Last week was the worst week for the market for almost three years.  The S&P 500 fell by a whopping 6.6%.  Investors seem to be dumping everything.  Usually, when stock markets crash, gold moves higher, but last week, gold fell $100 in a single day, the worst one-day drop in its history.  Silver and other commodities were crushed as well.  Billions of dollars are going into treasuries even though over half the S&P 500 companies have higher yields. 

What do you in times like these?  Would you be surprised if I said that a well-designed options portfolio might be the perfect solution?

Using Options to Prosper in Down Markets

At Terry’s Tips, we conduct an actual portfolio which we call the 10K Bear.  We believe that this portfolio offers a better alternative than any other as a downside hedge vehicle.  Even better, the market does not have to go down for you to make a gain.  A flat or slightly higher market also makes weekly gains most of the time

Here is the current risk profile graph for our 10K Bear portfolio.  It shows the loss or gain that should result from a $5200 investment in SPY put options on September 30 when the Weeklys expire in a few days.  Last Friday, SPY closed at $113.54  (This graph assumes that today’s option prices – VIX – will remain unchanged – if VIX falls significantly over the next 4 days, the gains would be less than the graph indicates.)

The graph shows that about an 18% gain would be made if the stock stays flat, and a higher gain would result if SPY fell up to $3 (if it fell that far, we would make an adjustment to extend the downside potential).  Commissions would reduce results somewhat as well. The stock could go up as high as $116.50 before a loss would occur on the upside.  Clearly, this is an excellent hedge against a market drop, and it has the added advantage of also making gains if the market is flat or slightly higher.

How do we create an options portfolio like this?  It is the strategy we use when we want to bet on the direction of the market.  Most of the portfolios at Terry’s Tips make the assumption that we have no idea of which direction the market will take in the short run.

The 10K Bear portfolio involves buying put options with several months of remaining life and selling short-term (Weekly) puts to someone else.  The puts we sell are mostly at lower strikes than those we own.  Rather than trying to sell short-term puts which maximize the amount of short-term decay we could collect, we aim to sell just enough short-term decay to cover the decay of the longer-term puts we own.

In Greek terms (pardon me for using Greeks if you are not familiar with them), we seek to maximize the negative net delta of the portfolio while maintaining a positive theta.  As the stock fluctuates during the month, adjustments are often required to maintain these two goals.  (Adjustments we made in the August expiration month enabled the 10K Bear  portfolio to gain 55% while the original positions at the beginning of the month projected a gain of less than half that amount).

While this may seem to be a little complicated right now, if you become a Terry’s Tips subscriber, it should all become quite clear.  You can follow how the 10K Bear operates over time (as well as several other bullish-leaning portfolios) so that you can do it on your own if you wish.  (Most of our subscribers don’t do it on their own, but sign up for the Auto-Trade program at thinkorswim and have them execute the trades automatically for them).

The New York Times published an article last week which showed how market volatility was greater than any time in history, and that there were many indications that such high volatility had now become the norm.

Some people call the current market activity a “wolf” market – neither a bear market nor a bull market, but one characterized by high short-term volatility, big swings in both directions, while the general market is not really charging higher or falling lower.

We have developed an options strategy to contend with a wolf market, and I would like to tell you a little about it today.

An Options Strategy That Can Deal With High Volatility

 

We call it the 10K Wolf portfolio.  It was started a little over a week ago with $10,000.  The portfolio consists of buying in-the-money SPY LEAPS that expire in June 2012.  We bought puts that had a strike price of 125 and calls that had a strike price of 115.

The advantage to buying long-term in-the-money puts and calls is that much of their value is intrinsic.  The time premium component is relatively small, and these options decay quite slowly, especially in the early months (before they have only 3 or 4 months of remaining life, when we would most likely sell them and replace them with longer-term puts and calls).

The total cost of each pair of LEAPS cost about $2800.  As long as SPY trades within the range of $115 – $125 (and we are not short any in-the-money options which we are careful to make sure of), the minimum value of the pair of LEAPS will be at least $1000. (Actually, if the stock moves outside that range, the total value of the put and call LEAPS would be greater than $1000).

That leaves $1800 of time premium that will decay over the 9 months of remaining life.  We will need to sell $200 worth of Weekly puts and calls each month to cover the decay of the LEAPS.

With today’s high option prices (they are high because volatility is high), we are able to sell out-of-the-money Weekly puts and calls that generate more than $200 in premium income each week.  If they remain out-of-the-money, they will expire worthless in a week and we can sell the next week’s out-of-the-money puts and calls, presumably collecting another $200 per pair of LEAPS that own).

You can see that we can sell enough premium each week to cover the decay that our long positions will suffer each month.  The other three weeks of option selling should be pure profit. The gains that we expect are really a little better than this example because in the early months, the pair of LEAPS will decay less than the $200 average that it will decay over the entire 9-month period.  In the later months when they will be decaying at more than $200, we would no longer own them.

Adjustments often need to be made during the week if the stock moves more than moderately in either direction.  Last week, SPY moved almost $5 higher.  We had to buy back short calls that had become in the money (the strike price was lower than the stock price) and replace them with higher-strike short calls.  Each of these trades meant that we had to shell out money, but at the same time, we bought back inexpensive well-out-of-the-money puts and replaced them with more costly higher-strike Weekly puts at a credit of approximately the same as rolling up the calls cost us.

Last week, in its first full week of operation, in spite of the volatility (the 10K Strategy does best in flat markets), the 10K Wolf gained 7.4% (after commissions, of course).  Some people would be happy with that kind of return for an entire year in today’s investment world.

Here is the risk profile graph for this portfolio for next week:

The break-even range is about $3 in either direction from the current SPY price of $121.52, assuming no adjustments are made. We would make about 7% in an absolutely flat market, or about 6% if SPY were to fluctuate less than $2 in either direction. Price changes higher than $2 would require that an adjustment be made, so it is not clear what the profit or loss might be.

Obviously, carrying out the 10K Wolf strategy takes a lot of work. Rather than doing it yourself, we think a better idea would be to become a Terry’s Tips Insider, sign up for the Auto-Trade program at thinkorswim and let them make all the trades that we make in this portfolio in your own account for you, so you will enjoy exactly the same results as our portfolio. You can read about your gains, and smile, when we send out the Saturday Report each week, or whenever you check up on your trading account.

Another crazy week in the market.  Investors vacillated from panic to manic and back to panic.  The net change for the week was not so significant, but the fluctuations were huge.  How can you cope with a market like this?

You might consider using options to hedge against market moves in both directions.  Check out how two of our portfolios are doing it.

Using Options to Hedge Market Risk   

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116): 

Using Options to Hedge Market Risk

  

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116):

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?Remember, this is an actual brokerage account at thinkorswim which any paying Terry’s Tips subscriber can duplicate if he or she wishes.  The graph shows that if the stock stays absolutely flat next week, there could be a gain of over $1000 for the week.  If the stock should fall by $2, an even higher gain should result.  (Once the stock falls by $2, we would likely make some downside adjustments so that further drops in the stock price would generate higher gains.  After all, this is our bearish bet.)

Where else could you expect a 20% gain if the market doesn’t move one bit?  In a single week?  Or even more if the market should fall?

Admittedly, today’s option prices are extremely high (in 92% of the weeks over the last 5 years, option prices have been lower than they are right now, so we are in truly unusual times).  The risk profile graphs for our portfolios usually do not look as promising as they do right now.

One of the bullish portfolios that we recommend to be matched against the 10K Bear portfolio is called the Ultra Vixen.  This portfolio is based on the underlying “stock” (actually an ETN, an exchange traded note) called VXX.  This index is based on the short-term futures of VIX (the measure of SPY option prices, the so-called “fear index”).  When the market drops, VIX generally rises (as do the VIX futures prices), and VXX usually moves higher.  Over the last month while the market dropped over 10%, VXX has more than doubled in price.  For that reason, many people consider VXX to be an excellent hedge against market crashes.

We don’t like VXX as an investment possibility, however.  Over time, due to a mechanism called contango (futures prices become more expensive in further-out months), VXX is destined to fall over time.  It may be a good hedge as a short-term investment but is awful as a long-term holding.  It fell for 12 consecutive months last year, for example, even though VIX fluctuated in both directions.

Our Ultra Vixen portfolio is set up to benefit when VXX goes down (which it does when the market is flat or goes up).  We generally maintain a net short position on VXX with some call positions for protection in case the stock does go up.  However, our portfolio does best if the market stays flat or moves higher, so it is a good hedge against the 10K Bear portfolio.

Here is the risk profile graph for Ultra Vixen for next Friday’s expiration (September 16th).  It is a $10,000 portfolio and the underlying stock (VXX) is trading about $45.83:

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?The graph shows that a 10% gain for the week is possible if the stock falls as much as $3 or goes up by as much as $2.  (Historically, in about half the weeks, VXX fluctuates by less than a dollar in either direction.)  Where else besides options do you find opportunities like this?  In a single week?

Both the 10K Bear and Ultra Vixen portfolios should make excellent gains every week when the market is flat, and one or the other should make gains when the market moves more than moderately in either direction.  Theoretically, if the two portfolios together break even in the high-fluctuation weeks and they both make gains when the market doesn’t do much of anything, the long-run combined results should be extraordinary.

Last week was a crazy one in the market – four days of gains and then a big crash on Friday when the jobs report came out and said that there were no new jobs created last month, the worst showing in eleven months.  It was a tough week for our portfolios (we generally hate volatility) but our bearish portfolio racked up a 5.5%, the seventh week in a row when it made gains.  Over this period, this portfolio has picked up 58% in value while SPY has fallen by 8.8%.

This week I would like to share some of my thoughts about my favorite subject.  Guess what it is?

Some Thoughts About Options Trading   

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 10K 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.