One of the important keys to owning calendar spreads in a volatile market is to have them at a variety of strike prices, some below and some above the stock price. At Terry's Tips, we maintain 3 portfolios using SPY as the underlying (one bullish, one bearish, and one super-conservative with a huge range of strikes for the calendar spreads). Last week these portfolios gained an average of 18%, or about half of the annual target - all in a single week.
The key to the success was the large range of strike prices of the calendar spreads. When you own calendar spreads, if the stock goes higher, the net delta position of your portfolio grows more negative, and when the stock falls, the net delta position becomes more positive. When your portfolio gets uncomfortably long or short, you have an incentive to adjust (maybe taking off some calendars at strikes far away from the stock price and replacing them with new calendars at a closer strike). As we discussed in the last two weeks, such adjustments are costly, and should be avoided if possible.
Last week SPY fluctuated all over the place. On one day it fell over $5 only to end up the day up a little. Yet we were not tempted to adjust when it had moved over 5% in a single day. The reason - an exceptionally large range of strike prices in our calendar spreads.
While those calendars at strikes furthest from the stock price will most likely lose a little money, they provide insurance protection in case you are tempted to keep up with the widely-fluctuating market. And that is the simple lesson for today - when markets are volatile, it is important to avoid having your calendar spreads only at a few strikes very near the current stock price. Instead, expand the range of strikes in both directions, and sleep better at night.
On the heels of the best five-day stretch since the 1930's and the first five-day winning streak in over a year the market decided to take a breather. While a pullback was expected, it was uncertain just how sharp the decline would be given the lack of confidence in the sustainability of the low-volume rally that occurred during the prior holiday-shortened week.
One thing is certain; the market has struggled with a direction over the past few weeks with the trading range getting tighter with each passing day. Can the news get any worse? The market has lost as much as 53% since the highs set just 14 months ago, but has it accurately discounted all of the poor economic news that has yet to come? Or can the economic news get any worse than it did this past week? While no one knows for certain where the market is headed over the short, intermediate or long-term it seems as though the bulls sided with the latter as they maintained a level of conviction this past week.
For instance, take Monday's 8.9% collapse. One day after the Thanksgiving week surge the market was faced with a severe short-term overbought state and an ISM reading of 37.3%, its worst reading in 26 years (a move below 50 is considered to be a contraction in the manufacturing sector so a move this far below the 50 threshold is worrisome).
"Manufacturing is in free fall," said Ian Shepherdson, chief U.S. economist at research firm High Frequency Economics, in a note to clients. "This survey promises continued recession."
The report is "weak across the spectrum," said Bob Brusca, an economist at Fact and Opinion Economics. "Clearly, employment, new orders and output are getting hit hard," he said.
After the trading day was over, the gains from the prior week looked to be all but washed away as the market headed into the middle of the week. Well, that did not happen. The market would dawdle around for the next few days, moving slightly higher until the next piece of important economic news was released before the opening bell Friday.
The highly anticipated monthly jobs report came in well below economists' expectations with a loss of 533,000. It was the largest decline since December 1974. The unemployment rate climbed to 6.7%.
"The economy is in a free fall," said Richard Yamarone of Argus Research. "It is as if someone flicked off the switch on hiring."
"It's a mess," said Mark Zandi, chief economist at Moody's Economy.com. "Businesses, battening down the hatches, are concerned about their survival and are cutting workers."
However, the horrible news could not keep the market down. The market trended higher throughout the entire days and was almost able to wipe away the sharp losses from Monday. Tuesday through Friday witnessed a 7.3% advance in the S&P. Even though the market finished lower for the week it was a moral victory for the bulls as the losses were minimal on the week.
Last week I stated the following: "on a technical basis, I have to admit I am a bit bearish over the short-term (1-3 day). This is mostly due to the outstanding gains (over 10%) in all of the major market indexes and the skeptical reasons stated in the above paragraphs. However, I do think that if the 850 level can act as a strong area of support over the next week we should expect to see the market experience a rally that carries into the New Year."
This is indeed what occurred and now it seems as though the market is set for a sustained move to the upside. I think we could once again see some short-term weakness early next week, but if the 850 level holds (S&P futures) we should expect to see a sharp advance.
The fourth quarter has been absolutely horrible so far the market, but as we move into one the strongest months of the year the market and its participants would not mind if the month of December lived up to its historical billing and finished the month significantly higher. Oftentimes, sharp moves during one month lead to a sharp move in the opposite direction the following month. Only time will tell.
Major Benchmarks
(received 12/5/08) - Just in case nobody is praising you, let me do just that! I am fascinated that I have made money both in an up market and in a down market - with no additional trades. Maybe someday I can figure out how you do it, but I love autotrade, so I had rather let you do it and I will play golf. You are doing great!!! KEEP IT UP! PLEASE! Thanks again!!!!!!!!! Larry Woodman