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.

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.

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).

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.