A good argument could be made that the craziness of last week will settle down soon, and that VIX (the most popular indicator of market volatility) will move back to historical levels. In the past, it has rarely stayed over 40 except for the late 2008 crash which was unprecedented in stock market history. Over the past two weeks, VIX has shot up from about 16 to over 40. Most traders believe it will not remain this high for long.
What do you do when you think VIX will be falling? The best bet might be to sell an iron condor spread. With option prices so high, you can create an extremely wide range of possible stock prices within which all the options would expire worthless and you could keep the entire proceeds you took in when you sold.
For the last few months, selling iron condor spreads was not a good idea. Premiums were so low that the risk-reward ratio just didn't make sense. People who sold them a month or so ago surely got killed last week. But with today's option prices it is an entirely different story.
For an example (not necessarily a recommendation), if you believed that SPY will fluctuate less than $6 in either direction in two weeks, at Friday's closing prices you could buy SPY May 100 puts, sell May 105 puts, buy May 122 calls and sell May 117 calls and collect $1.24 (after paying commissions). Your maximum loss (and net maintenance requirement) would be $3.79 (including commissions) so you would make 33% on you investment in two weeks if you were right and the stock ended up anywhere between $105 and $117. The maximum loss would occur if SPY closed below $100 or above $122.
Certainly the odds are greater than 90% that the change in SPY over a two-week period will be less than $6, so the bet makes sense by historical measures. But the market mentality right now is skittish, and the elevated VIX means people are uncertain, and expect high volatility. With this kind of outlook, it is psychologically difficult to bet on a market that behaves like it has most of the time in the past.
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.
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I look forward to having you on board, and to prospering with you.
Terry
P.S. If you order the book no later than May 17, 2010, I will send you a copy of Making 36% by first-class mail for the total price of only $9.97. Order it here and use the discount code of VAL.
I have stated numerous times over the past month that I felt as though the S&P 500 had maxed out its gains over the short to intermediate-term and should push back, at least to the gap from 3/5 over the intermediate-term - more specifically, a move to the $112.34 in the S&P 500 (SPY) or $45.76 in the NASDAQ 100 (QQQQ).
Well, that scenario played out this past week as the market began a steep sell-off on heavy volume Tuesday and carried that bearish sentiment into the market close Friday.
On Tuesday, the selling began as Greece's financial future moved back to the forefront. Fears became palpable once news hit that Greek citizens were rioting in the streets over the disappointment of how the country has handled the crisis. Market analysts' attributed the slump this past week to the renewed concern that the European debt crisis (if it came to fruition) would substantially slow U.S. the economic recovery.
While Greece economy isn't particularly large, many of the major European banks hold billions of dollars of the country's debt. A default or restructure of the debt would certainly lead to a cut-back on lending to conserve cash. Furthermore, if other indebted nations such as Spain, Portugal and Ireland run into issues financing their deficits tighter credit would follow and put a damper on Europe's overall financial well-being.
"Europe feels like we did after Lehman Brothers," said Barry Eichengreen, an economics professor at the University of California, Berkeley. "No one has seen this kind of thing before… and they are questioning the competence of their leaders to deal with it, and rightly so."
The losses extended into Wednesday and then the epic part of the week began. On Thursday the market was down roughly 350 points before the historical plunge occurred around 2:40 p.m. ET. The market sold-off at a rapid pace or to the tune of 998.50 points over the next ten minutes only to rebound significantly in the ten minutes to follow.
A day after the harrowing plunge officials were still uncertain what caused the historical plunge. Was it a 'fat finger' trade? Several possibilities were being investigated, but as of late Friday no clear explanation had emerged. Regulators were unable to answer the question on investors' minds Friday: What caused the near panic late Thursday?
"It's a pile of uncertainty… We don't have any more clarity than we did yesterday," said Art Hogan, chief market analyst at Jefferies & Co. in Boston. "We're going to have investors who are less inclined to be in this marketplace until we get some clarity."
Nonetheless, the market's wild swing Thursday remains elusive, leaving what amounts to a $1 trillion question mark hanging over the world's largest, and most celebrated, stock market.
Friday's trading left the Dow down 5.7% percent for the week and erased its gains for the year. The S&P fell about 6.4%, the Russell 2000 was off 8.9%, while the Nasdaq fell 7.9% for the week. The S&P and Nasdaq also went into the red for 2010.
The losses left the market closer to what analysts' call a correction, usually defined as a drop of between 10% and 20% following a sustained rise. The Dow is now 7.4% off its recent high of 11,205.03 reached on April 26. The S&P 500 is down 8.7% from its recent high of 1,217.28 reached April 23.
"We were in the midst of a pullback, we needed one, we got one," said Peter Cardillo, chief market economist at New York-based brokerage house Avalon Partners Inc. Cardillo said the choppy trading after such a drastic decline likely signals the market trying to find a bottom.
On a technical basis all four of the major indices have moved into a short-term oversold state so I would expect to see a bounce early next week, but if that scenario plays out I would not be to confident in a sustained rally.
As I stated last week, May is upon us and as the old Wall Street adage goes, "sell in May and go away."
May is historically one of the weaker performing months and it is certainly something to consider over the intermediate-term as the market was already overextended.
The Stock Trader's Almanac states that a $10,000 investment compounded to $544,323 during the November-April period over the last 56 years compared to a $272 loss for May-October. I think that sums up the significance of the historical period known as the "Summer Doldrums."
Keep this in mind as we move into the summer months. Corrections happen. Flat periods happen. The market can't continue to advance in this manner without corrections and lengthy consolidation periods. This is the nature of the market. Consider learning alternative investment strategies such as premium selling options strategies as a way to diversify your current portfolio so that you are better equipped in any market environment, bullish bearish or neutral.
Andy
Overbought/Oversold as of May 8, 2010
Major Benchmarks