Options Trader: Friday Morning Ideas

by: Philip Davis

I wish I was good at Photoshop.

This is a picture I put up on Thursday, May 17th to illustrate where I thought we were in the market. At the time I said:

Was I paranoid yesterday or is this really the top?

We won’t really know until the end of next week, but we’ve had far too good of a year so far to take chances up at this level. I doubt many hedge fund managers will disagree with me. My comment on the subject yesterday was: 'While we could drop 150-200 points by Friday I think that’s what most fund managers are expecting and NOT dropping 100 points by Friday will but me (as a fund manager) heading into the holiday weekend on the wrong side of the market. That will cause me to put money into things that seem like they will rally but should be safe like Microsoft Corp. (NASDAQ:MSFT), Google (NASDAQ:GOOG), Marvell Technology Group Ltd. (NASDAQ:MRVL), United Parcel Service (NYSE:UPS) … solid names that haven’t rallied with the markets.'


If you were to reverse this picture and overlay the daily movement of the Dow since that day, it pretty much follows the exact profile of that mountain - a little dip, back up to a slightly higher plateau and then - uh oh!

To keep things in perspective, we still have about 150 points left where we can grab onto that little outcropping but, if we can’t grab hold of it by 13,100, then we will have just our bungee cord at 13,000 for a bounce. If that breaks, it will be a long and bumpy ride back to 12,500.

President Bush is having a bumpy ride at the G-8 conference, becoming ill after having a meeting with Putin (uh-oh!) in which the Soviet Premier turned the tables on him and offered to base the European missile defense system in Azerbaijan - something the President will have a very difficult time objecting to after all that talk about how the program was in EVERYONE’S interest. Perhaps Bush was already feeling the heat as the other G-8 leaders decided to ignore him and move on with a global warming treaty without US input - flatly stating they will deal with his successor. This is a very poor political turn for Bush and his party as it puts the Democrats in the position of being able to meet with World leaders to tackle the issue while the Republican candidates are forced to toe the party line and pretend it isn’t happening.

Another thing we need to ignore is Asia’s continued drop. The Nikkei gave up another 274 points last night and the Hang Seng fell 291 points, while both sides of the Shanghai held fairly flat. The WSJ chooses to sum this up by saying: "Asian Stocks Ended Mostly Lower Friday." Gosh, I sure hope they never have a bad day!

European indices are in full retreat as well, giving up about a half point to a point across the board but tamer than yesterday’s 1.5% drop in the CAC (so far). Brent crude is down $1 in morning trading and a steep drop in energy prices is one of the only ways I can see us doing a quick reverse in the markets - it’s what the falling climber would call a hand-hold that we can grab onto…

In the US markets, we’ve got our SOX and Transport leadership, only not in the direction we were hoping for:



Day's Move

Must Hold

Comfort Zone

Break Out

Next Goal


















































Hang Seng 20,509 -291 20,200 20,600 21,000 22,000
Nikkei 17,779 -274 17,400 17,500 18,300 18,500
BSE (India) 14,063 -122 13,200 14,000 14,725 15,000
DAX 7,546 -72 6,900 7,000 7,400 8,000
CAC 40 5,867 -22 5,650 5,800 6,000 7,000
FTSE 6,466


6,325 6,450 6,600 7,000

US Markets

Oil MUST fall below $65 and the Transports MUST reverse, or you’d better hope our 13,000 bungee cord holds up. Until that, or some spectacular reversal in interest rates occurs, we will be mainly ignoring the analysts who are telling us to buy on the dips. We will be turning around and doing some upside hedging as we are now so far ahead on the downside that a big gain would be annoying! Our portfolio stands about 1/2 cash and will probably drift more so by the close of the day.

The SOX are looking terribly hopeless, which bodes ill for the Nasdaq so Happy Trading and I are keeping a close watch on the 2,525 mark, which would be the end of the bungee zone for that index. Expect strong goosing of various index leaders (Cramer’s "4 Horsemen", for example) and silly "BUYBUYBUY" talk from Wall Street pimps analysts because they need SOMEONE to take these shares of their hands before they fall any further:

Click to Enlarge

Fed Pres. Michael Moskow is on CNBC this morning telling us to keep "a longer term perspective" about this week’s dip, which is good advice but we can’t let the past cloud our future judgment. That would be as dangerous as signing a 45-year old pitcher (August 4th) to a $28M one-year deal based on past performance - it might work but it’s a major risk!

So let’s try to make a realistic assessment of where the market is now, not where it was or where we’d like it to be. Another thing that is not where we want it to be is Endeavor International (NYSE:END), my one positive oil play! That’ll teach me… Actually their well in the North Sea came up dry and the stock will probably test our $1.75 downside target. I’ll be back in if they hold it as a long-term buyer, but not a stock to stay in if you’re looking for a quick reward. See Zman’s comments this morning this morning.

Our trade deficit came in lower than expected ($58B vs $63B expected), which should give a boost to the dollar, lower rates and give us a small boost in the morning but until we get more than a 20% retrace of this week’s losses, there will be not much to read into. Unfortunately, we know that Chinese export prices are UP so it means we are paying more money for less goods. That brings us right back to inflation (and a slowdown in China’s exports to the US), so take it with a huge grain of salt when the analysts tell you that this number signals a turnaround.

Let’s remember that 25% ($1.2B) of that drop in imports is reflected in the 19M barrels of oil the energy crooks are parking offshore in order to create an artificial shortage and drive up the prices so they can deliver them for a hefty profit. They can’t pull that trick every month - at some point they run out of tankers!

Oil and Dollar

Also, a very important note:

Keep in mind that the sudden increase in market volatility has the net effect of driving up the prices of your option contracts. That means the reason your longer calls seem "bulletproof" is not because they are but because the implied volatility has increased more than the underlying stock has dropped. Once we settle down to consolidate at a lower level, those contracts will quickly deflate. One of the main reasons we’ve been buying options with such abandon this quarter was because they were priced too cheap relative to potential volatility - that situation is now changing fast and we will be much slower to enter new positions for a while!

• Rule #1 - Always sell into the initial excitement
• Rule #2 - When in doubt, sell half
• Rule #3 - Why are you even bothering reading this one if you didn’t listen to the first two rules?

Warren Buffet’s Rule #1 is: "Don’t lose money" and his Rule #2 is: "Don’t forget Rule #1," so please try to keep these five simple rules in mind today as my call for mainly cash includes lightening up on any leaps you would be sad to lose money on. As I said yesterday, the gains we made this week were silly and lucky and the best way to protect them is to turn them into some cash - I’m sure we’ll find something else to trade next week.

Pretty much everything is covered by as close to at the money calls as I could get, mostly erring on the side of caution (selling more in the money). My risk is very much to the upside, but I’d rather pay a bunch of callers $1 or so and have leaps in good shape on 7/20 than risk the alternative - a portfolio full of way out of the money losing leaps!

Be careful out there today!

Fun Apple trades from the Member Site:
Apple (NASDAQ:AAPL) - The problem with the ‘09 $120s is that they have very poor movement when the stock moves positive. You are much better off spending $5 more for the $110s, which put you deep in the money and will give you more than 50% of the upside gains, which is critical in case you end up having to keep up with your caller on a spike. Also worth noting is the relatively cheap Jan ‘10 $110s at $43, giving you 12 more months at sales for the just $7 more. Selling the June $125s is a sharp call as anytime someone is willing to pay you $2.50 to be $1 out of the money with six days to go you should find some way to take the fool’s money!

For people who don’t want to go that long, the Oct $125s are $12.70 and you can sell the June $125s against them for $2.50 with no margin penalty and a fairly cheap look at next week. If the stock goes to $130, you will owe your caller $2.50 but you can roll him to July $135s for $6 (about) and if the stock goes to $141 by July 20th, you would owe your caller $6. You could roll him to the Aug $150s for $4 (at worst with those gains in 50 days), taking $2 out of your pocket and if it goes up to $155 by the end of August, you could roll him to the Sept $160s for $6 and get your $2 back, and if it goes up to $166 by the end of September, what do you care because you’re $40 in the money!

This is an illustration for those of you who are paranoid about your callers going into the money… Worry about the stock going down, never about it going up!

Scott’s AAPL trade:

Buy $120 for $5.45
Sell 2 $125s for $2.58
Buy $130 for $1.08

Brilliant idea if it holds $120ish, but that’s a dangerous proposition if the markets keep going down. Still, I love low-risk, high reward plays because, if you play them regularly and choose them well, the averages tend to work out.