The Ultimate Stock Option Trading Strategy...

Tip # 6 — The 10K Strategy that Never* Loses Money

This is my favorite investment strategy, and the one I will give you the most help with. This is the strategy I used to make an average of over 50% a year for three consecutive years.  I have now added a twist to the strategy so that annual returns will be less than those years but it should never* lose money.

*The asterisk usually appears at the bottom, but here it is right up near the top.  We tested the strategy against the S&P 500 (SPY) for the past 10 years, and while there was an occasional losing month, there was not a single 12-month period when a portfolio would have fallen in value.  The average annual gain over the period was approximately 32% after paying all commissions.

If you buy the most conservative mutual fund you can find, you will invariably experience quarters (and entire years) when your portfolio values fall.  Since the 10K Strategy makes money even when the market in general takes a dive, you should never experience such a loss with our strategy.

The 10K Strategy takes a little work, and at least a small understanding of stock options, but it is well worth the effort. (Actually, you don't even have to understand it all if you subscribe to my Options Tutorial Program, where I email you every trade I make once it is made. You can mirror my trades, and maybe even get better prices than I do.) You can order it here.

I call it the 10K Strategy because it isn't a sprint nor is it a marathon. You have to exert lots of effort, but you see the results every month when you get new cash in your account and count up your winnings.

Are you willing to make the effort?

How would you feel about yourself if you did not take the hour or two it might take to learn how to make over 30% on your money every year, even if your stock doesn't go up at all?

On the other hand, how would it feel to know that you understood a trading strategy that could multiply your net worth many times over in a few short years? Think of the exotic vacations you could take, the fancy cars you could buy, and the early retirement you could earn — all possible because you understood and used an investment vehicle (stock options) that scare most people to death.

This is no fishy proposition.

While making 32% every year without taking big risks may sound too good to be true, this is no fishy proposition. I am not giving you fish — mahi-mahi, red snapper or sea bass. Holy mackerel, all I'm doing is teaching you how to fish. I will give you a formula. Once you have learned it, you may be able to make extraordinary returns on your money every single year – without any help from me.

You will be proud of your newfound ability to achieve stock market riches with this formula. Your family and friends will love you. Your business associates will envy you. Your mother will take full credit for your success.

Here's the fine print.

Okay, anything this good must have some drawbacks, so here they are:

1. I can't guarantee a 32% return in one year while not risking a loss. But I can show you the details of the backtest that showed no losing years, and an average gain of 43% each year.
2. You will have to work. That means placing option orders with your discount broker on or about the third Friday of each month. When you subscribe to Terry's Tips, I will email you the exact trades I make in every portfolio using the 10K Strategy (for two months there is no extra charge). Once you understand how the strategy unfolds you probably won't need my help any longer. You will know exactly what to do each month on your own.
3. You will need to have access to a telephone on or about the third Friday (expiration day), and sometimes for adjustments at other times. This is not always easy, but I have made hundreds of trades on the telephone from a remote island in the Bahamas, a bastide in Provence, and a small village in the middle of Russia. So it is almost always possible.
4. Most of your profits will be taxed as short-term capital gains.  This is a major disadvantage of the strategy and a big reason to carry it out in your IRA or other tax-deferred account.

Yes, you can use this strategy in your IRA. You will have to set up an IRA account with a broker who allows option spreads (very few brokers do). My favorite broker is thinkorswim, (Barron's choice of the #1 software-based options broker for both 2006 and 2007) and I highly recommend them for option traders. Their rates are quite low, their website is option-friendly, and you will have more information about your options (including deltas, gammas, and other Greek measures) than you will probably ever need.

Does the stock have to go up for the 10K Strategy to be profitable? 

As long as the stock moves only moderately (5% or so) during an expiration month, it doesn’t matter which way the stock moves.  We actually spend about half the invested amount in an insurance bet that pays off only if the stock falls (or in a cash reserve for a downside adjustment).

A Conservative Options Strategy

Many people believe that a conservative options strategy is an oxymoron.  Options are leveraged and depreciating investments that involve a great deal of risk.  However, for virtually every option that the 10K Strategy owns, there is an offsetting short option to protect against a moderate stock price move in either direction.

The 10K Strategy in a nutshell

The strategy consists spending about half of portfolio value to purchase call calendar spreads at strikes near and above the stock price. These calendar spreads (also called time spreads) involve buying options with several months of remaining life and selling the same-strike current month option against them.

Since the decay of the short-term (current month) option is considerably higher than that of the longer-term same-strike option, the portfolio gains in value every day that the stock remains relatively flat.

The other half of the investment consists of providing insurance against a big downdraft in the price of the stock.  This insurance is provided by purchasing what we call an exotic butterfly put spread.  Let’s take a brief look at the characteristics of a butterfly spread (please try to get through this brief discussion without having your eyes glaze over like they do for most people):

Brief Description of a Butterfly Spread: A typical butterfly put spread would be as follows:

Long 10 Aug08 132 puts
Short 20 Aug08 127 puts
Long 10 Aug08 122 puts    Total cost of this butterfly spread = $1.10 ($1100 for 10 spreads) – this might be the cost when the stock is selling at bout $127.

This is the risk profile graph for these positions:

The butterfly spread gets its name because a graph of its returns are supposed to look like a butterfly, but it never looked that way to me.

The maximum gain for a butterfly spread comes when the stock ends up exactly at the strike of the short options.  If it lands there, a very large gain results (in this case, over 4 times the cost of the spread).  There are some interesting aspects of butterfly spreads:

• The initial cost is your maximum loss.
• If the stock ends up above the highest strike or below the lowest strike, a total loss results.
• The closer the mid-point (the short option strike) is to the stock price when it is bought, the more expensive it is (if the above butterfly were bought with all the strikes 5 points lower, the spread would cost $.53 instead of $1.10).

Since we would like to use a butterfly spread to provide protection on the downside, we would select a mid-point at a strike much lower than the current price of the stock.  If the stock falls more than moderately so that the mid-point strike is approached, a large gain could occur which would offset the loss on the calendar spreads from the falling stock price.

If we added a butterfly whose mid-point was 10 points lower than the original stock price, it would only cost $.50 or so (this compares to the $3.00 or so in premium decay we would be collecting from the near-the-money and out-of-the-money call options we have sold in the calendar spreads).   Conceptually, we would be giving up some of our potential decay gain to provide excellent protection in case the stock were to fall by a large amount.

The typical butterfly spread has three characteristics:

1. The short options are at a strike which is mid-way between the two long strikes.
2. All options are in the same expiration month.
3. The options are placed in a 1-2-1 ratio (1 long option at each end and 2 short options in the middle.

The butterfly spread we use in the 10K Strategy is different from the typical butterfly on all 3 of the above characteristics.  That is why we call it an exotic butterfly.  Here is how the risk profile graph looks for the exotic butterfly:

Note that this spread makes more money for ever dollar the stock falls below it’s present level of $127.  It provides increasing protection against loss all the way down to $115 (which would be a drop in the stock price that has happened only 5 times including 9/11 in the last 120 months).  If the stock were to go up, this spread would lose money, but that loss would be covered by the higher-strike call calendar spreads that are in place.

On July 10, 2008, we set up a new portfolio where the above spread was combined with calendar call spreads at strike prices which were near and above the current stock price.  Here is what the risk profile graph looked like with all those positions in place:

We call this new portfolio the Mighty Stalagmite.  We believe it is a portfolio that will essentially never lose money, no matter what the market does.  In the above graph, you can see that a profit approximating 10% will result (the portfolio value is $10,000) if SPY were to land anywhere between $115 and $133 in five weeks.  On July 10, SPY was about $125 so it could fall by $10 or go up by $9 and we would still make that amount.

Part of our strategy is to hold some cash in reserve so that if the stock moves by about $7 in either direction, a new modified butterfly spread can be bought that will expand the break-even range so that a loss is averted.  When this second spread has to be placed, it is doubtful that the portfolio would gain money in that month, but it should at least break even.

Back-Testing the Mighty Stalagmite: I checked out how these positions might sugar off based on how much that SPY fluctuated each expiration month for the past 10 years.  It was not a simple task because it involved more than merely checking the fluctuation for a month and seeing what the gain or loss would be on the risk profile graph.  Instead, I had to calculate the maximum fluctuation for the month (both up and down) to see if it moved more than $7 so that a mid-month adjustment trade would be triggered.

The results were interesting.  Two-thirds of the time, no adjusting trade would be required, and a portfolio gain would be achieved.  One third of the time, an adjusting trade would be required, and this happened about equally between upward and downward moves (I had expected there would be more big moves on the downside).  Presumably, we would not make a gain in those months but a loss would be avoided.

For one period of time during the back-test (ending with the December 2008 expiration), the proposed configuration of the Mighty Stalagmite would have made a gain in 60 consecutive months.

In one month, the stock deviated from its starting price by a $7 move in both directions, and two adjustments would have been required (the second one would have involved taking off one of the calendars to come up with the cash to do it), and a small loss would probably have been experienced for that month.  But that was only one month out of 120.

The greatest change in a single month was $16.70 (in 9/11).   On the day that trading was resumed, the stock moved up $4, and two months later it was higher than it was before the tragic event.  Only 4 times out of 120 did the stock fall by over $12 in a single month.  In each of these circumstances, a butterfly spread that extended the no-loss range by $5 would have covered the unusually large fluctuation.

Of course, past experience is no guarantee of future performance, but the numbers seem extremely promising to me.

Buy the Book and Learn all About Calendar Spreads

If you would like to see how calendar spreads can be used to achieve consistent returns every year that the market moves moderately in either direction, all you have to do is buy a copy of my book (Making 36%).  This book covers half of the 10K Strategy formula (the calendar spread part).  To learn the specifics of the exotic butterfly spreads you would need to become a Terry’s Tips Insider and see the actual spreads that are placed in our six actual portfolios.

You can buy the book at the discounted price of only $12.94 - go to www.Making36Percent.com and enter the Discount Code TEE and you will receive:

1. An electronic version of Making 36%: Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad.
2. A copy of the paperback book mailed to you by first class mail.

This may seem a little hard to believe. For a total cost of $12.94, you will have everything you need to make superior investment returns for many years. It could easily be worth hundreds of thousands of dollars to you. There is nothing else for you to buy (unless you would like to learn even more, and become a Terry's Tips Insider).

Stock Options Strategy Book

In the book, I distill 30 years of option trading experience into a clear statement of an extraordinary options strategy. It is called Making 36%: Duffer's Guide to Breaking Par in the Market Every Year, In Good Years and Bad. The book is written with a golf motif to make it a little more interesting, but it is all about this unique way to make exceptional gains using stock options.

There are 18 chapters, each one only two or three pages long, so you don't have to spend hours learning all about options to get the basic idea. If you are interested in learning more about options, there are several appendices that will give you a good understanding of this investment alternative, including a discussion of the "Greek" measures of option prices.

The book was originally published at $19.95. You will receive an electronic version so you can start right away, and the paperback version will be mailed to you free of shipping and handling charges. Order it today at www.Making36Percent.com (Enter the discount code TEE and your cost will be only $12.94, including shipping by First Class mail).

Here is what the book looks like (but the good stuff is inside):

This could be the best investment decision you ever make. At least, you won't be risking much to learn the strategy. And it could change your investment outlook for a lifetime. Total cost, including shipping only $12.94 - www.Making36Percent.com (Enter the discount code TEE).

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