Weekly Stock Option Trading Tips: September 15, 2008

One month ago, we created a $10,000 portfolio using the Dow Jones Industrial Average tracking stock (DIA) as the underlying. We established calendar spreads in calls at the 115, 116, 118, 120, and 122 strikes, and what we call an exotic put butterfly spread at the 114-110-106 strikes.

Here is what the risk profile graph looked like when we started out the month:

Durable Diamond Graph August 2008

You can see that this portfolio would be expected to make a profit if DIA ended up anywhere between $110 and $123 in five weeks. In the great majority of months, DIA could be expected to remain in a range of that size for a 5-week expiration month. When we set up these positions, DIA was trading about $116.50, right about in the middle of the break-even range.

Our goal each month is to create a graph that looks more like a mesa than a mountain. We didn't totally achieve that goal with the above graph. As the month progressed, we took off some of the 120 calendar spreads and replaced them with more calendar spreads at the 115 strike. Those trades made the entire curve flatter. The expected gains for the month averaged about 15% across the same break-even range as the above graph.

Four of the five weeks have now expired. During that period, DIA traded as low as $110.50 but we were not tempted to make adjustments that would have expanded the downside break-even point to a lower number, and our patience was rewarded when the stock headed back to close last Friday at $114.79.

The portfolio is now worth $11,403 for a gain of 14% after commissions for the last four weeks. We have a policy of withdrawing cash from a portfolio whenever 6% is earned in a single expiration month. This month, we have had to withdraw that amount twice ($1200 will be withdrawn on Monday).

In order to generate sufficient cash to make that withdrawal, we rolled over the 120 calls (buying back the Sep-08 120 calls and selling Oct-08 120 calls) and closed out (sold) the 122 calendar spreads. With a week to go until expiration, we are still looking forward to additional gains over a fairly broad range of possible stock prices:

You can see that an additional 10% gain might come our way next week if DIA closes somewhere between $110 and $118. That would make a 24% gain for the 5-week expiration month.

How many investments do you know of which can make 24% in 5 weeks when the underlying ETF remains essentially flat (actually, it has lost a couple of dollars in value over the last month)?

For the 7 years of Terry's Tips' existence, we have called our strategy of multiple calendar spreads the 10K Strategy. Now we have made a change. Since we have added butterfly spreads and changed the basic objective of the strategy from making 50% - 100% annual gains to one of never losing money, it seems that we should no longer call it the 10K Strategy.

The new name for our basic strategy is the Mighty Mesa. The name derives from the desired shape of the risk profile graph when we start out each expiration month. For a while we were planning to call it the Mighty Stalagmite (a similar but smaller rock formation, but one which hangs out in caves, making it most un-photogenic, and I needed a nice photograph for the cover of the new book I am writing). So we are going with the mesa. You don't mess with a mesa.

It was another volatile week for the stock market and it was no surprise that the financial sector led the charge. Bailout nation continued with the U.S. government announcing a takeover of mortgage behemoths Fannie Mae and Freddie Mac last weekend. The move brought over three-quarters of the United States mortgage industry under public control.

The market responded positively with a huge gap to the upside on Monday. Buyers could not wait to step in at the open as many investors felt their concerns would be alleviated by the government intervention.

Of course, the issue of the governments actions can be debated (and already has at great lengths), but ultimately the market will decide if the move was the right decision. One thing is certain and that is uncertainty among investors. The price action displayed this uncertainty in great detail throughout each trading session.

In the technical analysis section of my market comments last week I talked about the after hours surge that occurred immediately following the news last Friday. I warned that a "gap of this magnitude often sees a move back to the high from the previous session and to "be aware of this tendency as we move into next week". This is indeed what occurred as the gap Monday marked the high of the week. The reason I mention this is just so you are aware of the tendencies for gap fades in the future. As they say on Wall Street, never buy into upside gaps or sell into downside gaps.

If the news about Fannie and Freddie were not enough, Lehman Brothers, who has struggled mightily for months faced heavy selling this past week. Speculation that the brokerage firm could potentially suffer the same fate as Bear Stearns ultimately led to the sell-off in the financial sector this past week. Furthermore, it was reported that AIG was having issues raising capital which led to a 46% decline in the stock's value last week.

The weekend could bring additional market-moving news. Many are speculating that Lehman will be sold by the time the weekend is over. Of course, no one knows how the market will react to the news so take heed to the gap tendencies I mentioned above if indeed one occurs.

"The markets are skittish and very tight," said Tanya Azarchs, managing director of financial institutions ratings at Standard & Poor's during a conference call Friday. "We don't expect Lehman to fail, but if any financial institution suffers a loss of confidence, I would think the Federal Reserve would be concerned."

"There seems to be no end to the shoes that keep dropping around the financial-services companies -- obviously we are dealing with an octopus -- and we just aren't sure who is next," said Kevin Giddis, managing director, Morgan Keegan & Co.

Economic news wasn't much better. Retail sales numbers were surprisingly soft and the PPI, although lower than in previous months, was higher than economists' expectations.

However, the whirlwind of bad news did not stop the market from moving slightly higher for the week. Did this past week mark the trading bottom that everyone has been waiting for or just another short-term oversold bounce led by the energy sector that will eventually roll over into a deeper decline?

The Dow, S&P, NASDAQ and Russell 2000 finished the week higher 1.8%, 0.8%, 0.2% and 0.2%, respectively.

The major benchmarks are all back in a neutral state so I really can't find a short-term edge at the moment. I do think volatility will continue to reign supreme (as it typically does during the week of options expiration) as we move towards options expiration.

My focus will continue to be on the price action of the major benchmarks, more specifically the 1260 area of the S&P (SPX). This level should act as a strong area of overhead resistance so a move back up to 1260 followed by a failure to hold could spell trouble going forward. However, a breach and hold of the 1260 level could spark a decent short-term rally. The week of options expiration is historically kind to the bulls so we shall see if history can repeat itself next week amid the constant flow of rumors.

Weekly Stock Options Trading Tips: September 15, 2008

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