When we establish option positions at the beginning of each expiration month, in most of our portfolios we assume that we have no idea which way the market will move over the next month. The result is a risk profile graph which shows the greatest gain coming if the stock stays absolutely flat.
(There are two exceptions - the Big Bear Mesa is our bearish portfolio for those who fear that the market will fall - it is set up to make the greatest gains if the market moves lower, and the Gold Bug which assumes that the market for gold will go higher so the graph shows the greatest gains at a slightly higher price of GDX).
If, during the month, the stock moves 5% or so in either direction, we might be dangerously close to the break-even point where a further change in the same direction might push into potential loss territory.
We have performed back test studies that show in the majority of the cases, a sudden move of more than 5% is almost always followed by some sort of retrenchment so that an adjustment is ultimately unnecessary. But we cannot afford to take the risk that the market might continue in the same direction rather than reversing itself. The potential losses are just too great.
Adjustments are much like insurance. They are a necessary cost of doing business. The cost of insurance reduces any gains that might come our way, but they lower the chances of a big loss taking place. Some of the time, we are lucky and do not have to purchase insurance for a particular month. Usually, these are the most profitable months we experience all year.
The most common adjustment is adding calendar spreads to the portfolio at strike prices which are close to the break-even price on the risk profile graph in the direction the stock has been heading. If the stock has been falling, the downside break-even point is the one to place new spreads.
Sometimes (if cash is needed to buy new spreads), calendar spreads at the other end of the break-even range might have to be sold. Closing out these spreads and replacing them with spreads at the other end of the spectrum has the effect of shifting the entire risk profile graph curve sideways in the direction of the newly-established spreads.
At the same time, the maximum possible profit (the upper limit of the graph) becomes lower for two reasons. First, there are transaction costs involved with taking off and adding on new spreads. Second, the spreads that are sold are generally at strike prices further away from the stock price and therefore yield less cash than the new spreads closer to the stock price will cost.
The video discusses making adjustments in more detail, including an explanation of what we call the average daily decay calculation which helps in deciding the proper time to roll the current month short options to the next month. You can access the video here.
We conduct two strategies at Terry's Tips - the 10K Strategy which uses LEAPS as the long side (and often has short options at different strike prices than the LEAPS) and the Mighty Mesa Strategy which normally consists of only calendar spreads. The video discusses adjustments that can be made with the Mighty Mesa Strategy only - a future video will cover adjustments in the 10K Strategy - they tend to be a little more complicated to explain.
In case you missed the earlier videos, you can catch the first one here - Why Stock Options are Better Than Mutual Funds. Click here for the second video - How to Create a Conservative Options Portfolio. And here for the third video - How to Use Options to Invest in Gold.
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 7 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
The market rallied again during the beginning of the week only to sell off during the shortened session Friday which eliminated all of the gains established earlier in the week.
The sharp decline was attributed to debt concerns in Dubai.
"Depleting market confidence in Dubai carries serious risks for Abu Dhabi," said Hani Sabra of Eurasia Group, a U.S.-based research firm that assesses political risk for foreign investors in Dubai and the Gulf.
"Differences between the two city-states remain on how to approach the economy and the financial crisis," Sabra added. "But now Abu Dhabi is obviously the more dominant emirate."
The Dow Jones industrial average fell 155 points Friday before the trading session ended three hours early due to the Thanksgiving holiday. The Dow declined as much as 233 points. The broad retreat from riskier assets also pushed Treasury prices higher and the dollar advanced against most other major currencies while most commodities tumbled.
"The biggest risk is a domino effect," said Kevin Shacknofsky, portfolio manager of the Alpine Dynamic Dividend Fund in Purchase, N.Y.
The S&P 500 (SPY), Dow (DIA), Nasdaq 100 (QQQQ) and Russell (IWM) finished the week 0.0%, -0.1%, -0.4% and -1.3%, respectively. For the year, the S&P 500 is up 20.8%, the Dow has advanced 17.6% and the Nasdaq is leading the way with a 36.1% gain.
On the economic front, the Existing Homes Sales report came in well above economists' expectations as sales rose in October 10.1% to 6.1 million homes. The report led to a notable move higher before volume plummeted as the market neared the Thanksgiving holiday.
Next week the economic calendar is once again thin, although on Friday the Unemployment report will be released which should bring quite a bit of attention and could substantially move the market as a result.
On the technical front, all of the major market indices I follow have pushed back into a short-term neutral state. The Russell 2000 (IWM) has pushed slightly into an oversold state which could signal a short-term push higher. Other than that there is not much to really go on as we head into next week. Hopefully, the market will reveal more as we move through next week.
Andy
Overbought/Oversold as of November 28, 2009
Major Benchmarks