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.

Our "Most Conservative" Options Portfolio

The November expiration month was a dreadful one for markets. They fell about 15%. Okay, the DOW only fell 8% (and this resulted in our option portfolio using DIA as the underlying to gain 40% in one month). The S&P 500 (SPY) fell 15% and the Russell 2000 (IWM) fell a whopping 23%. The huge drop in IWM caused both of our IWM portfolios to suffer big losses last month - there is a limit to how far the market can fall without hurting our portfolio values, and it looks like a monthly drop over 15% is where that limit stands. Fortunately, that number has been exceeded only once in over 20 years for SPY, and that was in October.

We have three SPY portfolios, and while the market fell 15%, these three portfolios gained an average of 18% last month. One of these portfolios is set up to do best when markets fall (we call it the Big Bear Mesa) and it understandably did the best, gaining 40% in a single month.

Today I would like to talk about our most conservative portfolio, the Big Dripper. We set this portfolio up on October 23, 2008 with $10,000. Our plan is to withdraw $150 in cash every month from this portfolio forever. That works out to 18% per year, after commissions. The annual goal is 20% - 25%, or less than our other portfolios which are aiming for 36% a year.

In its first month of operation, the market was not kind to the Big Dripper. SPY fell by 15%. Yet the portfolio gained 16.7% in value. In addition to the $150 monthly withdrawal, we took out another $1500 as a "windfall gain" withdrawal. If the market had not fallen so far last month, the Big Dripper would have made much more.

How did we do it? Simple. We established calendar spreads across a wide range of strike prices, going out at least 15% below the stock price and 15% above the stock price. Very few spreads were placed at near-the-money strikes. This is the risk profile graph which shows what these positions will produce in 4 weeks at the various possible stock prices (SPY closed at $79.52 on Friday).



As you can see, the Big Dripper will make a 35% gain if the stock falls by as much as 15% in 4 weeks, a 30% gain if the stock goes up by as much as 15%, or about 45% if the stock ends up about where it is today.

I must add that the above graph assumes that the current option values (IVs) of the long options will continue as they are right now. If VIX falls considerably, the gains projected by the software would be less than the above numbers. For the past two months, we have not seen any diminution of VIX, however.

Give yourself an early Christmas present, and learn exactly how to create the above portfolio in your own account by becoming a Terry's Tips Insider. You could establish these positions in your own account before Thanksgiving, and have something really exciting to look forward to each month from there on.

You can sign up today here. It could be the best Christmas present you ever gave yourself.

Terry

Stock Options trading

Our "Most Conservative" Options Portfolio

The November expiration month was a dreadful one for markets. They fell about 15%. Okay, the DOW only fell 8% (and this resulted in our option portfolio using DIA as the underlying to gain 40% in one month). The S&P 500 (SPY) fell 15% and the Russell 2000 (IWM) fell a whopping 23%. The huge drop in IWM caused both of our IWM portfolios to suffer big losses last month - there is a limit to how far the market can fall without hurting our portfolio values, and it looks like a monthly drop over 15% is where that limit stands. Fortunately, that number has been exceeded only once in over 20 years for SPY, and that was in October.

We have three SPY portfolios, and while the market fell 15%, these three portfolios gained an average of 18% last month. One of these portfolios is set up to do best when markets fall (we call it the Big Bear Mesa) and it understandably did the best, gaining 40% in a single month.

Today I would like to talk about our most conservative portfolio, the Big Dripper. We set this portfolio up on October 23, 2008 with $10,000. Our plan is to withdraw $150 in cash every month from this portfolio forever. That works out to 18% per year, after commissions. The annual goal is 20% - 25%, or less than our other portfolios which are aiming for 36% a year.

In its first month of operation, the market was not kind to the Big Dripper. SPY fell by 15%. Yet the portfolio gained 16.7% in value. In addition to the $150 monthly withdrawal, we took out another $1500 as a "windfall gain" withdrawal. If the market had not fallen so far last month, the Big Dripper would have made much more.

How did we do it? Simple. We established calendar spreads across a wide range of strike prices, going out at least 15% below the stock price and 15% above the stock price. Very few spreads were placed at near-the-money strikes. This is the risk profile graph which shows what these positions will produce in 4 weeks at the various possible stock prices (SPY closed at $79.52 on Friday).



As you can see, the Big Dripper will make a 35% gain if the stock falls by as much as 15% in 4 weeks, a 30% gain if the stock goes up by as much as 15%, or about 45% if the stock ends up about where it is today.

I must add that the above graph assumes that the current option values (IVs) of the long options will continue as they are right now. If VIX falls considerably, the gains projected by the software would be less than the above numbers. For the past two months, we have not seen any diminution of VIX, however.

Give yourself an early Christmas present, and learn exactly how to create the above portfolio in your own account by becoming a Terry's Tips Insider. You could establish these positions in your own account before Thanksgiving, and have something really exciting to look forward to each month from there on.

You can sign up today here. It could be the best Christmas present you ever gave yourself.

Options Trading

The Joys of Calendar Spreads and Our

On October 23, 2008 we started a $10,000 options portfolio that was to be our "most conservative" portfolio. I sent you a copy of the risk profile graph that showed the gain or loss that would come about in 4 weeks at the November 21 expiration. If you recall, the stock (SPY) could go up (or down) by 15% over that period and a large gain would result no matter where it landed within that range. (We also set aside $1,000 to make adjustments in case the stock started to move strongly in either direction.)

This new portfolio is called the Big Dripper because we intend to withdraw $150 in cash (1 ½%) from it every month forever, regardless of how much it gains or falls during a single expiration month. We will create positions that allow for a greater fluctuation in the stock price than any of our other portfolios for a gain to result. Our annual profit target for the Big Dripper is 20% - 25% a year (with an extremely high expectation of reaching that target).

Just in case a windfall gain (which we described as 20% or more in a single month) resulted, we would withdraw much of it so that new subscribers could mirror the portfolio (either on their own or through Auto-Trade with their broker) with about $10,000 to start.

Eight days has now expired, and the windfall gain has already come about. In this short period of time, the Big Dripper has made a whopping gain of 34%, well more than our target for the entire year. And the risk profile graph shows that further large gains are possible in the next three weeks over a wide range of possible stock prices (current price of SPY is $96.83). The stock can fluctuate by as much as 10% in either direction and we will gain an additional 20% in three weeks:



The New York Times has reported that October 2008 was the most volatile month in 80-year history of the S&P 500. At Terry's Tips we feature an stock options trading strategy that does best when volatility is low, so we would expect to get killed when stock prices are fluctuating all over the place as they have recently. However, over the past two weeks, our portfolios have gained an average of over 26%, and it is all due to the discrepancy in short- and long-term option prices that we hope will continue (if it doesn't we should be back to our historical above-average gains).

Our recent experience has demonstrated the exceptional opportunities that exist for a calendar spread strategy especially when there is a discrepancy between the option prices of short- and longer-term options. It is a phenomenon worth waiting for and plowing everything you can into when it comes up.

Maybe it is time for you to come on board and participate in these exceptional gains with us - it will cost you less than a decent dinner for two, and might dramatically change your investment returns for the rest of your life - check it out here.

Coping With an Emotionally-Driven Market

Short-term market activity is largely based on emotion rather than reason, and it is impossible to predict how collective emotions will be swinging in the short term. Except that we know that there is a cycle of emotions, and people tend to move in one direction until the pain (or euphoria) causes them to pause and reconsider.

For two days last week, the market focused on the 6 ½% unemployment rate, a number that had not been this high for 14 years. Inevitably, sometime in the next few weeks, some people will re-frame that statistic and think about the 93 ½% of Americans who do have a job. Many investors will realize that their personal life has not really gotten much worse, and that life goes on. The government seems eager to do something about the economy, and will not allow a protracted slowdown like the 1930's to happen again.

I can vividly remember how I felt after the 9/11 disaster. How could life as we knew it continue on, I thought? How could I ever get on an airplane again? Why should this market ever recover? And then a few days later as I was driving down my driveway listening to the local radio announcer playing my favorite same old songs and talking about the most mundane local things (like preparing for the invasion of the leaf-peepers in early October), it suddenly occurred to me that nothing really had much changed in my personal life, nor would it. A feeling of mellowness spread through my body and some of my natural optimism returned. I was ready to accept the possibility that the market might just go back up someday.

On a collective basis, that is how the market operates. For many months we have been thinking about the R word (while also worrying about the possibility of it getting worse and becoming the D word). Every layoff that was announced, every lowered earnings outlook, every new foreclosure number released - all contributed to our fears that a recession is on the way or already here. Many people dumped their stock, and the market fell by a huge amount, wiping out several years of gains.

And inevitably, at some point, people will start thinking about the 93 ½% number and make their own journey down their own driveway, and take a peek at the stock price of their favorite company and see a lower number than they have seen in many years, and get that feeling of mellowness that allows them to take a little nibble in the market. Collectively, the spreading feeling of optimism (or at least, muted pessimism) will cause the market to start edging back up.

We don't have any idea of when it will happen. But it will. We can be certain of that. The market has already gone down so far that the smart bet will be that the next big move should be to the upside. We don't want to suffer losses in our portfolios when that recovery takes place - it was bad enough suffering the losses when the meltdown came. It would be doubly painful to experience similar pain when the recovery finally comes.

So far, the Terry's Tips investment philosophy has been a great success. We hold leveraged positions that do best if the market doesn't fluctuate much. For the last couple of months, volatility has been greater than it has in the history of the market. We should have been killed in this kind of world. But the truth is that over the past three months, our composite portfolio values have gone up. When volatility eventually falls back to normal levels, as it inevitably will, we should enjoy gains that substantially outperform the market in general.

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.