Weekly Stock Options Trading Tips: January 11, 2010

Stock Option Trading Idea of the Week

A few years ago I wrote an article entitled "Puts May be Better Than Calls for Calendar Spreads." Since that time, I have sent this as part of our option tutorial program for Terry's Tips Insiders. Several new subscribers have written in to report that put calendar spreads are now more costly than call calendar spreads.

The main point of the article was that the risk profile of a calendar spread is identical regardless of whether puts or calls are used. The strike price (rather than the choice of puts or calls) determines whether a spread is bearish or bullish. A calendar spread at a strike price below the stock price is a bearish because the maximum gain is made if the stock falls exactly to the strike price, and a calendar spread at a strike price above the stock price is bullish.

When buying at-the-money calendar spreads, the least expensive choice (puts or calls) should usually be made. (An exception would be if we are using the 10K Strategy and anticipate rolling short calls to higher strikes, creating diagonal spreads rather than maintaining calendar spreads. If this is true, calls would be the preferred choice for new spreads.)

Up until last fall when the market crashed, call calendar spreads were more expensive than put calendar spreads (at the same strike). People were generally optimistic about the market, and purchased more calls than puts. Then they weren't so optimistic, and started buying more puts. Even though the market has risen for the last nine months, a great deal of pessimism continues to pervade the market. People are paying more for puts than they are for calls. This results in higher prices for put calendar spreads.

An argument could be made that since short-term puts can be sold for more than short-term calls, it might be worth to pay the extra amount for a put calendar spread - each month that the short puts are rolled over, a higher decay amount might be collected. But this argument is based on the assumption that the general market pessimism will continue; if it doesn't, put calendar spreads will suddenly be worth less than call calendar spreads, and you will be sorry that you paid the extra amount when you first bought the spread.

The choice of using puts or calls for a calendar spread is only relevant when considering at-the-money spreads. If you have a portfolio of exclusively calendar spreads (you don't anticipate moving to diagonal spreads), it is best to use puts at strikes below the stock price and calls for spreads at strikes which are higher than the stock price. If you do the reverse, you will own a bunch of well in-the-money short options, and rolling them over to the next month is expensive (in-the-money bid-asked spreads are greater than out-of-the-money bid asked spreads so you can collect more cash when rolling over out-of-the-money short options).

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

Market participants piled into stocks during the first full trading week of 2010. The Dow advanced 1.8% while the S&P 500 gained 2.7%. Both of the major benchmarks pushed to their highest levels in 15 months and raised hopes that the rally that started back in March of 2009 would continue after the worst market collapse since the 1930s.

The S&P 500 (SPY) logged five straight days of gains which was closely watched on Wall Street. The first five trading sessions are viewed as an early warning system as to how the market will perform over the course of the year. The last 37 times the major indexes advanced during the first five trading sessions of the year, the major benchmarks finished in positive territory by years end 32 times. Indeed, a positive indicator for the market going forward. It is hard to argue with a success rate of 90%.

"If the (market) is up in January, as I expect, then the odds are very high that it will be up for the year," noted economist Ed Yardeni of Yardeni Research in a Monday briefing.

"The American economy is far from being back to full health as we enter the first week of 2010," David Kelly, chief market strategist at JPMorgan Funds, pointed out to clients. "But waking up Monday, the world looks far less bleak than it did a year ago."

Economic data was in focus this week as the last few weeks have been somewhat desolate on the economic calendar.

The most newsworthy was Friday's December Nonfarm Payroll report which slipped 85,000. It was far worse than economists' anticipated, but the unemployment rate held steady at 10.0% as expected.

Last month's losses were all the more disappointing because Labor Department officials revised their November estimates to show that the economy actually gained 4,000 jobs that month - the first positive in nearly two years - instead of losing 11,000.

"The road to recovery is never straight," Obama said in announcing the grants that he said would create about 17,000 green jobs and would be paid for out of funds from last year's $787 billion stimulus bill.

Technically speaking, the market has moved into an "overbought" to "very overbought" state which typically means that a short-term reprieve is expected within the next 1-3 trading sessions. Given the recent strength of the advance and the string of days that the market has moved higher I would expect to see a decline early next week. Of course, as we all know this is only a probability, but as traders probabilities are one of the few tools we have to gauge the market and its next short/intermediate/long-term moves.

Andy

Overbought/Sold Condition Report

Overbought/Oversold as of January 11, 2010

Major Benchmarks

• S&P 500 (SPY) - 80.8 (very overbought)

• Dow Jones (DIA) - 71.6 (overbought)

• Russell 2000 (IWM) - 77.5 (overbought)

• NASDAQ 100 (QQQQ) - 71.9 (overbought)

Testimonial of the week

"I have used a variation of the 10K Strategy with Cummings Engine and Goldman Sachs ..., and have made a 100% return on both investments."   Jay