Fuzzy Math!
by Stock and Option Trades - August 3rd, 2008 9:34 am
Have you ever seen literature from a fund posting attractive gains and comparing its performance to that of the benchmark S&P 500? Have you ever investigated how the figures listed were calculated? If not, you will definitely want to read on!
Let’s take a fairly representative example. Fund Manager Joe Bull, for example, is very good at generating profits in bull markets. Let’s say Joe Bull made 20% in each of the years 2004, 2005, 2006 and 2007. But Joe Bull does not have the toolset to survive bear markets and finds in 2008 that he is down 30%. What has Joe Bull’s return been over 5 years?
It turns out, the answer to that questions depends greatly on what Joe Bull wants to report as his return! Why? Because little regulation exists to prevent Joe Bull from choosing any number of mathematical approaches to calculate his return!
For example, fund manager Joe could simply take the average of his returns over 5 years. This would be calculated as the sum of 20% + 20% + 20% + 20% -30%, all divided by 5. So, this would be equal to 50% / 5 or 10%.
Or Joe could choose to report the nominal annual rate with no compounding or the nominal annual rate with compounding or indeed the effective annual rate assuming continuous compounding! Depending which of these approaches was chosen, the returns would be 9%, 7.7% or 7.4% respectively!
So, step into fund manager Joe’s shoes for a moment. You need more investors because inevitably some existing investors will leave based on the most recent decline of 30%. How should you market your return? Which return should you choose? Which will attract most new clients?
Obviously, the double digit average return stands out. But that’s not where the marketing typically ends. Joe now will want not only to show his return but his return relative to some benchmark, say the S&P 500. So, if no regulation restricts Joe from choosing a methodology to denote the performance of the S&P 500, which do you think he will choose?
That’s right, the lowest return; the effective annual rate assuming continuous compounding!
Most investors simply hand over their money in trust. Few are sophisticated enough to know which method is used to calculate the overall return. But now that you know the subtleties, make sure to look closely to determine which figures are…
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DiggGifts In Disguise!
by Stock and Option Trades - July 8th, 2008 3:41 am
Somewhere over the rainbow…"the dreams that you dream of, dreams really do come true…"
The gloom, the mist, the darkness, the thunder, the rain, the storm, the lightning. After the thunder rolls and the lighning strikes, the rainbow appears. Today that rainbow appeared, but you would never guess it from the final results. The S&P 500 finished down 10.59 points, the NASDAQ down 2 points, the Russell down 7 points, the VIX up a point or so and the super spike theory we predicted some weeks ago in the SKF came to fruition. So, where is the rainbow? Keep reading!
We had targeted 1,240 as a low on the S&P 500 today and that was the precise point from which the S&P 500 started to rally intraday. The NASDAQ also showed strength from near the 2,200 marker, which it hit back in January and March. Both times it rallied soon afterwards. One of our members queried why we are leaning bullish at this time when everything looks so bearish. Well, we like to stand aside at the beginning of a carnage. But as Buffett famously said (and we’ll paraphrase), if you are bullish on the markets, you want stocks to go lower!
This seems like a paradox but it is easily explained by compounding returns over time. Let’s say I see a stock trading at $20 per share and have $20,000 to deploy. (Neglecting smart risk management!)…let’s say I buy 1,000 shares. If the stock rises up to $30, I make $10,000. But what if I had been patient while the stock dropped to $15, what would the impact of buying with the stock just $5 lower have been? It turns out I could have made 100% on my investment with the stock rising to $30 instead of 50% as was the case when purchasing the stock for $20 per share. Buying after a 25% decline meant the difference between making 50% and making 100%! Now extrapolate that out further in time and you’ll see selloffs really are stock market gifts in disguise!
The sharp selloff in the Russell is also indicative of a triple bottom. We have been waiting, waiting and waiting for this moment to arrive. And now it is time to see if we do indeed hold these levels. The Russell rallied sharply off its support level and it wouldn’t be surprising to see it test that level…
Creative Risk Management
by Stock and Option Trades - July 1st, 2008 3:14 am
Following recent correspondence with one of our members regarding the methodology behind adjusting bull put spreads, we thought we might use today’s relative calm in the markets to talk strategy; specifically bull put strategy adjustments!
Bull put spreads are popular among option traders because they can profit in multiple directions and use time-decay to great effect. Out-of-the-money bull put spreads can profit when stocks are flat, rise higher and even pull back slightly. But what about sharp declines? With the overall markets in a bearish funk, many out-of-the-money bull put spreads placed recently may now be in jeopardy of turning into in-the-money bull put spreads. And holding an in-the-money bull put spread means risking short put assignment!
As we mentioned previously, we refused to buy into the Dow breakout chatter around the 13,000 mark and have maintained healthy cash reserves during this most recent decline. With cash on hand and many stocks dropping to very attractive valuation levels, we still don’t wish to ‘catch any falling knives’ by purchasing stocks outright, but we are becoming increasingly vigilant in scanning for stocks that we would be happy owning at these or lower levels. And the bull put strategy can assist us in realizing those objectives.
Once a stock has been found and a bull put entered, the goal is for the bull put to expire worthless. But if the stock drops below the short put strike price, is it absolutely necessary to purchase the stock via assignment of the short put?
Not necessarily! Alternative adjustments exist which are perhaps more attractive and enable us to realize a number of objectives. And what are those objectives? Well, when taking assignment of a fundamentally solid stock, the expectation is that short-term weakness will be replaced by long-term strength over time. So, even if a short-term bull put runs into trouble, the conversion to a long-term stock position can lead to fabulous profits when direction and sentiment change – as they inevitably do, even if it doesn’t feel like it sometimes!
For those who are not attracted to the possibility of owning stock and incurring the associated capital obligations, lower risk alternatives are possible! Let’s use the New York Stock Exchange Euronext (NYX) to highlight one possibility.
We’ll consider a bull put example using ‘easy’ figures to demonstrate the alternative adjustment. First, we will consider a July $50/$55 bull put spread on NYX was initiated at some point in the past. Further, we will assume that…
The BackUp Plan!
by Stock and Option Trades - June 22nd, 2008 3:47 pm
In our June 19th blog we wrote "The bottom line is the flush is upon us. What is a flush you may ask? It is the final collapse of the indexes that pushes all the weak holders to their absolute limits and just beyond. It causes the courageous to become meek. Conviction is eroded and faith in the markets is destroyed. It is painful for many. It should not be painful for you, our members, because (we) warned of this correction and we stated we would stand aside from it. And we will swoop in with more aggression when it is done. We have already started to build longer term positions as evidenced by recent Trade Alerts. In the short-term the pain may last a little longer. If it does appear, it will be very painful for most. But it will be necessary before the long awaited uptrend finally appears. Fasten your seatbelts, it’s a rollercoaster ride, but the fun times are not far away now."
On June 20th, we viewed the flush that had just occurred with optimism but stated it was not a ‘Royal Flush’ and concluded "As of right now, the reward to risk ratios are not overwhelmingly positive, so we remain with our fingers on the trigger ready to jump in with greater abandon but are holding off until we have greater certainty."
Well, the best way of describing our feeling after Friday’s big declines is "PHEW!" It was oh so tempting to believe the bottom was in Thursday and we certainly believed it might have been possible, however discipline demanded we hold off until the markets presented us with greater clarity over future direction.
But that’s all in the past, the real question is how do we trade the market in front of us now?
Well, our preference is to return to what we call the The Backup Plan. When the going gets tough, confusion is rife, turbulence is prevalent and the stench of panic in the air, it’s time to go back to the basics. We thought it might prove helpful sharing our step-by-step process in finding a trade during such challenging times.
The first step is recognizing the climate is tough and that it’s okay to target lower returns while the markets are turbulent. …
Tiger Times!
by Stock and Option Trades - June 17th, 2008 4:10 am
Well if you were following the stock market closely today and wondering why much of it was uninspiring and unexciting, you needed only to have switched to NBC late in the afternoon to discover where everybody’s attention was…golf! That’s right, Tiger Woods clinched his 14th major title after forcing a playoff yesterday – check this out for a great reaction!
Indeed the market action today was so relatively dull compared to the golf that it’s almost tempting to do a blow by blow of the 19 hole playoff – that’s right 18 holes wasn’t enough to separate Rocco and Tiger. But in fairness to the non-golf fanatics, we’ll skip that and get straight to the market.
Sneaking up without garnering much attention of late (other than among the cognoscenti) is OptionsXpress. The stock is up approximately 25% since its low a few months ago and is slowly but steadily climbing ever higher. In our Trade Alert on OptionsXpress, we refused to limit the profit potential on the short calls at trade initiation (we entered fewer short calls than long calls) precisely because we expected the stock to make a substantial move higher at some point during 2008. At times like these, it pays to hedge; it just doesn’t pay to hedge too heavily sometimes! And our OptionsXpress Trade Alert from some months ago has been a prime example of what is needed to make money in this choppy market.
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Patience has been key and still is required!
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Due diligence; we believed in the fundamentals even when the stock was beaten down unfairly in tandem with other brokerage companies.
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Hedging; we’ve benefited from a number of short calls expiring worthless.
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Scaling; we’ve entered two of our three tranches.
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Adjustments; we’ve had to roll our latest set of short calls up in strike price and modify the structure of the trade.
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And planning; we’ve had to invoke Contingency Exit Plans while keeping an eye on our Target Exit Point all the while!
And mixing that assortment together, we have a darn good chance of escaping this Trade Alert with another profit!
While we did predict a volatile year ahead last December, we frankly did not expect the degree of volatility in the markets. Of the four Trade Alerts still open from January to May, two will be a close shave…
I-Day
by Stock and Option Trades - June 10th, 2008 2:55 am
Bloomberg reports on Bernanke: “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so,” Bernanke said today in remarks to a Boston Fed conference in Massachusetts. “The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations.”
The comments served to lend credence to expectations that the Fed would begin raising rates at the end of the year. But that seems a long way off now given the current market turbulence. Nothing in the charts today demonstrated much strength after last Friday’s collapse. The S&P 500 was fairly flat for the day, closing at 1361, despite reaching a low of 1350 intra-day and a high of 1370.
Perhaps of greater interest is the Russell 2000, which successfully tested the low-end of its rising channel that began in March. For those holding the bear call we initiated some weeks back with a strike 780 short call, this would be a prime time to close out the position if you were nervous last Thursday! We plan on holding our position through to expiration, though it could still prove a close race if the RUT races back to the high end of the channel with the same conviction with which it dropped in the past two days.
The NASDAQ dropped perfectly to its 50-day MA today before bouncing substantially from an intra-day low of 2429 to close at 2459. With technology names holding up so well of late, it was noteworthy that the NASDAQ stayed in the red all day despite the Dow staying green.
Indeed, the Dow closed up 70 points today, which ordinarily may be a positive, but following a near 400-point down day, it doesn’t inspire much confidence at all that this correction phase is over.
We have our eyes on the FXY given the test of its lower Bollinger Band and general support in the 92-93 region. Our currency plays are holding up reasonably well and while there is increasing speculation and rhetoric that the dollar will strengthen, we have been quite successful in sticking with the trend so far. Our philosophy is simple – if our dollars become increasingly worthless day by day, we might as well attempt to increase our supply of dollars by profiting from its demise!
I-Day has now come and gone! Apple’s price was as volatile as a…
Bright Spots!
by Stock and Option Trades - June 3rd, 2008 4:18 am
On down days like Monday, it’s so easy to see red and ponder "if only" or "what if", but profits arise from seeking and finding opportunities. And today, many bright spots appeared in the midst of the stormy weather. Before we get to those bright spots, however, note that the storm wasn’t nearly as bad as it may first have appeared. The Russell intra-day dropped all the way to its 20-day EMA, but bounced substantially to almost regain its 5-day EMA. It is apparent from the chart that the drop today did nothing to derail the uptrend. We’ll need to wait a few more weeks to discover the fate of the bear call we placed a few weeks back. So far, nothing to worry about it.
The Dow was down over 200 points at one stage, but finished the day down 134 points to finish at 12,503. The NASDAQ fell back below the 2,500 level, finishing down 31 points to 2,491. News items for the day included British lender, Bradford & Bingley selling a 23% stake to a US private equity firm. Add to that Standard & Poor’s downgrade of Lehman Brothers, Morgan Stanley, and Merrill Lynch. S&P also moved Banc of America and JP Morgan to a negative outlook. Further fuel was added to the fire as the S&P stated they could see additional write-downs and "sharp deterioration" in residential construction and mortgage loan virtual portfolios.
Further bad news came in the form May’s ISM index showing a fourth straight decline and Construction Spending dropped in April for the sixth time in seven months. No shocker there!
Plus Wachovia’s CEO, Ken Thompson, was fired and Washington Mutual’s CEO Kerry Killinger lost his role as Chairman.
One of the bright spots today was the FXI, which dipped menacinlgly to its 50-day MA today, before rising back above its 5-day EMA and displaying a candle that straddled its 20-day EMA. We don’t anticipate any issues for our bull put spread that was entered precisely at the last bottom around $150 a few weeks back. Again, nothing to worry about.
We have mentioned Nvidia quite a few times in recent weeks in our blog articles and its strength was noteworthy again today. Today, it reached its upper Bollinger Band, often a favorite price target of technical analysts during uptrends. All this in spite of a big drop in the major indexes during…
GE Whiz!
by Stock and Option Trades - May 28th, 2008 2:28 am
Conviction is defined as having a fixed or firm belief. And, at the start of May, our conviction was that the month would not end without a sharp decline that would take most by surprise! Last week was that surprise for many. Not for us, however and not for Phil. We were all quite skittish during the second run up to 13,100 just 6 trading days ago.
We went out on a limb late last week to call the top in oil also and backed up our conviction with a Trade Alert on the DUG. Unfortunately, we didn’t get the pullback we wanted today on the DUG, so we decided to be patient before executing the trade. If it comes in… great! We will add it to our Exxon bear call from a few weeks back, which is in good shape now. If the DUG never retraces, we will remain disciplined and will refuse to chase it. We went bullish on the FXE and benefited from a perfect open last Monday before Tuesday’s pop. The timing was equally spectacular on the FXI before that so we can’t expect the market to give us perfect opportunities every week!
One of our members asked recently about long-term plays and General Electric has popped up as a company that would fit well into this category now. We had an internal price target of $30 in the short-term and $30.40, where it closed today, is good enough for the purposes of this article. GE has not been this low for nearly 4 years (5-20-04). In fact, you would have to go back to 2003 to find a 10 year low for this international behmoth!
When GE was trading at $32 per share, its CEO was purchasing stock. With the stock trading almost $2 lower, we believe the $30 level could act as strong support. Technically, the RSI is quite oversold and fundamentally the reward to risk ratio is becoming ever more attractive. Even if $30 was broken, the next level down is $28, a point at which the stock hovered back in 2003.
The question is, does GE deserve to trade at the same price level as 5 years ago? Did the dollar not decline in that period? Does the company’s international exposure count for nothing? Does the diversification mean nought? Although diversifcation counteracts fast growth, surely its exposure to so many markets should insulate it from any…
(Ka)Boom Times!
by Stock and Option Trades - May 19th, 2008 2:37 pm
At first glance, the past 5 years or so has been a glorious time for US stock market investors – a boom time! The S&P 500 is up almost 80% since the low in March 2003, an annualized gain of almost 12% per year. This is very close to the average long-term forecast espoused by many financial analysts, and a full 4% points above the historical performance of the stock market.
If the only chart we paid attention to was that of the S&P 500, we might be lured into believing that this has been a boon period. But the next chart reveals "something is rotten" (as Marcellus in Shakespeare’s Hamlet is famous for saying!).
The US Dollar Index has suffered a massive decline from close to the 100 level to its most recent close around 72. Indeed, if the gains of the S&P were translated into euro terms, the result would be a 5 year gain of LESS THAN 20%, an annualized gain of less than 4%, which is HALF the historical growth rate!
If this is where the "rotten-ness" ended, we might be comforted. But digging still deeper, we can see clearly the results of the decision by the Federal Reserve to cut interest rates and to stand by the statement that the "government is prepared to do whatever it takes to maintain financial stability in our market system".
The result is soaring commodity prices and surging import prices. As these commodity prices soar and living expenses mushroom, confidence among consumers diminishes as we have already seen with simply horrible numbers reported recently!
As consumer confidence declines, spending on discretionary items tends to decrease. And with the consumer typically credited with comprising approximately two thirds of the economy, a consumer in trouble is an economy in trouble.
Perhaps, consumers could ride out the tough times if they had a glut of savings on which to fall back. But the chart below shows the Savings Rate is, well, not much of a Savings Rate at all!
Perhaps the absence of savings was not a problem while home values were appreciating; after all a line of credit could be tapped. But no longer is that the case in most parts of the country.
Moreover, consumers face an additional problem, that of wages failing to keep pace with inflation. If you’re wondering if your wages are keeping pace with inflation,…
Caveat Emptor!
by Stock and Option Trades - May 12th, 2008 11:12 pm
- High Oil Prices
- A huge earthquake in China
- A loss from Sprint Nextel (S)
- Plus a warning from Fedex (FDX) last Friday evening
Fedex was as low as $87.59 but managed to finish positive by days’ end, rising to $90.50 (+ $0.13).
Despite relatively low volume and concerns over today’s action being a short-covering rally, the strength in the markets remained throughout the day. This will be a very busy week with economic data and earnings reports, so we will soon find out if the strength will be maintained.
Earnings Reports
Wednesday: Arcelor Mittal (MT), Diana Shipping (DSX), Deere (DE), Freddie Mac (FRE), Macy’s (M), Sony (SNE), Ctrip.com (CTRP), Jack In The Box (JBX), Agilent (A), PetsMart (PETM).
Thursday: Blackstone (BX), Blockbuster (BBI), Urban Outfitters (URBN), Focus Media (FMCN), Hewlett-Packard (HPQ), Kohl’s (KSS), Nordstrom (JWN), Salesforce.com (CRM), Thornburg Mortgage (TMA), JC Penney (JCP).
Friday: Abercrombie & Fitch (ANF).
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Philip R. Davis is a founder Phil's Stock World, a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders...
Ilene is editor and affiliate program
coordinator for PSW. She manages the Favorites backup site
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