Stock Option Trading Idea of the Week - July 27, 2008

The Terry's Tips options newsletter features an options trading strategy that never loses money (based on a 10-year backtest which showed only 3 months with minimal losses out of 120 expiration months). However, we can't mathematically prove that this strategy will always turn at least a small profit each month (we feel more comfortable about making the claim when an entire year is used as the time frame).

There are several options trading strategies which are mathematically guaranteed to always turn a profit. When I was a market maker trading on the floor of the CBOE, much of my time was taken up in an effort to establish positions that always made money, no matter where the stock price went.

The most popular technique was called a reversal. It was especially successful when most investors where in a pessimistic mood and the prices for put options grew larger than the prices for call options. It is a fairly common occurrence.

Let's say that the stock price for XYZ (a non-dividend paying company) is $80, and a two-month put at the 80 strike can be sold for $4.50 while a two-month 80-strike call can be purchased for $4.00. If you search option prices, you can invariably find options on some companies with option prices similar to these.

With the reversal strategy you don't care whether the company has great potential or is a real dog - you will make money no matter which way the stock goes. Any company will do.

If you sell 100 shares of XYZ short, collecting $8000, sell an 80 put for $450 and buy an 80 call for $400, you have created what is called a reversal, and you will make a $50 profit, guaranteed (of course, commissions would cut into this somewhat). Your eventual gain is much larger than $50, however. For the term of your investment, you will collect interest on the $8000 cash in your account.

If the stock goes to $90, at expiration you would have lost $1000 on your short stock but you would be able to sell your 80 call for exactly $1000, offsetting the loss (the put would expire worthless, of course). If the stock were to fall to $60, you would gain $2000 from your short stock but would have to buy back the short put for $2000 (and your call would expire worthless). Either way, there is no loss no matter what the stock price does.

If you are trading on the floor, you enjoy several advantages that make reversals a viable strategy. First, you can often sell at the asked price and buy at the bid (after all, you are making the market for the options). This makes it much easier to sell a put for more than the same-strike call you buy. Second, your commission costs are negligible compared to what you would pay if your broker made the trades for you. And third, most importantly, since you have created a risk-free position, your clearing house will extend virtually unlimited credit to you.

When I was a market maker, there were times I was collecting interest on several million dollars of short stock while not having one penny of my own money at risk. It is no wonder that a seat on the CBOE sells for astronomical sums.

A similar strategy (called a conversion) involves buying stock, buying puts, and selling calls. In order for this to work, the time premium of the calls has to be greater than the cost of the puts as well as high enough to cover the interest on the long stock for the time period involved.

Reversals and conversions, while excellent plays for market makers, are difficult to establish from off the floor. Consequently, they are not practical alternatives for most investors.

A more realistic alternative for ordinary investors would be to carry out the 10K Strategy as featured at Terry's Tips. While this strategy can't be mathematically proven to never lose money, a 10-year backtest (the details of which we share with subscribers) shows that no losses resulted over any 12-month time period, and that average annual gains in the neighborhood of 32% would have been made.

With this strategy, initial positions are set up that will result in a profit if the stock moves moderately in either direction. Once the stock has moved about 5% in either direction, an adjustment is made that will expand the break-even range in the direction that the stock has moved.

An important part of the 10K Strategy is the setting aside of cash in case one of these adjustments becomes necessary. This spare cash means that portfolio protection can be kept in place in case the stock turns around and moves in the other direction. If the stock continues to move in the same direction as it did originally, as second adjustment might be necessary to once again establish positions that will not lose money. In those months when a second adjustment becomes necessary, little or no gain can be expected.

These adjustments cannot be set in place at the outset of the month because no one knows which way the stock might move. Depending on exactly what time of the expiration month, the more-than-moderate stock price move takes place, different adjustments might be called for. These adjustments add an "act of faith" dimension to the 10K Strategy that makes it impossible to mathematically prove that it will never lose value.

Until the strategy has stood the test of time we will have to depend on the 10-year backtest as "proof" that it actually works in the real world as we believe it should. We think the descriptive phrase "a strategy that never loses" has a nice ring to it. Do you?