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This week, we review the performance of our option and covered call ranks for our September quarter evaluation period, which ended 9/27/2011.  This definitely was a good time to be “long volatility” (and, hopefully, to be a subscriber to our service). Despite a sharp drop in the S&P 500, our rank 1 call buys actually scored a cumulative gain of 28.8%, thanks partly to surging implied volatilities, and partly to reasonably accurate common rank-order discrimination (rank 1 stocks lost considerably less than did rank 5s).  As might be expected, our rank 1 put buys scored an even larger gain of 172.9%, and our long/long hedge advanced 100.9%. Our premium-selling ranks showed generally correct rank order, with our rank 1 covered calls losing a lot less than the other covered call ranks (and most stocks as well).

The Return of Volatility

Over the thirteen weeks ending 9/27/2011 (our September quarter evaluation period), the stock market, as gauged by the cap-weighted S&P 500, swung in a 23.1% range, touching an intra-day high of 1356.48 on 7/5/2011 and a low of 1101.54 on 8/9/2011, before closing out the period at 1175.38, down 9.3% from beginning quarter levels.  Over the period, volatility rose sharply, as evidenced by a doubling in the VIX (S&P 500 implied volatility) from 19.2% at the beginning of the period to 38.7% at the end.

The abovementioned swings, broad as they were, were dampened somewhat by the relatively calm performance of big cap stocks. Among our common ranks, the swings were even larger, with all the ranks showing larger losses than the S&P 500. Fortunately for the performance of our option ranks, the common ranks showed generally correct rank order (although the rank 1 stocks lost less than the rank 2s and 3s). In Figure 1 below, we show the performance of our common ranks since the end of 2009.

11_14_11 September Quarter Option Rank Performance - 1

Note: the common rank performance as we evaluate it in the Options Survey is compiled from the compounded weekly results of the Timeliness Ranks for stocks in the Value Line Investment Survey and the Performance Ranks for stocks in the Value Line Small and Mid-Cap Survey or in the Value Line Investment Analyzer, weighted by the number of listed options for each stock.

Option Ranks: Helped by Volatility

In a period in which virtually all stocks were down, our rank 1 call buys managed to show a cumulative gain of 28.4%, while our put buys chalked up 172.9%.  While we are proud of this result, it does not necessarily mean that we “walk on water?”  First of all, all option buying ranks were helped by the rise in implied volatilities.   Secondly, our calculation of option rank performance assumes total rebalancing each and every week, which of course would be very costly in a real world situation.  Still, our option buying, writing, and covered call rank results this last quarter underscores the usefulness of our model’s ability to pick underpriced and overpriced premiums, especially when the common ranks are performing well. Let us look at the specific results:

Call buying and “naked” call writing, as can be seen from Figure 2 below, showed very strong results this past quarter.  With respect to “naked” call writing, this year has been a good one for the strategy. However, we need to alert investors to risks of the writing “naked” calls, since they can garner horrendous losses when markets bounce off of major lows. Look at the triple digit losses for the rank 5 call writes in 2002 and 2009 in the figure below.

11_14_11 September Quarter Option Rank Performance - 2

Put buying is a bearish, premium-buying strategy, while “naked” put writing is a bullish premium selling strategy (see Figure 3 on page 3). A typical rank 1 put is based on a 5 or 4 stock that our options model deems to be underpriced.  In the September quarter, our put buying ranks performed well, with our rank 1s gaining 172.9% and beating the other ranks.  We always urge investors to have at least some bearish puts in their portfolios, since even a small allocation can pay off handsomely when there is a major market pull back.

11_14_11 September Quarter Option Rank Performance - 3

With the market down our rank 5 “naked” put writes lost 78.7% this last quarter (these losses are based on the margin required to establish the positions).   Nevertheless, we can be proud of the fact that our put writing ranks showed the correct rank order this past quarter, and that cumulatively over the past ten years, our rank 5 puts have shown strong gains.

Covered call writing (Figure 4 below), 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.

11_14_11 September Quarter Option Rank Performance - 4

As with our put writing ranks, all our covered call ranks showed losses this past quarter, although the loss for the rank 1s covered calls was considerably less than were the losses for the other ranks. Over the past ten years, our covered call ranks have been highly successful, with our rank 1 covered calls way ahead of the main stock market benchmarks and the lower covered call ranks.

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 42.4% in the September quarter and 106.3%year-to-date. Long-term, the gain has been 680.5%.  The long/short put hedge (rank 1 put buys and rank 5 put writes) gained 47.1% this past quarter and is up 69.6% year-to-date. Long-term the gain has been 373.0%.

11_14_11 September Quarter Option Rank Performance - 5

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 34 out of the past 40 quarters). It was again a winner in the September quarter, showing a gain of 100.9%, and a year-to-date advance of 171.7%. In the short/short hedge, we combine the writing of rank 5 calls and rank 5 puts. The hedge showed an 11.4% loss in the September quarter and a year-to-date gain of 4.4%. Cumulatively, this strategy has shown a loss of 116.1% since 2001, having taken big hits in 2008 and 2009. Our combined hedges (all four hedges) showed a gain of 44.7% for the September quarter, a cumulative gain of 87.9% year-to-date and a long-term gain of 536.8%.

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