Are we having a correction or a pause for the next leg up?
As noted by Dave Fry on his weekly SPX chart, the data isn't taking us down yet. And, if earnings don't do the trick for the bears - then maybe Goldman Sachs (NYSE:GS) has a point with its just-released 1,900 prediction for the S&P 500. Given the fact that the Fed is inflating our money supply by about 10% a year and the BOJ is running its money supply up 20% a year - maybe it's not so outrageous to imagine our stock indexes will adjust accordingly.
What's really been disturbing us is that our Materials indexes aren't following though. Not just oil and gold - those are silly things anyway - but copper and iron and corn and wheat and rice and rebar - things that are, traditionally, consumed in a healthy economy.
But this is not an article about whether or not the S&P will be at 1,900 over the next couple of years or whether it SHOULD be at 1,600 now - this is an article about hedging for the upside - especially if you are in danger of being a bit too bearish now.
Often we find that taking aggressive long-term spreads with offsetting puts can give us very nice returns. For instance, in Friday's post, I suggested a bullish play on DBA, which has very much been lagging the current rally and my trade idea on that index (tracking corn, wheat, soy beans and sugar) was:
The DBA Jan $23/26 bull call spread is $2 and you can sell the 2015 $25 puts for $1.55 for net .45 on the $3 spread that's $2.78 in the money to start with a potential 566% return on cash if DBA makes $26 into January expirations.
Although the trade idea can make 566% on cash, it's not a very aggressive play as it's already in the money. The downside is owning DBA at net $25.45 (now $25.95) if it's put to you in January, 2015 and the 2009 spike low on DBA was $22 but it never stayed much lower than $24 for more than a week or two at any point and hasn't been below $25 since July 2010, when the S&P was at 1,050.
So, even in a bearish market - it's not going to be a bad position to work into. And, in a bullish market, you would think it's a no-brainer. Keep in mind you can always sell a few short calls against the position for income - the May $26 calls, for example are .35, 77% of the cash you are laying out for the spread. Not a bad 33-day dividend.
Those are the kind of trades we're looking for, ones where it would defy logic to have a growing global economy and not see at least some long-term improvement in a stock or ETF. Our second pick is one we would think is "too big to fail" - U.S. Steel (NYSE:X) is the biggest U.S. play on steel, which is stuff that usually gets consumed in a bullish economy. About 52% of the company's value is in its Flat Rolled Steel Business and 39% U.S. Tubular Steel, with the rest of the revenues from Coke and Iron Ore. The current price of $17.45 is still well above the 2009 lows of $12. But in 2009, X lost $1B on $16B in revenues, while this year the company is projected to make $122M on $19B in sales. Next year, the company is expected to make $288M on $20B in sales. Meanwhile, at $17.45, the whole company is valued at just $2.5B.
Selling the X 2015 $13 puts for $2 puts us in at net $11, that's $1 lower than the 2009 lows during an economic meltdown. We can pair that with the purchase of the $15/22 bull call spread at $2.80 and now we have a lovely net 0.80 spread that's $2.45 in the money and can make up to $6.20 (775%) if X crawls back to $22 by Jan 2015.
The risk becomes owning X at net $13.80 and let's say X is down to $8 by then. So we double down and then we're in 2x at an average of $10.90. In theory, we could then sell the 2017 $10 puts and calls for at least $3 and that would put us in a $7.90/8.95 buy-write with a risk of a 4x assignment. So I ask you, with X at $17.45 - how much are you willing to own in 2017 for net $8.95? In our $500,000 Income Portfolio - let's say we don't mind owning 4,000 shares at that price for $35,800, which would hit us for about $17,900 in margin. That would be 4x, so our 1x allocation is 1,000 shares, which means there's no reason at all for us not to risk 10 of the above spreads in our Income Portfolio, where we lay out net $800 in cash and take on about $3,300 in margin for a potential $6,200 upside on the play.
Think of $6,200 as our consolation prize for NOT being able to buy 4,000 shares of X at $8.95 if this runaway market continues unabated.
Click to enlargeIf We like steel, so we should certainly like iron. Cliff's Resources CLF has been a nightmare for us before and may be again. But the premise remains that if this massive equity rally is to be believed - as some point along the line, America's largest producer of Iron Ore Pellets should benefit. Like X, CLF is trading back around its 2009 lows ($15.43) but, also like X, that price did not last long and CLF rocketed up to $100 again in 2011. That makes $19.20 a pretty attractive entry right now - especially if we can hedge it too.
CLF 2015 $15 puts fetch a whopping $3.10 for a net $11.90 entry (38% below the current $19.20 price) so those are nice shorts by themselves with a $1.60 net margin, but "only" 150% return on margin there and we're greedier than that, right? Adding the $18/28 bull call spread for $3.20 brings our cash contribution up to .10 but our upside is $9.90 for 9,900% on cash there and THAT's the kind of upside we like to see!
On margin, we move up to $4.50 so it's about 200% return on margin - still very efficient if CLF manages to recover some of its former glory. But as with X, the key is that we're only making a 1x commitment on the short side. So even if CLF falls all the way to $10 (50% down) and we net in for $15.50, we could double down and have 2x at an average of $12.75. We already have 10 short 2015 $18 puts AND 10 short January $23 puts in our Income Portfolio, which we collected $7,600 for. So let's add 10 of the bull call spreads at $3.20 ($3,200) to give ourselves another nice block of upside if things go well.
Keep in mind that we're already well-hedged to the downside with 100 DIA June $144 puts in our Income Portfolio as well as 30 TZA May $38/44 bull call spreads. So we're going to be disappointed if CLF, X, etc. just go straight up from here, but we can console ourselves with our massive long-term gains, I suppose.
So that's three trade ideas that are based on the basics of an economic recovery, Food, Iron and Steel. We could go for copper, Freeport McMoRan (NYSE:FCX) is very attractive at $31.92 but our Income Portfolio already sold the 2015 $25 puts for $3.60 back in February and those are $3.20 now so just on track.
Though FCX is about 25% gold, I think we're better off here with a pure gold play as gold could do well in a collapse, as well as a rally. Barrick Gold (NYSE:ABX) has been "killing" us lately and we took a 2015 spread where we sold the 2015 $25 puts for $3.30 on March 18th. Now, with ABX at $22.62, those puts are $6.50. Of course our net on 15 short puts is $21.70, so the "loss" is a bit of an illusion, unless we get out of the position and make it real(ized).
We REALLY wanted to own ABX for net $21.70 in 2015 and it remains to be seen if we REALLY end up being able to but, for now, the fact of the matter is that the 2015 $20 puts can be sold for $3.30 for a net $16.70 entry, 26% off the current price. The net margin on the put sale is $2 so very margin-efficient by itself and ABX bottomed out at $20 in October of 2008, but only very briefly and this is it's first time below $25 since December, 2008, when gold was $950 an ounce (now $1,482). Very, very silly pricing on ABX but, YAY!, more for us! If we pair that sale with the purchase of the 2015 $20/30 bull call spreads at net $2.95, we STILL net a .30 credit on the overall spread (so the worst case is you end up owning ABX for net $19.70, another 10% off the current price) but now we have a spread that's $2.62 in the money to start with a $10.30 upside at $30 for a 3,090% potential upside to our cash credit. That should keep you hedged against anything but Zimbabwe-style inflation!
That's the point of these upside hedges. You don't have to believe we'll have runaway inflation but if you are willing to risk owning $19,700 worth of ABX (1,000 shares) then you can risk taking a $300 cash credit today. If inflation pushes gold back up and ABX recovers just a little of what it's lost over the next 20 months, then you put $10,000 in your pocket in January of 2015. As I often say, a good hedge is one where you make (in this case) 3,090% on cash but you're still pissed off that it didn't go the other way and give you the cheap entry.
Click to enlargeFinally, for hedge #5, let's stick to the basics and pick an index, any index. Well, not just any index, how about the index that's lagging the others by more than 5% and is still almost 40% off it's all-time highs. That's right, the Nasdaq. The best thing about being bullish on the Nasdaq is that it's a proxy for being bullish on Apple (NASDAQ:AAPL), only without the constant ulcer. In fact, back when AAPL was crashing, our $25,000 portfolio was down about $50,000 due to a heavy AAPL commitment and we split it into 2 portfolios, one "Aggressive" that's still going for the big win on AAPL and one that was "Margin Sensitive" for people who wanted to be more Conservative in trying to recoup those AAPL losses.
By switching to the more conservative strategy in the Fall and concentrating on a long QQQ position while selling the front-month QQQ calls for income - we have been able to shave the loss on the $25KPM down to $2,588 - almost a full recovery in less than 6 months while the $25KPA is still down $43,006 BUT, as I noted, sitting aggressively on 10 AAPL Jan $425 longs that gain $43,000 if AAPL can climb back to $500 by the end of the year, with anything else being a lovely bonus.
So where were we? Oh yes, going long on the Nasdaq! Well, that's easy as our $25KPA has the QQQ Jan $65 calls, which we bought for $5.99 on 10/24 and are now $6.74 - not too exciting for a 10% move up in the Nasdaq since then BUT the point is how well it works when we can sell calls against the position. With the QQQs at $69.94, the January $65 calls can be bought and covered with the sale of the $70 calls for $3.50 for net $3.24 on the $5 spread. While that doesn't sound sexy by itself, did you know you can sell the AAPL Jan 2015 $300 puts for $22.50? We could sell one AAPL 2015 $300 put to pay for 7 of the bull spreads on the Qs and that's $3,500 worth of upside on those against the downside of owning AAPL for 30% off it's current price in Jan 2015.
Click to enlargeThe true net cash commitment for this trade is $180, to make up to $3,320 (1,844%) if the Qs move up 6 cents and hold that (or over) through January of this year. It's also very important to note that the margin for selling 1 AAPL 2015 $300 put is $52, so this is our least margin-efficient trade. But if you like AAPL and don't mind owning 100 shares for net $300 ($30,000) then this trade can give you nice $3,500 bonus while you wait until things go well. You could substitute a short put on any stock you don't mind buying if the Nasdaq drops 30% instead of rising 0.1% (0.06 on the Qs) and I'm not even going to mention that AAPL would almost have more cash than the stock price at $300 in 2015 - I think I've made my bullish case on AAPL often enough to leave it at that.
So lots of fun ways to participate in the next mega-rally. We don't need S&P 1,900 - just holding 1,600 would do us quite well and I cannot emphasize enough that these are HEDGES to our current BEARISH stance - just in case we're wrong and a correction never comes and the markets go up and up forever and all of our bearish positions expire worthless - you know - what Cramer is promising...
Disclosure: I am long AAPL, DBA, X, CLF, ABX, SQQQ, TZA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Positions as indicated but subject to change (fairly bearish mix of long and short positions - see previous posts for other trade ideas).