On July 10, 2008, we established an entirely new philosophy and investment strategy at Terry’s Tips.  Rather than setting up portfolios that sought 50% or so, or even 36% annual gains, we decided to become more conservative.  We established 6 new portfolios (using 5 popular indexes as the underlying stock), and each portfolio was designed to never lose money no matter what the market does. 

While we expect that there will be individual months where a loss might take place, a 10-year back test of SPY volatility showed that there were no consecutive months where this strategy (we call it the Mighty Mesa) would have recorded a loss, and the average annual gain over that period was 26%.

October 2008 was the ultimate test of this new strategy.  It was the worst month for the market in 100 years.  Most investors were crushed.  Mutual funds and many individual stocks incurred losses of 30% - 40% or more.

Not only was the market down by huge amounts, volatility reached all-time highs.  The Mighty Mesa strategy does best when the market is quiet.  Last month was one of extreme volatility.  The most popular measure of volatility (VIX) hit an all-time high of 81.17 (in the past, anything over 30 was considered to be unusually high).

We figure that if our strategy could endure market melt-downs and volatility spikes like those that occurred in October 2008, we might really be on to something significant.  So how did it turn out?  We experienced mixed results.

Summary - Annualized Portfolio Gains for each Portfolio as of October 20, 2008:

Our Mighty Stalagmite (SPY) portfolio was set up with $10,000 on July 10, 2008.  It maintained a bullish bias so that the greatest gains would take place if the stock went up.  Instead, it went down by a large amount (23%).   However, the portfolio had gained 14% over the first 100 days (which works out to about 50% on annualized. 

One of the results of the huge jump in volatility was that the prices of short-term options has escalated higher than we have seen for years.  Since the prices of the longer-term options that we typically buy in our strategy have not increased as much, we believe that our current portfolio positions will make much greater gains than typical months. 

Here is the current risk profile graph for the Mighty Stalagmite portfolio for the November expiration:

On October 20, SPY was trading about $96, so the stock could fall or go up by 10% and a profit would be made for the month.  A smaller change than 10% could result in a gain of 40% or more for the month.  A cash reserve has been set aside in this portfolio to make an adjustment if the stock moves toward either end of the break-even range.  

Mini-Russell (IWM) – This portfolio is our only one which started with $5000 rather than $10,000.  The smaller investment amount made it difficult to retain as much cash as we would have liked for adjustment purposes, and when IWM fell by over 30% in the October expiration month, the portfolio incurred a large loss in value.  For it’s entire existence of 8 months, the portfolio has lost 16%. 

Rising Russell (IWM) -  This portfolio was set up with a bullish bias so that it would do best if the market went up.  The 30% drop in IWM in October caused the portfolio value to fall 25% from its starting value 3 ½ months earlier.  However, the current risk profile graph shows that the portfolio will recover this entire loss in the next expiration month over a fairly wide range of possible stock prices.

Oil Services (OIH) -  Since this ETF consists of only 18 companies in a single industry, it often fluctuates like a single volatile stock rather than an index.  We consider it to be our least conservative portfolio, and the huge drop in October proved just how risky it could be.  OIH fell by a whopping 46%, and our strategy just could not cope with such volatility.  In the 8 months of the portfolio’s history it has lost 26%, but as in the other portfolios, there is a good chance that the loss will be recovered in the next month.

Durable Diamond (DIA) – This portfolio was established three months ago and it took a big hit when the Dow fell by 23% in the October expiration month.  However, since its inception, the portfolio has gained 13% which works out to be about 52% annualized.

Summary and Learning Experiences: To best cope with huge market melt-downs like we saw in the October 2008 expiration month (and will probably never be duplicated again in our lifetimes), it is best to stick with the most broad-based indexes (DIA and SPY) which held up much better than IWM (considered to be the small-cap company index) and the most risky of all our portfolio offerings (OIH).

You can see every position and every trade we made in each of these portfolios by becoming a Terry’s Tips Insider – sign up HERE.

Cash Withdrawal Policy:  For all 6 portfolios, the goal is to maintain the portfolios near their “starting” values so that new subscribers can mirror the portfolio at nearly the same initial cost.  The “starting” values are $10,000 for all the portfolios except Mini-Russell ($5,000). Cash withdrawals will be made from portfolios in increments of 3% of starting portfolio value.  For example, for the 5 $10,000 portfolios, on the Monday following each monthly expiration, $300 will be taken out of the account if the account balance is over $10,300.  If a gain of over $600 is made in a month and the portfolio balance is over $10,600, $600 will be removed that month.  The goal is to remove $3600 from each $10,000 account over the course of a year (and $1800 from the Mini-Russell since it started with $5000) and continue to maintain the original starting value of the portfolio.

New Big Bear Mesa Portfolio Started on September 25, 2008:  This new $10,000 portfolio is designed to make money if the stock (SPY) stays flat or goes down moderately.  It is designed to complement the other portfolios that do best if the stock stays flat or goes up. (While we try to start out each expiration month in a neutral net delta condition, our portfolios tend to have a bullish bias because the market does indeed go up more months than it goes down, in spite of last month’s record.)  Most subscribers seem to have other stock and mutual fund investments that only prosper when markets go higher, so this portfolio should be an excellent diversification measure for them. 

In its first month of existence, the portfolio was set up so that if the stock fell by 10%, a gain of about 20% would result.  When the stock fell 10%, the break-even stock price was lowered so that the stock could fall another 6% and a profit would still be made.  When the stock fell 15% from where it started, another adjustment became necessary.  By the end of the month, the stock had fallen an unprecedented 23%, and the portfolio lost less than 5% as of October 20, 2008.  The risk profile graph shows exceptional promise for this portfolio for the next expiration month:

With SPY trading at $96, the stock could fall by 17% and a profit would result (even without an adjustment, and there is a large amount of cash set aside for such a move if it becomes necessary).  On the upside, the stock could go up by as much as 16% and a gain would result.  Smaller losses or gains could result in gains as much as 60% or more for a single expiration month.

Prior Years’ Record:Actually, before we made this change in our investment philosophy, our track record for the past two years was not so shabby.  From the beginning of 2005 until late in 2007, our portfolios had earned an average of over 50% each year.  But when the market fell nearly 15% in a single expiration month ending in January 2008 (a drop equaled only once before in over 20 years), much of the 2007 gains were erased.

In January 2008, we dropped all our portfolios which were based on individual stocks (we had made over 100% on Apple options for two years running but lost nearly 80% when the stock dropped from $180 to $120 in a very short time).  We also set our annual sights at the 36% target rather than a higher number, and created some portfolios that leaned to the bearish side for those subscribers who expected lower markets.

Many subscribers paired a bearish portfolio with a bullish portfolio using the same underlying as a way to hedge their investment bets.

For several months, the portfolios earned at better than the 36% annualized target, and then the June 2008 saw another big drop in the markets.  Our portfolios lost an average of 15%.  The losses in the bullish portfolios was not enough to cover the gains in the bearish portfolios.

This unhappy experience made it clear that we had a strategy that made good money in most months but then gave up much or all of those gains when things went badly.  We concluded that this was ultimately not a very sound long-term investment strategy.

On July 10, 2008, we amended our strategy to include exotic butterfly spreads to provide downside protection for the higher-strike calendar spreads which had proved to be so profitable in most of the months, sacrificing some potential gains for the security of having a portfolio that might never go down in value.

A 10-year back-test showed that 36% annual gains were possible with hardly any months that showed losses (over the 10 years, there was not a single month when SPY fell nearly as much as it did in October 2008, even in the 9/11 month when the terrorists attacks occurred).

For the record, here are the 6 portfolios we are now carrying out at Terry’s Tips, ranked from lowest to highest risk.  Speaking of risk, your entire investment is at risk, just like it would be if you purchased a portfolio of stocks. However, since the long positions generally have several months of remaining value, they should always be more valuable than the short positions regardless of what the market does.  This means that theoretically, you could never lose the entire investment.

Loss Conditions:  All 6 portfolios use exotic butterfly spreads for downside protection and have higher-strike calendar spreads to generate decay revenue.  Monthly losses might result when the stock falls so fast that an adjustment cannot be made (such as what happened on 9/11) or when two adjustment trades need to be made during a single expiration month.  Spare cash is retained at the beginning of the month so that the first adjustment can be made to expand the break-even point in the direction the stock has moved.  Usually adjustments are triggered when the stock has moved about 5% in either direction.  In those months when a single adjustment trade needs to be made, a small profit is expected.

If the stock moves more than moderately during a single expiration month, a second adjustment trade may need to be made.  Since the extra cash has already been spent, the second adjustment would involve taking off some positions at strikes the furthest away from the stock price, and replacing them with spreads at the other end of the range of strike prices.  In those months where this second adjustment is necessary, little or no profit (or a small loss) is to be expected.

The October 2008 expiration month required multiple adjustments because the underlying stocks fell by 23% (DIA) to as much as 46% (OIH).  This experience taught us how to cope with extremely high falling stock prices, and we believe that if it ever happens again, we will do a better job of containing losses for that expiration month.

Mighty Mesa Portfolios

Basic Strategy for all 6 Portfolios: Calendar spreads are set up at several strikes near and above the stock price.  The long side of these spreads is typically 4-6 months out and the short side is in the current expiration month.  A strong premium decay advantage exists with these spreads.  In addition, an exotic butterfly spread employing puts is added to provide downside protection.  The butterfly spread usually involves a small negative premium decay and expires worthless in most months.

Market Direction Desired for all 6 Portfolios: Each month the portfolio starts out in an essentially neutral position, meaning we don’t much care whether the market goes up or down as long as the change is moderate.   In spite of this neutrality goal, there is usually a bullish bias to all the portfolios except the new Big Bear Mesa which will have a bearish bias.

Mighty Stalagmite
Underlying: SPY (S&P 500 Tracking Stock)
"Starting" Value: $10,000
Gains Sought: 36% a year
Risk Level: This is our most "conservative" portfolio because the underlying S&P 500 is one of the most stable of the indexes. Most people consider the S&P 500 to be "the market".
Note: Options on SPY are available at increments of one dollar which allows for precise configuring of a balanced portfolio.

Rising Russell
Underlying: Russell 2000 (small-cap) - IWM
"Starting" Value: $10,000
Gains Sought: 36% a year
Risk Level: This is our second most "conservative" portfolio because the underlying Russell 2000 is a broad-based index and therefore not subject to the whims of a single company or small group of companies. In spite of being composed of mostly small companies (average market cap is about $1 billion), it is a fairly stable index.
Note: Options on IWM are available at increments of one dollar which allows for precise configuring of a balanced portfolio.

Durable Diamond
Underlying: Dow Jones Industrial Average tracking stock - DIA
"Starting" Value: $10,000
Gains Sought: 36% a year
Risk Level: This is our third most "conservative" portfolio. Historically, the Dow was one of the most stable of all indexes, composed of 30 of the largest Blue Chip companies. Recently, however, because of problems in the banking and automobile industries, the Dow has fallen by a greater percentage loss than most of the other market indexes.
Note: Options on DIA are available at increments of one dollar which allows for precise configuring of a balanced portfolio.

Mini-Russell
Underlying: Russell 2000 (small-cap) - IWM
"Starting" Value: $5,000
Gains Sought: 36% a year
Risk Level: This portfolio is a little more risky than the Rising Russell because with a smaller amount available for investment it may not be possible to fine-tune the positions as precisely as we can with the larger investment amount in the Rising Russell portfolio.
Note: Options on IWM are available at increments of one dollar which allows for precise configuring of a balanced portfolio.

Big Bear Mesa
Underlying: SPY (S&P 500 Tracking Stock)
"Starting" Value: $10,000
Gains Sought: 36% a year
Risk Level: This is our fourth most “conservative” portfolio because the underlying S&P 500 is one of the most stable of the indexes and most months, it goes up while this portfolio has a bearish bias.
Note: This is our only portfolio where the greatest gains come if the market is flat or goes down (the others do best if the market stays flat or goes up).

Oil Services
Underlying: OIH (Oil Services ETF - 18 companies in the Oil Services industry).
"Starting" Value: $10,000
Gains Sought: 50% a year
Risk Level: This portfolio is our most risky portfolio because the Oil Services ETF is made up of only 18 companies, all of which are in the same industry. Consequently, the stock often is as volatile as an individual company might be.
Note: Options on OIH are available at increments of five dollars up to $200 and $10 increments at strikes above $200. This does not allow as precise configuring of a balanced portfolio as the other indexes provide. On the other hand, since OIH is so volatile, option prices are quite high, and substantial premium decay is generally available.

Please check back on this Track Record page frequently. It will be updated on Monday following each monthly Friday expiration.

You can become a Terry’s Tips Insider and follow the progress of all six portfolios (or mirror them in your own account) by clicking here.  It could be the best investment click you ever make.

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