[lewman]

According to its prospectus, it invests in derivatives then use cash as collateral. It’s a common strategy used by index trackers for enhanced efficiency.

[lewman]

Powayseller, I noted you mentioned oil stocks. Are you attracted to oil stocks because of their low P/Es or is it because you think oil price will continue to rise or stay near these levels despite your conviction that recession is around the corner ?

Lately oil’s been coming down hard and fast. Some attributes that to the loss of war premium. I’m not sure because the world, or specifically middle east, doesn’t seem to be a safer place than it was just a few weeks or months ago. Rather, is it possible that oil traders are pushing oil prices down because they anticipate an economic downturn ?

And since oil prices is the main driver behind oil stocks. Would oil stocks still do well in absolute terms if oil prices were to level off ? If it does happen, the only way oil stocks will continue its up trend is a re-rating of the sector, i.e. the market assigning higher PEs to oil companies.

So many questions and so few answers.

Lewis

[lewman]

I suspect the fear of shorting has to do with the theoretical risk that losses could be infinite as opposed to going long where worst case scenario is just total loss. I think that becomes a real risk only if you short small companies so a relatively small amount of money can push the price through the roof. I just started shorting stocks about a month ago and I made sure these are fairly large companies. Plus I make sure there’s a stop loss in place and between these two policies I hope I’ve reduced the risk of getting squeezed to a minimal.

But I would also look into PUT options as they come with a built-in stop loss mechanism. So I can execute the trade then go away and know that while I may lose my shirt, I will definitely be able to keep my pants on.

Cheers
Lewis

[lewman]

I found it a bit interesting that some of you have very strong opinion about your own view and method and seem to suggest that it is mutually exclusive to others (e.g. keeping money in CDs vs shorting the market vs identifying sectors that’d still thrive despite a falling market). Rather I think they are just different investment methologies and risk management techniques that I believe could co-exist as that’s diversification and diversification is always good.

I figure if I position my portfolio in anticipation of an upcoming recession, I’m eseentially relying on a crystal ball of some sort because I’m making a call about the future that as clear as it seems when the call is made the outcome could easily be totally different (and yes to state my position, as of today I’m one foot in the housing-led recession camp and am looking into how I’d ride the S&P500’s fall in 2007).

At the same time I agree certain sectors could still work despite a recession and I’ll continue to go long on these. Precious metals is one and I’m debating on oil. But this also requires a crystal ball.

These versus analysing seasonality (my research confirmed that an investment in SP500 during the fall of each of the past 9 mid-term years would be a win; this kind of percentages just can’t be ignored) which does not require a crystal ball but does require a pattern in the past to continue to hold into the future. But for 2006, I’d like to see a deeper correction before I act.

For me, the objective is to make money without taking on too much risk while at the same time hopefully not missing too many opportunities due to “over risk avoidance”. So I’ll likely execute all three trades; make sure I have stop losses for all three and hopefully at least one out of three will be a win and the amount of profits will be greater than the losses … rather than arguing to death that one method has to be better than the others and it’s the only game in town.

Happy investing !

[lewman]

My crystal ball tells me things are getting really bad … recession or even stagflation later this year or next year and in fact like you sdrealtor I also sold my mutual fund holdings in june and just maintain a long position on oil-related stocks as a bet on energy prices staying high … but problem is my crystal ball had been wrong many times before so I’m trying learn how to make money by not having to rely on my crystal ball … ha ha ha

btw, chris, looks like you’ve reconciled with beijing as for the first time in months I can access your website & blog !

[lewman]

Further studied this and looked at rate increase / recession impact.

First question I asked: if I assume a recession is around the corner, should I still expect a market recovery starting from a mid-election year. Unfortunately during the past 40 years, there has never been a recession which began after the mid-election year rally started. So I can’t refute the theory that this pattern could repeat despite a recession (or otherwise). There had been a number of instances where a recession had already started before entering the mid-election year but I don’t think it counts as the market could have been anticipating the end of the recession thus started to bid up stock prices. To me this question remains unanswered. Having said that I don’t know if a recession is coming in the horizon anyway.

Second question I asked was whether the rate hikes since ’04 could have stopped this pattern from repeating. Since 1962, there were four instances where rates were increased before the mid-election year. They were 1966, 70, 74, and 78 and a nice recovery followed each of these mid-election years (+33% in 9 months from the low point in 66, +51% in 11 months from 70, +53% in 9 months from 74 and +22% in 6 months from 78).

But each of these were also preceded by a sizable market drop which I believe set up the subsequent rebound. In 1966, it took 9 months and a 22% correction to reach the low point in 1966, 17 months and 36% drop for 1970, 21 months and 48% drop for 1974, and 14 months and 20% drop for 1978.

We still have a few months before winter. If this pattern were to repeat, it perhaps means there ought to be a rather sizable correction over the next month or two.

I also want to look at market PEs but don’t know where to get historical PEs for the market. Anyone got a link for me ?

[lewman]

powayseller: good point about the recession and it is one of my concerns; was going to look at impact of a recession / rate increase & decrease but it was getting quite late and my brain wasn’t functioning anymore; having said that, while i share your opinion there will probably be a slowdown or even recession but fact is I don’t know that … using my personal life as an example: when I got married several years ago, the wedding would happen during the typhoon season; my wife wanted an outdoor wedding and I vetoed it … I figured if past pattern tells me the likelihood of rain on the wedding day is high then I got to trust it and if it later turned out to be bright and sunny … oh well … I know I will never hear the end of it for as long as I live but at least I won’t be the subject of a funniest home video

re: investing in october vs spring … I didn’t select spring, the months noted were the ones when the lowest point was registered on the S&P500 during a mid-election year in the past 40 years; I also looked at Nasdaq since 1974 and interestingly out of the 9 mid-election years since then October was the best time to buy during 5 of those years while July, August, and September each took one year.

[lewman]

Also add ITB to the list. It’s an ETF that tracks the Dow Jones US home construction index (yahoo symbol is ^DJUSHB).

I think the real estate downturn (plus higher energy cost etc etc) would finally put a stop to the resilient consumer so the next sector to watch (for shorts) would be retail. Compared to the construction sector, retailers have just barely nudged down and I think the worst has yet to come. Any comments here ?

[lewman]

I don’t find shorting stocks that scary as long as you have a stop loss and stick with large caps (large caps coz it would take a lot of capital to move say microsoft so you’re less likely to be caught off guard). And of course you have a stop loss so the theorectical risk of infinite loss becomes … well hopefully just theorectical.

But options are useful too. I think we’ve all been in situations before where you bought a stock, then the stock went down and triggered your stop loss; then the stock turned back up … the issue I have is time value. What’s considered a “cheap” option ? Is there a way to tell ?

I looked at the Jan 07 LEND put options with strike=$35.00
With stock trading at $33.44, the latest ask price for the option was $4.50 (so the intrinsic value is $1.56 and the rest is time value). And to profit, LEND has to go below $30.50 or -8.8% by January.

Is there a standard or convention with which I can judge if the option is priced too expensively ?

And sometimes I see 2 options for the same month & strike. Like LEND has ODQMG.X and QFWMG.X and both have strike=$35.00 for the month of Jan 07. Does anyone know why ?

Cheers, Lewis

[lewman]

first of all, leave CA … better yet leave the country and move to HK/Singapore where public transport is extremely convenient so you don’t need to own a car, visiting a GP would only cost you like 30 bucks, income tax is only around 16% and there’s no sales tax, capital gains tax, dividend income tax, interest tax or it’s a rainy day on monday tax … when it’s time for your kids to go to college tell them they have to pay their own way by getting financial aids, loans, taking part-time and summer jobs rather than backpacking in europe or going to daytona for spring breaks …

[lewman]

thanks coop; I guess the best we can do at the moment is to monitor the situation

I have zero experience in buying futures; do you have any expereince and know of an online broker that’s friendly to small investors with only a few thousand to do this ?

[lewman]

Been following the housing futures’ pregnancy since last year. I was happy finally the child was born … but there just isn’t enough volume for trading … hopefully one day interest will increase. In the mean time I was looking at shorting builders but when I looked at it back in March I thought the sector has already gotten too cheap (the big names already have PEs in the single and sometimes low single digits) but then of course the cheap got cheaper ha ha ha.

But then if may07 SD contract is currently priced at -3% from current index level may be it’s not all that bad to do a buy and hold. I prefer options for this type of strategy coz I can just go away and not have to worry about margin call etc but I imagine the premium and spread would be quite high given the illiqudity. I go to check the options page from time to time but it’s always blank does anyone know why ? Are CME housing options just not yet launched or am I looking at the wrong places ?

[lewman]

I agree with the peak oil arguments and would not be surprised if we see $100 oil in my life time. But knowing (or thinking you know) the long term direction of oil is one thing but turning that into profits is another because it won’t go up in a straight line.

If you look at the chart, oil’s been up with no meaningful interruption for several years now and probabilities are starting to favor a sizable correction even if the long term trend is up. Remember oil prices dropped like a rock in 2001 so if the current rounds of rate hike does eventually trigger a recession (or merely a fear of such), traders could use it as an excuse to drive oil prices way down.

For those of you who are zeal subscribers (I think there may be a few here), check out the gold/oil ratio chart dating back to the early 70s. At present, the ratio touched an all time low of 4 in mid-2005 then gold’s run up since last year push it back to around 8 now. And more importantly, there had only been a few instances during these 30 years where the ratio drops below 10 and usually it doesn’t stay that low for long before a significant rebound takes it back up. If you believe in mean reversion, then either gold is too cheap compared to oil or oil is too expensive compared to gold. That of course doesn’t mean that over the next year or so oil could not just hover around 60~70s while gold rises to catch up, but as I said before, I would not rule out the possibility that oil will be beaten down signficantly from these levels before it marches on once again to reach the moon.

Even though I’m a commodity bull, I’m preparing for it … at least psychologically for now.

Lewis

[lewman]

I like Zeal and continue to subscribe to the monthly. They have their own methodolody and are willing to explain that in details unlike most other newsletters I’ve seen and for this I consider them one of the most enjoyable readings (but actually if I were a newsletter writer I would be mum coz that’s like giving away the recipe of my secret sauce). But if you go back to 2003/04, you’d see that they got slaugthered by the general stock market rebound and lost big on repeated PUTs on NASDAQ & S&P500. Like powayseller said, they’re not yet proven on my book either as it would be interesting to see whether they can “turnaround” when the economy slows down and negatively affect resources prices. Having said that I do think that the law of averages is going back to Zeal’s favor and I think PUTing the general stock market will probably yield profitable results over the next few years.

One note on Zeal Speculator, notice the first year there was a loss of 59%, so word of caution, because unlike their stock recommendation which always come with a 20% auto stop loss, Zeal doesn’t use stop loss on options (coz the maximum loss of premium itself acts as a stop loss mechanism), you must prepare yourself for the possibility of total loss.

[lewman]

While I don’t know for sure as I haven’t seen any link/reference to the claim but I suspect Chris is right that a large proportion of options expire worthless … it certainly is true in my case when I buy options …
#@$%^&*#$%%^ ha ha ha

On the subject of covered call option, here’s a very good explanation of how to use this strategy to supplement a buy-and-hold one from Trend Rider. It essentially allows you to turn the normally undesirable time decay effect to your own beneifts:

Profit from the Trend:
“Become the Casino” with this simple options strategy …
Chris Rowe

To understand why you should make covered calls a regular part of your investment diet, ask yourself one question:

Why does a casino make so much money?

Because there are millions of people who are okay with taking bets, even when they know that the odds are against them. Every now and again, the casino loses and the gambler wins!

But does the casino ever really lose? I mean, is the casino really gambling at all?

The guests of the casino are doing all of the gambling. The casino is simply running a business. The casino knows that every now and again they will have to pay up. But the amount that they pay out once in a while is dwarfed by the amount that they collect from most of the other guests. Everyone knows that!

But when you are the buyer of short-term, out-of-the-money options, you might not realize that you are the same guy as the gambling casino guest.

When you are the person who is selling (aka writing) covered calls, YOU are the casino!

You are the one who is accepting payment after payment after payment from the guy who wants to see his $2.00 BOBC call option trade up to $10.00.
Once you have sold a covered call and received your payment, either you will keep the premium and your stock position, or else you will keep your premium, and you will sell your stock. BIG DEAL! Just be sure to sell covered calls only if you are willing to sell your stock at the strike price.

Ideally, you want to sell calls with a strike price that’s slightly higher than the stock’s current price. It’s also okay to sell calls with a strike price that’s at-the-money (the same as the stock’s current price) or slightly in-the-money (slightly lower than the stock’s price.) The idea is to profit from the decaying time value of the option that you have sold.

Ideally, you also want to sell calls that will expire in 30-45 days because that is when time value will decay most rapidly.

Now for the comparison:

Let’s say you are NOT that average stockholder (who never sells covered calls.)

Instead, you have taken the time to learn about covered calls, and you now have the advantage of an easily acquired education on the benefits of covered call writing …

You buy 1,000 shares of “Bob’s Car Wash” (BOBC) at $50.00 per share.

The stock now trades to $58.00 per share.

You say to yourself: “I would be willing to sell my stock at $60.00. Let’s see what the BOBC June 60 call options are trading at,” because you know that someone is willing to pay something for the right to buy your BOBC at $60.00.

You find out that you can sell the BOBC June 60 calls for $2.00.

Again, the stock is at $58.00, and so far you are up $8,000.00 on your stock position.

Remember these two keys:

Each option contract represents 100 shares. 10 option contracts represent 1,000 shares. So if you own 1,000 shares of BOBC, and you want to sell someone the right to BUY your 1,000 shares of BOBC, then you would sell 10 call options (to open,) because 10 options represents 1,000 shares.

Some people get confused about selling first and buying second. Traditionally people are trained to understand only buying something first and selling it second. But when you write an option contract (or sell an option contract,) then you are essentially “short” the option contract. You can first sell an option contract at $10 (to open,) and THEN buy the option 3 weeks later at $6 (to close) for a 4-point profit.

So again, BOBC has traded from $50.00 to $58.00 per share.

This time you sell 10 June 60 call options (to open), and you receive an extra $2.00.

That part of the transaction is now done. You now have an extra $2,000.00 in the bank, no matter what happens to the stock.

Now take a look at the difference.

There are four possibilities:

BOBC trades to $60.00+. Your BOBC is called away (sold) at $60.00 per share, and instead of $10,000.00, you net a profit of $12,000.00. ($10k on the stock and $2k on the option that you sold.)

Special note: Your stock will not necessarily be sold at $60.00 just because it trades over $60.00. Your stock may or may not be called away at any time before expiration. If, at 4:00 p.m. on expiration day, the stock is 25 cents in-the-money, or more (which means BOBC would be at $60.25 or higher), the call that you sold will automatically be exercised, and your stock will automatically be called away (sold).
Here is a quick picture of what this would look like.

BOBC trades down. You don’t feel so bad because you picked up that extra $2,000.00. If you didn’t sell that call option, BOBC would have still traded lower, but your account would be worth $2,000.00 less than it is worth right now! Whatever dollar amount the stock trades down by, the decline in value is reduced by $2,000.00.

For instance: If, after you take in that $2.00 premium, your stock trades from $58 down to $55, then instead of losing $3,000.00 in value, your 1,000 shares of BOBC would lose $1,000.00 in value since you will have been paid $2,000.00 for the call option that you sold. (If the stock trades down 3 points, you really only lose 1 point in value, because while the stock lost 3 points, you made 2 points by selling the call option.)
At least you take in an extra $2,000.00, and you will be free of any future obligation once the option contract expires. (Or else you can just close out the call option position by buying the same call back (to close) at its current lower price (see below).

Now here’s a fun twist: You actually have two choices if your stock trades lower.

a) You can do nothing and maintain both the “long” stock position, as well as the “short” call option position until the option contract expires.

b) You can simply buy the option contract (that you previously sold at $2.00) at a cheaper price. Imagine selling a gold watch for $2,000.00 and then buying it back from the person that you sold it to for $300.00. Not bad. That’s a $1,700.00 profit.

As the stock trades lower, the call option that you sold also trades lower. That means that if the stock trades lower, you can always buy the call option (that you’ve sold) at a cheaper price than what you received for it when you sold it. This is a profit on the option trade that will reduce the loss incurred on your stock position.

For example: If BOBC trades from $58.00 down to $55.00, then the call option that you sold at $2.00 (to open) may trade down to 30 cents. You can now buy the call option at 30 cents (to close). That’s a difference of $1.70. Since you originally sold (or shorted) that call option at $2.00, that $1.70 difference is a profit.

Said differently, if BOBC traded from $58.00 to $55.00 the stock position lost $3.00 in value. But since the call option that you sold at $2.00 (to open) is now at 30 cents, you have a profit of $1.70. So the net result is that, instead of your position losing $3.00 in value, it really only lost $1.30 in value.

Stock lost $3.00
Option gained $1.70
Total loss is $1.30

OR – as I said originally, you can let the option expire worthless and realize the entire $2.00 gain on the call. In this case, if the stock traded from $58-$55, then your entire position would have lost $1.00 in value instead of $3.00.

Stock lost $3.00
Option gained $2.00
Total loss is $1.00

After the option expires, you are free of your obligation. If you wish to do so, you can sell another call option and start the process over again.

BOBC doesn’t trade up or down, but sideways. GREAT! As time passes, the call option that you sold (to open) is losing its time value. Since you are “short” the call option, this is a good thing for you. Basically, as time goes by with the stock trading flat, you are making money as the call option loses value due to time decay.
If the stock pretty much trades flat until the option expires, even though the stock did absolutely nothing, you made an extra $2,000.00. This is awesome! Even though the stock never got to $60.00 per share, you still made $10,000.00 as you had originally hoped for! (You made $8,000.00 on the stock and $2,000.00 on the call option that you sold.)

Meanwhile, there is someone out there who was in the same position as you, but since they didn’t sell covered calls, they are sitting on a $58.00 stock, wondering whether or not it will trade to their target price of $60, so that they can make the $10,000.00 that you just made with zero movement in the stock.

The call option expires worthless, you now have two choices: You could either sell BOBC at $58 and skip down the street thinking about how cool you are for making $10,000.00 on a stock that only traded up 8 points, or you could sell another call (to open) that expires the following month or two out. Maybe you can sell the July 60 call (to open), or the August 60 call (to open) and take in yet another extra premium.

BOBC trades somewhere between $58 and $59.99. GREAT! I can’t wait to brag! Let’s say, for example, the option expires worthless, and BOBC is at $59.00 at the time. That means that you made $2,000.00 by selling the call option (you had sold that casino guest the right to buy your BOBC at $60,) and you are also up 9 points on the stock. If my calculations are correct, you are now up $11,000.00, and the stock never even hit your price target of $60.00!
So the moral of the story is this:

When you are long the option contract (said differently: when you are the owner/buyer of the option contract), Time Decay is your worst enemy, because as time passes, your option loses value.

When you are “short” the covered option contract (said differently: when you are the writer/seller of the covered option contract), Time Decay is your best friend, because as time passes, the option that you sold (to open) to someone else, loses value. You can either buy the option back (to close) cheaper, which will result in a profitable option trade (offsetting your stock’s loss of value), or you can let the option expire … which will also result in a profitable trade.

If this covered call lesson has helped you learn something new, then you are probably anxious to get out there and write some covered calls on stock that you own, and start grabbing all of that extra money that you have been leaving on the table each month. But before you do, first consider this last possible outcome …

What would happen, and how do you think you would feel, if you wrote a covered call on BOBC, which obligates you to sell BOBC at $60.00 per share, but 2 weeks later BOBC traded up to $90.00 per share? Hmm.

Before you read any further, think about that for a minute. Do you know what would have to happen in that case?

Well here it is: You would have to sell BOBC to someone at $60.00, even though it is selling at $90.00 in the stock market. Now, that might drive you crazy, even though your original plan was to sell at $60.00 anyway.

Ask yourself, how much of a loser would you feel like if you sold someone the promise that they could buy your stock at $60, only to see it trade to $90, 2 weeks later?

Answer: You should feel like a loser much as the casino feels like when someone puts $2.00 in a slot machine and wins $30.00.

The reason a casino is happy to give up a profit every once in a while is because they make so much more in the long run.

I hope that I have given you a clearer picture of why options can be used as a way to gamble, but also as a conservative way to reduce risk.

Chris Rowe
Chief Investment Officer
The Trend Rider

[Author]

Posts