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.

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.

Expiration Day Roll-Over Strategy:

For a normal third-Friday expiration, we have maintained that it doesn't make any real difference whether you buy back expiring out-of-the-money options on Friday (if they cost $.05 or less, there is no commission at thinkorswim) and also sell the next-month-out options on that day, or whether you let them expire worthless and wait until the following Monday to sell those options.

There are several reasons why the next-month-out options usually sell for less on Monday than they do on the previous Friday (especially if they are calls):

Two extra days elapse for decay to take place (Saturday and Sunday).Many investors who sell covered calls do that selling on Monday, and that depresses the prices of those calls.Markets are generally weaker on the Monday after an expiration.
All three of these reasons support the notion that even though there is a small cost to buying back out-of-the-money soon-to-expire options on Friday, the new options can be sold for sufficiently higher prices on Friday to more than cover that small cost.

Next Tuesday we have a mini-expiration when the September quarterly options expire 11 days later than the normal September options. At this expiration, none of the above three reasons is in effect.

Therefore, the proper strategy will be to allow out-of-the-money options to expire worthless, and sell new options (the October series) on Wednesday.

Here is the risk profile graph of our Durable Diamond portfolio going into next week's mini-expiration. You can see that we will make substantial gains if the stock ends up at any price above $110 in two days. If it falls below $110, we will do just fine as well because we will roll over September 110 quarterly puts to October at a very high price, and use the substantial cash we collect to add on new calendar spreads.




How often do you have the opportunity to make 18% on your total investment in only two days? That is what we are looking at right here, just as long as DIA does not fall below $110.

More next week.