This month's experience was a painful reminder of how difficult it is to make gains on your invested capital. There are other reminders all over the place. Real estate was a way to make steady gains for many years, and then it wasn't. Treasury bills are being sold for zero percent interest - and that is surely a loss because inflation will eat away at the value of the investment that yields nothing.
Every December, Smart Money magazine publishes a lead article entitled "Where to Invest in (Next Year)". Every year, they consult the top analysts they can find to help them come up with a list of the best investments for the coming year. For each company, they give a summary of the often-compelling reasons why that stock is sure to soar in the coming year. I have often been tempted to buy the stock in every one of the 12 or so companies they recommend to spread my risk (but as you know, I resist the temptation and still do not own one share of stock of any company).
I decided to look back to see how the Smart Money selections for 2008 worked out in the real world. Of course, 2008 was a bad year for stocks. For the Smart Money "year" (December 1, 2007 through November 30, 2008), the S&P 500 fell by 40.8%. The Smart Money portfolio did even worse, falling 53.6%. One of the selections fell by 94%. Imagine! These were the 12 best companies that the top analysts selected as their best bets for 2008. A monkey throwing darts at the Wall Street Journal would have randomly selected 12 stocks that did better than those chosen by the experts.
If the smartest financial people out there, those with billions of dollars of other people's money to invest, with all their research capabilities and inside information, can't outperform the monkeys, how can ordinary investors like you and me expect to do better?
At least the people who did mirror the Smart Money portfolio only lost a little over half their money last year. They could have put it with Bernard Madoff's company and lost it all.
Once again, I am convinced that the Mighty Mesa Strategy as it is currently configured, is the best alternative for long-term investment gains for most of us. True, we had a bad month last month. It was especially bad because we were so far ahead at one point. Bad months happen. The prior month saw almost as great gains as we had losses this month. For the two-month period, we have suffered about a 1% composite loss. The same cannot be said for most stock market pickers, for Smart Money followers, or for investors in Mr. Madoff's ponzi scheme.
Monday, December 22, 2008
Wednesday, December 17, 2008
Using a Butterfly Spread to Reduce Downside Risk
At Terry's Tips, we have been researching the possibility of using butterfly spreads to provide downside protection for our 10K Strategy. As you may recall, the 10K Strategy uses calendar spreads at several different strike prices and depends on premium decay to generate gains most every month.
This strategy has made exceptional gains when the market is stable or fluctuates moderately either up or down, but has experienced losses when a large drop occurs. The last couple of weeks have been painful for this strategy because many have dropped nearly 10% quickly.
This week we are establishing a new portfolio for Terry's Tips Insiders to follow if they wish. It is called the Mighty Stalagmite. It uses SPY (the S&P 500 tracking stock) as the underlying because this is a large and relatively stable index.
The key feature of the Mighty Stalagmite is that a butterfly spread is added to the calendar spreads to provide downside protection in case the stock moves more than moderately during the expiration month.
Brief Description of a Butterfly Spread: A typical butterfly put spread would be as follows:
Long 10 Aug08 132 puts
Short 20 Aug08 127 puts
Long 10 Aug08 122 puts
Total cost of this butterfly spread = $1.10 ($1100 for 10 spreads)
This is the risk profile graph for these positions:
The butterfly spread gets its name because a graph of its returns are supposed to look like a butterfly, but it never looked that way to me.
The maximum gain for a butterfly spread comes when the stock ends up exactly at the strike of the short options. If it lands there, a very large gain results (in this case, over 4 times the cost of the spread). There are some interesting aspects of butterfly spreads:
o The initial cost is your maximum loss.
o If the stock ends up above the highest strike or below the lowest strike, a total loss results.
o The closer the mid-point (the short option strike) is to the stock price when it is bought, the more expensive it is (if the above butterfly were bought with all the strikes 5 points lower, the spread would cost $.53 instead of $1.10).
Since we would like to use a butterfly spread to provide protection on the downside, we would select a mid-point at a strike much lower than the current price of the stock. If the stock falls more than moderately so that the mid-point strike is approached, a large gain could occur which would offset the loss on the calendar spreads from the falling stock price.
If we added a butterfly whose mid-point was 10 points lower than the original stock price, it would only cost $.50 or so (this compares to the $3.00 or so in premium decay we would be collecting from the at-the-money options we have sold in the calendar spreads). Conceptually, we would be giving up some of our potential decay gain to provide excellent protection in case the stock were to fall by a large amount.
Most investors use calls when placing butterfly spreads rather than puts, and often take off some of the positions if the market moves strongly in either direction. Usually they are placed with the short strikes close to the current market price so that the maximum gains come when the market is flat (of if the investor believes the market is headed higher, he or she would place the spread at higher strikes).
Next week, we will discuss permutations that can be used on the typical butterfly spread that provides downside protection over a much larger range.
This strategy has made exceptional gains when the market is stable or fluctuates moderately either up or down, but has experienced losses when a large drop occurs. The last couple of weeks have been painful for this strategy because many have dropped nearly 10% quickly.
This week we are establishing a new portfolio for Terry's Tips Insiders to follow if they wish. It is called the Mighty Stalagmite. It uses SPY (the S&P 500 tracking stock) as the underlying because this is a large and relatively stable index.
The key feature of the Mighty Stalagmite is that a butterfly spread is added to the calendar spreads to provide downside protection in case the stock moves more than moderately during the expiration month.
Brief Description of a Butterfly Spread: A typical butterfly put spread would be as follows:
Long 10 Aug08 132 puts
Short 20 Aug08 127 puts
Long 10 Aug08 122 puts
Total cost of this butterfly spread = $1.10 ($1100 for 10 spreads)
This is the risk profile graph for these positions:
The butterfly spread gets its name because a graph of its returns are supposed to look like a butterfly, but it never looked that way to me.
The maximum gain for a butterfly spread comes when the stock ends up exactly at the strike of the short options. If it lands there, a very large gain results (in this case, over 4 times the cost of the spread). There are some interesting aspects of butterfly spreads:
o The initial cost is your maximum loss.
o If the stock ends up above the highest strike or below the lowest strike, a total loss results.
o The closer the mid-point (the short option strike) is to the stock price when it is bought, the more expensive it is (if the above butterfly were bought with all the strikes 5 points lower, the spread would cost $.53 instead of $1.10).
Since we would like to use a butterfly spread to provide protection on the downside, we would select a mid-point at a strike much lower than the current price of the stock. If the stock falls more than moderately so that the mid-point strike is approached, a large gain could occur which would offset the loss on the calendar spreads from the falling stock price.
If we added a butterfly whose mid-point was 10 points lower than the original stock price, it would only cost $.50 or so (this compares to the $3.00 or so in premium decay we would be collecting from the at-the-money options we have sold in the calendar spreads). Conceptually, we would be giving up some of our potential decay gain to provide excellent protection in case the stock were to fall by a large amount.
Most investors use calls when placing butterfly spreads rather than puts, and often take off some of the positions if the market moves strongly in either direction. Usually they are placed with the short strikes close to the current market price so that the maximum gains come when the market is flat (of if the investor believes the market is headed higher, he or she would place the spread at higher strikes).
Next week, we will discuss permutations that can be used on the typical butterfly spread that provides downside protection over a much larger range.
Tuesday, December 16, 2008
Stock Options Trading Idea Of the Week
Making Adjustments in a Volatile Stock Market
Subscribers have been writing in and asking for a more definitive set of rules as to when to adjust. For example, what number establishes the point where we are "too short" and must make an adjustment? Others have asked why we just don't always maintain a neutral net delta. These are legitimate questions, and unfortunately, there are no easy answers in a market as volatile as this one has been. It might help to explain the reasoning I have been following lately.
Each day, I watch the net delta position of each portfolio and compare it to theta. If theta is higher than net delta, I know that the stock can move against us by a full dollar and we should enjoy a gain for that day. Of course, lately we would be happy if it only moved a dollar in a day - in the past that was considered to be a big move, but today it is a small one. If theta becomes less than net delta, I check out the portfolio on the Analyze Tab at thinkorswim, checking what will happen at the next expiration if the stock price were to move another 6% - 10% in either direction (if expiration is only a week and a half away, I use the 6% numbers, and if it is more than two weeks away, I look at the 10% numbers). If a large loss appears imminent at one of those extremes, an adjustment would be in order.
As we have talked about in the past, adjustments are expensive. They invariable involve early rolling over (or taking off) options at a strike which is furthest away from the stock. That is the time when rolling over yields a very small amount and taking off involves selling for a lower price than any of the other spreads. It becomes even more costly when we add back on spreads at the other end of the spectrum, usually at strikes which are closer to the stock price - these spreads are more expensive than the ones we sold. In the end, we are buying high and selling low.
In a vacillating market, the best strategy is to avoid adjusting as much as possible to avoid these costs. As much as we would like to be delta neutral at all times, we would go broke making the necessary adjustments to make that possible. When the market takes a big move in one direction, the odds increase that the next move will be in the opposite direction. When a reversal move does occur, we will have avoided making two adjustments, and a gain usually results. There will be months when the reversal does not take place during that month, and we will have to endure a loss for that month. Hopefully, we will gain it back in the next month when at least a partial reversal takes place.
That being said, adjustments are sometimes necessary to avoid a devastating loss in case the market continues to move in a single direction without reversing itself. When the risk profile graph shows that huge losses are imminent, an adjustment becomes necessary to ensure that we will still be around to play another day. It is hard to determine in advance exactly what mathematical parameters should dictate when this kind of adjustment needs to be made, and is often more of an intuitive decision.
The market has fallen by over 40% in one year. Retirement accounts have been decimated. Mutual funds are at lower levels than they have been for years. Everyone with stock market investments is suffering to one degree or another. But there have to be some good buys out there, and it is inevitable that at some point people will start edging back into the market. Who knows if it will happen this month or next, or the month after? But someday it should happen. All it has to do is to stop dropping for us to make exceptional returns in our portfolios. Even though we get longer as the market falls (and get shorter as the market rises), there are times like today when we must tolerate being a little longer or shorter than we would like.
Our goal is to make as few adjustments as possible and still protect against a devastating loss of portfolio value. One way of doing this is to establish, and keep, a wide range of strikes in our calendar spreads. We have already moved in that direction (especially in the Big Dripper), and will continue to do so.
As much as we would love to have hard-and-fast mathematical benchmarks for making adjustments, in this world of higher and higher volatility, it feels more like art than science, more intuition and less reason. It is an uncomfortable place to be for many of us, but that is the way it must be, at least right now.
Monday, December 1, 2008
Stock Options Trading
Understanding Market Manipulation at Options Expiration
Market makers are generally short current month at-the-money options (both puts and calls) while the general public is typically (on balance) long those options. Market makers enjoy special margin requirements (or more precisely, a lack of requirements) that allow them to be short options without posting collateral that is required for ordinary investors. If a stock ends up exactly at a strike price at expiration, the market makers can keep their entire gains from both puts and calls that they sold earlier.
Obviously, they have a vested interest to do what they can to manipulate the stock price to end up precisely at a strike price.
For many years, this phenomenon has been tracked by many investors who are looking for a clue as to which strike price the floor will shoot for at expiration. The concept is called the Maximum Pain Indicator.
One free site where you can follow the indicator is Option Pain Here is what they say about it - "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."
For many years, I followed this indicator each month, and often it was right on the target (last month it was absolutely dead on SPY, for example). However, I have not followed it recently for several reasons. First, the indicator sometimes misses badly, and if you follow it closely, you will probably start placing large bets on its accuracy, and end up losing your shirt. I have preferred taking the position that I have no idea of where the stock will end up, as that is most always the truth.
Second, the indicator works best with individual stocks that are easier for the floor to manipulate than it does for broad-based ETFs like those we use in our portfolios.
Third, the change to strikes at dollar increments reduces the significance of the measure. Back when most strike prices were $5 apart, it was more important to have an idea where the stock was most likely to end up at expiration.
And finally, going into expiration week, the highest total of short puts and calls is almost always at the at-the-money strike price. This doesn't really tell you much except to expect no change in the stock price (which we know is usually not the case).
In spite of all these objections, it remains an interesting concept, and should probably be consulted just in case there is a strong indication that the maximum pain point is a few points higher or lower than the existing stock price.
Understanding Market Manipulation at Options Expiration
Market makers are generally short current month at-the-money options (both puts and calls) while the general public is typically (on balance) long those options. Market makers enjoy special margin requirements (or more precisely, a lack of requirements) that allow them to be short options without posting collateral that is required for ordinary investors. If a stock ends up exactly at a strike price at expiration, the market makers can keep their entire gains from both puts and calls that they sold earlier.
Obviously, they have a vested interest to do what they can to manipulate the stock price to end up precisely at a strike price.
For many years, this phenomenon has been tracked by many investors who are looking for a clue as to which strike price the floor will shoot for at expiration. The concept is called the Maximum Pain Indicator.
One free site where you can follow the indicator is Option Pain Here is what they say about it - "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."
For many years, I followed this indicator each month, and often it was right on the target (last month it was absolutely dead on SPY, for example). However, I have not followed it recently for several reasons. First, the indicator sometimes misses badly, and if you follow it closely, you will probably start placing large bets on its accuracy, and end up losing your shirt. I have preferred taking the position that I have no idea of where the stock will end up, as that is most always the truth.
Second, the indicator works best with individual stocks that are easier for the floor to manipulate than it does for broad-based ETFs like those we use in our portfolios.
Third, the change to strikes at dollar increments reduces the significance of the measure. Back when most strike prices were $5 apart, it was more important to have an idea where the stock was most likely to end up at expiration.
And finally, going into expiration week, the highest total of short puts and calls is almost always at the at-the-money strike price. This doesn't really tell you much except to expect no change in the stock price (which we know is usually not the case).
In spite of all these objections, it remains an interesting concept, and should probably be consulted just in case there is a strong indication that the maximum pain point is a few points higher or lower than the existing stock price.
Obviously, they have a vested interest to do what they can to manipulate the stock price to end up precisely at a strike price.
For many years, this phenomenon has been tracked by many investors who are looking for a clue as to which strike price the floor will shoot for at expiration. The concept is called the Maximum Pain Indicator.
One free site where you can follow the indicator is Option Pain Here is what they say about it - "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."
For many years, I followed this indicator each month, and often it was right on the target (last month it was absolutely dead on SPY, for example). However, I have not followed it recently for several reasons. First, the indicator sometimes misses badly, and if you follow it closely, you will probably start placing large bets on its accuracy, and end up losing your shirt. I have preferred taking the position that I have no idea of where the stock will end up, as that is most always the truth.
Second, the indicator works best with individual stocks that are easier for the floor to manipulate than it does for broad-based ETFs like those we use in our portfolios.
Third, the change to strikes at dollar increments reduces the significance of the measure. Back when most strike prices were $5 apart, it was more important to have an idea where the stock was most likely to end up at expiration.
And finally, going into expiration week, the highest total of short puts and calls is almost always at the at-the-money strike price. This doesn't really tell you much except to expect no change in the stock price (which we know is usually not the case).
In spite of all these objections, it remains an interesting concept, and should probably be consulted just in case there is a strong indication that the maximum pain point is a few points higher or lower than the existing stock price.
Monday, November 24, 2008
Our "Most Conservative" Options Portfolio
The November expiration month was a dreadful one for markets. They fell about 15%. Okay, the DOW only fell 8% (and this resulted in our option portfolio using DIA as the underlying to gain 40% in one month). The S&P 500 (SPY) fell 15% and the Russell 2000 (IWM) fell a whopping 23%. The huge drop in IWM caused both of our IWM portfolios to suffer big losses last month - there is a limit to how far the market can fall without hurting our portfolio values, and it looks like a monthly drop over 15% is where that limit stands. Fortunately, that number has been exceeded only once in over 20 years for SPY, and that was in October.
We have three SPY portfolios, and while the market fell 15%, these three portfolios gained an average of 18% last month. One of these portfolios is set up to do best when markets fall (we call it the Big Bear Mesa) and it understandably did the best, gaining 40% in a single month.
Today I would like to talk about our most conservative portfolio, the Big Dripper. We set this portfolio up on October 23, 2008 with $10,000. Our plan is to withdraw $150 in cash every month from this portfolio forever. That works out to 18% per year, after commissions. The annual goal is 20% - 25%, or less than our other portfolios which are aiming for 36% a year.
In its first month of operation, the market was not kind to the Big Dripper. SPY fell by 15%. Yet the portfolio gained 16.7% in value. In addition to the $150 monthly withdrawal, we took out another $1500 as a "windfall gain" withdrawal. If the market had not fallen so far last month, the Big Dripper would have made much more.
How did we do it? Simple. We established calendar spreads across a wide range of strike prices, going out at least 15% below the stock price and 15% above the stock price. Very few spreads were placed at near-the-money strikes. This is the risk profile graph which shows what these positions will produce in 4 weeks at the various possible stock prices (SPY closed at $79.52 on Friday).
As you can see, the Big Dripper will make a 35% gain if the stock falls by as much as 15% in 4 weeks, a 30% gain if the stock goes up by as much as 15%, or about 45% if the stock ends up about where it is today.
I must add that the above graph assumes that the current option values (IVs) of the long options will continue as they are right now. If VIX falls considerably, the gains projected by the software would be less than the above numbers. For the past two months, we have not seen any diminution of VIX, however.
Give yourself an early Christmas present, and learn exactly how to create the above portfolio in your own account by becoming a Terry's Tips Insider. You could establish these positions in your own account before Thanksgiving, and have something really exciting to look forward to each month from there on.
You can sign up today here. It could be the best Christmas present you ever gave yourself.
Terry
Stock Options trading
Our "Most Conservative" Options Portfolio
The November expiration month was a dreadful one for markets. They fell about 15%. Okay, the DOW only fell 8% (and this resulted in our option portfolio using DIA as the underlying to gain 40% in one month). The S&P 500 (SPY) fell 15% and the Russell 2000 (IWM) fell a whopping 23%. The huge drop in IWM caused both of our IWM portfolios to suffer big losses last month - there is a limit to how far the market can fall without hurting our portfolio values, and it looks like a monthly drop over 15% is where that limit stands. Fortunately, that number has been exceeded only once in over 20 years for SPY, and that was in October.
We have three SPY portfolios, and while the market fell 15%, these three portfolios gained an average of 18% last month. One of these portfolios is set up to do best when markets fall (we call it the Big Bear Mesa) and it understandably did the best, gaining 40% in a single month.
Today I would like to talk about our most conservative portfolio, the Big Dripper. We set this portfolio up on October 23, 2008 with $10,000. Our plan is to withdraw $150 in cash every month from this portfolio forever. That works out to 18% per year, after commissions. The annual goal is 20% - 25%, or less than our other portfolios which are aiming for 36% a year.
In its first month of operation, the market was not kind to the Big Dripper. SPY fell by 15%. Yet the portfolio gained 16.7% in value. In addition to the $150 monthly withdrawal, we took out another $1500 as a "windfall gain" withdrawal. If the market had not fallen so far last month, the Big Dripper would have made much more.
How did we do it? Simple. We established calendar spreads across a wide range of strike prices, going out at least 15% below the stock price and 15% above the stock price. Very few spreads were placed at near-the-money strikes. This is the risk profile graph which shows what these positions will produce in 4 weeks at the various possible stock prices (SPY closed at $79.52 on Friday).
As you can see, the Big Dripper will make a 35% gain if the stock falls by as much as 15% in 4 weeks, a 30% gain if the stock goes up by as much as 15%, or about 45% if the stock ends up about where it is today.
I must add that the above graph assumes that the current option values (IVs) of the long options will continue as they are right now. If VIX falls considerably, the gains projected by the software would be less than the above numbers. For the past two months, we have not seen any diminution of VIX, however.
Give yourself an early Christmas present, and learn exactly how to create the above portfolio in your own account by becoming a Terry's Tips Insider. You could establish these positions in your own account before Thanksgiving, and have something really exciting to look forward to each month from there on.
You can sign up today here. It could be the best Christmas present you ever gave yourself.
Sunday, November 16, 2008
Options Trading
The Joys of Calendar Spreads and Our
On October 23, 2008 we started a $10,000 options portfolio that was to be our "most conservative" portfolio. I sent you a copy of the risk profile graph that showed the gain or loss that would come about in 4 weeks at the November 21 expiration. If you recall, the stock (SPY) could go up (or down) by 15% over that period and a large gain would result no matter where it landed within that range. (We also set aside $1,000 to make adjustments in case the stock started to move strongly in either direction.)This new portfolio is called the Big Dripper because we intend to withdraw $150 in cash (1 ½%) from it every month forever, regardless of how much it gains or falls during a single expiration month. We will create positions that allow for a greater fluctuation in the stock price than any of our other portfolios for a gain to result. Our annual profit target for the Big Dripper is 20% - 25% a year (with an extremely high expectation of reaching that target).
Just in case a windfall gain (which we described as 20% or more in a single month) resulted, we would withdraw much of it so that new subscribers could mirror the portfolio (either on their own or through Auto-Trade with their broker) with about $10,000 to start.
Eight days has now expired, and the windfall gain has already come about. In this short period of time, the Big Dripper has made a whopping gain of 34%, well more than our target for the entire year. And the risk profile graph shows that further large gains are possible in the next three weeks over a wide range of possible stock prices (current price of SPY is $96.83). The stock can fluctuate by as much as 10% in either direction and we will gain an additional 20% in three weeks:
The New York Times has reported that October 2008 was the most volatile month in 80-year history of the S&P 500. At Terry's Tips we feature an stock options trading strategy that does best when volatility is low, so we would expect to get killed when stock prices are fluctuating all over the place as they have recently. However, over the past two weeks, our portfolios have gained an average of over 26%, and it is all due to the discrepancy in short- and long-term option prices that we hope will continue (if it doesn't we should be back to our historical above-average gains).
Our recent experience has demonstrated the exceptional opportunities that exist for a calendar spread strategy especially when there is a discrepancy between the option prices of short- and longer-term options. It is a phenomenon worth waiting for and plowing everything you can into when it comes up.
Maybe it is time for you to come on board and participate in these exceptional gains with us - it will cost you less than a decent dinner for two, and might dramatically change your investment returns for the rest of your life - check it out here.
Monday, November 10, 2008
Coping With an Emotionally-Driven Market
Short-term market activity is largely based on emotion rather than reason, and it is impossible to predict how collective emotions will be swinging in the short term. Except that we know that there is a cycle of emotions, and people tend to move in one direction until the pain (or euphoria) causes them to pause and reconsider.
For two days last week, the market focused on the 6 ½% unemployment rate, a number that had not been this high for 14 years. Inevitably, sometime in the next few weeks, some people will re-frame that statistic and think about the 93 ½% of Americans who do have a job. Many investors will realize that their personal life has not really gotten much worse, and that life goes on. The government seems eager to do something about the economy, and will not allow a protracted slowdown like the 1930's to happen again.
I can vividly remember how I felt after the 9/11 disaster. How could life as we knew it continue on, I thought? How could I ever get on an airplane again? Why should this market ever recover? And then a few days later as I was driving down my driveway listening to the local radio announcer playing my favorite same old songs and talking about the most mundane local things (like preparing for the invasion of the leaf-peepers in early October), it suddenly occurred to me that nothing really had much changed in my personal life, nor would it. A feeling of mellowness spread through my body and some of my natural optimism returned. I was ready to accept the possibility that the market might just go back up someday.
On a collective basis, that is how the market operates. For many months we have been thinking about the R word (while also worrying about the possibility of it getting worse and becoming the D word). Every layoff that was announced, every lowered earnings outlook, every new foreclosure number released - all contributed to our fears that a recession is on the way or already here. Many people dumped their stock, and the market fell by a huge amount, wiping out several years of gains.
And inevitably, at some point, people will start thinking about the 93 ½% number and make their own journey down their own driveway, and take a peek at the stock price of their favorite company and see a lower number than they have seen in many years, and get that feeling of mellowness that allows them to take a little nibble in the market. Collectively, the spreading feeling of optimism (or at least, muted pessimism) will cause the market to start edging back up.
We don't have any idea of when it will happen. But it will. We can be certain of that. The market has already gone down so far that the smart bet will be that the next big move should be to the upside. We don't want to suffer losses in our portfolios when that recovery takes place - it was bad enough suffering the losses when the meltdown came. It would be doubly painful to experience similar pain when the recovery finally comes.
So far, the Terry's Tips investment philosophy has been a great success. We hold leveraged positions that do best if the market doesn't fluctuate much. For the last couple of months, volatility has been greater than it has in the history of the market. We should have been killed in this kind of world. But the truth is that over the past three months, our composite portfolio values have gone up. When volatility eventually falls back to normal levels, as it inevitably will, we should enjoy gains that substantially outperform the market in general.
For two days last week, the market focused on the 6 ½% unemployment rate, a number that had not been this high for 14 years. Inevitably, sometime in the next few weeks, some people will re-frame that statistic and think about the 93 ½% of Americans who do have a job. Many investors will realize that their personal life has not really gotten much worse, and that life goes on. The government seems eager to do something about the economy, and will not allow a protracted slowdown like the 1930's to happen again.
I can vividly remember how I felt after the 9/11 disaster. How could life as we knew it continue on, I thought? How could I ever get on an airplane again? Why should this market ever recover? And then a few days later as I was driving down my driveway listening to the local radio announcer playing my favorite same old songs and talking about the most mundane local things (like preparing for the invasion of the leaf-peepers in early October), it suddenly occurred to me that nothing really had much changed in my personal life, nor would it. A feeling of mellowness spread through my body and some of my natural optimism returned. I was ready to accept the possibility that the market might just go back up someday.
On a collective basis, that is how the market operates. For many months we have been thinking about the R word (while also worrying about the possibility of it getting worse and becoming the D word). Every layoff that was announced, every lowered earnings outlook, every new foreclosure number released - all contributed to our fears that a recession is on the way or already here. Many people dumped their stock, and the market fell by a huge amount, wiping out several years of gains.
And inevitably, at some point, people will start thinking about the 93 ½% number and make their own journey down their own driveway, and take a peek at the stock price of their favorite company and see a lower number than they have seen in many years, and get that feeling of mellowness that allows them to take a little nibble in the market. Collectively, the spreading feeling of optimism (or at least, muted pessimism) will cause the market to start edging back up.
We don't have any idea of when it will happen. But it will. We can be certain of that. The market has already gone down so far that the smart bet will be that the next big move should be to the upside. We don't want to suffer losses in our portfolios when that recovery takes place - it was bad enough suffering the losses when the meltdown came. It would be doubly painful to experience similar pain when the recovery finally comes.
So far, the Terry's Tips investment philosophy has been a great success. We hold leveraged positions that do best if the market doesn't fluctuate much. For the last couple of months, volatility has been greater than it has in the history of the market. We should have been killed in this kind of world. But the truth is that over the past three months, our composite portfolio values have gone up. When volatility eventually falls back to normal levels, as it inevitably will, we should enjoy gains that substantially outperform the market in general.
Monday, October 27, 2008
Which Way is the Market Headed?
More than anything, I think we can expect the current volatility to come down to earth. In the 10-year back test I performed on SPY, monthly changes of over 10% in either direction occurred less than once a year. The largest monthly drop over those 10 years was 16.7% at the 9/11 terrorist attack (and this was completely made back within 60 days). Last month, SPY dropped 24.8%, eclipsing all other changes by a wide margin. Most of the time, big moves in one month are followed by a smaller move in the opposite direction in the subsequent month.
P/E ratios have fallen to the lowest level in 23 years. According to the NY Times, the estimated P/E ratio for the S&P 500 was just below 12. Over the past century, the average P/E ratio was approximately 15.5.
Stocks, already down about 40%, have already priced much of the doom and gloom in. Only once since the 1930s has the Dow fallen more than 40%. It did plunge 89% during the Great Depression, but then it was sitting on frenzied 500% gains, and the markets lacked many of today's safety nets like FDIC insurance, not to mention a proactive and more-informed Fed and Treasury.
At the risk of being called a hopeless chronic optimist, I think the likely short-term change in the market will most likely be to the upside, but then, my record of short-term predictions has been very close to being right only about 50% of the time.
I feel much more confident about thinking that I really have no idea which way it is headed, and making my investment decisions accordingly. A basic premise that we follow at Terry's Tips is that we really do not know which way the market will go in the short run, and it is best to create positions that will gain if the market moves moderately in either direction (as you may recall, we always make good gains if the market stays flat).
If the market does move more than moderately in either direction, we have to be prepared to make adjustments to prevent losses in case the market continues to move in only one direction.
There is something nice about not having to guess which way the market is headed.
P/E ratios have fallen to the lowest level in 23 years. According to the NY Times, the estimated P/E ratio for the S&P 500 was just below 12. Over the past century, the average P/E ratio was approximately 15.5.
Stocks, already down about 40%, have already priced much of the doom and gloom in. Only once since the 1930s has the Dow fallen more than 40%. It did plunge 89% during the Great Depression, but then it was sitting on frenzied 500% gains, and the markets lacked many of today's safety nets like FDIC insurance, not to mention a proactive and more-informed Fed and Treasury.
At the risk of being called a hopeless chronic optimist, I think the likely short-term change in the market will most likely be to the upside, but then, my record of short-term predictions has been very close to being right only about 50% of the time.
I feel much more confident about thinking that I really have no idea which way it is headed, and making my investment decisions accordingly. A basic premise that we follow at Terry's Tips is that we really do not know which way the market will go in the short run, and it is best to create positions that will gain if the market moves moderately in either direction (as you may recall, we always make good gains if the market stays flat).
If the market does move more than moderately in either direction, we have to be prepared to make adjustments to prevent losses in case the market continues to move in only one direction.
There is something nice about not having to guess which way the market is headed.
Monday, October 20, 2008
Conservative Options Strategy
The Big Dripper - A Conservative Options Strategy
Subscribers have been clamoring for a super-conservative portfolio that will make less money than our other portfolios but will never lose money except perhaps in market crashes like this one (and losses will be considerably less if such a crash ever occurs again in our lifetimes). This will be our most conservative portfolio.The Big Dripper will start next Thursday (October 23rd) with $10,000, will use SPY as the underlying, and each month, $150 (1 ½%) will be withdrawn (hence, the name "dripper") regardless of the gain or loss for the portfolio that month. If a windfall gain comes along (which might be possible given the current option prices), larger chunks will be withdrawn to allow new subscribers to mirror the portfolio for approximately $10,000.
Here are the Basic Trading Rules for the Big Dripper portfolio:
Calendar spreads will be bought over a larger range of strike prices than our other portfolios. At first, we will use a range of 15% both below and above the stock price. This number will be reduced to approximately 10% when the market settles down to more normal times.
A minimum of 10% will be set aside for adjustments in case they are necessary.
Rather than waiting until expiration week to roll out short options to the next month, the roll-out will normally occur earlier than expiration week. This will reduce the potential gain but also reduce risk considerably.
In spite of the conservative nature of this portfolio, here is what the risk profile graph looks like right now. (It might not look quite this attractive next Thursday when we set it up, but it should be similar.)
If you study this graph carefully, you can see that a greater profit potential exists over a wider range of possible stock prices than ever before in any of our portfolios. The stock can go up $28 before a loss would result (SPY has never gone up by half that amount in any expiration month). On the downside, it could fall by 18% before a loss would occur (with no adjustments) - over 50 years, it has fallen only once by that amount (in October 2008, of course).
We would be holding at least $1000 to extend the lower break-even price in the event that the stock fell by 10%, so it is unlikely that we would encounter a loss even if the October crash repeated itself in November.
The Big Dripper is likely to be a dull portfolio that delivers 1 ½% in hard cash every month for decades to come. Except in unusual months like this one when short-term options are so much more expensive than long-term ones - we very well might make a windfall gain this month. The risk profile graph shows that truly unusual profits might be possible in these unusual market times.
Happy trading.
Monday, October 13, 2008
How Bad Was it?
A couple of months ago, I conducted a 10-year back test on volatility on SPY, and found that if the same risk profile graph could have been created over that time span, there would not be a single 12-month period when the Mighty Mesa stock options trading strategy would lose money.
Over that 10-year period, the worst monthly drop occurred at the 9/11 terrorist attack when SPY briefly fell 19.7% (and then recovered completely within two months). Over those 10 years, SPY fell by over 10% in a single month only 5 times, and it rose by over 10% in only 3 months. When we set up our Big Bear Mesa stock options trading portfolio less than three weeks ago, it seemed prudent to have a portfolio that would gain 20% even if the stock fell by 10% in one month. We later expanded this coverage by adjusting so that the stock could fall by 16% and we would still make a profit. In the entire 10 year back test, it had not fallen that far.
So far, this expiration month, SPY has fallen as much as 34% (from a start of $126.70 to a low of $83.58), or more than double its largest monthly loss over the past 10 years. This is truly a once-in-a-century event (which is even longer than most lifetimes) for stock options trading.
Should You Bail Out Now? That is the question being sent to me by dozens of subscribers. As far as my personal investments are concerned, I am staying the course, for at least two reasons:
This market will eventually recover. Only the timing and the speed are unknown.Our options strategy is the fastest way I know to recover from this market crash.
Last week, I personally borrowed from my home equity credit line and added to my stock options trading positions. I did it carefully and slowly, however, legging into positions by placing orders half-way between the bid and asked prices. When markets get as wild as they were last week, the bid-asked spreads were big enough to drive a truck through.
It was absolutely the worst time to panic and liquidate a stock options trading portfolio. For those subscribers who did so, I feel sorry for them. They got horrible executions. They would have done much better to wait until expiration when at least the expiring options could be bought back at near their intrinsic value.
When all else fails, try laughing instead of crying -
NEW STOCK MARKET TERMS for 2008 and beyond.
CEO --Chief Embezzlement Officer.
CFO-- Corporate Fraud Officer.
BULL MARKET -- A random market movement causing an investor to mistake himself for a financial genius.
BEAR MARKET -- A 6 to 18 month period when the kids get no allowance, the wife gets no jewellery, and the husband gets no sex.
VALUE INVESTING -- The art of buying low and selling lower.
P/E RATIO -- The percentage of investors wetting their pants as the market keeps crashing.
STANDARD & POOR -- Your life in a nutshell.
STOCK ANALYST -- Idiot who just downgraded your stock.
STOCK SPLIT -- When your ex-wife and her lawyer split your assets equally between themselves.
FINANCIAL PLANNER -- A guy whose phone has been disconnected.
MARKET CORRECTION -- The day after you buy stocks.
CASH FLOW-- The movement your money makes as it disappears down the toilet.
YAHOO -- What you yell after selling it to some poor sucker for $240 per share.
WINDOWS -- What you jump out of when you're the sucker who bought Yahoo @ $240 per share.
INSTITUTIONAL INVESTOR -- Past year investor who's now locked up in a nuthouse.
PROFIT -- An archaic word no longer in use.
Over that 10-year period, the worst monthly drop occurred at the 9/11 terrorist attack when SPY briefly fell 19.7% (and then recovered completely within two months). Over those 10 years, SPY fell by over 10% in a single month only 5 times, and it rose by over 10% in only 3 months. When we set up our Big Bear Mesa stock options trading portfolio less than three weeks ago, it seemed prudent to have a portfolio that would gain 20% even if the stock fell by 10% in one month. We later expanded this coverage by adjusting so that the stock could fall by 16% and we would still make a profit. In the entire 10 year back test, it had not fallen that far.
So far, this expiration month, SPY has fallen as much as 34% (from a start of $126.70 to a low of $83.58), or more than double its largest monthly loss over the past 10 years. This is truly a once-in-a-century event (which is even longer than most lifetimes) for stock options trading.
Should You Bail Out Now? That is the question being sent to me by dozens of subscribers. As far as my personal investments are concerned, I am staying the course, for at least two reasons:
This market will eventually recover. Only the timing and the speed are unknown.Our options strategy is the fastest way I know to recover from this market crash.
Last week, I personally borrowed from my home equity credit line and added to my stock options trading positions. I did it carefully and slowly, however, legging into positions by placing orders half-way between the bid and asked prices. When markets get as wild as they were last week, the bid-asked spreads were big enough to drive a truck through.
It was absolutely the worst time to panic and liquidate a stock options trading portfolio. For those subscribers who did so, I feel sorry for them. They got horrible executions. They would have done much better to wait until expiration when at least the expiring options could be bought back at near their intrinsic value.
When all else fails, try laughing instead of crying -
NEW STOCK MARKET TERMS for 2008 and beyond.
CEO --Chief Embezzlement Officer.
CFO-- Corporate Fraud Officer.
BULL MARKET -- A random market movement causing an investor to mistake himself for a financial genius.
BEAR MARKET -- A 6 to 18 month period when the kids get no allowance, the wife gets no jewellery, and the husband gets no sex.
VALUE INVESTING -- The art of buying low and selling lower.
P/E RATIO -- The percentage of investors wetting their pants as the market keeps crashing.
STANDARD & POOR -- Your life in a nutshell.
STOCK ANALYST -- Idiot who just downgraded your stock.
STOCK SPLIT -- When your ex-wife and her lawyer split your assets equally between themselves.
FINANCIAL PLANNER -- A guy whose phone has been disconnected.
MARKET CORRECTION -- The day after you buy stocks.
CASH FLOW-- The movement your money makes as it disappears down the toilet.
YAHOO -- What you yell after selling it to some poor sucker for $240 per share.
WINDOWS -- What you jump out of when you're the sucker who bought Yahoo @ $240 per share.
INSTITUTIONAL INVESTOR -- Past year investor who's now locked up in a nuthouse.
PROFIT -- An archaic word no longer in use.
Monday, October 6, 2008
A Great Time to Buy Calendar Spreads
Every once in a while, option prices are such that buying calendar spreads is particularly attractive. Now is one of those rare times.
Ideally, when you buy a calendar spread, you would like to buy the longer-term option when option prices for that month are "low" and sell a short-term option when those prices are "high."
What determines whether option prices are "high" or "low" is the Implied Volatility (IV) of the option. A "high" IV comes about when the market expects a stock will fluctuate a lot and a "low" IV results when the market expects the stock to be quiet.
For those of you who are mathematically inclined, IV is the average daily one-standard-deviation move of the stock, annualized. If the IV for the options on XYZ stock is 20%, the market believes that there is a 68% probability that XYZ will be within 20% of its present price one year from now; and there is a 95% probability of being within a 40% range of its present price one year from now.
When you can buy an option with a low IV and sell another in the same underlying which has a high IV, you have what is called an IV Advantage. You are essentially buying low and selling high at exactly the same time.
With the current extreme uncertainty in the stock market, short-term IV has skyrocketed. For example, IV for October 2008 at-the-money options on SPY carry an IV of 52% while SPY options that expire in March 2009 have an IV of only 30%. That is a huge IV Advantage.
Last Friday you could sell a SPY 110 October 2008 call (when SPY was selling for $110) for $4.50 (and there were only 13 days of remaining life for that option). You could buy a 110 March 2009 quarterly call for $10.30, or slightly more than double that amount, and this option had 179 days of remaining life.
In this example, the average decay rate of the option you are selling is $34.62 and the average daily decay of the option you buy is only $5.75. The spread would cost you $580 to buy (plus a $3 commission), for a total of $583. Each day the stock remained relatively flat, you would gain the difference in the decay rates ($28.87 although it would be greater than that because the March option would decay at less than the $5.75 average for the next couple of months).
In other words, if the stock stayed flat, you would earn almost 5% a day on your investment!
Of course, the stock will not usually stay flat, even for 13 days, so you would have to buy calendar spreads at several different strike prices or employ other spreads for protection against volatility as we do in our Mighty Mesa strategy, but this example gives you a general idea of the profit potential of buying calendar spreads at a time when there is such a large difference in the IVs of the shorter-term and longer-term options.
By the way, our Mighty Mesa strategy resulted in greater-than-50% gains for a single month in the September expiration for two of our six actual portfolios.
Finding calendar spreads with a huge IV Advantage is one great way to make exceptional gains in the options world if you know how to protect your spreads against any volatility that might result.
If you become a Terry's Tips Insider, you can see how we protect against volatility, and exactly how we did it in the above two portfolios last month.
Ideally, when you buy a calendar spread, you would like to buy the longer-term option when option prices for that month are "low" and sell a short-term option when those prices are "high."
What determines whether option prices are "high" or "low" is the Implied Volatility (IV) of the option. A "high" IV comes about when the market expects a stock will fluctuate a lot and a "low" IV results when the market expects the stock to be quiet.
For those of you who are mathematically inclined, IV is the average daily one-standard-deviation move of the stock, annualized. If the IV for the options on XYZ stock is 20%, the market believes that there is a 68% probability that XYZ will be within 20% of its present price one year from now; and there is a 95% probability of being within a 40% range of its present price one year from now.
When you can buy an option with a low IV and sell another in the same underlying which has a high IV, you have what is called an IV Advantage. You are essentially buying low and selling high at exactly the same time.
With the current extreme uncertainty in the stock market, short-term IV has skyrocketed. For example, IV for October 2008 at-the-money options on SPY carry an IV of 52% while SPY options that expire in March 2009 have an IV of only 30%. That is a huge IV Advantage.
Last Friday you could sell a SPY 110 October 2008 call (when SPY was selling for $110) for $4.50 (and there were only 13 days of remaining life for that option). You could buy a 110 March 2009 quarterly call for $10.30, or slightly more than double that amount, and this option had 179 days of remaining life.
In this example, the average decay rate of the option you are selling is $34.62 and the average daily decay of the option you buy is only $5.75. The spread would cost you $580 to buy (plus a $3 commission), for a total of $583. Each day the stock remained relatively flat, you would gain the difference in the decay rates ($28.87 although it would be greater than that because the March option would decay at less than the $5.75 average for the next couple of months).
In other words, if the stock stayed flat, you would earn almost 5% a day on your investment!
Of course, the stock will not usually stay flat, even for 13 days, so you would have to buy calendar spreads at several different strike prices or employ other spreads for protection against volatility as we do in our Mighty Mesa strategy, but this example gives you a general idea of the profit potential of buying calendar spreads at a time when there is such a large difference in the IVs of the shorter-term and longer-term options.
By the way, our Mighty Mesa strategy resulted in greater-than-50% gains for a single month in the September expiration for two of our six actual portfolios.
Finding calendar spreads with a huge IV Advantage is one great way to make exceptional gains in the options world if you know how to protect your spreads against any volatility that might result.
If you become a Terry's Tips Insider, you can see how we protect against volatility, and exactly how we did it in the above two portfolios last month.
Tuesday, September 30, 2008
Expiration Day Roll-Over Strategy:
For a normal third-Friday expiration, we have maintained that it doesn't make any real difference whether you buy back expiring out-of-the-money options on Friday (if they cost $.05 or less, there is no commission at thinkorswim) and also sell the next-month-out options on that day, or whether you let them expire worthless and wait until the following Monday to sell those options.
There are several reasons why the next-month-out options usually sell for less on Monday than they do on the previous Friday (especially if they are calls):
Two extra days elapse for decay to take place (Saturday and Sunday).Many investors who sell covered calls do that selling on Monday, and that depresses the prices of those calls.Markets are generally weaker on the Monday after an expiration.
All three of these reasons support the notion that even though there is a small cost to buying back out-of-the-money soon-to-expire options on Friday, the new options can be sold for sufficiently higher prices on Friday to more than cover that small cost.
Next Tuesday we have a mini-expiration when the September quarterly options expire 11 days later than the normal September options. At this expiration, none of the above three reasons is in effect.
Here is the risk profile graph of our Durable Diamond portfolio going into next week's mini-expiration. You can see that we will make substantial gains if the stock ends up at any price above $110 in two days. If it falls below $110, we will do just fine as well because we will roll over September 110 quarterly puts to October at a very high price, and use the substantial cash we collect to add on new calendar spreads.
How often do you have the opportunity to make 18% on your total investment in only two days? That is what we are looking at right here, just as long as DIA does not fall below $110.
More next week.
Thursday, September 25, 2008
A DIAmond Success Story!
One month ago, we created a $10,000 portfolio using the Dow Jones Industrial Average tracking stock (DIA) as the underlying. We established calendar spreads in calls at the 115, 116, 118, 120, and 122 strikes, and what we call an exotic put butterfly spread at the 114-110-106 strikes.
Here is what the risk profile graph looked like when we started out the month:
You can see that this portfolio would be expected to make a profit if DIA ended up anywhere between $110 and $123 in five weeks. In the great majority of months, DIA could be expected to remain in a range of that size for a 5-week expiration month. When we set up these positions, DIA was trading about $116.50, right about in the middle of the break-even range.
Our goal each month is to create a graph that looks more like a mesa than a mountain. We didn't totally achieve that goal with the above graph. As the month progressed, we took off some of the 120 calendar spreads and replaced them with more calendar spreads at the 115 strike. Those trades made the entire curve flatter. The expected gains for the month averaged about 15% across the same break-even range as the above graph.
Four of the five weeks have now expired. During that period, DIA traded as low as $110.50 but we were not tempted to make adjustments that would have expanded the downside break-even point to a lower number, and our patience was rewarded when the stock headed back to close last Friday at $114.79.
The portfolio is now worth $11,403 for a gain of 14% after commissions for the last four weeks. We have a policy of withdrawing cash from a portfolio whenever 6% is earned in a single expiration month. This month, we have had to withdraw that amount twice ($1200 will be withdrawn on Monday).
In order to generate sufficient cash to make that withdrawal, we rolled over the 120 calls (buying back the Sep-08 120 calls and selling Oct-08 120 calls) and closed out (sold) the 122 calendar spreads. With a week to go until expiration, we are still looking forward to additional gains over a fairly broad range of possible stock prices:
You can see that an additional 10% gain might come our way next week if DIA closes somewhere between $110 and $118. That would make a 24% gain for the 5-week expiration month.
How many investments do you know of which can make 24% in 5 weeks when the underlying ETF remains essentially flat (actually, it has lost a couple of dollars in value over the last month)?
For the 7 years of Terry's Tips' existence, we have called our strategy of multiple calendar spreads the 10K Strategy. Now we have made a change. Since we have added butterfly spreads and changed the basic objective of the strategy from making 50% - 100% annual gains to one of never losing money, it seems that we should no longer call it the 10K Strategy.
The new name for our basic strategy is the Mighty Mesa. The name derives from the desired shape of the risk profile graph when we start out each expiration month. For a while we were planning to call it the Mighty Stalagmite (a similar but smaller rock formation, but one which hangs out in caves, making it most un-photogenic, and I needed a nice photograph for the cover of the new book I am writing). So we are going with the mesa. You don't mess with a mesa.
Here is what the risk profile graph looked like when we started out the month:
You can see that this portfolio would be expected to make a profit if DIA ended up anywhere between $110 and $123 in five weeks. In the great majority of months, DIA could be expected to remain in a range of that size for a 5-week expiration month. When we set up these positions, DIA was trading about $116.50, right about in the middle of the break-even range.
Our goal each month is to create a graph that looks more like a mesa than a mountain. We didn't totally achieve that goal with the above graph. As the month progressed, we took off some of the 120 calendar spreads and replaced them with more calendar spreads at the 115 strike. Those trades made the entire curve flatter. The expected gains for the month averaged about 15% across the same break-even range as the above graph.
Four of the five weeks have now expired. During that period, DIA traded as low as $110.50 but we were not tempted to make adjustments that would have expanded the downside break-even point to a lower number, and our patience was rewarded when the stock headed back to close last Friday at $114.79.
The portfolio is now worth $11,403 for a gain of 14% after commissions for the last four weeks. We have a policy of withdrawing cash from a portfolio whenever 6% is earned in a single expiration month. This month, we have had to withdraw that amount twice ($1200 will be withdrawn on Monday).
In order to generate sufficient cash to make that withdrawal, we rolled over the 120 calls (buying back the Sep-08 120 calls and selling Oct-08 120 calls) and closed out (sold) the 122 calendar spreads. With a week to go until expiration, we are still looking forward to additional gains over a fairly broad range of possible stock prices:
You can see that an additional 10% gain might come our way next week if DIA closes somewhere between $110 and $118. That would make a 24% gain for the 5-week expiration month.
How many investments do you know of which can make 24% in 5 weeks when the underlying ETF remains essentially flat (actually, it has lost a couple of dollars in value over the last month)?
For the 7 years of Terry's Tips' existence, we have called our strategy of multiple calendar spreads the 10K Strategy. Now we have made a change. Since we have added butterfly spreads and changed the basic objective of the strategy from making 50% - 100% annual gains to one of never losing money, it seems that we should no longer call it the 10K Strategy.
The new name for our basic strategy is the Mighty Mesa. The name derives from the desired shape of the risk profile graph when we start out each expiration month. For a while we were planning to call it the Mighty Stalagmite (a similar but smaller rock formation, but one which hangs out in caves, making it most un-photogenic, and I needed a nice photograph for the cover of the new book I am writing). So we are going with the mesa. You don't mess with a mesa.
Monday, September 22, 2008
More on Durable Diamond Stock Options Trading Strategy
Last week I showed you the risk profile graph for our Durable Diamond portfolio - it showed that we would make a gain of 10% or more if DIA ended up at any price between $110 and $118 in one week ending on Friday.
Imagine our distress when the stock tanked to $106 early in the week. We made plans to roll over all the positions so that we could wait it out for another month. But then the huge rebound came along and DIA ended at $113.57, well within our profit range. Instead of a 10% gain, our actual portfolio gained over 20% in value. For the entire 5-week expiration month, our Durable Diamond portfolio gained 38%.
Our Mighty Stalagmite portfolio (using SPY as the underlying) also made a gain of 38% last month. In accordance with our Withdrawal Rules we took out $3,600 in cash from both those $10,000 portfolios. This withdrawal amount constituted our profit target for the entire year, and it came in only the second month of trading our Mighty Mesa strategy.
As nice as these returns were, we can't give the entire credit to the workings of the Mighty Mesa strategy (although others might be tempted to). A good share of the gain was made because the volatile market pushed up Implied Volatilities (IV) of the options. This results in an (often temporary) increase in the value of all options, and since our long options have a larger absolute value than the short-term options, our indicated portfolio values get higher.
A month ago, IV for SPY and DIA was about 21%, and now it is about 28%. The VIX has gone from about 20 to 32 today, and it was briefly over 40 during the madness last week. In future months we must remember that changes in IV work both ways and not be disappointed when the results at the end of a future month are not quite what the risk profile graphs indicated they would be.
Windfall Gains Possible? This month, in all but one of our portfolios, we rolled the expiring short September options to the Sep5-08 quarterlies rather than to Oct-08 options and it is almost like getting an extra expiration month. Check out the risk profile graph for the Durable Diamond - it shows remarkably high possible gains in a mere 11 days. We just might be able to enjoy 16 expirations each year rather than just 12 for these portfolios.
Here is the risk profile graph for our Durable Diamond portfolio for an expiration "month" that ends a week from next Tuesday:
The graph shows that we will make a profit at any price between $108 and $120, and better than 20% if it lands between $110 and $117. It will be an interesting wait over only 7 trading days.
I'll report back to you on how this portfolio fared.
Life is good.
Terry
Imagine our distress when the stock tanked to $106 early in the week. We made plans to roll over all the positions so that we could wait it out for another month. But then the huge rebound came along and DIA ended at $113.57, well within our profit range. Instead of a 10% gain, our actual portfolio gained over 20% in value. For the entire 5-week expiration month, our Durable Diamond portfolio gained 38%.
Our Mighty Stalagmite portfolio (using SPY as the underlying) also made a gain of 38% last month. In accordance with our Withdrawal Rules we took out $3,600 in cash from both those $10,000 portfolios. This withdrawal amount constituted our profit target for the entire year, and it came in only the second month of trading our Mighty Mesa strategy.
As nice as these returns were, we can't give the entire credit to the workings of the Mighty Mesa strategy (although others might be tempted to). A good share of the gain was made because the volatile market pushed up Implied Volatilities (IV) of the options. This results in an (often temporary) increase in the value of all options, and since our long options have a larger absolute value than the short-term options, our indicated portfolio values get higher.
A month ago, IV for SPY and DIA was about 21%, and now it is about 28%. The VIX has gone from about 20 to 32 today, and it was briefly over 40 during the madness last week. In future months we must remember that changes in IV work both ways and not be disappointed when the results at the end of a future month are not quite what the risk profile graphs indicated they would be.
Windfall Gains Possible? This month, in all but one of our portfolios, we rolled the expiring short September options to the Sep5-08 quarterlies rather than to Oct-08 options and it is almost like getting an extra expiration month. Check out the risk profile graph for the Durable Diamond - it shows remarkably high possible gains in a mere 11 days. We just might be able to enjoy 16 expirations each year rather than just 12 for these portfolios.
Here is the risk profile graph for our Durable Diamond portfolio for an expiration "month" that ends a week from next Tuesday:
The graph shows that we will make a profit at any price between $108 and $120, and better than 20% if it lands between $110 and $117. It will be an interesting wait over only 7 trading days.
I'll report back to you on how this portfolio fared.
Life is good.
Terry
Monday, September 8, 2008
How much does the market fluctuate in one month?
That is the critical stock options trading question for investors in the 10K Strategy of calendar spreads advocated at Terry's Tips.
When most people speak about "the market," they mean the S&P 500. We use that tracking stock (SPY) for one of our actual portfolios. This is what our positions might look like at the beginning of an expiration month:
SPY Options Portfolio Risk Profile Graph in 30 Days
The above portfolio of SPY options was set up at the beginning of an expiration month with $10,000 when SPY was trading at $124. The graph shows that the portfolio will gain about 10% (before commissions) in one month if SPY ends up at any price on expiration Friday between $115 and $133. In other words, the stock can fall by $9 (7.2%) or go up by $9 (7.2%) and a 10% gain will result.
Of course, it the stock moves beyond those limits in 30 days, losses will accrue which are much greater than 10%. An important part of a prudent options strategy would be to provide some protection for the portfolio when the stock moved to either end of the break-even profit range of $115 to $133.
Before we start a discussion of protection trades, let's see how often the stock might stay within those limits, and a gain of nearly 10% before commissions should result.
The 10-Year Backtest
Once the above graph has been created, the next step is to determine how much of the time that SPY manages to trade inside the break-even profit range of +/- 7.2%. This would be an easy task if all we had to do was calculate the percentage monthly changes that the stock had made over the past 10 years.
Here are those fluctuation numbers for each expiration month (expiration months are either 4-week or 5-week periods ending on the 3rd Friday of each calendar month, and therefore not exactly the same as calendar month fluctuations):
SPY changed by 7.2% in a single expiration month only 12 times in the past 10 years according to this table, slightly more than an average of one month each year. Four of those months occurred consecutively in 2002. While I don't want to get technical at this point, I should mention that when the stock is as volatile as it was in 2002, option prices become much higher. A risk profile graph created with those elevated option prices would have a much wider break-even profit range than the graph presented above with 2008 option prices.
From 2003 through 2007, a period of 5 years, SPY did not fluctuate more than 7.2% in either direction in a single expiration month. It is easy to understand why the actual portfolios at Terry's Tips made average gains of over 50% during that entire period (except in 2004 when unusual mid-month whip-saw price activity and 9-year low option prices conspired to cause losses - this was before the current strategy with downside insurance protection had been established).
If we only looked at the monthly fluctuations in the stock price you might conclude that the portfolio would make money 85% of the time, and that the average profit might be about 7% or 8% each month (taking commissions and roll-over transaction costs into consideration). Unfortunately, this would be an overly-optimistic assessment of the profit possibilities of the 10K Strategy.
A more realistic approach would recognize the dangerous position that the portfolio gets into when one end of the break-even profit range is approached. Huge losses can result if the stock moves outside that range. If you happen to be in one of those months like January 2008 when the stock fell more than 11%, you might lose half your profits for the past year in a single month.
Next week we will examine how many times that mid-month fluctuations have been so great that serious adjustments to the portfolio would be required, adjustments that would most likely eliminate any expected gain for that month.
Monday, September 1, 2008
All commission costs on stock options trading are not equal.
No one I know likes to pay commissions. Except me. When I pay a commission on the sale of an option, I know that in most cases, I will recover that commission cost in less than one day. How is that possible? Read on.
All stock options trading commission costs are not equal. I'm not talking about the difference between full-service broker commissions (which may go into the hundreds of dollars) with a discount broker's rate, however. Comparing those kinds of commissions is at least an apples-to-apples comparison.
No, I'm talking about the significance of the commission you pay when you buy stock or a mutual fund and when you sell an option. If you bought 100 shares of a $50 stock, you would shell out $5,000 plus about a $10 commission at your favorite discount broker. The only thing you know for certain about this purchase is that it ties up $5,010 that could be earning interest in a savings account.
A year later, unless the stock has increased in value, you still would not have covered the money you paid out for the commission. Even though the commission works out to only 0.2% of the total investment, it is no wonder that commissions are a concern for the stock trader.
Contrast the stock purchase to the sale of a single option for $1.50 (a one-month at-the-money call or put option on SPY could be sold for almost double this amount, but let's take the lower number). On the $150 sale, Terry's Tips subscribers at thinkorswim would pay a commission of $1.50. This works out to 1% of the purchase price, or 5 times the percentage you would have paid to buy the stock.
However, the option seller has sold a depreciating asset that goes down in value every day. Over the course of the next month, the time premium of the option that was sold for $150 will depreciate by an average of $3 per day. In other words, one day after selling the option, if the stock price doesn't change, the commission cost will have been totally recovered two times over.
Of course, if a call was sold and the stock went up, the option that was sold for $1.50 might cost more to buy back the next day, but the option-seller presumably owns an off-setting longer-term call that will also increase in value. But the bottom line is the same - every single day of the short option's life, the entire commission cost will be more than covered by the decay of the option.
The buyer of stock might have to wait a year or more for the stock to go up and finally cover his commission cost while the option seller will cover his commission cost before lunch-time the following day.
In his mind, the option-seller should think of the commission cost as evidence that he has made a good investment that will pay for itself in less than a day. The more commissions you pay, the more decay you will be collecting.
This is just another example that the world of stock trading is far different from the world of stock options trading. While it may take a year to recover the commission you pay on a stock purchase, you would be disappointed if it took an entire day to recover that cost if you sold an option.
Monday, August 25, 2008
The Economics of Using a Longer-Term Option in a Butterfly Spread:
In our Mighty Stalagmite portfolio we might place a Sep-08 126-122-120 put butterfly spread to provide downside protection. A traditional butterfly would have all three options in the same month, but we often use a longer-term put for the highest strike leg of a put butterfly. (We would use the same policy for the lowest-strike option in a call butterfly.)
This means that instead of buying a Sep-08 126 put for $1.85 we could pay $4.85 for a Dec-08 126 put. We would have to spend $300 more for the spread than we could have by having all the options in the Sep-08 month.
In 35 days, the Dec-08 126 should decay by $.75 (assuming the stock stays flat). That means our "cost" of the 125 put is $110 less expensive ($1.85 - $.75) than if we had bought the Sep-08 126 put. We have to put up an extra $300 to save $110, so our investment in the longer-term put yields us 36% for the 5-week period.
That surely seems like a good investment even though it means we have less cash for buying calendar spreads. If we could make 36% on our money in every 5-week expiration month we would have no complaints.
On the other hand, at times, traditional out-of-the-money butterfly spreads are so inexpensive that they should be placed anyway (and the money saved used for generating decay with calendars). The choice between exotic and traditional butterfly spreads must be made on a case-by-case basis, and different answers may well result for different portfolios at different times.
Tune in next week for more Stock Options Trading tips.
Monday, August 18, 2008
Terry's Tips Portfolio Expiration Report
All Six Portfolios Make Great Gains! The first expiration month using our modified 10K Strategy was a resounding success. In spite of devoting up to half of the entire portfolio value to an exotic butterfly spread that only provided insurance against a big market drop, substantial gains resulted in every portfolio.
The portfolios gained an average of 4.5% after commissions for the expiration month. That works out to be 54% annualized, far more than we expected. We had hoped for a 4% gain in those months where no adjustments were necessary. This month our gains exceeded this goal, and adjustments were made in every portfolio because it was a volatile month, with several market swings in both directions.
The Oil Services portfolio was the best example of the value of butterfly spreads. The underlying OIH fell by 11.3% for the month. In the past, this kind of volatility almost always resulted in large losses. This month, after the addition of a large number of butterfly spreads on the downside, the portfolio managed to gain of 6.4% in spite of the strong slide in the stock price.
Maybe we have indeed created an options strategy that never loses money. That is the ultimate goal of our modified strategy, and the first month's record was most encouraging.
The portfolios that had the greatest gains were the two that had been established before July - Mini-Russell (up 12% for the month) and Oil Services (up 6.4%). The four portfolios that were started in July had to cover the bid-asked spread penalty of a new portfolio, and the final results understate how well they did. Three of these portfolios were in existence for only 23 days, hardly enough to qualify for a month's results.
The lowest-gaining portfolio for the month, Mighty Stalagmite (up 2.6%) would cost about $10,560 to replicate now. This means that a fairer estimate of the gain was probably closer to 5%, and this was our worst-performer (largely because we made several adjustments that were later reversed).
Annualized Portfolio Gains for the August Expiration Month:
Mini-Russell (IWM) - up 144%
Oil Services (OIH) - up 77%
Durable Diamond* (DIA) - up 92%
Building BRIC* (EEM) - up 62%
Rising Russell* (IWM) - up 37%
Mighty Stalagmite (SPY) - up 31%
*Based on three week's results averaged over a year
You can see every position and every trade we made in each of these portfolios by becoming a Terry's Tips Insider - sign up HERE.
Next week we will discuss the economics of using what we call an exotic butterfly spread for downside protection.
The portfolios gained an average of 4.5% after commissions for the expiration month. That works out to be 54% annualized, far more than we expected. We had hoped for a 4% gain in those months where no adjustments were necessary. This month our gains exceeded this goal, and adjustments were made in every portfolio because it was a volatile month, with several market swings in both directions.
The Oil Services portfolio was the best example of the value of butterfly spreads. The underlying OIH fell by 11.3% for the month. In the past, this kind of volatility almost always resulted in large losses. This month, after the addition of a large number of butterfly spreads on the downside, the portfolio managed to gain of 6.4% in spite of the strong slide in the stock price.
Maybe we have indeed created an options strategy that never loses money. That is the ultimate goal of our modified strategy, and the first month's record was most encouraging.
The portfolios that had the greatest gains were the two that had been established before July - Mini-Russell (up 12% for the month) and Oil Services (up 6.4%). The four portfolios that were started in July had to cover the bid-asked spread penalty of a new portfolio, and the final results understate how well they did. Three of these portfolios were in existence for only 23 days, hardly enough to qualify for a month's results.
The lowest-gaining portfolio for the month, Mighty Stalagmite (up 2.6%) would cost about $10,560 to replicate now. This means that a fairer estimate of the gain was probably closer to 5%, and this was our worst-performer (largely because we made several adjustments that were later reversed).
Annualized Portfolio Gains for the August Expiration Month:
Mini-Russell (IWM) - up 144%
Oil Services (OIH) - up 77%
Durable Diamond* (DIA) - up 92%
Building BRIC* (EEM) - up 62%
Rising Russell* (IWM) - up 37%
Mighty Stalagmite (SPY) - up 31%
*Based on three week's results averaged over a year
You can see every position and every trade we made in each of these portfolios by becoming a Terry's Tips Insider - sign up HERE.
Next week we will discuss the economics of using what we call an exotic butterfly spread for downside protection.
Monday, August 11, 2008
Favorite Suggested Books for the Conservative Options Investor
sI am often asked about my favorite books on investing (other than my own Making 36%: Duffer's Guide to Breaking Par in the Markets Every Year, In Good Years and Bad).
Here is my list of favorites:
McMillan on Options, by Lawrence G. McMillan, (New York: John Wiley & Sons, second edition, 2004). This is generally accepted as "The Bible" on options. It is fairly expensive and the text is ponderous for most people, but everything is there.
Options Plain and Simple, by Lenny Jordan. (London: Prentice Hall, 2000). One of many books which describe just about all the option strategies with some good advice as to which ones work under which conditions. Much lighter reading than McMillan on Options.
Winning the Loser's Game, by Charles D. Ellis, (New York, McGraw-Hill, 4th Edition, 2002). While this is not about options per se, it is just about the most sensible book I have ever found that discusses stock market investments in general.
The Little Book That Beats the Market, by Joel Greenblatt, (New York, John Wiley, 2006). Again, this book is not about options, but is perhaps the best book written in the past several years about how to select individual stocks.
The Little Book of Common Sense Investing, by John C. Bogle (New York, John Wiley, 2007), Another book which is not about options, but I challenge anyone to read this book because if they do, I believe there is no way they would ever buy a mutual fund again (except a no-load broad market index fund).
Here is my list of favorites:
McMillan on Options, by Lawrence G. McMillan, (New York: John Wiley & Sons, second edition, 2004). This is generally accepted as "The Bible" on options. It is fairly expensive and the text is ponderous for most people, but everything is there.
Options Plain and Simple, by Lenny Jordan. (London: Prentice Hall, 2000). One of many books which describe just about all the option strategies with some good advice as to which ones work under which conditions. Much lighter reading than McMillan on Options.
Winning the Loser's Game, by Charles D. Ellis, (New York, McGraw-Hill, 4th Edition, 2002). While this is not about options per se, it is just about the most sensible book I have ever found that discusses stock market investments in general.
The Little Book That Beats the Market, by Joel Greenblatt, (New York, John Wiley, 2006). Again, this book is not about options, but is perhaps the best book written in the past several years about how to select individual stocks.
The Little Book of Common Sense Investing, by John C. Bogle (New York, John Wiley, 2007), Another book which is not about options, but I challenge anyone to read this book because if they do, I believe there is no way they would ever buy a mutual fund again (except a no-load broad market index fund).
Monday, August 4, 2008
Trading Options After a Stock Split
When EEM split 3-for-1 on July 24th, two series of options became available. The pre-split options had strike prices around the $130 level (and strikes at $5 increments) while the post-split option series had strikes around the $40 level (and strikes at dollar increments).
The immediate implication was that market professionals all jumped into the new option series and totally disdained the old pre-split series. Our new portfolio suffered for several reasons:
Our graphing software did not work, so it was difficult for us to see where we stood. The Analyze Tab at thinkorswim was no better - it showed 70% gains coming our way in two weeks across a huge range of possible stock prices. Option prices in the pre-split series fell considerably. Traders did not want to deal in options that did not easily translate to the current stock prices.The bid-asked spreads increased by a large margin, making it impossible to get decent prices when either buying or selling. This problem relates to the general issue that market makers just don't want to deal in the old series, and they make it expensive for anyone who wants to trade there.For the above reasons, we recommended that subscribers get out of the old series as soon as it was practical. For us, this meant waiting until the August expiration week when we would normally be buying back soon-to-expire short options and selling the next month out. Rather than continuing to trade the old series, we advised closing out all the pre-split options and starting over with the post-split series.
This policy would result in some costly bid-asked spread penalties and commission costs, but it is a better choice than continuing to trade in markets that have bid-asked spreads large enough to drive a truck through. Sometimes it is best to take your lumps and move on to better things. We expect that our EEM portfolio will be our worst-performing portfolio this month, and may even lose a little. Thankfully, 3-for-1 splits don't come along too often.
The immediate implication was that market professionals all jumped into the new option series and totally disdained the old pre-split series. Our new portfolio suffered for several reasons:
Our graphing software did not work, so it was difficult for us to see where we stood. The Analyze Tab at thinkorswim was no better - it showed 70% gains coming our way in two weeks across a huge range of possible stock prices. Option prices in the pre-split series fell considerably. Traders did not want to deal in options that did not easily translate to the current stock prices.The bid-asked spreads increased by a large margin, making it impossible to get decent prices when either buying or selling. This problem relates to the general issue that market makers just don't want to deal in the old series, and they make it expensive for anyone who wants to trade there.For the above reasons, we recommended that subscribers get out of the old series as soon as it was practical. For us, this meant waiting until the August expiration week when we would normally be buying back soon-to-expire short options and selling the next month out. Rather than continuing to trade the old series, we advised closing out all the pre-split options and starting over with the post-split series.
This policy would result in some costly bid-asked spread penalties and commission costs, but it is a better choice than continuing to trade in markets that have bid-asked spreads large enough to drive a truck through. Sometimes it is best to take your lumps and move on to better things. We expect that our EEM portfolio will be our worst-performing portfolio this month, and may even lose a little. Thankfully, 3-for-1 splits don't come along too often.
Monday, July 28, 2008
Stock Options Idea of the Week
The Terry's Tips options newsletter features an options trading strategy that never loses money (based on a 10-year backtest which showed only 3 months with minimal losses out of 120 expiration months). However, we can't mathematically prove that this strategy will always turn at least a small profit each month (we feel more comfortable about making the claim when an entire year is used as the time frame).
There are several options trading strategies which are mathematically guaranteed to always turn a profit. When I was a market maker trading on the floor of the CBOE, much of my time was taken up in an effort to establish positions that always made money, no matter where the stock price went.
The most popular technique was called a reversal. It was especially successful when most investors where in a pessimistic mood and the prices for put options grew larger than the prices for call options. It is a fairly common occurrence.
Let's say that the stock price for XYZ (a non-dividend paying company) is $80, and a two-month put at the 80 strike can be sold for $4.50 while a two-month 80-strike call can be purchased for $4.00. If you search option prices, you can invariably find options on some companies with option prices similar to these.
With the reversal strategy you don't care whether the company has great potential or is a real dog - you will make money no matter which way the stock goes. Any company will do.
If you sell 100 shares of XYZ short, collecting $8000, sell an 80 put for $450 and buy an 80 call for $400, you have created what is called a reversal, and you will make a $50 profit, guaranteed (of course, commissions would cut into this somewhat). Your eventual gain is much larger than $50, however. For the term of your investment, you will collect interest on the $8000 cash in your account.
If the stock goes to $90, at expiration you would have lost $1000 on your short stock but you would be able to sell your 80 call for exactly $1000, offsetting the loss (the put would expire worthless, of course). If the stock were to fall to $60, you would gain $2000 from your short stock but would have to buy back the short put for $2000 (and your call would expire worthless). Either way, there is no loss no matter what the stock price does.
If you are trading on the floor, you enjoy several advantages that make reversals a viable strategy. First, you can often sell at the asked price and buy at the bid (after all, you are making the market for the options). This makes it much easier to sell a put for more than the same-strike call you buy. Second, your commission costs are negligible compared to what you would pay if your broker made the trades for you. And third, most importantly, since you have created a risk-free position, your clearing house will extend virtually unlimited credit to you.
When I was a market maker, there were times I was collecting interest on several million dollars of short stock while not having one penny of my own money at risk. It is no wonder that a seat on the CBOE sells for astronomical sums.
A similar strategy (called a conversion) involves buying stock, buying puts, and selling calls. In order for this to work, the time premium of the calls has to be greater than the cost of the puts as well as high enough to cover the interest on the long stock for the time period involved.
Reversals and conversions, while excellent plays for market makers, are difficult to establish from off the floor. Consequently, they are not practical alternatives for most investors.
A more realistic alternative for ordinary investors would be to carry out the 10K Strategy as featured at Terry's Tips. While this strategy can't be mathematically proven to never lose money, a 10-year backtest (the details of which we share with subscribers) shows that no losses resulted over any 12-month time period, and that average annual gains in the neighborhood of 32% would have been made.
With this strategy, initial positions are set up that will result in a profit if the stock moves moderately in either direction. Once the stock has moved about 5% in either direction, an adjustment is made that will expand the break-even range in the direction that the stock has moved.
An important part of the 10K Strategy is the setting aside of cash in case one of these adjustments becomes necessary. This spare cash means that portfolio protection can be kept in place in case the stock turns around and moves in the other direction. If the stock continues to move in the same direction as it did originally, as second adjustment might be necessary to once again establish positions that will not lose money. In those months when a second adjustment becomes necessary, little or no gain can be expected.
These adjustments cannot be set in place at the outset of the month because no one knows which way the stock might move. Depending on exactly what time of the expiration month, the more-than-moderate stock price move takes place, different adjustments might be called for. These adjustments add an "act of faith" dimension to the 10K Strategy that makes it impossible to mathematically prove that it will never lose value.
Until the strategy has stood the test of time we will have to depend on the 10-year backtest as "proof" that it actually works in the real world as we believe it should. We think the descriptive phrase "a strategy that never loses" has a nice ring to it. Do you?
There are several options trading strategies which are mathematically guaranteed to always turn a profit. When I was a market maker trading on the floor of the CBOE, much of my time was taken up in an effort to establish positions that always made money, no matter where the stock price went.
The most popular technique was called a reversal. It was especially successful when most investors where in a pessimistic mood and the prices for put options grew larger than the prices for call options. It is a fairly common occurrence.
Let's say that the stock price for XYZ (a non-dividend paying company) is $80, and a two-month put at the 80 strike can be sold for $4.50 while a two-month 80-strike call can be purchased for $4.00. If you search option prices, you can invariably find options on some companies with option prices similar to these.
With the reversal strategy you don't care whether the company has great potential or is a real dog - you will make money no matter which way the stock goes. Any company will do.
If you sell 100 shares of XYZ short, collecting $8000, sell an 80 put for $450 and buy an 80 call for $400, you have created what is called a reversal, and you will make a $50 profit, guaranteed (of course, commissions would cut into this somewhat). Your eventual gain is much larger than $50, however. For the term of your investment, you will collect interest on the $8000 cash in your account.
If the stock goes to $90, at expiration you would have lost $1000 on your short stock but you would be able to sell your 80 call for exactly $1000, offsetting the loss (the put would expire worthless, of course). If the stock were to fall to $60, you would gain $2000 from your short stock but would have to buy back the short put for $2000 (and your call would expire worthless). Either way, there is no loss no matter what the stock price does.
If you are trading on the floor, you enjoy several advantages that make reversals a viable strategy. First, you can often sell at the asked price and buy at the bid (after all, you are making the market for the options). This makes it much easier to sell a put for more than the same-strike call you buy. Second, your commission costs are negligible compared to what you would pay if your broker made the trades for you. And third, most importantly, since you have created a risk-free position, your clearing house will extend virtually unlimited credit to you.
When I was a market maker, there were times I was collecting interest on several million dollars of short stock while not having one penny of my own money at risk. It is no wonder that a seat on the CBOE sells for astronomical sums.
A similar strategy (called a conversion) involves buying stock, buying puts, and selling calls. In order for this to work, the time premium of the calls has to be greater than the cost of the puts as well as high enough to cover the interest on the long stock for the time period involved.
Reversals and conversions, while excellent plays for market makers, are difficult to establish from off the floor. Consequently, they are not practical alternatives for most investors.
A more realistic alternative for ordinary investors would be to carry out the 10K Strategy as featured at Terry's Tips. While this strategy can't be mathematically proven to never lose money, a 10-year backtest (the details of which we share with subscribers) shows that no losses resulted over any 12-month time period, and that average annual gains in the neighborhood of 32% would have been made.
With this strategy, initial positions are set up that will result in a profit if the stock moves moderately in either direction. Once the stock has moved about 5% in either direction, an adjustment is made that will expand the break-even range in the direction that the stock has moved.
An important part of the 10K Strategy is the setting aside of cash in case one of these adjustments becomes necessary. This spare cash means that portfolio protection can be kept in place in case the stock turns around and moves in the other direction. If the stock continues to move in the same direction as it did originally, as second adjustment might be necessary to once again establish positions that will not lose money. In those months when a second adjustment becomes necessary, little or no gain can be expected.
These adjustments cannot be set in place at the outset of the month because no one knows which way the stock might move. Depending on exactly what time of the expiration month, the more-than-moderate stock price move takes place, different adjustments might be called for. These adjustments add an "act of faith" dimension to the 10K Strategy that makes it impossible to mathematically prove that it will never lose value.
Until the strategy has stood the test of time we will have to depend on the 10-year backtest as "proof" that it actually works in the real world as we believe it should. We think the descriptive phrase "a strategy that never loses" has a nice ring to it. Do you?
Monday, July 21, 2008
Conservative Options Strategy
Mighty Stalagmite - a Conservative Options Strategy That Doesn't Lose Money
The Mighty Stalagmite - A Conservative Options Strategy That Doesn't Lose Money
Is a "Doesn't Lose" Strategy Possible? Some people would argue that a truly efficient options market would theoretically not allow a totally risk-free strategy to exist for very long. Yet an option mechanism called a collar can be established that does guarantee no loss, and it is used fairly commonly as a hedging device by sophisticated investment banks. However, it is a little unusual to come up with a strategy that "guarantees" no loss but also allows for the possibility of a gain when the market behaves as we wish.
A 10-year backtest of the Mighty Stalagmite (underlying stock - SPY, the tracking stock of the S&P 500) showed that about one month out of three, an adjustment would have to be made because the stock had moved 8% in one direction or another - we expect there would be no profit or loss for the portfolio in those month.
The backtest showed that in the other 2 out of 3 months, an average monthly profit of about 4% would result. If these figures hold true, the portfolio would earn 32% each year with never a losing month.
I cannot offer a guarantee that the portfolio will never lose money. The risk profile graph we published last week clearly shows that if the S&P 500 falls by 10% in a single day, a loss situation will be faced. A stock price drop of that magnitude has occurred only once (9/11/01) in the past 10 years. But as one great sage noted, there is never only one cockroach. So we have to be prepared to handle these rare events.
After the 9/11 disaster, the strategy would have recovered nicely in the subsequent month, and a loss would have been avoided for the two-month period. Since I can't guarantee that two 9/11-type events would not occur in subsequent months, or the market did not quickly recover some of the loss in a subsequent month, I can't make the guarantee. But I believe that the odds are overwhelming that a loss will never result for even a two or three-month period. If the money is invested for an entire year, the odds should be dramatically higher that a gain will result instead of a loss.
A Complicated Strategy: The Mighty Stalagmite is not for the do-it-yourselfer subscriber. We cannot to offer up-front Trading Rules. While we can explain the general decision rules when placing the initial trades, the problem comes in the details of the adjustment trades. Depending on how much time has elapsed before the stock moved enough to trigger an adjustment, the solution may differ.
So the bottom line is that we firmly believe that we have created an options strategy that never loses money if it is carried out for a year. Such a claim is not possible for even the most conservative mutual or bond fund. They often lose money. Contrast that record with the Mighty Stalagmite which could handle a market (S&P 500) that dropped up to 5% every month of the year and the portfolio would still make a gain for the year.
I invite you to become a Terry's Tips subscriber and learn the full details about the Mighty Stalagmite, the option strategy that doesn't lose money. You can sign up here. It could be the best investment you make this summer.
Happy trading.
Terry
Monday, July 14, 2008
Stock Options Trading
Last week we gave you a brief description of a traditional butterfly spread. This week we will show a modified butterfly where the short positions are not in the middle and the ratio of long-short-long is not the typical 1-2-1 but 1-3-2. With SPY trading at $127, this is how a modified butterfly would perform in five weeks:
Note that this spread makes more money ever dollar the stock falls below it's present level of $127. It provides increasing protection against loss all the way down to $115 (which would be a drop in the stock price that has happened only 5 times including 9/11 in the last 100 months). If the stock were to go up, this spread would lose money, but that loss would be covered by the higher-strike call calendar spreads that are in place (out basic 10K Strategy).
On July 10, 2008, we set up a new portfolio where the above spread was combined with calendar call spreads at strike prices which were near and above the current stock price. Here is what the risk profile graph looked like with all those positions in place:
We call this new portfolio the Mighty Stalagmite. We believe it is a portfolio that will essentially never lose money, no matter what the market does. In the above graph, you can see that a profit approximating 10% will result (the portfolio value is $10,000) if SPY were to land anywhere between $115 and $133 in five weeks. On July 10, SPY was about $125 so it could fall by $10 or go up by $9 and we would still make that amount.
Part of our strategy is to hold some cash in reserve so that if the stock moves by $7 in either direction, a new modified butterfly spread can be bought that will expand the break-even range so that a loss is averted. When this second spread has to be placed, it is doubtful that the portfolio would gain money in that month, but it should at least break even.
Back-Testing the Mighty Stalagmite: I checked out how these positions might sugar off based on how much that SPY fluctuated each expiration month for the past 100 months (8 1/3 years). It was not a simple task because it involved more than merely checking the fluctuation for a month and seeing what the gain or loss would be on the risk profile graph. Instead, I had to calculate the maximum fluctuation for the month (both up and down) to see if it moved more than $7 so that a mid-month adjustment trade would be triggered.
The results were interesting. Two-thirds of the time, no adjusting trade would be required, and a portfolio gain would be achieved. One third of the time, an adjusting trade would be required, and this happened about equally between upward and downward moves (I had expected there would be more big moves on the downside). Presumably, we would not make a gain in those months but a loss would be avoided.
For one period of time during the back-test (ending with the December 2008 expiration), the proposed configuration of the Mighty Stalagmite would have made a gain in 60 consecutive months.
In one month, the stock deviated from its starting price by a $7 move in both directions, and two adjustments would have been required (the second one would have involved taking off one of the calendars to come up with the cash to do it), and a small loss would probably have been experienced for that month. But that was only one month out of 100.
The greatest change in a single month was $16.70 (in 9/11). On the day that trading was resumed, the stock moved up $4, and two months later it was higher than it was before the tragic event. Only 2 times out of 100 did the stock fall by over $12 in a single month. In each of these circumstances, a butterfly spread that extended the no-loss range by $5 would have covered the unusually large fluctuation.
Next week will expand our discussion to ask if it is a realistic possibility that we have come up with an options portfolio that doesn't lose money no matter what the market does (and may make as much as 10% in a single month if the market only changes moderately up or down).
I hope you are interested enough it this possibility that you would consider coming on board as a Terry's Tips Insider and watching the Mighty Stalagmite unfold in real time (it is one of our 15 actual portfolios).
You can sign up at http://www.terrystips.com/order.php, It could be the best investment you ever made.
Terry
Note that this spread makes more money ever dollar the stock falls below it's present level of $127. It provides increasing protection against loss all the way down to $115 (which would be a drop in the stock price that has happened only 5 times including 9/11 in the last 100 months). If the stock were to go up, this spread would lose money, but that loss would be covered by the higher-strike call calendar spreads that are in place (out basic 10K Strategy).
On July 10, 2008, we set up a new portfolio where the above spread was combined with calendar call spreads at strike prices which were near and above the current stock price. Here is what the risk profile graph looked like with all those positions in place:
We call this new portfolio the Mighty Stalagmite. We believe it is a portfolio that will essentially never lose money, no matter what the market does. In the above graph, you can see that a profit approximating 10% will result (the portfolio value is $10,000) if SPY were to land anywhere between $115 and $133 in five weeks. On July 10, SPY was about $125 so it could fall by $10 or go up by $9 and we would still make that amount.
Part of our strategy is to hold some cash in reserve so that if the stock moves by $7 in either direction, a new modified butterfly spread can be bought that will expand the break-even range so that a loss is averted. When this second spread has to be placed, it is doubtful that the portfolio would gain money in that month, but it should at least break even.
Back-Testing the Mighty Stalagmite: I checked out how these positions might sugar off based on how much that SPY fluctuated each expiration month for the past 100 months (8 1/3 years). It was not a simple task because it involved more than merely checking the fluctuation for a month and seeing what the gain or loss would be on the risk profile graph. Instead, I had to calculate the maximum fluctuation for the month (both up and down) to see if it moved more than $7 so that a mid-month adjustment trade would be triggered.
The results were interesting. Two-thirds of the time, no adjusting trade would be required, and a portfolio gain would be achieved. One third of the time, an adjusting trade would be required, and this happened about equally between upward and downward moves (I had expected there would be more big moves on the downside). Presumably, we would not make a gain in those months but a loss would be avoided.
For one period of time during the back-test (ending with the December 2008 expiration), the proposed configuration of the Mighty Stalagmite would have made a gain in 60 consecutive months.
In one month, the stock deviated from its starting price by a $7 move in both directions, and two adjustments would have been required (the second one would have involved taking off one of the calendars to come up with the cash to do it), and a small loss would probably have been experienced for that month. But that was only one month out of 100.
The greatest change in a single month was $16.70 (in 9/11). On the day that trading was resumed, the stock moved up $4, and two months later it was higher than it was before the tragic event. Only 2 times out of 100 did the stock fall by over $12 in a single month. In each of these circumstances, a butterfly spread that extended the no-loss range by $5 would have covered the unusually large fluctuation.
Next week will expand our discussion to ask if it is a realistic possibility that we have come up with an options portfolio that doesn't lose money no matter what the market does (and may make as much as 10% in a single month if the market only changes moderately up or down).
I hope you are interested enough it this possibility that you would consider coming on board as a Terry's Tips Insider and watching the Mighty Stalagmite unfold in real time (it is one of our 15 actual portfolios).
You can sign up at http://www.terrystips.com/order.php, It could be the best investment you ever made.
Terry
Monday, July 7, 2008
Using a Butterfly Spread to Reduce Downside Risk
At Terry's Tips, we have been researching the possibility of using butterfly spreads to provide downside protection for our 10K Strategy. As you may recall, the 10K Strategy uses calendar spreads at several different strike prices and depends on premium decay to generate gains most every month.
This strategy has made exceptional gains when the market is stable or fluctuates moderately either up or down, but has experienced losses when a large drop occurs. The last couple of weeks have been painful for this strategy because many have dropped nearly 10% quickly.
This week we are establishing a new portfolio for Terry's Tips Insiders to follow if they wish. It is called the Mighty Stalagmite. It uses SPY (the S&P 500 tracking stock) as the underlying because this is a large and relatively stable index.
The key feature of the Mighty Stalagmite is that a butterfly spread is added to the calendar spreads to provide downside protection in case the stock moves more than moderately during the expiration month.
Brief Description of a Butterfly Spread: A typical butterfly put spread would be as follows:
Long 10 Aug08 132 puts
Short 20 Aug08 127 puts
Long 10 Aug08 122 puts
Total cost of this butterfly spread = $1.10 ($1100 for 10 spreads)
This is the risk profile graph for these positions:
The butterfly spread gets its name because a graph of its returns are supposed to look like a butterfly, but it never looked that way to me.
The maximum gain for a butterfly spread comes when the stock ends up exactly at the strike of the short options. If it lands there, a very large gain results (in this case, over 4 times the cost of the spread). There are some interesting aspects of butterfly spreads:
o The initial cost is your maximum loss.
o If the stock ends up above the highest strike or below the lowest strike, a total loss results.
o The closer the mid-point (the short option strike) is to the stock price when it is bought, the more expensive it is (if the above butterfly were bought with all the strikes 5 points lower, the spread would cost $.53 instead of $1.10).
Since we would like to use a butterfly spread to provide protection on the downside, we would select a mid-point at a strike much lower than the current price of the stock. If the stock falls more than moderately so that the mid-point strike is approached, a large gain could occur which would offset the loss on the calendar spreads from the falling stock price.
If we added a butterfly whose mid-point was 10 points lower than the original stock price, it would only cost $.50 or so (this compares to the $3.00 or so in premium decay we would be collecting from the at-the-money options we have sold in the calendar spreads). Conceptually, we would be giving up some of our potential decay gain to provide excellent protection in case the stock were to fall by a large amount.
Most investors use calls when placing butterfly spreads rather than puts, and often take off some of the positions if the market moves strongly in either direction. Usually they are placed with the short strikes close to the current market price so that the maximum gains come when the market is flat (of if the investor believes the market is headed higher, he or she would place the spread at higher strikes).
Next week, we will discuss permutations that can be used on the typical butterfly spread that provides downside protection over a much larger range.
This strategy has made exceptional gains when the market is stable or fluctuates moderately either up or down, but has experienced losses when a large drop occurs. The last couple of weeks have been painful for this strategy because many have dropped nearly 10% quickly.
This week we are establishing a new portfolio for Terry's Tips Insiders to follow if they wish. It is called the Mighty Stalagmite. It uses SPY (the S&P 500 tracking stock) as the underlying because this is a large and relatively stable index.
The key feature of the Mighty Stalagmite is that a butterfly spread is added to the calendar spreads to provide downside protection in case the stock moves more than moderately during the expiration month.
Brief Description of a Butterfly Spread: A typical butterfly put spread would be as follows:
Long 10 Aug08 132 puts
Short 20 Aug08 127 puts
Long 10 Aug08 122 puts
Total cost of this butterfly spread = $1.10 ($1100 for 10 spreads)
This is the risk profile graph for these positions:
The butterfly spread gets its name because a graph of its returns are supposed to look like a butterfly, but it never looked that way to me.
The maximum gain for a butterfly spread comes when the stock ends up exactly at the strike of the short options. If it lands there, a very large gain results (in this case, over 4 times the cost of the spread). There are some interesting aspects of butterfly spreads:
o The initial cost is your maximum loss.
o If the stock ends up above the highest strike or below the lowest strike, a total loss results.
o The closer the mid-point (the short option strike) is to the stock price when it is bought, the more expensive it is (if the above butterfly were bought with all the strikes 5 points lower, the spread would cost $.53 instead of $1.10).
Since we would like to use a butterfly spread to provide protection on the downside, we would select a mid-point at a strike much lower than the current price of the stock. If the stock falls more than moderately so that the mid-point strike is approached, a large gain could occur which would offset the loss on the calendar spreads from the falling stock price.
If we added a butterfly whose mid-point was 10 points lower than the original stock price, it would only cost $.50 or so (this compares to the $3.00 or so in premium decay we would be collecting from the at-the-money options we have sold in the calendar spreads). Conceptually, we would be giving up some of our potential decay gain to provide excellent protection in case the stock were to fall by a large amount.
Most investors use calls when placing butterfly spreads rather than puts, and often take off some of the positions if the market moves strongly in either direction. Usually they are placed with the short strikes close to the current market price so that the maximum gains come when the market is flat (of if the investor believes the market is headed higher, he or she would place the spread at higher strikes).
Next week, we will discuss permutations that can be used on the typical butterfly spread that provides downside protection over a much larger range.
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