Weekly Stock Options Trading Tips: July 21, 2008

Option Trading Idea of the Week

Mighty Stalagmite - a Conservative Options Strategy That Doesn't Lose Money

The Mighty Stalagmite - A Conservative Options Strategy That Doesn't Lose Money

Is a "Doesn't Lose" Strategy Possible? Some people would argue that a truly efficient options market would theoretically not allow a totally risk-free strategy to exist for very long. Yet an option mechanism called a collar can be established that does guarantee no loss, and it is used fairly commonly as a hedging device by sophisticated investment banks. However, it is a little unusual to come up with a strategy that "guarantees" no loss but also allows for the possibility of a gain when the market behaves as we wish.

A 10-year backtest of the Mighty Stalagmite (underlying stock - SPY, the tracking stock of the S&P 500) showed that about one month out of three, an adjustment would have to be made because the stock had moved 8% in one direction or another - we expect there would be no profit or loss for the portfolio in those month.

The backtest showed that in the other 2 out of 3 months, an average monthly profit of about 4% would result. If these figures hold true, the portfolio would earn 32% each year with never a losing month.

I cannot offer a guarantee that the portfolio will never lose money. The risk profile graph we published last week clearly shows that if the S&P 500 falls by 10% in a single day, a loss situation will be faced. A stock price drop of that magnitude has occurred only once (9/11/01) in the past 10 years. But as one great sage noted, there is never only one cockroach. So we have to be prepared to handle these rare events.

After the 9/11 disaster, the strategy would have recovered nicely in the subsequent month, and a loss would have been avoided for the two-month period. Since I can't guarantee that two 9/11-type events would not occur in subsequent months, or the market did not quickly recover some of the loss in a subsequent month, I can't make the guarantee. But I believe that the odds are overwhelming that a loss will never result for even a two or three-month period. If the money is invested for an entire year, the odds should be dramatically higher that a gain will result instead of a loss.

A Complicated Strategy: The Mighty Stalagmite is not for the do-it-yourselfer subscriber. We cannot to offer up-front Trading Rules. While we can explain the general decision rules when placing the initial trades, the problem comes in the details of the adjustment trades. Depending on how much time has elapsed before the stock moved enough to trigger an adjustment, the solution may differ.

So the bottom line is that we firmly believe that we have created an options strategy that never loses money if it is carried out for a year. Such a claim is not possible for even the most conservative mutual or bond fund. They often lose money. Contrast that record with the Mighty Stalagmite which could handle a market (S&P 500) that dropped up to 5% every month of the year and the portfolio would still make a gain for the year.

I invite you to become a Terry's Tips subscriber and learn the full details about the Mighty Stalagmite, the option strategy that doesn't lose money. You can sign up here. It could be the best investment you make this summer.

Happy trading.

Terry

Andy's Market Report

The short-term reprieve that I mentioned last week came to fruition this week as the financial sector, oil prices and better than expected earnings reports help to push the market higher.

For the week the Dow, S&P, NASDAQ and Russell 2000 finished the week higher at 3.6%, 1.7%, 2.0% and 2.7%, respectively

The financial sector led the way lower on Monday after news was released over the weekend of a collapse in Indymac.

It was the second-largest banking failure in U.S. history, and its collapse can be viewed as a cautionary tale: Not just of how America recklessly embraced subprime mortgages, but of how these questionable home loans have ripped through the wider economy, shredding confidence in the markets and inciting a global credit crisis.

As a result the financial sector was hit with one of its worst one-day declines in over ten years, losing 6%.

The declines deepened Tuesday and the fear among traders was palpable. The major benchmarks had pushed into short-term "very oversold" levels that had not been seen in quite some time.

Concerns over sustainability of Fannie Mae and Freddie Mac were also heightened, but concerns were quickly quelled after Bernanke and Paulson's testimony in front of Congress at the beginning of the week.

A rescue proposed for mortgage finance giants Fannie Mae and Freddie Mac is "needed to respond to market concerns and increase confidence" in the government-sponsored firms, US Treasury Secretary Henry Paulson said Tuesday.

Paulson, testifying before the Senate Banking Committee, urged lawmakers to give speedy approval to a plan to allow the US Treasury to buy equity in the two firms to boost their capital along with other measures to raise confidence.

The news along with a sharp decline in oil prices and the short-term "very oversold" state of the market led to a rally Wednesday that would carry into options expiration.

When I state a decline in oil prices I probably should point out that this past week was witness to the largest weekly decline in crude prices ever.

Oil prices settled at $128.88 on Friday -- well below its trading record of more than $147 a week earlier.

"It's too early to say we've seen the worst of it," said Tom Kloza, publisher and chief oil analyst of the Oil Price Information Service in Wall, N.J. "We would be Pollyannish if we believe one week represents a trend."

While markets rallied this past week, the big question became, "was it the start of a sustainable advance or just a bear market rally".

Technically speaking, on a short-term basis the major market stalwarts (Dow and S&P 500) have pushed back into an overbought state. Typically, this type of reading dramatically increases the probability of a short-term decline (1-3 days).

Also, the trading day following options expiration is historically bearish. Furthermore, on a seasonal basis the 14th, 15th, and 16th trading days of July (Monday, Tuesday and Wednesday of next week) are by far the weakest trading days for the month on a historical basis.

Have great weekend!

Andy

Overbought/Sold Condition Report

Overbought/Oversold for July 18, 2008

• Dow (DIA) - 70.1 (overbought)
• S&P 500 (SPY) - 66.0 (neutral)
• Russell 2000 (IWM) - 36.9 (neutral)
• Nasdaq 100 (QQQQ) - 41.1 (neutral)

Emerging Markets (EEM) - 48.3 (neutral)

Testimonial of the week