In as much as our rank order performance was mixed, the March 2009 quarter was hardly the best period for our option model. However, we can still point with pride to the fact that, in a difficult market environment, buyers of our rank 1 calls and puts scored substantial profits, and writers of our rank 1 covered calls beat the S&P 500 by 8.5%. We often stress that this is a market in which you definitely need to use options. And, we like to think that the Value Line Daily Options Survey offers invaluable tools for successful option investing.
A Seesaw Market
Again the swings in the stock market were enormous. The S&P 500 reached an interim peak of 909.61 in early January and then ticked successively lower, finally touching a 12- year low of 666.79 on March 5th. By the end of the quarter, the S&P 500 had recovered to 797.87, helped by the U.S. Treasury’s promise to absorb the bulk of the banking system’s toxic assets. While the S&P 500 and the Dow Jones Industrial Index tracked each other quite closely, the tech-heavy NASDAQ 100 logged in a relatively strong performance, gaining 2.97%% over the 13-week period. In addition, some sectors were a good deal more volatile than others. Financial stocks, for instance, were the hardest hit early on, but then scored the largest gains at end-quarter.
The Contribution of the Value Line Common Ranks
The contribution of the Value Line common ranks to our option rank performance was mixed. Over the seven weeks when the market was falling, our common ranks tended to perform in correct rank order, with the rank 1s losing a lot less than our rank 5s. Over the five weeks when the market was recovering, however, this rank order slammed sharply into reverse, with the rank 5 stocks recovering a lot faster than the rank 1s. At endquarter, the results of the common ranks were as follow: rank 1s down 7.0%, rank 2s down 6.8%, rank 3s down 6.1%, rank 4s down 2.9% and rank 1s up 0.9%. (We post our common and option rank performance in the Ranksfile.Xls, which you can access from our Weekly Performance directory.)
Option and Covered Call Rank Performance
We base our option ranks on a weighted combination of the Value Line common stock ranks and our model’s estimation of the option’s underpricing (good for buying) or overpricing (good for writing). How accurate then was our option model in picking underpriced and overpriced options this quarter?
As has been the case for much of the past year, our model did very well in picking underpriced options for call and put buying and overpriced options for covered call writing. However, the results for our “naked” option writing recommendations were poor, indicating our model’s failure to anticipate large swings in many stocks. Below are the details of this past quarter’s performance.
Call buying (Figure 1) is a bullish, premium-buying strategy. A rank 1 call is likely to be an underpriced call that is based on a rank 1 stock. The results of our call buying ranks this past quarter were as follows: rank 1s up 57.6%, rank 2s up 95.8% and rank 3s down 3.4%.
Naked” call writing (also Figure 1) is a bearish, premium-selling strategy. A rank 5 call (best for writing) is typically an overpriced call that is based on a rank 5 or 4 stock. In the quarter just ended, our rank 5 call writes lost 61.0%, our rank 4s lost 32.8% and our rank 3s lost 1.7%.
“Naked” Put buying (Figure 2) is a bearish, premium-buying strategy. A rank 1 put is likely to be an underpriced put based on a rank 5 or rank 4 stock. In the March quarter, our rank 1 puts gained 17.9%, our rank 2 puts gained 5.9% and our rank 3 puts lost 2.3%.
“Naked” Put writing is a bullish, premium-selling strategy. A rank 5 put (best for writing) is likely to be an overpriced put based on a rank 1 stock. In the December quarter, our rank 5 put writes lost 11.5%, versus a loss of 9.7% for the rank 4s and a loss of 26.8% for the rank 3s.
Covered call writing (Figure 3) is also a bullish, premium-selling strategy. Here the investor buys the stock and writes a call on the same stock for income. A rank 1 covered call (best for covered call writing) is likely to be an overpriced call that is based on a rank 1 stock. The results of the March quarter were in perfect ranks order as follows: rank 1s down 1.3%, rank 2s down 1.5%, rank 3s down 1.9%, rank 4s down 4.3% and rank 5s down 19.3%. These results are particularly impressive when one considers that the common ranks preformed in reverse rank order.
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. Over the quarter just ended our hedge performance was marred by the steep losses of short option positions. For the year as a whole, the results were somewhat better thanks to very strong results from rank 1 call and put purchases.
In the long/short hedge, we combine either the purchase of rank 1 calls and the writing of rank 5 calls, or the purchase of rank 1 puts and the writing of rank 5 puts. (See Figure 4 on page 5.) The long/short call hedge lost 1.7% in the March quarter due to heavy losses from writing rank 5 puts. The long/short put hedge gained 3.2%.
In the long/long hedge, we combine the purchases of rank 1 calls and rank 1 puts. This hedge has continued to benefit from high underlying stock volatility, gaining 37.8% in the March quarter. This followed a 69.2% gain in the December quarter. In the short/short hedge, we combine the writing of rank 5 calls and rank 5 puts. As stated above, selling premium has been a perilous strategy in this market. The hedge lost 36.3% in the March quarter. Our combined hedge (all four hedges) benefited greatly from the strong performance of our rank 1 calls and puts. This past quarter, this hedge showed a marginal gain of 0.7%.
Matching Our Performance
Our performance results are based on week-to-week changes in premiums and (in the case of covered calls) underlying stocks, assuming full rebalancing of the portfolio every week. In the real world this level of trading would be hard to achieve. However, our results do indicate that significant gains could have been achieved by buying rank 1 calls and puts despite the fact that premiums were at nominally high levels.