This is a continuation of the post on Straddle / Strangle - from a "vegas" to a high probability "safe" trade.
I did 2 more trades - NVDA and RIMM. Both were pending earnings results. NVDA has announced and RIMM will announcing on 3/24 after market closes.
Keep in mind this is a high capital, low return, short time frame and high probability trade. It is meant to be closed after the event.
As long as I reach my target of annualized return of more than 50%, I may decide to close the trade.
1. NVDA
The trade was placed on 2/14 - 2 days before earnings.
I was debating on buying longer term put or a very short term put which expired in February 2 days after the earnings.
The problem with short term put is that the theta decay will instantly kill the trade without possibility of any adjustments. However, if the stock moves, it will probably yield better results because of the gamma or delta change.
There was a lot of excitement on NVDA. It was expected to move. It can be up or down. This is an ideal stock for such a trade.
Following was the Trade Structure opened on Feb 14th.
BTO 1000 stock = 23.16
BTO 10 Feb 23 C = 1.09
BTO 20 Feb 23 P = .94. ( Volatility is very high and option price was expensive )
STO 10 Jan 2012 25 SC = 3.5
Cost Basis = 26.1
Results were announced after market closed on Feb 16th. Pre-market shows that the price dropped slightly. There was not a lot of firework.
The market opened on Feb 17th with the stock dropping 2% in the first 15 minutes. My long puts and calls suffered high volatility crush. Since the stock did not move substantially, I was losing money. The first thing I did was to sell my puts and take the loss.
In about 2 hours, the stock price reversed and started to move up. The LC turned positive. The stock is making money. The trade turned profitable.
I had to decide whether to let the stock run or close the trade breaking even or enter a covered call.
The decided on a NTM covered call.
STC Feb 23 P = 0.41
STC Feb 23 C = 2.46
BTC Jan 25 SC = 5.05
STO March 24 SC = 1.45
Cost = 23.42
The Stock closed on Friday at 25.63
The CC is ITM now. As long as it stays above 24, I will be profitable with a annual ROI of about 30%.
On hindsight, I closed the legs of the trade too early. I should have let it run. It closed the on Feb 17th with a 10% gain. The trade would have exceeded my objective of 50% Annual ROI.
2. RIMM
RIMM is expected to announce earnings on March 24th - one day before March option expiration.
Trade placed on Feb 14
BTO Stock = 66.3
BTO March 65 P =2.04
BTO March 67.5 C = 2.12
STO Jan 2012 72.5 SC = 6.7
Cost Basis = 65.8
I was planning to close the trade after earnings.
But RIMM prices shot up over the next 2 days. I reached my target objective. I closed the trade.
STC stock = 69.3
BTC Jan 2012 72.5 SC = 8.35
STC March 67.5 C = 3.6
STC March 65 P = 1.01
Cost = 66.57
Return = 2.28% in 2 days or about 60% ROI.
This is a case that I did not wait for earnings. I can always place another trade before earnings. I did that for FSLR by placing a trade after taking profit 2 days on the trade. Currently, I am waiting for movement as they will be announcing earning results this week. I will report the results
This trade strategy has been all profitable so far.. While waiting for the big move on the stock, the profit / loss did not fluctuate a lot. It was pretty neutral. Once there was movement on either side, it made money. In some of the instances, I decided to take profit first as long as the objective of 50% annual ROI is reached.
Monday, February 21, 2011
Tuesday, February 15, 2011
Saturday, February 12, 2011
Straddle / Strangle – from a "vegas" to a high probability "safe" trade.
A straddle / Strangle is used when there is a fixed event that will move the stock up or down. The regular event is the earning announcement. It occurs every quarter. Other big movers are drugs awaiting FDA approval or a new product introduction, a big political event or pending merger or acquisition.
If the stock does not move after the event, the trade will lose money on this trade. It is an expensive trade. Besides suffering from time decay, your trade is negatively affected by the volatility crush after the event. Normally, IV will be high just before you enter the trade. Volatility crush will kill the trade without mercy. If you are wrong, you can lose up to 80% of the value. But if you are right, the upside is unlimited.
It is classified as a "vegas" trade. It is a more or less like a bet on a lottery.
But it does not have to be this way. Trade will lose a little money if the trend remains stagnant. Most of the time it can end with a profit with some minor adjustments.
The example given will show how to have high probability of winning in all directions.
It is done by cushioning the volatility. The time decay is minimized by acting quickly to close or adjust the trade once the results of the event is known.
The trade consists of a strangle and a collar.
Similar to on of the criteria of choosing a trade for strangle / straddle, you want a high volatility stock that will move after an event.
Similar to on of the criteria of choosing a trade for strangle / straddle, you want a high volatility stock that will move after an event.
FSLR is used as a case study below.
Background
FSLR is poised to announce earnings at the end of the month. Almost without fail, the stock moves after earnings.The stock will also move even before the earnings.
With the big run in the last few weeks, there is even a higher probability that the stock will move markedly after the earnings call.
Short ratio is currently very high at 30.37%.
Personally, I am not convinced of the competitive edge in the stock. The main competitive edge is the subsidy from the German government. This is not a sustainable edge. Their technology and cost positions are falling behind.
But again, I am not arguing with the fundamentals. Technically, the stock is moving bullish. Thus, I expect some big moves before or after earnings as emotions are running high. IV is above average.
Trade:
Trade was entered on Feb 10th - BTO 5 FSLR = 155.79
- STO 5 Jan 12 165 = 19.75
- BTO 10 Feb 155 put = 3.55 ( very short term put. Can also use March 155 )
- STO March 155 Call = 9.9
Cost = 153.04 ( 155.79-19.75+3.55*2+9.9)
The trade will make money if it is bullish or bearish. Anything about >5 % the trade will be profitable. The decision can be to close the trade and take profit or convert the trade to a CC if still bullish on the direction.
You can also close one leg of the Call or Put to maximize the unlimited potential if the trend justify.
In the even of a low probability that the stock does not move after the earning call, you can always close all the legs and Roll down the LEAP SC to make it a short term covered call. You should be able to regain all the small losses and make some small profit. For these adjustments, you do the following:
- Sell the LC and take some loss
- Roll the LEAP SC down to a nearer strike and take some profit. Add a 1 to 2 months expiration
ATM, ITM or NTM SC to create a new Covered call.
You now have a covered call. You can manage it to profitability with relative ease over time.
Closing the trade
FSLR went up > 6% to a high of 167.4 the next day.
I can hold the stock and wait till earnings are announced.
But I decide to close the trade and take profit although I believe it will make more money if I am right after earnings.. But I decide to be conservative and take the profit first. I have similar trades on NVDA and RIMM waiting for results.
STC Stock = 166.816 Profit = 11.02STC March 155 C = 17.22 Profit = 7.32
BTC Jan 2012 165 SC = 27.25 Loss = -7.5
STC Feb 155 P = .99 Loss = -5..12 ( 2 puts )
Net Profit = 5.12 or 3.74 % for 1 day
This is nice gain given the short duration and a relatively safe trade.
Holy Grail? Foolproof indicator? Highly Accurate Algorithm?
Very often, I am proposed with some special system, an algorithm, a foolproof indicator or a formula that guarantee you to win in the market. The offers can come from a small quick money making outfits but also some respectable analyst and financial institution with real mathematicians and scientists working on the system.
I received the following write up from Jeff Clark on Feb 8th and thought it is fun to post an excerpt:
“
The Final Piece of the Puzzle
By Jeff Clark
Tuesday, February 8, 2011
Tuesday, February 8, 2011
Everything is in place now.
For the past couple months, I've been harping about the potential for a bearish move in the market. Sentiment indicators, summation indexes, bullish percent indexes… all the technical indicators are warning of a swift and severe correction. The market doesn't care. It just keeps marching higher.
The high-frequency trading desks, the algorithmic computer programs, and the Bernanke printing press have overpowered the technical indicators and – like Atlas propping the world up on his shoulders – kept a persistent bullish bid beneath the market. The new high list keeps growing. Expensive stocks keep getting more expensive.
Every day I warn investors of the potential risks in the market. And every day I start the morning by washing the egg off my face. Why worry about risks when there are such large gains to be made? "It's a new world," the market says. "Either get on board or get out of my way."
So yesterday I sat at my desk, banging my forehead on my keyboard and wondering what else has to happen before the market corrects. What other indicator has to reach a ridiculously extreme level and warn of the impending doom before stocks finally take a breather? This was 9:41 in the morning, Pacific Standard Time (PST).
At 9:42, the phone rang and the final piece of the puzzle fell into place.
"Hi Jeff," the voice said, "It's your mom. Just wanted to get your opinion on the stock market. We're sitting in cash right now, earning 0%. And we're thinking about buying some stocks."
Get out of the market while you can, folks. The "Mother Indicator" has just issued a sell signal.
Mom is the perfect example of a public investor. She doesn't pay much attention to the financial markets. So if she's aware of a trend, or has an inkling to put money somewhere, you can bet the idea has gone mainstream. And she has a near-perfect track record as a contrary indicator.
Signals from the Mother Indicator don't occur often – perhaps just once every two or three years. They are, however, remarkably accurate… And they always seem to occur within days of important turning points. For example, I first acted on this signal in early February 1994. Stocks had been on a terrific run – up 20% in about eight months. The Fed was easing, so interest rates on CDs and money market funds had been falling. Mom was looking to get a bit more bang for her buck. And for the first time since August 1987, she wanted to buy stocks.”
Without fail, most of these systems fail eventually. Perhaps the exception is the prevailing proprietary high frequency (HFT) trading desks of major financial institutions that trades in nano seconds using powerful computers and high speed linkage to the Exchange. Great successes are reported for these systems. It is estimated that up to 56% % of trades are generated by these High Frequency Trades (HFT). So, it is very difficult for trader traders to beat these systems.
However, I remain sceptical. I believe any mechanical system will fail over time. The market is an emotional creature. It is difficult to use mechanical logic to reason with emotions.
It is wise to treat the market as totally unpredictable, at least short term. It seems to suffer from some bi-polar personality disorder, which varies from extreme happiness to deep depression. It can remain irrational longer than you can remain solvent.
Therefore, there are no secret formula or holy grail.
There is no easy path.
Trading is very much a probability game.
I have my fundamentals. I have my technical systems. But at best it gives me slightly more than 50% probability of winning. Although, longer term the fundamentals if done correctly will work in my direction but it could take a long time!
One great example is to look at Wal-Mart. Over the last decade Wal-Mart's earnings almost tripled from $1.25 per share to $3.42, growing at an impressive rate of 11.8 percent a year. This doesn't look like a stagnant, failing company; in fact, it's quite an impressive performance for a company whose sales are approaching half a trillion dollars. However, its stock chart led you to believe otherwise. The PE declined from 45 to 13.7, or about 12.4 percent a year. The stock has not gone anywhere.
Does that mean that the market is totally random? There are number of academics and books write to prove that we cannot time the market. They favour diversification, segment rotation and rebalance of portfolio to make steady gains. It is believed that the market is random and thus no one can beat the market.
Personally, I believe we can beat the market. I had done it for many years. The important thing is to understand the fundamental dynamics, emotions and irrationality. Market always over extended itself because of emotions. While being confident, we maintain with humility a healthy respect for the market.
How do I deal with the uncertainty?
To begin, I acknowledge that I cannot predict the market with certainty. I am rightly only slightly more than 50% of the time.
So risk control is my Holy Grail. I diversify, keep disciplined position size, rebalance once in while, conduct segment rotations and I hedge.
Successful traders hedge their risk. Primarily, I use options to hedge. It is the third leg of my trading process. The whole process is like playing chess with the market. Various adjustments are made in a trade structure until it is closed.
Using options properly has the wonderful effect of taming the volatility giving control over greed and fear. On the other hand, using options for the purpose of leveraging in a directional trade has the opposite effects.
I will not be afraid to buy into breakout or a change of trend as long as I have considered all the downside risks.
This is the system I believe I will beat the market both short and longer term.
Sunday, February 6, 2011
Possible events that derail the market
The DOW closed conclusively above 12000 and stayed there for a few days. If it can maintain this level, this market should be bullish over the next few weeks.
Many people, including me, is expecting a correction but it never came in January. It may not come in Feb.
This is the important lesson of trading. Never trade on what you feel but on what you see. Whether it is price actions or earnings, they are pointing to a bull market. I will trade on it as long as the direction maintains. I know my system will capture the downturn when it comes. Fundamentally, it is hard for me to believe that it is so bullish. But I see is what it is. Do not argue with the trend.
I expect some kind of drastic event that will derail the market. Here are some possibilities
- Ten year treasury bond spikes to 5% and money gets expensive
- Crude oil soars to >$130 in a short period of time because of fear of crisis in the middle east
- Ireland default and sends a domino throughout the Euro Union
- Stock prices continue to rise and the FED decides to end quantitative easing
All these events could happen. One event will trigger another. When it happens, it is usually fast as investors run for cover.
I still expect a 10% correction. It will happen. It should be within the next 4-5 weeks. I am watching it closely and remain extremely cautious as I continue to trade bullish going forward.
My Favourite Gold Stock
I discussed previously on my favourite silver stock last year, SLW.Besides GDX, there is one stock I have traded for the last 5 years. The stock is Gold Corp or Symbol: GG
So far the gold miners are still lagging behind the rise in gold prices. But cash flow are improving and so is profit margin as the price of gold goes up.Big miners are value play opportunity now. Companies should do very well as they report earnings during the next 1-2 months. The high price of gold favors their performance. Cost are kept relatively stable. Margins, cash flow and earnings have expanded. The market has not fully price in the margin expansion. Thus positive surprises can be expected.
Most big caps on gold moves in tandem with gold price. I expect that some will outperform the other once gold price break up again. I expect this to happen some time this year.
GG remains my favourite for many reasons:
Comparing, Goldcorp, NewMont and Barrick, I like Gold Corp.
Stock Estimated Estimated Percent Change
2010 Earnings 2011 earnings
GoldCorp $1.4b $2.5b +86%
Newmont $1.7b $2.0b +20%
Barrick $2.8 b $4.0 b +42%
Data from Bloomberg
As you can see, there is one clear winner. Goldcorp's net earnings will rise 86% from 2010's estimated net earnings. Barrick Gold's net will rise 42% in that scenario, while Newmont's nudges up 20%.
It turns out, Goldcorp is the cheapest among the three as well.
Here is another comparison:
Stock P/E est. 2010 earnings P/E est 2011 earnings
GoldCorp 24.2 13
Newmont 18.6 15.5
Barrick 19.4 13.7
At more than 24 times last year's earnings, Goldcorp may look expensive. But using my numbers for 2011, it's a great deal.
There's no guarantee gold will remain at $1347.5.There is still a probability it could sink to $1,200. It could also skyrocket to $1,800. But the big, long-term trend here is up… and if it continues, big gold miners are going to start rolling in profits. And the best deal in "big gold" is Goldcorp.
There's no guarantee gold will remain at $1347.5.There is still a probability it could sink to $1,200. It could also skyrocket to $1,800. But the big, long-term trend here is up… and if it continues, big gold miners are going to start rolling in profits. And the best deal in "big gold" is Goldcorp.
Gold Miner | PE Ratio at $1,350 per oz. | PE Ratio at $1,200 per oz. |
Goldcorp | 10.8 | 13.6 |
Newmont Mining | 13.5 | 29.7 |
Barrick Gold | 11.6 | 19.1 |
If you lower the gold price, they all get more expensive. But take a look at Goldcorp. Even if gold falls another $150 per ounce, it's still a great deal.
Wednesday, February 2, 2011
Credit Trades
This post will discuss credit trades. I will use bull put as an example but the discussion equally applies to a bear call.
Bull puts can be very profitable. The probability of winning is also very high. Often it is > 80% success probability if you structure it correctly.
However, if there is a down turn, it is usually fast and furious. You can lose 90% of the profits of your last 10 trades just with 1-2 trades!
It has been perplexing to me. I am finding some ways I can manage to profit consistently without suffering big loss once in a while
The usual strategies for bull put is usually as follows:
- enter the trade 1 or 2 strikes OTM when a bullish signal is given. It could be a breakout, a successful test of support or a bullish candle formation.
- Make sure the company is fundamentally sound
- If the direction goes against you, you are ready to assume ownership through the SP and roll the LP out and in for longer term protection. Upon assignment, add a SC and manage it forward as a collar until you are profitable.
The above are great strategies but it does have 2 problems.
First, you need capital to assume ownership. So you cannot increase the size of the puts as it will take too big a capital outlay if the size is too big.
Also, when the stock falls, normally it is going to continue to a while. Thus, it takes patience and time to nurture the converted collar to health again. It is certainly possible if fundamentally it is a good company but it takes time and effort.
I like to explore a pure trading strategy to manage bull put. This means that I am out if I am wrong. I am prepared to take some loss if the direction goes against me.
Strategies
- Always enter as a bull put and not a naked put. The protection is always worth the insurance and it does not cost much.
- Place the protective put at the below next support.Do not enter a bull put on the month of earnings announcement or anticipation of fundamental event mover of the stock. The IV may destroy your position.
- The trade is executed with the issue of bullish signals. If possible let it aligns with the overall market trend. If the market is bullish, there should have less hesitation to enter bull puts
- Determine on the exit point. Consider taking profit once the position reaches 80% of ROR. If the trade is really far OTM and the stock or market has no signs of resistance, you may target to keep 100% of the credit. Remember that this is only a small additional bonus. Do not be greedy. With any uncertainty, get out.
- When the trade goes against you immediately, consider adjusting.. If it is clearly bearish, the trade can be converted to a bear put. I prefer to get out most of the time with a loss.
- When it reverses and a bear signal is given, get out. You may lose some money or even make a profit if the reversal is not too serious. The question is what are the bull and bear signals? If depends on your technical system. It really does not matter. Many people can use very sophisticated algorithm and program but I believe a simple system will work just fine with around 60-70% accuracies. I have tested some technical algorithm and the results are not far away.It is important that you stick to the signals used for the trades to maintain consistency. My technical signal is a combination of support, resistance, MACD and candlesticks. For some trades, I draw Fibonacci retracement lines to gage the support and resistant. For others, a simple trend line will suffice. Any break up or break down above or below these lines from the candlestick will give me the signal. The MACD acts as a confirmation to my decision. It is a very simple system but gives me at least 60% accuracy.
- When the SP goes ITM or NTM, an alarm should ring. Never allow the SP to go ITM. If it is NTM, review the position. If the stock drops because of the overall market, wait for until the week before expiration before exiting. The theta of the SP will be working positively for the position. My experience is that SP ITM is the one that gives led me to some of the big losses. The tendency is to hope that it will recover but if it continues to go against the position, it is the route to no recovery.
I intend to try out the system. I will also update this post of any new observations or results
Encana Covered Call converted to collar
Natural gas has dropped a lot over the last 2 years and seems to show signs of bottoming over the last few weeks.
There is still abundant supply and a glut in the market but it will not continue that way forever. There will be new applications. Oil and coal price has gone up and the cold winter also contributed to the stabilization of price of Natural Gas.
The price may be at historic lows today but we can sure it will rise again at some point.
The way to start watching a bear market is when it gets from bad to less bad.
The simple fact today is natural gas it is the cheapest source of CLEAN energy in North America today. Eventually, the utility of natural gas and its low cost will create demand. If the price of natural gas heads up from $4 to $6 or $8 in the coming years, these assets will skyrocket in value.
Thus I am investing in one of my favourite stock, Encana, Symbol: ECA.
Background
Encana has a market cap of about $23billion. According to SEC filings, it has 19.5 trillion cubic feet of natural gas reserves.
Encana has 23,100 producing wells. It also has an inventory of 35,000 drilling locations.That's enough inventory to drill 1,500 wells a year for more than 20 years... without doing any exploration at all.
Below is a comparison of Encana verses its peers
Company Market Cap Price to Book Price to Cash flow PE
Encana $23b 1.24 7.44 13
Tailsman $23b 2.04 6.47 34.3
Husky $23b 1.55 9.31 18.8
Chesapeake $17.3 1.57 3.22 19.2
The key risk is the price of Natural Gas. It could go down further. The assumption is that the bottom is near.
During the worst period, Encana fell to a low of $19.21 – roughly 38% lower than today’s price. Even then, it reported a $1.9 B profit. The company paid 86¢ per share in 2009 and 2010 – two terrible years for natural gas producers. The company's production fell, its cash flow fell, and its earnings fell. But management remained conservative through the good years. It was prepared to pay its dividends even in the worst of times.
In 2010, the company bought 2% of its shares at an average price of $32.42 per share.
This is a safe and solid company.
Trades
I bought a covered call on January 12th 2011. All the buy signals were triggered.
BTO 1000 shares $ 29
STO Feb 30 SC $2.1
Cost Basis = 26.9
The stock went straight up after that and my SC went ITM
The company is scheduled to report earnings on 2/11
So I made the following adjustments:
1. Added a short term protection put on Jan 27th BTO Feb 33 P 1.25. New CB = 28.4
2. In order not be called out if there are good earnings, I rolled the Feb 30 SC to March 35 SC
The put is supposed to carried me through earnings.
If result is good, I can convert it to a bull put or just sell the put.
If negative results, I will roll the put to a longer period near expiration and roll the SC down and in – taking some profit from the current SC.
It is my intention to hold on to this stock longer term. My target is a >50% gain this year.
Currently, short term trend is down. The stock is overbought. Company is releasing earnings on Feb 10th.
Observations on the market
There are some interesting observations on the market.
With the downgrade of Japan, the yen actually went up and gold went down. Japan debt to GDP ratio is 200%. This level is second only to Zimbabwe and yet the market considers Japan a SAFE HAVEN to mitigate the risk of the unrest in Egypt when the market went down last Friday.
Sovereign debt in Europe continues. While there are all kinds of attempts to find solutions,
sovereign debt continues to be a problem. There are no improvements in the situation in Ireland and Portugal. Italy looks increasingly vulnerable. There is high still high probability that Ireland may default.The public has forgotten that these problems are still lurking in the background and will suddenly surface again.
USA deficit got worst with a report last week. At the Davos meeting this week, there was a proposal of US$100T credit ( or shall we say debt ) to support the growth of world economies. Thus, money printing rolls on globally. We had QE II and QE III is coming. There is no clear exit strategies for the Fed. Letting go a down slope while skiing is easy but the trouble is knowing how to stop.
Every time bond price dropped, it is supported by the next day. There is no secret of the Fed manipulation. Actually, the Fed is pretty open about it. They went in to buy more bonds. The question is how long it can continue.
In view of all these factors, gold price had a big correction this week in January until on Friday, it reversed up together with the dollar and oil because of the Egyptian unrest.
Over the last few weeks, there were talks of gold being a standard. The president of World Bank mentioned about a gold standard although he denied it later. Next came a surprise. Fed Governor Hoenig shocked many observers when he stated, “The gold standard is a very legitimate monetary system...We're not going to have fewer crises necessarily. You will have a longer period of price stability or price level stability, but I don't know that you'll have lower unemployment, I don't know that you'll have fewer bank failures.” For this to come out from a team member of the Fed reserve, it is an important timing. Finally, a comment made by Allan Greenspan in 1997 was revived on the Internet. Greenspan was the cause of this big bubble and money printing exercise. Apparently, his views as a good economist and his actions as a politician or civil servant is widely divergent. For gold to become some form of standard is a remote probability but it is interesting that it is being discussed more frequently.
Finally, food commodities continue to rise. During end January, it had a false break down but went straight up causing short traders to run for cover. High prices of food have started to cause instability in countries. There are riots not only in Tunisia and Egypt which finally caught the media on Friday. Other hot spots include Yemen and Jordan where unrest are starting to appear.
We are certainly threading on dangerous ground. While it is important that inflation needs to be tamed at the early stage. But what is happening is the the opposite. We are adding fuel to the fire denying that it has started.
We are certainly threading on dangerous ground. While it is important that inflation needs to be tamed at the early stage. But what is happening is the the opposite. We are adding fuel to the fire denying that it has started.
While the money-printing-induced high we're currently on may feel fun today, the unavoidable inflationary smackdown we'll experience tomorrow most certainly will not.
Well, the market rallied back on Monday. It is still very bullish. I have to agree to the adage “don’t fight the FED" and " the Trend is your friend”. All talking heads on CNBC are bullish now. But one question: “ If the economy is so good, why the need for quantitative easing?”
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