Weekly Stock Options Trading Tips: February 16, 2009

Stock Options Trading Idea of the Week

When to Roll Short Iron Condors

Last week was a dreadful one for the market – it fell about 5% across the board.  Meanwhile, our composite portfolio remained essentially flat.  Once again we were glad that we owned option positions rather than stocks or mutual funds.

This week I would like to share some thoughts about the best time to take off short iron condors you might have and replace them with next-month out short iron condor spreads (I am assuming that you have read some of our earlier letters where we discussed this kind of spread).

This is about the time of the expiration month when we have to decide whether to let short iron condors (hopefully) expire worthless, or buy them back and establish new ones for the following month.  Letting them expire worthless saves some commissions but gives up the decay that would come from being short the next month options for more days.

Last week in the Mighty Stalagmite portfolio, we bought back the February short iron condor for $21 and paid $6 in commissions ($27/9 remaining days = $3 average per day).  We had originally sold these spreads for $108 so we had a nice profit for the month.  Then we sold March iron condors for $148 each.  That works out to $4 decay per day for the 37 remaining days, so in 9 days the March spread might decay by $36 compared to the $27 cost of buying back (including commissions) the February spread. 

While most of the decay might be expected to come in the last few days of March, there is also a drop in short-term option prices just after an expiration, so the $4 daily average will probably hold up for the first 9 days of the March options.  (Two days after selling the iron condor, the best it could be sold for was $136, so we gained $12 for each spread while the February iron condor could be bought back for $19, so we gave up a gain of only $2).

Short iron condors are fascinating spreads for calculating risk-reward ratios.  In some respects, rolling over early is considerably less risky.  At the time when the spread could be bought for $21, the possible loss for the month was $279 (even though it was extremely unlikely to occur) – the stock would have to move by over $13 in either direction for a total loss to come about, and it would have to move by $10 in only 9 days for any loss at all to result.  On the other hand, risking $279 to make $21 (8%) is not a very attractive risk-reward ratio.

The March short iron condor was sold for $148, so after the $6 commission, $158 would be at risk, and $142 would be the maximum gain, for a 90% risk-reward ratio (even though there was a much greater chance that the full gain would not come about since there were 37 remaining days rather than 9 days and a shorter range between the short sides of the iron condor.

A similar risk-reward issue comes about when deciding whether to place the short iron condors with a 2-point range between the long and short strikes or the 3-point range that we have used so far.  The percentage maximum gain between the two choices is nearly identical.  The 93-90 calls, 80-77 puts iron condor we sold in the Mighty Stalagmite last week could be sold for $136 at the close Friday.  That works out to a risk-reward of 76% ($136-$6)/$170.  If we changed the strikes to 92-90, 80-78, the spread could be sold for only $91 which works out to a risk-reward of 77% ($91-$6)/$115.  So far we have opted for the 3-point range because we can place fewer spreads with a given investment which might save commissions if the range needs to be extended or one side of the spread bought back.

Andy's Market Report

To put it bluntly, it was not a good week for the stock market. Washington D.C. consumed the headlines and that is almost always a disaster for the fickle financial markets.

As I mentioned last week the stock market had pushed into a short-term overbought extreme which typically leads to a short-term reprieve and that is indeed what occurred this past week. The sharp sell-off occurred during the announcement of Treasury Secretary Geithner’s new financial bailout plan. 

The stock market fell more than 4% on Tuesday in response to Geithner’s speech, but I can’t think of a less reliable indicator of whether Mr. Geithner’s ideas will work.

“A few hundred points up or down in the market today or next week isn’t material to what’s at stake here,” said Daniel J. Arbess, who manages the Xerion hedge fund for Perella Weinberg Partners. “Government has to get it right this time because another false start risks triggering years of economic malaise.”

Mr. Arbess added, “This is about recovery from a financial system disaster that was decades in the making. Everybody knows it is incredibly complex. It’s not going to be resolved in a matter of days or weeks.”

Yes, Mr. Abbas is right, but unfortunately that doesn’t help with the uncertainty in the market that will most likely continue to plague the market in the coming weeks and months. Any clarity certainly seems far off.

Later that afternoon, Mr. Bernanke testified before the Financial Services Committee to discuss the Fed’s lending program and by that time most of 4% loss had already occurred.

Thursday was witness to another sharp decline as the weekly job numbers came in worse than expected at 631,000. However, late in the trading session it was reported that the Obama administration was/is working on a plan to subsidize mortgages. The news lifted the S&P 3.1% to eke out the day with a small 0.2% gain. Indeed, it was a worthy effort from the bullish camp.

Overall the market was left extremely disappointed as the S&P lost 4.8% for the week.

Next week brings a holiday shortened week and typically we like that as theta-driven traders. On a seasonal basis, the days surrounding President’s Day leave much to be desired. The three days following the holiday are historically negative, but I often do not trade based on a seasonal bias. Just some food for thought I suppose.

Overbought/Sold Condition Report

Overbought/Oversold as of February 13, 2009

• S&P 500 (SPY) – 36.4 (neutral)
• Dow Jones (DIA) – 31.8 (neutral)
• Russell 2000 (IWM) – 40.4 (neutral)
• NASDAQ 100 (QQQQ) – 51.3 (neutral)
• Oil Services (OIH) – 44.7 (neutral)

Testimonial of the week

I think of myself as a sophisticated investor and was certain my asset allocation was bullet-proof for the crash of 2008. I was out of stocks, 20% in precious metals, 10% in foreign currencies, 20% managed by (formerly) successful Commodity Trading Advisers.

The CTA's are down 50%, gold and silver are down, currencies are down - the only segment of my assets that has grown has been the slice which follows Terry's Tips and which is 'auto-traded' by my broker.  Terry has done remarkably well.  Thank you, Terry!  ~   Bill Masciarelli