Stock Options Trading Idea of the Week
Making Adjustments in a Volatile Stock Market
Subscribers have been writing in and asking for a more definitive set of rules as to when to adjust. For example, what number establishes the point where we are "too short" and must make an adjustment? Others have asked why we just don't always maintain a neutral net delta. These are legitimate questions, and unfortunately, there are no easy answers in a market as volatile as this one has been. It might help to explain the reasoning I have been following lately.
Each day, I watch the net delta position of each portfolio and compare it to theta. If theta is higher than net delta, I know that the stock can move against us by a full dollar and we should enjoy a gain for that day. Of course, lately we would be happy if it only moved a dollar in a day - in the past that was considered to be a big move, but today it is a small one. If theta becomes less than net delta, I check out the portfolio on the Analyze Tab at thinkorswim, checking what will happen at the next expiration if the stock price were to move another 6% - 10% in either direction (if expiration is only a week and a half away, I use the 6% numbers, and if it is more than two weeks away, I look at the 10% numbers). If a large loss appears imminent at one of those extremes, an adjustment would be in order.
As we have talked about in the past, adjustments are expensive. They invariable involve early rolling over (or taking off) options at a strike which is furthest away from the stock. That is the time when rolling over yields a very small amount and taking off involves selling for a lower price than any of the other spreads. It becomes even more costly when we add back on spreads at the other end of the spectrum, usually at strikes which are closer to the stock price - these spreads are more expensive than the ones we sold. In the end, we are buying high and selling low.
In a vacillating market, the best strategy is to avoid adjusting as much as possible to avoid these costs. As much as we would like to be delta neutral at all times, we would go broke making the necessary adjustments to make that possible. When the market takes a big move in one direction, the odds increase that the next move will be in the opposite direction. When a reversal move does occur, we will have avoided making two adjustments, and a gain usually results. There will be months when the reversal does not take place during that month, and we will have to endure a loss for that month. Hopefully, we will gain it back in the next month when at least a partial reversal takes place.
That being said, adjustments are sometimes necessary to avoid a devastating loss in case the market continues to move in a single direction without reversing itself. When the risk profile graph shows that huge losses are imminent, an adjustment becomes necessary to ensure that we will still be around to play another day. It is hard to determine in advance exactly what mathematical parameters should dictate when this kind of adjustment needs to be made, and is often more of an intuitive decision.
The market has fallen by over 40% in one year. Retirement accounts have been decimated. Mutual funds are at lower levels than they have been for years. Everyone with stock market investments is suffering to one degree or another. But there have to be some good buys out there, and it is inevitable that at some point people will start edging back into the market. Who knows if it will happen this month or next, or the month after? But someday it should happen. All it has to do is to stop dropping for us to make exceptional returns in our portfolios. Even though we get longer as the market falls (and get shorter as the market rises), there are times like today when we must tolerate being a little longer or shorter than we would like.
Our goal is to make as few adjustments as possible and still protect against a devastating loss of portfolio value. One way of doing this is to establish, and keep, a wide range of strikes in our calendar spreads. We have already moved in that direction (especially in the Big Dripper), and will continue to do so.
As much as we would love to have hard-and-fast mathematical benchmarks for making adjustments, in this world of higher and higher volatility, it feels more like art than science, more intuition and less reason. It is an uncomfortable place to be for many of us, but that is the way it must be, at least right now.
Andy's Market Report
A lack of conviction continued to dominate the market this past week. Dreadful earnings estimates, dreadful economic reports and a lack of faith in Washington's attempts to resolve the crisis that plagues Wall Street, and in turn Main Street, led to another week of historical firsts on a fundamental and technical basis.
On a fundamental basis, waves of poor earnings reports and economic data continued to flood the market at an alarming rate. Already down over 30% since the end of August, the market surprisingly seemed ill-prepared for the bad news it faced again this past week.
Best Buy, Intel, Wal-Mart and a host of others slashed earnings guidance for the fourth quarter. The dramatic reductions pointed towards the magnitude of the problems that leading companies currently face in the Untied States.
"Since mid-September, rapid, seismic changes in consumer behavior have created the most difficult climate we have ever seen," said Brad Anderson, vice chairman and chief executive at Best Buy.
This magnitude of the revisions became plainly evident on Friday when the Commerce Department reported that retail sales fell by 2.8% in October, the largest drop on record. The decline surpassed the old record of 2.6% that occurred after the terrorist attacks in 2001.
Jobless claims also jumped to a level not seen since the terrorist attacks that occurred on 9/11. The Labor Department reported on Thursday that jobless claims had increased by an additional 32,000 which brought the total to 516,000. It was much higher than analysts' anticipated and with reports of more massive layoffs the current unemployment rate of 6.5% will certainly increase to dismal heights.
"Consumers are battening down the hatches and this reflects the depth of the downturn," said Mark Zandi, chief economist at Moody's Economy.com. "All households are panicked and cutting back -- not just lower and middle-income families who are struggling with a bad job market and falling home values, but upper-income families who are upset with their diminished nest eggs."
"The economic news continues to be very negative," said Ben Halliburton, chief investment officer of Tradition Capital Management. "The realization that '09 is going to be a very bad year for economic activity is starting to dawn on people and they are starting to digest how bad it's going to be."
On top of the various poor reports that trickled into the market was the concern over the sustainability of the U.S. automobile industry and the manufacturing companies that support it. Would it receive the $25 billion needed just to stay afloat? The retail sales report stated a decline of 23.4% in sales of autos from last year and a decline of 5.5% from the prior month.
The ailing automobile industry has led to another fight in Congress and as a result a deepening lack of faith among most Americans in the ability of Washington to resolve the most problematic issues that face this country.
I could go on and on about the decades of mismanagement of the heads of the automobile industry, but I think I will leave that to the Thomas Friedman. Check out his recent op-ed column in the New York Times, appropriately named How to Fix a Flat.
Anyway, by Wednesday, the market had shed 15% in just six trading sessions. However, much of the aforementioned economic and earnings reports came after Wednesday's session. So why did we see the market gain 2.5% over the next two trading sessions. Well, it seems most of the bad news was baked in.
For weeks now market participants wanted to see a capitulation event and indeed Thursday's session had all the classic signs of a washout. Technically, an extreme oversold reading coupled with an all-time low in the NYSE TICK of -1940 (this means that at that moment 1940 stocks traded on a downtick rather than an uptick) washed out the stop-orders that were sitting on or slightly below the October 10 low and led to an immediate reversal. The swing would lead to an 11.3% move in the S&P 500 from the low established Thursday to the eventual close. The Dow experienced a 900 point swing.
Going forward, at least for the intermediate-term, I continue to side with an intermediate-term rally that carries into the New Year.
On top of the aforementioned technical mumbo jumbo, insider trades have picked up and have moved to positive for the first time in months and has spiked to a new high. This is generally a good sign going forward and one that I will be watching as we move ever closer to 2009.
Also, weak Octobers, often lead to positive Novembers. Buying after the first week of November has led to substantial average gains in the market. Furthermore, back to back -4% losses in the Dow (occurred Tuesday and Wednesday of this past week) have also led to positive gains 12 out of 13 times when this type of scenario has occurred.
Basically, all signs over the intermediate-term lean towards the bullish camp. As always, only time will tell.
Overbought/Sold Condition Report
Overbought/Oversold as of November 15 , 2008
Major Benchmarks
- Dow (DIA) - 36.1 (neutral)
- S&P 500 (SPY) - 41.1 (neutral)
- Russell 2000 (IWM) - 47.8 (neutral)
- Nasdaq 100 (QQQQ) - 34.6 (neutral)
- Emerging Markets (EEM) - 46.4 (neutral)
Testimonial of the week
"By the way, not that it matters a whole lot, but I think you're selling yourself short on the annualized gain of the Big Dripper portfolio. 3392/10000 is about 34% and even calling it two weeks (1/26th of a year) would make it 34*26 or 884%. If you used the 8 days, it'd work out to 34*(365/8) or 1551%. Even if you just used business days (say 250/yr) it'd be 34*(250/8) or 1062%..any way you figure, I think it's much higher than 123%, though that's still incredible."
-- Eugene H. (received 11//08)