Whee, that was fun!

We got the drop we expected but at 9:56, with the Dow down 80 poiints at 12,875, I said to members: "Well I dumped my QID calls so I guess I think this is a bottom, not sure yet though but a quick heads up to watch the callers!"  We were already looking for the turn because right at 9:37, with the market plummeting our game plan was to take out our callers on the dip - we just didn’t think it would only take 20 minutes to turn!

Of course my opening comment in the morning post was "I love the smell of pullback in the morning" and it’s what our system is all about - we stay well covered (and we did cover up again at  2:07, with the Dow up 125 points from our bottom call) so we can take advantage of the market’s irrational peaks and troughs. 

We were so bullish yesterday we even day-traded XOM for a nice 35% gain.  Our NYX went through the roof, finally breaking $70 but we covered as we became concerned about a pullback and the premiums offered were very high considering they expire in 7 sessions.  FSLR was also a big day-trade winner but we got out too early, with "just" 37% profit, which is the problem with taking momentum calls on stocks you think are overpriced…  FDX was a nice 50% profit on the day trade and the only other short-term trades we made went the other way with puts on COP June  $85 puts at $1.75 and our old pals, the QID $38s for $1.90, looking for some overnight action ($2.40 target).

Sometimes we can go days without day trading and sometimes there is a new one every hour - it’s just the kind of market we are in.  While day trading can be fun and profitable, our bread and butter plays remain our spreads and the LTP made it’s usual, steady improvement, picking up about 3% on the day with very little fuss.

I would have been more bullish on the market overall if oil wasn’t creeping up to $121 as Criminal Narrators Boosting Crude pumped the GS "Super Spike" call at every station break and that doesn’t bother me as much as the fact that investors swallow this BS as if it was really news BUT IT’S NOT!  This is the EXACT SAME REPORT from the EXACT SAME GUY who said on March 9th that "$200 a barrel could be a reality in the not-too-distant future in the case of a "major disruption."  At the time, this was used to push oil up over $105 and I guess it worked so well they bring it out again and pretend it’s news 2 months later at $120 to break that barrier.

Are we really just the stupid lemmings that Media and their corporate masters obviously think we are?  How is it possible that 2 full months later a major telivision network (who is owned by a corporation that makes tens of Billions of dollars on energy projects that wouldn’t exist if oil were at normal prices) can recycle a story, treat it as news and not one "news" organization in this country steps up to question this nonsense. 

Back on March 11th, I laid out my case for why oil cannot sustain anything near $200 and I stand by that.  If you want to play this scenario, you are better off picking up the many cheap gold miners that are still out there than the insanely priced oil companies that are being peddled by Cramer and his pals at Fast Money.

Rather than get too far into it again, I’ll leave off with this.  Just look at one of the many sites or watch yesterday’s Fast Money to hear the bulls lay out their case for $200 oil and why it’s not too late to get in and compare that to this April 2006 article on why you should invest in the housing market:

 "An influx of out-of-state families moving in and a tight resale home supply have put an increased demand on the local new home market. At the same time, builders have been struggling to develop enough finished lots, with the lot supply dropping to less than 18 months in the first quarter of 2006. During the same time last year, the lot supply was two years.  Couple that dynamic with increasing interest from out-of-state investors looking to move their capital from slowing coastal markets, and what we see is strong competition for available land," Rude says. On top of the increases in materials costs since the hurricanes last fall, higher lot pricing will translate into escalating home prices for buyers in all price ranges as we move into late 2006 and 2007."

Today’s tickers: BID, EP, KB, SHLD, AMD, PSS, LM, MLM, CSCO, YHOO

BID- The market has, if not relished, then at least found it easy to knock on shares of Sotheby’s in recent months. Given a worldwide crisis in credit markets, languishing real estate prices, fears of recession, and genuine concern about the willingness of the well-heeled to shell out for big ticket items, it stands to reason that shares in the venerable auction house would be left to face the firing range with other ultra-specialized, cyclical companies as the rest of the market ducked for cover. Shares have barely come off a cataclysmic decline last autumn and now at $27.48 they’re trading 1.2% below yesterday’s close and just $4 above the low of last fall. But some option traders may be ready to take a chance on Sotheby’s, which not only reports earnings on Friday, but this week will drop the hammer on its much-vaunted sale in New York of Impressionist and Modern Art pieces. This may explain the 16-fold increase our scanner detected in Sotheby’s options as implied volatility shows traders pricing in a third more risk over the next 30 days than is already apparent in Sotheby’s chart. With calls outmoving puts by 4 to 1, many traders feel the risk at last is worth running to the upside on Sotheby’s – at least as evidenced by the keen buying interest we observed in May 30 calls, bought today for around 70 cents apiece. Breakeven on this position would imply a test of the $31 level last seen in Sotheby’s in March.

KB- American depositary receipts in South Korea’s largest bank, Kookmin Bank, extended Asian session declines with a 3.4% slide to $66.96. The bank was hit by a pair of ratings downgrades by the likes of UBS and Morgan Stanley following a 47% decline in reported Q1 net income. Our “hot by option volume” scanner detected an unusual pickup in trading volume. While the 4,670 lots trading actively today look modest in absolute terms, the volume must be considered in light of the fact that there were just 4,766 open option options in Kookmin Bank heading into today. It looks today as though some traders struck a contrarian pose on the downgrades using short put spreads in the June contract to express a bullish view. If this is so, the traders are buying June 60 puts at $1.10 against the sale of 65 puts for $2.00, taking a $0.90 credit on the transaction that yields maximum profit for the buyer if the spread between the premiums narrows as Kookmin’s share price rises and both contracts expire worthless.

EP- Option activity in El Paso Corp. the owner of the country’s largest network of natural gas pipelines, continued at a frenzied clip today as shares tacked on a 2.3% gain to $18.20. Yesterday the company announced the discovery of oil on an offshore field near the coast of Brazil, and with earnings due out on Thursday to boot, the market has kept El Paso’s share price buoyed near the 52-week high as a result. With calls outmoving puts by 13 to 1 today it may be safely said that consensus favors further upside, and the 21% elevation in implied volatility above the historic reading suggests plenty of steam to move. Heavy buying on volume of more than 22,000 lots was noted today in June 19 calls at 55-60 cents apiece. Open interest at this strike numbered no more than 784 contracts prior to today.

SHLD- An ugly showdown at the Sears Holdings annual meeting between hedge fund manager-cum-CEO Eddie Lampert and rival William Ackman (who is also Sears’ fourth-largest shareholder) sent shares in the retailer 4.4% lower at $95.67. Ackman is reported to have blasted Lampert in an unusual public display, taking him to task for the company’s lackluster valuation and his own poor communication skills, later telling the Chicago Tribune that he had to take his beef to the company’s annual meeting because Lampert has refused to take his calls. Who’s next to weigh in on this unusual corporate showdown – Erica Kane? Sensing the tensions roiling under the surface of this contentious company, the option market sent implied volatility 10% higher to 50.6% - indicating nearly 25% more price risk to Sears Holdings’ shares over the next 30 days than has been charted historically. Puts and calls are trading on comparable volume, with virtually all of today’s volume situated in the June contract in anticipation of its May 25 earnings release. Heavy volume was noted at the June 80 and 110 puts, and again at the 110 calls.

AMD- There’s no want of potential catalysts to explain the 8-fold intraday increase in option trading volume in Advanced Micro Devices on our platform today, making it the single-biggest relative volume gainer earlier today. An 8.7% gain for its shares to $7.10 comes two days before its annual shareholders’ meeting, one day after expanding its laundry list of antitrust grievances against arch-rival Intel, and hot on the heels of an industry report claiming a 3.8% increase in global chip sales during the first quarter of the year. After remaining largely static for much of the day, implied volatility rose 20% later in the day to 51.1%. A closer look at today’s active trading volume revealed calls outtrading puts by 4 to 1, a proportion that on the surface of things might imply real validation that the end of AMD’s share price tribulations is high. But while the July contract did indeed show a sizable overweight of calls bought at strikes 7, 8 and 9, we saw a huge, near 23,000-lot glut of volume – far outweighing the existing open interest - in January ’09 calls at the $7.50 strike, trading mostly to sellers for $1.30 today. Another 10,000 lots was reported in excess of open interest at the May 7.00 calls, again selling mostly to the bid at 35 cents. We wonder if this willingness among option traders to sell call premium freshly – be it against an underlying stock position or not - has to do with a closer reading of the legal briefs filed Monday in the ongoing Intel wrangle, as explored in yesterday’s online edition of PC World, which noted that AMD will have to more than double its share of the microprocessor market in the long term, just to survive, stating bleakly: “Fresh concerns about AMD’s long-term sustainability coupled with existing worries about the company’s fiscal health – weakened by the delayed release of its Quad-Core Opteron processor and mounting long-term debt – could lead CIO’s to consider computers based on Intel’s chips instead.”

PSS- Collective Brands - Shares in the Topeka-based parent of Payless ShoeSource tanked 14% to $10.50, a new 52-week low, after losing a $305 million federal court ruling that found the discount shoe franchise violated copyrighted designs owned by Adidas Group. While Collective Brands has vowed to pursue all avenues of appeal, implied volatility in its options rose more than 20% to 81.7%, suggesting particular vulnerability for its shares over the next month. The volume we observed early on in June 17.50 calls seems likely to be the closing purchase of existing short positions, as the value of these contracts has dwindled to practically naught. Elsewhere, option traders were all about 7.50 puts in the September and December contracts, where these positions were bought heavily. A 5,000-lot position in the January contract in 10 puts and 17.50 calls may be a strangle or collar to protect an underlying share position. Overall its options traded at 15 times the normal level.

LM- Option traders took cold comfort in Legg Mason’s first-ever quarterly loss since its IPO, on news that the company was compelled to funnel $255 million into money-market funds heavily exposed to subprime-related debt. With shares down 9.5% to $56.97, the 40.2% implied volatility reading on all Legg Mason options shows a continued elevation above the 34.8% historic reading. With options trading at 3.4 times the normal level, we saw a brisk two-way traffic in June 65 calls, but heavy buying in deep-out-of-the-money January 40 puts at $1.50 apiece – traders buying freshly into this position despite the fact that option traders currently ascribe barely a 1% chance of the position landing profitably.

MLM- Martin Marietta Materials – In a reprise of the increasingly familiar refrain of high implied volatility – even post-earnings release – we find options in Martin Marietta, the country’s second-largest U.S. supplier of construction aggregates such as crushed stone, sand and gravel. The company has, predictably, been a collateral casualty of the homebuilding doldrums, and its 37% drop in Q1 earnings was attributed to the continued slowdown in groundbreaking. Despite the report, shares closed flat at $112.00 this afternoon, having traded higher for much of the day. Our scanners picked up a 7-fold increase in option trading volume occurring as implied volatility remained virtually unchanged from pre-report levels – the present 41% reading shows an 18% elevation above the historic reading. This translates into higher premiums as the cost for locking in prices on a stock with potential for greater-than-usual volatility increases. Two spots on the option calendar showed an unusual level of volume today, first the May 105 puts, and again at the June 110 calls, which traded to the middle of the market at $8.70. We’re not sure if this is long positioning in anticipation of Martin Marietta shares continuing to shrug off the construction slowdown and build upon May price levels above $110 – although the price of the position itself would require a test of the $120 level not seen since January - or traders selling those calls (an eminently risky strategy) to take advantage of unusually high premiums given the implied volatility reading. It should be noted that option traders hold twice as many call positions as puts in Martin Marietta.

CSCO- Cisco - After-the-bell numbers from the maker of networking hardware will be painstakingly sifted through for clues to the tech sector outlook. With shares up 3.3% at $27,14, Cisco’s front-month options pared back price move expectations since Friday. Where the closest-to-the-money strikes were predicting as much as a 9% up-or-down move as of Friday, today’s options show only about a 6% likely move, and early market action showed many traders crowding into May 26 calls for 85 cents apiece (a 22% discount from yesterday’s levels) while relatively more puts at the May 25 strike sold. Put spreads may have been deployed at strikes 24 and 26 owing to comparable volumes at those strikes.

YHOO- Today’s 6% gain for Yahoo shares to $25.82 seems hardly the plaudit for its tenacious refusal to succumb to Microsoft’s buyout overtures that the company’s management is keen to depict. The company has entered a new phase of the corporate potboiler, in which speculation has turned to whether activist hedge-fund shareholders may vote out the entire Yahoo board, file suit for the company’s failure to observe its fiduciary responsibility to investors, or even demand the head of Jerry Yang. All these factors contributed to sending implied volatility another 10% higher to the 60% mark this morning. While 3 times as many calls are trading as puts this morning, we note that most of the traffic is in May calls at strikes 25-30, all strikes with massive existing open interest, where volume has been two-way all the way.

Oh I love the smell of pullback in the morning!

We can blame UBS for this one as Europe came back from a holiday weekend to find already cut in half UBS may not have been cut enough as the bank lost the $11Bn XOM found last week.  Now we know what spurred last week’s coordinated Fed and ECB liquidity moves which I predicted on Friday.  Like I always tell members, it’s not paranoia when they really are all conspiring to hide something! 

On Friday I said: "No matter what, we are going to cover into the weekend, something is still wrong as the Fed just coordinated with the ECB to boost liquidity with our Fed boosting term loan availability for US banks to $150Bn (up 50%).  That’s a lot of money to toss into the pot for no reason so I’m a little concerned that we’ll find out why on Monday morning, possibly another BSC-type blow up."  This kept us well protected yesterday and puts us in great position for this morning’s drop.

We’ll see how far down this takes us and watch our levels (see last Night’s Big Chart review) but I’m encouraged that BLK is immediately stepping in to grab $15Bn of UBS’s mortgage assets (a 33% discount on Alt-A and sub-prime loans) as the firm axes 1/2 of their investment banking staff. "We clearly see investors coming to the market, which we view in itself as some strong support for current price and valuation levels," UBS Chief Executive Marcel Rohner told a conference call.  UBS says they will NOT be seeking fresh capital. At the end of March, the bank held $15.65 billion in subprime securities, roughly half of the year-end level. Alt-A securities were trimmed to $17.1 billion from $26.67 billion, and commercial real estate to $6.33 billion from $7.78 billion. A spokesman for UBS declined to update the figures to account for the BlackRock deal.

FNM was no help on this side of the pond, losing $2.57 per $28 share vs. $0.81 expected by the 15 analysts who are paid to follow this company for a living.  One could say it’s a big improvement over the Q4 loss of $3.80 per $35 share in January but the $27Bn company (and falling) says they need to raise $6Bn and is cutting their dividend by 28% so a test of $25 would be kind. 

Bernanke has firmly joined my camp, along with Barney Frank of course, and is attempting to push the administration to giving aid directly to homeowners.  In his speech at Columbia last night, Ben said: "When the source of the problem is a decline of the value of the home well below the mortgage’s principal balance, the best solution may be a write-down of principal or other permanent modification of the loan by the servicer, perhaps combined with a refinancing by the Federal Housing Administration or another lender.”  He even had a scary Power Point presentation!

Frank has already put up a bill that would allow a borrower or loan servicer of an eligible loan to arrange a new loan with an FHA-approved lender, who would determine the size of a loan that the borrower could reasonably repay. If the current lender or mortgage holder agreed to a write-down the debt to that level, the new FHA-lender will pay off the reduced loan and the government would effectively insure repayment.  Our President, of course, is adamantly against helping people and has already threatened a veto.  Without a way to extend homeowners the same ability to "write-down" loans as the administration is gleefully allowing the banks to do at will, then American families will continue to lose 7,000 homes a day to foreclosure.  I guess they are simply just not "too big to fail."

More little people unlikely to be helped by Bush (who only managed to scrape together $700M last week to help out the 2Bn people on the planet who are starving to death as fuel costs and his oil for fuel program have doubled the cost of basic foods since last year) are the people of Myanmar, with 22,000 now declared dead from the cyclone.  Why should we care?  Because Myanmar’s number one export was rice, which is already spiraling out of control. 

The Nikkei was closed again this morning and the rest of the Asian markets were pretty flat.  Airline stocks took a nosedive in Hong Kong and Shanghai sold off as oil hit $120, causing everyone to worry about corporate profits.  DB is not worried and is moving ahead with plans to take over 18 floors of the Hong Kong International Commerce Center, a move that will give them room to double their head count there.  So the banks are still betting heavily on the Asian boom never ending - and we know how good they are at timing the markets!

Speaking of firms with questionable timing - Goldman Sachs, the same guys who advised clients to BUYBUYBUY housing at the 2006 top, are still herding their sheep into oil.  This week (as they have been hammering this for a month) analyst Arjun Murti (the "Super Spike" hero of 2005) has put out a report stating: "The possibility of $150-$200 per barrel seems increasingly likely over the next six-24 months, though predicting the ultimate peak in oil prices as well as the remaining duration of the upcycle remains a major uncertainty.”  To be fair to Mrl Murti, this actual statement is nowhere near as definative as Criminal Narrators Boosting Crude are making is sound but it’s Tuesday so it must be time to pump oil as they pulled this exact same nonsense last week and we’ll be shorting oil again because we’ve seen this movie before.

 Europe is off about a point on the combination of record oil prices and record bank losses with UBS off 6% this morning.  Swiss Re also took a big sub-prime hit  and warned of more to come and the UK service sector ground to a halt with their version of the ISM at 50.4 with the business component at 45.1, the lowest level in 5 years.  This is good for US as it means the BOE has a reason to cut and that Europe is as screwed up as we are and our plan for the year is simply for US markets to suck LESS than Europe and Asia - so far so good!

We got good news for our NYX holdings as they came in better than expected and we are rewarded for risking them naked in the LTP (NOW we cover with the $70s!).  I’ll do an earnings report this evening and kudos to FilmFan on his excellent Apple Manifesto, a clear illustration of why this is one of our core holdings at PSW.  I’m not expecting much out of the markets if oil doesn’t break and we have the big ECB meeting on Thursday as the dollar hovers at 73 but can’t break the critical 73.5 mark it needs to get back to 76, which is what we need to send oil back to the low $100s. 

Let’s be careful out there!

One of our members recently asked us a question regarding generating monthly income while mitigating risk, and so we thought it might prove helpful to share some of our thoughts, particularly given the recent run up in equity prices.  The member had 5,000 shares of company stock and was concerned the stock would decline if the overall market fell.  At the same time, he didn’t want to sell his stock in case the stock managed to creep higher.  While he thought some upside was possible, he felt it was limited.  For every situation, an optimal strategy exists and for this situation, the Covered Call fit the bill! 

While Covered Calls may be applied in myriad ways, the strategy that best met all the stated objectives was the at-the-money Covered Call.  The at-the-money Covered Call simply comprises opening short call options at a strike price close to the stock price.  In general, for every 100 shares owned, 1 short call contract is sold.  So, for a 5,000 share position, 50 short call contracts may be entered.  The stock in question was Cypress Semiconductor, trading on Monday’s close at $26.86.  The nearest strike short calls were the strike 27 short calls, which in May offered $0.60 of premium.  Knowing the premium and the strike means that our Cypress shareholder wouldn’t want to see the stock rise above $27 by more than the net credit amount prior to May’s expiration - otherwise it would have been more lucrative in the short-term to simply hold the stock position.  Because $27.60 is so close to the existing $26.86 stock price, and with the market running up so quickly since our mid-April bottom call, a June strike 27 option offering $1.40 credit may be considered more prudent.  The additional credit means additional protection if the stock were to fall.  And it also means if the stock should rise higher, our member would be no worse off with the stock rising $1.40 above strike 27, hence to $28.40 by June’s expiration than simply holding the stock alone. 

The result of selling $1.40 or premium on 50 contracts is a $7,000 windfall in 45 days!  Not a bad return given that the 5,000 share position is worth $134,300.  Just think about doing this every 45 days for a whole year, the result would be $56,000! 

Now what happens most people when they first encounter this strategy is they begin a journey of self-discovery.  First, the joy!!  Whoohooo!  Our member had been working for 8 years at Cypress and had amassed the 5,000 share position from stock options, bonus plans, employment stock purchase plans and so forth.  The potential to boost income by as much as $56,000 over the course of the year was welcomed enthusiastically!  But we cautioned against too much exuberance because most traders new to the strategy react favorably until….greed takes over!  While most traders are happy when the stock stays flat, rises a little or falls, because in all those situations they end up in a better position with short call options than without them, most also experience the big bullish up trend and end up with short calls in-the-money at some point!  When this occurs, the risk of being assigned an obligation to sell the underlying stock at the agreed upon strike price is high.  Certainly by expiration, if the short call is in-the-money, assignment will automatically occur.  And that’s when regret kicks in.  Most traders chastise themselves for limiting their profit potential.  So what can be done to alleviate the emotional roller-coaster?

Simply step back and ask some questions.  For example, if I could get $1.40 every 45 days from short call premiums, what would that equate to over the course of a year?  Answer: $11.20.  Do I expect a $26.86 stock to rise by $11.20 this year?  Perhaps.  But $11.20 amounts to a 41% stock gain.  Next question:  Do I expect the stock to increase by 41% next year and the year after, and the year after that and forever more?  Obviously not!  In short, if a longer term view is taken, the benefits of shorting calls regularly is obvious!  In the short-term could it be more profitable to simply hold stock?  Certainly. But this is not a short-term game and those that fall victim to chasing short-term gains often suffer longer-term under-performance!

As an aside, we will consider a few other Covered Call examples below: 

First, we will look at Microsoft (MSFT).  Now that MSFT retracted its bid for Yahoo, the stock has found a home near the $29 level.  If we were to purchase 1000 shares of MSFT and sell to open 10 short call contracts at strike $30 in June, we could take in $730 of premium.  The Cost Basis in the trade would be calculated as the cost of the stock, $29.08, minus the short call premium, $0.73.  Hence, the Cost Basis would be $28.35.  The result of the short call at strike 30 is an obligation to sell Microsoft at $30 if the stock should rise above that level by June’s expiration.  This would equate to a $1.65 per share profit in approximately 6 weeks, which amounts to an annualized gain of 46%!  Note the stock simply needs to rise $0.92 for the overall position to profit $1.65!  Hence, a 5.8% gain can be banked even if the stock only rises 3.2%!  And if the stock were to drop lower, 2.5% downside protection is afforded by the 6 week short calls.  Obviously, if the stock were to continue dropping, further short calls could be added to reduce cost basis and risk.

Next up, we’ll look at Potash (POT).  Potash certainly does move around quite a bit and is not for the faint of heart!  The more aggressive (or higher risk) trader may be 110% fine with simply buying some shares and expecting the shares to rise considerably.  But what about a more conservative trader?  The Covered Call strategy might suit their risk tolerance much better!  The stock purchase would amount to an outlay of $193.89 as of the close on Monday while a June strike 195 short call offers $15 of premium.  This means the net cost of entering the position is $178.89.  If the stock were to rise to $195, the result would be a per share gain of $16.11, which equates to a return on risk of 9%!  Again the movement in stock price required to produce a very handsome gain is minimal.  In this case the stock must simply rise $1.11, less than 1% to make 9%!  Beat that buy-and-hold investors!  We won’t even discuss annualized gains for such a position, but suffice to say they are quite attractive! 

As you already know from our Trade Alerts, we have built up more hedges and bearish positions entering May.  For those of you that are stock holders, some hedging in the form of Covered Calls aligns well with the “cautious” theme!

Make it a great day!

Stock & Option Trades