Last Friday the April options expired and we could tally up the results for our 8 actual portfolios. Six of them made gains for the month, and the only significant loser was our only portfolio based on a single-stock underlying rather than an ETF made up of many companies - the underlying fell by 7.3% during the month and our portfolio lost 6.7%.
Our capstone portfolio (based on SPY) gained 13.1% for the month and is now up over 66% over its one-year and three-week lifespan. Actually, since we withdrew $6600 over the year from its starting $10,000, the average amount invested was about $7300, making the actual annual gain close to 90% for just over one year. Our subscribers who followed this portfolio are generally happy campers.
This week I would like to share the results of a 10-year back test of market action on the Monday following a Friday options' expiration using the S&P 500 tracking stock (SPY) as the underlying. Interesting conclusions could be made regarding two popular trading maxims. Enjoy the report.
For many years, we have noticed that markets seem to trade lower on the Monday after an expiration. Others have noted that markets on that day tend to trade in the opposite direction that they did on Friday. This notion would support our belief that market professionals usually engage in some minor market manipulation on Friday to force many stock prices to a point very near a strike price so that their short options at that strike will expire nearly worthless.
If such market manipulation does take place, it would involve trading in the stock on Friday rather than options. If the stock needed a nudge to the upside to move it exactly to a strike price, these professionals would be buying the stock. They would be selling stock if they desired a lower stock price on Friday.
In either case, they would be expected to reverse those stock trades on Monday, moving the market in the opposite direction that it moved on Friday.
If we were confident that either of these observations could be relied on, there would be some major benefits to our option trading in at least two important ways:
The decision of whether to roll over out-of-the-money options on Friday or wait until Monday.
Up to this point, we have assumed that we have no idea which way the market will move on Monday. Since we know that if the market is the same on Monday as it was on expiration Friday, both put and call options will be about $.05 lower on Monday (there are two days of theoretical decay over the weekend). So we have considered it a toss-up between the two choices. Buying back out-of-the-money options on Friday will cost a little (although there is no commission at thinkorswim if the cost is $.05 or less) but you should be able to get about $.05 more for the next-month options when you sell on Friday rather than waiting until Monday.
Clearly, if we were confident of which way the market might move on Monday, we would not consider it to be a toss-up decision. If we believed the market would trade lower on Monday, we would buy back out-of-the-money calls on Friday and sell next-month calls, and we would let out-of-the-money puts expire worthless because we would expect better prices would be available on Monday. We would do the reverse if we believed the market would be higher on Monday.
The decision of whether to close out short iron condor spreads on Friday or let them expire worthless and wait until Monday to establish new positions.
We face the same decision with short iron condors as we do with expiring out-of-the-money options on expiration Friday. Assuming that we had a successful short iron condor in place and both expiring short puts and calls were out of the money, we could buy back those short options on Friday and establish new iron condors, or let them expire worthless on Friday and place new condors on Monday.
The same conclusion would apply here -- if we were confident of which way the market might move on Monday, we would not consider it to be a toss-up decision. It is a little more complicated with short iron condors than it is with calendar spreads, however. In order to close out a short iron condor (and free up the maintenance requirement), you have to buy back both the expiring puts and calls.
But now comes the interesting possibility. If we believed there was an excellent chance that the market would trade lower on Monday, we could buy back both the short expiring puts and calls on Friday, and place the call side of the next-month short iron condor on Friday. If the market does indeed trade lower on Monday, the put side of the short iron condor would command a higher price on Monday (while the call side would command a lower price, we would already have that side of the spread in place).
Of course, we would do just the opposite if we believed there was a good chance of a higher price on Monday, we would place the put side of the new short iron condor on Friday and wait until Monday to place the call side.
Legging into a short iron condor can be a little dangerous because if you are wrong, you would collect much less for the spread than you could have taken in by executing both the puts and calls at the same time.
It seemed like a good idea to check out the history of price changes on expiration Friday and the following Monday to see if we might gain a statistical edge in predicting what will happen on Monday in future months.
Here are the results over the past 10 years of expirations:
On Monday, SPY ended up lower than Friday's close 57% of the time. However, another 14% of the time, the stock traded at least $.50 lower on Monday during the day but ended closing up. This means that if you waited until the stock was $.50 lower on Monday and made your trades, you would likely get better prices on the short puts you sold in 72% of the months.
The average change for the Monday following an expiration was -$.10. If you did not count the November 2008 change when the market was at its craziest, over the 10-year period, the stock fell by an average of $.29 on Monday.
The idea that the market traded in the opposite direction as it did on Friday was absolutely incorrect. Exactly 50% of the time, the stock traded in the same direction on Monday, and another 50% of the time, it traded in the opposite direction.
However, if you only bet on a lower market on Monday when the stock rose on Friday, your chance of success would rise slightly (to 75%) if you used the same $.50 rule as a guide as to when to sell. (Using this rule would result in more better prices on Monday but would miss out on the 36% of the time when the stock fell by at least 1% (about $.90) on that day.
In conclusion, betting on a lower market on Monday is a pretty good wager, but betting that the market will reverse Friday's direction on Monday will not result in incremental gains.
Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
You can see every trade made in 8 actual option portfolios conducted at Terry's Tips and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?
I look forward to having you on board, and to prospering with you.
Terry
Major stock indexes finished the week in mixed fashion as the Dow rose 0.2% while the S&P closed the week 0.2% lower. The tech-heavy Nasdaq was the best performing index as it ended the week with a 1.4% gain.
In economic news March CPI came in at 0.1% while the core CPI remained unchanged. Both were in-line if not better-than-anticipated.
The low inflation supports the Fed's ongoing decision to keep the key interest rate near 0% for the foreseeable future. Recently, Fed Chairman Ben Bernanke has stated that the economy is "far from being out of the woods."
March retail sallies increased 1.6% which was 0.4% higher than the 1.6% that economists' had anticipated.
The aforementioned were certainly positive for the market, but there were a few negative reports that came out this past week. Initial unemployment came in higher than expected as it rose 24,000 to 484,000 which were 44,000 higher than economists' anticipated.
Employment gains are necessary to help spur consumer spending, which accounts for about 70 % of the economy. "We're not making rapid progress" in bringing down claims, Neal Soss, chief economist at Credit Suisse Holdings USA Inc. in New York, said in an interview with Bloomberg Radio.
Furthermore, the U of M consumer sentiment survey came in at a multi-month low of 69.5 which was significantly lower than the consensus expectation of 75.
On the technical front the indices are still in technical extremes. We would have to see a move below the $115 level in the S&P 500 (SPY) and the $47 level in the Nasdaq 100 (QQQQ) to indicate that the selling is real and that an intermediate-term bearish move could be in the making. Both levels are areas of strong support so it will be interesting to see what happens around these levels.
As of Friday morning all of the technicals that I follow were near or at historic extremes, which typically means that high-beta stocks are either about to peak or at best under-perform the broader market.
Couple this with the typically bearish week after options expirations and I think we could be in for a very interesting week next week. I would like to repeat what I stated last week as well. It is just one more reason why I think we are in store for a decent pullback over the next few weeks.
Moreover, there is also a tendency to see stocks pull back during earnings season after a rally has occurred. We have seen this occur time and time again.
As I stated last week, to my amazement, the bulls have continued to roll over every bearish set-up over the past month or so.
I am still sticking with a short to intermediate-term move to the downside over the next few weeks to months. The decline, if and when it happens, should move back down to the gap from 3/5. My feeling is that the S&P 500 has maxed out its gains over the short to intermediate-term and should push back, at least to the gap from 3/5. More specifically, a move to the $112.34 in the S&P 500 (SPY) or $45.76 in the NASDAQ 100 (QQQQ)
The probability of the move has further increased the recent historic extreme in the ISE Equity Put-Call Ratio, a very reliable indicator.
The reading has pushed to 276 at yesterday's close which makes it only the fourth such reading to move above the notable 275 mark. This means that traders purchased nearly three times more call options than put options.
It has been a month and a half since the S&P has lost more than 1% so it makes since that call buyers have become more and more speculative as time has passed.
There have been four other times when the ISE Equity Put-Call Ration has pushed above 275 and each time the S&P has declined dramatically over the next two weeks.
| 6-15-07 | S&P lost -1.9% |
| 7-12-07 | S&P lost -4.0% |
| 10-8-07 | S&P lost -3.2% |
| 10-28-07 | S&P lost - 6.6% |
If the aforementioned is to hold true then we could be in for a rough week next week. We shall see soon enough.
Andy
Overbought/Oversold as of April 17, 2010
Major Benchmarks