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Legging Into a Short Iron Condor Spread:
In my weekly Saturday Report that I send to paying subscribers, on January 4, 2014 I set up an actual demonstration portfolio in a separate trading account at thinkorswim in which I made long-term bets that three underlying stocks (GOOG, SPY, and GMCR) would be higher than they currently were at some distant point in the future. The entire portfolio would make exactly 93% with the three spreads I chose if I were right about the stock prices.
Almost two months later, things are looking pretty good for all three spreads, but that is not as important as what we can learn about option possibilities.
If you recall, early this year I was quite bullish on Green Mountain Coffee Roasters (GMCR) which has recently changed their name to Keurig Green Mountain. The major reason was that three insiders who had never bought shares before had recently made huge purchases (two of a million dollars each). I Googled these men and learned that they were mid-level executives who were clearly not high rollers. I figured that if they were committing this kind of money, they must have had some very good reason(s), Also, for four solid months, not a single director had sold a single share, something that was an unusual pattern for the company.
My feelings about the company were also boosted when a company writing for Seeking Alpha published an article in which they had selected GMCR as the absolute best company from a fundamental standpoint in a database of some 6000 companies.
This is what I wrote in that Saturday Report – “The third spread, on Green Mountain Coffee Roasters (GMCR), is a stronger bullish bet than either of the first two, for two reasons. The stock is trading about in the middle of the long and short put prices (70 and 80), and the time period is only six months (expiring in June 2014) rather than 11 or 12 months. I paid $540 for the Jun-14 80 – Jun-14 70 vertical put credit spread. My maximum loss is $460 per spread if the stock closes below $70, and I will make 115% after commissions in six months if it closes above $80.”
This vertical put credit spread involved selling the Jun-14 80 puts for $13.06 and buying the Jun-70 puts for $7.66, collecting $540 for each spread. I sold 5 of these spreads, collecting a total of $2700. There would be a maintenance requirement of $5000 for the spreads (not a margin loan which would have interest charged on it, but an amount that I couldn’t use to buy other stocks or options). Subtracting what I received in cash from the maintenance requirement, my real cost (and maximum loss) would be $2300. If GMCR closed at any price above $80 on June 21, 2014, both puts would expire worthless and I could keep my $2700 and make 115% after commissions (there would be no commissions to pay if both puts expired worthless).
An interesting side note to the $2700 cash I received in this transaction. In the same account, I also owned shares of my favorite underlying stock. I am so bullish on this other company (which is really not a company at all, but an Exchange Traded Product (ETP)) that I owned some on margin, paying 9% on a margin loan. The cash I received from the credit spread was applied to my margin loan and reduced the total on which I was paying interest. In other words, I was enjoying a 9% gain on the spread proceeds while I waited out the six months for the options to expire.
In case you hadn’t heard, GMCR announced on February 5th that they had executed a 10-year contract with Coke to sell individual cups on an exclusive basis. The stock soared some 50%, from $80 to over $120. In addition, Coke bought 10% of GMCR for $1.25 billion, and gained over $600 million on their purchase in a single day. Obviously, those insiders knew what they were doing when they made their big investments last November.
Now I am in an interesting position with this spread. It looks quite certain that I will make the 115% if I just sit and wait another 4 months. The stock is highly unlikely to fall back below $80 at this point. I could but back the spread today for $.64, ($320 for the 5 spreads) and be content with a $2380 gain now rather than $2700 in June.
But instead, I decided to wait it out, and add a twist to my investment. Since the deal with Coke will not reach the market until at least 2015, it seems to me that we are in for a period of waiting until the chances of success for single servings of Coke are better known. The stock is probably not going to move by a large amount in either direction between now and June.
With that in mind, I sold another vertical credit spread with June options, this time using calls. I bought Jun-14 160 calls and sold Jun-14 150 calls and collected $1.45 ($725 less $12.50 commissions). These options will expire worthless if GMCR is at any price below $150 on June 21, 2014, something that I believe is highly likely. I think it has already taken the big upward move that it will take this year.
If the stock ends up at any price between $80 and $150, I will make money on both spreads that I sold. Now the total I can gain is $3400 (after commissions) and my net investment has now been reduced to $1600 and my maximum gain is 212% on my money at risk.
This new spread will not have any maintenance requirement because the broker understands that I can’t lose money on both vertical spreads I have sold. He will look at the two spreads and notice that the difference between the long and short strike prices is 10 for both spreads. As long as he is setting aside $5000 in a maintenance requirement on the account, he knows that I can lose that maximum amount on only one of the two spreads.
What I have done is to leg into what is called a short iron condor spread (legging in means you buy one side of a spread to start, and then add the other side at a later time – the normal way to execute a spread is to execute both sides at the same time). You don’t have to know any more about it than know its name at this time, but I invite you to become a Terry’s Tips Insider and learn all about short iron condors as well as many other interesting options strategies.
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I look forward to having you on board, and to prospering with you.
Terry
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