Apple (AAPL) announced blow-out earnings last week, up double from a year earlier. Wouldn’t you be happy if you owned some of the stock? You would have picked up a nice gain of 7.8% last week. Some people would be happy with that kind of gain for a whole year in this current market.

If you were a Terry’s Tips subscriber, and followed our actual options portfolio using AAPL, you would have been even happier. Your investment would have gained 27.2% last week, more than three times as much as the stock went up. (I personally own 6 units of this portfolio, and gained enough last week to pay for a semester of college for one of my grandchildren.)

Today I will explain a little about this portfolio which uses stock options as a proxy for owning stock in AAPL (or any company of your choosing as long as options are traded on that company).

Using Options as an Alternative to Buying Stock 

At Terry’s Tips, we do not advise buying stock in companies. We don’t think we’re smart enough to pick the big winners. Instead, we make the assumption that we have no idea which way the market is headed, and trade options on the market in general (the S&P 500 tracking stock – SPY).

But we know that people love to pick stocks. So we have devised a demonstration option portfolio to show how you can make several times as much money with options than you could by just buying shares of the company’s stock. We selected AAPL as the underlying stock for this portfolio.

We call this strategy the Shoot Strategy (as in Shoot for the Stars). One neat thing about this strategy is that it makes money even if the stock stays absolutely flat. It doesn’t make a lot of money if the stock stays flat, but anything at all is better than the return you get from owning the stock (unless it pays a dividend, of course).

The Shoot Strategy consists of buying longer-term call options (sometimes called LEAPS) and also selling short-term calls against these long calls. The short calls are at higher strike prices than the long calls we own. Rather than maximizing the short-term time premium that we collect from selling the calls, we sell just enough to slightly more than cover the premium decay that will take place in the longer term calls we own (all options decline in value over time if the stock stays flat, but the short-term calls we have sold to someone else decline at a faster rate than the longer-term calls that we own).

Here is the risk profile graph for our current AAPL demonstration portfolio (we call it the William Tell) for an $8700 unit as of July 22nd when the stock closed at $391.49. The graph shows how much will be gained or loss at the August 19, 2011 expiration of the August calls that we have sold (at the various possible prices of AAPL on that date).

You can see that if the stock remains absolutely flat, the portfolio should gain $1517.80 (about 17%) in a single month (admittedly, that is unusually high for this portfolio, and we will probably make a trade next week which will cause a lower gain at a flat stock price and higher gains if the stock moves higher.

If the stock does move higher by $10 or $20 over the next month, the portfolio should gain over 20%.  The stock can fall as much as $10 before a loss will result (owners of the stock lose money even if it falls by a single dollar).   

We have written a detailed report on how the actual William Tell portfolio gained over 100% in 2010-11 while the stock rose only 25%.  You will learn how you can use the Shoot Strategy on any other stock of your choosing as well.  You can get this special report free when you subscribe to the Terry’s Tips service for a price which is less than a dinner for two at a decent restaurant – only $79.95 for the whole enchilada, including:

1)    My 72-page White Paper which explains my favorite option strategies in detail, including Trading Rules for each, and 20 companies to use with the “Lazy Way” Strategy, (which guarantees a 100% gain in 2 years if the stock stays flat or goes up).

2)    2 FREE months of the Options Tutorial Program (a $49.90 value), which includes:
·    A 14-lesson tutorial on trading stock options which will give you a thorough understanding of trading stock options.
·    A weekly update of 8 actual portfolios so that you can follow their progress over time.
·    Specific trades for each portfolio emailed to you so you may mirror them in your own account if you wish.
·    Access to historical analytic reports and portfolio updates posted in the Insiders section of Terry’s Tips.
·    If you choose to continue after the 2 free months, do nothing, and you’ll be billed at a discounted rate of $19.95 per month.  

3)    A FREE special report  “How We Made 100% on Apple in 2010-11 While AAPL Rose Only 25%“.

With this one-time offer, you will receive everything for only $79.95, the price of the White Paper alone. But you must order by Tuesday, August 2, 2011. Click here and enter Special Code 802 in the box at the bottom of the page to get the special Apple report as a free bonus.

We have a portfolio called the Last Minute portfolio. It remains in cash all week until Thursday near the close when we have to make a decision. Do we expect that SPY will fluctuate by more than a dollar, or less that a dollar on the next day.

If we think it will fluctuate less than a dollar, the best move is to buy calendar spreads, buying options with 8 days of remaining life and selling options that will expire the very next day. These spreads are designed to make money if the stock (SPY) changes by less than a dollar on Friday.

On Thursdays which precede the government monthly job reports, or when the stock option for that week has been unusually volatile, a different strategy is employed. Rather than betting that SPY will fluctuate by less than a dollar, we buy either a straddle or strangle that will most likely make money if SPY moves by more than a dollar on Friday.

Last week, there was no economic news coming out on Friday that might spook the market, but SPY had fluctuated by more than a dollar in three of the first four days that week. This would suggest that the best bet would to buy a strangle or straddle, but we did not feel too confident that the high volatility would continue, and since there is a higher risk involved in the straddle-strangle alternative, we decided to stick with calendar spreads.

With about 15 minutes of trading left on Thursday, SPY was trading at $131.10 and we bought 40 Jul4-11 – Jul-11 131 put calendar spreads, paying $.87 per spread. The stock immediately fell $.30 and we bought an additional 20 identical spreads at the 130 strike, paying $,85 for these as well. In a back test study we had learned that if a big move took place on Friday, three out of four times it was on the downside, so our initial positions should usually be set up to be bearish.

Our starting positions were heavily skewed to the downside. We could handle a $1.25 move in that direction but only a $.75 move to the upside. The actual upward move of $.76 for the day should have resulted in a break-even at best.

When the market opened up about $.40, our short position became quite uncomfortable. Shortly after the open, we were lucky enough to close out the 130 calendar spread for $.05 more than we paid for it, exactly enough to cover commissions and break even. Later in the day when SPY had fallen to near $131, we sold half our 131 spreads for $1.12, a nice premium on the $.87 cost (we gained $20 per spread after commissions, or $400 on a $1740 investment).

We were hoping that the stock would close out the day very near the current price and we would make a huge gain. We weren’t so lucky as the stock shot suddenly higher in the last half hour of trading, and we closed out the remaining spreads for $1.05 for a $14.75 gain per spread after commissions (we bought back the expiring 131 calls for $.02, avoiding the commission).

Bottom line, we were quite pleased with a 13.3% gain after commissions for the day on our capital at risk when the stock did not move in the direction we were hoping. Over the last two weeks, the Last Minute portfolio has gained $2059 on an average investment of $3630 (56%) . How many stock investments do you suppose did this well?

We have a portfolio called the Last Minute portfolio. It remains in cash all week until Thursday near the close when calendar spreads are placed, buying options with 8 days of remaining life and selling options that will expire the very next day. These spreads are designed to make money if the stock (SPY) changes by less than a dollar on Friday (we set money aside to make a hedging bet on Friday if it becomes necessary).

On Thursdays which precede the government monthly job reports, a different strategy is employed (we have noticed that volatility tends to be extreme on those days when the jobs report comes out). Rather than betting that SPY will fluctuate by less than a dollar, we buy either a straddle or strangle that will most likely make money if SPY moves by more than a dollar on Friday.

This was the Trade Alert we sent out to Insiders on Thursday with about 10 minutes remaining in the trading day:

“July 7, 2011 Trade Alert – Last Minute Portfolio

With the government jobs report due tomorrow, we would rather bet that the stock moves by a dollar or more rather than placing calendar spreads that make a gain only if the stock moves by less than a dollar. We will invest only about a quarter of our available cash:

BTO 30 Jul2-11 135 put (SPY110708P135)

BTO 30 Jul2-11 136 call (SPY110708C136) for $.68 (buying a strangle)”

With SPY trading just about half way between $135 and $136 Thursday afternoon, we decided to buy the above strangle rather than a straddle. If the stock had been closer to one particular strike price, we would have opted for a straddle instead.

We bought 30 strangles for $68 each, investing $2040.

If at any point on Friday, SPY changed in value by more than $1.00 in either direction, we could probably sell those options at a profit. (At any price above $136.50, the calls could probably be sold for more than $68 we paid for the strangle, and at any price below $135.50, the puts could be sold for more than we paid for the strangle.) A small amount could also probably be gained by selling the other side of the strangle as well (unless the stock moved well more than a dollar).

When the government report came out on Friday, the market was spooked by the poor numbers – Non-farm private payrolls were expected to grow by 110,000 while the actual number was a disappointing 57,000. Total nonfarm payrolls grew only 18,000 compared to an expected 80,000 (government jobs dropped by 39,000). The stock (SPY) opened down $1.40 and moved down almost $2 during the day.

Early in the day while the 135 puts were trading at about $1.00, we placed a limit order to sell 25 of our 30 puts at $1.10, and the order was executed about a half hour later. This would insure that we made a profit for the day no matter what happened from that point forward. We were hoping that either the stock moved lower and we could sell the remaining 5 puts for a higher price or the stock would make a big move upward and maybe we could collect something from selling our 30 calls at the 136 strike.

The stock continued to fall, and later in the day we placed an order to sell the remaining 5 puts. We collected $1.52 ($152) each for them. That wasn’t the absolute high for the day but it was darn close. Had we waited until the close, we would have only received $.37 for those puts, and lost money on our investment. This proves the value in taking a profit on the great majority of positions whenever it might come up rather than waiting for a possible windfall gain if the stock continues in only one direction.

Bottom line, we collected a profit for the day of $1363 after commissions on our investment of $2040, or 67%.

Straddle buyers like volatility as much as we don’t like it in our other portfolios. There are many ways to profit with options. It is best to remain flexible, and use the option strategy that best matches current market conditions. Buying straddles or strangles when option prices are low and volatility is high is one very good way to make extraordinary gains, as we happily did last week.

The downside to buying straddles or strangles is that if the market doesn’t fluctuate much, you could lose every penny of your investment (although if you don’t wait too much longer than mid-day on the day options expire, even out-of-the-money options retain some value and should be able to be sold for something). This makes it a much riskier investment than the other option strategies we recommend at Terry’s Tips. However, straddle- or strangle-buying can be quite profitable if the current market patterns persist.

Sometimes someone else says it as well as I think I can.  Today I would like to pass on what Steve Sears at Barrons.com wrote about trading on rumors of a takeover.  I agree with him completely.  Bottom line, I believe the answer is to do nothing about them.

“Everyone loves the idea of owning a stock, especially call options, on a company that might be taken over at a hefty premium. But the options market inflates with at least 10 false takeover rumors for every real deal. Individual investors need to be careful to avoid getting fleeced for reasons that have far more to do with market realities than risk-aversion.

The best bet for most investors is ignoring takeover rumors. If you own options on a takeover stock, sell them, and book the profits. How much better can it get? When rumors become facts, or fail to become facts, implied volatility declines.

If you must trade takeover rumors, buy inexpensive out-of-the-money calls that expire in three months or less. If the deal emerges, you’ll make money, and not lose much if nothing happens.

To be sure, institutional investors who own dud stocks, or who want to create profits where none exist, spread rumors to drive options and stock prices higher to attract unsophisticated investors.

The game works like this: traders buy enough out-of-the-money call options to be spotted by unusual-trading volume screens that monitor the options markets. Inevitably, a reporter, or one of the market-trading subscription Websites notes the unusual trading, and deal speculation sweeps the market. Takeover talk attracts greedy investors who pay top prices for call options, which creates selling opportunities for those who started the rumor.

No one has statistics on how many takeover rumors fail to materialize, but when you feel eager to get a piece of the action, think of the rows of grizzled gamblers hunched over Las Vegas slot machines. They have no special knowledge. They have no special skills. They just hope to get lucky. The same rubric applies to most takeover traders.

“Losers,” as seasoned traders like to say, “always come back to Vegas.”

As you probably know, VIX is a volatility index, a measure of the implied volatility of the option prices on the S&P 500 tracking stock, SPY. VIX is often called the “Fear Index” since it tends to rise when the market falls or investors are concerned about the future.  When VIX is high, option prices in general are high, and vice versa.

Unfortunately, you can’t trade VIX.  It is just a measure of how high option prices are.  However, another instrument was created that is designed to mirror VIX, and you can trade this one.  It is an ETN called VXX.  Its value is derived from the futures prices of VIX and is supposed to be highly correlated with the volatility measure VIX.

Since VIX typically rises when the market (SPY) falls, VXX has been promoted as a good hedge against a stock portfolio.  Several months ago when VIX was about 16 and VXX was trading about $28, I recommended VXX as a good buy because I did not believe that VIX would trade much lower than 16, and if the two were highly correlated, that meant that VXX was unlikely to fall by very much.

At last Friday’s close, VXX was at $25.24 while VIX was at 21.85.  Over the past several months since I made my recommendation, VXX had fallen 10% while VIX had risen 35%.  That certainly is not a positive correlation.  I was bamboozled by the reports that said they were highly correlated.

I thought it would be interesting to compare the two instruments over time. Check out the graphs of the two equities for the past year:

VIX for Last 12 Months

VXX for Last 12 Months

Can you find any correlation between these two equities?  VIX has fluctuated in both directions throughout the year while VXX has done nothing but consistently move lower. In fact, last year VXX had to do a reverse 4-1 split of its shares so it would still have enough value to continue trading. While it looks from the chart that VXX traded about $120 a year ago, it was actually at only $30 (when the reverse 4-1 split took place on October 26, 2010).  The chartists had to multiply those old numbers by 4 to get them on the same scale as the current numbers.

The bottom line:  VXX is clearly a real dog, and seems destined to fall no matter what VIX does.

True, when VIX shoots higher, VXX follows right along, but VXX consistently fails to hang onto those higher numbers, even if VIX remains at the higher level.

The VXX chart suggests that selling the stock short might be a good investment idea.  I have personally done some of that, in fact. One problem may be that it might be difficult to short VXX.  Schwab (and other brokers) have VXX on their “Hard to Locate” list for borrowing to cover the short sale.  So far, I have not had problems shorting it at thinkorswim (although once I had to telephone in the order because the electronic order was rejected).

An even greater opportunity exists, however, at least in my opinion, using options.  We have created a portfolio at Terry’s Tips to carry out an option strategy for paying subscribers to mirror (or have trades executed automatically for them through the Auto-Trade service that thinkorswim offers).

Here is the risk profile graph for that portfolio for the July 16, 2011 expiration, less than four weeks from now:

This graph shows the theoretical loss or gain from a $10,000 portfolio based on VXX (currently trading at $25.24).  If the stock is at this exact same price on July 16th, the portfolio should gain about 8%.  If it falls into the $23 – $25 range, the gain should be about 10%.  On the upside, a profit should result at any stock price that is less than $28.

Since most months, VXX has steadily declined in price, it seems to us that this portfolio has a very good chance of making 100% a year if that price behavior continues into the future.

I invite you to join our service and participate in this investment opportunity along with us.  This is not just a theoretical exercise.  I have my own money riding in it, as I believe in it totally.

In the past when we were trading only Monthly options, one of the decisions we needed to make on Fridays was whether it was better to buy back out-of-the-money options on Friday and sell new Monthlys on that day or let them expire worthless and sell new Monthlys on Monday. Most of the time we decided that it was a toss-up because the cost of buying back the options on Friday (and paying an extra commission) was usually about the same as the decay in the Monthly options over the weekend.

The story is entirely different now that Weekly options are available – we have determined that it is overwhelmingly better to roll over Weekly options on Friday than it is to let them expire worthless and sell new options on Monday. Last Monday, for example, the at-the-money SPY options could be sold for an average of $.15 less on Monday than they could have been sold for on Friday. (The Monthly at-the-money SPY options decayed about $.10 over the weekend).

The cost of buying back out-of-the-money options on Friday usually is about $.02 or $.03. This is an extremely low cost, and makes even more sense for investors like us who trade at thinkorswim (no commission is charged at thinkorswim for buying back options for $.05 or less).

On average, near-the-money options sold for $.10 less on Monday than they could have been sold for on Friday. Again, it is better to pay the small price to roll over on Friday than it is to wait until Monday. Since these Weekly options have only a few days of remaining life, the decay over the weekend is significant.

Buying Straddles with Weekly Options

For the past 7 days, SPY had fluctuated more than $1.00 every day. One of the portfolios that we carry out at Terry’s Tips involves placing calendar spreads near the close on Thursday (buying options with 8 days of remaining life and selling options that will expire the next day). The risk profile graph for these spreads shows that a profit will be made if SPY fluctuates by less than a dollar in either direction on Friday (which it has done historically most of the time).

However, with 7 consecutive days of greater-than-$1.00 fluctuations, it did not seem like a prudent bet to place calendar spreads on Thursday (especially since SPY tends to be more volatile on Fridays when the Weekly options expire than it is on the other days).

Instead of buying calendar spreads, we bought SPY 132 puts and calls which would expire on Friday, paying $97 for each pair (with commissions, $99.50 each). At the time, SPY was trading right at $132.

This is called buying a straddle. If at any point on Friday, SPY changed in value by more than $1.00 in either direction, we could sell those options at a profit. (At any price above $133, the calls could be sold for more than we paid for the straddle, and at any price below $131, the puts could be sold for more than we paid for the straddle.)

SPY managed to change $2.00, beating the $1.00 threshold for the 8th consecutive day. Subscribers who held their straddles until near the close were able to double their money on Friday (admittedly, most of us pulled the trigger earlier than that, but I did manage to keep a few spreads until the end in my personal account).

Straddle buyers like volatility as much as we don’t like it in our other portfolios. What they like best is a whip-saw market where the market moves sharply higher (and they sell their calls) and then down (when they unload their puts). There are many ways to profit with options. Buying straddles when option prices are low and volatility is high is one very good way to make extraordinary gains.

The downside to buying straddles is that if the market doesn’t fluctuate much, you could lose every penny of your investment. This makes it a much riskier investment than the other option strategies we recommend at Terry’s Tips. However, straddle-buying can be quite profitable if the current market patterns persist.

I think the key to options trading success is the exact same key to stock trading success; the ability to pick stocks or ETFs that will perform exactly as you would like it to.

In stock trading, you make money only when you buy stocks that go up or short stocks that go down.

In options trading, you make money when you apply bullish options strategies on stocks that go up, bearish options strategies on stocks that go down, neutral options strategies on stocks that remain stagnant or volatile options strategies on stocks that stage quick and explosive breakouts.

You only lose money in options trading when you apply bullish options strategies on stocks that goes down, bearish options strategies on stocks that go up, neutral options strategies on stocks that breaks out and volatile options strategies on stocks that remain stagnant.

Even though the key to success in options trading is largely the same as the key to success in stock trading or any other forms of investment or trading, options trading does have a few tricks up its sleeves to help put the odds in your favor.

First of all is leverage and protection. The ability to risk lesser capital for the same profit or a lot more profit with the same capital already puts the benefit of risk in your favor.

Second is the ability to make a profit in more than one direction! Yes, since the key to success in options trading is the ability to “guess” the correct direction the underlying stock or index is going to take, won’t your chances of success be dramatically increased if you could profit in more than one direction?

For example, the strategy which we employ at Terry’s Tips (a strategy using calendar spreads at several different strike prices) makes a profit when the stock goes upwards, remains stagnant OR drops a little! Yes, all 3 directions. Won’t your chances of success be dramatically increased with a strategy like that?

The key to stock investing is to pick the right stock(s). Almost no one, even the professionals can do that consistently. That is why options trading increases the odds of success in your favor if you use a strategy that profits from more than one direction. This is a huge advantage that you do not get when you invest in stock – it only exists in option trading.

For the past year, we have been carrying out a demonstration options portfolio on one individual stock. Our favorite months are those when the stock stays absolutely flat and our portfolio gains value. This portfolio has consistently out-performed the gains that would have been made if we had just bought shares of the stock instead. In several time periods, our portfolio gained three times as much as the stock price did. Properly executed, options trading can be far more profitable the merely buying stock.