Weekly Stock Option Trading Tips: May 24, 2010

Several weeks ago I discussed the possibility of buying the Exchange Traded Note (ETN), VXX, as protection against a drastic fall in the market (specifically SPY). VXX is based on the short-term futures for VIX (the average implied volatility of SPY options). When markets fall, VIX tends to go higher (it is called the "Fear Index"). For several months, we ran a demonstration for Terry's Tips subscribers where we compared changes in VXX and SPY each week.

We also reported on another ETN called VXZ which traced the mid-term futures for VIX. While VXZ costs more than double VXX, several studies had showed that it held up better in flat or up markets than did VXX.

The results were clear - when SPY fell, both VXX and VXX rose by a slightly higher absolute value than SPY fell. Both ETNs are indeed a good hedge against a big market drop.

However, two problems come up if you buy VXX or VXZ as a hedge against a down market. First, you tie up a lot of cash that could be used for making gains somewhere else. Second, they will likely lose money if the market moves higher. For the past 80 years, the market has averaged almost a 10% annual gain. In those years, your investment in VXX or VXZ would presumably go down.

We believe that our Big Bear portfolio offers a better alternative as a downside hedge vehicle. The biggest difference is that if the market stays flat, the portfolio is designed to make a gain (albeit a smaller gain than what should occur if the market is lower). Even better, there should be no loss if the market goes up moderately. Only if the market is up strongly should this portfolio lose money in any given month.

Here is the risk profile graph for our Big Bear portfolio. It shows the loss or gain that should result from a $3500 investment in SPY put options on June 19 when the June expiration arrives. At the beginning of the expiration month, SPY was trading at $109.12. (This graph assumes that today's VIX level will remain unchanged - if VIX falls over the next 4 weeks, the gains would be less than the graph indicates.)

The graph shows that a 17% gain would be made if the stock stays flat, and a higher gain would result at virtually any lower price for SPY. The stock could go up as high as $114 before a loss would occur on the upside. Clearly, this is an excellent hedge against a market drop, and it has the added advantage of also making gains if the market is flat or slightly higher.

How do we create an options portfolio like this? We call it our Shoot Strategy, as in Shoot for the Stars. It is the strategy we use when we want to bet on the direction of the market. Most of the portfolios at Terry's Tips use what we call the 10K Strategy which makes the assumption that we have no idea of which direction the market will take in the short run.

The Shoot Strategy in the Big Bear portfolio involves buying put options with several months of remaining life and selling short-term puts to someone else. The puts we sell are at lower strikes than those we own. Rather than trying to sell short-term puts which maximize the amount of short-term decay we could collect, we aim to sell just enough short-term decay to cover the decay of the longer-term puts we own.

In Greek terms (pardon me for using Greeks if you are not familiar with them), we seek to maximize the net delta of the portfolio while maintaining a positive theta. As the stock fluctuates during the month, adjustments are often required to maintain these two goals. (Adjustments we made in the May expiration month enabled the Big Bear portfolio to gain over 43% while the original positions at the beginning of the month projected a gain of less than half that amount).

While this may seem to be a little complicated right now, if you become a Terry's Tips subscriber, it should all become quite clear. You can follow how the Big Bear operates over time (as well as several other bullish-leaning portfolios) so that you can do it on your own if you wish.

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

I actually heard the term 'yo-yo sessions' describe the price action in the market this past week. It was indeed, a fitting description.

The week of options expiration is typically filled with lots of volatility and this past week proved to be no different. Volatility was extreme at times, as the VIX vacillated widely between 28 and 48. The so-called 'fear index' jumped to its highest level since April 2009 during Thursday's trading session as the market experienced its largest decline of the year.

The major stock indexes are currently lower approximately 9% from their peak back in late April. The indexes had pushed to 12% before the late day rally on Friday pushed the market higher. Declines of 10% or more are considered a correction. They are typical during a bull market and often seen as healthy after a market has pushed steadily higher with few interruptions. Certainly, this is the type of price action that we have witnessed since the bull run began back in March 2009.

The three-week slide since the market hit its peak in late April has shaved $1.3 trillion of value from the S&P 500 index in the 19 trading days through Thursday. That's more than the $1 trillion Europe and the International Monetary Fund (IMF) pledged to shore up weak European economies.

Whether the so-called correction has run its course or turns into a bear market, defined as a decline of 20% or more, is anyone's guess. All of the major market indices have now moved into a short-term oversold state, so I would expect to see a short-term bounce over the next few sessions. Practically every sector has moved into a short-term oversold state which increases the probability of a short-term bounce. Whether or not the bounce is sustained is anyone's guess. I will be watching the S&P to see how it fares around the 1140 level. I would expect to see some overhead resistance at this level. As for the downside, I am watching for a breach of the May 6 "Flash Crash" lows. The level was tested on Friday, but the bulls held the level with much conviction.

Furthermore, out of the 27 technical/sentiment indicators that are followed by many Wall Street traders, 26 of them have moved decisively towards the bullish camp. Put/call ratio, VIX, VXN, Rydex ratio, odd lot short sales, liquidity premium in SPY, and the ISE Sentiment Index are just a few on the long list.

Dave Lutz, managing director at Stifel Nicolaus Capital Markets, said there are a "tremendous number of indicators" that suggest the whole market is oversold and "a sharp rally is at hand."

Many feel that uncertainty is the factor that is driving the markets right now. There are so many unresolved issues with Europe's debt crisis, the flash crash, US housing market, and financial reform and no one truly knows how it is going to play out. However, we must remember (as I have stated numerous times over the past few weekly reports) that volume was extremely low during the latest mini-rally that began several months ago. Conviction was not there and when that occurs, particularly when the market is in a intermediate-term overbought state, a correction occurs.

So are we headed for more doom and gloom? Who knows? Are we headed for more "pie in the sky"? Who knows? One thing is certain, when the market is uncertain and fear sets in, options premiums move higher and that is exactly what we have witnessed over the last few weeks. What does that mean? It means that options selling strategies historically reign supreme when fear moves into the market.

Economic News at a Glance:

Inflation stays in check (PPI and CPI remain muted)
Core CPI is up 0.9% - smallest year over year rate increase since 1966
Jobless claims increased 25,000 to 471,000 - consensus 439,000
Senate passed financial reform bill - stills needs house approval

Andy

Weekly Stock Options Trading Tips: May 24, 2010

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Using Options to Prosper in Down Markets

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