnings growth and multiple expansion that we’ve already had in the US, it could be a better place to invest, even with the currency risks. I’m not going to go big into trading European stocks, but would like to add some puts on a good EU ETF. What are some of you using for your EU exposure? VGK, IEV and FEZ jumped out on my first query for optionable large-cap European stock indexes. Do any of you sell options on these or other ETFs I need to consider?