Weekly Stock Options Trading Tips: August 16, 2009

Stock Options Trading Idea of the Week

Finding an Implied Volatility Advantage

We have just finished the 4th week of a 5-week expiration month, and the composite value of our 7 actual option portfolios has gained over 10% so far, thanks to a less-volatile market than we have experienced over the past several months.  Last week the market was down and we managed to make nice gains anyway because the drop was not very large.  That is the happiest time of all for our strategy – when most investors lose and we gain.  Somehow it is sweeter when it works out that way.

We discuss an important part of our strategy today.

Terry

Finding an Implied Volatility Advantage

When market professionals talk about the Implied Volatility (IV) of a particular stock or ETF, they are referring to the at-the-money current-month put and call options for that underlying instrument.

While it makes total sense that every option for a particular underlying should have the same IV, in reality it is usually not the case.  Some options are more expensive than they “should” be and others may be cheaper than they “should” be.

When I was a market maker on the CBOE, one of my favorite tactics was to find discrepancies in IVs of options on the same underlying, selling the “over-priced” options and buying the “under-priced” options.  I would try to maintain a neutral net delta condition at all times so I didn’t care whether the stock went up or down while I waited for the market to correct itself and move the IVs of both sets of options closer to parity.   (I surely wasn’t alone in using this tactic, as it was, and still is, one of the most widely-employed strategies on the floor.)

The 10K Strategy that we carry out at Terry’s Tips involves buying LEAPS and selling short-term options against them.  In the best of all possible worlds, we would seek out underlying stocks where the LEAPS carried a lower IV (so they were “cheaper”) than the IV of the short-term options (which were more “expensive”).  Whenever we enjoyed this difference in IVs, we know that we have an IV Advantage.

While having an IV Advantage stacks the deck in your favor, it should not be used as a sole determinate in choosing an underlying instrument to trade options on.  It is possible to make good returns with the 10K Strategy when you don’t enjoy an IV Advantage, but it is helpful nonetheless.

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 7 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

Andy's Market Report

It was a volatile week for the market, as economic indicators and the Fed delivered a mix of information that pleased the bulls and bears. As a result, the market struggled to continue the four week advance. Oh well, streaks are meant to be broken, right?

The short-term pullback this past week certainly was not a surprise given the extreme overbought nature of the market and the strong overhead resistance that has been present since the 7/30 gap upward in
the S&P 500 (SPY). Since then the market has struggled to sustain any attempt at an advance. I would not be surprised to see a further decline that closes the gap before any meaningful advance occurs. I will
be closely watching the $98.09 level on the S&P 500 (SPY), which is the high from the day prior to the gap upward.

The hesitation to move the market over the past few weeks seems to be a continued concern that consumers will be the downfall to the economic recovery. The slightly sour sentiment seems to be a fair one given the latest University of Michigan index of consumer sentiment and the ongoing depletion in employment.

The Consumer Sentiment Index fell significantly short of economists’ expectations. The index fell to 63.2 from 66.0 in July and as I stated before, was well shy of the consensus estimate of 69.0. The pullback was taken as a sign that consumers are cutting back due to ongoing employment concerns. One thing is certain in an economy that depends on consumer spending, it is imperative that unemployment make a turn for the better. This would instill confidence in the consumer and in turn, promote spending.

The disappointing consumer spending news also came after a reported decline in retail sales which only compounded the worries. However, not all the news was bad. The Fed left the fed funds rate unchanged. The move was expected,
but it was the news of that the FOMC expects inflation to remain “subdued” for quite some time. As a result, the Fed stated that it will keep the fed funds rate at current levels for an extended period of time to hopefully promote the ongoing economic recovery.

"Valuations were beginning to price in a sunnier a future, but not all the data is sunny yet," said Lawrence Creatura, portfolio manager at Federated Clover Capital Advisors, referring to stock prices. "There is still going to be a tug of war between good news and bad news as we move through the coming months."

In the end, the market’s reprieve was small as the S&P 500 (SPY) lost 0.6%. When you consider the surge since the low set in March, the decline is rather insignificant. The S&P has advanced over 50% since that low and is currently up 11.2% ytd.

Next week brings option expiration so I expect to see more volatility. I would not be surprised to see a close of the 7/30 gap in the S&P 500, nor would it surprise me to see another test of the recent highs. It should be interesting which way the market decides to move once the current two week range ($98 - $102) is broken.

Overbought/Sold Condition Report

Overbought/Oversold as of August 15, 2009

• S&P 500 (SPY) – 56.1 (neutral)
• Dow Jones (DIA) – 55.5 (neutral)
• Russell 2000 (IWM) – 47.3 (neutral)
• NASDAQ 100 (QQQQ) – 49.3 (neutral)

Testimonial of the week

"I don't know if a lot of subscribers thank you but my wife and I have watched the money that we have invested in your program grow at an alarming rate.  We especially like the fact, which no other investments offer, the ability to cash out profits every month if they are earned. Cheers to you and your staff."     -- Rob Slaving