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.

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.

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.

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.