Stock Options Trading Idea of the Week
Continued Discussion of a Conservative Options Strategy that Should Never Lose Money
The Economics of Using a Longer-Term Option in a Butterfly Spread: In our Mighty Stalagmite portfolio we might place a Sep-08 126-122-120 put butterfly spread to provide downside protection. A traditional butterfly would have all three options in the same month, but we often use a longer-term put for the highest strike leg of a put butterfly. (We would use the same policy for the lowest-strike option in a call butterfly.)
This means that instead of buying a Sep-08 126 put for $1.85 we could pay $4.85 for a Dec-08 126 put. We would have to spend $300 more for the spread than we could have by having all the options in the Sep-08 month.
In 35 days, the Dec-08 126 should decay by $.75 (assuming the stock stays flat). That means our "cost" of the 125 put is $110 less expensive ($1.85 - $.75) than if we had bought the Sep-08 126 put. We have to put up an extra $300 to save $110, so our investment in the longer-term put yields us 36% for the 5-week period.
That surely seems like a good investment even though it means we have less cash for buying calendar spreads. If we could make 36% on our money in every 5-week expiration month we would have no complaints.
On the other hand, at times, traditional out-of-the-money butterfly spreads are so inexpensive that they should be placed anyway (and the money saved used for generating decay with calendars). The choice between exotic and traditional butterfly spreads must be made on a case-by-case basis, and different answers may well result for different portfolios at different times.
Tune in next week for more Stock Options Trading tips.
Andy's Market Report
All of gains from the prior week were lost this past week as credit concerns, geopolitical tensions, and a string of negative economic reports plagued the market.
The Dow, S&P, NASDAQ and Russell 2000 finished the week lower -0.3%, -0.5%, -1.5% and -2.1%, respectively.
Once again, the financial sector led the overall market lower as continued concerns over Freddie, Fannie and Lehman Brothers kept bullish sentiment in check. The sector was lower -6.5 for the week. Over the past year Fannie and Lehman have witnessed declines in share value of 95% and 76%, respectively.
The ongoing credit concerns were evident this past in the latest chapter of the Lehman Brothers saga. The investment bank has been tormented by the sub-prime crisis and as a result the underlying stock has been obliterated. Shares have declined from a high of approximately $80 last summer to $14.41 at Friday's close.
"Investors are unwilling to accept any positive view of the company; management is unwilling to sell out at a deeply distressed value," stated Richard Bove, an analyst at Ladenburg Thalmann. "The stage is set for a hostile bid to take over the whole company."
Oil prices finished the week slightly higher as the Russian-Georgia conflict made light of the deteriorating relations between the US and Russia. Crude reached a high of $120 a barrel on the news before falling back towards the latter part of the week to close slightly below $115.
"The specter of conflict between Russia and NATO is firmly in peoples' minds and...price activity backs this up," said Andy Riddell, an energy broker at ODL Securities in London.
The economic picture did not look any brighter this past week either with a sharp increase in the producer price index (PPI), a sharp decline in housing starts and a rise in initial claims.
The PPI report, a measure of wholesale inflation, witnessed an unexpected increase of 1.2% in July, well above economists' forecasts of 0.4%. The annual rate of increase has now moved to its highest level in over 27 years.
Housing starts declined another 11% in July after a small advance and a potential glimmer of hope in the June numbers. The July report displayed the weakest production numbers in over 15 years.
"Inflation is way too hot and with housing way too cold, we have the opposite of a Goldilocks economy," said Joel Naroff, president of Naroff Economic Advisors.
The overall market and most of the major sectors have moved back into a neutral state so there really isn't a probable edge at this juncture. As expected, volume has tapered and will continue to do so until the upcoming holiday season has passed. The low volume should make for some volatile trading next week.
Last week I stated that seven out of the last eleven years have witnessed a sharp decline during the final week of August so it will be interesting to see how next week sets up before the seasonal end of August weakness arrives. The declines have been substantial with an average loss (during the final five trading days) in the Dow, S&P, and NASDAQ of -2.6%, -2.3%, and -2.1.
Furthermore, there are quite a few "under the hood" bearish indicators that have moved into the market such as the latest Commitment of Traders report and the Equity Put/Call Ratio. Both have reached levels that have accurately indicated in the recent past that at a minimum a short-term correction is near. While of course no one knows for certain I will be taking this into consideration as we approach a very weak seasonal time frame.
Overbought/Sold Condition Report
Overbought/Oversold for August 22, 2008
Major Benchmarks - Dow (DIA) - 54.5 (neutral)
- S&P 500 (SPY) - 62.5 (neutral)
- Russell 2000 (IWM) - 57.5 (neutral)
- Nasdaq 100 (QQQQ) - 63.2 (neutral)
- Emerging Markets (EEM) - 45.4 (neutral)
Stock options trading benchmarks.
Testimonial of the week
Nice Job so far! I'm standing aside during testing... Sometimes paying more is a better bargain that catching the falling piano! Paraphrasing Helen Keller "When one of life's doors closes, another opens. Unfortunately, many people spend too much time staring at the closed door." -- Bob
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