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.

Therefore, the proper strategy will be to allow out-of-the-money options to expire worthless, and sell new options (the October series) on Wednesday.

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.

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.

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

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.

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.