Last week we made a little trade that doubled our investment in one day.  Every month, a similar opportunity presents itself.  Of course, it doesn’t always work out this nicely, but it seems to do well most of the time.  Today, I would like to share our thinking with this trade.

An Interesting Post-Expiration Play

Many investors are aware of a couple of phenomena which seem to prevail in the market.  The first is that the Monday after the regular monthly options expiration is generally a weak day for the market.  The second is that the first trading day of each month is usually a strong day.

When other indicators also suggest that these generalizations might hold true, it might be a good time to make the outright purchase of a put or call.

On Friday, July 20, the regular monthly options expired.  At that time, the market was also in an overbought condition (one of the indicators that we follow, RSI, was over 70).  Overbought conditions are not nearly as important indicators as are oversold conditions, but they are something to consider nonetheless.

Our favorite ETF to use when buying options is the Russell 2000 Small-Cap (IWM).  It seems to fluctuate in the same direction as SPY, but by larger percentages.  On expiration Friday, with IWM trading right around $79, we bought a Jul4-12 Weekly 79 put for $.85.  Actually, we bought 5 of them, shelling out $425 plus $6.25 for commissions (our broker, thinkorswim, charges Terry’s Tips subscribers a flat $1.25 per option contract).

On Monday, we placed a limit order to sell those puts if the price got up to $1.73.  The stock tumbled almost $2 on that day, and our order executed.  We were delighted to double our money after paying the commissions.  After commissions, we made a profit of $427.50 on our initial investment of $425.

We could have made more if we had waited a little longer, but we’ll take double our money any day.  Selling when we did ultimately proved to be a good idea because by the end of the week, our puts expired worthless when the stock rose to above $79.

Last week was a great one for anyone who bought either puts or calls.  Option prices were low (lower than they are this week) and volatility was high.  If you were willing to accept a moderate profit on your option buy, you could have done well either with puts or calls last week.

For most of the past couple of months (and all of last summer as well), option prices have been lower than the actual volatility of the market (SPY, and IWM).  This means that a good strategy has been to buy options rather than sell them (which is our usual preference).

This week, the first trading day of August falls on Wednesday.  We might be inclined to buy a call on IWM because the market is often strong on that day.  However, option prices (VIX) rose 5% Monday morning so options are not quite so cheap this week.  With the big run-up in the market last Friday (SPY gained almost 2%), we are probably due for some weakness soon, so we are probably not going to buy a call this time around.  We like to see other indicators which support our buying decision, and we don’t see any at this point in time.  (RSI is neutral, for example.)

Buying options is still probably a good short-term idea, but sometimes it is safer just to sit on the sidelines for a week or so and wait for a more opportune time.

Last week, VIX fell to as low as we have seen in four years.  I believe this has created a short-term buying opportunity.  Option prices (volatility) should be headed higher (in my opinion). 

How to Cash in on the Crash of VIX:  

As most of you know, VIX is the volatility measure based on option prices of the S&P 500 tracking stock, SPY. Last week, it had fallen all the way to 15.45, about the lowest level we have seen in several years. 

VIX is the so-called “fear index,” and historically has moved higher when there was uncertainty (or lower stock prices) in the market.  Back in 2007, a VIX this low was probably appropriate.  The stock market had been on a slightly-upward flattish direction for many months, and there was little unrest in our domestic economy or around the world.  In 2008 when markets imploded, VIX rose as high as 80.

Today, there seems to be uncertainty all over the place.  Some people are talking about the possibility of a double dip recession, while others focus on escalating oil prices, high unemployment, and most of all, a melt-down in several European countries that might have a domino effect on our economy.

So where has all the market fear gone?  There are a huge number of uncertainties in the current economic world, both at home and abroad, and the market seems to be ignoring them. 

Over the years, VIX has shown a strong inclination to revert to the mean, and the mean is 20.54.  I think it is inevitable that VIX will climb back up toward, or above, 20 in the near future.  If this is the case, how can you benefit from it?

A Time to Buy VXX? This stock (actually an exchange-traded note, ETN) is highly correlated to VIX.  It is based on the futures of VIX which are generally closely related to VIX.  It closed yesterday at $13.20, the lowest price in quite a long time.  About six months ago (when VIX was in the 30’s), VXX traded in the low $40’s).

On one hand, I believe that it is highly unlikely to go much lower, and on the other, I expect that some unforeseen event will surely come along at some point to spook the market and send VIX and VXX sharply higher.

There is one serious shortcoming of owning VXX, however.  Due to the way it is constructed, something called contango reduces its value every month that the futures for VIX remain unchanged.  For this reason, the only time that it is a good idea to buy VXX is when VIX is unusually low (and there are reasons to believe that it is headed higher).

An ETN that benefits every month from contango is the inverse of VXX.  It is called XIV (the inverse of VIX).  Last October, when XIV was trading about $6.70 (and VIX was in the 30’s), I made a major investment in VIX (and made an impassioned plea to my subscribers to do the same).  Now that VIX is less than half what it was then, last week I sold most of my holdings for more than $13, almost doubling my money over that period.  With VIX so low, I believe that there is a better chance that XIV will suffer from a rising VIX than there is that it will benefit from the contango tailwinds that it usually enjoys.  (When VIX moves over 20, I will probably buy XIV once again).

On last Friday when the market fell by almost 1%, VIX rose from 15.45 to 16.27 (5.3%) and VXX rose from $12.55 to $13.20 (5.2%) to give an idea of the potential gain for VXX if option volatility moves back to its mean average of 20.54.

Another way to play VXX is to buy the stock and write a call against it, or at least against some of it.  With VXX trading at $13.20, an August 14 call could be sold for $.74 which would give you a 5.6% gain for one month if the stock doesn’t change, or an 11.6% gain if it closes above $14, the call you sold is exercised, and you lose the stock.  Either scenario does not seem so bad for a single month. 

The key assumption here is that VXX is quite unlikely to trade any lower than it is right now.  I believe that this is a reasonable assumption to make.  While it might trade lower temporarily, history says that it won’t stay down there for long.

VXX has been recognized as one of the best hedges against a falling market.  Some analysts have stated that a $10,000 investment in VXX will protect a $100,000 market portfolio of stock (although my estimate is that it would take about a $25,000 investment to accomplish that).  Once again, however, because of the contango issue, when VIX is at or above the mean of 20.54, it is generally not a good idea to buy VXX unless you strongly believe that uncertainty, and option prices, are headed higher.

In any event, I think VXX is a good short-term buy right now as a bet that option volatility will rise as things in Europe start spooking the market once again (in spite of the contango issue that will depress its value somewhat).

For most of the last year, the market (SPY) and many individual stocks have fluctuated more than the implied volatility of the options would predict.  This situation has made it quite difficult to make gains with the calendar spread strategy that we have long advocated.

Now we are experimenting with buying straddles as an alternative to our basic strategy.  This represents a total reversal from hoping for a flat market to betting on a fluctuating one.

Today I would like to report on a straddle purchase I made last week.

Another Buying Straddles Story

I selected the Russell 2000 (Small-Cap) Index (IWM) as the underlying. For many years, this equity seems to fluctuate in the same direction and by about the same amount as the market in general (SPY) although it is trading for far less ($80 vs. $134) so the percentage fluctuations are greater.

On Monday morning, IWM was trading right about $80. I bought an 80 straddle using IWM (Jul2-12 puts and calls), paying $1.53 for the pair.  If IWM moved by $1.53 in either direction, the intrinsic value of either the puts or calls would be $1.53, and there would be some time premium remaining so that either the puts or calls could be sold for a profit.

How likely was IWM to move by more than $1.53 in either direction in only one week?  Looking back at weekly price behavior for IWM, I found that in 62 of the past 66 weeks, IWM had fluctuated at least $1.60 during the week in one direction or another.  That is the key number I needed to make the purchase.  That meant that if the historical pattern repeated itself, I could count on making a profit in 94% of the weeks.  I would be quite happy with anything near that result.

Buying a straddle fits my temperament because I was not choosing which way the market might be headed (something I know from experience that I can’t do very well, at least in the short term), and I knew that I could not lose 100% of my investment (even on Friday and the stock had not moved, there would still be some time premium remaining in the options that could be sold for something).

One on the biggest problems with trading straddles is the decision on when to sell one or both sides of the trade.  We’ll discuss some of the choices next week.  What I did was place a limit order to take a reasonable profit if it came along.  When IWM had fallen about $1.75, I sold my puts for $1.85 on Thursday.  On Friday the stock reversed itself, and I was able to collect $.17 by selling the calls, making a total 20% after commissions for the week. Not a bad result, I figured.  

At some point during the week, there were opportunities to sell both the puts and calls for more than I sold them for, but I was delighted with taking a reasonable profit.  You can’t look back when trading straddles.  If I had not sold the calls but waited until the end of the week, I would have lost about 70% of my original purchase.  So selling when you have a small profit is clearly the way to go.

Last Friday was the government’s monthly jobs report.  Historically, the market has been unusually volatile on those Fridays when the actual numbers either exceed expectations or are disappointing.  Last week we gave the results of a strangle trade we made a year ago which resulted in a gain of 67% for the day.

Last Thursday we made a similar bet, this time using a straddle.  Here is how it worked out for us.

Last Week’s Trade – Buying Straddles With Weekly Options

Near the close on Friday, the stock (SPY) was trading right around $137 and it was possible to buy both a Jul2-12 137 put and a 137 call which would expire one day later for $1.18 ($118 per spread plus $2.50 commissions).  We bought 7 spreads, paying $843.50 including commissions.  

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 $138, the calls could be sold for more than we paid for the straddle, and at any price below $136, the puts could be sold for more than we paid for the straddle.)

The market expected that 100,000 new jobs would be created, but the actual results were lower – about 80,000.  When the market opened up just over a dollar lower, it seemed not to be going anywhere so we took a profit, selling the puts for $155 each, collecting $1076.25 after commissions (the calls expired worthless and no commission was involved).  Our net gain on the trade was $235, or 27.8% on the initial investment.

We were hoping that the stock would reverse itself after the early drop so that we could sell the calls later in the day and add to our gain, but that never happened.

If we had waited until later in the day the profit could have been more than double this amount but if we had waited until the end of the day it would have been less.  There is no easy answer as to when to sell a straddle, but we will probably continue our strategy of taking a moderate profit when it comes along.  Another way to play it would have been to sell enough of the spreads to break even and let the others ride in hopes of a windfall gain.

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.  Right now, VIX (the so-called “fear index” that measures how high option prices are for SPY options) is at 17.10 compared to its mean average of 20.54.  This means that option prices are relatively low right now.  Last December, for example, when VIX was about 25, the same straddle we bought last week for $118 would have cost over $200.

On Friday, a SPY 137 at-the-money straddle with one week of remaining life (expiring July 13, 2012) could have been bought for $1.99 ($199 each).  If at any time during the next week, if SPY fluctuated more than $2, the straddle should be trading for more than $2.  Over the past 13 weeks, SPY has moved in one direction or another by at least $2 in 11 of those weeks, and in one week it fell by $1.94 at one point.

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.

Exactly one year ago, we spoke about an interesting options play that might be made before the July jobs report came out.  This Friday, the July 2012 report will come out before the market opens, and a similar trade might be in order.  It is interesting to note that one year ago, the market (SPY) was almost exactly where it is today.

 

Here are my exact words delivered on the Monday following the jobs report: “This week I would like to share an actual investment we made last Thursday which involved buying a close relative of a straddle called a strangle (buying a put and a call but at different strike prices).  Admittedly, the word strangle does not have the greatest of connotations, but it can be a wonderful thing as we learned last week.

 

Terry

 

Buying Strangles With Weekly Options (and How We Made 67% in a Single Day Last Week)

 

On Thursdays which precede the government monthly job reports,  we have sometimes employed a strategy that only does well if the stock (SPY) moves significantly in either direction once the report is published (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 on Friday (the usual kind of bet we make), on the Thursday preceding the Friday jobs report, we sometimes 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, July 7, 2011 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.

 

A personal thought – I think that expectations are so low for Friday’s jobs report (and May’s report was so disappointing), that there is a good chance that the market will surge on Friday.  Instead of buying a straddle or strangle, I plan to spend a very small amount of money buying an out-of-the-money Jul1-12 Weekly call (maybe paying $10 or less per option) just in case the stock skyrockets.  It is my lottery ticket purchase for the week, a reward to myself for having had such a good week (I have been quite long AAPL).  Chances are, I will lose the entire investment, just as the chances are hopelessly against you when you buy a lottery ticket.  At least my odds are better than being hit by lightning (the lottery ticket odds).