HERE'S THE BEST TRADE I MADE IN ‘07

This is the story of how I legged into extremely low-cost, long-term put spreads on DIA, QQQQ and SPY. So I’ve been whistling “Zip-A-Dee-Doo-Dah” for the last few months instead of getting whiplash from the ups and downs of a see-saw market.

My intent is to share insights into how you can use protective puts to guard against recession, take advantage of changes in implied volatility to leg into a spread, and hopefully offer a few choice nuggets about trading psychology. This post might prove handy to you in 2008, if we’re in for a downturn.

I started 2007 long 170 DIA, 125 SPY, and 300 QQQQ in my TradeKing account. (Yes, I’m a lazy investor so it’s a lazy man’s setup.)  Please note: I use DIA in my illustrations of market movements. But they were fairly well paralleled by SPY and QQQQ, and I made the same moves across the board.

OPPORTUNITY LOST LEADS TO LESSONS LEARNED

On March 5, after a February slump, DIA traded at a yearly low of $120.28. Then, the bulls broke loose. By July 17, DIA rose to $140.46. (That’s a 16.8% move in just over four months, for those of you without a calculator handy.) Needless to say, I was filled with glee. And beer.

Yet a curious thing was happening in the media. Predictions of a crisis brought on by defaulting sub-prime mortgages were getting more pervasive. I was still bullish, but a persistent voice in my head said, “Buy protective puts!”

Protective puts would allow me to remain bullish, while maintaining an “insurance policy” on my exchange traded funds – just in case the media crackpots were right. But we were in a rally, and buying puts during a rally is a damn hard thing to do.

On the other hand, the VIX (also known as “the fear index”) is usually pretty low during a bull run. Because implied volatility is lower, it’s cheaper to buy puts on the upslope than the downslope. Yet I failed to pull the trigger. I figured, “I’m not blowing precious beer money on puts because of a few media crackpots.” Right?

Wrong. By August 15, DIA slid to $130.21. That’s a decline of 7.2% in less than a month. And there was much weeping and gnashing of teeth.

I knew protective puts would have been a smart move. But by mid-August it was way too late. Implied volatility had spiked from 15% to 30%, and puts became prohibitively expensive. I popped open a strong Belgian ale to dull the pain. It didn’t work. So I had another three or four, and that finally did the trick.

LESSONS LEARNED LEAD TO OPPORTUNITY GAINED

Fortunately, as fall approached, we had another rally. Between August 15 and October 1, DIA regained the 7% it had lost, and once again hit what I reckoned to be a ceiling of $140.00. Meanwhile, the media crackpots were escalating their rhetoric, and predicting worldwide economic collapse. (Scary talk gets ratings, folks!) Due to the bull run, volatility was fairly low at about 18%, and it seemed like a perfect time to buy puts. I wouldn’t pass up the chance again.

But what expiration date and strike price would I choose? Heck, I didn’t know when the bottom would drop out (if at all), or how far it might fall, or how long a potential recession might last. It’s not like I manage a freaking hedge fund. So I figured 5% OTM long-term (LEAPS) puts were a pretty safe bet. That would give me long-term insurance in case traders started jumping out windows along Wall Street sometime in 2008.

On October 4, the first thing I did was convert 70 DIA and 25 SPY to cash. That left me with 100 DIA, 100 SPY and 300 QQQ in my TradeKing account – nice even numbers for put contracts.

Then, I bought 1 contract DIA DEC 08 $137 PUTS at $8.50, 1 contract SPY DEC 08 $151 PUTS at $9.65, and 3 contracts QQQ DEC 08 $50 PUTS at $3.42.

Altogether, it cost me $2,841 to guarantee the total value of my ETF holdings would be worth a minimum of $43,800 – no matter what happens – until December, 2008. I looked at it this way: given the sub-prime fiasco, it was like buying home insurance on a trailer in South Florida with a potential hurricane brewing right off the coast.

As it turned out, the storm hit a lot sooner than I suspected. By mid-November, DIA sank to $130, and all of my puts were deep ITM. The good ol’ VIX ratcheted back up to 30 as the fear set in. So that meant puts would once again be very expensive – a great time to sell. I decided to leg into long put spreads by selling lower-strike OTM puts.

Establishing a spread had two benefits. I’d get back much – if not all – of the cost of the puts I’d bought in October. Plus, being short the lower-strike puts would neutralize the effect of time decay on my long puts.

Still, options are always a double-edged sword. The tradeoff was that the lower-strike puts would limit my protection in case of a really serious crash. But heck, I figure if Warren Buffett says the economy is robust, I shouldn’t worry too much.

I decided to keep as much protection against a downturn as possible, while getting back most of the cost of the puts I’d bought.

On November 15, I sold 1 contract DIA DEC 08 $121 PUTS at $8.20, 1 contract SPY DEC 08 $135 PUTS at $9.35, and 3 contracts QQQ DEC 08 $50 PUTS at $3.25.

Sale of the lower-strike puts amounted to $2,730. Taking into account my previous purchase of puts at $2,841, I wound up with a net debit of $111. Huzzah! That’s some cheap-ass insurance, folks.

Since I’m still long DIA, SPY and QQQQ, I say bring on the bulls for 2008! But if the bears come out, I don’t have to worry much. DIA would have to stay below $121 until next December before I really start to bleed. As of today, DIA is at $134.34. So I’m guarded against a decline of nearly 10% for an entire year.

And that, my friends, was the best trade I pulled off all year.

My worst trade was the split-strike butterfly I ran on SPX while I was in China last summer. A couple of days before expiration Friday, I went to sleep $400 ITM, and woke up $1000 OTM after the market was closed! The moral of that trade is: don’t EVER run speculative option plays when you’re on the opposite side of the planet.

Thanks for reading. I wish you a happy and prosperous 2008.