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?

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

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

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.