Options Trader Weekly Review: Not Such a Good Week

by: Philip Davis

Not such a good week!

Last week was FANTASTIC. We had 28 winning trades out of 36 with an average gain of 42% on the winners and an average loss of 12% on the losers - now THAT’S A GOOD WEEK. We were stopped out of most of our bearish trades on Monday but we took a lot of new ones, which I’ll get into later... Of course, since we are rangish and play both ends, the good news is we still had our "losers" and puts that we sold on long positions. Those turned into huge winners in just 5 days:

  • Alcoa (NYSE:AA) at $13.30, out at $15 - up 12.7%
  • Apple (NASDAQ:AAPL) Jan $165 puts sold for $7.40, now $4.70 - up 36%
  • Bank of America (NYSE:BAC) Oct $17 puts sold for .97, now .28 - up 71%
  • DIA Nov $92 calls at $5.40, now $7.30 - up 35%
  • McGraw-Hill (MHP) 2011 $25 puts sold for $5.20, now 5.10 - up 2%
  • Research in Motion (RIMM) March $100 calls at $1.45, now $1.25, down 13.7%

So, of the six that were not working last week, five are winners this week. As I mentioned at the end of last week’s wrap up, we were more than satisfied with our 5% drop that week. We did expect a bit of a bounce but we made the mistake of thinking the 250 points we gained by Tuesday morning was the end of it. But at the end of the week, we were another 100 points higher and right back where we started from when we shorted into the rally in mid September.

Last weekend we were at a great point in our range as all our put plays had just paid off. This will be an interesting contrast as we have serious problems with our new short plays and we have a little less conviction than we had in mid-September that we will get our correction. At least, not after such a sharp turn off the 5% line this week. Nonetheless, we did stay 55% bearish into the weekend overall - still playing for our range. But, I’m getting ahead of myself, so let’s go back to Monday and see how we got here….

Monday Market Manipulation - Goldman’s CIT Bonanza

I was not at all pleased with the scam Goldman Sachs (NYSE:GS) was running on CIT Group (NYSE:CIT) and neither were many in the press. But their attention span lasted all of 24 hours as the markets mysteriously began to take off, neatly drawing people’s attention elsewhere.

Our concern over falling tax revenues and record deficit spending led us to conclude that TBT would be a good play right in the main post. It was a play that came out of our weekend discussions in member chat where we decided the single best hedge for the uncertainty ahead was going to be the ultra-short on Treasuries. All roads seemed to point to a rate increase down the road, but we had no idea it would happen so soon! The play we took was a 2011 spread. I don’t review spreads in the wrap-up because they are not directional and take too long to play out whereas our directional plays follow clear rules and are either on or off target. I will say that spread is up 20% already this week. So we’re very pleased and TBT is now well above our $43 target, which yields a 90.5% return if we hold it through Jan 2011.

My comment from Monday’s post was pretty much our gameplan for the week:

As I mentioned on our Weekly Wrap-Up, we went into the weekend fully covered on our long index hedges as we have come to expect shenangians into the weekend. I also posted a comment early Saturday morning that we need to remain VERY cautious because we know it’s all BS manipulation. The fact that we know this is BS won’t stop the markets from going higher on low volume. Especially with the crap I saw Friday morning where the Pound was jammed back to $1.60 and the Euro hit $1.465 even though the Yen "fell" back to 90 to the dollar and oil was pumped up over $70 with gold back at $1,007. So, "amazingly" the dollar was strong against the Yen when the Nikkei was open despite being very weak in Europe. That kind of meddling (probably by Japan, not GS) makes for a very dangerous investing climate.

Watch gold, oil and copper to give you a real sense of the economy and the critical levels to watch in the markets are: Dow 9,535, S&P 1,032, Nas 2,070, NYSE 6,668 and [Russell] RUT 586, which are the expected bounce zones off our 5% rule.

By 9:44 in Member Chat, we noted the action was turning bullish and I said:

Transports moving higher very fast (NYSEARCA:IYT) on no volume. Looks like we will be getting an early morning pump as SOX are flying too and that means horesemen probably next.

That led to RIMM being our first directional trade of the day:

  • RIMM Nov $65 puts sold for $3, now $2.25 - up 25%
  • DIA Oct $97 puts sold for $2, now .37 - up 81%
  • GLD Nov $101 puts for net $3 (rolled from $98 puts), now $2.10 - down 30%

Of course on a play like GLD, we scale into the short position so consider you have $5,000 to play the short with. You buy $1,000 worth of $98 puts first. If it goes your way, great, take the money and run. If it goes against you (and gold did by gapping up the next day) you decide to kill the position or add to it (scale in, a form of dollar cost averaging) or roll. In the case of the GLDs, since we thought the dollar was being manipulated lower and the gold run wouldn’t last, we rolled up to a higher strike for .90. That takes our example’s $1,050 commitment (5 contracts at $2.10) up to $1,500.

We still have $3,500 cash on the side for this trade, which is why we’re willing to have a 30% loss at the moment as it’s 30% of 30% of our allocation and, if our allocation is 10% of the portfolio or less, then we are looking at no more than a 1% loss so far. Options are volatile and scaling into positions is essential, as is cutting losses. There are detailed discussions of this in our Strategy Section so I won’t rehash the whole thing here.

Tempting Tuesday - You Call that a Sell-Off???

We were incredulous, to say the least about the rally. My critical mistake of the week was thinking we were in the same pattern as the previous week, where a big spike on Tuesday led to the drop-off we had been waiting for. 69230.strip

I should have listened to my morning self, as I wrote right at the top of the post:

We may have gone a little too bearish yesterday as we don’t have the same catalyst today (Consumer Confidence) to take down the market that we had last week. We have another Consumer Confidence report this evening at 5pm, but that doesn’t stop the pump-monkeys from attacking the dollar this morning as they float rumors that the dollar will be replaced by OPEC as an exchange currency. This sent the dollar down to 89 Yen and $1.475 to the Euro and $1.605 to the Pound - all based on nothing but a rumor.

I often discuss with members that the danger of being a good fundamentatlist is that you can be totally right, but have the timing wrong. And then that’s just as wrong as if you didn’t have a clue in the first place. I made my case for the dollar, pointed out that the M3 Money Supply was falling, not rising and that consumer spending was contracting, not increasing but none of that stopped gold from gapping up $30 that morning and adding another $10 by the week’s end.

In my 9:47 Alert to Members I laid out our strategy:

Don’t forget to roll up or add to any short position you want to stick with if you are at an early point in your scale. But we’ll have to wait out a test of Sept upper consolidation areas most likely, which are: Dow 9,700, S&P 1,060, Nas 2,120, NYSE 6,950 and Russell 610.

We protected ourselves with a QQQQ bull call spread ($41/42), which made us 22% and took the sting out of our bad gold bet at least. Other plays were:

  • DIA Oct $98 puts sold for $1.88, now .65 - up 65%
  • DIA Oct $99 puts sold for $2.30, now $1.07 - up 49%
  • EDZ at $6.59 (buy/write), now $6.43 - down 2%
    • I’ve decided to track our hedged buy/writes as a straight stock play, just so we don’t forget we took them. Our buy/writes usually have a 15-20% discount built into the purchase. (see "How to Buy a Stock for a 15-20% Discount").
  • TZA at $12.07 (buy/write), now $11.32 - down 6%
  • RIMM Nov $65 puts sold for $3.30, now $2.25 - up 28%

That’s two days in a row so you know I liked that one a lot!

  • Mosaic (NYSE:MOS) Oct $50 calls sold for $1.10, now .75 - up 31%
  • MEMC Electronic Materials (WFR) Nov $16 puts sold for $1.35, now 1.20 - up 11%
  • Freeport-McMoRan Copper & Gold (NYSE:FCX) Oct $70 calls sold for $2.50, stopped out at $3 - down 20%
  • OIH Oct $120 calls sold for $2.30, rolled to a spread of Nov $120 puts and Oct $125 puts
  • FXP Jan $10 calls for $1.35, now .90 - down 33%

Notice the pattern that is forming, we were long on tech and semis and shorting oil, China and commodities. TZA is a hedge against small businesses having credit issues and EDZ is a hedge against a monetary crisis in the Baltics. Unfortunately, I was already seeing some problems with our strategy that evening and I said to Members in chat:The Bad News Bears

Bad news bears: I’ve been mulling over what rational explanation there could be for a huge run in commodities, despite the fact that 15% of the global population is not working (so clearly 10% less commodities being used). The only logical rationale is "they" are anticipating a massive stimulus program, one that will tank the dollar and spike commodities and boost stocks despite the fundamental economy… Only a completely worthless currency can justify people buying oil, gold and copper at these prices. And even then, you’d run out of room in storage (we already are with oil and nat gas) and crash the market anyway so there has to be an end game on demand and that can only be a stimulus project. Notice Caterpillar (NYSE:CAT) and Deere (NYSE:DE) are on the move too, that’s a stimulus sign. It would have to be something with infrastructure that makes a lot of jobs…

My early Wednesday morning Alert to Members had the following commentary:

Maybe I’m nuts for thinking this kind of stuff matters. I really intended to find some upside plays but this is just like last week where I can’t, in good conscience, make a bunch of bullish plays that I simply don’t believe in given the economic situation.

We’ll continue to find acceptable long plays like RIMM and WFR and earnings should give us lots of opportunites to pick up stocks that have bad quarters and sell off but I can’t go chasing things up here until we break out over our 33% levels across the board and we’re only waiting for 6,959 on the NYSE so that’s not too much to ask (60 points) is it? Thirty-three percent on the Transports is 2,086 and they were a good top indicator in Sept so we should take that seriously too. SOX need 362 so they are pretty hopeless at 319 but also gave a clear top signal a couple of weeks ago so we’ll keep our eyes on them.

The Hang Seng is just below its 33% mark (21,440) this evening so that will be interesting but the Nikkei is miles away at 9,806, needing 12,261 to get within 1/3 of its crazy highs. The FTSE is within striking distance of 20% off and the DAX is just over 33% but the CAC is nowhere close, currently 8.5% below 33% off at 4,200 so Europe is, in short, all over the place and not a great indicator. So not much resolved this morning but at least we know what we’re looking at…

Will We Hold It Wednesday?

We were still too far ahead of ourselves and I said in the morning post:

What is keeping us most bearish is that I think the dollar is way oversold and this "rally" has been nothing more than a commodity run spurred on by severe dollar weakness that, as I pointed out yesterday, is being driven by rumors - not fundamentals. David Merkel has an excellent article on the dollar this morning.

Despite David Merkel agreeing with us, our watch levels did not and we decided to take DBC as a cover since I didn’t mind owning that ETF long-term:

The 2011 $20 calls are very reasonable at $3.90, with just $1.77 in premium over 15 months (.12 per month) and you can half cover with Nov $23 calls at .40 to knock out the premium and give you a 2.5% return on your investment in the first 45 days. We also like our bull call spreads in these situations and the April $19 calls are $3.55 and you can sell the Apr $22 calls for $1.70, which puts you in the $3 spread for net $1.85, which pays you back 176% if DBC holds $22 through April.

The 2011 $20s are now $4.40 (up 13%), offset somewhat by the .125 per long gain on the 1/2 covers. The April spread is now $2.10 (up 13.5%), which is what we want to accomplish with long cover spreads as they tend to be much bigger bets than our individual front-month plays so we do not seek the same kind of volatility we get in the shorter-term contracts. Conceptually, if we have 5 $5,000 plays we are scaling into, they may have an average of $2,000 committed on each ($10,000). We may also feel that a big move against us will cost us $3,000. That being the case, we may take perhaps $6.000 worth of the long cover spread as that should make about $2,000 back on a big move (it made $1,000 on a small move already) but shouldn’t lose much more than $1,000 should our $10,000 group turn around and gain 30%. That’s what good hedging is all about.

It is having those hedges in place that allow us to take chances with short-term plays. Yes, it is still possible to get blown out of your positions but very big market moves - that is how hedge funds "blow-up". But if you consistently employ this kind of strategy year after year, it is the best vehicle for achieving above-average market returns. We generally want to move our balance from 60/40 bullish to 60/40 bearish, depending on where in the range we find ourselves. The reason we have so many misses this week is that we’re hitting the top of our expected range and, if we break it, we’ll have to scramble to get more bullish. However, our additional picks on Wednesday were still moving us towards a more bearish stance:

  • QQQQ Oct $41s at $1.20, now $1.60 - up 33%
  • Amazon (NASDAQ:AMZN) Nov $95 calls sold for $6, now $6.30 - down 5%
  • AMZN Nov $85 puts sold for $2.70, now $2.15 - up 20%
  • Baidu (NASDAQ:BIDU) Oct $420 calls sold for $8.30, now $14.20 - down 71% (rolling, of course. if we have to)
  • Whole Foods (WFMI) Nov $30 calls sold for $2.40, now $2.90 - down 20%
  • Progressive Corp. (NYSE:PGR) Feb $17.50 calls at .80, now .80 - even
  • First Solar (NASDAQ:FSLR) Oct $155 calls sold for $5.10, now $5 - even

That left us pretty darned bearish overall and AA had a beat that day and my comment on that was:

Like everything else, AA is simply limboing under a very easy bar of expectations. After earnings expectations were revised down 207% over the past 7 quarters, they are now up 16% from last October’s -47% (which most companies missed). So +16% after being down 47% last Q is 116% of 53% or 61.48% of the Oct ‘07 earnings. Woo-hoo, break out the bubbly!!!!

Sarcasm on AA aside, I was worried enough that we could pop through our levels, that I made a special Members only Watch List. In it we started lining up some bullish positions should we break over the September highs on 3 of our 5 indexes.

I set new upside targets that I considered a "real" technical breakout and those were: Dow 9,829, S&P 1,071, Nas 2,146, NYSE 7,047 and Russell 620 and once again I was brilliant in my targeting as we finished the week at Dow 9,864, S&P 1,071, Nas 2,139, NYSE 7,015 and Russell 614. Our rule of thumb is: We’ll play bullish if 3 of 5 of our indexes are over and we’ll then use the 3 of 5 rule as an indicator to get more bearish again.

Thrilling Thursday Morning

As you can see from the image I chose on Thursday morning, we were expecting some fireworks on Alcoa’s earnings. Despite our own misgivings, we play the crowd, not the fundamentals at times like these. Also, Mr. Cramer and company were acting as though AA was turning tin into gold, rather than just being less pathetic than originally thought… We were long on AA but we hit our $15 target and got the hell out. We also got better-than-expected jobs numbers on Thursday but 520,000 more unemployed people is not something we should celebrate just because it wasn’t 540,000.

My morning commentary was:

My overriding concern is still that the dollar is way too low and although it’s making China happy (their Yuan is pegged to the dollar so Chinese exports are super-cheap again), it’s making Japan miserable and Europe is starting to get very nervous as well.

I pointed out that the Chinese and OPEC SWFs both had a vested interest in keeping the dollar down and that:

I still think we’ve come too far too fast and this "great" data is already baked into the valuations. But it doesn’t matter what I think - it matters what Yi Gang thinks, so we’re just going to watch our levels and buy accordingly.

In the morning Alert, I said to members:

I still, in my heart, don’t believe in this rally so I’m going with strictly mechanical betting based on the levels. You have to take the emotion out of it when the market goes nuts…

  • EWJ Dec $10 calls at .30, now .35 - up 14%
  • TBT 2011 $28 calls at $16.20, now $19.50 - up 20% (vertical spread)
  • TBT 2011 $35 calls at $11.20, now $13.90 - up 24% (vertical spread)
  • USO $37 puts for $1, out at $1.60 - up 60%
  • USO $38 puts for $1.70, out at $2.50 - up 47%
  • TZA Nov $12.50 puts sold for $2, now $2 - even
  • GLD Oct $101 puts at .45, now .50 - up 11%
  • SRS Nov $9 puts sold for .80, now .75 - up 6%
  • FSLR Oct $155 calls sold for $6.10, now 5 - up 18%
  • EDZ at $6.52 (buy/write), now $6.43 - down 1%
  • EDZ Nov $7 puts sold for $1.20, now $1.20 - even
  • DIA Oct $98 calls sold for $1.10, now .65 - up 40%

Still generally too bearish but notice most of my trade ideas are for selling premium, not buying it. We were taking advantage of the still-high VIX to sell a lot of puts and calls to other people, as it gives us a little leeway in case things don’t go well. Notice FSLR, for example, was a 2nd round for those who took our Wednesday sale at $5.10. By scaling in, the position had lost 20% at $6.10 so if we had 2 contracts sold at $5.10 ($1,020), we then sell 2 more at $6.10 ($1,220) and we then have an average basis of $5.60 sold on 2 contracts. As we explain in our Strategy section, once we get back below $5 (and those calls fell to $4.30 on Friday morning), we can buy back 2 contracts, which leaves us with 2 and a sold basis of $6.20 again (the $5.60 average plus the .60 profit we took off the table on the half sale).

From that point we can set a stop, say, back at $5.60 to lock in those profits. Or we may even decide to add some more. But generally, with naked call selling, we don’t intend to use a full scale, it’s just our fallback cash in case of an emergency. Using FSLR as an example, if we sell 2 at $5.10 and 2 at $6.10 and it kept going up, we would have rolled our $2,440 obligation up to the Nov $175 calls (now $5.70). Had those gone in the money, we would likely roll them to the Jan $210 calls.

The point is, if you ask me today am I willing to sell FSLR (now $156) Jan $210 calls (now $3.60) for $6? I would be THRILLED to sell more than 4. At each rolling or scaling point, we need to make a similar decision - if this move doesn’t work, are we willing to make the next adjustment. If not, it’s simply time to take our losses and close the trade…

Friday - The Fed Finally Supports the Dollar

This was the day that confused me the most all week. I was thrilled that Bernanke and others finally came out supporting the dollar, right on our key support (hopefully) line at 76. I thought we’d be "ringing the register" on our short plays and going into the weekend with much more cash but the great market sell-off of October 9th lasted all of 3 minutes before the buying began - nowhere near enough time for us to do anything but watch as the Dow jumped 50 points in 15 minutes. My morning post outlook was:

We’re bearish but well-hedged but ready to get more bearish if we get a proper breakdown. As always in this crazy market, we take our bear-side profits quickly off the table because they sure don’t seem to last long. Our upside breakout levels remain Dow 9,829, S&P 1,071, Nas 2,146, NYSE 7,047 and RUT 620 and we tested but did not break them yesterday - which is why we ended up with so many bearish bets. Our aim is to go neutral into the weekend, we’re not expecting a cliff dive and Monday is a holiday and should have slow trading, which usually means an up day.

As I mentioned, things went against us very quickly and my 9:44 Alert to Members said:

No change in status on our covers yet, we still could go higher and retest the highs as the volume is very low this morning so far.

Friday trade ideas were as follows:

  • ERY Nov $12 calls at $1.75, now 1.65 - down 6%
  • DUG at $13.36 (buy/write), now $13.39 - even
  • Oil short at $72 in the futures, out at $71 - up $1 but the futures pay $10 per penny per contract so very nice there!
  • URE at $5.80, out at $5.86 - up 1% (we were using it as a hedge on our SRS etc)
  • BIDU Oct $430 calls sold for $7.20, now $8.60 - down 19%
  • Rite Aid (NYSE:RAD) at $1.57, now $1.56 - down 1%
  • RSX Nov $28 puts at $1.15, now $1.10 - down 4%
  • QID $22 calls at .90, now .90 - even
  • URE at $5.80, now $5.91 - up 2%
  • DIA Nov $97 puts sold for $2.05, now $2, up 2%

Again, way too many short picks and we went into the weekend still officially 55% bearish (using covers against open positions to even things out). But we're very nervous as we are both pushing up against our breakout levels AND in the top of the 5% rule range (indicating follow-through is likely) AND heading into a low-volume holiday trading day on Monday that I already said would likely be an up day. Why then, you may ask, are we still bearish? Well, as the great stock analyst Elaine once said, this whole "rally" just seemed fake, fake, fake, fake!

We sure have plenty of bearish bets on the table, but we also recognize the need to take up some aggressive bullish positions if our indexes give us another green day on Monday. Of course Monday’s and October don’t always go well together… We have tons of data and tons of earnings next week but it’s a strange one as there is no data until Wednesday next week. so nothing to stop this crazy train until then-- other than a major earnings miss. Starting Weds though, we have huge data including Retail Sales, Biz Inventories, Fed Minutes, CPI, Philly Fed, TIC Flows, and Industrial Production. A week later, on 10/21, we get the Beige Book and that’s always a mover. Nothing with earnings Monday. Next week looks like:

So we’ll have a damn good picture of the economy by Friday and Weds, with all that data and earnings can move us 300 points up or down. It’s going to be fun! As I said in my closing Alert to Members:

I’m rolling up my short plays (better strikes, more shares) and keeping well covered. Monday will be another low volume day but if they don’t break us over on Monday, that should be of major concern to the bulls.