Conditions That Might Cause a Monthly Loss in the 10K Strategy
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While the stock can fluctuate in either direction by 5% in a single expiration month and the strategy essentially always makes a gain, there are some circumstances which might cause the strategy to lose money.
Three possible events could cause a loss:
1. Sudden, huge market drop.
When the 9/11 disaster struck, SPY fell by 9% in a single day, and then the markets were closed for a week. Part of the strategy consists of making one adjustment each month if the stock moves significantly in either direction. In those months where an adjustment becomes necessary, we expect to make little or no profit (but not necessarily a loss, either). On 9/11 we could not have made that adjustment. When the market re-opened, the stock recovered enough so that we could have made the adjustment before expiration and no loss would have resulted had we been trading this strategy at that time, but there is no way of guaranteeing that such a recovery would take place in the future.
2. Whipsaw market action.
When the market moves more than moderately (about 5% for most indexes), the 10K Strategy involves making an adjustment to guard against a further stock price move in that same direction. If the market whipsaws during that month so that it then moves 5% in the other direction, we are just fine. However, if it goes in one direction by 5% and then turns around and moves by 10% in the other direction, we could incur a loss for that month. Fortunately, this kind of price action in a single expiration month is a fairly rare occurrence.
3. Large drop in Implied Volatilities (IV) of option prices.
This is not the place to discuss technical issues concerning option pricing, but suffice it to say that IV is an important variable that determines option prices. When IV falls, option prices in general fall across the board. In the 10K Strategy, we own longer-term options (LEAPS) that have a higher value than the short-term options that we are short. When all option prices fall, our higher-valued options usually fall by a greater absolute amount than the short options, and our portfolio values may fall temporarily.
A very large drop in IV would have to take place to make a significant negative impact on 10K Strategy portfolios, but it did occur in late 2008 and early 2009 when S&P 500 option IVs fell from the 80s (a level never seen in the history of the stock market) to the 40s in a two-month period. Typically, these IVs stay in the 20s where they had fallen to by August 2009. (Of course, if IVs suddenly increase, 10K Strategy portfolios should gain in value.)
That's it. Short of these kinds of Black Swan events, the 10K Strategy is designed to rarely lose money, and just might make 36% or more each year.