Stock Options Trading Idea of the Week
A Great Time to Buy Calendar Spreads
Every once in a while, option prices are such that buying calendar spreads is particularly attractive. Now is one of those rare times.
Ideally, when you buy a calendar spread, you would like to buy the longer-term option when option prices for that month are "low" and sell a short-term option when those prices are "high."
What determines whether option prices are "high" or "low" is the Implied Volatility (IV) of the option. A "high" IV comes about when the market expects a stock will fluctuate a lot and a "low" IV results when the market expects the stock to be quiet.
For those of you who are mathematically inclined, IV is the average daily one-standard-deviation move of the stock, annualized. If the IV for the options on XYZ stock is 20%, the market believes that there is a 68% probability that XYZ will be within 20% of its present price one year from now; and there is a 95% probability of being within a 40% range of its present price one year from now.
When you can buy an option with a low IV and sell another in the same underlying which has a high IV, you have what is called an IV Advantage. You are essentially buying low and selling high at exactly the same time.
With the current extreme uncertainty in the stock market, short-term IV has skyrocketed. For example, IV for October 2008 at-the-money options on SPY carry an IV of 52% while SPY options that expire in March 2009 have an IV of only 30%. That is a huge IV Advantage.
Last Friday you could sell a SPY 110 October 2008 call (when SPY was selling for $110) for $4.50 (and there were only 13 days of remaining life for that option). You could buy a 110 March 2009 quarterly call for $10.30, or slightly more than double that amount, and this option had 179 days of remaining life.
In this example, the average decay rate of the option you are selling is $34.62 and the average daily decay of the option you buy is only $5.75. The spread would cost you $580 to buy (plus a $3 commission), for a total of $583. Each day the stock remained relatively flat, you would gain the difference in the decay rates ($28.87 although it would be greater than that because the March option would decay at less than the $5.75 average for the next couple of months).
In other words, if the stock stayed flat, you would earn almost 5% a day on your investment!
Of course, the stock will not usually stay flat, even for 13 days, so you would have to buy calendar spreads at several different strike prices or employ other spreads for protection against volatility as we do in our Mighty Mesa strategy, but this example gives you a general idea of the profit potential of buying calendar spreads at a time when there is such a large difference in the IVs of the shorter-term and longer-term options.
By the way, our Mighty Mesa strategy resulted in greater-than-50% gains for a single month in the September expiration for two of our six actual portfolios.
Finding calendar spreads with a huge IV Advantage is one great way to make exceptional gains in the options world if you know how to protect your spreads against any volatility that might result.
If you become a Terry's Tips Insider, you can see how we protect against volatility, and exactly how we did it in the above two portfolios last month.
Andy's Market Report
It was a historical week for the market.
The Dow, S&P, NASDAQ and Russell 2000 lost -7.3%, -9.4%, -10.8% and -12.1%, respectively.
The week began with a surprise out of Congress, more specifically the House of Representatives. Over the prior weekend, Congressional leaders met to discuss the final details of the relief plan and by all accounts an agreement was finalized. Unfortunately, the leaders who met over the weekend did not adequately represent the sentiment of the rank-and-file members of their respective parties.
House members voted "no" to the relief plan and the market suffered as a consequence.
The surprising news led to a 778 point loss in the Dow the largest one-day point loss in the popular major-market benchmark. The S&P would lose 8.8% on the day, which marked the seventh worst day ever on a percentage basis and the largest one-day percentage drop since the crash of '87. The Nasdaq fell 9.1%, its third worst day on a percentage basis and also its worst decline since the crash of '87.
"The stock market was definitely taken by surprise," said Drew Kanaly, chairman and CEO of Kanaly Trust Company, referring to the House vote. "If you watched the news stream over the weekend, it seemed like it was a done deal. But the money is being held hostage to the political process."
On Tuesday and Wednesday the market bounced back to regain over half of the losses from Monday's historical trading session. However, the snap back rally would not last long as the market quickly rolled over Thursday and moved to new lows for the week during the final hour of trading Friday.
A large portion of decline from Thursday occurred during the after hours market Wednesday shortly after the Senate passed the revised version of the relief plan that night. Traders would wake up to a sharp gap to the downside that would eventually lead to a trend day lower.
"This is clearly positive news but there's still the lower house vote, so there is little room for optimism. Even if the bill is passed, worries remain over the global economic outlook so financial markets are unlikely to stabilize," said Masamichi Adachi, a senior economist at JPMorgan Securities in Japan.
On Friday, the House of Representatives would vote to pass the revised relief plan, but again, it just wasn't enough to convince traders that it would be enough for the severely troubled credit market. Traders are still faced with overwhelming uncertainty.
"We're three weeks into a severe credit crunch and it's causing untold economic damage to the country," said Hank Smith, chief investment officer at Haverford Investments. He said while the bill's passage will help Wall Street, the broader effects of the paralysis in the credit markets have yet to emerge.
"It's fairly reasonable to assume that this should help unfreeze the credit markets but what we don't know is what's happened so far. How much of a dent has it put into the economy?"
The economic news out this week certainly did not help the cause.
· The ISM survey reached its lowest level since October 2001
· 4.0% decline in August factory orders
· Initial jobless claims reached their highest level since September 2001
· August non-farm payroll moved to the largest level since March 2003
"Washington, the labor market has a problem," said Joel Naroff, president of Naroff Economic Advisors. "Firms are hunkering down and running as lean as possible. ... We are likely to see more months of job losses before conditions turn around."
Technically speaking, the current markets have moved into an extreme short-term oversold state. Typically, when we see this type of short-term extreme enter the market a short-term bounce follows and if further downside occurs it is usually limited and not sustainable.
Furthermore, sharp losses like we witnessed last week have historically been met with a relief rally that has lasted from one to three months. Will history repeat itself?
Overbought/Sold Condition Report
Overbought/Oversold for October 6, 2008
Major Benchmarks - Dow (DIA) - 20.8 (oversold)
- S&P 500 (SPY) - 18.8 (very oversold)
- Russell 2000 (IWM) - 17.4 (very oversold)
- Nasdaq 100 (QQQQ) - 14.2 (very oversold)
- Emerging Markets (EEM) - 22.6 (oversold)
Testimonial of the week
"I only have 5% of my invested capital following your portfolios at the present time, but it has done better than any of my other investments for the past year, and I am planning to add considerably to your strategies when I retire later this year." Manual P. (received 10/2/08)
