Stock Option Trading Idea of the Week
The Importance of VIX
VIX is a measure of the average Implied Volatility of SPY, the tracking stock of the S&P 500. It is often referred to as the "fear index." When investors get scared, they often buy put options and/or sell call options to protect themselves against a big market drop. When this happens, VIX (and option prices in general) usually moves higher.
At Terry's Tips, we use an options strategy that consists of owning calendar (or diagonal) spreads at many different strike prices, both above and below the stock price. Six of the eight actual portfolios we carry out use SPY as the underlying.
When VIX moves sharply higher, the long side of our calendar spreads (the options with more remaining life and therefore the ones with a higher absolute value) increase in value by more than the short-term options that we are short.
If an option trading at $6.00 goes up 10%, the option will be worth $.60 more, while a short option covered by that longer-term $6.00 option might be trading at $.90, and it might only go up by $.09. If you had 10 of those spreads in place, your portfolio would increase in value by $510 just because of the higher option prices that result when VIX moves higher.
VIX almost always moves in the opposite direction of the market. If the market moves higher, VIX usually moves lower, and vice versa.
The biggest implication of this pattern for our portfolios is that we should maintain a positive net delta (i.e., be long, hoping the stock will move higher) as much of the time as possible, even if we believe the market is headed lower. (Since we really don't know what the short-term direction of the market will be, we shouldn't be guessing anyway.)
In our strategy of multiple calendar spreads, we become positive net delta by placing more spreads at strikes above the stock price than below it.
If the market moves higher, we should make some gains because of our positive delta condition (in addition to decay gains that should take place regardless of what the market does). These gains might be partially or wholly offset by losses we might incur if VIX falls with the rising market. On the other hand, if the market falls, we would lose value from the long delta condition but might make it up because VIX might rise. Maintaining a positive net delta serves as a hedge against a change in VIX.
For the last year or so, the market has moved mostly higher, and VIX has recently fallen to a 4-year low. In spite of the uncertainties in the economic world, investors seem to feel confident about the stock market, and they have not bid up option prices.
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
Andy's Market Report
Range-bound trading persists. All of the major indices finished the week flat essentially flat for the week. The small-cap index, Russell 2000 (IWM), outperformed the other major benchmarks with a 0.9% gain for the week. The Dow (DIA), S&P 500 (SPY) and Nasdaq (QQQ) all closed the week slightly lower.
Crude oil moved higher for the week, with crude trading around $100.58 near the close Friday. Gold was also higher for the week as it closed at $1533.71 an ounce at the end of Friday's trading session.
I am beginning to feel like we could see the markets move sideways for a few more months. Are the summer doldrums already upon us? How long can SPY stay in this range of roughly $126 to $137?
If the market does continue to trade sideways for the next few months it could be lucrative for options selling strategies. The VIX is still quite low so quite low at 15.98, so premium is somewhat limited in the S&P 500 (SPY), but another push to the bottom of the range should set up another excellent opportunity to sell more premium as the VIX would most likely move back to the low 20's. Of course, a move lower would indeed have to take place and with the Fed propping up the market it might be difficult.
However, the easy money days could be long gone once QE2 officially ends in the next month. Just look at the incredible gains the market has produced since QE1 back in March 2009.
Last week I mentioned a study from Nautilus Capital that I think is worth repeating. Nautilus Capital is an institutional research firm that I find to be very savvy with the research they present. The research firm recently stated that cyclical bull markets within secular bears have tended to average just 26 months, with an average gain of 85%, while cyclical bears within secular bears have averaged 19 months, with steep average losses of -39%. Market cycles tend to be truncated during secular bears, averaging a full bull-bear cycle duration of just 45 months (3.75 years), for a full-cycle average gain of just over 12% (3.3% annualized). Of course, fundamentals still tend to grow faster than 3.3% over the cycle, resulting in valuations that are lower at each bear market trough, even if prices are higher in absolute terms. I recognize that outcomes like these are unpleasant and inconvenient to contemplate, but denying the possibility doesn't make anyone a better investor.
We are currently in the 26th month of a cyclical bull in a secular bear and I think the 39% drop is not too much of a push. A 39% loss would bring the S&P back down to close both of the gaps I discussed last week and would fall right in line with my prediction over the 9-12 months.
In notable economic news this week, consumer spending rose 0.4%, reflecting an advance in food and gasoline prices. Personal incomes were higher by 0.4%, but after tax inflation incomes were basically flat. My stance hasn't changed from last week. I expect that we will see a series of gaps close in the S&P 500 (SPY) beginning with the 4/20 gap, followed by the 12/1/10 gap at $118.0 with the potential of a close of the 9/1/10 gap at $104.41. I do not expect the latter gap to close this summer, but it would not surprise me to see the gap close over the next 12-18 months.
With price valuations at historical levels, the end of QE2 and all sorts of troubling economic numbers I think the market is due for a pullback. I mean come on, the bulls have enjoyed a 102% ride from the bottom a few years ago, so an expected pullback really would not be out of the ordinary.
Andy
Overbought/Sold Condition Report
Overbought/Oversold as of May 27, 2011
- S&P 500 (SPY) - 45.3 (neutral)
- Dow Jones (DIA) - 48.2 (neutral)
- Russell 2000 (IWM) - 63.1 (neutral)
- NASDAQ 100 (QQQQ) - 55.8 (neutral)
Testimonial of the week
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