Craig's Trade Log

Some Words From the Masters

2009-07-10T07:57:00.001-04:00

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Some Words From the Masters

via Daily Options Report by Adam on 7/10/09

Some great points on volatility that everyone needs to internalize, via Bernie Schaeffer's July newsletter. Keep in mind it went out to subs on June 25th, before the recent modest upswing in volatility.

You can't refer to the cheapness or the richness of the Chicago Board Options Exchange Market Volatility Index (VIX) outside the context of historical volatility. The VIX is, first and foremost, a measure of the anticipated volatility of the near-term options on the S&P 500 Index, and the most important clue over the years to the current level of the VIX has been the short-term (10-day or 20-day) historical volatility of the S&P (the VIX calculation doesn't exactly equate to a historical volatility but it is close enough). So the use of the VIX level as a "fear gauge" must always be assessed net of the major influence of historical volatility on the VIX. While it is tempting after today's VIX implosion to less than half its peak levels in January to suggest that investor fear has dissipated to dangerously low levels, this assessment is seriously complicated by the fact that the VIX is not "low" in the context of the recent volatility of the S&P.

Yup. It's a point we here tried to always hammer home as well. Implied volatility attempts to divine the volatility of the underlying over the stated time frame (commonly the next 30 calendar days). There are always expectations of news events, earnings, et. al., but the best "prediction" tool is simply the volatility of the underlying over the past 2-4 weeks. What else would you base your markets on than what you "feel" right now? And as we know, realized volatilities utterly caved early in the cycle and those "cheap" options actually overbid. It's not uncommon to see that, in fact McMillan showed an average 4 pt overbid of IV relative to HV.

And Bernie goes on with another favorite topic, the seasonality of volatility.

Equity volatility is seasonal. According to a recent study by Larry McMillan: "There is also a seasonality to VIX trading patterns. ... You can see several patterns (over the past 20 years). Early in the year, there is typically a small peak in VIX in January, followed by a slightly higher one in March. Then it goes into a decline during the spring and into mid-summer. It probably comes as a surprise to no one that the low in volatility occurs around July 1st of each year. What might come as a surprise though is that volatility typically rises quite a bit during July and August. Then it really gets going in the fall -- In September and October, when the stock market typically has major declines. It peaks in October. After that, volatility becomes surprisingly docile for the rest of year, until by Christmas it is almost back at the July lows. Not every year follows the pattern exactly, but most are a reasonable approximation. 2008 followed quite closely, and this year the pattern is typical as well." So is it time to assume that the VIX will rally according to these past seasonal patterns? Perhaps, but I'd also suggest the possibility, based in part on the ongoing compression of historical volatility, that the VIX might continue to decline to surprisingly low levels – perhaps as low as 20 - before it bottoms.

Well, first of, feel great that two of the absolute masters in this biz agree with some data I threw in my book. I came to similar conclusions re the early July cycle trough.

Which is also why it drives me nuts seeing "analysis" on that cheap VIX without putting it in it's proper context. And that analysis took the form of assertive directional calls in both directions.On one hand "smart" options money was right lowering bids as they "knew" the bull would continue this summer. On the other hand, 26 VIX was a red flag of complacency and bearish.

In truth, neither interpretation was correct. It was a prediction that the always slow start of summer was upon us, plain and simple.

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Verlerger on Oil Glut: "There has never been anything like it"

2009-07-07T02:01:00.001-04:00

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Verlerger on Oil Glut: "There has never been anything like it"

via naked capitalism by Yves Smith on 7/6/09

While oil is a finite resource, focusing on the long term can blind one to near-term dynamics. There has been surprisingly little mention in the mainstream media of how large the current oil surplus is. The collective view seems to be that this will take care of itself in short order. But that may be longer in coming than most believe.

Some veteran oil analysts, in particular Philip Verlerger, beg to differ. From the Los Angeles Times (hat tip reader Michael):

Downward pressure on oil prices is so great that crude could trade for as little as $20 a barrel by the end of the year -- less than a third of what it traded for this week and an 86% drop from its peak last year, analysts said...

The reasons are simple, said Philip K. Verleger Jr., an expert on energy markets at the University of Calgary in Canada: The still-sputtering economy has lessened demand at a time when there is already a big surplus of oil.

For eight straight months, oil supplies have been running about 2 million barrels a day higher than the global demand of 83 million barrels a day, Verleger said. Eventually, he and others predicted, suppliers will tire of paying to store all of the surplus oil and flood the market.

"That is the largest and longest continuous glut of supply that I have seen in 30 years of following energy prices," Verleger said. "It's a huge surplus. There has never been anything like it."

The market will eventually correct itself, pushing prices down, Fadel Gheit, senior energy analyst for Oppenheimer & Co., wrote in a note to investors. "Excessive speculation and a weak dollar have lifted oil prices to levels not sustainable by market fundamentals," Gheit wrote.

Crude has traded in the range of about $70 a barrel for much of the last month, closing Thursday at $66.73. The markets were closed Friday.

With so much oil available and so little need for that amount, investors, oil companies and even some banks have bought and stored surplus oil everywhere they can. By one estimate, before oil surged to its high this year of $73.38 a barrel in June, as many as 67 supertankers -- each capable of carrying 2 million barrels of oil -- were being used as floating storage.

Verleger said it represented a largely risk-free investment for those who could sell that oil for huge profits on the futures markets.

But the glut has gone on for so long, he said, that the cost of all of that storage is bound to rise. When it rises enough, some suppliers will refuse to pay and a lot of that oil will be dumped onto the market.

"Oil will drop to $20 a ba

rrel by the end of the year because this situation just cannot be sustained," Verleger said.

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Update to today's scenario

2009-06-23T21:43:00.002-04:00

I've turned a pretty bearish eye on the market, but not so much as to think that Armageddon is near. Here is a plot of how your P/L will look on July 18 compared to the DOW 30:

(double click for larger image)

Pretty flat curve going down with a likely gain of about $3000. We're hurt most by a hard rally.

We have short deltas in CSX (freight trains), financials, and oil services. Sold a call against the 100 shares of MON - I don't think it will rally much higher.

We have long deltas in natural gas (the commodity, not companies) and a refinery stock (WNR) that just plummeted as soon as I bought the calls on it. Boo.

We'll be building some more neutral positions over the coming weeks that have a bearish tilt and adding positive deltas (and positive theta - time decay) to our natural gas position.

Overall - looking for a down wave here that will head to March levels, maybe lower. Sustained rallies don't happen when the market goes up and down by 2% every day. I'm bullish on natural gas, but not on oil.

A good post from VIXandMore

2009-06-21T17:54:00.000-04:00

Go here:
http://vixandmore.blogspot.com/2009/06/chart-of-week-lack-of-volume-and.html

What he said:

Sunday, June 21, 2009

Chart of the Week: Lack of Volume and Breadth Threatens Bull Move

In the last few weeks, stocks have struggled to add to recent gains, suffering even more from a lack of buying interest than from selling pressure.

The chart of the week below is an attempt to use two basic indicators to capture the lack of volume and market breadth that has undermined the March to mid-June rally. As a measure of market volume, I have chosen to highlight on balance volume (OBV), which is a running total of the volume on up days minus the volume on down days. This indicator is excellent at highlighting trends which are at risk due to declining volume, which is exactly what the warning suggested when there was a peak in OBV during the first two weeks of May.

In a similar vein, the McClellan Summation Index (aka the NYSE Summation Index or NYSI) shows market breadth as derived from the net daily advancing stocks minus declining stocks. The McClellan Summation Index did turn up at the end of February, just before the March bottom and is generally an excellent tool for gauging trends in market breadth.

In addition to the May highs, note that both OBV and the McClellan Summation Index have recently made lower highs as well. While OBV shows some indications of steadying at current levels, the larger concern is the decline in market breadth issues highlighted by the McClellan Summation Index.

Like all indicators, these two are far from perfect, but they often provide important information about the decline in strength and potential for reversal in major trends.

Falling volume is a bad sign for a rally

2009-06-11T15:05:00.003-04:00

Falling volume as we rally higher.

Looking at the SPY (SP 500 ETF) here. All the indexes look the same. Huge volume at the bottom in March that is steadily declining as we grind higher.

This is not a good omen for higher prices. We will have another leg down soon. July maybe?

FSLR

2009-05-28T09:35:00.003-04:00

Long position in FSLR.

Bought the Jul 180/185 Call Back Spread and sold a Jun 170/155 put vertical to finance the theta decay for the first month...

What the heck does that all mean?

1st:
- Market is attempting to shake off its weakness and push higher
- FSLR pulled back to a breakout gap from last month after earnings - on the pullback, there was a very narrow range with very high volume as it dropped like a stone. That means that there were buyers more than happy to take the stock off the hands of the sellers at that low price. Demand is higher than supply even though it is a down day (look at the 5-26-09 day)
- I want to be long FSLR, I don't like just owning stock outright usually, and I am concerned that implied volatility of the options (the price of the options) will drop in FSLR if it gets in a malaise at this level.

Four pictures:

Here is the P/L graph for 2 long Jul 185 calls.
Total risk is $3080.
Potential gain is unlimited.
If the stock price stagnates, we could lose $3080.

Now sell a Jul 180 Call to less some of the pain.
Total risk is if it expires right at 185 in July, max loss of $1826, if it plummets, max loss is $1350.
If it stagnates, the loss will be somewhere between those numbers.

This is a short vertical. Max gain is if it stagnates, goes down just a little, or up any amount. That profit is $430. Max loss is below 155 in Jun, that is $1070.

Putting them all together, this is how it looks at Jun expiration:
Max loss is $2350 with stock below 155.
Loss is less than $400 as long as it stays above 170.
Profit is unlimited.
If it makes it this months high again, the profit would be around $1500.
If it breaks out as I believe it may, it could go to several thousand.

OBTW, the margin required for this trade is $2920. This is more than the max loss. We're putting on one of these for every $40,000 in the account.

A look at Gold

2009-04-10T16:21:00.003-04:00

Two looks at where gold may go.

These are screenshots of the Gold Futures contract because it is easier to look at and more liquid than GLD. The first shows a head and shoulders topping pattern suggesting a fall in gold prices to 830.

The second one shows gold in a solid long-term uptrend approaching support that should push it higher.

Bottom line: conflicting views. Probably down in the near term, up in the long term. I am personally long GLD.

Gold

2009-02-28T07:35:00.004-05:00

Barron's had an article about the miners doing better than gold. It's a good point. The XAU is an index of miners (gold and silver). Unfortunately, being an index and not an ETF, you can't actually buy shares of it. Fortunately for us, we have options accounts that can trade the options on it!

Look at these several months of the XAU. Upward trend of prices. Pulling back to the upward sloping trendline just as it is approaching the Pivot support line. That means there is a better than average chance it will turn higher.

We also have a point of "indecision" in the market as the prices were little changed from open to close yesterday. That can be an inflection point. (Not always). If we get a close on Monday higher than the open and higher than Friday's close, we should look for a trade here.

This might be a good time to go long calls. More to follow.

DSX

2009-02-25T08:16:00.008-05:00

Here's a look at DSX. The chart shows a general uptrend over the past 3 months. The monthly pivots (blue squares arranged in a stair step) show the pivot is eaking higher. (Is "eaking" a word?)

The stock is now trading near it's monthly support level (green squares). It does not show a reversal pattern right now. If it did, we could just go long the stock. Volume is low on yesterday's rally compared to the last two days. That is not a good sign in itself, but all is not lost for the bulls on this one.

Bias: moderately bullish (not bearish). Could go sideways.
We can capitalize on the sideways action with options, and if assigned use it to gradually build inventory of stock in the company without reckless exposure all at once.

(click to enlarge)

Here is a short sale of 1 contract of the Jun 10 Put:

Sell 1 Jun 10 Put for $1.40
Max profit: $140
Max loss: $860
Break even: 8.60
52 week low: 6.85
At Jun expiration:
Stock >10: Profit $140. Position evaporates.
Stock at 8.60: Break even. Assigned 100 shares with cost basis of $8.60. No cash needed.
Stock at 6.85: Loss of $175. Assigned 100 shares with cost basis of $8.60. No cash needed.
Max return: 140/860 = 16%
Probability of a win = 58%
Probability of a max win = 49%

(click to enlarge)

Probability analysis:
Look at the slices below the pretty graph. There is a column for each expiration cycle. Look at June. It shows the probability of expiring in each region of the plot. These slices match the analysis page.

(click to enlarge)

DRYS

2009-02-24T23:28:00.007-05:00

Here is the screenshot of DRYS. Selling the Jun 5 Put for $2.25. It's the same as buying 100 shares of DRYS (now at 4.03) and selling a Jun 5 Call for $1.22.

Here it is with 30 contracts:

Notice the total risk is in the right hand data column, the price levels in the left one. The second column from the right is the P/L for each level.

All in all, the total risk (of a bankrupt DRYS) is $275/contract. The maximum reward is $225/contract. Break even is $2.75 stock price.

On June expiration, we either pocket the entire sale for a nice profit, or own 100 shares of the stock/contract at $2.75 a share.

Ignore the news

2009-02-24T09:50:00.002-05:00

Yesterday was a whopper for the buy and hold crowd. For us, we are partially hedged to the downside. However, the very nice hedge I had on with the SPX (SP500) I closed on Wednesday, just a few days early. We pulled some nice money out of the market with that and it offset some of the losses up to that point in are limited long positions.

Depending on where you look or who you listen to, the market is either heading for Armageddon or ready for a hard snap-back bear market rally. As usual, the news is usually wrong or outright lying to us.

That said, there are patterns forming on the daily chart that show we could be heading a lot lower. I also see resistance levels below/at this level that could fuel a nice snapback rally. Lots of folks talking about oversold-this and oversold-that.

This market is impossible to predict because of the massive attempt at manipulation and ineptitude at the federal level. In the end, they will lose and take us with them if we are not careful.

So where do we go from here?

In the IRAs, we need to hedge all our long positions with options. We can have a bias to the up- or down-side, but we must be nimble and keep an eye on it.

MON is basically breakeven after all this time and almost triggered my mental-stop to get out (close below 74.50). If it does, that's fine. It may even rally back. That's fine too. If I can set it up, we'll hedge some downside risk on the next rally.

Oil and Nat Gas are still in a long grind down. Eventually they will go back up. In my account, I just put on a downside hedge on Nat Gas to offset my upside position in Oil. Would you like to hear about that?

I have a position on in DRYS in my accounts. Lottery ticket here. Not for the faint of heart. Would you like to hear about that too?

STLD is driving me nuts. It's just not doing what I expect. It is hedged nicely, so no reason to bail just yet, but wow. It's all over the place!

As always, this market is not for the faint of heart or the buy-and-hold investor. In the IRAs, I am keeping mostly to cash. There is no reason to think that this is a bad strategy for months to ome.

Well, that's about it for now.

SPWRA

2009-02-04T10:48:00.005-05:00

Sunpower is a solar stock that was a high flyer last year. I think it will come back. The recession will end. Energy prices will rise. There will be government incentives to go green. Solar will return.

You saw the favorable review in Barron's.

SPWRA is the common class A stock. SPWRB is the preferred stock with 8 times the voting rights. SPWRA is trading higher, has more options listed, and seems to give a better opportunity than the class B shares. The actual price chart of each is similar with no advantage to either despite the difference in price.

The weekly chart is above and shows huge volume as the stock drops and then it tapers as it forms a base. There is a volume spike on earnings, and it goes nowhere.

Outlook: longterm up with a need to form a base for now.

Strategy: buy long term In The Money (ITM) calls with "low" extrinsic value. Sell slightly Out of The Money (OTM) near term calls to cover the extrinsic value.

Long Sep 25 Calls at 13.95
Short Mar 35 Calls at 4.30
Net: 9.65 debit

25 + 9.65 = 34.65. The stock is trading around 35+.
If the stock shoots to 100, we will make about $50 on the spread.
If volatility plummets (no one wants to buy the options and the extrinsic value goes to zero) we'll make about $50.
If the stock goes to zero, we are out $965. If it stay where it is, we'll likely make about $340. After the March expiration (3rd Friday), we'll evaluate the position. for followon adjustment.

We'll unwind if there is a massive up move or massive down move.

Below is the risk profile for 2 spreads.

OBTW, I put in this order for your IRA, my IRA, and my margin account. Only yours got filled. The bid-ask spread is kind of wide going out to September, we'll see how this works for my accounts. Yours look good.

Rolled PCG

2009-02-02T11:16:00.002-05:00

Rolled out PCG Feb 40 Calls to March for a credit of .70. The Feb calls were only hedging about .30 of risk per contract. Not a lot. It was time to roll it out to Feb to allow for 1.00 of hedge.

As of 2-2-09:

Delta is 30 SPX or so (for every point the SPX goes up or down, we make or lose $30). Kind of high, but I feel there is still a chance we could rally.
Theta is about 24. (Bring in $24 a day ($750/month) if all variables stay the same.)

USO

2009-02-02T11:11:00.002-05:00

Recession recovery play:

The recession will likely start to bottom this year. Could it go longer? Sure.

Will the recovery be sharp and up hard? Not likely.

We will likely see an extended "L" shaped recovery.

Regardless of the type and timing, eventually we will recover globally. When that happens, we'll need energy. Nat gas and Oil are hammered. They will come back. When? I have no idea. Before the recession bottoms? Not likely.

This is a good time to look at using options to simulate a covered call.

USO is an oil ETF that "tracks" the price of West Texas Intermediate Crude Oil. We are going long Jan 2010 30 Calls in USO, and short March 30 Calls. This is called a calendar spread or time spread. The total at risk is the price of the long dated call minus the short dated call. In this case, about $400 per spread. We'll start with a total exposure of 2% of capital and work up from there after the March expiration.

Update so far

2009-02-02T11:04:00.003-05:00

So for January 2009, the broad market was off 8.5% for the month.

The IRA trades are off just 0.25%. Not bad.

I read a funny yesterday, "In bear markets, the one who wins is he who loses least."

I think we're winning.

Of note, my margin accounts are using different trades and strategies. One is strictly trading GLW. It's ok.

The others are generally short volatility/time premium on options and are doing well. Most of the trades work in cash accounts too, but not all. I may revisit my IRA strategies to mirror the margin strategies. For January, the margin strategies are up 6% for the month. That annualizes to 100%, or a clean double. That said, I've double that account the past 2 years in a row, so that makes sense. However, as I said, sometimes it requires margin.

FCX - margin acct only

2009-01-13T05:23:00.004-05:00

Only doing this one in my margin account.

I built up an inventory of positions generating positive theta (time decay). Current theta is about 18 on the position, the delta is high at 77. That means that a theta of 18 should add $18 to my account over the next 24 hours. The delta of 77 is multiplied by the change in the stock. Stock goes up by +0.20, then 77 x 0.20 = $15.40. If it dropped by -1.00, the 77 x (-1.00) = -$77.

I am short the following:
Jan 20 put
Jan 30 call
Feb 22.5 put
Feb 25 put
Feb 30 call
I am long:
May 20 put
May 30 call
May 40 call

Profile without any new trades or adjustments:

I am adding a diagonal short Feb 20 put / long May 17.5 put - this has the effect of adding 1.75 to the theta (almost $2 more dollars a day) with little effect on delta.

I'd like to take my delta down to less than 25 or so. A good technique would be to sell 77 deltas of stock (77 shares). I am evaluating that option. It's probably the right call.

I am also rolling my short Jan options out to February once they get down to a nickel.

Profile after shorting 100 shares:

TK

2009-01-09T08:53:00.004-05:00

Starting with the chart on top, I see the price action climbing to what is called a "doji" pattern (highlighted with the blue dot 2 days ago). A doji is a Japanese candlestick charting term that means the open and close of the day were about equal. It tends to signify turning points.

The next day was a thick red candle where the stock opened and the price dropped all day to close near the low. The price is approaching an overhead resistance level (the red line of squares that we can talk about another day), with a reversal, and then a confirmation down day. The close is less than the 1 day Simple Moving Average (SMA) of the average of the high+low+close (H+L+C)/3. That in turn is less than the 3 day SMA of the (H+L+C)/3.

(H+L+C)/3 is called a pivot point level and usually helps show the direction of the trend. Prices above the pivot tend to go up.

So we put on a diagonal spread using puts. The long put in April is a proxy for short stock. The short put in February is our money maker. We are selling premium like an insurance company sells policies. We collect a little here and a little there that add up to nice sums.

We will continue to watch this stock chart as it drops. When it shows signs of turning up again, we'll put on an opposite position (if it makes sense) to turn it into a truly neutral trade.

Next week: "the greeks"! This is when it gets really fun!

What I think for the start of 2009

2009-01-04T00:02:00.007-05:00

Looking at the SPX (SP500) index, it appears that the big down move is done for now and that we may see a bit of a rally before the overall weak economy really drags everything down.

Covered calls and short puts: short puts are synthetically the same as covered calls. Selling a single put, is the same as buying 100 shares of stock and selling a call against it. In our case, selling an out of the money put (strike price less than stock price), gives a nice downside cushion and the opportunity to win whether the stock goes up, stays the same, or drops less than about 10-15%. All in all, it's a nice opportunity. (See the bottom chart below for the profile on STLD with a breakeven at 1.80)

TSO

So for new trades, I am looking for strong stocks moving to the upside. Tesoro (TSO) is a leader in the refinery business that is now making money since the price of oil is coming down. Looking to sell a Feb 12.5 put for about 1.20. This is a return of >10% if the stock settles above the strike price of 12.5 on the third Friday in Feb. I am doing this trade in my margin account only for now. Return to risk is good, but not great.

STLD

Sell the Feb 12.5 put for 1.70. Real nice return for the risk here. STLD is a steel producer that we played before on the gut-wrenching down turn. It's going to be volatile, but there is a nice downside cushion to 10.80.

Not sure it's this simple, but...

2008-12-08T04:33:00.002-05:00

From iVolatility.com:

Last Friday’s equity market trading reminded us of this old Wall Street saying,

“The market bottom is defined when it stops going down on bad news.”

Recall last October the equity markets were still going down on what should have been considered good news with respect to the actions that were being taken by the Treasury and Federal Reserve to rescue the credit markets and the financial sector.

The employment report released last Friday with job losses of 533,000 in the month of November 2008 was bad news for the economy.

Here is what The New York Times said,

“The nation’s employers cut 533,000 jobs in November, the Bureau of Labor Statistics reported Friday.”

“Not since December 1974, toward the end of a severe recession, have so many jobs disappeared in a single month – and the current recession, far from ending, appears to be just gathering steam.”

While there could be many explanations why the equity markets ended the day higher and not lower on the bad news, including short covering on the widely expected bad employment report. We also wonder if there is another possible answer like the one raised by Richard Russell last October when he said:

"Bear declines end in only one way – in exhaustion."

Has most of the selling been done and could we be near the exhaustion point? Friday’s market action raises this possibility.

PCG

2008-12-01T10:17:00.004-05:00

OK,
I cancelled the working order on ETR in favor of PCG. Same type of company, but west coast.

Why? ETR just wasn't getting filled. The option quotes are too wide. PCG is more liquid it appears.

Bought a Jan 2010 30 call - too simulate the stock
Sold a Jan 2009 40 call

Bought the spread for 9.20 stock trading at 37.75.

If the Jan 2009 call expires worthless, we own a Jan 2010 30 call for 9.20. That is the same as if we bought 100 shares of the stock itself for 39.20.

Bullish on ETR

2008-11-30T23:18:00.001-05:00

Creating a neutral-bullish trade in ETR, an electrical power and natural gas distribution company from the gulf coast.

I'd like to set up a covered call trade without all the risk.

Sell the Jan 90 Call
Buy the Jun 70 Call as a proxy for the stock.

This diagonal will costs 85.65 at the mark. We'll let it work for a day and see if we can get filled.

If the Jan call expires worthless, we will own a Jun 70 Call for 15.65, only 50 cents of premium to the current stock price.

Why ETR? The utilities SPDR has been sparring with the energy SPDR for top dog. ETR is one of the strongest in the sector with a chart to be proud of even in a bullish mark. It established a nice strong base over the past several weeks and broke out on volume last week.

We're buying 1 diagonal for every 30k in account value (5% of account).

Selling a call

2008-11-19T04:22:00.006-05:00

Yesterday I said we'd look at a spread today. I got ahead of myself. Let's sell a "naked" call.

A "naked" option is one that is long or short without an offsetting position.

Let's start by going back to the Analyze tab, back to PEP, expand Dec 08 options chain, and focus on the Dec 50 calls again.

We see that PEP didn't move yesterday and the option prices are nearly unchanged. Let's sell the Dec 50 Call for 4.70 by clicking on the bid price for the Dec 50 call. We can change the price from 4.60 (the bid) to 4.70 (the mark) just by adjusting it with the up/down arrows in the trade window below that is now highlighted in red.

Go to the risk profile portion of the Analyze tab. You see that the green line for expiration shows your maximum profit is the amount you sold the option for. This is always true.

Your max loss is theoretically unlimited since PEP stock price could go up a gajillion percent in the next 5 weeks and wipe you out. Not likely, but possible. The total risk is equal to being short 100 shares of PEP minus the profit of selling the option of $470. Your total profit is limited to $470. Your break even is 4.7 points higher than the strike of 50, or 54.70 (at expiration).

We now have two tools in our bag: naked long options, and naked short options. There is a time and place for them both, but tying them together, we can now make "spreads" that hedge their risk of loss.

A little behind

2008-11-17T20:11:00.004-05:00

I haven't exactly explained them well yet. Let's start simple and build up.
First, let's only talk about calls and ignore puts. I don't think puts were even invented until the 80s anyway...

Let's focus on one stock and one option. PEP
PEP closed at 52.97 today.
-The Dec 50 Call is trading for 4.50 bid 4.70 ask. Options are contracts on 100 shares but priced per single share. So multiple their prices by 100. Therefore, we can buy it for $470 or sell it for $450.
-Let's buy it for the "mark" (the average of the two) of 4.60. The option will expire at 4pm on Dec 19th. At that time, the option will settle for a price equal to the share price minus $50. This is known as the "intrinsic value" of the option. The value attributed to actual share price, and not time or volatility premium.
-Let's say PEP closes at $60 on Dec 19. The option will settle for a value of exactly 10.0, or $1000. If you buy at 460 and sell at 1000, you made a nice profit.
-If PEP closes at $50 on Dec 19, the option will settle for a value of $0. A total loss.
-If PEP closes at $20 on Dec 19 (an incredible crash), the loss is the same $0.
-Buying an option limits your loss to the amount you put in.

Try this, go to the analyze tab on the tos platform.
Go to "add simulated trades" on the bottom.
Expand the Dec options chain.
You should see a column labeled "strike" - look for 50.
To the left of the strike column are the calls.
Find the column "ask"
Under "ask" next to "50" you should see 4.70.
Left click on 4.70 - you just simulated a trade.

Go to the risk profile tab within the analyze tab
The green line is the profit/loss (p/l) for Dec 19.
The white line is the p/l today.
Why are they different?
Options lose value over time. The difference is called "extrinsic value" or "time premium" or "volatility premium".
Think of it as buying an insurance policy. The longer you have until expiration, the more likely the stock will rocket higher, so the more money the seller of the insurance policy is going to require to take on that risk.
It is an insurance policy because it limits your loss to something much less than the total outlay for a straight stock purchase.

-While looking at the pretty picture, look to the bottom of your screen where your simulated trade is highlighted in green. Move your eyes to the right until you see the white x in a red circle on the far right edge. Slide your eyes up the screen one inch and you should see a date field with a little calendar icon next to it.
-click on the up arrow next to the date field to advance the simulation one day at a time and watch the white line (that day's value) approach the green line.

This tool will do more to explain the benefits (and hazards!) to option trading. It is not for everyone because it is more complicated that up and down. There is also side to side and tomorrow and yesterday. That said, even Warren Buffett starts his positions with options, but few people talk about it.

Tomorrow, I'll talk about spreads.

Weekend update

2008-10-25T10:10:00.002-04:00

You've probably heard by now, the futures went limit-down on the overnight session before Friday's open. It is roughly a 5% limiit that will halt trading lower. It reopens at 8:30 Chicago time with the real stockmarket.

Losses were less than I expected.

NSC still trading well. Might consider another similar trade in CSX.

Also entered a bearish option trade on WDC after a strong earnings report. It was up 13% on a down day, but it halted right at previous overhead supply. Sold Nov 15 calls and hedged with Dec 17.5 calls for a slight credit.

MOS update

2008-10-24T12:21:00.002-04:00

OK,

I went against my rules and put on a trade testing the waters with MOS. I pretty much got bitten by a shark on this one. Nice job. Closed for a 15% loss. Jackass.

Lesson: follow the rules. Stay with the trend. Don't try to anticipate a rule forming before the bar/day has closed. Have a planned exit on every position.

MOS

2008-10-20T20:19:00.001-04:00

MOS showing signs of accumulation

10/2 shows hidden buying pressure.

There is some weakness after that, but it is treading water sideways. Looking for a test or no supply bar in the vicinity of previous strength (lower area of the range).

Barrons Ideas

2008-10-19T08:55:00.004-04:00

ISCA (NASCAR) - Initial thought is that conventional wisdon says advertising dollars are redeployed during recessions. That can be bad for NASCAR. However Google (an advertising company) just reported great earnings for this past quarter.

Technically, it looks to be attempting to bottom.

The contrarian in me says this could be a good trade.

STLD (Steel Dynamics) - an old favorite of mine. The weekly chart shows professional money buying into a fall. Might not be turning today, could be turning up over several weeks to months.

KO (Coke) - Sorry mom. Good earnings report behind us, chart showing some possible buying. Keep watching.

No short opportunities right now. Everything is gearing up to rally. It may fall from there, but for now, we are in cash or going long. (or neutral-long with a diagonal option spread.)

NSC trade

2008-10-18T20:27:00.002-04:00

The diagonal in NSC is behaving well. The beauty of a diagonal spread is that you don't have to be right from the get go to avoid being stopped out. You can absorb some moves against you before you need to unwind the trade.

The volatiliy priced into these options is through the moon (but probably less than they should be). There are two concerns with a diagonal:

1. A big move against you (in this case down) that cannot be foreseen.

2. A big dropped in implied volatility (the cost of the "time premium" of an option) will cause the long portion of the back month to drop and have little residual value.

In our case, 2 is mitigated because if volality dropped to a historical level of 35%, we'd still be quite profitable.

Closed the AUDUSD trade

2008-10-18T20:26:00.001-04:00

Got stopped out of the AUDUSD trade for even money. Pretty volatile right now.

Did I goon it on GLD?

2008-10-16T11:31:00.002-04:00

Looks like I mistook a No Demand bar on 10/14 for what it was. GLD is off 6% today.

I think it was No Demand on 10/14. Upthrust on 10/15.

The next trigger price is in the vicinity of 74.30.

What did I miss?

9/17 and 9/18 there is obvious selling pressure.

9/24 shows a lack of selling.

9/29 is an upthrust.

10/1 is No Demand

10/8 almost looks like End of a Rising Market.

10/9 is similar to No Demand, but not quite. Nonetheless, it is certainly not showing strength.

10/10 is showing possible strength but it is followed by No Demand.

Testing the lows are just still going down?

2008-10-16T08:14:00.002-04:00

Not sure if we are retesting Friday's low or just in one continuous down move. If one day constituted the entirety of my expected up-move, then the market is in trouble.

Yesterday's close was lower than Friday on most indexes. The Nasdaq is really taking a shot in the gut. It is hanging out at the low of Friday.

OBTW, the NSC trade took a big hit on day one. Still a good trade for now.

AUD/USD short trade is playing out nicely.

Trade in NSC

2008-10-15T10:02:00.002-04:00

NSC - Norfolk Southern Corp (trains)

Selling the November 50 put/buying the Jan09 45 put for a credit of .25

This is a bullish diagonal put spread. The idea is that the NSC chart shows support at the 45-50 level. I am selling the Nov 50 put with the expectation that it will expire worthless in one month. As a hedge, I am buying the Jan09 45 put for just about equal money.

The advantage of this is that the short put acts like a covered call. The long put acts to cut the losses unexpected crazy moves to the downside.

At expiration in November (3rd Friday of the month), we will roll the short option to December for some more credit.

Selling this spread for even money (or small credit) means that we have eliminated most risk from a volatility implosion. Worst case an a huge upmove, the position goes to a $25 profit per spread.

Max loss on a move lower is $475 per spread.

I am putting on two spreads per 10k in the account with the expectation that I will unwind the position on a close below 40 for a 50% loss on the position.

Trade in the Australian Dollar

2008-10-15T00:12:00.004-04:00

Just went short the AUD/USD forex pair at .6957 with a stop loss at .7245.

Thesis: the rest of the world is just now catching up to the US in this mess. The USD will be rallying against just about everyone except Japan (we are now becoming more like them.)

Technical: AUD/USD was sold off heavily. It was marked up over the past few days. Yesterday appeared to be an upthrust to wash out stops by the professionals coincident with a previous level of weakness.

Stop loss above the high of the upthrust.

10-14 Update

2008-10-14T23:20:00.003-04:00

Dow and SP500 slightly down on higher volume than "up-day Monday". The NASDAQ on the other hand got kicked in the groin. Down 4.5%. Ouch. I see this as weakness in all the indices.

I'd like to see a more orderly down day on reduced volume from the day prior before I declare a rally in place. It's hard enough to navigate the markets like it is, throw in some handy free-market fascism and it's even harder.

Let's continue to see how this goes. Could be a few days before it settles into a "trend".

Let's look at some specifics I mentioned:

AAPL-down 5.6% on higher volume. Stand aside.

CME - meandoring.

NSC - Friday was a reversal day (low into new low ground, reversed to close on or near the high on very high volume.) That is professional buying. Looking for a good "in".

DE - Reversed lower after breaking out. Reversed on higher volume. Bad sign for now.

GLD - Gold is showing signs of a market "test". Low volume day. Narrow range. Close in the middle. The answer to the test of the market was, "There's no action at this price. No buyers. No sellers." Tomorrow should be telling.

Oil and Nat Gas - no sign of a turn. Still going lower, but I'm not putting money on it.

Elliott Wave - Am I seasick?

2008-10-13T23:38:00.003-04:00

One of the bloggers I follow is an investment advisor named Mish Shedlock. He combines a lot of fundamental data, news bits, and some technical analysis to draw common sense logical well-thought-out conclusions:

In Elliott Wave terms the market is in a 4 of 3 up. See the S&P 500 Crash Count for more details. In terms of price, given the magnitude of today's move on top of the huge move up from Friday's low, the rally may be 65% over already. In terms of time, the rally likely has several weeks to a couple of months to play out.

Whether you buy into Elliott Wave or not doesn't matter. You may not buy into any technical analysis at all. That is fine. My point is that there are technical reasons that point to this rally matching the fundamental scariness of our economy.

His analysis of this rally being 65% over would pretty closely match my top-end rally of 10,500 on the Dow where you see the next major level of overhead supply.

Holy crap!

2008-10-13T22:26:00.006-04:00

+10%. Biggest gain since March of 1933.

Hard to argue with that. Looks pretty positive from my seat even without my fancy charts from the home laptop.

We erased all the losses back through Wednesday. That's good.

Two ways to play from here:
1. We will look to go long for short term (days to weeks) trades.
2. If we see signs of a top, we'll look to go short in our margin accounts and use options to generate short "delta" in our retirement accounts.

Is this the bottom? Probably not.

Is this the bottom for now? Hard to think otherwise.

Definition:
Range - The difference between the high and low of the day.
Delta - Option term that says 1 share of stock has a delta of +1. A delta of 100 means that a $1 move up in the stock price means a $100 profit. If you have an option postion with a delta of -50, the position is equivalent to being short 50 shares of stock. A decrease in the price of the stock by $1 results in a profit of $50.

No trades today. We are now looking for some stocks from my watch list that surged out of consolidation (like DE) to pull back on low volume with a narrow range.

Update 11:15 pm. A note from one of my favorite bloggers concerning big up days in bear markets:

If you wait it out though, you'll, likely you'll get a better opportunity to buy, also via Quantifiable Edges. :
Typically when the market gaps up by massive amounts it tends to pull back at some point in the next few days. Below (click thru to see) are listed all instances where the SPY gapped up by 2% or more. In 19 of 20 cases it posted a close below the gap open within the next 5 days:

Volatility into options expiration week

2008-10-12T22:47:00.003-04:00

I follow a blog by an old options market maker. (By old, I mean he is my age. It's a young man's game.) He had the following comment today:

Remember also that volatility into expiration week tends to beget volatility ON expiration week. It's almost a self-fulfilling prophecy as options shorts were certainly the one's squeezed this cycle. To say the least.

We are rolling into expiration week. Lots of folks saw all this FAT premium in out of the money calls (call options that have a strike price above the stock price.) Anyone who sold a call for income, will have to defend the position by BUYING stock as the stock price rises. This turns a bearish bet into a bullish bet by turning the short call option into a covered call position. It flops the profit/loss profile backwards.

The point is that any rally(selloff) in expiration week can be self-sustaining.

I'll attach some p/l charts later this week when I am working from home to demonstrate.

CME

2008-10-12T04:53:00.001-04:00

Another one that I like is CME. The "Merc" is the Chicago Mercantile Exchange. It competes with the Chicago Board of Trade as a futures exchange but offers different products.

All the back-room deals that led to the current crisis are likely going to be moved to a transparent exchange-traded model with a clearing agent. This is good. It is also good for the exchanges that get the products.

Other candidates I suppose are CBOT and The ICE. I always liked the exchange stocks. They are certainly doing well now. (Business-wise even if their stocks are a bit out of breath.)

CME is currently trading in congestion. Good chance it could pop higher on any reaction rally.

Barrons Picks

2008-10-12T04:37:00.001-04:00

Some stocks from today's "Up & Down Wall Street" piece that are worth looking at. I have done ZERO research on these, this is more of a note for me so I remember which ones, and where I found the ideas.
MSFT
EMC
MVW
ADBE
SY
ORCL
LWSN
JDAS
NOK
CSCO
AAPL

Other random hits in this week's magazine:
XOM
KBR
UTX
DE
CAT

Got some homework to do.

UPDATE: DE seems to have some potential to be building a meaningful bottom. Need to wait for it to break up to the high side and then pullback on low volume to get in. That will minimize our risk for a downside washout of the position.

AAPL

2008-10-12T00:10:00.000-04:00

AAPL is holding up "nicely" in light of the massive sell-off this week. There is a huge increase in volume this week over last. High-low daily ranges are high.

Once the market turns, I believe that AAPL will shoot higher fast.

I'm not prepared to take a position quite yet, but Monday or Tuesday may be telling. I'll keep an eye on it and consider a future position to the long side in AAPL as early as Wednesday.

Overall Market Trend

2008-10-11T22:20:00.000-04:00

The overall stock market is in an obvious downtrend, maybe even a crash.

Fundamentals.

The economies of the world are a wreck.

I believe we are headed into a deflationary scenario. Deflation according to Ivestopedia:

A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.
Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.

Technicals.

The action of the past two days on the DOW and NASDAQ looks like we may be slowing our descent. A few stocks in particular are actually holding up rather well considering the overall market. Iwill look at one in particular, AAPL, in the next post.

Commodities are cratering. Oil and gas are down. Industrial metals (copper and silver) are down. Gold is in a several month down trend but a one month up trend.

In general, the market is oversold and likely to bounce. Any bounce will be anemic and could last for as long as 2-3 months, and that's about it. I would expect it to bounce only as high as 10,500 on the Dow before it turns back down. I believe the ultimate bottom will not be found until mid-2009 or later and could be in the area of 7000.

This market will be difficult to trade. I'll be watching long side trades closely and likely use stops to protect profits. I will not use covered calls very much simply because the downside risk outweighs the potential profit even with the juiced premium we can get in today's market.

Short side trades have the potential to work well. I am standing to the side now because of the high risk of a high energy up-bounce that can wreck the best of trades. I am looking to short into anemic rallies that have the potential to fail.

The dollar.

The Euro is going to be much worse off than the dollar. Same for the GBP.

The EU is toast.

Welcome

2008-10-10T13:09:00.000-04:00

This is a running commentary of my trades and views.

We'll be trading mostly stocks. Specifically high volume optionable stocks that are members of SP100, SP500, DJ65.

We'll go long and short. We'll use options to generate short positions in IRA/cash accounts.

We'll also discuss some forex trades mostly so that we all know my mindset.

There may be an occasional futures trade.

I use thinkorswim for my broker, some charts, and all option analysis. I also use TradeGuider's VSA techniques and software to assist me in recognizing support and resistance levels as well as supply and demand areas. I use Infinity Futures as a futures broker in addition to tos.

-Craig