Federal spending cuts and tax increases are looming, nay, circling and closing in as the year draws to a close. The tax environment is likely more favorable for closing positions now than it will be next year. There are a lot of gains out there yet - the broad market is still up about 10% for the year. Economic data is unlikely to bail us out. Add the insult of uncertainty about exactly which horrible outcome will play itself out and it is no wonder the markets have been getting slammed.
It's been shock and awe since the election, and frankly we are surprised that sentiment isn't much, much worse. We expect the next few weeks will have markets crying like a hungry baby, reminding everyone how scary that is, and lawmakers will scramble to be the ones that save the world in a market-friendly manner.
But no matter what lawmakers announce in the next thirty days, we do not believe it will be substantive. We think markets will not be satisfied until they've had the chance to give us a front page scare and put the dreaded "2008 again?" question back on pundits' lips. Bluntly, we think the rest of the year is a bear market, pure and simple.
We've been tracking our $33,000 American Portfolio seeking acceptable risk for the average investor. We now also wish to track trades that are more risky and shorter term. We will call this the $100,000 Bold Trader's Portfolio and start with (drum roll please) ... $100,000. The goal of this portfolio is capital appreciation through short term trading.
We expect financials to get slammed again - the value of their holdings is a block box of uncertainty to begin with, and the tax code affects them in incomprehensibly numerous and complex ways. That is the definition of financial uncertainty.
Bank of America (BAC) certainly fits the bill. We think others like Citigroup (C), JP Morgan (JPM), US Bancorp (USB), and Wells Fargo (WFC) are in trouble too but BAC is up a whopping 63% for the year. With profits like that and an uncertain outlook, we think America's bank gets slammed by fearful profit-takers.
Another reason we picked Bank of America is that its options are very liquid - lots of volume and tight spreads (a few pennies difference between the bids and asks).
We like the time frame of December 22 expiration for the puts we would like to buy. Let's look at those:
Those puts with a $9 strike and 36 cent asking price fit the bill. If BAC gets below $8.64 between now and December 22nd, it becomes profitable. Before we pull the trigger, let's look a little further out in time, to May:
If we paid for the extra 5 months and got the same puts for 94 cents, those options would become profitable if BAC goes below $8.06. We like the extra time but not the loss of profit. What about those $11 puts going for $2.25? If BAC goes below $8.75, it becomes profitable, which is better than the $9 December puts, but the amount of time we have is nearly six-fold. In addition, if BAC were to remain where it is, we would recoup most of our investment, whereas the $9 puts are a total loss. The trade-off is that to equal the amount of return the cheaper puts can provide, we have to risk more capital, but that's what we choose.
We like to do things in thirds, our total bear play will be a third of the portfolio and this trade will be one third of that.
- Buy 50 BAC May 18 2013 $11 Puts @ $2.25 = $11,250
What's the upside? While we break even at $8.75 we could have a payday if BAC drops all the way to $7. In that case our puts are worth:
50 Puts X 100 shares per put X $4 intrinsic value = $20,000
Agnico-Eagle (AEM) made a snazzy video of CEO Sean Boyd saying "as we move into 2013 it's more of a consolidation year, it's a building year." Ouch. Well, as long as no one would be tempted to take profits, how has 2012 treated you?
Up 42%, aye (as they say in Canada, which is a mess)?
With an uninspiring short-term outlook and profits to be taken, it is no wonder this Canadian miner was down so much today. We think the slide continues and this one could see 30s by the end of the year. So let's look at the options:
We think this looks juicy. Let's start by selling some $50 strike calls with a bid of $3.15. We think there is no chance those calls expire in the money and we will use them to help fund the rest of the trade:
- Sell AEM 20 December 22 $50 Calls @ $3.15 = $6,300
Safety first, we will buy some higher strike calls to give us a stop loss in case someone like Barrick Gold (ABX) comes out of left field and buys them out:
- Buy AEM 20 December 22 $55 Calls @ $1.01 = $2,020
If the Eagle lands above $55, we will be on the hook for the 5 dollar difference, times 2,000. So that's $10,000, minus the $6,300 we were paid, and plus the $2,020. So if all fails, we would be down $5,720. Best case is both calls expire worthless and we keep the difference, $4,280. We break even right over $52:
We'll increase our exposure to one-ninth of the portfolio by going for the jugular and buying some puts. Let's give ourselves a little more time and look further out on the calendar, to January:
Looking at the $50 strike puts, we can see that for less than a dollar per option we can get another month from December, and some of those days could be crucial with respect to the fiscal cliff. We like those puts:
- Buy AEM 20 January 19 $50 Puts @ $2.51 = $5,020
If AEM goes to $40 by January 19th, we'll have quadrupled our outlay:
20 calls X 100 shares per call X $10 intrinsic value = $20,000.
It would be a shame if we were right about the trajectory of the market but picked two bad plays, so our third play is a short term bet against the broader market. We'll focus on technology (never considered a safe haven) and look at the NASDAQ PowerShares (QQQ):
We like that $4.37 bid on the call with the $58 strike. We think the QQQ's can easily fall under that price in the tumultuous month ahead. We'll sell calls at that strike and protect ourselves by buying the $63 calls.
- Sell QQQ 70 December 22 $58 Calls @ $4.37 = $30,590
- Buy QQQ 70 December 22 $63 Calls @ $.97 = $6,790
Our downside is again limited here to about one ninth of the portfolio. If the Q's settle above $63 we are out:
70 Calls X 100 shares per call X $5 intrinsic value = $35,000
However we netted $30,590 - $6,790 = $23,800, so our exposure is $35,000 - $23,800 = $11,200.
Best case scenario is the Q's close under $58 come December 22, and we net $23,800. Break even is a little lower than where we are now:
If the Q's close at $62 we owe 70 X 100 X $4 = $28,000. $28,000 - $30,590 + $6,790 = -$4,200.
If the Q's close at $61 we owe 70 X 100 X $3 = $21,000. $21,000 - $30,590 + $6,790 = +$3,200.
Until Next Time
These trades might be too risky for most people so please use this to play along vicariously or as a starting point for further research. We have tried to be aggressive without being stupid, even if the next great bull market begins tomorrow, we kept our maximum losses to one third of the portfolio and will have plenty of dry powder. If we are right, that will be very handy in the bottom coming in January.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.