Geldpress

If you have been attempting iron condors on the Russell 2000 index, then you may be feeling some pain lately, in the form of lost money.  Iron condors can do very well when the underlying index trades within a smooth and pre-determined channel.  Take a look at the Russell 2000 over the last year, and notice two distinct environments - a friendly iron condor environment and a potentially fatal iron condor environment.

There are many iron condor trade alert services that promise big monthly gains with iron condors.  And I’ve seen some make claims that iron condors are big money makers with only 5 minutes of work per week.  In a friendly iron condor environment that may be the case, but if you are not prepared for the unfriendly iron condor environments (Hint:  NOW!), then you probably should just stay away altogether.  Unfriendly iron condor environments can be navigated through successfully, but they are tricky and require knowledge and planning - prior to the unfriendly environment striking.

In the latest issue of SFO, John Sarkett interviewed Dan Harvey, considered the “Supertrader of Index Condors”.  Dan Sheridan of Sheridan mentoring is also mentioned in the article.  The article is freely available and highly recommended for any iron condor trader.  In the article, Dan Harvey outlines his condor trading rules and guidelines:

• Place your short strikes correctly with low deltas of between five to seven
• Watch the current psychology of the market
• Study position greeks, charts and graphs every night
• Make timely adjustments when necessary
• If you stay in the iron condor trade during expiration week, then make sure you are 2.5 to 3 standard deviations out of the money to avoid delta and gamma risk
• Optionally, place contingent orders to protect against unpleasant surprises

Dan refers to three alternative adjustments to make to iron condors entering undesirable territories, including:

1. Mickey Mouse ear - an example would be a long put debit spread near the lower limit of the original condor channel.
2. Embedded calendar - Dan mentions adding an embedde calendar  two standard deviations out of the money, and either taking profit and repositioning further out on a continuation movement, or stopping out for a loss on a reversal.
3. Mighty Mouse ear - This adjustment is more expensive than the mighty mouse ear or the embedded calendar.  It refers to buying additional puts two to three strikes in front of the short strike.

Iron condors are great when they work, but you must be prepared for the potential losses, and learn the skills necessary to adjust and steer clear from trouble.  In addition to reading the entire SFO article, I’d also recommend purchasing the following book on option trading adjustments.

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

Jim Jubak, number one columnist for MSN Money, just named his list of the “10 financials you’ll want to buy“, broken down into two categories - “famous but broken” and “Survivors ready to pick up the pieces”.  Of the ten, only one looks mildly appealing to me.  Read on to learn more.

Among the first category are Banc of America (symbol BAC), ICICI bank (symbol IBN), ING Group (symbol ING), Ping An Insurance Group (symbol PNGAY), and State Street (symbol STT).  Of that list, I’m not so sure Ping An Insurance is very famous; I haven’t heard of it until reading his article.  But more importantly, I’m not ready to put a single dollar of my money into any of those five financial, as the broken in Jubak’s “famous but broken” is far understated.  Those five names are on serious life support!

The other five “survivors” are a little more interesting, and a lot less scary.  The list includes HSBC (symbol HBC), Banco Itau Financeira (symbol ITU), Northern Trust (symbol NTRS), US Bancorp (symbol USB) and Wells Fargo (symbol WFC).

Here is my quick and dirty opinion of the Jubak’s “survivor” list:

• HBC - Not easy to find financial data on Yahoo or Google Finance.  Also, to much exposure to emerging markets that are now waiting in line for IMF bailouts!
• ITU - Based in Brazil.  No thank you!  Can you say whacky accounting and emerging market bailout?!?!
• NTRS - I wouldn’t classify a company that lost $148 million last quarter as a “survivor”.
• *USB - Much healthier than most other banks, and also heavily owned by Warren Buffett at prices higher than the current $25.80 per share.  They did post a $576 million profit in the latest quarter ending September 30, but they are certainly not immune from the financial crisis.  Net loan charge offs increased nearly 250% from Q3 2007 to Q3 2008, largely due to commercial loans gone wrong.  There latest charge off rate for the quarter was 1.19%.  But overall, I would agree with classifying them as a potential “survivor”.
• WFC - It’s recent purchase of Wachovia makes them just to difficult to analyze.  It makes me wonder if the entire acquisition was performed solely as a tactic to complicate their reporting and conceal some of their ugliness.  On top of that, they are based in San Francisco, one of the biggest and still deflating real estate bubble markets in the country.  This one is just to risky for my taste!

Summary - A nice list of 10 potential financial investments from Jubak, but certainly not a list I want to blindly throw my money at.  The only one that looks even mildly appealing is US Bancorp, but even that one is not worth diving into.  Perhaps dipping a toe in is the preferred strategy.

Disclosure - I currently do not own shares in USB, but I may or may not purchase them in the future.  Also, as always, TRADE AT YOUR OWN RISK!

Volatility is definitely the name of the game in 2008.  But today’s action in the S&P Index showed that volatility and wild swings are not just for weekly or monthly cycles.  Intraday volatility was in full force today with multiple crosses of the zero line, and a S&P Index trading range (820-913) that approached 100 points from low to high.  That 92 point trading day measured against yesterday’s S&P close of 852 is a staggering 11%! The S&P itself closed up just short of 7%.

So how do you trade these crazy high volatility markets that have become the norm?

A) Buy and Hold!  No Trading for me.

B)  Forget trading.  My money’s much safer under the mattress.

C)  I’m a bank CEO, and I have no time to trade.  I’m to busy spending the taxpayer bailout money!

D)  No money to trade.  I went broke from attempting to trade the market earlier in the year!

E)  Very patiently, and methodically, with well hedged positions and a mix of long and shorts.

If you answered E, then there’s a good chance your 2008 returns are crushing the rest of the market participants, perhaps even etching out a modest gain for the year.

With my own account, I stay away from intraday trading, and leave that type of behavior to the maniacs on TV.  But I’m not even close to a buy and hold investor either.  On the contracy, I do pay my broker several trade commissions on any given week, but I hedge almost everything I buy, and I almost always have trades on both sides of the fence - long and short.

My methods for hedging my positions:

Covered calls - great to hedge a portion of your downside, and do very well in a flat market, but they won’t protect you against a radical decline that goes past the point of your covers.

• Time for cover - the covered call
• Covered calls - removing the covers and going naked
• Covered call writers love high volatility
• Covered Calls - Scottrade, Tradeking, Fidelity

Collars, Index puts or Proshares Inverse ETF’s - Collars limit both downside but also cap your upside potential.  Index puts protect your downside but leave your upside uncapped.  But the two disadvantages are that they can be very costly (especially during times of high volatility), and they are often difficult to implement correctly for beginners.  Proshares Inverse ETF’s offer a quick and convenient way to play the downside in the market, without worrying about option pricing or short selling rules.  But it is critical to check the prospectus of proshares to understand the risks of using them, including counterparty risk and correlation risk.

• Bring your collar into these volatile markets
• Proshares and Profunds leveraged ETF’s
• Proshares biggest counterparty risk is US Government (Article on the risk of using proshares)

Mix of long and short positions - Balance your portfolio with a mix of long and short positions to reduce some of the wild swings in your account, and help you sleep better at night.

• Balanced and hedged portfolio using proshares
• Trading strategy - hidden jewel in the shorts

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.

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.

Barron’s just published an excellent article on convertibles, those mysterious investment vehicles often shunned by individuals and rarely understood even by “professionals”.  According to the article, convertibles have fallen 36% so far this year.

Converts have been hit hard for three main reasons: The stock market is down, the corporate bond market has been whacked, and hedge funds, once the dominant investors in convertibles, have been forced sellers after terrible performance this year.

Convertibles can be either preferred stock or bonds, which are often high yield.  Preferred shares ranks higher then common shares in the event of a bankruptcy, but carries no voting rights that the common shares do.  Preferred shares may also offer preferred dividends which are in line ahead of common share dividends for payment.

The Barrons article mentions three companies that offer convertible funds - Fidelity, Vanguard and Putnam.  I’ve listed three of the funds to start your own research, if you buy into the potential recovery of convertible funds that Barron’s does.

• Fidelity Convertible Securities Fund (FCVSX)
• Vanguard Convertible Securities Fund (VCVSX)
• Putnam Convertible Income Growth Fund (Class A Shares:  PCONX, Class B Shares:  PCNBX)

I wrote about some of the great stock screening tools in previous posts, but those free tools seem to get better all the time.  If you are looking for some great screening tools, start off with the following:

• Easy stock picks using free screening tools
• The best free technical stock screen from etrade
• Free technical analysis stock screens

In today’s volatile environment, I look for medium sized companies with solid earnings and a decent dividend.  Here is the criteria I used just today, as shown from the google finance stock screener. The criteria I use in today’s market is going to be very similar to the above.  For a medium sized company, I’ll search for market caps between 1 and 50 billion.  I don’t like to buy companies that are losing money, so I search for positive price to earnings ratios between 5 and 15.  Dividends are king so I make sure to look for ones that are paying something back to me as an investor, and a dividend yield between 3% and 5% should do the trick.  And to top it off, I like to screen for the 52 week price change.  I like beaten down stocks, but not ones such as financial institutions that have lost 90% of their value and losing money hand over fist.  I set the threshold at negative 40% on the low side.  And on the high side, I prefer to stay away from bubble territory, so a positive 20% is good enough on the high side for 52 week change. For diversification, you can also limit the results for a particular sector or exchange.  It’s best to take a look at your own portfolio distribution.  If you are currently heavy in energy, you can limit the google screen to healthcare, conglomerates or another sector that balances your portfolio out a little more. The screen above returned 65 matches that you can do additional research on to find something to buy.  Some of the additional things I like to do are the following:

• Screen out anything based on personal biases or current portfolio weightings - If you only want American companies, you can rule out Honda Motors.  If you are fearful of anything related to the auto industry, you can rule out Genuine Parts.  You can also eliminate ETF’s which sometimes come up in the results.  The particular results above returned several iShares ETF’s.
• Limit the search to specific sectors as a tool to diversify your own portfolio - Use the drop down sector box to pick a specific industry you feel you need to buy in order to balance out your own portfolio.
• Take a look at the google finance Income Statement (example income statement here).  I personally look at the Net Income in the middle of the page and the Diluted Normalized EPS.  I like to see positive and somewhat stable numbers for the last 5 quarters.  Currently, google only has quarterly data available going back 5 quarters, but you can also look at the yearly data to go back a few years without the quarterly breakdowns.
• Take a look at the google finance Balance Sheet (example balance sheet here).  I personally like cash rich companies so I look at the Cash and Equivalents at the top of the page.  This is especially important in today’s very tight credit markets.  I also look at the Total Debt numbers in the middle of the page.  Is it a manageable number as compared to their existing Free Cash Flow?  Is their total debt increasing, decreasing, or stable?
• Take a look at the google finance Cash FLow Statement (example cash flow statement here).  I look to the Net Change in Cash near the bottom of the statement.  I like to see positive numbers for all viewable quarters and annual periods available.  I won’t necessarily rule out a company with an occasional negative cash flow, but I may have to dig deeper to justify the negative cash flow.  I also like to compare the annual positive cash flow in relation to the long term debt.  A good rule of thumb is the number 3.  If a company is capable of paying off their entire long term debt with 3 years of positive cash flow, then their debt levels are manageable.  Note, I’m not implying that a company needs to pay off their long term debt, only that they are capable of doing so.
• Optional - If you have any faith in efficient market theory, you can stop here and pick one of the results that matched your additional and manual screens.  The other approach is to analyze yourself into a corner by digging deeper into the quarterly and annual reports, listening to the conference calls, and reading research reports, and blog and message board reviews.  But it’s virtually guaranteed you will stumble into something you don’t like - pending lawsuits, consistent “one time” charges, underfunded pension liabilities, higher input costs, labor disputes and more.

The next question - to hedge or not to hedge? Once you find something you are willing to throw your money at, the next question to ask yourself is whether you want to hedge your bets.  The idea of hedging is that no matter how much research you do, you can still be wrong, and still lose money.  Hedging offers you a way to limit your downside risk in exchange for capping some of your upside risk.  Here are some other articles that discuss hedging, and a book recommendation on PUT Options (one of the most common hedging techniques).

Note:  While it’s great to have the free information in the articles at Geldpress, sometimes it really does help to buy a good book to get the entire picture.

• Trading strategy - hidden jewel in the shorts
• Portfolio protection - hedging todays roller coaster market ride
• Selling puts for income, or as a cheaper investment
• Time for cover - the covered call

Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey M. Cohen

Today’s Fast Money show introduced several prevailing themes that Geldpress has been reporting on for some time.  There is no question that the commentators on Fast Money are magnitudes more intelligent then Cramer, but unfortunately, they are not as “fast” as the name of their show implies.

1. The dollar is rising, and there are ways to play it.  See Geldpress article from September 1st entitled:  Preparing for and playing the dollar recovery - bye bye euro
2. Rating agencies are useless and crooked companies.  See Geldpress article from August 8 entitled Why does Warren Buffett like Moody’s?
3. Hedging your investments by being long and short simultaneously.  See Geldpress articles:

• Balanced and hedged portfolio using proshares
• Trading strategy - hidden jewel in the shorts
• Portfolio protection - hedging todays roller coaster market ride

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

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!