Last week, we placed the following short iron condor when DIA was trading just over $88 –
BTO 3 DIA Feb-09 98 calls (DAVBT)
STO 3 DIA Feb-09 95 calls (DAVBQ)
BTO 3 DIA Feb-09 77 puts (DIJNY)
STO 3 DIA Feb-09 80 puts (DIJNB) for a credit of $1.15 (selling an iron condor)
It is important to consider commissions in these spreads since they contain 4 contracts per spread (which works out to $6 at thinkorswim for Terry’s Tips subscribers who have the Premium Service for two portfolios). This means that each of the above spreads generated $109. The amount at risk is $300 per spread (the maximum the spread would have to be bought back for) less the $109 received, or $191.
In the above trade of 3 spreads, we have $573 at risk and a possible gain for the six week period of $327. We will make the maximum gain ($327, or 57% of the amount risked) if the stock closes at any price between $80 and $95. Within that range, all of the options would expire worthless, and we would get to keep the $327 we collected at the outset.
In other words, if the stock moves by less than about 10% in the six-week period (which is usually the case), we would make a 57% gain. But for every dollar that it moves beyond those extremes we would lose $300 up to the maximum $573 possible loss.
If the stock does moves to one of the extreme prices ($80 or $95), we would presumably make an adjustment. At that time, a butterfly spread could be purchased to extend that end of the short iron condor. For example, if the stock moved up to $95, in the above trade, we could place the following order:
BTC 3 DIA Feb-09 95 calls (DAVBQ)
STC 6 DIA Feb-09 98 calls (DAVBT) – half of these would be STO
BTO 3 DIA Feb-09 101 calls (DIABW) for a debit of $.60 (buying a butterfly)
This trade would reduce our potential gain by $66 after commissions, to $43, but would expand the maximum profit range on the upside to $98 from $95. Even this reduced amount would not be too shabby – it amounts to 23% for the six weeks.
If the stock moved up to the $95 level, the lower-strike put spread might be rolled up to higher strikes and a little extra cash gained to offset some of the butterfly spread cost.
Most of the time, these short iron condors can be expected to make the maximum gain, and they provide excellent protection against a drop in IVs. However, since there is the possibility of losing a substantial amount, a good cash reserve (or some calendar spreads) should also be in place to insure that we don’t run out of money in those rare months when the maximum possible loss results.
Of course, we could have sold an iron condor with a larger (or smaller) maximum profit range. The larger the range, however, the less you collect, and the greater will be the maximum loss. If we expanded the range by $3 in each direction at the outset, we would collect only $60 after commissions, and have $240 at risk per spread.
Dismal economic reports and the continued woes in the financial sector once again plagued the market. The woes in the financial sector were the major culprit in the continued losses as the sector (XLF) lost 16% during the week.
More specifically, the continued hemorrhaging of the banking stalwarts, Bank of America and Citigroup, influenced the majority of the market declines this past week as they lost up to 46% and 59%, respectively.
Most of the losses came early in the week when several members of Congress stated that the remainder of the bailout fund might not be handed over to the banks so easily.
The news led to the sharp declines in the sector and particularly in the two aforementioned banks. However, later in the week it was assured by Senate approval that the banks would continue to receive the next $350 billion of TARP funds.
"It's that tug of war between problems and promise," said Alan Gayle, senior investment strategist at RidgeWorth Investments. "I think there is a bit of a sigh of relief that there is assistance coming for Citi and Bank of America, but it seems like there is an ongoing need for this assistance."
On Friday both companies reported 4th quarter losses this past week. Citigroup stated a loss of $8.3 billion while BofA lost $2.4 billion. "The banks still have to account for sins of the past -- the bad assets," said Bert Ely, an independent bank analyst. "Now with the bad economy, that causes even more losses and you get bigger and bigger holes in the balance sheets."
The economic news was also dreadful this past week. December retail sales were absolutely horrible as retailers reported a decline of 2.7% which was the sixth straight month of reported losses. Moreover, industrial production declined in the 4th quarter at an annual rate of 11.5%. Lastly (at least for the bad news), weekly jobless claims pushed through the 500,000 to 524,000 this past week after reporting below the 500,000 mark over the last two weeks.
However on Friday, there was an inkling of good news (if you want to call it that) as the Labor Department reported that the consumer price index fell 0.7% in December due to falling energy prices. Economists’ predicted a decline of 0.9%.
Overall it was another poor week on the economic front and as Obama continues to state, “things will get worse before they get better.” Thanks for the insight.
On the technical side of things, the major market indexes continue to be in a short-term oversold state. The S&P fell to hit strong support at 820 midweek which put the index in a short-term “very oversold” state and it quickly bounced back to 850 on Friday. Even with the bounce the index remains in a short-term oversold state so a continuation of Friday’s bounce looks likely during the early part of next week. Although it must be pointed out that the day after options expiration is historically weak so it would not be a surprise to witness a smallish decline Tuesday.
As I stated over the past few months, the market would most likely rally into the New Year and experience a sharp decline shortly afterwards and that is exactly what has happened. Now I think we will be range-bound for quite some time, but slowly extending the range as time passes. I would not be surprised to see a retest of the lows established back in late 2008.
Overbought/Oversold as of January 16, 2009