A regional idea.  Georgia was under a "severe" drought over the last 2 or 3 years.  Yes, I put the severe in quotes because I wasn't a believer, but that's another debate for another day.  What was serious is that a mini-war amongst states began.  Alabama and Florida started bitching and complaining about Georgia not letting enough water down the Chattahoochee River which is their fresh water source.  This went to court and became front page news for many months until the ruling came down against Georgia.  We could not withhold water from the downstream states.

Fast forward to the last few months where we've seen floods and we're close to setting an all time rainfall record for the month of October.  Now we're talking "negotiations" and other civil means for dealing with neighboring states and water.  This was less than civil just a few months ago.

Rainfall averages are just that, averages.  Like the market, from time to time, they will deviate, sometimes wildly, but eventually the snapback will happen.  When the news here was that Atlanta could possibly be a desert, I wanted to be long rain.  If that were possible, I would be talking of my windfall at this point.

However, what if the trend changed permanently.  What if fresh water or water supplies were severely crippled or cut off in a region.  How could/would that be remedied? What sort of companies could provide relief in a serious situation? I know the water angle isn't new, but the water angle in the US is.  This has my eye on Claymore's CGW ETF.  Unfortunately, this is "global" in nature, but I suspect that a US water ETF is an idea for the future.  The next time there is a regional water crisis and the discussion turns to ghost towns in a major region of the United States, a good speculative play might be water.  High risk / high reward, for sure.

So we're back to arguing politics in the Atlanta area, not whether or not we're going to have to abandon our homes in search of H2O.  Forecast in Atlanta, rain showers, maybe some thunder, just in time for the weekend.

I have not initiated any new trades from the speculative account, but the recent down turn has allowed me to close the short XLF calls out at 0.09 (original credit of 0.31).  Also, I wanted to update a wildly speculative position I put on with MSFT.  I called it Long Term Double Calendars.  In a nutshell, I hold way out of the money long puts on the downside and long calls on the upside.  MSFT was about $25 when I opened, so $20 puts and $30 calls were my strike choices.  I bought APR options and sold NOV options at the same strikes.

MSFT earnings last week apparently made the street quite happy and MSFT shot up past $28 (briefly touching $29).  The NOV short put went way out of the money and I closed it for 0.01.  The APR puts are big losers, but they've lost much less than what the long calls have gained.  I did not expect MSFT to shoot up this fast and my plan at this point is to close the call side if MSFT stays around 28-29 by NOV expiration.  I may or may not keep the long put, depending on IV.  It's worth so little, I may just keep it as free insurance.

As I mentioned, the recent down draft hasn't allowed me to write any calls yet, but I am looking to write some puts.  There are some new faces I've had my eye on and they are indexes that I might like to hold, so whether I'm going to do spreads or run naked has not yet been determined.

Stay tuned.

I have a trading system that I retired right about the time the downturn started.  It was in the final phases of live testing, but I decided that I didn't like the actual results enough to continue committing capital. It also had a lot to do with the fact that another trading system I was testing was showing better results. It operated against individual Dow components, so before too long, I found myself holding 1/3 of the Dow.  Then whoosh, the bottom fell out.  The trading plan didn't have a stop loss, only a bar time out.  So I decided to "outsmart" the trading system and hold on to these guys because I was certain the market would bounce back.  Well, it has bounced back (although I didn't expect to be sitting on these positions for over a year).  Like most, I'm a little nervous about being excessively overweight in equities, so this has provided me with a great opportunity to unload some of these speculative equity positions from market cycles past.

So two things are accomplished here, one, I get to fix mistakes from the past and second, I get to lower my equity exposure.  Another win/win.

October expiration has passed, so it's time to analyze closed positions and think about new ones for November and December strikes.

Position Recap

The GE calls @ 18 expired worthless.  So I keep 100% of the 0.15 premium.  Not exactly juicy, but not too bad considering the stock hasn't done much but bounce around since I sold the calls in the middle of September.

The IWM trade flagged on September 2nd and taken on September 4th, brought in an 0.18 credit.  These options also expired worthless allowing me to keep the full credit.

November's SPY 92/94 vertical spread is well out of the money.  In fact, I tried to close this on Friday for 0.04, but didn't get filled.  With the original 0.31 credit, that would've been a fast move.  Usually things have to get way out of the money (since it's a spread) to be closed this quickly.  Well, the SPY has done so, but not enough for the market makers to give me 0.04 to close the position.  If there is another decent move up, I should be able to close it out, which would be nice.

The DEC XLF calls are showing a profit, but I'm getting less comfortable with these as time passes.  These calls were essentially a way for me to lock in some gains on my underlying XLF shares.  I felt pretty strongly that the financials were in for a set back.  Due to earnings, volatility shot up on the XLF and for a short time, the position was at break even.  The original credit was 0.41 when the XLF was around 15.35.  The XLF is now around 15.15 with the calls trading around 0.18.  I'm going to look to close this out around 0.10 and see if I can't catch a wave up and write some calls at 17 or 18 for December.  Stay tuned on that.

Looking Forward

Writing calls against GE is my top priority.  I don't like the credit offered for November at this point, I think the numbers weren't as bad as the market thought and shows some stability in the company. Maybe it won't happen this year, but I think people will slowly begin to buy up GE again. Hopefully it's next week and I can write a call or two.

The trading system that I write the verticals with isn't on a calendar, it's a mean reversion system, so it could flag trades at any time, but gets triggered on pullbacks. I'm comfortable enough with the wider strikes as I did with the 92/94 put credit spread on SPY. I'll stick with a 2 strike distance and see how that goes for awhile.  So far the trading system is 3 for 3.  Bill trying outguess the trading system is 0 for 1.  Imagine that.

And I'm still paying for the sin of writing puts against C back in 2007. If you weren't with us, my puts were exercised @ 22.50. That's not a typo. So with credits since, my cost basis is still somewhere around $21 which is obviously nowhere near the $4.60 C trades at today. I never bought any more C because I had little faith in the price and my original take was that Citi was big enough to absorb the losses without too much of a hit.  I was wrong and have been paying ever since. I decided that since I was wrong that I would not average a loser and held true to that. Now I feel that Citi is stabilizing in price and it's time for me to get some premium. I'll be looking at the $4 puts on another move down or a spike in implied volatility. The worst case is that I'm assigned at $4 which will lower my cost basis for C substantially and possibly get me out of this hole. It will be a happy day seeing C out of my trading account.

I spent a portion of the weekend getting caught up on older issues of Futures & Options Trader magazine.  If you're not a subscriber, you should be (it's free).  It can be downloaded from http://www.futuresandoptionstrader.com/.  Current issues are free, back issues are not.  I'm going to be referring to the May 2009 issue, so if you don't have it, I'll summarize the relevant bits.

Each month, the magazine has a feature entitled Options Trading System Lab.  The major players for the software OptionVue are the main contributors.  The feature takes a relatively well known strategy and runs a back test on historical data using the OptionVue software.  The results are usually disappointing. I don't mean that in a disparaging way.  If you've done backtesting for any length of time, you'll know that most of the ideas put forth are real stinkers.  In fact, I'd say over the course of many years, even before my days of working on RightEdge, I'd tested hundreds and now thousands of trading systems.  To this day, I use about 3 trading systems out of thousands tested.  There are some systems that have shown signs of promise in the lab and some that just plain stink, but I took an eye to May's Iron Condor results.

Strategy Summary

If you're not familiar with iron condor strategy, it's really just a fancy name for two vertical spreads put on in tandem.  It's basically an out of the money bear call spread and out of the money bull put spread. Both are credit spreads.  The P/L structure for an iron condor is below. 

spy-iron-condor.png (47.83 kb)

Most iron condor traders are looking to put the short strikes around one standard deviation.  In the P/L structure above, you can see that one standard deviation is marked by the vertical red dashes.  As a result, I put the short puts at 99.00 and the short calls at 115.00.  The long options can be placed anywhere you feel comfortable.

Risk

Now here's the catch on iron condors, my maximum reward is 0.44 less commissions.  My maximum risk is 4.00 - the credit.  This puts the risk/reward ratio at around 1 to 10.  That's not 10 to 1, that's 1 to 10.  This means that 1 losing month can wipe out 10 months of winners.  Couple this with the fact that one standard deviation means that it's probable the price has a 68% chance of staying within your shorts on either side, it sounds like a mathematical loser all the way around.  You need 90% winners in a case where statistically the price will only stay within your boundaries 70% of the time.

Backtesting the Strategy

Normally, this idea would be discarded especially with the pitiful risk/reward ratio.  Admittedly, it's not one of my favorite strategies, but let's see the results anyhow.

The test period started in January 2001 and ran through April 2009.  The starting capital is $10,000 and each month an iron condor was opened one standard deviation out.  They used 5 call and 5 put spreads. The system is always in the market and cycles the position (i.e. closes the current month and opens a new one for the next month) on the second Friday of each month.  The system had a 75% win rate with an average win of $763 and an average loss of $1,314.  What's noteworthy is the annualized return of 28.7%.  This would give you a return of 236% for the time period tested.  The S&P 500 had a negative return over the same time period.  Wow.

Discrepancies of Note

OptionVue constructs positions based on historical data.  I find the further out of the money the spread, the harder it is to get filled.  At best, the bid/ask spread on these positions is pretty lousy.  This probably wasn't accounted for.  Even dividing the bid/ask spread in half usually won't get you filled.  Second, the authors list the risk/reward ratio of 1 to 4.  I think that's generous.  I've seen in real life the ratio as poor as 1 to 12.

My Take

Given the discrepancies noted, if you were to consider putting on ICs, I strongly recommend using 1 contract positions and also putting them on the SPY ETF and not the big S&P 500 futures contracts (which are leveraged instruments).  Of course, never put on anything until you know what you're doing. Even in light of this impressive test, I'm still not very interested in iron condors because of the horrible risk reward.  I do, as most readers know, put on bull put verticals on the indexes when my trading systems flag them as a buy.  This has turned out to be successful so far in my first phases of live testing.

Now that I've had a few minutes to digest a bit more about last week's trading sessions, I've made what I think are some interesting observations.  First, the VIX had a hell of a down week (probably releasing some earnings anxiety) and second, long term treasuries were socked pretty hard on Thursday and Friday to end the week down over 3%.  Meanwhile, the overall market continued its steady climb upwards with the S&P 500 up over 4%.

Why this struck me is because it looks "normal".  The market is up, the VIX is down and bonds are down.  Gold went in various directions (mostly up because of the worldwide speculation of de-dollaring) but seemingly uncorrelated to both stocks or bonds.  This is a pretty normal market 1 year after everyone in every asset class lost their minds.

I've had the feeling that all asset classes that I hold were short term overvalued.  I felt the inverse one year ago and I bought with reckless abandon.  I've been holding cash on the sidelines waiting for something to crack and the first thing was bonds.  I snapped up some TLT this week and I have my eye on some TIPs probably when they crack below $101.00 and some more at $100 and so on.  If the inverse movements between bonds and equities continue, I may even sell some stock and beef up on bonds.  This will hopefully hedge against the snap back that may or may not occur.

The market is feeling a little "text book", which has me nervous.  [grin]

I still have some GE short calls open for OCT.  These are well in the money and are on the verge of being closed.  What's going to push the issue is when GE reports earnings before the bell on Friday, which happens to coincide with the expiration date of the options.  However, there's an entire session to be had.  Given the current tone of earnings season, they'll probably exceed the low bar and move higher.  My ideal case is to buy back the calls sometime before Thursday's close next week, wait for the earnings pop for a boost higher and sell some NOV calls either at a higher strike than last month or at the same strike but for a juicier premium.  Will it play out that way?  Probably not, but that's the way I see it at this point.

If I don't talk to you before, have a great weekend.

I like to watch old stalwarts with high volume in boring ranges. This is why I pick symbols like GE, MSFT, etc.  Another one that's been on my radar for a couple of years is WMT.  Actually, it comes and goes on the radar screen because it is extra boring.  A recent article at the Beating Buffet Blog piqued my interest again.  Had I been keeping on an eye on WMT like I should have, I would've already made this play.  The position is a simple short put.  The P/L of a short put is shown below in case you forgot.  It is limited gain with stock risk.  Stock risk means that I am insuring the buyer of the puts from the strike down to $0. 

wmt-naked-put.png (42.59 kb)

When do I write puts as opposed to a vertical spread?  I invite you to read my article entitled Having Problems Buying?  Consider Selling Puts.  In a nutshell, I only write puts against assets that I don't mind holding.  Writing puts should feel like a win/win situation because if the asset goes up, you keep the premium (score!) and if the asset falls and you get assigned, you own the asset at the lower price + you keep the premium to lower your cost basis even more.  Win!  So bottom line, if you don't want to own it, don't sell puts.

Looking at the stock price, I'd like to write November 45's for a 0.30 credit.  They're currently trading around 0.28, so that's not a big move to get filled.  We'll see what tomorrow's session has in store.

Usual disclaimer: This is not a recommendation to anyone to buy or sell.  I'm not a professional and I don't have much sense, so following me is hazardous to your finanical health.  The point of the post is to share ideas and hopefully get some feedback so that we can all improve our understanding of the subject.

I started something new a couple of weeks back that I thought I'd share.  My idea here is that folks think the market is bound to move in the next several months.  Will the bulls continue to trounce the bears or will the bears finally have another day in the sun and the pullback "everyone" has been waiting for will finally become reality?  Who knows, or at least, I don't know, and I don't really care a ton.  To try and capitalize on a big move, I picked a stock that I watch frequently that seems to be in the middle of its long term range.  That stock is MSFT.  Between 20 and 30 for the longer term, I think feel it can hit either one of those targets in the next few months.  So how to capitalize on that move?  Well, buying long dated options is expensive and time decay (theta) will slowly chew away at your profits.  Also, the further out of of the money, typically means higher premium because of volatility skew.  As you may have guessed from the titled, I've opted for out of the money calendar spreads.  My put strikes are at 20 and my call strikes are at 30.  I have purchased April 2010 calls and puts at the strikes mentioned.  I have helped "finance" this purchase by selling calls and puts at those strikes for NOV.  I received on average an $8 credit and on average paid about $45 per spread.  My thought here is to continue getting on average $8-10 in credits each month which, if MSFT goes nowhere, means I break even.  If MSFT makes a move (and hopefully doesn't shatter through the strikes), the profit will exceed the other options loss and I will close at a profit.

This is going to be tricky for three reasons.  First, imagine that MSFT makes a move up to $27, not a big enough move to take a profit, yet, I'm going to lose a lot of credit on the put side.  Will that be made up on the call side?  I'm not sure.  Second, volatility risk.  Calendars are long vega, if the volatility drops, my credit shrinks and I'm once again, not getting enough to finance this trade.  Third, a massive run up that puts either side in the money.  The short option has more gamma than the long options and may chew up profits fast should there be a fast run into the money.

This Is Only Test

I'm testing with real money, but only using a single contract.  The reasons above leave me enough doubt not to put anything significant into this. I firmly believe that I'd have to try this several times with single contracts to feel any sort of comfort throwing real money at this idea.  Even then, that doesn't mean that it's going to work every time or ever again.

If you've tried something similar, I'd appreciate sharing the pitfalls and nuances that go along with this.

Newest trading system flagged a buy on most of the indexes since it was a reasonably big down day.  It isn't uncommon when all of the indexes to flag a buy for there to be another down day, although usually not as dramatic as the one before.  This sort of behavior gives one the idea to "outsmart" their trading system.  I've learned better over the year.  However, logistically, I really can't add positions for all indexes, so I'm going to increase my exposure on what I feel the best spread is from an risk/reward perspective.  The best of the bunch was a SPY vertical with the short strike at 94.00.  To increase my exposure and to further test my trading system, I'm going to open up my strike distances by one strike.  So instead of a 93/94 put credit spread, I'm going to do a 92/94 put credit spread.  See the risk graph below and as usual, click to enlarge the picture.

spy-vertical-spread-november-2009.png (48.37 kb)

This graph is an approximate credit amount, if we gap up this morning (which doesn't seem likely thanks to continued weak payroll numbers), I might hold off.  If we gap lower, I'll probably take the increased credit as opposed to lowering my strikes.  Will update with fill information.

Usual disclaimer: This is not a recommendation to anyone to buy or sell.  I'm not a professional and I don't have much sense, so following me is hazardous to your finanical health.  The point of the post is to share ideas and hopefully get some feedback so that we can all improve our understanding of the subject.

UPDATE: Filled @ 0.31 per spread.