Dear Friend,

Terry

Last Week’s Trade - Buying Straddles With Weekly Options

Near the close on Friday, the stock (SPY) was trading right around $137 and it was possible to buy both a Jul2-12 137 put and a 137 call which would expire one day later for $1.18 ($118 per spread plus $2.50 commissions).  We bought 7 spreads, paying $843.50 including commissions.  

This is called buying a straddle.  If at any point on Friday, SPY changed in value by more than $1.00 in either direction, we could sell those options at a profit.  (At any price above $138, the calls could be sold for more than we paid for the straddle, and at any price below $136, the puts could be sold for more than we paid for the straddle.)

The market expected that 100,000 new jobs would be created, but the actual results were lower – about 80,000.  When the market opened up just over a dollar lower, it seemed not to be going anywhere so we took a profit, selling the puts for $155 each, collecting $1076.25 after commissions (the calls expired worthless and no commission was involved).  Our net gain on the trade was $235, or 27.8% on the initial investment.

We were hoping that the stock would reverse itself after the early drop so that we could sell the calls later in the day and add to our gain, but that never happened.

If we had waited until later in the day the profit could have been more than double this amount but if we had waited until the end of the day it would have been less.  There is no easy answer as to when to sell a straddle, but we will probably continue our strategy of taking a moderate profit when it comes along.  Another way to play it would have been to sell enough of the spreads to break even and let the others ride in hopes of a windfall gain.

Straddle buyers like volatility as much as we don’t like it in our other portfolios.  What they like best is a whip-saw market where the market moves sharply higher (and they sell their calls) and then down (when they unload their puts).   There are many ways to profit with options. Buying straddles when option prices are low and volatility is high is one very good way to make extraordinary gains.

The downside to buying straddles is that if the market doesn’t fluctuate much, you could lose every penny of your investment.  This makes it a much riskier investment than the other option strategies we recommend at Terry’s Tips.  

However, straddle-buying can be quite profitable if the current market patterns persist.  Right now, VIX (the so-called “fear index” that measures how high option prices are for SPY options) is at 17.10 compared to its mean average of 20.54.  This means that option prices are relatively low right now.  Last December, for example, when VIX was about 25, the same straddle we bought last week for $118 would have cost over $200.

On Friday, a SPY 137 at-the-money straddle with one week of remaining life (expiring July 13, 2012) could have been bought for $1.99 ($199 each).  If at any time during the next week, if SPY fluctuated more than $2, the straddle should be trading for more than $2.  Over the past 13 weeks, SPY has moved in one direction or another by at least $2 in 11 of those weeks, and in one week it fell by $1.94 at one point.

Straddle buyers like volatility as much as we don’t like it in our other portfolios.   There are many ways to profit with options. It is best to remain flexible, and use the option strategy that best matches current market conditions. Buying straddles or strangles when option prices are low and volatility is high is one very good way to make extraordinary gains, as we happily did last week.

The downside to buying straddles or strangles is that if the market doesn’t fluctuate much, you could lose every penny of your investment (although if you don’t wait too much longer than mid-day on the day options expire, even out-of-the-money options retain some value and should be able to be sold for something).  This makes it a much riskier investment than the other option strategies we recommend at Terry’s Tips.  However, straddle- or strangle-buying can be quite profitable if the current market patterns persist.

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Any questions?   I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.

You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here.   

I look forward to having you on board, and to prospering with you.

Terry

The holiday shortened week was a tale of two halves.
The pre-July 4th price action continued from the prior Friday’s bullish ways. Volume was almost non-existent so the bulls were able to take advantage of the momentum to push the S&P 500 back up to a level of strong overhead resistance at 1370. The bullish move pushed the market higher over 70 points in two and a half days trading which also left the market in a short-term overbought state.

The push higher was attributed to everything, but end of quarter window-dressing. I continue to be amazed by the cherry-picking of news-related market events from the financial media and how useless they are in our trading endeavors. Implied volatility is much better gauge for expected market moves.

Anyway....the post-4th price action was significantly different . After the S&P hit strong overhead resistance at 1370 coupled with a short-term overbought state the fun was over for the bulls. The market turned almost immediately after hitting those levels. Indeed it was short-lived.
Friday’s weak jobs report certainly didn’t help the bullish cause.

As they say at NASA: "Houston, we have a problem." As it currently stands, the U.S. economy is in a very dangerous spot.

"80,000 jobs isn't enough to keep up with population growth," says Keith Hall, a senior research fellow at the Mercatus Center at George Mason University and the former Chief Economist for the White House Council of Economic Advisers. By his math, 130,000 jobs need to be created each month just to maintain. "Even at a quarter million, that's making progress. But it's going to take years and years and years to get back those (13 million) lost jobs," Hall says.

It was the third straight month of a weaker than anticipated report.

And I know we all haven’t forgotten about the dreadful European economy. Promises, promises and more promises is really all we have received over the past several years and nothing, and I mean nothing has changed.

Both the weakening U.S. economy and continued European woes will keep the market in its current month long trading range.

Moreover, the seasonal weakness that July, August and September bring should help the bears push the market back to the lower portion of the range near the mid-1200 level in the S&P.

"Traders are happy going in and out of the market within a range, but for the average investor it's a market in which the path is still unclear," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.

Next week, quarterly report cards from Alcoa and JPMorgan could fade into the background as news-driven traders prepare for key data from China and more central bank headlines.

After three major central banks eased monetary policy this past week, investors will comb through the minutes of the latest Federal Reserve policy meeting, which will be released on Wednesday, to see what officials said about a further round of asset purchases.

This next month could be quite telling for the future of the market in 2012. If the S&P races lower and breaches the 200-day moving average again I suspect this time a bounce of that level will not occur so quickly. The smart money has moved to the sidelines in droves. In fact, according to several reports money managers are at their highest cash levels in over fifteen years, while the dumb money is just starting to ramp up their investments....food for thought.

“Btw, the last 8 months or so have really been a fantastic learning experience with the current strategies!”  ~ Sylvio

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Sincerely,
Dr. Terry Allen
Terry's Tips