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A Useful Way to Think About Delta

Monday, September 9th, 2013

This week we will start a discussion about the “Greeks” – the measures designed to predict how option prices will change when underlying stock prices change or time elapses. It is important to have a basic understanding of some of these measures before embarking on trading options.

I hope you enjoy this short discussion.

Terry 

A Useful Way to Think About Delta: The first “Greek” that most people learn about when they get involved in options is Delta. This important measure tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.

If you own a call option that carries a delta of 50, that means that if the stock goes up by $1.00, your option will increase in value by $.50 (if the stock falls by $1.00, your option will fall by a little less than $.50).

The useful way to think about delta is to consider it the probability of that option finishing up (on expiration day) in the money. If you own a call option at a strike price of 60 and the underlying stock is selling at $60, you have an at-the-money option, and the delta will likely be about 50. In other words, the market is saying that your option has a 50-50 chance of expiring in the money (i.e., the stock is above $60 so your option would have some intrinsic value).

If your option were at the 55 strike, it would have a much higher delta value because the likelihood of its finishing up in the money (i.e., higher than $55) would be much higher. The stock could fall by $4.90 or go up by any amount and it would end up being in the money, so the delta value would be quite high, maybe 70 or 75. The market would be saying that there is a 70% or 75% chance of the stock ending up above $55 at expiration.

On the other hand, if your call option were at the 65 strike while the stock was selling at $60, it would carry a much lower delta because there would be a much lower likelihood of the stock going up $5 so that your option would expire in the money.

Of course, the amount of remaining life also has an effect on the delta value of an option. We will talk about that phenomenon next week.

A Strategy of Buying Weekly SPY Straddles

Wednesday, August 28th, 2013

I performed a back-test of weekly SPY volatility for the past year and discovered that in just about half the weeks, the stock fluctuated at some point during the week by $3 either up or down (actual number 27 of 52 weeks).  That means if you could have bought an at-the-money straddle for $2 (both an at-the-money call and put), about half the time you could sell it for a 50% gain if you placed a limit order to sell the straddle for $3.  As long as the stock moves at least $3 either up or down at some point during the week you can be assured that the straddle can be sold for $3.

Here are the numbers for SPY for the past six months:

 

SPY Straddle Chart

SPY Straddle Chart

The weekly changes (highlighted in yellow) are the ones where SPY fluctuated more than $3 so that a 50% gain was possible (by the way this week is not over yet, and the stock fell over $3 at one point yesterday).

An interesting strategy for these months would be to buy 10 at-the-money SPY straddles on Friday (or whatever your budget is – each straddle will cost about $200). With today’s low VIX, an at-the-money straddle last Friday cost $1.92 to buy (one week of remaining life),  In the weeks when VIX was higher, this spread cost in the neighborhood of $2.35  (but actual volatility was higher, and almost all of the weeks showed a $3.50 change at some point during the week).

Over the past year, in the half of the weeks when the stock moved by at least $3, your gain on 10 straddles would be $1000 on the original straddle cost $2.  If the change took place early in the week, there would be time premium remaining and the stock would not have to fluctuate by quite $3 for the straddle to be sold for that amount.

The average loss in the other weeks would be about $700, maybe less.  On Friday morning, the worst-case scenario would be that you could sell the 70 straddles for $700 (causing a loss of $1300). This would occur if the stock were trading exactly at the strike price of the straddle – on Friday morning it could be sold for about $.70 because there would be some time premium remaining for both the puts and calls.  The maximum loss that occurred in about a third of the losing weeks was about $.70 but another third of the weeks when the 50% gain was not triggered, you could have broken even (on average) by selling the straddle at the close on Friday.  I calculated that the average loss for all of the last 12 months would be about $700 in those weeks when the 50% gain was not triggered.

This means an average investment of $2000 (10 straddles) would make an average gain of $150 per week. While that might be considered to be a decent gain by most standards, it could be dramatically improved if you varied the amount that you invested each week by following the volatility patterns.

There was a remarkable tendency for high-volatility weeks to occur together.  In the above table you can see that at one point there was a string of 14 weeks when 12 times a 50% gain was possible (high-lighted in yellow) and two weeks (high-lighted in red) when a small gain was possible because the closing price was greater than $2 away from the starting price.  Only one week out of the 14, 5/28/13 would a loss have occurred, and that would have been negligible because the stock closed $1.86 lower, almost covering the $2 initial cost of the straddle.

The same went for low-volatility weeks – there were strings of them as well. At one point early in 2013 the strategy would have incurred a string of seven consecutive weeks when no 50% was possible, and in the last six months pictured above, there were two four-week strings when SPY fluctuated by less than $3 in either direction.

If you invested $4000 in weeks after you made a gain and $2000 in weeks after a 50% gain was not possible, your net gains would be much higher.  This is the most promising part of the strategy.

Another way of playing this strategy would be to invest only in those weeks when a 50% gain would have been possible in the previous week, and sit on the sidelines for the other weeks.  Of course, since the average gain for all weeks was positive (but small), you would be giving up a little by not investing each week.

In this world of low option prices (VIX is at historical lows) and relatively high volatility, this might be an exceptionally profitable strategy to follow.  We plan to carry it out in one of the portfolios we run at Terry’s Tips.

Using Puts vs. Calls for Calendar Spreads

Tuesday, March 12th, 2013

A lot of our discussion lately has focused on pre-earnings-announcement strategies (we call them PEA Plays).  This has been brought about by lower option prices (VIX) than we have seen since 2007, a full six years ago.  With option prices this low it has been difficult to depend on collecting premium as our primary source of income with our basic option strategies. 

But the earnings season has now quieted down and will not start up again for several weeks, so we will return to discussing more conventional option issues. 

Terry 

Using Puts vs. Calls for Calendar Spreads 

 It is important to understand that the risk profile of a calendar spread is identical regardless of whether puts or calls are used.  The strike price (rather than the choice of puts or calls) determines whether a spread is bearish or bullish.  A calendar spread at a strike price below the stock price is a bearish because the maximum gain is made if the stock falls exactly to the strike price, and a calendar spread at a strike price above the stock price is bullish. 

When people are generally optimistic about the market, call calendar spreads tend to cost more than put calendar spreads.  For most of 2012 and into 2013, in spite of a consistently rising market, option buyers have been particularly pessimistic.  They have traded many more puts than calls, and put calendar prices have been more expensive. 

Right now, at-the-money put calendar spreads cost more than at-the-money call calendar spreads.  As long as the underlying pessimism continues, they extra cost of the put spreads might be worth the money because when the about-to-expire short options are bought back and rolled over to the next short-term time period, a larger premium can be collected on that sale.  This assumes, of course, that the current pessimism will continue into the future.

If you have a portfolio of exclusively calendar spreads (you don’t anticipate moving to diagonal spreads), it is best to use puts at strikes below the stock price and calls for spreads at strikes which are higher than the stock price.  If you do the reverse, you will own a bunch of well in-the-money short options, and rolling them over to the next week or month is expensive (in-the-money bid-asked spreads are greater than out-of-the-money bid asked spreads so you can collect more cash when rolling over out-of-the-money short options). 

The choice of using puts or calls for a calendar spread is most relevant when considering at-the-money spreads.  When buying at-the-money calendar spreads, the least expensive choice (puts or calls) should usually be made. An exception to this rule comes when one of the quarterly SPY dividends is about to come due.  On the day the dividend is payable (always on expiration Friday), the stock is expected to fall by the amount of the dividend (usually about $.60).  Since the market anticipates this drop in the stock (and knowing the specific day that the stock will fall), put prices are generally bid higher in the weeks before that dividend date. 

The bottom line is that put calendar spreads are preferable to call calendar spreads for at-the-money strikes (or even at strikes slightly higher than the stock price) coming into a SPY dividend date.   Even though the put spreads cost more, the Weekly options that can be sold for enough extra to cover the higher cost.  You do not want to own SPY call calendar spreads which might become in the money on the third Friday of March, June, September, or December because you will have to buy them back on Thursday to avoid paying the dividend, and you may not want to make that purchase to keep your entire portfolio balanced.

Invest in Yourself in 2013 (at the Lowest Rate Ever)

Monday, December 31st, 2012

To celebrate the coming of the New Year I am making the best offer to come on board that I have ever offered.  It is time limited.  Don’t miss out.

Invest in Yourself in 2013 (at the Lowest Rate Ever)

The presents are unwrapped.  The New Year is upon us.  Start it out right by doing something really good for yourself, and your loved ones. 

The beginning of the year is a traditional time for resolutions and goal-setting.  It is a perfect time to do some serious thinking about your financial future.

I believe that the best investment you can ever make is to invest in yourself, no matter what your financial situation might be.  Learning a stock option investment strategy is a low-cost way to do just that.

As our New Year’s gift to you, we are offering our service at the lowest price in the history of our company.      If you ever considered becoming a Terry’s Tips Insider, this would be the absolutely best time to do it.  Read on…

Don’t you owe it to yourself to learn a system that carries a very low risk and could gain 36% a year as many of our portfolios have done?

So what’s the investment?  I’m suggesting that you spend a small amount to get a copy of my 70-page (electronic) White Paper, and devote some serious early-2013 hours studying the material. 

And now for the Special Offer – If you make this investment in yourself by midnight, January 9, 2013, this is what happens:

For a one-time fee of only $39.95, you receive the White Paper (which normally costs $79.95 by itself), which explains my two favorite option strategies in detail, 20 “Lazy Way” companies with a minimum 100% gain in 2 years, mathematically guaranteed, if the stock stays flat or goes up, plus the following services :

1) Two free months of the Terry’s Tips Stock Options Tutorial Program, (a $49.90 value).  This consists of 14 individual electronic tutorials delivered one each day for two weeks, and weekly Saturday Reports which provide timely Market Reports, discussion of option strategies, updates and commentaries on 8 different actual option portfolios, and much more. 

2) Emailed Trade Alerts.  I will email you with any trades I make at the end of each trading day, so you can mirror them if you wish (or with our Premium Service, you will receive real-time Trade Alerts as they are made for even faster order placement or Auto-Trading with a broker).  These Trade Alerts cover all 8 portfolios we conduct.

3) If you choose to continue after two free months of the Options Tutorial Program, do nothing, and you’ll be billed at our discounted rate of $19.95 per month (rather than the regular $24.95 rate).

4) Access to the Insider’s Section of Terry’s Tips, where you will find many valuable articles about option trading, and several months of recent Saturday Reports and Trade Alerts.

5) A FREE special report “How We Made 100% on Apple in 2010-11 While AAPL Rose Only 25%”. This report is a good example of how our Shoot Strategy works for individual companies that you believe are headed higher.

With this one-time offer, you will receive all of these benefits for only $39.95, less than the price of the White Paper alone. I have never made an offer better than this in the twelve years I have published Terry’s Tips.  But you must order by midnight on January 9, 2013.  Click here, choose “White Paper with Insider Membership”, and enter Special Code 2013 (or 2013P for Premium Service – $79.95).

Investing in yourself is the most responsible New Year’s Resolution you could make for 2013.  I feel confident that this offer could be the best investment you ever make in yourself.

Happy New Year!  I hope 2013 is your most prosperous ever.  I look forward to helping you get 2013 started right by sharing this valuable investment information with you. 
Terry

P.S.  If you would have any questions about this offer or Terry’s Tips, please call Seth Allen, our Senior Vice President at 800-803-4595.  Or make this investment in yourself at the lowest price ever offered in our 8 years of publication – only $39.95 for our entire package - using Special Code 2013 (or 2013P for Premium Service – $79.95).

All About Back Spreads

Sunday, December 9th, 2012

Back spreads and ratio spreads are usually discussed together because they are simply the mirror image of each other. Back spreads and ratio spreads are comprised of either both calls or both puts at two different strike prices in the same expiration month. If the spread has more long contracts than short contracts, it is a Back Spread. If there are more short contracts, it is a Ratio Spread.
Since ratio spreads involve selling “naked” (i.e., uncovered by another long option) they can’t be used in an IRA.  For that reason, and because we like to sleep better at night knowing that we are not naked short and could possibly lose more than our original investment, we do not trade ratio spreads at Terry’s Tips.

Back spreads involve selling one option and buying a greater quantity of an option with a more out-of-the-money strike. The options are either both calls or both puts.
A typical back spread using calls might consist of buying 10 at-the-money calls and selling 5 in-the-money calls at a strike low enough to buy the entire back spread at a credit. 
Ideally, you collect a credit when you set up a back spread.  Since the option you are buying is less expensive than the one you are buying, it is always possible to set up the back spread at a credit.  You would like as many extra long positions as possible to maximize your gains if the underlying makes a big move in the direction you are betting. 
If you are wrong and the underlying moves in the opposite direction that you originally hoped, if you had set up the back spread at a net credit at the beginning, all of your options will expire worthless and you will be able to keep the original credit as pure profit (after paying commissions on the original trades, of course).
Call back spreads work best when the stock price makes a large move up; put back spreads work best when the stock price makes a large move down.
One of the easiest ways to think about a back spread is as a vertical with some extra long options. A call back spread is a bear vertical (typically a short call vertical) plus extra long call options at the higher of the two strikes. A put back spread is a bull vertical (typically a short put vertical) plus extra long put options at the lower of the two strikes.
The purpose of a back spread is to profit on a quick extended move toward, through and beyond the long strike. The purchase of a quantity of more long options is financed by the sale of fewer short options. The danger is that because the short options are usually in the money, they might grow faster than the long out-of-the-money options if the stock price moves more slowly or with less magnitude than expected. This happens even faster as expiration approaches. The long out-of-the-money options may lose value despite a favorable move in the stock price, and that same move in the stock price may increase the value of the short options. This is when the back spread loses value most quickly. This is depicted in the “valley” of the risk profile graphs. The greatest loss in the graph occurs at exactly the strike price of the long options.

There are two reasons that I personally don’t like back spreads.  First, they are negative theta.  That means you lose money on your positions every day that nothing much happens to the underlying strike price. 

Second, and more importantly, the gains you make in the good time periods are inconsequential compared to the large losses you could incur in the other time periods.  If the stock moves in the opposite way you are hoping, you end up making a very small gain (the initial credit you collected when the positions were originally placed).  If the underlying doesn’t move much, your losses could be huge.  On the other hand, in order for you to make large gains when the market moves in the direction you hope it will, the move must be very large before significant gains come about.

Here is the risk profile graph for a back spread on SPY (buying 10 Dec-12 142 calls for $1.55 and selling 6 Dec-12 140 calls for $2.78 when SPY was trading at $142.20 and there were two weeks until expiration):

You have about $1100 at risk (the $1200 maintenance requirement less the $115 credit (after commissions) you collected at the outset.  If the stock falls by more than $2.20 so that all the calls expire worthless, you would gain the $115 credit.  If the stock moves higher by $2, you would lose just about that same amount.  It would have to move $2.20 higher before a gain could be expected on the upside, and every dollar the stock moved higher from there would result in a $400 gain (the number of extra calls you own).

The big problem is that if the stock doesn’t do much of anything, you stand to lose about $1000, a far greater loss than most of the scenarios when a gain could be expected.  In order for you to make $1000 with these positions, the stock would have to go up by $5 in the two-week period.  Of course, that happens once in a great while, but probably less than 10% of the time.  There there is a much greater likelihood of its moving less than $2 in either direction (and a loss would occur at any point within that range).

Bottom line, back spreads might be considered if you have a strong feeling that the underlying stock might move strongly in one direction or another, but I believe that there are other more promising directional strategies such as vertical spreads, calendar or diagonal spreads, or even straddles or strangles that make more sense to me.

Three New (Weekly) Options Series Introduced

Tuesday, November 20th, 2012

The world of stock options is every changing.  Last week, three new series of options were introduced. Options trades should be aware of these new options, and understand how they might fit into their options strategies, no matter what those  strategies might be.

Three New (Weekly) Options Series Introduced

Last week, the CBOE announced the arrival of several new options series for our favorite ETFs as well as four individual popular stocks which have extremely high options activity.

Here they are:

For the above entities, there are now four Weekly options series available at any given time.  In the past, Weekly options for the following week became available on a Thursday (with eight days of remaining life).

This is a big change for those of us who trade the Weeklys (I know that seems to be a funny way to spell the plural of Weekly, but that is what the CBOE does).  No longer will we have to wait until Thursday to roll over short options to the next week to gain maximum decay (theta) for our short positions.

The stocks and ETFs for which the new Weeklys are available are among the most active options markets out there.  Already, these markets have very small bid-ask spreads (meaning that you can usually get very good executions, often at the mid-point of the bid-ask spread rather than being forced to buy at the ask price and sell at the bid price).  This advantage should extend to the new Weekly series, although I have noticed that the bid-ask spreads are slightly higher for the third and fourth weeks out, at least at this time.

The new Weeklys will particularly be important for Apple.  Option prices have traditionally sky-rocketed for the option series which comes a few days after their quarterly earnings announcements.  In the past, a popular strategy was to place a calendar or diagonal spread in advance of an announcement (further-out options tend to be far less expensive (lower implied volatility) than those expiring shortly after the announcement, and potentially profitable spreads are often available.  The long side had to be the newt monthly series, often a full three weeks later.

With the new Weekly series now being available, extremely inexpensive spreads might be possible, with the long side having only seven days of more time than the Weeklys that you are selling.  It will be very interesting come next January. 

     Bottom line, the new Weekly series will give you far more flexibility in taking a short-term view on stock price movement and/or volatility changes, plus more ways to profit from time decay.  It is good news for all options traders.

 

 

Another Interesting Time to Buy Options

Monday, August 6th, 2012

For the past several weeks we have been discussing how to make money buying options.  For those of you who have been following us for any extended time, you understand that this is a total departure from our long-standing belief that the best way to make maximum returns is to sell short-term options to someone else.

A combination of low option prices and high actual volatility has recently caused us to reverse our strategy.  Now seems to be a good time to be buying either or both puts or calls.  Rather than blindly buying an option and hoping for the best, we are continually on the look-out for something that will give us an edge in making this buying decision.

Last week we couldn’t find an edge we were comfortable with.  We considered buying a straddle on Thursday in advance of the jobs report but the market had been quiet all week and we sat on the sidelines.  Unfortunately, as it worked out.  SPY rose almost 2% on Friday and we would have easily doubled our money if we had pulled the trigger.

Today we will talk about one of those possible edges.

Another Interesting Time to Buy Options

It seems to happen every summer.  While the overall market doesn’t seem to do much of anything (that’s why they call it the summer doldrums I suppose), on many days, the market just seems to jump all over the place.  It could be that so many traders are on vacation that the few who are working are able to move the market with very few trades.

A more likely explanation is the computer-generated program trading that has taken over the market lately.  The average holding period for a stock in our country is now less than two seconds according to one study.  When the computers sense unusual buying or selling coming into the market, they place trades in advance of the orders getting to the exchanges.  This adds to the momentum and pushes the market sharply in one direction or the other.

At some point, the momentum shifts, and the market moves sharply in the other direction.

Check out the price action of SPY on Fridays for the past ten weeks:

June 1        -3.30
June 8        +1.05
June 15    +1.30  Monthly X dividend
June 22    +1.05
June 29     +3.31
July 6        -1.30
July 13        +2.20
July 20        -1.30    Monthly X dividend
July 27        +2.51
Aug 3        +2.70

If you had bought a slightly out-of-the-money put and call (or an at-the-money straddle) on essentially any one of the Thursdays preceding these Fridays, you would have surely made money when the stock moved well over a dollar the next day.  These puts and calls with only one day of remaining life are quite cheap, and could easily double or triple in value if the market moves by over $2 which it has on half of the Fridays this summer.

This edge probably does not extend to other months of the year, however.  In April and May, the stock did not move over $.75 on any Friday.  So it seems to be a summer phenomenon.

Buying options is risky business because you can lose 100% of your investment.  But doing it with small amounts when you see an edge like this Friday action (or before jobs reports, or on the Monday following the monthly option expiration), the odds may shift in your favor.

Be careful, and good luck.  Never invest money that you can’t afford to lose.

Another Buying Straddles Story

Monday, July 16th, 2012

For most of the last year, the market (SPY) and many individual stocks have fluctuated more than the implied volatility of the options would predict.  This situation has made it quite difficult to make gains with the calendar spread strategy that we have long advocated.

Now we are experimenting with buying straddles as an alternative to our basic strategy.  This represents a total reversal from hoping for a flat market to betting on a fluctuating one.

Today I would like to report on a straddle purchase I made last week.

Another Buying Straddles Story

I selected the Russell 2000 (Small-Cap) Index (IWM) as the underlying. For many years, this equity seems to fluctuate in the same direction and by about the same amount as the market in general (SPY) although it is trading for far less ($80 vs. $134) so the percentage fluctuations are greater.

On Monday morning, IWM was trading right about $80. I bought an 80 straddle using IWM (Jul2-12 puts and calls), paying $1.53 for the pair.  If IWM moved by $1.53 in either direction, the intrinsic value of either the puts or calls would be $1.53, and there would be some time premium remaining so that either the puts or calls could be sold for a profit.

How likely was IWM to move by more than $1.53 in either direction in only one week?  Looking back at weekly price behavior for IWM, I found that in 62 of the past 66 weeks, IWM had fluctuated at least $1.60 during the week in one direction or another.  That is the key number I needed to make the purchase.  That meant that if the historical pattern repeated itself, I could count on making a profit in 94% of the weeks.  I would be quite happy with anything near that result.

Buying a straddle fits my temperament because I was not choosing which way the market might be headed (something I know from experience that I can’t do very well, at least in the short term), and I knew that I could not lose 100% of my investment (even on Friday and the stock had not moved, there would still be some time premium remaining in the options that could be sold for something).

One on the biggest problems with trading straddles is the decision on when to sell one or both sides of the trade.  We’ll discuss some of the choices next week.  What I did was place a limit order to take a reasonable profit if it came along.  When IWM had fallen about $1.75, I sold my puts for $1.85 on Thursday.  On Friday the stock reversed itself, and I was able to collect $.17 by selling the calls, making a total 20% after commissions for the week. Not a bad result, I figured.  

At some point during the week, there were opportunities to sell both the puts and calls for more than I sold them for, but I was delighted with taking a reasonable profit.  You can’t look back when trading straddles.  If I had not sold the calls but waited until the end of the week, I would have lost about 70% of my original purchase.  So selling when you have a small profit is clearly the way to go.

Back-Testing the 10K Classic Options Strategy

Monday, June 25th, 2012

This week I would like to share a report I sent to paying subscribers this week.  It is a back test of a portfolio we set up just a month ago to carry out the precise strategy outlined in my book, Making 36%: Duffer’s Guide to Breaking Par in the Market Every Year in Good Years and Bad (the revised 2012 edition is the 5th printing).  I believe it gives a definitive answer to the question “Do calendar spreads really work?”

Back-Testing the 10K Classic Options Strategy

The originally-stated goal of the 10K Classic portfolio was to deliver consistent 3% monthly gains and never have a losing month.  This portfolio uses S&P 500 tracking stock (SPY) as the underlying, and uses true deep in-the-money LEAPS as the long side (a full 19 months out to start) and Weekly short calls at several strikes both above the stock price (usually 2 out of 5 to start the week) and below the stock price (usually 3 out of 5 to start the week).  We generally do not make any adjustment trades until Thursday when some calls might be rolled to the next Weekly series at a different strike to make the portfolio more neutral net delta.

I wanted to see what would happen if we made absolutely no adjustments to the 10K Classic during the week based on the risk profile graph of the $9800 portfolio on June 15, 2012 and the weekly price changes for SPY that had taken place over the past 100 weeks.  Here are the results:

This table groups the weekly price changes in dollars into 19 groups and multiplies the number of occurrences in each group by the loss or gain that would have occurred with that price change according to the risk profile graph displayed with the thinkorswim software.  I reduced the indicated gain or loss by $50 each week to account for commission costs and transaction costs (we typically buy back out-of-the-money expiring calls for $3 or so, or pay a small premium when rolling over in-the-money calls).  Of course, VIX was relatively high on this date (about 22), so the gains might be less if VIX were appreciably lower.

In 76% of the weeks, a gain would have been made and in 24% of the weeks, a loss would have resulted. In the gaining weeks, the average gain was $284 and the in the losing weeks, the average loss was $445.   On an average of once a year (1 week out of each 50), a greater-than-15% loss would have occurred if no adjustments were made.

The bottom line is most encouraging.  It says that the portfolio would earn 100% over two years if those positions were in place and no adjustments were made during the week.  In order to carry out a strategy of making no adjustments, however, we would have to be willing to tolerate a weekly loss of about $1400 once every year.  

Since about two weeks a year, very large weekly losses might occur (averaging about $1000), it seems best to slightly alter our goal of never having a losing month.  When we encounter one of these weeks, the other 3 weeks of the month might not always do well enough to cover that large a loss.  Our new goal will to never have a losing month as long as the stock does not fluctuate more than $7 in one week during the month.  The more important 3%-a-month goal will continue to be in place. 

The first month for the portfolio (up 5.1%) is certainly an encouraging start, especially with the volatility that we experienced during that time period. 

The originally-stated goal of the 10K Classic portfolio was to deliver consistent 3% monthly gains and never have a losing month.  This portfolio uses S&P 500 tracking stock (SPY) as the underlying, and uses true deep in-the-money LEAPS as the long side (a full 19 months out to start) and Weekly short calls at several strikes both above the stock price (usually 2 out of 5 to start the week) and below the stock price (usually 3 out of 5 to start the week).  We generally do not make any adjustment trades until Thursday when some calls might be rolled to the next Weekly series at a different strike to make the portfolio more neutral net delta.

I wanted to see what would happen if we made absolutely no adjustments to the 10K Classic during the week based on the risk profile graph of the $9800 portfolio on June 15, 2012 and the weekly price changes for SPY that had taken place over the past 100 weeks.  Here are the results:

This table groups the weekly price changes in dollars into 19 groups and multiplies the number of occurrences in each group by the loss or gain that would have occurred with that price change according to the risk profile graph displayed with the thinkorswim software.  I reduced the indicated gain or loss by $50 each week to account for commission costs and transaction costs (we typically buy back out-of-the-money expiring calls for $3 or so, or pay a small premium when rolling over in-the-money calls).  Of course, VIX was relatively high on this date (about 22), so the gains might be less if VIX were appreciably lower.

In 76% of the weeks, a gain would have been made and in 24% of the weeks, a loss would have resulted. In the gaining weeks, the average gain was $284 and the in the losing weeks, the average loss was $445.   On an average of once a year (1 week out of each 50), a greater-than-15% loss would have occurred if no adjustments were made.

The bottom line is most encouraging.  It says that the portfolio would earn 100% over two years if those positions were in place and no adjustments were made during the week.  In order to carry out a strategy of making no adjustments, however, we would have to be willing to tolerate a weekly loss of about $1400 once every year.  

Since about two weeks a year, very large weekly losses might occur (averaging about $1000), it seems best to slightly alter our goal of never having a losing month.  When we encounter one of these weeks, the other 3 weeks of the month might not always do well enough to cover that large a loss.  Our new goal will to never have a losing month as long as the stock does not fluctuate more than $7 in one week during the month.  The more important 3%-a-month goal will continue to be in place. 

The first month for the portfolio (up 5.1%) is certainly an encouraging start, especially with the volatility that we experienced during that time period.

How to Make a Portfolio of Calendar Spreads Either Bearish or Bullish

Monday, June 11th, 2012

I am pleased to offer the 2012 ebook version of Making 36% for only $2.99. This is your chance to learn everything you need to know about options (ok, maybe almost everything) for a lower price than ever before.  Order here and use the code [this code is no longer valid].  The order form will say that you will receive the 2011 paperback edition but if you use the [this code is no longer valid] code, you will receive the 2012 ebook instead. (The revised 2012 paperback edition will be available in about two weeks if you would prefer to wait and get the hard copy at the regular price).

Even if you have purchased an earlier edition of my book, you might want to see the new version.  Two new important strategies are spelled out for the first time – the 10K STUDD (Short Term Ultra Double Diagonal) and the Calendar Twist (a new approach to placing calendar spreads).  Either strategy might change everything you ever thought about trading options.

How to Make a Portfolio of Calendar Spreads Either Bearish or Bullish:

At Terry’s Tips, we use an options strategy that consists of owning calendar (or diagonal) spreads at many different strike prices, both above and below the stock price.  Six of the eight actual portfolios we carry out use SPY as the underlying so we are betting on the market as a whole rather than any individual stock.

We typically start out each week or month with a slightly bullish posture since the market has historically moved higher more times than it has fallen.  In option terms, this is called being positive net delta.  Starting in May and extending through August, we usually start out with a slightly bearish posture (negative net delta) in deference to the “sell in May” adage.

Any calendar spread makes its maximum gain if the stock ends up on expiration day exactly at the strike price of the calendar spread.  As the market moves either up or down, adding new spreads at different strikes is essentially placing a new bet at the new strike price.  In other words, you hope the market will move toward that strike.

If the market moves higher, we add new calendar spreads at a strike which is higher than the stock price (and vice versa if the market moves lower).  New spreads at strikes higher than the stock price are bullish bets and new spreads at strikes below the stock price are bearish bets.

If the market moves higher when we are positive net delta, we should make gains because of our positive delta condition (in addition to decay gains that should take place regardless of what the market does).  If the market moves lower when we are positive net delta, we would lose portfolio value because of the bullish delta condition, but some or all of these losses would be offset by the daily gains we enjoy from theta (the net daily decay of all the options).

Another variable affects calendar spread portfolio values.  Option prices (VIX) may rise or fall in general.  VIX typically falls with a rising market and moves higher when the market tanks.  While not as important as the net delta value, lower VIX levels tend to depress calendar spread portfolio values (and rising VIX levels tend to improve calendar spread portfolio values).

Once again, trading options is more complicated than trading stock, but can be considerably more interesting, challenging, and ultimately profitable than the simple purchase of stock or mutual funds.

Making 36%

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

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

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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Success Stories

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