OK, now I'm putting pressure on myself.
I hate saying top 20 because the top 20 could change next week if the market conditions change but, for now, I did a lot of reading and thinking over the weekend and that led to me writing "The Worst-Case Scenario: Getting Real With Global GDP!" in which the short story is: Things are just simply not bad enough to sit on our hands with a big pile of cash.
PLEASE keep that in mind at all times - our buying premise is that we have cash (with a target of staying at least 75% cash right now) and we ALREADY have our disaster hedges, which are already in the money. If we have a 5% hedge in place that pays 25% on a market drop of no more than 20% below where we are now, then we can expect to have 25% of our money from that hedge to pay for any stocks that are put to us and, if we are only allocating 20-25% of our cash to buy round 1 here, then logically, that extra 5% we're putting up as insurance will pay for the rest.
That means, if we spent $25,000 to buy round 1 of stocks and $5,000 of insurance that pays 500% if we hit our assignment area (down 20%) and we are assigned a basked to stocks, which force us to double down, then the $25,000 we need to double down with will come from our insurance hedge and that means we'll be in 2x the stock for $30,000 with $75,000 more cash on the side (assuming it was a $100K Virtual Portfolio).
Let's keep this example dead simple and say we buy the SPY for $106.82 and let's say we buy 300 shares for $32,000. Now we cover that with the sale of the March $103 calls for $12 and the $95 puts for $7 and that nets out to $87.82 ($26,346) and our upside at $103 is $15.18 ($4,554 or 17%). We are committed to owning 600 shares of SPY at the $87.82 we paid for 300 plus another 300 at $95 for an average of $91.41 on 600 or $54,846.
Now comes the hedge. In order for us to lose money on this SPY trade, SPY has to go down below $87.82, which is our break-even point. We don't NEED insurance above that spot as we already have it from the puts and calls we sold and REMEMBER, if SPY falls 13.5% to $87.82 we don't make any money for that period but we have a lot of SPY at a price we REALLY wanted it for. So now we need to pick our insurance based on what makes us comfortable.
SDS is an ultra-short on the S&P and for the S&P to go down 13.5%, then SDS should go up 27%, from $35.75 to $45.40. Based on that, all we need to do is take the SDS Jan $37/45 bull call spread for $2 and that will pay $8 on a 13.5% drop in the S&P. If we risk $1,000 on the insurance, that's all we can lose and our upside is $4,554 on the bull side so net $3,554 if the S&P heads higher. If we go down, 10 contracts at $1,000 would pay back $4,000 at SPY $86ish and that protects 600 shares (because they will be put to us) with an additional $6.66 each! So, for $1,000 worth of insurance with NO MARGIN REQUIREMENT, we are able to buy SPY right now for net $87.82 and we are break-even down to $81.16.
Now, we can get fancier and hedge the hedge with a put sale like the Jan $25 puts for $1 and now the protection costs us nothing and we can buy 20 of the bull call spreads for $2K which pays $8K if the S&P is put to us, giving us an additional $13.33 of downside protection on our SPYs ($74.49) and our risk comes in if the S&P goes up 14% (to 1,200) and drops SDS 28% to $25 and triggers those puts. We can, of course roll them and we have to figure that, sometime around 1,100 on the S&P, that we would wake up and take some action but it's always good to consider the worst cases.
Of course we DON'T play the SPY this way because the payoff is lame but the hedge is nice to protect against a 20% drop in the S&P from here. I generally prefer hedges that are in the money but one solution is buying the bull call spread for $1 and only selling puts (hopefully better ones) IF the S&P starts going higher AND you still are worried about a pullback. Othewise, if we rocket back up over 1,100 – you don't need to protect a SPY $103 payout (S&P 1,030) unless the index breaks back below 1,000.
Hopefully that clarified more than confused. The main point is there is a mathematical certainty to hedging SPY with SDS but not so much with others, which is why we choose our Buy List carefully and try to get the best performers which generally have good correlation to the indexes we intend to hedge with. When the market goes lower, we may take bigger risks but right now we pretty much EXPECT to lose on our bullish plays - this is all about just not wanting to miss out if we do rally higher. Being able to buy with confidence while other people are panicking is step one to the "Buy Low" part of smart stock trading!
And now, 20 stocks I really like – even if the world ends:
AA (6/6 – $10.84) People need tin! Buying the stock at $10.84 and selling the 2012 $10 puts and calls for $4.70 for net $6.14/8.07. AA bottomed out at 4.91 when the World was ending last March.
AET (6/6 – $30.21) Insurance companies are hard to pin down but Aetna has over $20Bn in assets as long as those "Long-Term Investments" aren't in Greece or Spain, or Italy or Ireland or France or… Anyway, so you never can really tell what the assets are or what the liabilities are but you can tell a company has made steady profits through the crisis and, more importantly, grown revenues, from $27Bn in 2007 to $34Bn last year, yet they trade at almost 1/2 the 2007 highs. Buying the stock at $30.21 and selling the 2012 $30 puts and calls for $11.60 is net $18.61/24.31 for a nice 20% discount or a 62% upside if the stock just holds $30.
C (6/6 – $3.79) is a crazy stock. The only way we like playing them is to hope they don’t go bankrupt and take the 2012 $2.50/4 bull call spread at .75 (no stock) and sell the $2.50 puts for .50 and that’s net .25 on the $1.50 spread so you make 500% if C manages to hold $4 through 2012 or you end up owning C for net $2.75. You can also play this more aggressively by selling 1 $5 put for $1.85 for each 4 spreads and that would knock out 40% of your margin and raise your cost to .30. That means if C is at $2 in Jan 2012, you own 100 shares of C at $5.30 with a $3.30 loss vs owning 400 shares of C at $2.75 with a .75 loss but, if they go BK, you lose 1/2 as much with the 100 $5s.
CCJ (6/6 – $23.03) Oil isn't working and whether we build nukes here or Iran is just Christmas shopping, there is bound to be a long-term market for uranium and CCJ is a huge player and, when you think about it – it's in the government's interest not to allow competion in this space for security reasons. Better to keep control of uranium with people you have a working relationship with. You can buy the stock for $23.03 and sell the 2012 $22.50 calls for $5 and the $20 puts for $3.20 for net $14.83/17.42 for a very nice 51% if called away .53 below the current price.
DIG (6/6 – $27.14) Other than the normal oil futures buy above the $70 line, I am liking a Dec bull/call paried with a short put sale but they are very thinly traded. We should have hurricanes coming off last year’s el nino and, of course, $65 oil isn’t likely to last so the Dec $18/27 bull call spread for $5 (no stock) paired with the sale of the $23 puts at $3 has a nice 350% upside if DIG holds the line and a b/e way down at $22, where DIG has only ever been below for 3 weeks outside of a few quick spikes.
GENZ (6/6 – $47.75) We got them on fat-finger day at my target (see older Buy List post) but not too bad here and we can buy the stock at $47.75 and sell the 2012 $45s for $10.40 and the $42.50 puts for $5.30 for net $32.05/37.27 and that's up 40% if called away 5% below the current price.
GLW (6/6 – $16.23) Actionable trade on DELL’s new mini-IPad is GLW as I suspect a global glass shortage soon. We can buy the stock for $16.23 and sell the 2012 $17.50 puts and calls for $7.40 for net $8.94/13.22.
HOV (6/6 – $4.90) is a funny one but I think they are one of the best builders and you can get the craziest discounts betting they won't go BK. I like buying the stock at $4.90 and selling the 2012 $5 puts and calls for $4 for a net .90/2.95 spread with a very nice 455% upside if called away 10 cents above the current price. I also like the 2012 $2.50/5 bull call spread for $1.25 paired with a 1/2 sale of the Jan (2011) $5 puts at $1.25, which puts you in the $2.50 spread for net .68 and hopefully the puts expire in Jan and we can sell 2012 puts to lower the bais further. Selling 10 of the puts should not cost you more than $1,250 in net margin ($2,500 for potential assignment less the $1,250 you collect from put sale) and then you can buy 20 of the bull call spreads for $2,500 so you are out of pocket $1,250 of cash and $2,500 in margin but the margin is done in Jan (hopefully) and you are left with $1,250 invested on 20 spreads that return $5,000 in 12 more months if HOV holds $5.
INTC (6/6 – $20.95) is a great, great stock that we'd be happy to own in 2012 so why bother owning it now when we can take the 2012 $10/20 bull call spread for $5 and sell the $17.50 puts for $2.50? That puts us in the $10 spread for net $2.50 with a break even way down at $13.75 (34% down from here). This iis what I call an Artificial Buy Write, where we are still happy to have stock put to us but, if it is, it's only 1x and still at a very good discount. Also note that this play pays off $7.50 if INTC finishes .95 LOWER than it is now while buying the stock outright (which would cost more than this play) would not make you $7.50 unless INTC hit $28.45. Isn't this stuff great? What's your worst case? You own INTC for net $13.75 long term…
MON (6/6 – $49.02) Buying the stock at $49.02 (2.2% dividend) and selling the 2012 $47.50 puts and calls for $19.50 is a net $29.52/38.51.
MRK (6/6 – $33.17) Buying the stock at $33.17 (4.6% dividend) and selling the 2012 $35 puts and calls for $11.40 is net $21.77/28.39. That's a little aggressive but I like the long-term prospects for big Pharma and we want to keep getting that dividend.
MO (6/6 – $20) Pays a 7% dividend so, despite the fact that they are evil, you gotta love the stock! Buying the stock for $20 and selling the 2012 $17.50 puts and calls for $5.65 is net $14.35/17.18. I worry about new taxes so a bit of a hedge but you collect $1.40 a year in dividends so figure $2.10 back in the 18 months to expiration gooses your total returns by 14.6%.
OIH (6/6 – $93.40) is another artificial candidate. The 2012 $94.10/124.10 bull call spread is $9 and you can just go with that with a $30 upside (up 233%) or you can sell the $60 puts for $5.50 to knock the net down to $3.50 on the $30 spread with a put-to price of net $63.50 (down 32%) on an ETF that's very unlikely to be going away.