Every once in a while, we enjoy a total vindication of the options strategy that we carry out at Terry's Tips. The August expiration month was one of those times. While the market went up about 9%, the composite value of our 7 option portfolios gained 18%, about double the gain in the market averages.
Only one of our portfolios lost money (down 3.3%), and that portfolio is set up to be a bearish bet on the market (as a hedge for subscribers who have other investments that do best when markets are higher). This portfolio is designed to make money if the market goes up by less than 5% in a month, or falls by as much as 10% (or more, after adjustments). When the S&P 500 rose 9.4%, it moved into a loss situation, although with only a single day to go, it was ahead for the month, but SPY rose almost $2 on Friday which proved to be the straw that broke our Big Bear's back.
I invite you to check out our Track Record page to see how each of our portfolios performed last month - http://www.terrystips.com/TrackRecord/.
Today we will discuss how to play Implied Volatility spikes, something that comes up about every three months for several companies just before an earnings announcement, and for other companies when something like a buy-out rumor surfaces.
Enjoy the report.
Terry
Playing Implied Volatility Spikes
Prior to an important company event such as an earnings announcement, Projected Volatility (IV) of the options which expire just after the event tends to shoot way up in value.
This is especially true for companies whose earnings fluctuate widely (perhaps because of a new product with an uncertain market potential, such as Apple Computer) or companies that don't offer the analysts much in the way of guidance (such as Google). Several months before the earnings announcement, there will be extremely high IVs for the options in the expiration which occurs just after the announcement.
This is especially true for Google which (surely not accidentally) often announces earnings a day or two before a Friday option expiration.
A huge IV Advantage can be gained by buying LEAPS (or any future month options) and selling the earnings-announcement month options. Sometimes, short-term IV might be close to double that of the longer-term options. A huge potential gain often exists during these times.
The great disadvantage to buying calendar spreads prior to an earnings announcement for companies such as Apple and Google is that the actual volatility of the stock is often substantial at that time. There is a reason for those short-term option prices to be high.
One interesting strategy is to guess which way you think the market will move after the announcement, and buy a calendar spread in that direction (buying at a strike price that is closest to the price where you think the stock will end up after the announcement). If you are right, you might just double your money. If you are wrong, there will still be some value to your longer-term long option, so you haven't lost everything.
From my experience, you are better off betting that the stock will fall after the announcement than betting that the stock will shoot up even higher. Oftentimes, earnings exceed expectations but fall short of the "whisper" numbers, and the stock falls in spite of the good results.
It doesn't make any difference whether you use puts or calls for these calendar spreads, although I prefer using calls for strikes that are higher than the stock price and puts for strikes that are below the stock price.
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 portfolios (12 portfolios if you count the Shoot Strategy ones as well) 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
It was another volatile week for the market. After a sharp decline Monday that S&P 500 (SPY) managed to quickly reverse course and was able to close the week with a 2.2% advance. In addition the Dow, Russell and Nasdaq 100 finished the week higher 2.0%, 3.1% and 1.8% respectively.
Last week I stated in my market comments that "the short-term pullback two weeks ago was anticipated due to 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 advance. I would not be surprised to see a further decline that closes the gap before any meaningful advance occurs."
Indeed the gap did close on Monday. As we saw from the performance of the major market benchmark, once the gap was closed the bulls were able to push the market back up to what has been an area of strong overhead resistance. Where next? Well, of course no one knows for certain, but the major benchmarks have pushed back into a short-term overbought state so that typically means that a short-term reprieve is to follow. Historically, the trading day that follows expiration is bearish by nature so Monday could see the dip that would bring the market back to a neutral state. Only time will tell.
Monday's sharp decline was attributed to the two-week correction that has occurred in the Shanghai index. Chine had advanced 109% since October so a reprieve was long overdue. Indeed it did occur Monday and it had a direct affect on most of the world's major benchmarks.
However, once the decline occurred and the gap closed, the buying effort was strong, mostly in reaction to this week's economic data. According to briefing.com we had "negative housing data on Tuesday -- July Housing Starts 581,000 vs. 599,000 consensus; Building Permits 560,000 vs. 577,000 consensus -- and negative employment data on Thursday -- Initial Jobless Claims 576,000 vs. 551,000 consensus -- but equities closed modestly higher both days. Then on Friday, a better-than-expected Existing Home Sales figure (5.24 million vs. 5.00 million consensus) led to a 1.9% rally in the S&P 500."
On Friday, Federal Reserve Chairman Ben Bernanke stated what investors wanted to hear, "that the economy is indeed on the verge of recovery". The market responded with a rally that sent the major indexes to new highs for the year.
"Although we have avoided the worst, difficult challenges still lie ahead," Bernanke told the gathering of fellow bankers, academics and economists. "We must work together to build on the gains already made to secure a sustained economic recovery."
Next week brings an abundance of economic data. More housing numbers are due out Tuesday and Wednesday with the release of the S&P/Case-Schiller Home Price Index and July New Home Sales. Wednesday also brings July Durable Goods Orders. However, the major focus will be on the release of the second quarter GDP on Thursday. Economists' are forecasting a revision to -1.4%.
Overbought/Oversold as of August 21, 2009
Major Benchmarks