Weekly Stock Options Trading Tips: January 4, 2010

Stock Option Trading Idea of the Week

The options market is dramatically different at the beginning of 2010 compared to what it was one year ago:

1. Option prices are about half what they were a year ago.
2. Actual market volatility is less than half what it was a year ago.
3. Longer-term options have greater Projected Volatilities than short-term options.

These new conditions call for a revised strategy for 2010.

First, a Look Back: Entering 2009, we had just gone through the most volatile period (and the greatest drop) in the history of the stock market. Option prices were at extreme high levels that had never been seen before (and hopefully will never be seen again in our lifetimes).

With such high option prices, it was possible to construct a portfolio of calendar spreads at several different strike prices which yielded a mesa-shaped risk profile graph that provided a near-double digit monthly gain over a wide range of possible stock prices. The market (SPY) could go up or down by 8% (an extremely large monthly change by historical standards) and the same high gain could result.

We called this strategy the Mighty Mesa Strategy because of the neat shape of the risk profile graph curve. The possible gains seemed too good to be true. In fact, it turned out that they were. For 6 consecutive months (the last 4 of 2008 and the first 2 of 2009), the market experienced mid-month swings of greater than 10%. The portfolio that could withstand a market swing of 8% in either direction suddenly started losing large amounts when the market moved by more than that amount.

During this period, the key to survival was to make adjustments to keep up with the fast-changing market. We were forced to take off calendar spreads at strikes far from the stock price and replace them with new spreads at the other end of the spectrum. Frequent adjustments are expensive (transaction costs and the bid-ask-spread-penalties), and always depressed portfolio values.

To cope with this kind of market, we moved away from the 10K Strategy which used LEAPS for the long side and instead, used shorter-term long positions because they were easier to trade out of than LEAPS were. Bid-asked spreads tend to become greater as the number of remaining months in an option increases. Making adjustments by selling LEAPS is extremely costly. Once you buy a LEAP, it is usually best to hang onto it for a very long time. The fast-changing market a year ago did not allow that luxury, and the Mighty Mesa Strategy was the preferred way to cope with the volatile market.

Early in 2009, once volatility started moving lower, we set up portfolios that employed the 10K Strategy rather than the shorter-term long positions that the Mighty Mesa Strategy used. These portfolios (Boomer's Revenge, Marco Polo, Leaping Lizard) did very well in 2009, gaining at annualized rates averaging nearly 50%. The Mighty Mesa Strategy portfolios made much smaller gains. (The only losing portfolio for the last six months was the Big Bear Mesa which maintained a bearish stance while the market moved steadily higher from March on).

Bottom-Line Success Characteristics Over 8 Years of Trading: For 8 years, we have carried out a strategy based on owning longer-term slower-decaying options and selling short-term higher decaying options. Our best years were those when actual market volatility was less than the projected volatility (PV) of the option prices. Our worst year was 2004 when actual volatility was much greater than option prices could support. In that year, most of our money was in QQQQ options, and this underlying was far more volatile than PV. (QQQQ has continued to fluctuate more than its option prices would predict, and it continues to be a poor underlying choice for our strategy, in spite of the very attractive liquidity of those options.)

Over the 8 years, we averaged over 50% annualized gains when the market volatility was moderate, even if option prices (PV) were low. That was the case in 2005, 2006, and up until the last month of 2007 when actual volatility suddenly spiked.

A Closer Look at Today's Option Market: The most popular measure of the option prices is VIX, the average Implied Volatility of S&P 500 (SPY) option prices. (While the most common term is Implied Volatility, I prefer to call it Projected Volatility because that is closer to the true meaning of the concept - a measure of how volatile the market is expected to be).

Here is the VIX chart for the past five years.

The chart clearly shows how unusual market volatility was starting in late 2008 and extending into 2009. Now it is less than 20, and more in line with historic levels. That is generally good news for our strategies (the only caveat being that if actual volatility sky-rockets, we will suffer). PV and actual volatility usually move toward one another over time, so the period of suffering is usually short if actual volatility escalates.

But VIX does not explain a more important feature of option prices that is equally important to our strategies - the difference between PV of the longer-term options that we own and the short-term options that we sell. We like low PVs (option prices) for the longer-term options and high PVs for the short-term options. Unfortunately, that is not the case in today's market. The market thinks that in the short term, the market will be flat, but in the longer term, there will be more volatility.

In the past, there were times when we enjoyed an Implied Volatility advantage (higher IVs for short-term options), and good gains almost always resulted. But there were other times when we made good gains while not having an Implied Volatility advantage. The key to success has always been what the actual volatility ended up being, and of course, that is the one thing that we cannot know in advance.

So What's the Best Thing to do Now? In a market of lower option prices and no Implied Volatility Advantage it is impossible to create the mesa-shaped risk profile graphs that we could have made a year ago. We cannot buy calendar spreads whose strike prices are more than 5% away from the stock price and have positive theta on the spread. We will have to be content with a more traditional risk profile graph which is shaped more like a mountain than a mesa.

In this kind of a market, it will be best to go out a little further with our long options than we have recently in the Mighty Mesa Strategy portfolios. While we will be able to buy fewer spreads, we will enjoy a much greater decay advantage on each spread.

With longer-term long positions (often LEAPS), we will not want to sell them when the market makes a big move. Rather, we should sell the majority of short-term options at the strike which offers the most decay. This means that we will likely end up with more diagonal spreads than we have calendar spreads.

There are some real advantages to not being limited to calendar spreads. If the market falls, instead of taking off a calendar spread to adjust, we can sell new options at a lower strike without having to come up with any cash. If the market rises, we can roll short options up to higher strikes (although such a move will require cash unless it is rolled to a further-out month at the same time).

We have also learned that the best policy is to avoid making adjustments as long as possible. In nearly every instance in the recent past, the market has reversed itself whenever a short-term sharp move was made in one direction or the other. By adjusting too quickly, we often got whip-sawed and lost money where we would have made good gains by doing nothing. In 2010 our goal will to be more patient, and tolerate being on the edge of a break-even point on the risk profile graph without making big adjustments. When we do make adjustments, they will usually be made in small increments rather than wholesale shifting the portfolio in one direction or the other.

Implications of the 2010 Strategy: With longer-life long options, we will have fewer spreads. Adjustments, when they become necessary, will usually involve shifting the strike prices of short options rather than taking off long positions as well. There should be fewer trades, fewer commissions, and fewer bid-ask-spread-penalties to pay.

On the other hand, potential returns are likely to be less than they were a year ago (of course, due to the extreme volatility a year ago, those potential returns as displayed on the risk profile graphs disappeared and often turned to losses) . In today's option market, our annual returns will not likely exceed 50% as they have in many years in the past, but I believe that 36% is an achievable target.

I believe that if a year from now when we look back at our results for 2010, we will be delighted if our average portfolio registered a 36% gain for the year. I also believe that this is a highly probable outcome for our portfolios. Unless market volatility spikes, we should be able to make exceptional gains in 2010. I feel better about our prospects than I have for quite a long time.

Terry

P.S. If you have any questions about this offer or Terry's Tips, please call Seth at 800-803-4595. Or make this investment in yourself at the lowest price ever offered in our 8 years of publication - only $39.95 for our entire package - http://www.terrystips.com/order.php using Special Code 8YEAR.

Andy's Market Report

It was a slow, holiday shortened week with most market participants taking a (should I say) much needed break.

Low-volume dominated and resulted in a fairly uneventful week for the market. However, the short-term 'very overbought' status that the market entered during the Santa Claus rally the week prior needed to be attended to and the bears did just that on Thursday as the market sold-off.

With several foreign markets closed on Monday and Thursday, the calendar extremely thin on trading catalysts and again, market participants nowhere to be found, volume was well below average. To put things into perspective, Tuesday and Thursday were the lightest volume days of the year, even less than the day after Turkey Day when the market traded for only a half session.

But it is because of the extremely light volume that Thursday's late session decline was possible. The move was certainly not news related. As I stated before, it is most likely a short-term 'very overbought' sell-off.

Even though the stock market closed out 2009 with a loss the year as a whole was remarkable. Stocks managed their best year since 2003 as they recovered from a financial crisis and ongoing recession.

"Everyone is looking to put a ribbon on the year and wrap things up," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

Ablin said investors will be looking at upcoming corporate profit reports and jobs numbers to determine whether the market can hold its huge gains in 2010.

"I have a certain belief that the market can keep going, albeit at kind of a shallower pace, but that's going to require some help from corporate America and the economy itself," he said.

Next week, the economic calendar will be back in focus. The employment sector will most likely be the main catalyst for the week as Nonfarm Payrolls and the Unemployment Rate for December will be released late in the week.

Andy

Overbought/Sold Condition Report

Overbought/Oversold as of January 4, 2010

Major Benchmarks

• S&P 500 (SPY) - 40.6 (neutral)

• Dow Jones (DIA) - 36.2 (neutral)

• Russell 2000 (IWM) - 57.0 (neutral)

• NASDAQ 100 (QQQQ) - 48.7 (neutral)