Weekly Stock Option Trading Tips: September 22, 2008

Last week I showed you the risk profile graph for our Durable Diamond portfolio - it showed that we would make a gain of 10% or more if DIA ended up at any price between $110 and $118 in one week ending on Friday.

Imagine our distress when the stock tanked to $106 early in the week. We made plans to roll over all the positions so that we could wait it out for another month. But then the huge rebound came along and DIA ended at $113.57, well within our profit range. Instead of a 10% gain, our actual portfolio gained over 20% in value. For the entire 5-week expiration month, our Durable Diamond portfolio gained 38%.

Our Mighty Stalagmite portfolio (using SPY as the underlying) also made a gain of 38% last month. In accordance with our Withdrawal Rules we took out $3,600 in cash from both those $10,000 portfolios. This withdrawal amount constituted our profit target for the entire year, and it came in only the second month of trading our Mighty Mesa strategy.

As nice as these returns were, we can't give the entire credit to the workings of the Mighty Mesa strategy (although others might be tempted to). A good share of the gain was made because the volatile market pushed up Implied Volatilities (IV) of the options. This results in an (often temporary) increase in the value of all options, and since our long options have a larger absolute value than the short-term options, our indicated portfolio values get higher.

A month ago, IV for SPY and DIA was about 21%, and now it is about 28%. The VIX has gone from about 20 to 32 today, and it was briefly over 40 during the madness last week. In future months we must remember that changes in IV work both ways and not be disappointed when the results at the end of a future month are not quite what the risk profile graphs indicated they would be.

Windfall Gains Possible? This month, in all but one of our portfolios, we rolled the expiring short September options to the Sep5-08 quarterlies rather than to Oct-08 options and it is almost like getting an extra expiration month. Check out the risk profile graph for the Durable Diamond - it shows remarkably high possible gains in a mere 11 days. We just might be able to enjoy 16 expirations each year rather than just 12 for these portfolios.

Here is the risk profile graph for our Durable Diamond portfolio for an expiration "month" that ends a week from next Tuesday:

The graph shows that we will make a profit at any price between $108 and $120, and better than 20% if it lands between $110 and $117. It will be an interesting wait over only 7 trading days.

I'll report back to you on how this portfolio fared.

Life is good.

Terry

Wow! What else can you say? I am at a loss for words right now completely exhausted from trying to absorb all the information that was thrown my way. It was the week that felt like a year, certainly one for the trading ages.

The Dow, S&P, NASDAQ and Russell 2000 finished the week slightly mixed -0.3%, 0.8%, 0.2% and 0.2%, respectively.

However, the overall weekly performance doesn't accurately tell the whole story. From the low Thursday to the high Friday the Dow, S&P, NASDAQ and Russell 2000 climbed 9.8%, 11.6%, 12.0% and 12.0%, respectively. Simply amazing!

Recounting the events in full would require a working novel so I will try to hit the highlights with brief description.

The week began with a 3% gap to the downside in the S&P that eventually led to a 4.7% decline. The gap lower and eventual follow through to the downside came on the stunning news that Lehman Brothers, after aggressively seeking a suitor to avoid bankruptcy, could not find any takers to avoid the inevitable. The 158 year-old firm, that pioneered innovative financing techniques during the market crash of 1929, would have to file for bankruptcy protection (Chapter 11).

"The collapse of Lehman Brothers has sent a major jolt through global financial markets as it is by far the biggest victim of the credit crisis that started in August 2007 and had been considered too big to fail," said Global Insight economist Howard Archer.

"There is obviously widespread concern about other banks' exposure to Lehman Brothers, not only in the US but also in Europe. Lehman's collapse also increases concerns that other banks could fail."

Moreover, it was reported early Monday that AIG, one of the world's largest insurers, might be headed for a similar fate if it could not raise an enormous sum of capital very soon.

If that wasn't enough, Merrill Lynch reported that it would be sold to Bank of America to avoid Chapter 11.

"Lehman Brothers' decision to file bankruptcy and worries that the credit crisis could claim American International Group as the latest casualty are fueling the fears on the Street," analysts at Charles Schwab & Co. said in a note to clients.

"Merrill's purchase has traders fretting that hidden problems abound and more firms could be looking at a fate similar to Lehman's."

On Tuesday the market recouped some of the losses from Monday's sharp decline, but the rally would prove to have no legs by the time Wednesday's trading session rolled around.

On Wednesday it was reported that AIG's woes would be resolved by a 2-year, $85 billion dollar securitized loan by the Fed. Initially the market responded favorably to the news in the premarket futures, but once the opening bell rang and market participants realized the loan did not resolve the bigger picture, the market gapped lower and moved steadily lower throughout the trading day for another 4.7% loss in the S&P.

The move by the Fed was met with mixed reviews.

"The move represents the largest lurch toward socialism that this country has ever seen, and signals the end of the vibrancy of America's once vaunted free market economy," said Peter Schiff, president of Euro Pacific Capital.

Thursday session proved to be the catalyst day for the market. It began with a quick roll over and what looked to be another 5.0% decline in the markets, but news that the U.K. would halt short-selling proved to form a bottom in the market intraday, before the big news came out. Shortly after the news from the U.K. was reported, it was rumored that the Fed was working on an enormous bailout plan to rescue banks from bad debt. The market surged on the news to close near the highs of the day.

"Everything they had done had been a Band-Aid approach, at the margins," said Jay Mueller, economist at Strong Capital Management. "Now we're dealing with the root problem."
The plan would call for a $700 billion bailout to buy bad mortgages in what would be the largest financial bailout since the Great Depression. The plan would give the government the ability to buy bad debt of any U.S. financial institutions for the next two years.

"I am convinced that this bold approach will cost American families far less than the alternative -- a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion," Paulson said. "The financial security of all Americans ... depends on our ability to restore our financial institutions to a sound footing."

From the low on Thursday to the eventual close, the S&P surged 6.4%.

If that wasn't enough it was reported during the overnight session that the Fed had decided to also temporarily halt the short-selling of 799 financial institutions.

The halt on short-selling was met with confirmation that the Fed would indeed go through with the rumored financial bailout from the prior day's session.

The news led to an enormous gap to the upside in the market. The major indexes were able to hold most of the gains.

Okay, I could go into so many different tangents at this point, but again, I want to keep the report reasonably short. There are so man mixed views on what occurred this past week and no one will know the final result for quite some time. With that being said I would like to take a look at the technical picture going forward.

First, all of the major benchmarks are back in a neutral state. However, there are some large gaps lingering below that typically close before a substantial rally begins. Will the gaps close soon? Well, while there really isn't a short-term edge on a technical basis, the Monday following options expiration is historically very week. I do think the gaps will close sooner than later and I would not be surprised to see another test of the recent lows as traders try and figure out what exactly happened last week and how it would ultimately affect the market. Personally, I can't help but think the halt on short-selling could have some drastic affects when it expires on October 2, but that remains to be seen and I will cross that bridge when it comes.

I will leave you with a few blurbs that sum up my opinion on the matter.

"I don't think it's going to accomplish what they're after," said Jeff Tjornehoj, senior analyst at fund research firm Lipper Inc. Without short sellers, he said, investors will have a harder time gauging the true value of a stock.

"Most people want to be in a stock for the long run and want to see prices go up. Short sellers are useful for throwing water in their face and saying, `Oh yeah? Think about this,'" Tjornehoj said. As a result, restricting the practice could inflate the value of some stocks, opening the door for a big downward correction later.

"Without offering a flip-side to the price-discovery mechanism, I think there's a pressure built up in stock prices that only gets relieved in a great cataclysm," he said.

Weekly Stock Options Trading Tips: September 22, 2008

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