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Tom Armistead's  Instablog

Tom Armistead
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I'm a well-informed retail investor and post on SA in order to expose my thought process to critical examination and comment from readers. It makes me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that encouraged me to... More
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  • How To Sell At The Top (And Buy At The Bottom)

    I'm being facetious: everybody knows that buying low and selling high is easy in theory, but hard in practice. But there is one method or procedure that will get you pointed in the right direction.

    Pick a day, any day, and make sure you are holding an adequate amount of cash. What's adequate is a matter of debate: however, I like 30%.

    From there, if the market goes up 1%, sell something. Then every time it goes up another 1%, sell something more. If it goes down 1%, buy something; and, if it goes down another notch, buy something more. The incremental buys and sells can be small, 1% or 2% of portfolio.

    That way, when the market finally tops out, you will be selling at the top. And when it finally bottoms, you will be buying at the bottom. If the market has been trending up for a while, you might want to wait until it goes down 5% to start buying again, and vice versa.

    If at some point on the upward journey it becomes too difficult to part with any of your various treasures that are still massively undervalued, start selling short.

    A lot of my investments are in the form of vertical or diagonal call spreads, where selling the spread may mean buying back a call that is at the money and has a lot of time premium compared to what it had when it was sold. To get around that, it's possible to sell the underlying short. That way, you can wait until the time value on the covered call wears off before finally closing out the position.

    Or, if you can stand doing naked calls, the long side of the call spread can be sold off, or portions of it sold off.

    I prefer to do the above maneuvers on a conservative basis, selling short enough to make the position delta neutral.

    There are numerous articles that make the bearish case for individual stocks. For example, Dunkin Brands (NASDAQ:DNKN) is getting a lot of attention that way, due to the shares having run up since the IPO, and the debt load being heavy. I sold a small amount short, just to lean against the wind of the market rally. Urban Outfitters (NASDAQ:URBN) has had recent changes of CEO and CFO, there could be stress and dissension in the executive suite. I sold a small amount short.

    The way I work it, I set an alert on SPY, I'm using 1 point to keep the math simple. If it goes to 142, I will sell something, and reset the alert 1 point higher. If it goes down to 135, I will buy something, and set the alert 1 point lower.

    I will be selling at the top.

    Tags: SPY
    Mar 28 11:12 AM | Link | 2 Comments
  • Managing A Diagonal Call Spread
    This is an old trade that illustrates why diagonal spreads can be profitable for long term trades, as a substitute for owning the shares. The format is, the long, deep in the money calls are presented separately from the short, out of the money calls, to illustrate the purpose and profitability of rolling.

    At the time, the company had considerable cash to support the price at the low end, and between that and the volatility it was a good prospect for this type of trade.

    The point is, that simply by rolling back and forth between the 2.5 and 5.0 strikes on the long leg, the premiums received for rolling up, and occasionally out, exceeded the premiums paid to roll down. In effect, I was able to get a non-recourse, notional loan of $2,500 or $5,000, it varied, to invest in owning the shares. Or more accurately, in controlling them. I was paid $501.12 to leave my money on the table.

    There was also income from selling the covered calls, it totalled $275.63. Eventually the stock went through the strike, but that was good news, since the lower leg had a fine profit of $1,116 from the directional move when I closed it. The whole trade had an IRR of 37.53%, over a period of over a year and a half, compared to 13.78% that could have been realized buying and holding the shares over the same time span.

    This works because volatility has a tendancy to increase when the shares decline, and the time value for an option that is close to the money is higher than one that is deep in the money. When the stock goes down far enough, roll down. After it recovers, roll back up. The premiums paid for rolling down from 5.0 to 2.5 were less than the premiums received rolling up and out from 2.5 to 5.0 and forward 6 months in two cases.

    This was kind of a laboratory case, to see how long I could continue the process. I gave it up when the stock went over $7.50 on a run that finally took it over $10.00.

    The stock has been back to the $5-6 area, and I'm working on getting this trade going again.

    Disclosure: I am long HLIT.

    Additional disclosure: Current positions are long HLIT 2.5 calls and short HLIT 5.0 calls.

    Mar 07 6:01 PM | Link | 1 Comment
  • Trimming The Sails

    After giving it some thought last night and this morning, I reduced my positions to raise cash to about 25% of portfolio. Of course, the upward revision on 4th quarter GDP was welcome, and the market is rallying sedately.

    Using a ratio of GDP to S&P 500, based on historical averages the market is getting fairly close to a midpoint. If and when the S&P 500 hits 1,400, from my point of view expected returns going forward are about 5% annualized, not a compelling reason to be in equities.

    If I use an alternative method, relying on the ratio of GDP to corporate profits, a midpoint of 1,600 would be indicated. There is ongoing concern that margins, which are at historical highs, will be coming under pressure. The alternative method gives a higher indication because margins have been so fat lately.

    The portfolio consists almost exclusively of options - diagonal call spreads, long deep in the money LEAPS and short covered calls against them. Computing leverage on a dollar delta basis, I just reduced it from 1.67:1 to 1.36:1. About 1.2:1 would be more appropriate, so I will be looking to reduce exposure further if the market continues to rally.

    The point is, there is less reason to use leverage when returns are expected to be modest, and the risk of giving back gains on a correction increases as the market continues to make new highs.

    Feb 29 10:26 AM | Link | 1 Comment
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