January’s rally was admirable. Its perseverance frustrated bears. The infrequent single day declines maxed out at -0.6%.

And the last nine days of the month were more than mind-numbing for most traders as the market traded in a very tight range.

There’s no doubt the bears are ready. Almost every technical and sentiment measure I follow has pushed into a bearish state. Typically, I am ecstatic by the weight of the bearish measures, but it seems everyone is aware of the measures and have joined my short-term bearish camp. And when the herd is anticipating something a bearish move might have a hard time coming to fruition.

That was certainly the case last month.
We must remember that January is one of the strongest month of the year for the market. February not so strong with a historical return of 0.0%.

February swoon? Not yet.

After Friday’s unemployment report, the bulls managed to push the indices, particularly the Dow to highs not seen since before the financial crisis in 2008. A drop in the unemployment rate to its lowest level in three years (8.3%) propelled stocks.

“In this economy only one variable matters right now and that variable is employment,” said Lawrence Creatura, an equity portfolio manager at Federated Investors.

“This report was great news. It was beyond all expectations, literally. The number was higher than even the highest forecast.”

After three months of gains a decline seems the likely scenario. Again, almost all technical and sentiment measures have reached short to intermediate-term extremes, but will they win out for the bears or will the mighty power of the bulls push through the consolidation that has lasted nine long trading days?

Talented analyst Jason Goepfert of Sentimentrader.com recently stated that when “the S&P 500 closed at a six-month high with volume 10% off its low from the past month (as it did on Thursday), then the next two days were positive only 12 out of 46 times.”

Out of the 12 positive occurrences, only twice did it advance more than 1%. Thirteen times it closed with a loss greater than 1%.

Another interesting stat provided by Mr. Goepfert is “the last 8 Fridays when the Nonfarm Payroll report was released” all have closed lower than the prior trading day.

In fact, if you went back to September 2009 and purchased shares of the S&P and sold at the close of the trading day you would have only made a paltry 1%.

Couple the aforementioned studies with short-term overbought readings in three out of the four major indices and I expect to see a short-term pullback over the next 1-5 days.

The two best performing days (on a historical basis) in February are now behind us and now we are entering into a period of bearish seasonality.
Just more food for thought.

Last week I recommended an options spread on AAPL prior to its earnings announcement on Tuesday.   The spread would have made money if the stock fell, remained the same, or rose moderately.  The only scenario where a loss would take place was if it shot considerably higher.

I believed that since the stock had already gone up $50 over the last month, much of the expected earnings blow-out had already been priced into the stock.

I was wrong, and the stock soared about $40 on the announcement.  Today I would like to discuss what we did about it.

Update on Last Week’s Apple Trade

If you missed last week’s trade, this is what it was:

Buy to Open 1 AAPL Feb-12 440 call (AAPL120218C440)
Sell to Open 1 AAPL Jan4-12 435 call (AAPL120127C435) for a debit of $1.05  (buying a diagonal)

The stock shot up to about $452 on Friday.  We had to buy back the Jan4-12 435 for about $17 ($1700).  We retained the Feb-12 440 call, and sold a Feb1-12 450 call, collecting $3 ($300).

This left us with a diagonal spread that will be worth a minimum of $1500 if the stock ends up any higher than $450.  We could earn more than that if it stays flat or moves slightly higher so we can sell more premium in the next two weeks.

With the stock up again this morning, we have recovered about $300 of our loss.   Here is what the risk profile graph looks like with our current positions:

The graph shows that in the next 4 days we should recover up another $400 or so if the stock stays above $450 (it is trading about $452 right now).  We have the opportunity to sell new Weeklys against the Feb-12 435 call for the next two weeks, so additional gains could easily come our way.  We have a very good chance of covering our loss from last week’s trade.

I apologize that this graph (and our manner of contending with a bad trade) is confusing.  Unless you are familiar with option trading, it should be confusing.  I hope you will continue receiving this free newsletter anyway.  Other reports should make more sense to you.

In spite of having 3 of last week’s suggested trades in our actual Terry’s Tips AAPL portfolio, the portfolio gained 25% last week and is now up 170% since we started the portfolio 20 months ago.  This is more than 2 ½ times as great as AAPL has gone up over this period, proving once again that an options portfolio can seriously outperform the outright purchase of stock (if you pick a stock that goes up).

Happy trading.

Simply stated, the rally continues.

?Nothing, and I mean absolutely nothing can hold this market down.

Numerous downgrades from Fitch, Moody’s the S&P and more importantly the World Bank, more European woes, news of inevitable Greek default, financial sector struggles, among bearish technical and seasonal readings hasn’t helped the bears at all during 2012.

As a result, the market has managed to advance on ten of the past twelve trading days leading to gains of 4.6% in the S&P 500, 4.1% in the Dow and a staggering 7.0% in the Nasdaq – in three weeks, yes, three weeks.

If you tack on the gains since December 19th, when this rally started, the gains are even more impressive as they reach over 9% in the S&P.

Are all of these gains really sustainable?

I think we all know the answer to that question. But, just in case you are unsure, just look at the list of indicators at extremes that are now bearish for the market.

VIX. Fidelity Sector Breath, OEX Determination Index, Put/Call Ratio – OEX Open Interest Ratio, Down Pressure – S&P, Down Pressure – NDX, NASDAQ/NYSE Volume Ratio, CSFB Fear Barometer, Rydex Bull/Bear RSI Spread, Daily Cumulative Tick – NASDAQ, TRIN – NYSE, Put/Call Ratio – Equity De- Trended, Put/Call Ratio – Equity Moving Averages, Put/Call Ratio – Equity Options Only, Put/Call Ratio – Total of All Options. Put/Call Ratio – Total of Moving Averages, Liquidity Premium – QQQ, Liquidity Premiun – SPY, TRIN – NASDAQ, NH/NL Ratio – NYSE, Up Issues Ratio – NYSE, Up Issues Ratio – NASDAQ, Up Volume Ratio – NYSE, Up Volume Ratio – NASDAQ, VIX Transform, Sentiment Survey – AAII and AIM Model.

Tack on almost every ETF I follow in a “very overbought” state and you can see why I am leaning towards the bearish camp.

And next week could be the week for the bears. Not only do we have some key earnings plays coming up out week including Apple, but the Fed is also supposed to give us some insight into where they think the economy is headed.

If all of the aforementioned information wasn’t enough to at least make you reconsider being at least a short-term bull, the week after options expiration is historically bearish.

There is no doubt, the risk is to the upside at this juncture.?If you were not privy to the stats I provided last week by the wonderful sentiment analyst Jason Goepfert
of Sentimentrader.com he recently stated the following:?

“Starting around the 2nd week in January, stocks have had a consistent tendency to weaken. Or at least not show much strength. Especially technology.

I don’t want to hammer on this too much. Seasonality is a tertiary indicator at best, and can easily be overwhelmed by fundamental developments, technical breakouts and changes in sentiment.

The performance of various sectors since the day honoring Martin Luther King, Jr. became an exchange holiday in 1998. The performance of QQQ was positive only 1 out of 11 years into the end of the month.”

He goes onto to provide a wonderful chart that shows sector performance after the MLK holiday and the Nasdaq 100 only has a 9%, yes 9% chance of closing higher than its price level before the holiday.

The bears are already in the whole 2.0% and almost 3.0% on the S&P and Nasdaq, respectively so in order for history to repeat itself the bears better start getting to work.

This week I will share an options play that we are taking in advance of tomorrow’s earnings announcement by AAPL.  If you think it is a good idea, you will have to place the trade before the market closes Tuesday, January 24, 2012.

Options Tip Of The Week

Expectations are sky high for Apple.  The company reports earnings for the 4th quarter tomorrow, and Christmas sales are rumored to be through the roof.  People have reported long lines for a month at Apple retail stores.

Demand is so high for iPhones in China that hordes of country dwellers have been hired to take a train to a city to buy a single iPhone (payment $16 for a day’s “work”) but the stores don’t have enough products so many people were turned away.  A riot broke out and the stores were eventually closed (the website stills sells their products, but you wonder why they hire buyers if consumers can buy online).

It is always a good sign for a company when the biggest obstacle to success is making enough of the products rather than selling them.

On a fundamental basis, AAPL is trading at less than 11 times forward earnings, an extremely low number for a company growing at 39% a year (although it may be more than this amount – we will know tomorrow).

So will the stock skyrocket on Wednesday after the earnings announcement?  The answer is an unequivocal “maybe, maybe not”.  Expectations are so high that investors may be disappointed no matter what the numbers are.  The stock has gone up about $50 in the last month in advance of the announcement.   Maybe it will be another “buy on the rumor and sell on the news” event, and the stock falls in spite of the good news.

Terry’s Tips subscribers are already happy about our AAPL portfolio.  It has gained 136% since we started in April 2010, well more than double the increase in the price of the stock.

Here is the trade I am proposing to make right now (we did several similar to this last week in our AAPL portfolio).

Buy to Open 1 AAPL Feb-12 440 call (AAPL120218C440)
Sell to Open 1 AAPL Jan4-12 435 call (AAPL120127C435) for a debit of $1.05  (buying a diagonal) 

This trade will cost $105 (plus a commission of $2.50 at the rate paid by Terry’s Tips subscribes at thinkorswim).  There will also be a maintenance requirement of $500 because the strike price of the long side (440) is higher than the strike price of the short side (435).  The broker holds your cash aside to protect against the maximum possible loss you might incur.

When the Jan4-12 435 call expires next week, if the stock is trading below $435, you do not have to do anything.  That call will expire worthless, and you will be left with a long 440 call which has 3 remaining weeks of life.  No matter how low the stock might fall, it is unlikely that this call will be selling at less than $1.05 (your original cost).  In other words, if AAPL goes up as much as $10 from its current price of $125, or if it falls in value, the spread should make a profit.

If the stock is above $435, you will have to buy back the expiring call and sell the Feb-12 440 call at the same time.  It is uncertain what value of the option might be, but unless the stock goes up be an extremely high amount, the Feb-12 440 call should be worth at least $6.05 more than the expiring call so that you can still make a profit.

I hope if you try this little idea and you make a small gain, you will use it to come on board and start your option education for real.

__________________

Any questions?   I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.

You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here.   Why wait any longer to make this important investment in yourself? 

I look forward to having you on board, and to prospering with you.

Terry

Most of the time, we talk about the wonderful aspects of investing in options. I am proud that the new strategy we set up five weeks ago has now had five consecutive weeks of gains (averaging over 5% a week), but today I would like to discuss some of the negatives in trading options.  Unfortunately, there are a few.

A Look at the Downsides of Option Investing

1.    Taxes.  Except in very rare circumstances, all gains are taxed as short-term capital gains.  This is essentially the same as ordinary income.  The rates are as high as your individual personal income tax rates. Because of this tax situation, we encourage subscribers to carry out option strategies in an IRA or other tax-deferred account, but this is not possible for everyone.  (Maybe you have some capital loss carry-forwards that you can use to offset the short-term capital gains made in your option trading).

2.    Commissions.  Compared to stock investing, commission rates for options, particularly for the Weekly options that we trade in many of our portfolios, are horrendously high.  It is not uncommon for commissions for a year to exceed 30% of the amount you have invested.  Because of this huge cost, all of our published results include all commissions.  Be wary of any newsletter that does not include commissions in their results – they are misleading you big time.

Speaking of commissions, if you become a Terry’s Tips subscriber, you may be eligible to pay only $1.25 for a single option trade at thinkorswim.  This low rate applies to all your option trading at thinkorswim, not merely those trades made mirroring our portfolios (or Auto-Trading).

3.    Wide Fluctuations in Portfolio Value.   Options are leveraged instruments.  Portfolio values typically experience wide swings in value in both directions.

One of our most popular portfolio (we call it the 10K Bear) has gained nearly 70% (after commissions, of course) in the last six months.  The underlying stock for the 10K Bear is the S&P 500 tracking stock, SPY, one of the most stable of all indexes.  Yet our weekly results included a loss of 34.7% in the last week of November when SPY rose $8.52 in a single week (a highly-unusual upside move).  Many times over the past six months, our weekly gains were above 20%, however, when SPY fell in value during the week.

Many people do not have the stomach for such volatility, just as some people are more concerned with the commissions they pay than they are with the bottom line results (both groups of people probably should not be trading options).

4.    Uncertainty of Gains. In carrying out our option strategies, we depend on risk profile graphs which show the expected gains or losses at the next options expiration at the various possible prices for the underlying.  We publish these graphs for each portfolio every week for subscribers and consult them hourly during the week.  

Oftentimes, when the options expire, the expected gains do not materialize.  The reason is usually because option prices (implied volatilities, VIX, – for those of you who are more familiar with how options work) fall.   (The risk profile graph software assumes that implied volatilities will remain unchanged.).   Of course, there are many weeks when VIX rises and we do better than the risk profile graph had projected.   But the bottom line is that there are times when the stock does exactly as you had hoped (usually, we like it best when it doesn’t do much of anything) and you still don’t make the gains you originally expected.

With all these negatives, is option investing worth the bother?  We think it is.  Where else is the chance of 50% or 100% annual gains a realistic possibility?  We believe that at least a small portion of many people’s investment portfolio should be in something that at least has the possibility of making extraordinary returns.

With CD’s and bonds yielding ridiculously low returns (and the stock market not really showing any gains for the past 4 years), the options alternative has become more attractive for many investors, in spite of all the problems we have outlined above.