An Options Strategy That Can Deal With High Volatility

The New York Times published an article last week which showed how market volatility was greater than any time in history, and that there were many indications that such high volatility had now become the norm.

Some people call the current market activity a “wolf” market – neither a bear market nor a bull market, but one characterized by high short-term volatility, big swings in both directions, while the general market is not really charging higher or falling lower.

We have developed an options strategy to contend with a wolf market, and I would like to tell you a little about it today.

An Options Strategy That Can Deal With High Volatility

We call it the 10K Wolf portfolio.  It was started a little over a week ago with $10,000.  The portfolio consists of buying in-the-money SPY LEAPS that expire in June 2012.  We bought puts that had a strike price of 125 and calls that had a strike price of 115.

The advantage to buying long-term in-the-money puts and calls is that much of their value is intrinsic.  The time premium component is relatively small, and these options decay quite slowly, especially in the early months (before they have only 3 or 4 months of remaining life, when we would most likely sell them and replace them with longer-term puts and calls).

The total cost of each pair of LEAPS cost about $2800.  As long as SPY trades within the range of $115 – $125 (and we are not short any in-the-money options which we are careful to make sure of), the minimum value of the pair of LEAPS will be at least $1000. (Actually, if the stock moves outside that range, the total value of the put and call LEAPS would be greater than $1000).

That leaves $1800 of time premium that will decay over the 9 months of remaining life.  We will need to sell $200 worth of Weekly puts and calls each month to cover the decay of the LEAPS.

With today’s high option prices (they are high because volatility is high), we are able to sell out-of-the-money Weekly puts and calls that generate more than $200 in premium income each week.  If they remain out-of-the-money, they will expire worthless in a week and we can sell the next week’s out-of-the-money puts and calls, presumably collecting another $200 per pair of LEAPS that own).

You can see that we can sell enough premium each week to cover the decay that our long positions will suffer each month.  The other three weeks of option selling should be pure profit. The gains that we expect are really a little better than this example because in the early months, the pair of LEAPS will decay less than the $200 average that it will decay over the entire 9-month period.  In the later months when they will be decaying at more than $200, we would no longer own them.

Adjustments often need to be made during the week if the stock moves more than moderately in either direction.  Last week, SPY moved almost $5 higher.  We had to buy back short calls that had become in the money (the strike price was lower than the stock price) and replace them with higher-strike short calls.  Each of these trades meant that we had to shell out money, but at the same time, we bought back inexpensive well-out-of-the-money puts and replaced them with more costly higher-strike Weekly puts at a credit of approximately the same as rolling up the calls cost us.

Last week, in its first full week of operation, in spite of the volatility (the 10K Strategy does best in flat markets), the 10K Wolf gained 7.4% (after commissions, of course).  Some people would be happy with that kind of return for an entire year in today’s investment world.

Here is the risk profile graph for this portfolio for next week:

The break-even range is about $3 in either direction from the current SPY price of $121.52, assuming no adjustments are made. We would make about 7% in an absolutely flat market, or about 6% if SPY were to fluctuate less than $2 in either direction. Price changes higher than $2 would require that an adjustment be made, so it is not clear what the profit or loss might be.

Obviously, carrying out the 10K Wolf strategy takes a lot of work. Rather than doing it yourself, we think a better idea would be to become a Terry’s Tips Insider, sign up for the Auto-Trade program at thinkorswim and let them make all the trades that we make in this portfolio in your own account for you, so you will enjoy exactly the same results as our portfolio. You can read about your gains, and smile, when we send out the Saturday Report each week, or whenever you check up on your trading account.