Weekly Stock Options Trading Tips: August 3, 2009

Stock Options Trading Idea of the Week

The Exponential Factor - Still Feeling Poor?

This week I would like to talk a little about a mathematical nuance that helps explain why most of us aren't feeling rich even after the recent market rise.  I also show how it works wonders for a certain ETF.

Terry

The Exponential Factor - Still Feeling Poor?

The Exponential Factor - Still Feeling Poor?  In spite of the recent market surge, most people are not feeling whole by any stretch of the imagination.  There is a good reason for it.  They aren't anywhere near back to where they once were.  Part of the reason lies in the way percentage changes are calculated.  When the market falls, the starting base number (the denominator of the fraction) is at a high point, so the percentage change number is lower than it would be if the stock had gone up where the starting base number had been lower.  For example, if a stock is at $100 and falls 40% much like the market as a whole did last year, it would then be $60.  If the stock then goes up 40%, it only gets back to $84.  So the owner of the stock is still down 16% in spite of two identical percentage swings in the stock price.
 
John Bogle recently calculated that if you had invested a dollar in the S&P 500 at its peak, by March this year the index had fallen 57%, reducing your dollar to a mere 43 cents.  After a 40% gain, your little stash was worth only 60 cents.  If your initial investment fell 50%, you would need a 100% gain to return to the starting line.  This is called the "exponential factor" in losses and recoveries.
 
This exponential factor is what explains why ultra-short ETFs such as SKF (which on a daily basis returns double the downside percentage change of the financial ETF,  XLF) often fall in value even when the underlying stock also falls.   What is true on a daily basis does not work out over several months because of the exponential factor.  Three months ago, I reported to Terry's Tips subscribers that my favorite day trader shorted SKF when it was $170.  It is now less than $33 because XLF has gone up since then, but it would have presumably have been less than $170 even if XLF had fallen over that time period.  My friend told me that it was the first time when he felt totally confident that he was betting with the house.

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 

Andy's Market Report

The market made modest gains this past week as the S&P was able to tack on another 0.8%. The push led to new highs on Thursday before the market decided to pull back and take a pause. For the week the Dow, S&P, Russell and NASDAQ 100 advanced 0.9%, 0.8%, 0.6% and 1.5% respectively.

As I stated last week the market had gained over 11% during the past two weeks which pushed it into a short-term "very overbought" state. The probability of at least a short-term pullback looked high. Well, the bulls were able to hold steady, but not without a fight from the opposition. The bears came in early and often during the first three sessions of the week, but the bulls put the hammer down each afternoon and kept the market within the trading range that it had established the prior Friday. That is, until the reigns were let loose on Thursday and the bulls pushed the market to new highs on the year.
 
However, the effort has left the market in a bit of a short-term quandary. As I stated before, the market remains in a short-term "overbought" to "very overbought" state in addition to an unclosed gap from the market (SPY) on Thursday. Furthermore, the gap higher was unable to produce any type of sustained rally which with all of the other info stated above tells me that we will see a closure sometime next week, most likely during the first few trading sessions.

Economic data stood at the forefront this week as there was quite a few market moving releases this past week although none of them seemed to play a major part in the trading psyche of market participants.

Consumer Confidence was the release everyone seemed to be focused on, yet when the numbers came in lower than expected (46.6 vs. 49.0 consensus) the market seemed to shrug of the disappointing news as it was able to tack on a modest gain afterwards before settling into the range it has established over the past few trading sessions.

New Home Sales was released during the early part of the week and came in better than anticipated. Economists' predicted 352,000 but were pleasantly surprised when the number came in at 384,000. New Home Sales has improved each month since hitting a low back in January. However, rising unemployment remains influential in the economic recovery process for the housing market, so this may simply be a stabilization at depressed levels.

"As long as jobs are being lost, regardless of all the federal programs out there to help the borrowers, you're still going to have problems in the housing market," says Steve Cumbie, executive director of the Center for Real Estate Development at the University of North Carolina's Kenan-Flagler Business School.

Next week brings the end to the second-quarter earnings season. Couple that with the technical mumbo jumbo I stated above and I think sellers could take a short-term hold on the market. After over a 12% gain during the last three weeks I think it is fairly safe to say that a reprieve should be expected. Only time will tell.

Overbought/Sold Condition Report

Overbought/Oversold as of August 1, 2009

Major Benchmarks

• S&P 500 (SPY) - 83.0 (very overbought)
• Dow Jones (DIA) - 83.7 (very overbought)
• Russell 2000 (IWM) -  78.5 (overbought)
• NASDAQ 100 (QQQQ) - 73.1 (overbought)

Testimonial of the week

"You're a class act and it's obvious to me why you have become so successful.  Keep up the good work.   I look forward to staying with you for a long time."  ~ Tim