The Economics of Using a Longer-Term Option in a Butterfly Spread:

In our Mighty Stalagmite portfolio we might place a Sep-08 126-122-120 put butterfly spread to provide downside protection. A traditional butterfly would have all three options in the same month, but we often use a longer-term put for the highest strike leg of a put butterfly. (We would use the same policy for the lowest-strike option in a call butterfly.)

This means that instead of buying a Sep-08 126 put for $1.85 we could pay $4.85 for a Dec-08 126 put. We would have to spend $300 more for the spread than we could have by having all the options in the Sep-08 month.

In 35 days, the Dec-08 126 should decay by $.75 (assuming the stock stays flat). That means our "cost" of the 125 put is $110 less expensive ($1.85 - $.75) than if we had bought the Sep-08 126 put. We have to put up an extra $300 to save $110, so our investment in the longer-term put yields us 36% for the 5-week period.

That surely seems like a good investment even though it means we have less cash for buying calendar spreads. If we could make 36% on our money in every 5-week expiration month we would have no complaints.

On the other hand, at times, traditional out-of-the-money butterfly spreads are so inexpensive that they should be placed anyway (and the money saved used for generating decay with calendars). The choice between exotic and traditional butterfly spreads must be made on a case-by-case basis, and different answers may well result for different portfolios at different times.

Tune in next week for more Stock Options Trading tips.

Terry's Tips Portfolio Expiration Report

All Six Portfolios Make Great Gains! The first expiration month using our modified 10K Strategy was a resounding success. In spite of devoting up to half of the entire portfolio value to an exotic butterfly spread that only provided insurance against a big market drop, substantial gains resulted in every portfolio.

The portfolios gained an average of 4.5% after commissions for the expiration month. That works out to be 54% annualized, far more than we expected. We had hoped for a 4% gain in those months where no adjustments were necessary. This month our gains exceeded this goal, and adjustments were made in every portfolio because it was a volatile month, with several market swings in both directions.

The Oil Services portfolio was the best example of the value of butterfly spreads. The underlying OIH fell by 11.3% for the month. In the past, this kind of volatility almost always resulted in large losses. This month, after the addition of a large number of butterfly spreads on the downside, the portfolio managed to gain of 6.4% in spite of the strong slide in the stock price.

Maybe we have indeed created an options strategy that never loses money. That is the ultimate goal of our modified strategy, and the first month's record was most encouraging.

The portfolios that had the greatest gains were the two that had been established before July - Mini-Russell (up 12% for the month) and Oil Services (up 6.4%). The four portfolios that were started in July had to cover the bid-asked spread penalty of a new portfolio, and the final results understate how well they did. Three of these portfolios were in existence for only 23 days, hardly enough to qualify for a month's results.

The lowest-gaining portfolio for the month, Mighty Stalagmite (up 2.6%) would cost about $10,560 to replicate now. This means that a fairer estimate of the gain was probably closer to 5%, and this was our worst-performer (largely because we made several adjustments that were later reversed).

Annualized Portfolio Gains for the August Expiration Month:

Mini-Russell (IWM) - up 144%

Oil Services (OIH) - up 77%

Durable Diamond* (DIA) - up 92%

Building BRIC* (EEM) - up 62%

Rising Russell* (IWM) - up 37%

Mighty Stalagmite (SPY) - up 31%

*Based on three week's results averaged over a year

You can see every position and every trade we made in each of these portfolios by becoming a Terry's Tips Insider - sign up HERE.

Next week we will discuss the economics of using what we call an exotic butterfly spread for downside protection.

Favorite Suggested Books for the Conservative Options Investor

sI am often asked about my favorite books on investing (other than my own Making 36%: Duffer's Guide to Breaking Par in the Markets Every Year, In Good Years and Bad).

Here is my list of favorites:

McMillan on Options, by Lawrence G. McMillan, (New York: John Wiley & Sons, second edition, 2004). This is generally accepted as "The Bible" on options. It is fairly expensive and the text is ponderous for most people, but everything is there.

Options Plain and Simple, by Lenny Jordan. (London: Prentice Hall, 2000). One of many books which describe just about all the option strategies with some good advice as to which ones work under which conditions. Much lighter reading than McMillan on Options.

Winning the Loser's Game, by Charles D. Ellis, (New York, McGraw-Hill, 4th Edition, 2002). While this is not about options per se, it is just about the most sensible book I have ever found that discusses stock market investments in general.

The Little Book That Beats the Market, by Joel Greenblatt, (New York, John Wiley, 2006). Again, this book is not about options, but is perhaps the best book written in the past several years about how to select individual stocks.

The Little Book of Common Sense Investing, by John C. Bogle (New York, John Wiley, 2007), Another book which is not about options, but I challenge anyone to read this book because if they do, I believe there is no way they would ever buy a mutual fund again (except a no-load broad market index fund).

Trading Options After a Stock Split

When EEM split 3-for-1 on July 24th, two series of options became available. The pre-split options had strike prices around the $130 level (and strikes at $5 increments) while the post-split option series had strikes around the $40 level (and strikes at dollar increments).

The immediate implication was that market professionals all jumped into the new option series and totally disdained the old pre-split series. Our new portfolio suffered for several reasons:
Our graphing software did not work, so it was difficult for us to see where we stood. The Analyze Tab at thinkorswim was no better - it showed 70% gains coming our way in two weeks across a huge range of possible stock prices. Option prices in the pre-split series fell considerably. Traders did not want to deal in options that did not easily translate to the current stock prices.The bid-asked spreads increased by a large margin, making it impossible to get decent prices when either buying or selling. This problem relates to the general issue that market makers just don't want to deal in the old series, and they make it expensive for anyone who wants to trade there.For the above reasons, we recommended that subscribers get out of the old series as soon as it was practical. For us, this meant waiting until the August expiration week when we would normally be buying back soon-to-expire short options and selling the next month out. Rather than continuing to trade the old series, we advised closing out all the pre-split options and starting over with the post-split series.

This policy would result in some costly bid-asked spread penalties and commission costs, but it is a better choice than continuing to trade in markets that have bid-asked spreads large enough to drive a truck through. Sometimes it is best to take your lumps and move on to better things. We expect that our EEM portfolio will be our worst-performing portfolio this month, and may even lose a little. Thankfully, 3-for-1 splits don't come along too often.

Stock Options Idea of the Week

The Terry's Tips options newsletter features an options trading strategy that never loses money (based on a 10-year backtest which showed only 3 months with minimal losses out of 120 expiration months). However, we can't mathematically prove that this strategy will always turn at least a small profit each month (we feel more comfortable about making the claim when an entire year is used as the time frame).

There are several options trading strategies which are mathematically guaranteed to always turn a profit. When I was a market maker trading on the floor of the CBOE, much of my time was taken up in an effort to establish positions that always made money, no matter where the stock price went.

The most popular technique was called a reversal. It was especially successful when most investors where in a pessimistic mood and the prices for put options grew larger than the prices for call options. It is a fairly common occurrence.

Let's say that the stock price for XYZ (a non-dividend paying company) is $80, and a two-month put at the 80 strike can be sold for $4.50 while a two-month 80-strike call can be purchased for $4.00. If you search option prices, you can invariably find options on some companies with option prices similar to these.

With the reversal strategy you don't care whether the company has great potential or is a real dog - you will make money no matter which way the stock goes. Any company will do.

If you sell 100 shares of XYZ short, collecting $8000, sell an 80 put for $450 and buy an 80 call for $400, you have created what is called a reversal, and you will make a $50 profit, guaranteed (of course, commissions would cut into this somewhat). Your eventual gain is much larger than $50, however. For the term of your investment, you will collect interest on the $8000 cash in your account.

If the stock goes to $90, at expiration you would have lost $1000 on your short stock but you would be able to sell your 80 call for exactly $1000, offsetting the loss (the put would expire worthless, of course). If the stock were to fall to $60, you would gain $2000 from your short stock but would have to buy back the short put for $2000 (and your call would expire worthless). Either way, there is no loss no matter what the stock price does.

If you are trading on the floor, you enjoy several advantages that make reversals a viable strategy. First, you can often sell at the asked price and buy at the bid (after all, you are making the market for the options). This makes it much easier to sell a put for more than the same-strike call you buy. Second, your commission costs are negligible compared to what you would pay if your broker made the trades for you. And third, most importantly, since you have created a risk-free position, your clearing house will extend virtually unlimited credit to you.

When I was a market maker, there were times I was collecting interest on several million dollars of short stock while not having one penny of my own money at risk. It is no wonder that a seat on the CBOE sells for astronomical sums.

A similar strategy (called a conversion) involves buying stock, buying puts, and selling calls. In order for this to work, the time premium of the calls has to be greater than the cost of the puts as well as high enough to cover the interest on the long stock for the time period involved.

Reversals and conversions, while excellent plays for market makers, are difficult to establish from off the floor. Consequently, they are not practical alternatives for most investors.

A more realistic alternative for ordinary investors would be to carry out the 10K Strategy as featured at Terry's Tips. While this strategy can't be mathematically proven to never lose money, a 10-year backtest (the details of which we share with subscribers) shows that no losses resulted over any 12-month time period, and that average annual gains in the neighborhood of 32% would have been made.

With this strategy, initial positions are set up that will result in a profit if the stock moves moderately in either direction. Once the stock has moved about 5% in either direction, an adjustment is made that will expand the break-even range in the direction that the stock has moved.

An important part of the 10K Strategy is the setting aside of cash in case one of these adjustments becomes necessary. This spare cash means that portfolio protection can be kept in place in case the stock turns around and moves in the other direction. If the stock continues to move in the same direction as it did originally, as second adjustment might be necessary to once again establish positions that will not lose money. In those months when a second adjustment becomes necessary, little or no gain can be expected.

These adjustments cannot be set in place at the outset of the month because no one knows which way the stock might move. Depending on exactly what time of the expiration month, the more-than-moderate stock price move takes place, different adjustments might be called for. These adjustments add an "act of faith" dimension to the 10K Strategy that makes it impossible to mathematically prove that it will never lose value.

Until the strategy has stood the test of time we will have to depend on the 10-year backtest as "proof" that it actually works in the real world as we believe it should. We think the descriptive phrase "a strategy that never loses" has a nice ring to it. Do you?

Conservative Options Strategy

Mighty Stalagmite - a Conservative Options Strategy That Doesn't Lose Money

The Mighty Stalagmite - A Conservative Options Strategy That Doesn't Lose Money

Is a "Doesn't Lose" Strategy Possible? Some people would argue that a truly efficient options market would theoretically not allow a totally risk-free strategy to exist for very long. Yet an option mechanism called a collar can be established that does guarantee no loss, and it is used fairly commonly as a hedging device by sophisticated investment banks. However, it is a little unusual to come up with a strategy that "guarantees" no loss but also allows for the possibility of a gain when the market behaves as we wish.

A 10-year backtest of the Mighty Stalagmite (underlying stock - SPY, the tracking stock of the S&P 500) showed that about one month out of three, an adjustment would have to be made because the stock had moved 8% in one direction or another - we expect there would be no profit or loss for the portfolio in those month.

The backtest showed that in the other 2 out of 3 months, an average monthly profit of about 4% would result. If these figures hold true, the portfolio would earn 32% each year with never a losing month.

I cannot offer a guarantee that the portfolio will never lose money. The risk profile graph we published last week clearly shows that if the S&P 500 falls by 10% in a single day, a loss situation will be faced. A stock price drop of that magnitude has occurred only once (9/11/01) in the past 10 years. But as one great sage noted, there is never only one cockroach. So we have to be prepared to handle these rare events.

After the 9/11 disaster, the strategy would have recovered nicely in the subsequent month, and a loss would have been avoided for the two-month period. Since I can't guarantee that two 9/11-type events would not occur in subsequent months, or the market did not quickly recover some of the loss in a subsequent month, I can't make the guarantee. But I believe that the odds are overwhelming that a loss will never result for even a two or three-month period. If the money is invested for an entire year, the odds should be dramatically higher that a gain will result instead of a loss.

A Complicated Strategy: The Mighty Stalagmite is not for the do-it-yourselfer subscriber. We cannot to offer up-front Trading Rules. While we can explain the general decision rules when placing the initial trades, the problem comes in the details of the adjustment trades. Depending on how much time has elapsed before the stock moved enough to trigger an adjustment, the solution may differ.

So the bottom line is that we firmly believe that we have created an options strategy that never loses money if it is carried out for a year. Such a claim is not possible for even the most conservative mutual or bond fund. They often lose money. Contrast that record with the Mighty Stalagmite which could handle a market (S&P 500) that dropped up to 5% every month of the year and the portfolio would still make a gain for the year.

I invite you to become a Terry's Tips subscriber and learn the full details about the Mighty Stalagmite, the option strategy that doesn't lose money. You can sign up here. It could be the best investment you make this summer.

Happy trading.

Terry

Stock Options Trading

Last week we gave you a brief description of a traditional butterfly spread. This week we will show a modified butterfly where the short positions are not in the middle and the ratio of long-short-long is not the typical 1-2-1 but 1-3-2. With SPY trading at $127, this is how a modified butterfly would perform in five weeks:



Note that this spread makes more money ever dollar the stock falls below it's present level of $127. It provides increasing protection against loss all the way down to $115 (which would be a drop in the stock price that has happened only 5 times including 9/11 in the last 100 months). If the stock were to go up, this spread would lose money, but that loss would be covered by the higher-strike call calendar spreads that are in place (out basic 10K Strategy).

On July 10, 2008, we set up a new portfolio where the above spread was combined with calendar call spreads at strike prices which were near and above the current stock price. Here is what the risk profile graph looked like with all those positions in place:



We call this new portfolio the Mighty Stalagmite. We believe it is a portfolio that will essentially never lose money, no matter what the market does. In the above graph, you can see that a profit approximating 10% will result (the portfolio value is $10,000) if SPY were to land anywhere between $115 and $133 in five weeks. On July 10, SPY was about $125 so it could fall by $10 or go up by $9 and we would still make that amount.

Part of our strategy is to hold some cash in reserve so that if the stock moves by $7 in either direction, a new modified butterfly spread can be bought that will expand the break-even range so that a loss is averted. When this second spread has to be placed, it is doubtful that the portfolio would gain money in that month, but it should at least break even.

Back-Testing the Mighty Stalagmite: I checked out how these positions might sugar off based on how much that SPY fluctuated each expiration month for the past 100 months (8 1/3 years). It was not a simple task because it involved more than merely checking the fluctuation for a month and seeing what the gain or loss would be on the risk profile graph. Instead, I had to calculate the maximum fluctuation for the month (both up and down) to see if it moved more than $7 so that a mid-month adjustment trade would be triggered.

The results were interesting. Two-thirds of the time, no adjusting trade would be required, and a portfolio gain would be achieved. One third of the time, an adjusting trade would be required, and this happened about equally between upward and downward moves (I had expected there would be more big moves on the downside). Presumably, we would not make a gain in those months but a loss would be avoided.

For one period of time during the back-test (ending with the December 2008 expiration), the proposed configuration of the Mighty Stalagmite would have made a gain in 60 consecutive months.

In one month, the stock deviated from its starting price by a $7 move in both directions, and two adjustments would have been required (the second one would have involved taking off one of the calendars to come up with the cash to do it), and a small loss would probably have been experienced for that month. But that was only one month out of 100.

The greatest change in a single month was $16.70 (in 9/11). On the day that trading was resumed, the stock moved up $4, and two months later it was higher than it was before the tragic event. Only 2 times out of 100 did the stock fall by over $12 in a single month. In each of these circumstances, a butterfly spread that extended the no-loss range by $5 would have covered the unusually large fluctuation.

Next week will expand our discussion to ask if it is a realistic possibility that we have come up with an options portfolio that doesn't lose money no matter what the market does (and may make as much as 10% in a single month if the market only changes moderately up or down).

I hope you are interested enough it this possibility that you would consider coming on board as a Terry's Tips Insider and watching the Mighty Stalagmite unfold in real time (it is one of our 15 actual portfolios).

You can sign up at http://www.terrystips.com/order.php, It could be the best investment you ever made.

Terry