Weekly Stock Option Trading Tips: September 8, 2008

That is the critical stock options trading question for investors in the 10K Strategy of calendar spreads advocated at Terry's Tips.

When most people speak about "the market," they mean the S&P 500. We use that tracking stock (SPY) for one of our actual portfolios. This is what our positions might look like at the beginning of an expiration month:

SPY Options Portfolio Risk Profile Graph in 30 Days The above portfolio of SPY options was set up at the beginning of an expiration month with $10,000 when SPY was trading at $124. The graph shows that the portfolio will gain about 10% (before commissions) in one month if SPY ends up at any price on expiration Friday between $115 and $133. In other words, the stock can fall by $9 (7.2%) or go up by $9 (7.2%) and a 10% gain will result.

Of course, it the stock moves beyond those limits in 30 days, losses will accrue which are much greater than 10%. An important part of a prudent options strategy would be to provide some protection for the portfolio when the stock moved to either end of the break-even profit range of $115 to $133.

Before we start a discussion of protection trades, let's see how often the stock might stay within those limits, and a gain of nearly 10% before commissions should result.

The 10-Year Backtest

Once the above graph has been created, the next step is to determine how much of the time that SPY manages to trade inside the break-even profit range of +/- 7.2%. This would be an easy task if all we had to do was calculate the percentage monthly changes that the stock had made over the past 10 years.

Here are those fluctuation numbers for each expiration month (expiration months are either 4-week or 5-week periods ending on the 3rd Friday of each calendar month, and therefore not exactly the same as calendar month fluctuations):

SPY changed by 7.2% in a single expiration month only 12 times in the past 10 years according to this table, slightly more than an average of one month each year. Four of those months occurred consecutively in 2002. While I don't want to get technical at this point, I should mention that when the stock is as volatile as it was in 2002, option prices become much higher. A risk profile graph created with those elevated option prices would have a much wider break-even profit range than the graph presented above with 2008 option prices.

From 2003 through 2007, a period of 5 years, SPY did not fluctuate more than 7.2% in either direction in a single expiration month. It is easy to understand why the actual portfolios at Terry's Tips made average gains of over 50% during that entire period (except in 2004 when unusual mid-month whip-saw price activity and 9-year low option prices conspired to cause losses - this was before the current strategy with downside insurance protection had been established).

If we only looked at the monthly fluctuations in the stock price you might conclude that the portfolio would make money 85% of the time, and that the average profit might be about 7% or 8% each month (taking commissions and roll-over transaction costs into consideration). Unfortunately, this would be an overly-optimistic assessment of the profit possibilities of the 10K Strategy.

A more realistic approach would recognize the dangerous position that the portfolio gets into when one end of the break-even profit range is approached. Huge losses can result if the stock moves outside that range. If you happen to be in one of those months like January 2008 when the stock fell more than 11%, you might lose half your profits for the past year in a single month.

Next week we will examine how many times that mid-month fluctuations have been so great that serious adjustments to the portfolio would be required, adjustments that would most likely eliminate any expected gain for that month.

Last week I stated that one thing was for certain, Wednesday would bring volume back to Wall Street. Indeed it did as heavy volume and a continued lack of conviction and nervousness among traders led the way to a decisively lower week for the market.

The Dow, S&P, NASDAQ and Russell 2000 finished the week lower -2.8%, -3.2%, -4.7% and -2.8%, respectively.

The holiday shortened week began with a relief rally that quickly fizzled out shortly after the open Tuesday. The 1300 level on the S&P, which I mentioned in the report last week, proved once again to be a formidable area of resistance for the S&P.

The first few days of the trading week witnessed a continued sell-off in oil. A barrel of oil fell as much as $10, or 9% during Tuesday's trading session and continued to move lower throughout the week. Many analysts' attributed the sharp decline to weakening global demand and certainly Friday's poor unemployment report did not help the cases. Oil pushed to a five month low on Friday to close out the week at $106.33 a barrel.

"There's been a terrific amount of growing concern about the outlook for demand globally," said John Kilduff, senior vice president of risk management at MF Global. "Today's employment report emboldened that concern."

On Thursday, Bill Gross, manager of the world's largest bond fund, stated that the U.S. government needs to start using more of its money to support markets to stem a burgeoning "financial tsunami''.

"Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami," Gross said. "If we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury."

The somber tone of Gross's message furthered the sharp decline during the trading session Thursday.

On Friday, after what had been an already tough week for the bulls, the highly anticipated August jobs report was to be announced so tension was thick. The tension quickly became palpable once the Labor Department announced a loss of 84,000 jobs during the month of August for a total of 550,000 in 2008. The unemployment rate rose to 6.1%, the highest level in five years.

"This was an ugly number that pretty much confirms that our economy continues to trend downward," said Jack Ablin, chief investment officer of Harris Private Bank. "I had thought things were stabilizing, and this just knocks the legs out of any hope of seeing much economic improvement right now."

The report topped off what was an absolutely horrible week for the overall market.

However, shortly after the bell the futures started to rally. Why? What was happening? Upon further investigation, I found out that the Wall Street Journal had announced a government takeover over the mortgage giants, Fannie Mae and Freddie Mac.

The report was officially confirmed, but this did not stop the market from rallying hard and given the current short-term oversold levels in the market we could see a substantial rally early next week.

Yes, as you probably have already guessed the market and many of the sectors moved into a short-term 'oversold' to 'very oversold' state this past week. A short-term oversold state often leads to a short-term reprieve or bounce over the next few days. If the current post market levels hold we could indeed witness a sharp rally Monday off of the oversold levels. My only concern is the gap that will occur if these price levels hold into Monday's trading session. A gap of this magnitude often sees a move back to the high from the previous session so just be aware of this tendency as we move into next week.


Tip 1: All About Stock Options	Tip 5: Double Your Money The Lazy Way
Tip 2: Risk-Free Option Strategies	Tip 6: The 10K Strategy That Never* Loses Money
Tip 3: Never Buy A Mutual Fund	Tip 7: Trading ETF Options
Tip 4: Turbocharge Your IRA, Roth IRA, or 401K	Tip 8: Other Stock Option Resources
Check out our track record \| Tell A Friend About Terry's Tips.com

Vermont Web Design, Vermont Search Engine Optimzation and Website Hosting provided by Vermont Design Works

Stock Options Trading Strategies from Terry's Tips, since 2002.

Weekly Stock Options Trading Tips: September 8, 2008

This Week's Tips

Weekly Archive

Stock Options Trading Idea of the Week

How much does the market fluctuate in one month?

Andy's Market Report

Overbought/Sold Condition Report

Testimonial of the week

Stock Options Trading Customer