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Note for ROI in May 2010

In May 2010 the US stock market corrected by 12% in 13 trading days, starting with the unexpected and yet to be explained "flash crash" on May 6th.  The Monthly Cash Thru Options (MCTO) options advisory service successfully rolled all of its May bull put spreads into equivalent or lower strike price June bull put spreads at no cost or for a credit.  In other words, we successfully protected all of our trades by extending them 30 days at no cost, giving the market an additional month to stabilize and find a bottom.

In addition to rolling our threatened trades into June, we also continually "clicked down" our strike prices as the market was correcting and opened additional bull put spreads on the Russell 2000 index (RUT) allowing us to bring in more premium, which would help cover any losses that we might have when rolling.  (In this case we rolled at no cost)  We felt comfortable in "clicking down" and opening more spreads as the market pulled back since the US economy along with corporate earnings are expanding, not contracting like they were in 2008.  Click here for some of the advisories that we sent out to our subscribers during the correction that cover the macroeconomic, volume, advance/decline and sentiment based indicators that we were following and how they were predicting that we were close to a bottom.  Moreover, we made the case that we were not in a long term bear market and that we were merely in a long overdue correction.

Below is what the market looked like when we were deciding if/when to open our May bull put spreads, showing the S&P 500 and Russell 2000 indexes.  It was becoming obvious that the market was overbought, our analysis for several weeks was telling us that the UP trend would be soon running out of steam, and the charts were getting "choppy & toppy" towards mid April, so we were expecting a pullback.  However, it's impossible to know if a negative catalyst is going to hit that would cause a severe correction.  Looking at the prior 55 days, as an example, from mid-February to mid-April, no bad news hit the airwaves so every time an economic announcement was released, and most were ok to good, the market spun it as positive news and it continued to trend higher for 55 trading days. 

 

Because our analysis was telling us that the market was topping out, as shown above, we did the following:  1) Took our time to open our May bull put spreads feeling confident that a pull back was coming - we just didn't know how deep it would be;  2) We selected conservative 90% probability strike prices, as we usually do;  3) We made the recommendation to slowly collect our bull put spreads over a 2 week period to spread out the risk, recommending to use 10% to 15% of our cash each day when our credit spreads were filling;  and 4) We didn't waver and get tempted to move our strike prices higher, which would have made them more profitable, but more aggressive. (We tend to be more on the conservative side anyway)

Below is one of our recommended bull put spreads on the Russell 2000 index - RUT.  All of our other recommended May strike prices were lower than this.  We made sure to open our initial bull put spread below the January high and not to be tempted to move it any higher.  For more on how to read this risk/reward graph please go to the Learning Center and read entry #19 - "How to read a risk/reward graph".

 

Below is what happened next in the following 13 trading days.  The perfect storm hit right when most traders and investors believed that the market was overbought, thus everyone had an itchy trigger finger to sell on the first whiff of bad news.  First, and out of the blue, we had the "flash crash" on May 6th where the DOW plunged 1000 points in 15 minutes.  Regulators are still trying to figure out why this happened.  A few days later as investors were trying to pick up the pieces, the next piece of bad new came when the European debt problems started to escalate.  This rapid succession of negative events was the exact catalyst needed to start a flood of selling, and the markets proceeded to correct as much as 15% in 13 trading days.

 

Because we purposely delayed in opening our bottom May bull put spreads, and because we held firm on our decision to keep our strike prices below certain past support levels, we were able to hold onto most of our spreads up until the last 2 days.  We were very close in our strike price selection, but no cigar.  When the selling became just too intense, we were forced to roll our spreads at no cost or for a credit into June.  By doing this it added 30 days to our existing bull put spreads, but it also gave us 4 weeks of breathing room to allow the correction to run its course.  In summary, the trades were safe.