Stock Option Trading Idea of the Week
The New Monthly Mesa Strategy
The Mesa part of the name derives from the shape of the risk profile graph curve that we establish when new positions are place. If you buy a single calendar spread, the graph looks like a mountain, with the peak at the precise strike price. That strike is the tip of the mountain. It is where the maximum gain comes when the short option expires. As the stock moves away from that strike in either direction, the gain diminishes until at some point it turns into a loss.
A mesa-shaped graph can be created by placing several calendar spreads, some above and some below the current stock price. Our goal was to create a curve that showed an approximately equal gain regardless of where the stock ended up at expiration (as long as it was inside a range of stock prices that SPY historically traded).
In addition to the calendar spreads, we also placed some butterfly spreads expiring in August at both extremes of the break-even range. All the calendar spreads involved long September options and short August options. Although the risk/reward numbers are identical for calendar spreads regardless of whether puts or calls are employed, we used calls for strikes higher than the stock price and puts for strikes below the stock price.
Here is what the graph looks like for a $10,000 portfolio we set up on Friday, July 23rd when SPY was trading at $110. The shoulders of the mesa-shaped graph are at $104 and $115. If the stock ends up at any price within that range when the August options expire on the 21st, a double-digit gain (after commissions, of course) will result for the 4 weeks of life.
So the stock can go up as much as $5 in 4 weeks, or fall by as much as $6 and pretty much the same gain should result. In the great majority of months, SPY fluctuates less than these amounts.
We set aside $1500 of the original $10,000 to be used to expand the break-even point in either direction if SPY manages to move close to either shoulder of the mesa (i.e., near $104 or $115). Although there are several ways we can accomplish this adjustment, one of our favorite methods is to add a new calendar spread at a higher strike price (if the stock has moved higher). Doing so would shift the risk profile graph curve to the right, showing greater gains at higher stock prices and lower gains at lower stock prices.
This portfolio is different from any of the other portfolios we carry out at Terry's Tips because when the August expiration comes around we will liquidate all the positions and end up totally in cash, and then set up a similar mesa-shaped risk profile graph for the following month, using October options as the long side and September options as the short side. And when the September expiration comes along on the 18th we will liquidate once again and end up once again totally in cash.
If you are not familiar with options, much of this may seem like mumbo-jumbo right now. A subscription to our service includes an inexpensive and comprehensive options tutorial that will clear up most of your confusion (and if you still have questions, I will be happy to answer them for you).
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
The market went everywhere and ended up nowhere this past week. The week was much like the rest of July, which witnessed market participants buying on strong earnings and selling on notably weak economic numbers. Volatility reigned supreme once again and in the end, the result was a flat market. It was a fitting end to a wildly vacillating month in the market.
After a rough June, July was a welcome surprise for market participants. July was the best performing month in over a year as the S&P 500 and Dow advanced, 6.9% and 7.1%, respectively. It was the first winning month for the major market indices since this past April.
Even with a bullish market during the month of July, many market participants decided it was safer to remain on the sidelines. Volume is typically low during the summer months, but July usually displays strong volume. However, this July market participants did not show the same conviction as the volume was particularly slow. Low volume has been quite evident during each bull phase over the past year or so.
"The biggest crowds aren't on the trading floor, they are on the beach. People don't want to be involved in the market now," said Jeffrey Frankel, president of Stuart Frankel & Co. "One day they are up, one day they are down. Nothing is making any sense. That's why there is no volume."
The lack of conviction during the advance coupled with some technical bearishness has many on Wall Street concerned over the next few months. A repeat performance in August seems unlikely given that second-quarter earnings season is practically over which, as I mentioned before, has been the spark during this latest rally.
"Even though earnings and guidance have been better than expected, there's still skepticism in the market because jobs have been missing in action," said Alec Young, an equity strategist at Standard & Poor's.
The lack of conviction is also plainly evident that investors are still not convinced that earnings growth rates in upcoming quarters will be met, which is essentially no different than what was the concerns were in June when the market declined substantially.
The clearest evidence of that concern can be found in the recent issuance in Treasury market, which had no problem digesting $100 billion in 2-year, 5-year, and 7-year maturities. The yields ended the week lower than when they were issued and actually witnessed historical lows on Friday.
Technically speaking, the market is entering a seasonally bearish time of year. August and September are two of the three worst performing months in the S&P with the average return in August being 0.0% and September -0.7%. The other is February with an average return -0.02%.
Moreover, we have seen countless trading days where the S&P has struggled with strong overhead resistance that conveniently sits right below the closely-watched 200 day moving-average.
Furthermore, the market is nearing a short-term overbought state so a short-term reprieve looks likely at this juncture. I will continue to watch the 1050 as an area of support and the 1120 as an area of resistance. A breach in either direction should lead the market in some type of direction.
Andy
Overbought/Sold Condition Report
Overbought/Oversold as of July 31, 2010
Major Benchmarks
- S&P 500 (SPY) - 54.7 (neutral)
- Dow Jones (DIA) - 61.7 (neutral)
- Russell 2000 (IWM) - 57.5 (neutral)
- NASDAQ 100 (QQQQ) - 52.5 (neutral)
Testimonial of the week
"I'm an auto-trader of multiple portfolios (7 currently). Naturally, my favorite days as a Terry's Tips trader are those days where the profits come pouring in. My second favorite days, however, are days when the market is totally tanking, but the Terry's Tips portfolios are experiencing only mild losses." - Mark