Geldpress

Today, Google did for stock prices what I was never able to do in bowling.  It hit that magic 300 level, and as of just a few minutes ago, it was several points under that mark.

Anything that goes up over 700% in such a short time is bound to revert to trendline sooner or later.  Google IPO’d at $85 not to long ago, and it eclipsed the $700 mark several times in October 2007.  It just goes to show you that gravity is still alive.  It was alive for the dot-com bubble, it’s alive of the still unwinding real estate bubble, and combined energy and commodity bubbles, and it’s now hit Google.

Congratulations, Google!  In honor of your special sub-300 day, I have decided to leave your ads off this post.

But for those wanting a more detailed view on bubbles, and gravity, check out the following:

Irrational Exuberance by Robert J. Shiller

And for those who came for bowling advice, I’ll direct you to Criticalmas – Change My Pitch Up – Bowling Night.  In the article, MAS recommends several tips for bowling a better game, including number 5 on the list, “Get lane with gutter bumpers”.  Hmm… Perhaps Google needs some bumpers to protect them from advertising declines.

If you have any friends from Europe, chances are they may tease you about how America caused the 2008 financial crisis the world is now facing, and how America’s contagion is spreading through Europe.  It’s true that America bares a large part of the blame for its own financial woes, largely caused by irresponsible mortgage lending to sub-prime borrowers, and reprehensible INACTION by rating agencies and government officials.  But the brewing financial storm showing its head in Europe is about to get a lot worse.  Watch in the coming months as it sweeps through the continent with a vengeance that will make America’s own crisis seem insignificant.  Browse through some of coverage on the European crisis below:

• From a recent Bloomberg article, – “European banks’ lending to emerging markets is about 21 percent of Europe’s GDP and U.K. banks’ loans are around 24 percent of national output, compared with 4 percent for the U.S. and 5 percent for Japan”
• From a recent Christian Science Monitor article – Not my favorite publication, but they do sum up the problem quite well.  Emerging market interest rates are high, so emerging market citizens (Iceland being the most famous) take on mortgage and and other loans in euros, pounds, or Swiss francs.  Once emerging market currencies collapse, emerging market mortgage holders face little chances of repaying the loans denominated in euros. From the article, “Eastern European countries currently hold about $1.6 trillion in foreign currency debt, according to Morgan Stanley, and it’s overwhelmingly owed to Western Europe, whose large banks own 60 to 80 percent of Eastern Europe’s banking sector”.
• From a recent UK Telegraph article – Austria’s exposure to emerging markets is a staggering 85 percent of that country’s GDP.  What chance does Austria have in collecting those loans when the recipients of those loans are now all in line for IMF bailouts?  From the article, “Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The US figure is just 4pc”




If you are currently holding european stocks or any accounts denominated in euros, don’t hold your breath waiting for the recovery…

This is a follow-up to an earlier post that mentioned correlation risk with leveraged ETF’s.  Many people are surprised that there is not better correlation to the underlying with the leveraged ETF’s.  To clarify that point, consider these facts:

• The Dow Jones ended today’s session at 8943.81, up 248.02 points, or 2.85%
• The Proshares Ultra 2X Dow ETF (symbol DDM) ended today’s session at 34.65, up 1.71 points, or 5.19%
• The Proshares Inverse Ultra 2X Dow ETF (symbol DXD) ended today’s session at 74.48, down 4.83 points, or 6.09%

Correlation risk is explicitly listed in the Proshares prospectus.  If there were no correlation risk, then DDM and DXD would have moved exactly twice the percentage of the underlying Dow Jones average, or 5.7%.  For today’s session, the inverse ultra came closer to that mark with a negative return of 6.09%.  But on any given day, it is fairly random as to which of the Proshares Ultras come closer to their stated objective of returning twice the underlying.  Because of the correlation risk, it may even be possible for the underlying index to go UP slightly for the day and the Ultra ETF to go DOWN.

Why don’t the leveraged ETF’s correlate perfectly? – This is a great question to answer, especially in light of even more leveraged ETF’s expected to hit the markets soon.  I previously wrote about the Direxion 3X leveraged ETF’s, which also list correlation risk in their prospectus.  Leveraged ETF’s can use a number of investment vehicles to target the 2X or 3X returns of an index.  The Proshares prospectus lists the following:

• Futures contracts and options on futures contracts
• Swap agreements -  In a standard “swap” transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments.  The Funds are subject to credit or counterparty risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.
• Forward contracts – two-party contracts entered into with dealers or financial institutions where a purchase or sale of a specific quantity of a commodity, security, foreign currency or other financial instrument is agreed upon at a set price, with delivery and settlement at a specified future date.”
• Options on securities and Stock indexes and investments covering such positions

Consider for the moment that the new Direxion 3X ETF’s will use one or all of the same vehicles.  Any of them would be capable of coming CLOSE to returning 3X the index, but all none would correlate perfectly.  Let’s look at the possibility of using stock options only to simulate the leveraged ETF’s 3X exposure.

Starting point:

• Start with exactly $10,000 enough to buy 110 shares of the DIA (ETF that simulates the Dow Jones index) at today’s closing price of 90.13, and have ~$86 remaining (not counting commissions).
• The December 60 strike options have a closing ASK price for the day of $30.15.  Purchasing 3 contracts of the December 60 would cost $9,045, leaving $955 remaining.

At the quoted price of the DIA December 60 strike, it has very little extrinsic value.   This is because the 60 strike option on DIA is deep in the money by 30 strikes.  The price movement of deep in the money options behave have very close to the price movement of the underlying stock.  If DIA goes up 5% from 90.13 to 94.63, then the December 60 strikes will go from 30.15 to a minimum of 34.63 just to keep their intrinsic value in tact.  A price change in the 60 strike to 34.63 result in a 14.86% change, just short of 3X leverage, and the first reason for correlation error.

The correlation risk so far is explainable due to the un-invested capital difference in the two plays – $955 for the option play and only $86 for the pure play ETF.  Surely, you would say, the professional managers of Proshares, Rydex or Direxion leveraged ETF’s would not leave un-invested capital lying around.  And you are probably right.  But in our simple example, it’s not clear exactly what they would do with only $955.  The most direct way for 3X leverage is with the 60 strike, but there are not enough funds remaining for an entire contract and partial contracts are not allowed.  The other option is to purchase less expensive and less in the money contracts with the remaining funds.  The December 84 strike contract on DIA goes for roughly the $955 remaining.  But the price movement in the December 84 strike will not move at 3X the rate DIA.  Additionally, because the December 84 strike is less in the money, it is necessary to pay additional time premium for the contract.  That time premium will be lost by expiration.  That is the second reason for correlation error.

Now consider what happens if DIA moves downward violently, to the 65-70 level.  That changes the entire dynamic of the originally purchased deep in the money December 60 strikes.  Instead of being deep in the money, they are now closer to at the money, and will inherit significant extrinsic value, or time premium that the underlying shares are not affected by.  That is the fourth reason for correlation error.

If those three reasons were not enough evidence of correlation error, then let me add a few more.

1. Spreads – The volatility in the market is causing significant increases in the BID/ASK spreads of options.
2. Adjustments – The managers may need to consistently adjust the targeted strike prices that were initially chosen to simulate 3X leverage.  All those adjustments require rolling contracts, and incurring additional spreads and commission costs.
3. Expirations – As option expiration nears, it is necessary to roll those options forward, incurring additional spread and commission costs.
4. Management fees – A 1% management fee would also add to correlation error.
5. Volatility – changes in volatility have a significant impact on option pricing, especially at the money options.

Other Thoughts – First, let me be clear that the leveraged ETF prospecut’s do not disclose their specific strategy for targeting 2X or 3X returns.  The example above is merely an example of a potential method for doing so.  But regardless of the methods used, there is no doubt that significant correlation error does occur in the leveraged ETF’s.  On top of that, there are also other signficant risks in owning leveraged ETF’s. Chief among those risks, in my opinion, is the counterparty risk.  But for all their inefficiencies and risks, the leveraged ETF’s do provide a quick and convenient method for enhancing returns in the market.  They are also quite useful for hedging your existing portfolio.

As many people are aware, covered calls are a great way to hedge your positions, and potentially enhance the returns on your portfolio.  I have written quite a bit about them, as well as selling naked puts.  The volatility in these markets makes 2008 the year of the covered call and naked put selling.  For those that understand the theory on options and covered calls, but are stuck on the order entry syntax, here is a primer for a few popular platforms.

Prerequisites for covered calls:

• You understand the concepts of options and covered calls.
• You know how to pick your own strike price and expiration month.
• You have purchased or intend to purchase 100 shares of stock to COVER your call.
• You have an account approved for options.  If not, call your broker and ask for an options form.

Assumptions for the examples below:

• Today is November 7, 2008 and the example below assumes writing a covered call on Apple (symbol AAPL).  Note:  This is NOT a recommendation!
• AAPL trades at 98.24, and the December option chain for AAPL is shown below, per Yahoo Finance:
• Write a 100 strike December covered call on Apple

Steps of writing a covered call:

1. Start by purchasing 100 shares of an optionable security.  Our example uses Apple (AAPL).
2. Decide on expiration month and strike price to sell.  Our example uses a December 100 strike.
3. Open the trade options order form for your broker.   The Scottrade options order form is shown below.
4. In the buy/sell (or similar) box, there are usually four choices – Buy to Open, Buy to Close, Sell to Open and Sell to Close.  For a covered call, select “Sell to Open”.
5. Contacts – For a single covered call involving 100 shares, then the number of contracts is 1.  The money received from selling a covered call is equal to 100 times the quoted price in the option chain.
6. Symbol – This is where syntax matters.  In the image above, Yahoo Finance lists the AAPL December 100 strike as “QAALT.X”.  But the option syntax on the order entry forms for each broker can be completely different.  For Scottrade, it would be entered as “.QAALT”, for Fidelity it would be “-QAALT”, and for Tradeking it would be “QAALT”.  Call your broker directly if you need help with the syntax.
7. Order Type – Market or Limit.  For options trading, I NEVER use market orders! I’ll start with a limit order somewhere in between the BID and the ASK.  If it doesn’t get filled after a few minutes, then I’ll change my order accordingly and try again.  As an example, if my limit order of 8.35 is accepted, then 100 times that amount ($835) gets deposited into my account immediately.
8. Duration – Day order only means that if it doesn’t get filled today, then the order is cancelled.  Good until cancelled means that your broker will keep the order open until it gets filled or until you cancel it.  In some cases, your broker may have a time limit such as 30 days where they will cancel open orders regardless.

Aftermath of writing a covered call – In theory you could do nothing and just wait.  If Apple is above 100 per share at December expiration, your broker will automatically take your 100 shares away from you, and deposit an additional $10,000 in your account.  If Apple is less then 100, your shares But you do have other options.  You can close the contract early by using a “BUY TO CLOSE” order.  Doing so would leave you with just your 100 Apple shares and you would then have the option to sell a January, or other covered call and collect additional premium.

Appearance in your account – There are two things that confuse first time covered call writers.  The first is that covered calls appear as a negative quantity in your account.  Once you sell a December Apple 100 strike, it appears in your account as a quantity of negative 1, with a corresponding debit value (i.e. -$835).  Second, options are less liquid than stock.  It is possible that even if a stock rallies 10 or 20% on a single day, the last option may not have traded for several days prior.  In those instances, the value of the options in your account usually reflect the last traded amount, and not an amount resembling the current BID/ASK values.

Other Geldpress articles on covered calls:

• Time for cover – the covered call
• Covered calls – removing the covers and going naked
• Interesting covered call on AIG – 150 percent return (No longer relevant, but interesting to read)
• Covered call writers love high volatility

Also, I highly recommend the following book on covered calls.  Free articles are great, but if you are going to trade, then you need to get serious and spend a few dollars on a good book.

Don’t delay!  Buy it NOW!  You’ve lost enough money already!

The $81.90 is a worthwhile investment to slow or stop the bleeding in your accounts, and the 4% Amazon commission will help support this site.  Also, check out the Geldpress bookstore for other great options books.

Covered Calls and LEAPS–A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading) by Joseph R. Hooper

Leveraged ETF’s, despite their significant risks (counterparty risk correlation risk to name a few), are gaining in popularity.  There are several institutions offering double exposure ETF’s, and now a new entrant is even offering TRIPLE EXPOSURE ETF‘s.  Here is a sampling of the leveraged lineup:

• Proshares - offers single and double exposure index, sector and international ETF’s.  Also offers inversed double exposure ETF’s.
• Rydex - similar offering to that of proshares, with 14 double exposure ETF’s.
• Powershares -In general, their ETF’s hold fewer positions than traditional ETF’s, but they are not leveraged as of yet.  But I do like their dollar bull ETF (symbol UUP).
• Horizon Betapro ETF’s – Offers HBP Bull+ ETFs for double the daily performance of their underlying equity index or commodity, and HBP Bear+ ETFs for double the daily performance opposite that of the underlying index or commodity.
• Currencyshares – Not quite a leveraged lineup, but certainly worth mentioning.  These ETF’s offer a convenient way to bet on foreign currencies.  Personally, I’m more of a dollar bull then ever, but I do like the Japanese yen strength these days.  The symbol is FXY, but buy it at your own risk!
• Direxion Funds – Currently offers 1.25x and 2.5x leveraged ETF’s.
• Direxion Shares – In an industry first, they will soon offer triple leveraged (300%) ETF’s.  There will be 16 available, including the Large Cap Bull 3X (BGU), Small Cap Bull 3X (TNA), Large Cap Bear 3X (BGZ) and the Small Cap Bear 3X (TZA).

The most interesting fromt he list above are the new 3X leveraged ETF’s.  From the prospectus, there are numerous risks associated with these ETF’s.  The ones that stand out to me are:

• Correlation risk – In a nutshell, it’s virtually impossible to achieve exactly 3X the performance of the index, so don’t be surprised if the underlying goes up 1% and the 3X ETF only goes up 2.5%, and vice versa.
• Counterparty risk – Direxion uses counterparties that have access to financial instruments used to target those 300% returns.  There is no guarantee that those counterparties are, or will remain solvent in the future.  (Hint:  Bear Sterns, Lehman Brothers)  From the prospectus, “The Funds will not enter into any agreement involving a counterparty unless the Adviser believes that the other party to the transaction is creditworthy“.
• Credit risk – From the propsectus, “A Fund could lose money if the issuer of a debt security is
  unable to meet its financial obligations or goes bankrupt”.

More on correlation risk – In general, the leveraged ETF issuers do not disclose their methods for achieving 2X or greater leverage.  With the 2X funds, my own speculation tells me that the counterparties involved are either double short or double long the underlying.  The counterparties pay significant margin interest which is then passed on to the issuing fund (proshares or rydex for example), and eventually to the investors.  But with 3X funds, it’s more likely they need to access the futures and options markets to achieve the triple leverage.   If so, that could significantly increase the correlation risk for the following factors:

• Time decay – Options and futures have time premiums and time decay, which could cause more correlation differences in the 3X funds.
• Spread risk – The BID/ASK spreads on options and futures is increasing with the increasing volatility of the markets.  The institutions certainly would get the best prices, but the spreads are still not free, and the options/futures spreads are certainly larger than the spreads on stocks and ETF’s.
• Liquidity of options and futures market – It’s great for amateur investors, but if these 3X funds take off, they could find it difficult to roll contracts due to the volume involved.

Also check out:

• Correlation Error With Leveraged ETF’s

Here is a hilarious parody of Der Untergang (The Downfall), a classic movie that depicts the Nazi dictator’s final days in his Berlin bunker at the end of WWII.  The audio is legitimate, but the subtitles have been overwritten with parodied accounts of foreclosure, financial crisis.  Hilarious!

Mr. Mortgage just wrote up a great summary of the soon to be released pending legislation on the free mortgage bill.   The good news is that government “leaders” are finally realizing that the housing “boom” of the last 8 years was fake.  Part of the massive bailout program occuring now is a mandate to dig deeper into the ridiculous housing loans made during the last 8 years, and assess the magnitude of insanity.  The bad news is that it ain’t pretty!

They now realize that the entire housing “boom” was aritificial and brought upon by mortgage loan programs and leverage that were only available for a brief period of time and that will never exist again. Most of the loan programs contained fraud because the way the programs were structered. Ultimate affordibility through creative financing made it so everyone in the nation earned $150k a year and housing prices reacted accordingly.  Unsuspecting buyers who really earned $150k bought homes under fraudulent conditions and are now 50% underwater in their homes. They will be asking for a bailout as well.

And now the really bad news.  Initial attempts to restructure failing mortgages are failing.  New lending standards require that people have actual jobs with real and verifiable income in order to refinance, and can no longer count the anticipated appreciation in their homes as “income” as they once so commonly did.  (DUH!!)

Many banks are all of a sudden coming out with pre-emptive loan modification plans.  This is because they have finally realized that everything the housing market was built upon in the past six years was fake.   Wachovia was one of the first.  But from early reports I am getting the program is failing miserably. Apparently Wachovia’s close ratio is less than 10%.  This is because they did not estimate how many ‘liar loans’ were really out there or how far housing values have fallen.

And now the really really really bad news.  There are massive lobbying efforts going on now to create an unprecedented homeowner bailout, including the possibility of fully subsidizing mortgage payments for three years.

The Next Bubble – If such a program is passed, it will encourage ALL borrowers to stop all mortgage payments, because there would no longer be risk of default.  What do you get when millions of financially strapped borrowers no longer need to make their $2000-$5000 mortgage payments?  Answer - Wind fall free cash flow to buy new televisions, cars, vacations and more.  Just when you thought the debt ridden consumer was finally dead, trillions of dollars will soon be pumped into irresponsible borrowers hands with the explicit instructions to SPEND, SPEND, SPEND!

What Happens After Three Years – Hint.  It’s not going to be pretty.  If you thought the 2008 financial crisis was fun to watch, stay tuned for the next version – the 2011 Financial Crisis!

I just bought shares in the Market Vectors double short Euro ETN (symbol DRR).  ETN stands for exchange traded notes, which according to the website are “senior, unsecured debt securities issued by Morgan Stanley that deliver exposure to the exchange rate of foreign currencies.”  I have been a believer in a strong dollar recovery for quite some time, and the DRR is another instrument available to capitalize on it.   It is relatively new, with its inception date earlier this year on May 6, 2008.  I wrote about other ways to play the dollar recovery several months ago:

• Preparing for and playing the dollar recovery – bye bye euro

In that article, I mentioned several justifying factors for a strong dollar recovery, and those factors have led to a significant dollar bull market since that time.  I also mentioned a few ways to play the dollar recovery.  The Market Vector’s double short euro ETN (DRR) is a recent discovery.

Over the last few years, the dollar has been absolutely hammered for justifiable reasons – huge trade and budget deficits, plus lack of leadership to present a plan to rectify the imbalance.  But despite the fiscal recklessness within the United States, it is important to note that currencies only trade in relation to other currencies.  It was easy for traders to ignore problems in the rest of the world and focus on the weaknesses in America.  But the dirty laundry has come home to roost in Euro-land, and traders around the world are finally waking up to smell it, and punish the euro accordingly.  Among the european zone problems:

• Rising unemployment
• Falling manufacturing growth
• Tumbling real estate markets (Despite common belief, reckless lending did occur in Europe too!)
• Europe aggressively cutting interest rates
• European bank failures and bailouts
• Debt to GDP ratios that make America look responsible – From Nationmaster, the United Kingdom debt per GDP ratio is a staggering 387%.  France has a ratio of 173%, Germany 144%, Greece 148%, Ireland 758%, Italy 117%, and Finland 135%.

There are certainly more direct ways to play the currency markets on the Forex, but I do prefer the convenience of doing so with ETF’s or ETN’s.  But I also recognize that there is more risk in trading currency ETF’s and ETN’s as compared to trading directly on the Forex.  The DRR fact sheet lists out several of the risks associated with the double short euro ETN, including:

• Leverage risk – double exposure magnifies losses as well as gains
• Currency risk
• Non-diversification risk – susceptible to single market events
• Tracking risk – high volatility and effects of interest rates in the U.S. and Europe
  may cause Index return to deviate from a 2X leveraged short exposure to the spot exchange rate
• Issuer default risk – not secured debt; subject to credit risk

The last one is the one that shines out most, and is also the reason that I’m very careful with these ETN’s.  Just two years ago, it was simply inconceivable to most people that Lehman, Bear Sterns, AIG, Morgan Stanley, Goldman Sachs or other big name financial firms would face risk of collapse.  Morgan Stanley has escaped collapse thus far in the financial crisis, but they are certainly not in the clear as far as I’m concerned.   If Morgan Stanley goes under, there is a strong possibility that shareholders in DRR could be wiped out, regardless of the direction of the euro.  If you can’t handle that possibility, then stay away from these derivative currency plays.

Disclaimer: Trade at your own risk.  Nothing in this post, or anything at Geldpress shall be considered investment advice.