Daily Options Survey
The Weekly Option Strategist, June 30, 2011

June Quarter Option Rank Performance

This week, we review the performance of our option and covered call ranks for our quarterly evaluation, period which ended 6/28/2011.  As with the March quarter, our common ranks performed very well (i.e., showed perfect, or near-perfect, rank order).  Additionally, our option model’s ability to differentiate between overpriced and underpriced options clearly added to the results of our option and covered call ranks. In a down market, our top ranks for bullish strategies (i.e., rank 1 calls and rank 1 covered calls) made money. Also, with only one exception (rank 3 put buys gained more than the rank 2 puts), all our option ranks showed the correct rank order. Finally, all our market-neutral strategies registered gains.  Thus, while the quarter just ended was not an especially good one for the stock market, it was an excellent one for our track record, and hopefully, for users of our options service.

Our Common Ranks Score Again

In the thirteen weeks ended 6/28/2011, all our common ranks registered losses (as did all the major stock indexes); however, among these ranks there was near-perfect rank order discrimination.  Rank 1s lost 2.3%, rank 2s lost 1.1% (losing less than rank the 1s), rank 3s were down 2.9%, rank 4s down 4.4%, and rank 5s down 6.3%.  Cumulatively for the March and June quarters, the results were as follows; rank 1s up 6.8%, rank2s up 5.6%, rank 3s up 3.1%, rank 4s down 0.7%, and rank 5s down 6.5%.  These results suggest that, in this stage of the economic recovery, we are in a “stock picker’s market” in which there is a significant bias in favor of stocks with superior earning growth and price appreciation potential.

Option Ranks: A Holy Grail?

In what had been a down market, our top ranked options for the three basic bullish strategies (i.e., call buying, covered call writing, and put writing) scored gains and outperformed the other ranks.  Does this mean that Value Line Options is the “Holy Grail” of investing?  Perhaps not: for a number of reasons.  First of all, our numbers are averages of literally thousands of options, so investors cannot exactly replicate our results (although they might do better).  Secondly, this past quarter was one in which “all the stars aligned” (i.e., good common rank performance, predictable volatility swings, and easy benchmarks to beat).  Still, an examination of our year-to-date track record, and our performance over the years (for all strategies except for “naked” call writing), indicates the effectiveness of a disciplined approach  such as ours.

This past quarter, call buying and “naked” call writing (Figure 1 on page 3), showed impressive results this past quarter.  Rank 1 call buys scored a 29.2% gain, beating the other ranks.  Rank 5 call writes also showed a profit and beat the other call writing ranks.  Year-to-date, the results for both strategies are very good, with rank 1 calls showing a cumulative 116.6% advance and rank 5 call writing showing a 11.1% gain. Looking at our long-term performance (i.e., beginning in 9/25/2001), our call buying track record has been very strong; however, the “naked” call writing cumulative performance has been poor, both in terms of large losses and in terms of relative rank performance.  Simply stated, writing naked calls on beaten-down stocks can result in massive losses when markets recover, as can be seen from the results from 2003 and 2009.

Put buying is a bearish, premium-buying strategy, while “naked” put writing is a bullish premium selling strategy (see Figure 2). A typical rank 1 put is based on a 5 or 4 stock that our options model deems to be underpriced.  In the June quarter, our put buying ranks performed well, with our rank 1s gaining 40.0%. Our put writing ranks did O.K., all things considered (rising volatility and falling stocks), registering a small 2.3% gain. Year-to-date, the result for both strategies are mixed, but not bad. Our rank1 put buys are up 25.1%, beating the rank 2s, but underperforming the rank 3s. Our rank 5 puts have scored a respectable 19.8% gain, somewhat underperforming the rank 4s, but beating the rank 3s by a wide margin.  Over the long term, the results for both strategies has been generally satisfactory. While the rank 3 put buys have done better than the rank 2s, the rank 1s have outperformed both by wide margins.

Covered call writing (Figure 3), like put writing, is a bullish, premium-selling strategy. With covered calls, the investor buys the stock and writes a call on it. A rank 1 covered call (best for covered call writing) is likely to be an overpriced call based on a rank 1 stock.  This past quarter, our covered call ranks stacked up well: rank 1s were up 1.9%, rank 2s up 0.8%, and rank 3s down 1.4%.  Year-to-date, the track record is robust, as is the long-term track record.  Since 9/25/2001, our covered call ranks have performed as follows: rank 1s up 137.4%, rank 2s up 77.6%, rank 3s up 59.3%, rank 4s up 47.8%, and rank 5s down 15.8%.  These results suggest that covered call writing can be a good strategy most of the time, and a really excellent one if you choose your positions wisely.

Our Market Neutral or “Hedge” Strategies

One of the ways we gauge how well our option ranks have performed is to calculate the results of our four market-neutral (or hedge) strategies. The long/short call hedge (rank 1 call buys and rank 5 call writes) gained 22.3% in the June quarter and 63.9%year-to-date. Long-term, the gain has been 638.1%.  The long/short put hedge (rank 1 put buys and rank 5 put writes) gained only 21.1% this past quarter and is up 22.5% year-to-date. Long-term the gain has been 316.3%.

In the long/long hedge, we combine the purchases of rank 1 calls and rank 1 puts. This hedge has been our most consistent winner over the years (profitable in 33 out of the past 39 quarters). It was again a winner in the June quarter, showing a gain of 34.6%, and a year-to-date advance of 70.9%. In the short/short hedge, we combine the writing of rank 5 calls and rank 5 puts. The hedge showed a 8.8% gain in the June quarter and a year-to-date gain of 15.5%. Cumulatively, this strategy has shown a loss of 120.2%  since 2001, having taken big hits in 2008 and 2009. Our combined hedges (all four hedges) showed a gain of 21.7% for the March quarter, a cumulative gain of 43.2% year-to-date and a long-term gain of 415.6%.

Matching Our Performance

Our performance results are based on week-to-week changes in mid-point premiums and (in the case of covered calls) underlying stocks, assuming full rebalancing of the portfolio every week. In the real world, these results would be hard to match considering transaction costs (i.e., bid/ask spreads and commissions). However, our numbers as we compile them strongly suggest that significant gains can be attained by following useful volatility analysis and a disciplined approach to option investing.

Prepared by Lawrence D. Cavanagh, vloptions@valueline.com

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