Weekly Stock Options Trading Tips: February 8, 2010

Stock Option Trading Idea of the Week

Beware the Ultra-Short and Ultra-Long ETFs

There are a large number of ETFs (mostly established quite recently) that magnify the results of another ETF, index, or measure. Many of them deliver 200% or even 300% of the daily change in an underlying stock or ETF, or the inverse of the daily change.

For example, SKF is an ultra-short based on XLF (the ETF of financial companies that we use in our Marco Polo portfolio). Every day, XLF is configured to go up twice as much as XLF goes down, and vice versa. It works perfectly well on a daily basis.

The problem is, however, that it does not work over the long run. If the ultra-short SKF is at $20 and the underlying XLF goes down by 5% in one day, SKF will go up 10%, to $22. If in the next period, if XLF goes up by 5%, SKF will fall by 10%, but since the absolute value of SKF is now higher, it will fall by $2.20. At the end of the two periods, the underlying XLF has not changed at all while the ultra-short SKF is $19.80 instead of the $20 where it started. This same phenomenon works in every market fluctuation over time.

As a real world example, at the end of October, the underlying XLF closed at $15.50 and the ultra-short SKF closed at $27.00. Last week, XLF had fallen to $14.00, so theoretically, SKF would have gone up by twice that drop, and would be trading at $30. In the real world, SKF was trading at $25.40. It had fallen in value while the underlying had fallen just like it was hoped to do for investors who were betting on the short side. The ultra-short actually lost money while the underlying stock dropped.

Note: my favorite day-trader sold call options on SKF naked short about a year ago (and I copied him with a single call because naked short has always scared me) when it was trading at $170 - while he made 100% of the premium he collected, he would have done much better shorting SKF itself or buying a naked put.

This problem exists for all the ultra-short or ultra-long ETFs that have been created. They have a definite downward bias. In addition to the percentage change problem, the company that manages the ETF charges about 1% a year in fees and has trading expenses that further dampen results.

The bottom line is that ultra-short or ultra-long ETFs are fine instruments to use if you need or want protection in a certain direction for a single day, but are not good instruments for the long run.

• 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.

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Terry

Andy's Market Report

All of the major indexes fell again this week - it was the fourth straight week of declines. Surprisingly, during this recent short-term bearish move most of the companies in the S&P have reported better than expected earnings. However, fears surrounding the fiscal viability of several European countries as well as China tightening its monetary policy left the market dumbfounded once again and led to another bearish pause.

As I stated before world markets took a beating this past week, namely the European markets. The debt crisis enveloping Greece spread to other vulnerable countries in Europe such as Portugal and Spain. On Friday,stock markets in Greece, Portugal and Spain led the retreat in Europe - Greece's main composite index was down a further 3.5%, while Portugal's PSI 20 fell 3% and Spain's IBEX dropped 2.6%.

"It has been a worry for Greece for weeks but it is now spreading like wildfire, driving equity markets lower, causing further concerns both about medium-term growth prospects and in currency markets," said Kit Juckes, chief economist at ECU Group.

"It's been a dismal 24 hours for global markets as stock markets, commodities and currencies have fallen around the world, while bond default risk has soared, as investors have fled risky assets into the relative safety of the dollar," said Michael Hewson, an analyst at CMC Markets.

On a technical basis, world markets and the U.S. market are generally oversold. Since the bullish move that began last March, each blip like the one that has occurred over the past several weeks has been met with strong interest from the bulls. If we are indeed still in an uptrend I would expect this type of trading environment to continue or at least a defined trading range over the next 6-8 months.

Although, over the short-term, with the major indices in an oversold state and sitting on strong support levels I anticipate a bounce over the next 1-3 days. Friday's move during the last hour a trading was certainly indicative of a bullish move in the near future, the question is - how long will it last? As Terry stated talked about last week - a reversion to the mean - I think the reversion might have begun late Friday. We will certainly find out soon enough.

Andy

Overbought/Sold Condition Report

Overbought/Oversold as of February 8, 2010

Major Benchmarks

• S&P 500 (SPY) - 41.0 (neutral)

• Dow Jones (DIA) - 30.7 (neutral)

• Russell 2000 (IWM) - 32.2 (neutral)

• NASDAQ 100 (QQQQ) - 32.2 (neutral)

Testimonial of the week

"'scuse me for jumping in here. I also subscribe to "Terry's Tips". First advisory service I ever have subscibed to ... I've been pleasantly surprised. As an option writing beginner (lost plenty with naked calls) as you say you learn the basic strategy very quickly. What Terry adds is the small details. How do you handle things in the last days of expiration. What to do with options you wrote which have very little time value approaching expiration. How to select the correct strike for next months writes etc.
 
 I'm sure these are all obvious to you, but have provided an interesting education for me.
 -  Steve (on Yahoo! Finance Message Board)