Stock Options Trading Idea of the Week
Changing Calendar Spreads Into Short Iron Condors
When IV is falling, it is best to be short as many options as you can. One of the best strategies for a falling IV environment is short iron condors. Calendar spreads get hurt when IV falls because the absolute drop in the value of the longer-term long options is greater than the absolute drop in the short short-term options.
A couple of weeks ago, our SPY portfolios using the Mighty Mesa Strategy had calendar spreads at several strike prices, ranging from 85 to 100 at a time when SPY was trading around $93. We were long March quarterly options and short January options, using puts for strikes below 93 and calls for strikes above 93.
With Implied volatilities (IV) falling, we were suffering a decline in portfolio values, and we decided to convert some of our calendar spreads into short iron condors. It was quite easy to do it. We only converted those calendar spreads at the extreme ends of the range. On the lower end, we sold out March 85 puts and replaced them with January 82 puts, gaining a lot of cash in the process.
On the upper end, we sold the March 100 calls we owned and replaced them with January 103 calls, again gaining much cash. The new short iron condor spreads involved a maintenance requirement of $300 per spread, the difference in strike prices between our long and short options.
These short iron condors will expire worthless and yield a nice gain if SPY ends up at any price between $85 and $100 when they expire on Friday, January 16, 2009. If SPY falls to the $85 level next week (from its current $89), we would probably replace the lower half of the short iron condor with a butterfly spread that would extend the downside maximum gain number to 82 but would cut the gain in half.
Changing the calendar spreads to short iron condor spreads generated more than enough cash to cover the $300 per spread maintenance requirement, and we used the extra cash to add some short iron condors for February, this time using a larger range of strikes since there was more time over which SPY might fluctuate in price.
Happy trading.
Terry
Andy's Market Report
After a steady climb higher to start the New Year the market, during its first full week of trading, decided it was time to take some of the short-term profits that 2009 had to offer.
The market entered the week in a short-term overbought state and the spike higher Monday pushed the market into a short-term overbought extreme so a reprieve was anticipated, especially with the uncertainty surrounding the always important employment report out Friday.
The market held the extreme overbought state into Tuesday, but was faced with a barrage of selling as the market moved into Wednesday. The cause was the grim ADP report. The report, which measures private non-farm employment, stated a loss of 693,000. It was a number far worse than economists' expected and it would foreshadow the government's employment report due out Friday.
"This is an eye-poppingly bad number," Art Hogan, the New York-based chief market analyst at Jefferies & Co., said of the ADP report. "The economy is in very difficult shape and that's been proved out over the economic data from the past month."
The market would hold steady Thursday, but the most market participants knew the Labor Department's much anticipated report would be dismal, but just how dismal was the unknown that drew fear into the market.
The report stated a loss of 524,000, slightly less than the predicted 550,000. The unemployment rate jumped to 7.2% from 6.8% in November.
"People say that they know how bad the economy is. But they don't know how it feels to have the reality hit home," said Stu Schweitzer, global markets strategist at J.P. Morgan's Private Bank. "It's not the facts -- it's how the facts feel. And it feels terrible to have so many Americans losing jobs, and so many more likely to follow in the coming months."
The US economy witnessed a loss of 2.6 million jobs in 2008, the most in over 50 years. In an economy that relies heavily on consumers, two-thirds to be exact, a loss of this magnitude will certainly erode consumer spending which is why the market continues to struggles to make any substantial progress. We could see a range-bound market for quite some time.
Next week could be even worse for the market as the market is greeted with the first fourth quarter earnings reports.
"Everyone is expecting bad results," said Jim Swanson, chief investment strategist at MFS Investment Management. But he said Wall Street has also set expectations so low that results would have to be far worse than expected to startle the market.
"Anything that's not catastrophic will probably be greeted mildly or even a little bit positively," he said.
On the technical side of things the market, or should I say the S&P 500 has been able to hold the 880 area which seems to be a strong area of support. Furthermore, my shortest-term overbought/oversold readings have pushed into an oversold state which typically means a short-term pop is in the making. If 880 does hold and a pop does indeed occur I would not be surprised to see a move back close to 1000 in the S&P, but I think that would it for the intermediate-term rally. Again, I expect to see range-bound persist for much of the year, albeit a 150 to 200 range, but a range nonetheless.
Overbought/Sold Condition Report
Overbought/Oversold as of January 9, 2008
Major Benchmarks
- Dow (DIA) - 35.0 (neutral)
- S&P 500 (SPY) - 37.9 (neutral)
- Russell 2000 (IWM) - 37.1 (neutral)
- Nasdaq 100 (QQQQ) - 43.9 (neutral)
- Oil Services (OIH) - 48.0 (neutral)
Testimonial of the week
Terry's Tips makes me feel smarter than the professionals
by out-performing the market even during the worst down-turn in decades! ~ Gavilán