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5 Option Strategies if you Think the Market is Headed Lower

Saturday, June 27th, 2015

A subscriber wrote in and asked what he should do if he thought the market would be 6% lower by the end of September.  I thought about his question a little bit, and decided to share my thoughts with you, just in case you have similar feelings at some time along the way.Terry

5 Option Strategies if you Think the Market is Headed Lower

We will use the S&P 500 tracking stock, SPY, as a proxy for the market.  As I write this, SPY is trading just below $210.  If it were to fall by 6% by the end of September (3 months from now), it would be trading about $197 at that time.  The prices for the possible investments listed below are slightly more costly than the mid-point between the bid and ask prices for the options or the option spreads, and include the commission cost (calculated at $1.25 per contract, the price that Terry’s Tips subscribers pay at thinkorswim).

#1.  Buy an at-the-money put.  One of the most common option purchases is the outright buy of a put option if you feel strongly that the market is crashing.  Today, with SPY trading at $210, a September 2015 put option at the 210 strike would cost you $550.  If SPY is trading at $197 (as the subscriber believed it would be at the end of September), your put would be worth $1300.  You would make a profit of $750, or 136% on your investment.

Buying a put involves an extremely high degree of risk, however. The stock must fall by $5 ½ (about 2.6%) before you make a nickel of profit.  If the market remains flat or goes higher by any amount, you would lose 100% of your investment.  Studies have shown that about 80% of all options eventually expire worthless, so by historical measures, there is a very high likelihood that you will lose everything.  That doesn’t sound like much of a good investment idea to me, even if you feel strongly about the market’s direction.  It is so easy to get it wrong (I know from frequent personal experience).

If you were to buy an out-of-the-money put (i.e., the strike price is below the stock price), the outlook is even worse.  A Sept-15 205 put would cost about $400 to buy.  While that is less than the $550 you would have to shell out for the at-the-money 210 put, the market still has to fall by a considerable amount, $9 (4.3%) before you make a nickel.  In my opinion, you shouldn’t even consider it.

#2.  Buy an in-the-money put.  You might consider buying a put which has a higher strike than the stock price.  While it will cost more (increasing your potential loss if the market goes up), the stock does not need to fall nearly as far before you get into a profit zone.  A Sept-15 215 put would cost you $800, and the stock would only have to fall by $3 (1.4%) before you could start counting some gains.  If the market remains flat, your loss would be $300 (38%).

If the stock does manage to fall to $197, your 215 put would be worth $1800 at expiration, and your gain would be $1000, or 125% on your investment.  In my opinion, buying an in-the-money put is not a good investment idea, either, although it is probably better than buying an at-the-money put, and should only be considered if you are strongly convinced that the stock is headed significantly lower.

#3.  Buy a vertical put spread.  The most popular directional option spread choice is probably a vertical spread.  If you believe the market is headed lower, you buy a put and at the same time, sell a lower-strike put as part of a spread.  You only have to come up with the difference between the cost of the put you buy and what you receive from selling a lower-strike put to someone else.  In our SPY example, you might buy a Sept-15 210 put and sell a Sept-15 200 put.  You would have to pay $300 for this spread.  The stock would only have to fall by $3 before you started collecting a profit.  If it closed at any price below $200, your spread would have an intrinsic value of $1000 and you would make a profit of $700 (230% on your investment), less commissions.

With this spread, however, if the stock remains flat or rises by any amount, you would lose your entire $300 investment.  That is a big cost for being wrong.  But if you believe that the market will fall by 6%, maybe a flat or higher price isn’t in your perceived realm of possible outcomes.

Another (more conservative) vertical put spread would be to buy an in-the-money put and sell an at-the-money put. If you bought a Sept-15 220 put and sold a Sept-15 210 put, your cost would be $600.  If the stock closed at any price below $210, your spread would be worth $1000 and your gain ($400) would work out to be about 64% after commissions. The neat thing about this spread is that if the stock remained flat at $210, you would still gain the 64%.  If there is an equal chance that a stock will go up, go down, or stay flat, you would have two out of the three possible outcomes covered.

You also might think about compromising between the above two vertical put spreads and buy a Sept-15 215 put and sell a Sept-15 205 put.  It would cost you about $420.  Your maximum gain, if the stock ended up at any price below $205, would be $580, or about 135% on your investment.  If the stock remains flat at $210, your spread would be worth $500 at expiration, and you would make a small gain over your cost of $420.  You would only lose money if the stock were to rise by more than $.80 over the time period.

#4.  Sell a call credit vertical spread.  People with a limited understanding of options (which includes a huge majority of American investors) don’t even think about calls when they believe that the market is headed lower.  However, you can gain all the advantages of the above put vertical spreads, and more, by trading calls instead of puts if you want to gain when the market falls.  When I want to make a directional bet on a lower market, I always use calls rather than puts.

If you would like to replicate the risk-reward numbers of the above compromise vertical put spread, you would buy a Sept-15 215 call and sell a Sept-15 205 call. The higher-strike call that you are buying is much cheaper than the lower-strike call you are selling.  You could collect $600 for the spread.  The broker would place a $1000 maintenance agreement (no interest charge) on your account (this represents the maximum possible loss on the spread if you had not received any credit when placing it, but in our case, you collected $600 so the maximum possible loss is $400 – that is how much you will have to have in your account to sell this spread).  Usually, buying a vertical put spread or selling the same strikes with a credit call vertical spread cost about the same – in this case, the call spread happened to be a better price (an investment of $400 rather than $420).

There are two advantages to selling the call credit spread rather than buying the vertical put spread.  First, if you are successful and the stock ends up below $205 as you expect, both the long and short calls will expire worthless.  There will be no commission to pay on closing out the positions. You don’t have to do anything other than wait a day for the maintenance requirement to disappear and you get to keep the cash you collected when you sold the spread at the outset.

Second, when you try to sell the vertical put spread for $10 (the intrinsic value if the stock is $205 or lower), you will not be able to get the entire $10 because of the bid-ask price situation.  The best you could expect to get is about $9.95 ($995) as a limit order.  You could do nothing and let the broker close it out for you – in that case you would get exactly $1000, but most brokers charge a $35 or higher fee for an automatic closing spread transaction.  It is usually better to accept the $995 and pay the commission (although it is better to use calls and avoid the commissions altogether).

#5.  Buy a calendar spread.  My favorite spreads are calendar spreads so I feel compelled to include them as one of the possibilities. If you think the market is headed lower, all you need to do is buy a calendar spread at a strike price where you think the stock will end up when the short options expire. In our example, the subscriber believed that the stock would fall to $197 when the September options expired.  He could buy an Oct-15 – Sept-15 197 calendar spread (the risk-reward is identical whether you use puts or calls, but I prefer to use calls if you think the market is headed lower because you are closing out an out-of-the-money option which usually has a lower bid-ask range).  The cost of this spread would be about $60.  Here is the risk profile graph which shows the loss or gain from the spread at the various possible stock prices:

Bearish SPY Risk Profile Graph June 2015

Bearish SPY Risk Profile Graph June 2015

You can see that if you are exactly right and the stock ends up at $197, your gain would be about $320, or over 500% on your investment (by the way, I don’t expect the stock will fall this low, but I just went into the market to see if I could get the spread for $60 or better, and my order executed at $57).

What I like about the calendar spread is that the break-even range is a whopping $20.  You can be wrong about your price estimate by almost $10 in either direction and you would make a profit with the spread.  The closer you can guess to where the stock will end up, the greater your potential gain.  Now that I have actually bought a calendar spread at the 197 strike, I will buy another calendar spread at a higher strike so that I have more upside protection (and be more in line with my thinking as to the likely stock price come September).

There are indeed an infinite number of option investments you could make if you have a feeling for which way the market is headed.  We have listed 5 of the more popular strategies if someone believes the market is headed lower.  In future newsletters we will discuss more complicated alternatives such as butterfly spreads and iron condors.

How to Make 80% a Year With Long-Term Option Bets

Thursday, May 28th, 2015

One of my favorite options plays is a long-term bet that a particular stock will be equal to or higher than it is today at some future date.  Right now might be a perfect time to make that kind of a bet with one of my favorite stocks, Apple (AAPL).Each January, I pick several stocks I feel really positive about and buy a spread that will make an extraordinary gain if the stock is flat or any higher when the options expire one year out.  Today I would like to tell you about one of these spreads we placed in one of the Terry’s Tips portfolios we carry out, and how you can place a similar spread right now.  If AAPL is only slightly higher than it is today a year from now, you would make 100% on your investment.

Terry

How to Make 80% a Year With Long-Term Option Bets

I totally understand that it may seem preposterous to think that over the long run, 80% a year is a possible expectation to have for a stock market investment.  But if the AAPL fluctuates in the future as it has in the past, it will absolutely come about. It can be done with a simple option spread that can be placed right now, and you don’t have to do anything else but wait out a year. If the stock is any higher at the end of the year, the options expire worthless and you don’t even have to close out the spread.  You just get to keep the money you got at the beginning.

Let’s check out the 10-year chart for Apple:

10 Year Apple Chart May 2015

10 Year Apple Chart May 2015

In 9 of the last 10 years, AAPL has been higher at the end of the calendar year than it was at the beginning.  Only in the market-meltdown of 2008-2009 was the stock at a lower price at the end of the year than it was at the beginning.

In January of this year, in one of our Terry’s Tips portfolios, we placed the following trade when AAPL was trading at $112.  We felt confident that the stock would be at least a little higher a year from then.  The precise date would be January 15, 2016, the third Friday of the month when monthly options expire.  This is the trade we made:

Buy To Open 7 AAPL Jan-16 105 puts (AAPL160115P105)
Sell To Open 7 AAPL Jan-16 115 puts (AAPL160115P115) for a credit of $5.25 (selling a vertical)

For each spread, we collected $525 less $2.50 in commissions, or $522.50.  For 7 spreads, we collected $3657.50 after commissions.  The amount at risk per spread was $1000 – $522.50, or $477.50.  For all 7, that worked out to $3342.50.

The proceeds from selling the spread, $3657.50, was placed in our account when the sale was made.  The broker placed a maintenance requirement on us for $7000 (the maximum we could lose if the stock ended up below $105 at expiration.  Our actual risk if this happened would be $7000 less the $3657.50 we received, or $3342.50.  If AAPL ends up at any price above $115 on January 15, 2016, both options will expire worthless and we will make a gain of 109% on our investment.

Since we placed that spread, AAPL has moved up nicely, and it is now at $132.  If you did not want to wait another six months to collect the 109%, you could buy back the spread today for $2.67 ($269.50 per spread after commissions).  Buying back all 7 spreads would cost $1886.50, resulting in a profit of $1771.  This works out to be a 53% gain for the 4 months.  We are waiting it out rather than taking a gain right now, knowing that 109% will come our way even if the stock falls about $17 from here.

AAPL might not be headed to $240 as Carl Ichan (net worth, $23 billion) believes it is, but it seems likely that it might be higher a year from now than it is today.  Options for June, 2016 have just become available for trading.  As I write this today, AAPL is trading at $132.  If you were willing to bet that over the next 12 months, the stock might edge up by $3 or more, you could sell the following spread (in my personal account, I made this exact trade today):

Buy To Open (pick a number) AAPL Jun-16 125 puts (AAPL160617P125)
Sell To Open ((pick a number) AAPL Jun-16 135 puts (AAPL160617P135) for a credit of $5.10  (selling a vertical)

Each contract will cost you about $500 to place, after commissions. This spread will make a 100% profit after commissions if AAPL ends up at any price above $135 on June 17, 2016.

You might wonder why the title of this blog mentioned 80% as a long-term annual gain possibility.  If AAPL behaves in the next 10 years as it has in the last 10 years, and makes a gain in 9 of those years, over the course of a decade, you would gain 100% in 9 years and lose 100% (although the actual loss might be less) in one year, for an average gain of 80% a year.

For sure, you would not want to place all, or even a large part, of your investment portfolio in long-term spreads like this.  But it seems to me that a small amount, something that you can afford to lose, is something that you might consider, if only for the fun of doubling your money in a single year.

How to Make Gains in a Down Market With Calendar Spreads

Thursday, May 14th, 2015

This week I came to the conclusion that the market may be in for some trouble over the next few months (or longer).  I am not expecting a crash of any sort, but I think it is highly unlikely that we will see a large upward move anytime soon.

Today, I would like to share my thinking on the market’s direction, and talk a little about how you can use calendar spreads to benefit when the market (for most stocks) doesn’t do much of anything (or goes down moderately).

Terry

How to Make Gains in a Down Market With Calendar Spreads

For several reasons, the bull market we have enjoyed for the last few years seems to be petering out.  First, as Janet Yellen and Robert Shiller, and others, have recently pointed out, the S&P 500 average has a higher P/E, 20.7 now, compared to 19.5 a year ago, or compared to the 16.3 very-long-term average.  An elevated P/E can be expected in a world of zero interest rates, but we all know that world will soon change.  The question is not “if” rates will rise, but “when.”

Second, market tops and bottoms are usually marked by triple-digit moves in the averages, one day up and the next day down, exactly the pattern we have seen for the past few weeks.

Third, it is May.  “Sell in May” is almost a hackneyed mantra by now (and not always the right thing to do), but the advice is soundly supported by the historical patterns.

The market might not tank in the near future, but it seems to me that a big increase is unlikely during this period when we are waiting for the Fed to act.

At Terry’s Tips, we most always create positions that do best if the market is flat or rises moderately.  Based on the above thoughts, we plan to take a different tack for a while.  We will continue to do well if it remains flat, but we will do better with a moderate drop than we would a moderate rise.

As much as you would like to try, it is impossible to create option positions that make gains no matter what the underlying stock does.  The options market is too efficient for such a dream to be possible.  But you can stack the odds dramatically in your favor.

If you want to protect against a down market using calendar spreads, all you have to do is buy spreads which have a lower strike price than the underlying stock.  When the short-term options you have sold expire, the maximum gain comes when the stock is very close to the strike price.  If that strike price is lower than the current price of the stock, that big gain comes after the stock has fallen to that strike price.

If you bought a calendar spread at the market (strike price same as the stock price), you would do best if the underlying stock or ETF remained absolutely flat.  You can reduce your risk a bit by buying another spread or two at different strikes.  That gives you more than one spot where the big gain comes.

At Terry’s Tips, now that we believe the market is more likely to head lower than it is to rise in the near future, we will own at-the-money calendar spreads, and others which are at lower strike prices.  It is possible to create a selection of spreads which will make a gain if the market is flat, rises just a little bit, or falls by more than a little bit, but not a huge amount.  Fortunately, there is software that lets you see in advance the gains or losses that will come at various stock prices with the calendar spreads you select (it’s free at thinkorswim and available at other brokers as well, although I have never seen anything as good as thinkorswim offers).

Owning a well-constructed array of stock option positions, especially calendar spreads, allows you to take profits even when the underlying stock doesn’t move higher.  Just select some spreads which are at strikes below the current stock price.  (It doesn’t matter if you use puts or calls, as counter-intuitive as that seems – with calendar spreads, it is the strike price, not whether you use puts or calls, that determines your gains or losses.)

Why Calendar Spreads Are So Much Better Than Buying Stock

Wednesday, April 22nd, 2015

One of the great mysteries in the investment world (at least to me, an admitted options nut) is why anyone would buy stock in a company they really like when they could dramatically increase their expected returns with a simple stock options strategy instead.  Of course, buying options is a little more complicated and takes a little extra work, but if you could make two or three times (or more) on your investment, wouldn’t that little extra effort be more than worth it?  Apparently not, since most people take the lazy way out and just buy the stock.Today I will try to persuade you to give stock options a try.  I will show you exactly what I am doing in one of my Terry’s Tips portfolios while trading one of my favorite stocks.

Terry

Why Calendar Spreads Are So Much Better Than Buying Stock

I like just about everything about Costco.  I like to shop there.  I buy wine by the case, paying far less than my local wine store (I am not alone – Costco is the largest retailer of wine in the world, selling several billions of dollars’ worth every year).  I like Costco because they treat their employees well, paying them about double what Walmart pays its people.  I like shopping at Costco because I know I am never paying more than I should for anything I buy.  It seems to me that the other customers like it, too.  Everyone seems to be happy while roaming the aisles and enjoying the free samples they offer (I have a skinflint friend who shops at Costco once a week just for the samples – they are his lunch that day).

But most of all, I like the stock (COST).  It has been very nice to me over the years, and I have consistently made a far greater return using options than I would have if I had just gone out and bought the stock.

I recently set up an actual brokerage account to trade COST options for the educational benefit of Terry’s Tips paying subscribers.  I put $5000 in the account.  Today, it is worth $6800.  I started out buying calendar spreads, some at at-the-money strike prices and others at higher strike prices (using calls).  I currently own October 2015 calls at the 145 and 150 strike prices (the stock is trading about $146.50), and I am short (having sold to someone else) May-15 calls at the 145, 147, and 150 strike prices.  These calls will expire in 23 days, on May 15, 2015.  (Technically, the 147 calls I am short are with a diagonal spread rather than a calendar spread because the long side is at the 145 strike.  With calendar spreads, the long and short sides are at the same strike price.)

Here is the risk profile graph for my positions.  It shows how much money I will make (or lose) at the various possible prices where COST might be on May 15th when the short options expire:

COST Risk Profile Graph April 2015

COST Risk Profile Graph April 2015

In the lower right-hand corner, the P/L Day number shows the expected gain or loss if the stock stays flat ($148.54), or is $3 higher, or lower, than the current price.  If the stock stays absolutely flat, I should make about $976, or about 14% on the $6800 I have invested.

I could have bought 46 shares of the stock with $6800 instead of owning these options.   If the stock doesn’t go up any in the next 23 days, I would not gain a penny.  But the options will make a profit of about $976.

If the stock falls $2 by May 15, I would lose $92 with my stock investment, and my options would make a gain of $19. I am still better off owning the options.  Only if the stock falls more than $2 ½ dollars over those three weeks would I be worse off with the options positions.  But I like this stock.  I think it is headed higher.  That’s why I bought COST in the first place.

If I am right, and the stock goes up by $3, I would make $138 if I owned 46 shares of the stock, or I would make $1,700 with my options positions.  That’s more than 10 times as much as I would make by owning the stock.

Can you understand why I am confused why anyone would buy stock rather than trading the options when they find a stock they really like?  It just doesn’t make any sense to me.

Of course, when the options I have sold are set to expire in 23 days, I need to do something.  I will need to buy back the options that are in the money (at a strike which is lower than the stock price), and sell new options (collecting even more money) in a further-out month, presumably June.  The lazy guys who just bought the stock instead of owning stock are lucky in this regard – they don’t have to do anything.  But if the stock had stayed flat or risen moderately over those three weeks, I know that I am way ahead of the stock-owners every time.

While stock owners sit around and do nothing, my job on May 15 will be to roll over the short calls to the next month (and use the cash that is generated to buy new spreads to increase future returns even more).  I show my subscribers exactly what and how to make those trades each month (in both the COST portfolio and 9 other portfolios which use different underlying stocks).  Hopefully, eventually, they won’t need me any longer, but they will have discovered how to use stock options to dramatically increase their investment returns on their own.

Update on Oil Play Designed to Make 25% in One Month

Friday, April 3rd, 2015

About a month ago I sent out a strategy we were using to capitalize on the price of oil falling further (as many analysts, including those at Goldman, Citi, and Barclays, were predicting).  We set up a small demonstration portfolio which had $2910 to start, and bought calendar spreads at the 18, 17, and 16 strikes when USO was trading at $18.45.When the price of oil did retreat further, USO fell to about $17, and we sold our calendar spreads at the 17 and 18 strikes and replaced them with calendar spreads at the 15 and 14 strikes.  Since the strike prices of calendar spreads is what determines whether you are bullish or bearish on the stock, when we had all our calendar spreads at strikes below the stock price, we were extremely bearish.

Then the stock turned around and headed higher, taking away the gains we had made, and we were right back to where we started.  Today we made a new start, and I would like to share our thinking at this time.

Terry

Update on Oil Play Designed to Make 25% in One Month

USO is an Exchange Traded Product (ETP) which is highly correlated to the price of oil (West Texas Intermediate). But there is another component that is not as easy to contend with, and that is the speculative element.  Oil prices are less than half of what they were a year ago, and in spite of most of the big investment banks warning that even lower prices are coming, there seems to be some people out there who are betting that oil prices will eventually recover, and this may be a good time to get on board.  For example, Robert Shiller, Nobel laureate and Yale University economist  made a strong pitch to “buy oil” this week.  Consequently, over the past few days, USO has inched up a bit in spite of these recent developments:

• The supply of oil is at an 80-year high, and grew at more than 4 million barrels last week in spite of expectations far less than that.
• The rate of oil rigs closing down has fallen drastically (and it appears that the rigs that have been closed down so far were the lowest-producing ones so the supply of oil gets higher each week)
• There appears to be an accord with Iran which could flood the market with new oil from Iran if sanctions are removed.

We are siding with the investment banks’ predictions instead of Mr. Shiller’s (who is likely to be thinking longer-term). While we believe the short-term price of USO is headed lower (for the above reasons and the headwinds caused by contango), we hedged our bet a little, and established new positions in our demonstration portfolio.  We own puts expiring in Jan-16 and we have sold Apr-4 15 puts which expire in 3 weeks (on April 24th).  We have 8 calendar spreads at the 15 strike, 8 at the 16 strike, and 5 at the 17 strike at a time when the stock is trading at $17.45.  Our portfolio is worth $2910 today.

This is the risk profile graph for these calendar spread positions for April 24th:

USO Risk Profile Graph April 2015

USO Risk Profile Graph April 2015

The graph shows that if USO doesn’t change one cent in value for the next three weeks, we will make about 20% with our positions.  If it falls by about a dollar (or more) as we expect, we could make double that amount.  If we are wrong, and it goes higher by a dollar in three weeks, we will break even.

We like our chances with these positions, and they demonstrate how you can make extraordinary gains with options, even if you are not quite right in guessing which way a stock price is headed.  I always like the feeling that if the stock doesn’t change at all (which is so often the case), I will still make a nice gain when the short options expire.

An Oil Play Designed to Make 25% in One Month

Tuesday, March 3rd, 2015

Bernie Madoff attracted billions of dollars because he said he had a system that would generate gains of 12% a year.  For many investors, 12% must seem like a pretty good return.  Options investors think differently.  They prefer to have at least some of their investment capital in something that could conceivably make a far greater return.Today I would like to discuss an investment I made this week in a demonstration (actual money on the line) portfolio for Terry’s Tips Insiders.  It is designed to make about 25% in the next four weeks.

Terry

An Oil Play Designed to Make 25% in One Month

One of our favorite underlyings these days is USO, an ETP (Exchange Traded Product) which closely tracks the price of oil.  If you have filled your car with gas lately, you know that the price of oil must have been trading lower over the recent past.  In fact, it has.  A barrel of oil has fallen from about $100 to $50, while USO has dropped from about $40 to about $18.

There are a couple of reasons to believe that the downward trend of USO might continue for a while longer.  First, the way this ETP is designed, it suffers from contango (futures prices for further-out months are higher than the spot price of oil).  At the current level of contango, if the price of oil remains the same, USO should lose about 21% of its value over the course of a year due to the influence of contango.

Second, some large investment banks (e.g., Citi) have come out and said that the price of oil is likely to fall in half once again before the current glut is eliminated and oil might start recovering in the third quarter.

With these two reasons suggesting that oil (and USO) might be headed lower, at least  for the next month or so, we looked back at every calendar monthly change in USO for the recent past, and we learned that in the last 25 months, on only two occasions did USO fall by more than 15% in a single month, and only once did it rise by more than 5.6%.

If this historical pattern continues for the next month, the portfolio we set up has an 88% chance of making a gain, and the average gain over most of the possible stock prices is over 25%.

Here are the calendar spreads we placed in a portfolio that could be set up for no more than $2900 at today’s prices with USO trading about $18.45:

Buy to Open 8 USO Jan-16 16 puts (USO160115P16)
Sell to Open 8 USO Mar4-15 16 puts (USO150327P16) for a debit of $1.26  (buying a calendar)

Buy to Open 8 USO Jan-16 17 puts (USO160115P17)
Sell to Open 8 USO Mar4-15 17 puts (USO150327P17) for a debit of $1.42  (buying a calendar)

Buy to Open 4 USO Jan-16 18 puts (USO160115P18)
Sell to Open 4 USO Mar4-15 18 puts (USO150327P18) for a debit of $1.58  (buying a calendar)

Here is the risk profile graph for these spreads for March 27th when the short puts expire:

USO Risk Profile Graph March 2015

USO Risk Profile Graph March 2015

The vertical red lines on the graph are set at -15% on the downside and +5% on the upside, and roughly indicate the break-even range for the positions.  Over the past 25 months, USO has fluctuated inside this range in 22 of the 25 months.  You can eyeball the potential gain and see that across a very large portion of the possible prices within this range, the indicated gain is close to $1000, or about 33% on your investment.

We like our chances with these positions.  It seems like a much higher chance of making double what Mr. Madoff was promising, and in only one month rather than a full year.  Option investors think differently than stock buyers.  I will report back on how well we do.

An Even Better Way to Play Oil With Options

Tuesday, February 10th, 2015

Yesterday I sent you a note describing an interesting way to make some serious money with options, betting that the price of oil will either stabilize or move higher from today’s low levels.  Thanks to subscriber Thomas, there is a better underlying out there.  Just in case you were planning to place the trades, I thought you should check this one out first.

Terry

An Even Better Way to Play Oil With Options

This is a re-write of yesterday’s letter, except the underlying is USO (another ETF) rather than OIH.  The chart for USO is remarkably similar to that of OIH:

The chart for USO is remarkably similar to that of OIH:

USO Historical Chart 2015

USO Historical Chart 2015

There is a distinct advantage to USO, however.  The options are far more liquid and bid-ask spreads are much smaller for USO.  In other words, you can get much better prices when you place orders or roll over your short positions to the next month.

USO closed at $19.60 Friday.  Here are the trades I plan to make today:

Buy 3 USO Jan-16 19 calls (USO160115C19)
Sell 3 USO Mar-15 19.5 calls (USO150320C19.5) for $1.45 (buying a diagonal)

Buy 1 USO Jan-16 19 call (USO160115C19) for $3.35
The spread order is priced at $.02 higher than the mid price between the bid and ask price for the spread, and the single call order is placed at $.05 higher than the mid price between the bid and ask.  You should be able to get those prices.

If you got those prices, your total investment would be $435 plus $335 plus $5 commission (Terry’s Tips commission rate at thinkorswim) for a total of $775.

This is the risk profile graph for these positions when the March calls expire on March 20:

USO Risk Profioe Graph 2015

USO Risk Profile Graph 2015

The graph shows that if the price of USO ends up in a range of being flat or moving higher by $3, the portfolio should gain at least $200, or about 25% for the six weeks of waiting.  The nice thing about owning options is that you can make this 25% even if the ETF doesn’t go up by a penny (in fact, if it actually is flat, your gain should be $327, or over 40%).  If you just bought USO instead of using options, you wouldn’t make anything if the ETF didn’t move higher.

Even better, if USO falls by a dollar, you still make a profit with the options positions.  If you owned the ETF instead, you would lose money, of course.

Owning an extra uncovered long Jan-16 19 call gives you upside protection in case USO moves dramatically higher.  It also leaves room to sell another short-term call if USO drifts lower instead of remaining flat or moving higher. Such a sale would serve to reduce or eliminate a loss if the ETF moves lower.

When the March calls expire, you would buy them back if they are in the money (i.e., the ETF is above $19.50) and you would sell Apr-15 calls at a strike slightly above the current ETF price.  You should be able to collect a time premium of about $100 for each call you sell.

There will be 10 opportunities to sell one-month-out calls for $100 before the Jan-16 calls expire. It is conceivable that you could collect $300 every month and get all your mney back in 3 months, and further  sales would be clear profit.  As long as the Jan-16 calls are in the money when they are about to expire, you would collect additional money from those sales as well.

This strategy involves making trades around the third Friday of each month when the short-term short options are about to expire.  That could be a pain in the neck, but to my way of thinking, it is a small price to pay for the possibility of doubling my money over the course of a year.  There is a variety of other option strategies you might employ, but this one makes good sense to me.

 

How to Play Oil Prices With Options

Sunday, February 8th, 2015

If you are anything like me, I have enjoyed filling up my car lately.  It almost seems too good to be true. How long do you think gas prices will stay this low?    I figure that the price is more likely to move higher from here than it is to move lower, but I could be wrong.  It seems like a prudent bet would be that it won’t move much lower from here, and that the price of oil is more likely to stay the same or move higher over the next year.  If either scenario (flat or up) is true, you can easily double your money using options.  Today I will show you one way that might be accomplished.

Terry

How to Play Oil Prices With Options

If you want to bet on higher oil prices, you might consider buying the ETF (Exchange Traded Fund) OIL.  This is simply a measure of the price of crude oil.  I don’t like to trade OIL, however, because the price is too low (under $12) to have meaningful option prices (and the options market is not very efficient which means it is hard to get decent prices because bid-ask ranges are too high).

An alternative ETF is OIH.  This covers the oil service companies, like drillers and transporters.  There is an extremely high correlation between the prices of OIL and OIH, and OIH has the advantage of having a higher absolute price ($35.50 at Friday’s close) and a more efficient options market (including weekly options and LEAPS).

Check out the chart for OIH for the last year:

OIH Historical Chart Feb 2015

OIH Historical Chart Feb 2015

If you had been smart (or lucky) enough to buy OIH when it rose above its 30-day moving average a year ago, you might have owned it while it rose from about $46 to about $55 when it fell below its 30-day moving average and then if you sold it short, you might make gains all the way down to $36 (you would have had to resist buying it back when it briefly moved above the moving average a few months ago).

Now OIH is well above this moving average and this might be a good time to make a bet that it will move higher going forward.  If you wanted to bet that the price of oil (and OIH) will remain flat or move higher, you might consider these trades (with OIH trading at $35.50):

Buy 3 OIH Jan-16 35 calls (OIH160115C35)
Sell 3 OIH Mar-15 36 calls (OIH150320C36) for $3.05 (buying a diagonal)

Buy 1 OIH Jan-16 35 call (OIH160115C35) for $4.45

These prices are at $.05 more than the mid-point between the bid and ask prices for the option or the spread.  You should be able to get those prices – be sure to enter it as a limit order because bid-ask ranges are a little high (although narrower than they are for OIL).

If you got those prices, your total investment would be $915 plus $445 plus $5 commission (Terry’s Tips commission rate at thinkorswim) for a total of $1365.

This is the risk profile graph for these positions when the March calls expire on March 20:

OIH Risk Profile Graph 2015

OIH Risk Profile Graph 2015

The graph shows that if the price of OIH ends up in a range of being flat or moving higher by $3, the portfolio should gain about $300, or about 20% for the six weeks of waiting.  The nice thing about owning options is that you can make this 20% even if the ETF doesn’t go up by a penny.  If you just bought OIH instead of using options, you wouldn’t make anything if the ETF didn’t move higher.

Even better, if OIH falls by a dollar, you still make a profit with the options positions.  If you owned the ETF instead, you would lose money, of course.

Owning an extra uncovered long Jan-16 35 call gives you upside protection in case OIH moves dramatically higher.  It also leaves room to sell another short-term call if OIH drifts lower instead of remaining flat or moving higher. Such a sale would serve to reduce or eliminate a loss if the ETF moves lower.

When the March calls expire, you would buy them back if they are in the money (i.e., the ETF is above $37) and you would sell Apr-15 calls at a strike slightly above the current ETF price.  You should be able to collect a time premium of about $100 for each call you sell.

There will be 10 opportunities to sell one-month-out calls for $100 before the Jan-16 calls expire.  Once you have collected $100 for each of 3 monthly calls you sell, you will have all your original investment back, and further  sales are clear profit.  As long as the Jan-16 calls are in the money when they are about to expire, you would collect additional money from those sales as well.

This strategy involves making trades around the third Friday of each month when the short-term short options are about to expire.  That could be a pain in the neck, but to my way of thinking, it is a small price to pay for the possibility of doubling my money over the course of a year.  There is a variety of other option strategies you might employ, but this one makes good sense to me.

Further Discussion on an Options Strategy Designed to Make 40% a Month

Thursday, December 4th, 2014

Last week we outlined an options play based on the historical fluctuation pattern for our favorite ETP called SVXY.  This week we will compare those fluctuations to the market in general (using the S&P 500 tracking stock, SPY, as the market definition). We proposed buying a vertical call spread for a one-month-out expiration date with the lower strike about 6% above the starting stock price.

The results were a little unbelievable, possibly gaining an average of 65% a month (assuming the fluctuation pattern continued into the future). If you used an outside indicator to determine which months were more likely to end up with a winning result, you would invest in just under half the months, but when you did invest, your average gain might be in the neighborhood of 152%.  Your average monthly gain would be approximately the same if you only invested half the time or all the time, but some people like to increase the percentage of months when they make gains (the pain of losing always seems to be worse than the pleasure of winning).

This week we will offer a second way to bet that the stock will rise by 12.5% in about 38% of the months (as it has in the past).  It involves buying a calendar spread rather than a vertical call spread (and sort of legging into a long call position as an alternative to the simple purchase of a call).

Terry

Further Discussion on an Options Strategy Designed to Make 40% a Month

First. Let’s compare the monthly price fluctuations of SPY and SVXY.  You will see that they are totally different.

Here is a graph showing how much SPY has fluctuated each month over the past 38 months:

Over the 38 months of the time period, SPY rose in 28 months and fell in 10 months.  By far, the most popular monthly change was in the zero to +2.5% range.  Note that in less than 8% of the months (3 out of 38) SPY fluctuated by more than 5%, while in over 92% of the months, the fluctuation was less than 5%.

Compare the monthly fluctuations of SPY with those for SVXY over the same time period:

SVXY rose in 28 of the 38 months, exactly the same number as SPY. However, the absolute percentage price changes are far higher for SVXY.  In nearly half the months, SVXY fluctuated by more than 10% either way (18 of 38 months).  In 24 of the 38 months (63%), SVXY changed by more than 5% in either direction compared to less than 8% of the months for SPY.  In 21 of the 38 months (55%)  SVXY gained over 5%.

Bottom line, monthly fluctuations for SVXY are considerably greater than they are for SPY.  In most months, the price change for SPY is relatively insignificant and for SVXY, the price is rarely anywhere near where it started out each expiration month.

Buying Vertical Spreads:

If you were to buy a one-month vertical spread on SPY, buying the at-the-money strike price and selling at a strike $5 higher, the spread would cost about $1.65 ($165) and you could sell it for $5.00 ($500) if the stock rose about 2 1/2% or more.  However, if the historical pattern persisted, you would make the maximum gain in only 13 of 38 months, or 34% of the time.

The same 5-point spread in SVXY would cost far more ($2.50) but you could look forward to making the maximum gain in 21 of 38 months (55% of the time).  While buying this spread would give you a statistical edge, it probably is not the best spread to purchase.  A more profitable spread would be at higher strike prices – betting that the stock would increase by 12.5% or more (which it has 38% of the time).  Since this higher-strike price would cost far less, your statistical edge would be much greater as would your gains in those months when a big increase took place.

A second alternative would be to simply buy a call which was about 6% above the purchase price.  Last week, in a demonstration portfolio at Terry’s Tips, with SVXY trading at $75, we bought a one-month-out 80 call.  It cost $1.40.  If the stock rose by 12.5% from $75, it would be trading around $84 ½ and you could sell the call for about 3 times what you paid for it.

We also bought some SVXY Dec4-14 – Dec2-14 80 calendar call spreads for $1.14.  This is a way of buying a 5-week call at the 80 strike, paying less than a 4-week call which cost $1.40.  When the Dec2-14 short calls expire in two weeks, we would not replace them, and stick with uncovered long calls that expires a week later than the Dec-14 call.  The only extra risk we are taking here is that the stock skyrockets 12.5% in the very first two weeks so that the Dec2-14 80 call finishes in the money (something that seems unlikely to happen his month since VIX is so low so that most of the increase in SVXY should come from the contango component).  This spread seems to be a better alternative than just buying the Dec-14 80 call, but we will see how it works out. Of course, I’ll report back to you.

So far, the stock has edged up to close today about 5% higher than it started out last week (after recovering from a big drop on Monday).  Contango is above 10%, unusually high, but not so unusual for the month of December because of the “holiday effect” (December is often characterized by low volume and higher stock prices, and VIX futures for this month are typically lower than any other month).  The contango number is a rough approximation of how much SVXY should increase in one month from the daily adjustment which is made (selling the one-month-out futures and buying at the spot price of VIX).  Of course, if VIX fluctuates, SVXY will move in the opposite direction.  If VIX moves higher, SVXY might move lower even if it is helped by the contango tailwinds.

 

An Options Strategy Designed to Make 40% a Month

Friday, November 28th, 2014

I hope you had a wonderful Thanksgiving with your family and/or loved ones, and are ready for some exciting new information.  Admittedly, the title of this week’s Idea of the Week is a little bizarre.  Surely, such a preposterous claim can’t possibly have a chance of succeeding.  Yet, that is about what your average monthly gain would have been if you had used this strategy for the past 37 months that the underlying ETP (SVXY) has been in existence.  In other words, if the pattern of monthly price changes continues going forward, a 40% average monthly gain should result (actually, it would be quite a bit more than this, but I prefer to underpromise and over-deliver).  Please read on.

We will discuss some exact trades which might result in 40%+ monthly gains over the next four weeks.  I hope you will study every article carefully.  Your beliefs about options trading may be changed forever.

Terry

An Options Strategy Designed to Make 40% a Month

First of all, we need to say a few words about our favorite underlying, SVXY.  It is not a stock.  There are no quarterly earnings reports to push it higher or lower, depending on how well or poorly it performs.  Instead, it is an Exchange Traded Product (ETP) which is a derivative of several other derivatives, essentially impossible to predict which way it will move in the next week or month.  The only reliable predictor might be to look how it has performed in the past, and see if there is a way to make extraordinary gains if the historical pattern of price changes manages to extend into the future.  This price change pattern is the basis of the 40% monthly gain potential that we have discovered.

SVXY is the inverse of VXX, a popular hedge against a market crash.  VXX is positively correlated with VIX (implied volatility of SPY options), the so-called fear index.  When the market crashes or corrects, options volatility, VIX, and VXX all soar.  That is why VXX is such a good hedge against a market crash.  Some analysts have written that a $10,000 investment in VXX will protect against any loss on a $100,000 stock portfolio (I have calculated that you would really need to invest about $20,000 in VXX to protect against any loss in a $100,000 stock portfolio, but that is not a relevant discussion here.)

While VXX is a good hedge against a market crash, it is a horrible long-term holding.  In its 7 years of existence, it has fallen an average of 67% a year.  On three occasions, they have had to engineer 1-for-4 reverse splits to keep the stock price high enough to bother trading.  In seven years, it has fallen from a split-adjusted $2000+ price to today’s under-$30.

Over the long run, VXX is just about the worst-performing “stock” that you could possibly find.  That is why we are so enamored by its inverse, SVXY.

Deciding to buy a stock is a simple decision.  Compare that to SVXY, an infinitely more complicated choice.  First, you start with SPY, an ETP which derives its value from the weighted average stock price of 500 companies in the S&P 500 index.  Options trade on SPY, and VIX is derived from the implied volatility (IV) of those options.  Then there are futures which are derived from the future expectations of what VIX will be in future months. SVXY is derived from the value of short-term futures on VIX.  Each day, SVXY sells these short-term futures and buys at the spot price (today’s value) of VIX.  Since about 90% of the time, short-term futures are higher than the spot price of VIX (a condition called contango), SVXY is destined to move higher over the long run – an average of about 67% a year, the inverse of what VXX has done.  Simple, right?

While SVXY is anything but a simple entity to understand or predict, its price-change pattern is indeed quite simple.  In most months, it moves higher.  Every once in a while, however, market fears erupt and SVXY plummets.  In October, for example, SVXY fell from over $90 to $50, losing almost half its value in a single month.  While owning SVXY might be a good idea for the long run, in the short run, it can be an awful thing to own.

Note on terminology: While SVXY is an ETP and not literally a stock, when we are using it as an underlying entity for options trading, it behaves exactly like a stock, and we refer to it as a stock rather than an ETP.

We have performed an exhaustive study of monthly price fluctuations (using expiration month numbers rather than calendar month figures).  Our major finding was that in half the months, SVXY ended up more than 12% higher or lower than where it started out.  It was extremely unusual for it to be trading at the end of an expiration month anyway near where it started out.  This would suggest that buying a straddle (both a put and a call) at the beginning of the month might be a good idea.  However, such a straddle would cost about 10% of the value of the stock, a cost that does not leave much room for gains since the stock would have to move by 10% before your profits would start, and that occurs only about half the time.

A second significant finding of our backtest study of SVXY price fluctuations was that in 38% of the months, the stock ended up at least 12.5% higher than it started the expiration month.  If this pattern persisted into the future, the purchase of an at-the-money call (costing about 5% of the stock price) might be a profitable bet.  There are other strategies which we believe are better, however.

One possible strategy would be to buy a one-month out vertical call spread with the lower strike about 6% above the current price of the stock.  Last week, with SVXY trading about $75, we bought a Dec-14 80 call and sold a Dec-14 85 call.  The spread cost us $1.11 ($111 per spread, plus $2.50 in commissions at the special thinkorswim rate for paying Terry’s Tips subscribers).  This means that if the stock ends up at any price above $85 (which it has historically done 38% of the time), we could sell the spread for $497.50 after commissions, making a profit of $384 on an investment of $113.50.  That works out to a 338% gain on the original investment.
If you bought a vertical call spread like this for $113.50 each month and earned a $384 gain in the 14 months (out of 37 historical total) when SVXY ended up the expiration month having gained at least 12.5%, you would end up with $5376 in gains in those months.  If you lost your entire $113.50 investment in the other 23 months, you would have losses of $2610, and this works out to a net gain of $2766 for the total 37 months, or an average of $74 per month on a monthly investment of $113.50, or an average of 65% a month.  Actually, it would be better than this because wouldn’t lose the entire investment in many months when the maximum gain did not come your way.

But as good as 65% a month seems (surely better than the 40% a month I talked about at the beginning), it could get better.  Again using the historical pattern, we identified another variable which could tell us whether or not we should buy the vertical spread at the beginning of the month. If you followed this measure, you would only buy the spread in 17 of the 37 months.  However, you would make the maximum gain in 10 of those months. Your win rate would be 58% rather than 38%, and your average monthly gain would be 152%.  This variable is only available for paying subscribers to Terry’s Tips, although maybe if you’re really smart and can afford to spend a few dozen hours of searching, you can figure it out for yourself.

Starting in a couple of weeks, we are offering a portfolio that will execute spreads like this every month, and this portfolio will be available for Auto-Trading at thinkorswim (so you don’t have to place any of the orders yourself).  Each month, we will start out with $1000 in the portfolio and buy as many spreads as we can at that time.  We expect it will be a very popular portfolio for our subscribers.  With potential numbers like this, I’m sure you can agree with our prognosis.

Of course, this entire strategy is based on the expectation that future monthly price fluctuations of SVXY will be similar to the historical pattern of price changes.  This may or may not be true in the real world, but we think our chances are pretty good.  For example, for the November expiration that ended just one week ago, the stock had risen a whopping 34%.  In the preceding October expiration month, it had fallen by almost that same amount, but at the beginning of the month, our outside variable measure would have told us not to buy the spread for that month, so we would have made the 338% in November and avoided any loss at all in October.

There are other possible spreads that could be placed to take advantage of the unusual price behavior of SVXY, and we will discuss some of them in future reports.  I invite you to check them out carefully, and to look forward for a year-end special price designed to entice you to come on board for the lowest price we have ever offered. It could be the best investment decision you make in 2014.

Update on the ongoing SVXY put demonstration portfolio.  This sample demonstration portfolio holds a SVXY Mar-15 75 put, and each week, (almost always on Friday), we buy back an expiring weekly put and sell a one-week-out put in its place, trying to sell at a strike which is $1 – $2 in the money (i.e., at a strike which is $1 or $2 above the stock price).  Our goal in this portfolio is to make 3% a week.

Last week, SVXY rose to just less than $75 and we bought back the expiring Nov-14 73 put  and sold a Dec1-14 75 put (selling a calendar), collecting a credit of $1.75 ($172.50 after commissions).

The account value was then $1570, up $70 for the week, and $336 from the starting value of $1234 on October 17th, 5 weeks ago.  This works out to $67 a week, well more than the $37 weekly gain we need to achieve our 3% weekly goal.  In fact, we have gained 5.4% a week for the 5 weeks we have carried out this portfolio.

At this point, we closed out this portfolio so that we could replace the positions with new options plays designed to take advantage of the SVXY price fluctuation pattern we spoke about today.  It seems like very few people were following our strategy of selling weekly puts against a long Mar-15 put, but we clearly showed how 3% a week was not only possible, but fairly easy to ring up.  Where else but with stock options can you achieve these kinds of investment returns?

Making 36%

Making 36% — A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

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Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

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I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

~ John Collins