November 22nd, 2009

Protect Yourself Against An Imminent Market Correction

Winning in this game we love means your portfolio out performs a benchmark index because if all you do is match the market, you might as well put your money in an index fund or market index ETF and not even go through the motions of playing. However, if you do play then beating the market when it trends up is tough and demands near perfect stock selection (pick stocks with positive relative market performance and cut losses from mistakes early). But beating the market when it trends down is easy …. if you successfully manage or avoid the downturns.

The important questions isn’t if it’s true to the Lunar cycle theory or not (last week, the market has sold off 1.6% since the New Moon and there are still seven more trading days until Full Moon on Wednesday, December 2) but where the market will be in 3-6 months and how best (i.e., with the least risk) might we prepare our portfolios to make the best advantage of whatever move occurs.

Optimistically, momentum indicators have finally confirmed that a bull market is intact since the 200-dma just recently crossed above the 300-dma. This long-awaited cross puts all the moving averages in perfect alignment, fastest on top to slowest, with the Index above them all, an arrangement I’ve dubbed a “bullish cross”. In March 2008, the mirror image of this alignment (slowest on top to fastest with the Index beneath all) confirmed the onset of a bear market of major proportions, the Financial Crises Crash. A final step to nailing down the bull market will be when the 300-dma finally turns up for the first time since January 8, 2008. Mathematical extrapolations (see my post “Mark These Dates“) say the turn should occur around December 3 (just in time, coincidentally, with the new lunar phase).

Many traders and investors believe this bull market has unstoppable momentum and has now finally gained a permanence, overwhelmed the bears and will continue for the foreseeable future. But others who look at fundamental economic and financial indicators like P/E ratios or Fibonacci guidelines (50% retracement of bear market decline) argue the market is due for a correction.

I’m in the latter camp, albeit having arrived early (see “Begin Pruning, Trimming and Weeding Your Portfolio” of October 16, “Ascending Everest: the Mid-Station Rest Camp” of October 18, “More Evidence We’re Approaching a Top” of October 23 and “One View of Market’s Future” of November 9). I prefer both the simplest of momentum indicators (moving averages) and the simplest of trend analysis (resistance and support trendlines). They’ve suggested to me from the outset of this bull move in March that the 1125-1150 area could be significant because it is an area of past congestion and an area where equilibriums between buyers and sellers have ended in reversals (in other words, an area of many pivot points). There’s a strong likelihood, therefore, that the area can again produce a pivot point (why? because of market psychology and behavioral finance).

“If so, what’s our strategy”, you must be asking? How can we create some protection with minimal risk while at the same time leave room for upside opportunity in the event that our calculations are wrong? We know that the long-term momentum indicators point to further upside gains; it’s the 10-15% market correction we want to protect against. It’s at this point that the bald former football player on Fast Money shouts, “I hedge my bets through options!” Of course, he’s “selling his book”, as they say on The Street. However, this time he may just be right. What options do we have?

  • “Buy and hold”: only protects against opportunity losses in the event we’re wrong and the market continues going up; but it provides no protection against real losses if the market goes down instead.
  • Diversification: only a partial successes – if you select correct places to diversify into and if all asset classes don’t move in tandem as they did last year.
  • Sell positions and move into cash: outstanding strategy in confirmed bear markets but a less than optimal defense in corrections because it protects against losses but creates opportunity losses if our timing is off either in getting out or in coming back in.
  • Hedge positions: Bingo! Involves limited risk yet offers upside potential

Assume that you have a $100,000 portfolio whose performance moves precisely in tandem with the S&P 500 Index. A simple and direct option hedging strategy is available: buy SPY puts. For about 9.5-10.00% of the value of the portfolio, or approximately $10,000, you could buy ten on-the-money puts with March expiration that would insulate a $100,000 portfolio through increased option value (beyond the cost of the premium). If you were wrong and the market moved up, at expiration you would retain the increase in portfolio value offset by the premium paid for the options.

But the “insurance” premium of the options and exposure to risk can now be reduced without giving up any upside potential because of the introduction of Ultra (2X) and UltraPro (3X) SPY longs and shorts. These ETFs also have call and put options available; because these ETFs themselves are leverage, ProShares now provides the means for a more efficienct leveraged investment “insurance”. This ability of buying options on double and triple ETFs appearsto be an inequality in the market that doesn’t appear to me to have yet been arbitraged away. Rather than costing 9.5-10.0% through options on the underlying security, and equal portfolio value can be “insured” with fewer on the money calls or puts on SPY UltraShort (SDS) or UltraLong (SSO) ETF’s, respectively, for about 4.5%, half the cost. [Because they are only less than 6 months old, I have excluded the UltraPro etf’s from consideration.]

Click here to download a spreadsheet summary of this SDS calls hedge strategy (with comparison to SPY puts), plus this graph:

Note that the spreadsheet is an example using data as last week when I purchased these options. Before you pursue the strategy, you should do your own analysis and evaluation for correctness and appropriateness for your own situation. I welcome comments and suggestions on why my analysis might be faulty or how it might be improved.

November 16th, 2008

Those "Perpetual, In-the-Money Call Options": Follow-up

I know you’re going to find it hard to believe but it’s the honest truth.

I wrote my previous post, Those “Perpetual, In-the-Money Call Options”, at 1:53pm on Sat, Nov 15. I just learned (Sunday, Nov. 16) that Mike Santoli of Barron’s Street Wise column wrote an excellent piece for the on-line version about the various signs indicating the market may be nearing a bottom. He concludes the article by saying:

“LAST YEAR, WITH THE MARKET near what would prove its ultimate high, I noted a perverse pattern in which triple-digit-priced stocks were consistently outperforming other issues, a sign of momentum-chasing speculation (Streetwise, May 14, 2007).

We’ve come nearly full circle, as single-digit midgets abound and stocks are pounded harder once they lose a digit before the decimal place. Ned Davis Research tracks the price of the 25th-lowest-priced stock in the S&P, which tends to mark a low as bear markets culminate, as a marker of speculative juices having been wrung out of investors. It’s now around $6, near levels of the 2002 bottom [emphasis mine], though not yet the 1974 low — near when Barron’s ran a story pointing to the abundance of sub-$2 stocks that were effectively warrants on the survival of American capitalism.”

This is exactly what I concluded, in different ways and to a different end. Ned Davis Research uses the abundance of low priced-stocks as a metric for marking the bottom; I see $’s in front of all those single-digit stocks and see them as opportunities to make large percentage gains through their “non-expiring call options” characteristic.

The Barron’s article, entitle “Welcome to the Mind-Numbing Market” is well worth reading. It was brought to my attention from a recent post again on Barry Ritholtz’s Big Picture.

Great minds do think alike.

November 15th, 2008

Those "Perpetual, In-the-Money Call Options"

While watching CNBC last night, I was struck by the number of single-digit stock prices there were in the quotes crawler band at the bottom. Wow, look at all those non-expiring “options”! Familiar names whose stock price today wasn’t far from where an in-the-money LEAP might have been priced on the same stock last year. Sure, some are low priced because of the strong possibility that they will be worth $0.00 next year. But a good proportion of them carry low prices merely because of fear and today’s investor psychology.

Another way of looking at the situation. Could I put together a speculative basket of some low-priced stocks, put them away and lock them for some time far in the future. Obviously, some will wind up being worth nothing but the % gain on the others would be more than enough to absorb those loses and still generate a very nice profit (o.k., you got me; this just may be one “buy-and-hold” strategy I could endorse).

So how many stocks are there selling under $10? It’s more than you might imagine. According to my chart service data, 41% of the Russell 3000 stocks, or 1201, closed Friday at under $10. Is that amazing or what? And of those 1200 stocks, more than half closed under $5.

Of course, the economy is bad and getting worse but is the world coming to an end? Are all these companies going to go bust? Will this country be thrown back to the 19th century in terms of our economic and societal development? Without taking the time to analyze their financials to understand how bad their condition actually is, here are some of the names in the under-$5 group:

  • TSN (Tyson Foods) – 4.90
  • VOL (Volt Info Sciences) – 4.90
  • PERY (Perry Ellis) – 4.83
  • TWPG (Thomas Weisel Partners) – 4.05
  • LUB (Luby’s) – 4.04
  • PBY (Pep Boys Manny ….) – 3.58
  • MTEX (Mannatech) – 3.38
  • ARNA (Arena Pharm) – 3.40
  • OWW (Orbitz WW) – 3.00
  • SWHC (Smith & Wesson) – 2.54
  • GY (Gencorp) – 2.62
  • RMIX (US Concrete) – 2.10

You get the picture. Granted, some of these will go bust but many of them will survive and, with a high degree of probability, sometime over the next 5-10 years will get into the mid-teens. I can’t guarantee it but that’s the way the pendulum swings. If half go bust and the other half increases by 10%, it’s a wash. If the surviving half doubles (not unreasonable for low priced stocks) while half go bust, the return on the whole basket is 80%. Obviously, if less than half go belly up, the returns improve. You do the math.

The last thing I wanted to see was how this compares to the 2003 Tech Bubble Crash.

The number of stocks closing $5 or less is almost 43% more than there were at the bottom in 2003. The either says this economy and market crash are more severe than conditions in 2003 or that the market is more pessimistic than in 2003 [note: 674 stocks were added to the Index since 2003; Telechart has to explain the 70 missing charts].

In the interest of full disclosure, I need to point out that the stocks comprising the S&P 500, Nasdaq 100 and the DJ 30 faired better vs. 2003 than the smaller firms in the Russell 3000 (or, we’re facing further market declines in the stocks comprising these other indexes). Their results were:

Again, this could be a strategy but one to be considered only after an unequivocal bottom has been established (for example, after the MTI signals the all-clear).

June 30th, 2008

Comparing ETFs vs. Puts on S&P 500 Decline to 1150

In the last post, I presented graphs comparing the price of various indexes and their corresponding PowerShares UltraShort ETFs. But another option for capitalizing on the market decline I believe we’re facing over the balance of the year is purchasing put options instead. The question you should be asking, therefore, is “If I have $10,000 to invest, why not puts rather than UltraShort ETFs?” Well, here’s the comparison:

Put Options

S&P 500

1278

1250

1225

1200

1175

1150

SPY

127.5

125

122.5

120

117.5

115

5 Mos

4,951

6,317

7,942

9,833

11,997

14,423

4 Mos

4,413

5,799

7,471

9,443

11,716

14,271

3 Mos

3,767

5,168

6,901

8,981

11,396

14,120

2 Mos

2,954

4,362

6,181

8,416

11,042

14,000

1 Mos

1,833

3,219

5,181

7,710

10,703

14,016

0 Mos

0

0

3,623

7,246

10,870

14,493

The above table assumes: the funds are invested in put options on the S&P 500 ETF, or SPY, with an expiration of December 31 and a strike price of 125, or slightly under Friday’s closing price of the SPY, or 127.5 (corresponding to the S&P 500 close of 1278). On Friday, approximately 1450 put options could be bought at the closing price of $6.90/option for a total investment of $10,000.

Using an option pricing website like Hoadley or Numa, the options projected value could be estimated at different points in future and for different projected levels of the SPY/S&P 500 Index. If the S&P does decline to 1150 by the end of September (3 months remaining till the options expiration), the total value of the put options would be $14,120. You’d have a loss on the Put options if the S&P 500 Index ends the year at anything more than about 1180 which represents the premium paid and needing to be recouped first.

And how does that compare with purchasing the UltraShorts ETF on the S&P 500 (SDS)?

UltrShort ETFs

1278

1250

1225

1200

1175

1150

127.5

125

122.5

120

117.5

115

5 Mos

9,993

10,579

11,026

11,324

11,771

12,740

4 Mos

9,993

10,579

11,026

11,324

11,771

12,740

3 Mos

9,993

10,579

11,026

11,324

11,771

12,740

2 Mos

9,993

10,579

11,026

11,324

11,771

12,740

1 Mos

9,993

10,579

11,026

11,324

11,771

12,740

0 Mos

9,993

10,579

11,026

11,324

11,771

12,740

If the Index does decline to 1150, regardless of when, the investment would be worth $12,740. As contrasted with the Put which generate a loss if the Index doesn’t decline to 1180, so long as the Index doesn’t increase while you own it, the ETF should produce a profit.

In sum, while the Put might generate a larger profit, there’s a much higher risk of a loss. Betting on the market to decline is risky strategy in and of itself since it’s declined 20% already from the October highs but investing with no chance of a profit unless it declines by another 5.5% (the premium of the Put contract) is more risk than I’m willing to bet.

Remember, this is a strategy aimed at generating some profits if the market declines. The safe route is to sit on cash just waiting this market turmoil to pass.