This month's experience was a painful reminder of how difficult it is to make gains on your invested capital. There are other reminders all over the place. Real estate was a way to make steady gains for many years, and then it wasn't. Treasury bills are being sold for zero percent interest - and that is surely a loss because inflation will eat away at the value of the investment that yields nothing.
Every December, Smart Money magazine publishes a lead article entitled "Where to Invest in (Next Year)". Every year, they consult the top analysts they can find to help them come up with a list of the best investments for the coming year. For each company, they give a summary of the often-compelling reasons why that stock is sure to soar in the coming year. I have often been tempted to buy the stock in every one of the 12 or so companies they recommend to spread my risk (but as you know, I resist the temptation and still do not own one share of stock of any company).
I decided to look back to see how the Smart Money selections for 2008 worked out in the real world. Of course, 2008 was a bad year for stocks. For the Smart Money "year" (December 1, 2007 through November 30, 2008), the S&P 500 fell by 40.8%. The Smart Money portfolio did even worse, falling 53.6%. One of the selections fell by 94%. Imagine! These were the 12 best companies that the top analysts selected as their best bets for 2008. A monkey throwing darts at the Wall Street Journal would have randomly selected 12 stocks that did better than those chosen by the experts.
If the smartest financial people out there, those with billions of dollars of other people's money to invest, with all their research capabilities and inside information, can't outperform the monkeys, how can ordinary investors like you and me expect to do better?
At least the people who did mirror the Smart Money portfolio only lost a little over half their money last year. They could have put it with Bernard Madoff's company and lost it all.
Once again, I am convinced that the Mighty Mesa Strategy as it is currently configured, is the best alternative for long-term investment gains for most of us. True, we had a bad month last month. It was especially bad because we were so far ahead at one point. Bad months happen. The prior month saw almost as great gains as we had losses this month. For the two-month period, we have suffered about a 1% composite loss. The same cannot be said for most stock market pickers, for Smart Money followers, or for investors in Mr. Madoff's ponzi scheme.
Monday, December 22, 2008
Wednesday, December 17, 2008
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.
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.
Tuesday, December 16, 2008
Stock Options Trading Idea Of the Week
Making Adjustments in a Volatile Stock Market
Subscribers have been writing in and asking for a more definitive set of rules as to when to adjust. For example, what number establishes the point where we are "too short" and must make an adjustment? Others have asked why we just don't always maintain a neutral net delta. These are legitimate questions, and unfortunately, there are no easy answers in a market as volatile as this one has been. It might help to explain the reasoning I have been following lately.
Each day, I watch the net delta position of each portfolio and compare it to theta. If theta is higher than net delta, I know that the stock can move against us by a full dollar and we should enjoy a gain for that day. Of course, lately we would be happy if it only moved a dollar in a day - in the past that was considered to be a big move, but today it is a small one. If theta becomes less than net delta, I check out the portfolio on the Analyze Tab at thinkorswim, checking what will happen at the next expiration if the stock price were to move another 6% - 10% in either direction (if expiration is only a week and a half away, I use the 6% numbers, and if it is more than two weeks away, I look at the 10% numbers). If a large loss appears imminent at one of those extremes, an adjustment would be in order.
As we have talked about in the past, adjustments are expensive. They invariable involve early rolling over (or taking off) options at a strike which is furthest away from the stock. That is the time when rolling over yields a very small amount and taking off involves selling for a lower price than any of the other spreads. It becomes even more costly when we add back on spreads at the other end of the spectrum, usually at strikes which are closer to the stock price - these spreads are more expensive than the ones we sold. In the end, we are buying high and selling low.
In a vacillating market, the best strategy is to avoid adjusting as much as possible to avoid these costs. As much as we would like to be delta neutral at all times, we would go broke making the necessary adjustments to make that possible. When the market takes a big move in one direction, the odds increase that the next move will be in the opposite direction. When a reversal move does occur, we will have avoided making two adjustments, and a gain usually results. There will be months when the reversal does not take place during that month, and we will have to endure a loss for that month. Hopefully, we will gain it back in the next month when at least a partial reversal takes place.
That being said, adjustments are sometimes necessary to avoid a devastating loss in case the market continues to move in a single direction without reversing itself. When the risk profile graph shows that huge losses are imminent, an adjustment becomes necessary to ensure that we will still be around to play another day. It is hard to determine in advance exactly what mathematical parameters should dictate when this kind of adjustment needs to be made, and is often more of an intuitive decision.
The market has fallen by over 40% in one year. Retirement accounts have been decimated. Mutual funds are at lower levels than they have been for years. Everyone with stock market investments is suffering to one degree or another. But there have to be some good buys out there, and it is inevitable that at some point people will start edging back into the market. Who knows if it will happen this month or next, or the month after? But someday it should happen. All it has to do is to stop dropping for us to make exceptional returns in our portfolios. Even though we get longer as the market falls (and get shorter as the market rises), there are times like today when we must tolerate being a little longer or shorter than we would like.
Our goal is to make as few adjustments as possible and still protect against a devastating loss of portfolio value. One way of doing this is to establish, and keep, a wide range of strikes in our calendar spreads. We have already moved in that direction (especially in the Big Dripper), and will continue to do so.
As much as we would love to have hard-and-fast mathematical benchmarks for making adjustments, in this world of higher and higher volatility, it feels more like art than science, more intuition and less reason. It is an uncomfortable place to be for many of us, but that is the way it must be, at least right now.
Monday, December 1, 2008
Stock Options Trading
Understanding Market Manipulation at Options Expiration
Market makers are generally short current month at-the-money options (both puts and calls) while the general public is typically (on balance) long those options. Market makers enjoy special margin requirements (or more precisely, a lack of requirements) that allow them to be short options without posting collateral that is required for ordinary investors. If a stock ends up exactly at a strike price at expiration, the market makers can keep their entire gains from both puts and calls that they sold earlier.
Obviously, they have a vested interest to do what they can to manipulate the stock price to end up precisely at a strike price.
For many years, this phenomenon has been tracked by many investors who are looking for a clue as to which strike price the floor will shoot for at expiration. The concept is called the Maximum Pain Indicator.
One free site where you can follow the indicator is Option Pain Here is what they say about it - "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."
For many years, I followed this indicator each month, and often it was right on the target (last month it was absolutely dead on SPY, for example). However, I have not followed it recently for several reasons. First, the indicator sometimes misses badly, and if you follow it closely, you will probably start placing large bets on its accuracy, and end up losing your shirt. I have preferred taking the position that I have no idea of where the stock will end up, as that is most always the truth.
Second, the indicator works best with individual stocks that are easier for the floor to manipulate than it does for broad-based ETFs like those we use in our portfolios.
Third, the change to strikes at dollar increments reduces the significance of the measure. Back when most strike prices were $5 apart, it was more important to have an idea where the stock was most likely to end up at expiration.
And finally, going into expiration week, the highest total of short puts and calls is almost always at the at-the-money strike price. This doesn't really tell you much except to expect no change in the stock price (which we know is usually not the case).
In spite of all these objections, it remains an interesting concept, and should probably be consulted just in case there is a strong indication that the maximum pain point is a few points higher or lower than the existing stock price.
Understanding Market Manipulation at Options Expiration
Market makers are generally short current month at-the-money options (both puts and calls) while the general public is typically (on balance) long those options. Market makers enjoy special margin requirements (or more precisely, a lack of requirements) that allow them to be short options without posting collateral that is required for ordinary investors. If a stock ends up exactly at a strike price at expiration, the market makers can keep their entire gains from both puts and calls that they sold earlier.
Obviously, they have a vested interest to do what they can to manipulate the stock price to end up precisely at a strike price.
For many years, this phenomenon has been tracked by many investors who are looking for a clue as to which strike price the floor will shoot for at expiration. The concept is called the Maximum Pain Indicator.
One free site where you can follow the indicator is Option Pain Here is what they say about it - "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."
For many years, I followed this indicator each month, and often it was right on the target (last month it was absolutely dead on SPY, for example). However, I have not followed it recently for several reasons. First, the indicator sometimes misses badly, and if you follow it closely, you will probably start placing large bets on its accuracy, and end up losing your shirt. I have preferred taking the position that I have no idea of where the stock will end up, as that is most always the truth.
Second, the indicator works best with individual stocks that are easier for the floor to manipulate than it does for broad-based ETFs like those we use in our portfolios.
Third, the change to strikes at dollar increments reduces the significance of the measure. Back when most strike prices were $5 apart, it was more important to have an idea where the stock was most likely to end up at expiration.
And finally, going into expiration week, the highest total of short puts and calls is almost always at the at-the-money strike price. This doesn't really tell you much except to expect no change in the stock price (which we know is usually not the case).
In spite of all these objections, it remains an interesting concept, and should probably be consulted just in case there is a strong indication that the maximum pain point is a few points higher or lower than the existing stock price.
Obviously, they have a vested interest to do what they can to manipulate the stock price to end up precisely at a strike price.
For many years, this phenomenon has been tracked by many investors who are looking for a clue as to which strike price the floor will shoot for at expiration. The concept is called the Maximum Pain Indicator.
One free site where you can follow the indicator is Option Pain Here is what they say about it - "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."
For many years, I followed this indicator each month, and often it was right on the target (last month it was absolutely dead on SPY, for example). However, I have not followed it recently for several reasons. First, the indicator sometimes misses badly, and if you follow it closely, you will probably start placing large bets on its accuracy, and end up losing your shirt. I have preferred taking the position that I have no idea of where the stock will end up, as that is most always the truth.
Second, the indicator works best with individual stocks that are easier for the floor to manipulate than it does for broad-based ETFs like those we use in our portfolios.
Third, the change to strikes at dollar increments reduces the significance of the measure. Back when most strike prices were $5 apart, it was more important to have an idea where the stock was most likely to end up at expiration.
And finally, going into expiration week, the highest total of short puts and calls is almost always at the at-the-money strike price. This doesn't really tell you much except to expect no change in the stock price (which we know is usually not the case).
In spite of all these objections, it remains an interesting concept, and should probably be consulted just in case there is a strong indication that the maximum pain point is a few points higher or lower than the existing stock price.
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