Options Trader: Weekly Wrapup

by: Philip Davis

What a crazy week!

I pretty much did a wrapup yesterday morning (I think I stopped myself at Thursday) but I just put up a blow-by blow account of Wednesday which we will put in the educational archives as an example of how to remain calm and rational while the markets are falling apart.

I think the great advantage of having a community like ours is that we can always have someone to talk to when things get tough. It’s very hard having to deal with tough weeks on your own, with no one but an overworked broker to talk to about your account…

Luckily our game plan for the week (hedged and ready for a drop, weighted heavily on oil sector and homebuilder puts) was pretty much exactly the right way to play the market. On Tuesday I used the China Syndrome to describe the market and either it wasn’t that original or a lot of media people read us because that was the phrase that paid for the rest of the week.

We pulled most of our big winners off the table last week as I said at the time: "Keeping the bulk of the portfolio fairly even as we cherry pick the winners and sell them in a nice non-greedy fashion…The ripples are spreading and starting to affect the people who lend money to the lenders like Lehman Brothers Holdings (LEH) and The Bear Stearns Companies (NYSE:BSC), who both took 5% hits at the end of the week - but don’t think the buck will stop there in this very tangled web of sub-prime financing..."

Maybe I was a little too prescient on Monday when we talked about the margin calls and the new SEC regulation and concluded, "We are gonna party like it’s 1929 as this is a rollback of laws that were put in place during the great stock market crash in order to prevent this sort of nonsense…"

Stock Market Crash Ahead

I maintained my grumpy attitude despite the markets flying up in Monday’s pre-market futures and I cautioned: "With all that money pouring into the markets you would think we should be heading up from here but let’s make sure we are really breaking up before we all go and drink the Kool Aid."

(At this point in the article I’d like to point out to the Wall Street Journal that I have used just a single exclamation mark to convey my thoughts today - criticism taken constructively, thank you!) Oops, make that two …

We closed Monday very worried, and I said: "We didn’t hit one level! And after having such a nice open - not a good sign…On the whole, nothing to celebrate. Al Gore won an Oscar and in his film he said Antarctica was "a canary in the coal mine" - I wonder what he would think of today’s market?"

"Markets are not looking that good - still on my iShares Russell 2000 Index (NYSEARCA:IWM) puts - way too dangerous looking. That was a terrible pullback off the morning open on the Dow and Nas! I was looking for oil to buy and I ended up adding to my puts… "

Well, you know the rest of the story. By Tuesday morning it was too late to do much about it as the Shanghai Stock Exchange dropped 9% and I pointed out: "A 9% drop is VERY bad over there as they have a 10% limit down on Individual securities, so that indicates a pretty broad and nasty sell-off."

What was the strategy that morning? Since we were well covered on the downside we decided to go shopping: "In a move that may finally goose our American International Group, Inc. (NYSE:AIG) leaps, French reinsurer SCOR (NYSEARCA:SCO) is attempting a hostile takeover for Swiss reinsurer Converium Holding AG (NYSE:CHR). Any time something like this goes on, it draws analysts' attention to industry fundamentals. I'll adding to our AIG Jan ‘09 $70s at $8.50 or lower, hoping for a move here, still a light position until we’re ready to sell against it."

My Tuesday morning position statement:

We’re going to be careful today but there is no reason to panic:

Let’s watch our iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI) puts and try to bracket down our caller. From a portfolio perspective I’m pretty excited about this as we only have 41 uncovered calls against 40 straight puts and eight calls we sold in our short-term portfolio. Only seven of our uncovered puts are March and, other than Apple (NASDAQ:AAPL), which we already got half out of, those were already in bad shape anyway (that’s why we were stuck with them).

The worst hit might be our new Google (NASDAQ:GOOG) $480s and it will be interesting to see if I did save us some damage by moving more out of the money. Like I always say, if you’re going to lose money - at least try to learn something!

Zman gave us the go-ahead to short more oil, despite the push up as he pointed out that EPS growth is slowing for the component companies who are hammering the E&P companies with cost increases anyway. "Something’s got to give," he said, and I wholeheartedly agreed.

I think I picked a better bottom call on PetroChina Company Limited (NYSE:PTR) than Warren Buffett, who bought a heck of a lot at the $125-130 range. We waited for the retest of the $115 mark, though, which failed on Thursday, but we started a hedged position anyway.

I made my best or worst call of the week on Tuesday (remains to be seen), when I said:

"Gold still needs to break $690 if it’s going to get to $700 (duh…) but it better do it soon or momentum will evaporate. If gold follows stocks and the dollar down then we know we are watching a deflating commodity bubble rather than a global equity panic - the two are very hard to tell apart with commodity stocks making up over 20% of the markets!" (That’s three.)

That is the basis on which we went long into the weekend - wish us luck…

HR

Tuesday was by far the best day we’ve had since I started this portfolio! (that deserves an exclamation point) The last time we had a day this good was in the little collapse back in March of last year, which I called on the button, but that one took weeks to drop 600 points - we did this in just one day.

The great advantage of hedging options vs. stocks is that options have less downside and more upside in a major market move so, if you play both sides and do it properly, your gains can outpace your losses two to one.

While it may be tedious and seem silly to carry all those bets in different directions, as Options Sage said in our very first educational article: "Warren Buffett famously quoted, 'The first rule is don’t lose money' and the second rule is, 'Don’t forget the first rule!' (That was Buffett’s exclamation point, not mine). "By spreading our risk amongst many different trades we mitigate our risk of any single position detrimentally impacting our portfolio to a significant degree. History has shown what happens to investors who risk too much on one position." Ah, it’s no wonder we call him Options Sage.

Chinese Character

Wednesday morning I warned against "bargain hunting" and we were all supposed to take a post-it and put it up in the corner of our monitors, where we couldn’t ignore it and write in a nice, thick marker: It is NOT my Job to Save the Market! (And you absolutely NEED that exclamation point.) My daughters’ Mandarin lessons are finally starting to pay off as we were able to recognize not opportunity, but danger and change in the markets - "You will hear many pundits today telling you how real men buy on the dips or some such nonsense and you must ignore them - These people are up to their eyeballs in positions and they want you to come in and save them."

My morning notes on Wednesday were pretty clear: "If we don’t recover Dow 12,400, be afraid, be very afraid - next stop is 12,200 on the express train to 12,000. Since anything down is bad we need to set very tight stops on all March and April uncovered calls and normal stops on longer contracts - including uncovered leaps…You can take my advice with a grain of salt but members will do well to remember my oft-repeated adage: When in Doubt - Sell Half!" (Oh, I give up. I’ve just gotta be me!)

"Don’t get excited unless we break and hold most of our levels! You will be inundated with messages telling you to hang on. Nobody wants you to get out of stocks, not your broker (he wants the commissions), not the media (if you don’t have stocks, why watch CNBC?), not the analysts (same ratings issue) and not the newsletter writers who want you to keep in the markets and keep up the subscriptions (if I wrote a truly commercial newsletter, that comment would have been edited out by some corporate jackass - long live Electronic Media!)."

You’ve already got the blow by blow description of how Wednesday went for us, nothing that happened that day made me turn very bullish, especially http://usmarket.seekingalpha.com/article/28356 "deficit storm." I closed "Wimpy Wednesday " saying: "I like to think that not going down was good but it was the end of the month and funds may have wanted to hold out before taking their losses so they could dress up one last portfolio (and what a great excuse the drop is for the underperformers to point to!)."

I let myself get just a tiny bit bullish and sold our Diamonds Trust, Series 1 (NYSEARCA:DIA) $124 puts at $3.50 (up 169%) while holding the June $124 calls of the spread but, had I been really bullish, I would have DD’d on the calls…

Thursday morning Greenspan retracted his recession statement but I said: "It’s too late to put the fear genie back in the bottle though and it will take a lot more than a "mea culpa" to restore investors to a state of less than rational exuberance."

Both ZMan and I had had enough of the oil shenanigans and I said: "Keep this in mind when CNBC tells you about the rising global demand for oil against as the World’s number one and two economies both just significantly lowered their economic forecasts."

ZMan had my favorite comment of the week on Thursday morning when he posted:

• Erroneous Comment Watch: From Bloomberg: ''The demand is there and that will underpin prices,’’ said Angus Geddes, chief executive officer of Fat Prophets in Sydney. “Inventories for gasoline in the U.S. have dropped to 12-month lows so that’s having a positive impact on prices.’’

• Comment: Not Even If I Stand On My Head To Read This Chart (Aussie Perspective) Do I Get “Inventories at 12-month Lows”! Come on Bloomberg!

U.S. Gasoline Stocks

Fun and Profits - Just like it says on the banner!

As to the markets themselves, my Thursday outlook was still bleak: "I hope I was clear yesterday when I said: If you drop a ball from five feet and it bounces one foot, do you bet 10% of your portfolio that the next bounce will be two feet? No - you get the air pump! Today is not a day for market heroics - today is a day for Duck and Cover! If we break these levels we have a lot of protective puts we can add to and I will be putting up a list of index plays on the member site this morning that we can jump into if the sell-off gathers momentum. I hope the lunacy of oil rallying into a global market melt-down doesn’t escape you - this marks 45 days of unfounded gains since crude tanked to $51 in early January. We’ll see how they hold up today, but let’s keep an eye on Suncor Energy Inc. (NYSE:SU), who have been a more realistic indicator of direction."

Nonetheless we decided it was an excellent day to pick up Qimonda AG (QI) for $14.52 but I never filled on my June $17.50s.

Thursday afternoon we had simply made too much money and we dumped most of our puts after running the entire portfolio up 115% for the week as I said: "It seemed to me there was more risk in leaving our recent successes on the table than reward in letting them ride (as they were generally shorter positions)."

Since two thirds of the value of the portfolio was on the short side, it seemed like a very good idea to not risk a sudden recovery taking back a big chunk of our profits. While we could have done better riding it out another day - it’s hard to look at our numbers for the week and not smile…

Twelve of the 37 positions we closed Thursday had gains of 200% or more with another 12 doing better than 66%. When you have a week like that you really do need to know when to quit - even if it is a bit early.

By Friday we were ready for a break and I started the day intending to throw in the towel at the first sign of trouble saying: "I’ve been spending the morning reviewing the week so I could decide what stance to take over the weekend and it looks like that stance will be cash if we don’t get positive ahead of the weekend."

I did give a potential positive outlook for the market in the morning saying: "Am I painting too rosy a picture? I don’t think so, I’m a fundamentalist, not an artist, and I just don’t see anything I can really point to to say "this has changed this week." We knew about the debt, Iraq, Iran, the deficit, the semi glut, the oil "crisis," the option scandal, dollar weakness, the housing glut, the sub-prime mess, the unwinding yen carry trade and It Just Didn’t Matter! Why should it matter now; what has changed?"

"If all this starts to matter, we’ll be talking about Dow 10,000 soon enough but I cling to my new global paradigm and I think we will weather this storm in the near future. That doesn’t mean I’m going to bet real money on it - just that I’m looking for it to happen and ready to climb on board when it’s ready to go. Our post-it for today: There is NOTHING I Can Personally Do to Move the Markets! Let the big boys have their fun, we’ll pick our spots as things develop!"

I suppose it was oil bouncing off my $62 target and failing into the close that kept me from selling, playing into my commodity bubble premise. That and the fact that our portfolio really didn’t suffer all that much damage, even with most of the puts gone.

The day ended miserably though and I am VERY mad at myself for letting it go into the weekend underhedged, once I removed the puts I left the remaining portfolio far too vulnerable to damage on a major drop as we do not have enough coverage to ride it out. Monday will be very interesting but I will say now that, even if the market gaps up 200 points that I will be lucky - not smart. No matter how far ahead you get, there is never a good reason to take foolish risks.

I hit the trifecta on the Three Vices of Trading: Perfectionism (I wanted to make money on both side of the portfolio), Ego (I was giddy with success and feeling invulnerable) and Overconfidence (I just called a top so I made myself call a bottom without waiting for it to properly form).

The only hedge I took (aside from our remaining puts and covers) was a bear call spread on the DIA $124s, as I was already stuck with 250 of them at .63 from a series of double downs, hoping to catch the market turning up. In an attempt to make lemons out of lemonade, I sold 150 $122s against them for $1.35, which has a potential gain of just $4,500 and a potential (but unlikely) loss of $9,750 if the Dow hits 12,400 exactly but, since I have few remaining puts, the top half of the portfolio "should" more than make up for it. As it’s a spread, it does make good weekend insurance, hopefully I can exit for a dime if things are fairly flat.

Like I said, I’ll be very lucky to escape this one without a spanking, but hopefully it’s a lesson that will stick - my instincts were to scrap the whole short-term portfolio on Friday morning, take a breather and watch the markets and I’d be sleeping a lot better this weekend if I’d stuck to that plan…

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My ego and overconfidence came from simply having too good of a week and forgetting that profits are real money too and need to be protected properly, no matter how obscene they are.

We finished last week with a 35% average gain on 93 open positions in our short-term portfolio, but on Thursday the gain was 115%, despite us having taken a lot of winners off the table on Tuesday and Wednesday. This threw it completely out of whack with the long-term portfolio and just made me very uncomfortable as the ratio is supposed to be 75% long and 25% short-term investments.

The quick solution was to take most of the short side off the table as the market ticked up on Thursday and, unless it really falls much lower, I still don’t feel bad about that. When all the smoke cleared on Friday we were left with 67 open short-term positions with an average gain of 11%, which is really not bad after pulling out 57 positions with an average gain of 135% with a total cash return of 120% after 15 average days held.

Don’t forget that this is a very distorted return as we left all our bad trades on the table but the entire remaining balance is additional profit as we are well in the money on the trades we closed.

Now money management comes into play as we want to get as much of the remaining $121K off the table as possible, but that works out perfectly as Options Sage and I have decided to dedicate this quarter to teaching good cash management systems - which is the reason we are starting a new portfolio next week.

We’ll be using a virtual account set up in OptionsXpress to test our mettle against the CNBC Challenge which runs from Monday through May 25th - we will start with the same $1 Million they are using but we will make the plays mainly in options, employing various strategies from our members site but with a slightly more aggressive attitude.

Obviously, if we like an option we like the stock so our members should sign up to CNBC as Zman, Sage and myself will be gearing some picks to attack the challenge as well as trying to maintain a sensible, winning portfolio.

Speaking of sensible, winning portfolios - our Long-Term portfolio was well tested last week as we virtually ignored it while trying to manage our gains off the Short-Term list but it came through with flying colors, gaining 2% in net profit, up 106% or $137K after we closed out just a few positions during all the fuss.

We find ourselves left with 49 open plays (up 7) with an average gain of just 62% but, as I said last week, the nature of the portfolio (selling calls against leaps) means we expect fluctuations like that during the month. We should have done better, we did not have enough puts nor did we sell enough cover calls as we were still fairly bullish into the week. Again, we had become a bit complacent from too many consecutive up weeks so this was just the splash of cold water we needed to get this portfolio back on track and producing a monthly income like it’s supposed to.

All in all it was a pretty super week but we are left with the wimpy Clark Kent market and I really hate to go all bearish. We’ll hope for a bounce, but I’ll be going into next week with eyes wide open, looking for a good opportunity to weigh in on the plus side but armed with a long list of short ideas just in case this turns out to be a protracted downturn.

If you were on the wrong side of the markets last week, don’t worry, Jim Cramer is right when he says "no one ever made a dime by panicking." On the other hand, there are plenty of sad stories out there from people who didn’t know when to call it quits either….

Don’t buy more stock on the way down, dollar cost averaging is a dangerous game. We sometimes double down our options because it costs us SIGNIFICANTLY less to buy another round on a dip but chasing a stock down is a very dangerous game that ties up a lot of capital for a long time.

See last week’s article on Kinder Morgan Energy Partners LP (NYSE:KMP) for some ideas on what you can do to cheaply protect a stock portfolio: Our 100 shares of stock for $5,050 finished the week at $5,080 while the Jan ‘09 $50 puts we picked up for $400 dropped to $370 keeping us neutral for the week (but remember we’re in this for the 6.5%dividend). The March $52.50s we sold for $35 have already dropped to $25 as another bonus, even though the underlying security went up. Needless to say the Exxon Mobil (NYSE:XOM) Jan $72.50 puts we discussed in the same article are doing quite nicely!

Our other open educational play, on Sears Holding (NASDAQ:SHLD), is doing very well indeed:

We bought the June $185s for $12 and sold the March $180s for $7.80. Although SHLD did have great earnings, it wasn’t enough to push them higher and the $180s quickly dropped off to $2.30 while the Jun $185s have dropped down to $8.60. While it’s sad that we lost money, we lost FAR less than our caller and our net gain (so far) on our $4.20 net investment is $2.10 - a neat 50% gain since 2/12 if we were to take it off the table right here (but we won’t because we will sell April and May calls too!).

There is always an option if you know where to look for it!

Have a very good weekend,

- Phil