Holy cow, what a week!
Will the market ever stop going up? Well, if it doesn't, we need to be prepared – just like we were at the beginning of the year with our "Secret Santa Inflation Hedges" it is once again time to put a little thought into more strategies that can make us 300-1,000% gains on cash so we can make small commitments that will do a lot to protect our sidelined cash from yet another 10% drop in the dollar.
That's the stop on these trades, it is still very much my thought that the market will tank hard should the dollar recover but we already have that covered with disaster hedges against our longs – now it's time to hedge our cash against devaluing simply because we were dumb enough not to spend it. The above chart is of the indexes priced in Euros with a view of the stunning fall in the dollar as it dropped 5% in 2 months. That means the money we left on the sideline buys 5% less stuff than it did just 2 months ago – this is how FEAR of inflation drives money into equities and commodities.
Fortunately, we can stay well ahead of that. As I mentioned, our Secret Santa hedges were good for up to 1,000% in just 4 months so committing just a few percent of our cash to a hedge can keep us well ahead. On Monday I was worried that this week would go the way it did (up and up) and I suggested the GLD Jan $140/165 bull call spread at $790 (one contract) as a superior bet to physical gold ounces and the suggestion was to layer into the Jan $145/165 spread on a cross over $1,550 and here we are already.
So, how does this work out? Well, it's early but the original Jan $140/165 spread is already $1,120 and the new layer (the Jan $145/165 spread), came in at $750 so right on track with a $330 profit on the first layer (41%) in just 5 days while an ounce of gold went from $1,425 to $1,563, making "just" $138 on $1,425 committed (9.6%). Generally, we just keep layering up every $50 and we can continue to out-pace the actual gains in gold by 4 to 1 and, since gold is out-gaining the decline in the dollar by 5 to 1 – that's a pretty good hedge!
We have fun playing the NYMEX down from the $112.50 line so it was almost a free bet take the contrarian play with the USO July $43/47 bull call spread at $1.70, selling the Jan $35 puts for $1.30 for a net $40 per contract spread with 1,000% upside if USO hits it's targets. USO ended the week up $2 to $45 (up 4.6%) and the $43/47 spread only got to $1.90 so far but the long puts fell to $1.16 for a net $74 per contract, up 85% on the week.
In Member chat on Monday, we countered those trades with a bet against silver, which seemed to be the most overpriced commodity and the play there was the AGQ June $345/335 bear puts spread for $5.50. The timing was great and AGNC crashed Monday and Tuesday and that spread peaked out at $8.20 (up 49%) but is now back to $5.50 again so maybe good for next week too!
While I'm on Monday, that same morning comment had a backspread on OPEN. In case I forget to mention it this weekend, these earnings backspreads are THE BEST. Our play was buying 3 Jan $135 calls for $12 ($3,600) and selling 4 May $115 calls for $8 ($3,200) for a $400 spread into earnings. The Jan $135s dropped to $9.87 ($2,961) and the May $115s fell to $5 ($2,000) for net $916 – up 140% on the week. On the other side of that trade, I suggested buying 4 Oct $110 puts for $13.50 ($5,400) and selling 3 May $110 puts for $5.50 ($1,650), which was a much more aggressive net $3,750 entry aimed at establishing a long-term short on OPEN. That one is also a winner, of course as OPEN fell right to our target range and finished the week with the Oct $110 puts at $17 ($6,800) and the May $110 puts at $6 ($1,800) for a net $1,250 (up 33%) gain on the week. That play is less sexy but the idea is to stay short long term and keep selling puts for income as OPEN melts down. The call play is meant for a quick kill because, obviously, we had no intention of being long – that is just the hedge we use to guard against a move against us at earnings.
We'll be doing plenty of those during earnings season but keep in mind they are NOT good for any old play. They work when you get the targets right and, if not, you are stuck with a spread to work out. On Monday afternoon we had another inflation hedge that did not work out as, despite the massive jump in the markets, oil, metals etc. and the huge drop in the Dollar – TBT, for whatever reason, went DOWN for the week. Our Monday trade on them was the Sept $34/40 bull call spread at $2.60, selling the Sept $36 puts for $2.33 for net .27 on the $6 spread.
TBT fell to $35.65 from $36.50 and the $34/40 spread is now $2.36 and the $36 puts are $2.57 for a net loss of .35 or 129% on the week. Of course it's all premium and the key when taking ANY of these hedges is that you MUST be willing to be a long-term holder of the stock or ETF that you are hedging with if things go the other way because, if all you are doing is playing the percentage gains and losses – a trade like this will stop you out very early in the cycle on almost any move down.
The way we look at these trades is there's a net risk of owning TBT for net $36.27. At the time we took it, TBT was $36.50 and now it's $36.65 so the spread lost a lot less cash than the ETF did (.85) but, even so, you have to be careful with these. If you are a true long-term player, then you look ahead to the 2013 $30 puts, which are $2.82 so an evenish roll for your September putter and that's another 20% down from here. If you don't REALLY want to be long on TBT at net $30.27 – THEN you need to consider killing this trade when it goes against you. Obviously, it seems ridiculous for rates to be this low and I don't think anyone really thinks it will last but Japan has been doing this for 20 years so don't count the possibility completely out.
Another hedge from Monday that went the wrong way was EDZ, where we looked at the June 14/17 bull call spread at $1.40. That's still $1.40 actually so no biggie there and we WISELY hedged that with CHK, thinking that if Emerging Markets continued to do well then energy demand would stay high and natural gas would finally begin to act like a commodity and that should be good for CHK, who we like as a company and REALLY want to own at net $30.08 so we sold the CHK June $31 puts for .92, which are now $2.67 out of the money at .61 so our .48 spread there is now .79 for 64.5% gain EVEN THOUGH EDZ itself went the wrong way on us.
Hedging is GOOD. It does take practice to get used to the relative moves of various stocks and ETFs in various market situations but it's just a matter of time and practice. In Gladwell's “Outliers: The Story of Success,” the author makes a very good case in which studies have also shown that excellence at a complex task requires a minimum level of practice, and experts have settled on 10,000 hours as the magic number for true expertise. This is true even of people we think of as prodigies, such as Mozart. Gladwell quotes neurologist Daniel Levitin as follows:
In study after study, of composers, basketball players, fiction writers, ice-skaters, concert pianists, chess players, master criminals, this number comes up again and again. Ten thousand hours is equivalent to roughly three hours a day, or 20 hours a week, of practice over 10 years… No one has yet found a case in which true world-class expertise was accomplished in less time. It seems that it takes the brain this long to assimilate all that it needs to know to achieve true mastery.
I'm bringing this up because it's very important NOT to go overboard while you are learning how to trade. Trading is a profession and takes time and practice to get used to. There are no short-cuts. I talked last week in our Investing for Income Virtual Portfolio (up fantastically already, thanks to the silly markets) about how there are very few successful young investors. Being 55 years old and playing the markets with a bunch of cash you made in Real Estate or as a Doctor DOES NOT make you an experienced investor. You may be ahead on life skills but you have no more trading ability than a kid out of Wharton sitting at a desk at Goldman Sachs and they certainly don't hand those guys any major accounts until they have had YEARS of practice and training, working under the best teachers in the business.
That's what our virtual portfolios are for – you can get tons of practice following along, hopefully accelerating the learning process without having to risk a lot of cash – learning from our ups and downs along the way until you get to the level where you are confident in your ability to handle trading an account. Notice that many of our most experienced Members tend to find something they specialize in like JRW's Russell trading, Income Trader and Peter D's short strangle strategies, Pharmboy's Biotech Stocks, etc.
Over time and with practice, you will find the style of trading you are most comfortable with and those will be the skills you work on. Just like in baseball, football or any other sport – if you expect to be a professional, you are going to have to master a position – you can't seriously expect to master them all.
With that in mind, let's see if we can try out a couple of inflation hedges as we now have our 100% lines to let us know when it's time to get out (3 of 5 breaking would be key and the Dow still is not above so that's one already!). Keep in mind what worked and what did not work from this week as well as from our December selection. Of course we make picks like this all the time – on Tuesday we added XLF on the bull side, on Wednesday it was CCJ, DDM and JAG (still cheap), Thursday we went with TNA and TBT (even cheaper now!) in the Morning Alert and then UNG with an upside play on the VIX (also still playable) and yesterday it was back to EDZ (June spread again) on the short side with ABX (still good of course) as a new gold hedge.
Our directional bets have not been working at all which is why we allocate very little of our virtual portfolio to short-term trading. In a $100,000+ virtual portfolio, we are 20/15 bullish (35% invested) with most of that money allocated to long-term buy/writes that are generally 20/5 bullish (the short call is the bearish portion). That leaves us just 10% to play with on the short side and the rule of thumb is we allocate for at least 10 positions ($1,000 each on a $100K virtual portfolio) and scale in on a 1x:2x:4x level, which means our initial risks are kept very low ($100-$150) on directional plays (see Strategy Section for more detail as well as "Smart Virtual Portfolio Management I, II and III" articles).
Even in our bearish 10%, we shouldn't go 100% bearish – that's why we always try to have a balance of bullish and bearish trades as 75% one way or the other is about as far as we ever want to go.
Keeping that in mind, we're going to discuss UPSIDE hedges but the assumption is you have some of our disaster hedges in place (TZA, SDS, EDZ) to offset a sudden drop in the markets on some Japan-like event that sinks the markets faster than we can stop out.
The way AGQ held up, which is 50% ahead of the gain of SLV (see Monday's post for chart) and the way gold is taking off makes me think SLV may not be so crazy of an inflation hedge. I don't really have much faith in commodities holding up but we can just kill this kind of trade (on the long side) if gold fails to hold $1,500 or silver fails $47.50. Keep in mind we're not playing for silver at $50, we're playing for $75 so we take advantage of the out-of-the-money premiums on long calls and take the SLV Jan $47/57 bull call spread at $3.10 on the $10 spread, which has a potential 222% upside if SLV gets to $57 and holds it through January expiration.
The net delta on the spread is just .22 so, for each $1 SLV drops (2.5%) you can expect to lose .22. Looking at it this way, you really only have to hedge to your stop (say .60) with something you think will do well if silver drops, like short AGQ May $540 calls at $3.20. So 5 SLV Jan $47/57 bull call spreads at $3.10 ($1,550) can be hedged with on short AGQ May $540 short call at $3.20 ($320) to offset a stop of a 20% drop, which should be a 10% drop in silver, which should be a 20% drop in AGQ from $358 to $286 which, even at just a 0.08 delta on the short calls should be a a pretty sharp drop (and, of course, at $286, we'd feel pretty good about riding them out to expiration).
Not to complicate things too much but let's look several moves ahead. We have 5 long $10 spreads with $6.90 of upside each ($3,450) offsetting the possibility of getting burned on AGQ to the upside. Since we are just selling one short call, we have a buffer, long-term of $34.50 per short call so we don't really get into trouble unless AGQ is over $574.50 at Jan expiration.
Meanwhile LAYERING is the key to these trades. If AGQ goes up $50 and the short calls double, then you can either buy them back for a $400(ish) loss and hope to collect that $3,450 down the road on the 5 longs or you can buy 5 more long spreads at a higher strike, put a stop on the gains of your lower spread and now you have 10 potential $690 gains ($6,900) that will be 100% in the money long before AGQ hits $500.
Layering you winning spreads is a great skill to master. Usually, the markets aren't crazy enough to give you much experience but, these days, it's almost the norm! As you can see from Monday's gold trade, the bottom layer made 40% by the time we trigger a buy on the next layer. Our hedge still protects us and we add a new layer and put a stop at a 30% gain on the original layer. If we keep protecting 30% gains and keep layering up, by the time we add our 4th layer to the trade we have locked in a 90% gain on the trades below it (but we would have raised the stops on the lowest layers too).
And, of course, when we choose a short call to protect ourselves it works very well with a layering strategy as the May $540 calls on AGQ can be rolled out to 1/2 the June $570 calls (now $7.50) and we'd go higher but nobody in their right mind thinks silver is going that high so there simply are no higher calls (yet) – all the way out to 2013. Now, doesn't that make you feel better about selling the short call?
Going the other way, if silver drops and we stop out of the $47/57 bull call spread at $2.50 then, as I said, the AGQ should be in the bag and we get our money back. If we get worried that silver may bounce – it's a no-brainer to just buy another spread at a lower set of strikes to protect ourselves. Silver fell from $31 to $26 in January, for example. In a similar drop perhaps the VIX would have spiked up and the $540 short calls may have annoyingly held their value despite the 15% decline in silver that month. Well, for one thing – at some point they do expire and, for another thing, we can just buy the (going back to our current price example) Jan $42/52 bull call spread for $3.10 and roll the $540s over to June and pick up $3+ more or, of we are feeling brave, simply add a short June call and put a stop on the May calls.
Unfortunately, like chess, the what-ifs quickly multiply beyond the ability to lay them out on paper which is WHY, if you are going to be serious about being a trader, you have to learn HOW to trade and understand WHY you are making the trade and you should NOT just follow picks other people give you. That is not learning and you are WASTING the 10,000 hours you should be putting into mastering a skill by (for lack of a better word) cheating.
There is of course, much merit in learning by example but people learn nothing just following the trades of others – I've seen it over the years, the people who learn the best are the ones that make their own suggestions and enter their own trades and ask for advice on adjustments or the fundamentals and the students who "never get it" are the ones who simply follow whatever is being traded – they can do that for 20 year and, on the 21st year, they still need someone to make picks for them!
I am not saying don't follow any trade ideas – we have many, many good ones but I am saying you need to ALSO come up with trades of your own so you can better understand WHY we do things the way we do. Like chess, you can only learn so much from a book and there are only so many "rules" that can apply. In fact, once you get past the first few opening moves, there are no books to guide you – there are simply too many possibilities and each game is unique unto itself. Only experience will get you to a level of proficient play and isn't that what you are trying to do with your trading as well?
We looked at one gold hedge on Monday and another simple one you can do as a long-term gold play is the GLD 2013 $150/200 bull call spread at $13, selling the $130 puts at $8.20 for net $4.80 on the $50 spread with a nice 941% of upside if gold hits $2,000 and holds it through 2013. So the real question for a gold bug is: How much are you willing to lose if you are wrong? Assuming you don't REALLY want to own gold at $1,300 an ounce if it's below $1,300 an ounce, how much of a risk were you willing to take on gold in the first place?
If you were considering allocating 5% of a $250,000 virtual portfolio ($12,500) to gold as a hedge against inflation, we can assume you didn't intend to ride gold down to zero but, of course you were going to stick it out for a 20% loss ($2,500) so let's call that our risk tolerance and structure the play to make that a 50% loss on the position so we're talking about a 10 contract spread at net $4,800 that will cost us $2,400 if gold moves against us. The delta on the short puts is .25 so our cushion on this trade is only about $10 on GLD going down so let's say $1,400 with this structure so you have to be pretty bullish on gold but the upside is a nice $45,200 at GLD $200 which would be an 18% pop to a $250,000 virtual portfolio.
Here's where scaling in can help you a lot. Rather than an all or nothing bet on gold going up $450 before it goes down $100, you can begin with a 25% position and scale into it. If gold goes down OR UP $100 and once, you can add another round, adjusting the strikes if you have to and then again at another $100 move each time. That way, you are expanding your range by $200-300 before you make a full commitment. Keep in mind that making 914% is A LOT and you don't NEED to structure plays to make 900% – rather you can take advantage of trades that CAN make 900% to prudently set yourself up to make about 300% as you sensibly scale in. If 300% isn't keeping you ahead of inflation – we have bigger problems than the returns on your trade!
Another way to buffer your downside risk to being long on gold is going short on gold. ABX is a miner we like and you can play the 2013 $60/50 bear put spread at $6.30 which pays $3.70 if ABX fails to hold $50. 5 of those spreads will cost you $3,150 and pretty much a loss if ABX goes up 20% but we can assume that won't happen unless gold goes up 20% to $1,860, putting your 10 long spreads $36,000 in the money so you are HEDGING 20% of the anticipated profits to protect $1,850 of the anticipated downside loss.
This is the kind of fancy hedging hedge funds do but keep in mind that hedge funds have a gold desk and there are guys who do nothing but man the gold trades all day long. It is VERY ambitious for a regular trader to do this sort of juggling and you are often better off just keeping some cash handy to buy short-term puts on GLD when it breaks support (say, below the $1,500 line) of a size that will buffer your long-term losses, which will allow you to keep and/or roll the long position – assuming your long-term opinion of gold doesn't change or to get out with a lesser loss than you would have if you do change your mind.
Again, it's a case of – the more you understand the hows and whys of the trades, the more options become available to you – more tools that you will be able to apply to your virtual portfolio as the situation evolves.