Weekly Stock Options Trading Tips: February 22, 2010

Stock Option Trading Idea of the Week

The Black Swan Hedge

On February 17, I set up a $10,000 demonstration account to test the idea that the Exchange Traded Note (ETN), VXX, would serve as protection against a drastic fall in the market (specifically SPY). There is a high inverse relationship between the price of VXX and the price of SPY, almost 100%. If SPY goes down $2, VXX has historically gone up by about $2. (VXX is based on the futures of VIX, the so-called "fear index" of SPY option prices.)

A $10,000 investment in VXX is supposed to protect a $30,000 investment in SPY from a market melt-down such as occurred in late 2008. At that time, SPY fell about 40% while VXX rose from about $30 to about $120. (With those numbers, a $30,000 investment in SPY would have lost $12,000 while a $10,000 investment in VXX would have gone up by about $40,000). In theory, if the market rallies strongly, VIX will also go higher, and VXX as well, so presumably both the VXX investment and the SPY stock purchase would go higher.

VXX should drift lower if SPY stagnates or fluctuates only moderately. However, since we are using the Black Swan Hedge against a SPY portfolio that does best in flat markets, it seems like it might be the perfect hedge for several units of our portfolios based on SPY (we will not know how many units until we get some experience with how VXX fluctuates).

In this sample portfolio, we are also hedging against the downward bias of an instrument that is based on the change in another underlying as ETN does. We are doing this by selling short a call option on VIX. Again, we do not know what the proper number of calls need to be sold to offset 300 shares of VXX, but we have started out by selling 10 April 32.5 calls on VIX when VIX was at 21.91 (we sold the calls for $1.10, picking up $1085 after commissions). VIX would have to rise nearly 50% before these calls came into the money, and if VIX rose by that much, VXX would surely rise be a very large amount as well.

There is a maintenance requirement on the naked short sale of these options, so this strategy cannot be used in an IRA. However, you could buy VXX in an IRA and sell the naked calls in a regular margin account. In our sample account, the maintenance requirement is taken against the equity in the stock (VXX), and there is no margin loan required. The amount at risk figure in the following table is the value of the account less the available dollars in the account.

Our account took quite a hit in the first week. The 300 shares of VXX fell by more than double the amount that SPY rose. This drop in value was closer to the percentage loss in VIX as might be expected. The VIX calls we sold for $1100 ($1085 after commissions) fell to $975 so we picked up a little there.

The goal in this account is to maintain a $10,000 value while providing a hedge against a black swan event and the market crashes. Only time will tell if it works.

In case you missed the videos I offered over the past few weeks, you can catch them here by clicking on the title you missed

• Why Stock Options are Better Than Mutual Funds.
• How to Create a Conservative Options Portfolio.
• How to Use Options to Invest in Gold.
• Making Adjustments to a Conservative Options Portfolio.

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 8 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

U.S. stocks finished the week higher for a second consecutive week as there was no sign of holding the bulls down during the holiday shortened week. It was the Dows biggest weekly gain since November. The S&P tacked on 3.1% over the course of the week as the market was able to digest a few notable earnings reports, some economic news and rather surprising news from the Fed.

The Fed was the main focus this past week as the FOMC minutes were released Wednesday. Fed members agreed that the most likely next move will be an increase in an interest rate the Fed charges on emergency loans to banks, the discount rate, now at 0.5%.

Indeed, on Thursday after the closing bell, the discount rate was raised to 0.75%.

The Fed emphasized that the reason for such a move was not to tighten credit broadly across the economy but to reestablish the penalty against banks for borrowing from the Fed in emergency situations. Before the financial crisis, the discount rate was one point higher than the federal funds rate which is what the banks charge each other for overnight loans. The Fed made the penalty much smaller during the crisis to help banks in need.

In the recent statement, Fed policymakers said they expect the rate will stay "exceptionally low" for an "extended period." It repeated that assurance Thursday.

"It's not a tightening of monetary policy, it has no effect on anything," said Dan Greenhaus, chief economic strategist at Miller Tabak & Co.

The announcement of the rate increase initially was bearish for the global markets. Investors feared that this might be the beginning of the Fed raising other rates such as consumer and business rates because of inflation fears even though they stated otherwise. Ideally the Fed only raises rates to slow the economy and keep inflation from pushing higher.

Howver, Friday's CPI report calmed the market and the futures came back to almost neutral at the opening bell. The January CPI reading on Friday was lower than economists' has predicted, which helped calm some inflation fears after PPI came in a little hotter than expected.

"The economy is still suffering from major problems," said Sal Guatieri, an economist at BMO Capital Markets. "The Fed is going to err on the side of keeping policy loose because of the high unemployment rate and the minimal risk that inflation will move higher over the next couple of years."

Next week, the market enters the week after options expiration which is often bearish for the market, particularly the trading day following expiration. All of the major market indices currently sit in a short-term 'oversold' to 'very oversold' state while at an area of strong overhead resistance. Couple this with the historical bearish 'trading day after options expiration' phenomenon and I think we should expect to see a short-term reprieve as we enter next week. Moreover, the Wilder RSI (2) for several of the major market indices pushed above 99 which means that the probability of a short-term reprieve looks likely.

Andy

Overbought/Sold Condition Report

Overbought/Oversold as of February 22, 2010

Major Benchmarks

• S&P 500 (SPY) - 77.6 (overbought)

• Dow Jones (DIA) - 78.0 (overbought)

• Russell 2000 (IWM) - 81.6 (very overbought)

• NASDAQ 100 (QQQQ) - 77.1 (overbought)