Geldpress

According to the futures report from Bloomberg (as of 10:56pm pst), the market looks like it may continue the rally tomorrow that it built on today. The DJIA and S&P futures are UP 17 and 5 points, respectively.  Good news?  Perhaps.  But just because the futures look good prior to the markets open does not mean the marekts will remain in positive territory through the trading day tomorrow.

One potential red flag for a possible market blood bath tomorrow is the open interest in the October 90, 95 and 100 strikes on the volatility index (VIX).  Since 2000, and prior to 2008, the VIX had only breached the 50 mark twice.  The first time was immediatley following the 911 attacks, and the second time was in the summer of 2002 due to the uncertainty and fear after Enron’s collapse.  WIth the credit crisis of 2008, the VIX has already set several new records, including today when it surpassed 80 for the first time in history.

In general, the VIX increases as the market’s head down and decrease as the market recovers.  But it takes way more than a mild downturn for the VIX to reach beyond the 50 mark.  And each subsequent 10 point increase in the VIX – to 60, 70, 80, etc – requires an even more severe market downturn.   In order for the traders who bought those October 85 and higher strikes in the VIX to make money, it is going to take one hell of a bloodbath in the markets tomorrow.  Do they know something we don’t know?  Sometimes money in the market spells solid rumors in the street.  And if the traders that placed those bets on a high volatility spike for tomorrow are right, then we may definitely see one hell of a blood bath in the markets tomorrow as the VIX reaches for par (100 mark).

Let’s hope they are wrong…

Other volatility articles:

• The volatility clue to the market
• Bring your collar into these volatile markets
• Time for cover – the covered call

Do you send your dog into the streets without a collar?  If not, then why do you continue to trade stocks without the appropriate collar protection?

For anyone wondering, NO, it is NOT NORMAL for markets to go down over 30% in just a few weeks, then shoot up 11% in a single day.  Take a look at this chart of the S&P (via SPY) for September and October.  Does this look like a safe environment to trust your money?  Certainly not without a collar on your trades!

What is a collar trade? - Simply put, a collar trade is an option strategy that limits both the losses and the gains on your investments over a pre-determined length of time.  Since option contracts are always in lots of 100, and the collar trade utilizes option contracts, then placing a collar around your trades also requires share increments in 100.  In order to implement a collar, it is also necessary to also understand PUT options and covered calls.

Put options – Put options on equities are essentially insurance policies for your investment portfolio.  In exchange for paying an up front premium, you are entitled to SELL 100 shares of a certain stock, at a certain price, for a pre-determined amount of time.  The best analogy is car insurance.  You pay an insurance company $600 for a 6 month policy on your $20,000 car.  If your car is completely destroyed within that 6 month period, then the the market value of the car quickly goes to ZERO.  But the insurance company is required to pay you $20,000 for that worthless car.  Your car insurance premium is like the PUT OPTION premium you pay for stocks.

Covered Call – You can read the Geldpress article on covered calls here.  But in summary, a covered call is a call option you sell against stock you already own (in 100 share lots).  You collect a premium by selling the covered call, and the purchaser of that premium owns the right (but not the obligation) to purchase your shares of stock for a pre-determined time period, at a pre-determined price.

More on the collar – The collar trade involves 3 transactions.  The first transaction is buying 100 shares of stock.  As a single transaction, buying stock has limited, but substantial risk (it can only go to ZERO) and unlimited gain (it can theoretically go to infinity).  To limit the downside risk, you could purchase a PUT option on the shares of your stock.  But PUT OPTIONS can be expensive, especially in volatile markets, where the cost of portfolio insurance via Puts becomes very expensive.  To reduce the expense of protecting your stock with put options, you can also sell an out of the money covered call, and collect back some or all of the premium you paid out for the put option insurance.

Collar Example – (NOTE – ARBITRARY EXAMPLE ONLY!!! TRADE AT YOUR OWN RISK!!!)

Step 1 – Pick a stock that you are happy to own, but also want to limit risk, and don’t mind limiting some of the gain.  Example:  Apple (symbol AAPL)

Step 2 – Pick a time period that you need the collar trade insurance policy to last.  Then look to the option chains of that expiration period to find the best risk/reward trade off for your own investing style.  This is a subjective exercise.  Arbitrary collar trade time period – January 2009 option chain.

Step 3 – Decide on the strike price for the PUT option for the time period you need collar insurance for.  Use the current or purchase price of the stock as a guideline.  As of the time of this writing, AAPL trades at $107.62.  The January 100 PUT trades for an ASK price of 13.05 ($1305 per contract).  Purchasing 100 shares of Apple, and (1) contract of a a January 100 PUT on Apple would cost $10,762 + $1,305 = $12,067.  The two transactions by themselves protect the purchaser on the downside, but the cost of the insurnace ($1305) now require Apple shares to rally beyond $120.67 just for this trade to be profitable.

Step 4 – Attempt to reduce the cost of the expensive PUT option in Step 3, by also selling covered calls against your Apple position.  But remember that any covered call you sell can also reduce your profit potential on the trade.  Choosing the strike and expiration of the covered call portion of the collar trade is also a subjective exercise, but as another arbitrary example, you could sell (1) covered call on Apple using the January 2009 140 strike.  As of the time of this writing, it had a BID price of $5.10 ($510 per contract).

Step 5 – analyze total cost of trade.  The total cost of the collar trade on Apple, using the examples given is the cost of the stock, plus the cost of the put insurance, minus the cost of the covered call.  Adding it up, we get $10,762 + $1,305 – $510 = $11,557.

Step 6 – analyze maximum risk of the collar trade.  Even if Apple goes to ZERO prior to January 2009 expiration, you could still exercise your PUT option and collect the $10,000 from your PUT insurnace policy.  Therefore, the maximum loss of this trade is $11,557 – $10,000 = $1,557.

Step 7:  analyze the maximum gain of the collar trade. If Apple hits $160 at January 2009 expiration, then the PUT insurance expires worthless.  But the $140 covered call you sold as a way to reduce your PUT insurance worked to reduce your profit potential by $20 per share, or $2,000.  Your covered call will be exercised at the 140 strike price, giving you $14,000.  The maximum profit is equal to the strike price of the covered call (times 100) minus the initial cost of the trade, or $14,000- $11,557 = $2,443.

Other variations/adjustments to the collar trade:

• Put’s and covered calls do not need to be in the same month.  You could buy a January Put and sell a November covered call.  After November expiration, you can sell a December, and then again for January.
• You can remove the Put at any time, if you want to recover a portion of your insurance premium and open up the risk to the downside.
• You can also remove the covered call at any time if you sense that the underlying shares are about to rally and you want to uncap your upside potential.
• You can adjust the strike prices or expirations at any time by rolling your options.  For the put, you sell to close the existing put, and buy to open the new put.  For a covered call, you buy to close the existing covered call and sell to open a new covered call.

Other related option articles from Geldpress:

• Time for cover – the covered call
• The VIX index and covered calls
• Covered calls – removing the covers and going naked
• Understanding the bear call credit spread

Book recommendations for more detailed information, and examples:

McMillan on Options, Second Edition (Wiley Trading) by Lawrence G. McMillan

The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour

It appears that world leaders were scurrying yet again with more rescue packages in time for this week’s opening bell.  Marketwatch reports that world rolling out emergency financial moves.  Among the highlights:

The U.K. government is finalizing plans to invest billions of pounds in four of its largest banks as part of its efforts to stabilize the country’s financial system, a move that could lead to the suspension of London stock trading Monday.

Australian Prime Minister Kevin Rudd said Sunday that his government will guarantee all deposits with institutions for the next three years to bolster confidence in the banking system.

The United Arab Emirates said Sunday it will guarantee all credit risks and deposits at national banks and interbank lending among all banks operating in the UAE.

Germany’s government will set up a fund to provide as much as 100 billion euros ($135 billion) of equity capital to help the nation’s banks through the economic turmoil.

The futures market is already responding ahead of the opening bells this week, and the current expectation is for a green day tomorrow on all the U.S. major indexes.  But just as with other weekend stimulus pumping sessions, there is no guarantee that the positive reactions will sustain themselves.  I can see the future, and the future looks green, but I’m not ready to jump back into these wavy market waters with my money.

Note:  Static image below!  Trade at your own risk!

The Associated Press reported this morning on rumors of the Italian government shutting down their markets:

Italian Premier Silvio Berlusconi said Friday that world leaders might consider suspending stock markets in response to the financial meltdown.

Berlusconi told a press conference in Naples that EU leaders may hold a summit on the crisis Sunday in Paris. He also said leaders from the Group of Eight also were considering a summit in the coming days.

The solutions to the crisis will have to be “global and innovative,” Berlusconi said. “There is talk of suspending the markets” while international financial rules are “rewritten.”

Rumors like these, especially when substantiated by a direct quote from one of the G-7 officials, is just adding more fuel to the drastic sell off.  In this environment, it has been proven that what starts as a rumor often ends in fact.  As of noon eastern time, all three major indexes in the United States are off 4-5% or more.  The 2008 financial crisis is a very serious matter caused by reckless credit markets of the last decade.  World financial leaders need to understand that continually changing rules – prohibiting short selling and shutting down markets – only serve to incite additional panic and more selling.  If the G-7 leaders want to work together to solve this crisis, they should start by working together to keep their mouths shut until they have something of value to say, and preferably something final.

Marketwatch also reported on the market closing rumors:

The White House denied Friday that it had any intention of closing financial markets. “There are absolutely no plans or discussions to interfere with the functioning of markets in the United States,” White House spokesman Tony Fratto said in an email message.

Hmmm…Didn’t the U.S. government also deny that it would rescue failed inurance giant AIG, just days before it swooped in with an $85 billion rescue package?

Thoughts?

Here is a link to an excellent and concise 12 minute video from 60 minutes, in case you missed it this past week.

It began with a terrible bet that was magnified by reckless borrowing, complex securities, and a vast, unregulated shadow market worth nearly $60 trillion that hid the risks until it was too late to do anything about them.

The Associated Press reported today that the credit crisis is now hitting Canada too.

The global credit crisis is starting to restrict the ability of Canadians to obtain loans for mortgages, cars and investments, Canada’s finance minister said Thursday.

But the rest of the article goes on to say that “Canada’s banks are the world’s strongest”, and that “Canada will avoid the mortgage meltdown and banking crisis that are hitting the United States and Europe hard”.

It would not be entirely surprising if Canada escapes the financial crisis entirely, or at least fares better then the rest of the world.  This is a testament to Canada’s transparency on public finance, as well as their drive to reduce reckless spending.  Canada’s current national debt stands at $457.6 billion, as of the end of 2007-2008 fiscal year, but it has declined every year since the 1995-1996 fiscal year, as shown in the graph below.  Canada had a surplus of $9.6 billion for 2007-2008.

Canadian accounting methods – Not only has the national debt of Canada been decreasing, but the government is using accepted and well defined accounting standards, unlike the United States, which intentionally conceals the truth behind their national accounts.  The annual financial report of the government of Canada is a model of transparency that employs generally accepted accounting principals (GAAP).  If the United States is looking for a way out of the current financial mess, they can start with looking toward Canada’s example of responsible accounting.

Here is an interesting story from Businessweek that outlines the 10 worst states facing severe budget shortfalls.  California makes the top 10 on the list, along with the others shown below.  Perhaps if California wasn’t carrying a 60% debt load, as compared to their tax revenue, their outlook would be better.

1. California – 22% shortfall, and need for $22.2 billion
2. Arizona – 19.9% shortfall, and need for $2 billion
3. Florida – 19.9% shortfall, and need for $5.1 billion
4. Nevada – 16% shortfall, and need for $1.2 billion
5. Rhode Island – 13.1% shortfall, and need for $430 million
6. New York – 9.8% shortfall, and need for $5.5 billion
7. Alabama – 9.5% shortfall, and need for $784 million
8. Georgia – 8.7% shortfall, and need for $1.8 billion
9. New Jersey – 7.7% shortfall, and need for $2.5 billion
10. Maryland – 7.2% shortfall, and need for $1.1 billion

This data should come as no surprise, given the atrocious accounting standards and reckless spending of the government.

For related stories:

• California’s exploding debt problem
• Washington state debt history – does Dino Rossi understand it?
• The United States has not had a balanced budget since 1957!
• The United States national debt limit has become a joke
• Congress working hard to make T Boone Pickens even richer
• Financial crisis – bailout bookstore open

Jim Cramer expressed his outrage at the Fed today on his Mad Money show.  He was outraged because the coordinated rate cut was not enough, and called for “many more larger rate cuts”.

Cramer said the Fed needed to be much more aggressive. And why not? Former Fed Chairman Alan Greenspan brought rates down to 1% in 2003 when the economy and markets were in much better shape. Bernanke, despite all the hardship we’ve seen, is still holding rates at 1.5%.

As of today, the Federal funds rate stands at 1.5%, after a .5% reduction this morning.  Let’s assume for a moment that a 1% reduction would be good enough for Cramer as a single rate cut.  But Cramer also stated explicitly today that not only was the rate cut not large enough, but that we needed “many more” rate cuts to get this economy going.  If we assume that “many more” implies only 3 additional rate cuts, that would put Jim Cramer’s requested fed funds rate at a NEGATIVE 1.5%.  That’s right, Jim Cramer wants the federal government to pay us to borrow money.

Rather than pay citizens to borrow money, here is another idea.  Let’s banish Jim Cramer so we can get on with handling the financial crisis in a more responsible manner, freeing the mostly ill informed populous from his idiotic rants.

Thanks to a loyal Geldpress reader for forwarding this link showing the many sad faces of traders around the world, with very entertaining and humorous captions included.

Sad guys on trading floors

Who exactly is to blame for what future historians will cause the 2008 financial crisis?  There is no shortage of answers to this question, just as there is no shortage of questions about how we will get out of the crisis.  But one thing that everyone agrees on is that we need more transparency and more effective regulation (not necessarily more regulation)  in the financial industry.  But if really expect our private corporations to have better transparency, shouldn’t we expect the same from our government?

In a previous article, I reported on the rampant deception in the US Government accounting practices.  The US government accounting standards are so morphed, they have even fooled CNN into thinking we are much better off then we actually are.  The deception goes far beyond the national government, and extends to state and local government as well.  In Washington state, for example, we have political campaign advertisements based on erroneous information related to the fiscal state of Washington.  It’s not entirely surprising, given the chaotic accounting and reporting methods employed by the state of Washington, and other municipalities.  And California is even worse.   I would challenge California treasurer Bill Lockyer to accurately answer questions related to the budget of California.  I’ve studied the Califronia treasury reports, and the numbers are anything but straight forward.

As of September 1, 2008, the total outstanding debt of California state is $57.610 billion, according to this California treasury website link.   But the total debt is $65.398 billion, according to this other California treasury website link.  I called the California treasury office for an explanation, and their response was the following:

The total amount of debt is 57.610 billion.  The other figure included lease revenue debt which is not a part of the GO debt.  Lease Rev debt is paid with lease revenue.

I’m not entirely sure what type of lease revenue they are referring to, but I’ll just let this one go for now.  What about the yearly trend of California’s state debt, determined by their total outstanding and unpaid bonds?  Unfortunately, California makes this question very difficult to answer, but the short term trend can be determined by trudging through the Treasurer’s Debt affordability reports, one by one.  Unfortunately, there is no rhyme or reason to these reports; each one uses a completely different template, a different set of headings, and obscures the total debt in an entirely different section.  Here are the results, as of July 1st of each year listed:

• 2008 – $57.882 billion, from page 36 of this report.
• 2007 – $41.3 billion, from page 10, figure 5 of this report.
• 2006 – $37.066 billion, from page 3 of this report.
• 2005 – $34.644 billion, from page B-4 of this report.
• 2004 – $33.026 billion, from page 4 of this report.
• 2003 – $27.607 billion, from page B-3 of this report.
• 2002 – $28.46 billion, from page 5 of this report.
• 2001 – $26.89 billion, from page 11 of this report.
• 2000 – $24.55 billion, from page 12 of this report.
• 1999 – $22.5 billion, from page 24 of this report.

Just how bad is the fiscal situation in California and the trend of increasing debt?  It was bad enough that California issued an emergency request for a $7 billion dollar loan from the federal government, because the market for its own bonds was drying up due to the increased risk.  California had $96.38 billion in general fund revenue for the 2007-2008 fiscal year, which gives them a debt to income ratio of over 60%.  But California prefers to use the less realistic and less shocking measurement of measuring only the yearly interest payments ($4.42 billion) of their debt as a percentage of their revenue, which came to 4.92%.

California prefers to blame their current financial woes on the rating agencies, and not their own economic policies that got them into the mess they currently face.  The 2008 debt affordability report is worth reading cover to cover for hints on their reckless spending, and blame game.  One noteworthy excerpt from the report follow below.

Letter to rating agencies – This letter to the rating agencies appears in the appendix of the 2008 debt affordability report.

We, the undersigned representatives of major municipal bond issuers, urge the rating agencies you head to create new rating standards for U.S. municipal debt. For years, municipalities have been held to a higher standard than corporate issuers…  For investors, the current system greatly inflates the risk of investing in municipal bonds relative to alternative investments, leading to investment decisions that are not based on the best information…

I can’t decide if I should laugh or cry about municipalities being held to a higher standard than corporate issuers.  For all the financial problems being exposed in private corporations, at least they are held to reasonable accounting practices (GAAP), something municipalities have never embraced!

Other Geldpress public finance articles:

• The United States has not had a balanced budget since 1957!
• Canada public finance transparency a model to the world
• Washington state debt history – does Dino Rossi understand it?
• States crumbling under the weight of their debt