Option Trading Idea of the Week
Last week we gave you a brief description of a traditional butterfly spread. This week we will show a modified butterfly where the short positions are not in the middle and the ratio of long-short-long is not the typical 1-2-1 but 1-3-2. With SPY trading at $127, this is how a modified butterfly would perform in five weeks:
Note that this spread makes more money 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 100 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 (out basic 10K Strategy).
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 $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 100 months (8 1/3 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 100.
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 2 times out of 100 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.
Next week will expand our discussion to ask if it is a realistic possibility that we have come up with an options portfolio that doesn't lose money no matter what the market does (and may make as much as 10% in a single month if the market only changes moderately up or down).
I hope you are interested enough it this possibility that you would consider coming on board as a Terry's Tips Insider and watching the Mighty Stalagmite unfold in real time (it is one of our 15 actual portfolios).
You can sign up at http://www.terrystips.com/order.php, It could be the best investment you ever made.
Terry
Andy's Market Report
Did we see a short-term bottom this past week? It is often said that a spike in market volatility often signals a potential trading bottom. Certainly, the kind of volatility that we have witnessed in recent weeks could be interpreted as such with a VIX (investors fear gauge) that is back up to what seems to be a statistically significant level at 30. Also, the recent action in the VIX has a well respected VIX guru and several of his compadres anticipating a bullish signal in the near future.
Of course, this is no guarantee that a market bottom (not a trading bottom) is near. However, it does provide a bit of solace for bullish traders who wonder when a reprieve is near.
I would also like to point out that the Dow (DIA) and S&P (SPY) are back in a short-term oversold state. Typically this means the probability of a short-term reprieve (1-5 days) is close.
Couple the two aforementioned reasons and a few others technical indicators I use and I want to concur with the short-term oversold bounce, but unfortunately I still think the NASDAQ 100 (QQQQ) has some room left on the downside. My thought is that we will see the 3/24 gap close in the tech-heavy benchmark or a move to the $43.00 level. My hope is that we see a capitulation event that causes the gap to close, but that would be too perfect.
The good news is that the kind of volatile price action coupled with the recently oversold market, more often than not mark a trading bottom as opposed to a major market bottom, but a bottom nonetheless.
For the week the Dow, S&P, NASDAQ and Russell 2000 finished the week mixed at -1.7%, -1.9%, -0.3% and 1.4%, respectively.
Speculation over the future of government sponsored enterprises Fannie Mae and Freddie Mac were the fuel that sparked the volatile markets this past week.
The health of the Fannie and Freddie is seen as synonymous with the U.S. housing market since the two mortgage giants own or guarantee more than $5 trillion in mortgages.
Of course the two companies rejected the rumors and said they have plenty of capital.
Senator Christopher Dodd, D-Conn., the Senate Banking Committee chairman, raised the prospect that the companies could be given access to emergency Federal Reserve lending. Dodd, who spoke Friday to Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson, said the two are "looking at various options" for propping up the firms if they ultimately need help. Those include giving them access to the Fed's emergency lending "discount window," Dodd said.
"I think everybody's just holding their breath in expectation that something substantive from the government will happen today or over the weekend," said Karen Shaw Petrou, managing partner of consulting firm Federal Financial Analytics.
Oil continued to give traders the run around as price fluctuated between $135 and $147. Unfortunately the price of crude settled near the highs of the week slightly below $145. Geopolitical concerns, namely the Israel-Iran rumors, helped to prop up the price of crude late in the week.
Economic woes were reflected in several of the reports released this past week, but next weeks economic calendar should prove to be a more valuable indication as to where this economy is headed over the near future.
The two highly anticipated key inflation reports, PPI and CPI, will be released. Bernanke gives his semi-annual testimony to Congress and June FOMC minutes will be released. Oh yeah, I almost forgot to mention, the slew of important earnings reports from several key financial and technical companies.
Combine all of the above during the week of options expiration and I think next week could be an interesting one.
Overbought/Sold Condition Report
Overbought/Oversold for July 14, 2008
Major Benchmarks - Dow (DIA) - 29.8 (oversold)
- S&P 500 (SPY) - 26.3 (oversold)
- Russell 2000 (IWM) - 38.7 (neutral)
- Nasdaq 100 (QQQQ) - 36.9 (neutral)
Emerging Markets (EEM) - 45.2 (neutral)
