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.

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.

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.