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.