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Saturday, July 13, 2024

Take-Off Tuesday – Playing the One-Way Market

Up, up and away! 

It's Super Market!  Strange index from another reality, who ignores bad news and achieves p/e multiples far beyond those of rational markets.  Super Market, who can break resistance on low volume, move higher without consolidation and who – disguised as a genuine Price Discovery Mechanism, an actual indicator of the true-value of listed companies – Instead fights a never-ending battle with rational thinking and negative data because, in America, the market is only allowed to go one way!  

OK, I got that sarcasm off my chest, now we can cheer-lead.  Go Russell 800 go!  Is today finally the day?  After a rational-looking sell-off yesterday on very legitimate concerns over the fact that Portugal is now borrowing money at over 7% interest (a rate that would cost the US over $1Tn in interest annually), we had essentially a "Free Money Day," where the market goes up and up and now we have even better futures, where another 0.5% is being tacked on in early trading (7:30).  

Let's embrace the positives first and foremost.  Both Japan and China have now stepped up to assist the 17-member EU to beat back high rates by pledging to actively participate in this week's bond auctions, the first of the new year.  The IMF (mostly the US) has also pledged to backstop loans – all this is giving the Euro a nice 0.5% bounce that has knocked the dollar down to 81, which is down 0.6% from yesterday's open so of course our markets are up 0.6% – THATS WHAT ALWAYS HAPPENS!  

What doesn't always happen is the Nasdaq punching through the 2,700 mark on the back of AAPL's run to $345 as the expected announcement of the Verizon IPhone is pushing Apple's expected 2011 earnings past the $20 per share mark so $340 (p/e 17) sounds almost conservative compared to BIDU (p/e 87), AMZN (p/e 74) or NFLX (p/e 71) and, if you think about it, Apple has a search engine, sells things on-line and has Apple TV, which does Netflix's job so if Goldman Sachs can call Netflix the "killer app" for tablet computers – what does that make Apple TV, which is designed to run off the IPad and includes Netflix as just one of its offerings?

The Wednesday before last, we made shorting the AAPL 2013 $175 puts at $8 the base for buying 2 SPY 2012 $125/135 bull call spread at $4.80 each for a net $1.60 in cash on $20 of potential upside (1,150% potential upside).  That's a pretty bullish bet as SPY was just $125 at the time so we are playing for a 10% gain.  This is a hedged offset as we are GUARDING against a SPY run of 10% by agreeing to buy AAPL at $175 if the market collapses.  

I think if people are ever going to understand hedging, this is the best example as the main premise here is:  IF someone wants to sell us AAPL at $175 per share (now $340) in 2013, we will be happy to buy it.  So now we say we're willing to buy 500 shares, which would cost us (at 50% margin) $43,750 and AAPL would then be a long-term investment for us at 50% off the current price.  In exchange for promising to buy AAPL in 2013, the person who currently owns the stock at $340 pays us $8 per share now or $4,000.  We take that $4,000, plus $800 more and buy ourselves 1,000 of the SPY 2012 $125 call options and sell 1,000 of the SPY 2012 $135 call options for net $4.80 each (10 contracts of 100) and now our WORST CASE is owing 500 shares of AAPL at $175 and our best case is getting back $10,000 at SPY $135 or higher (we always have a $10 advantage over the caller) against the $800 of cash we laid out.  Even if we had to set aside the entire $43,750 in margin (it's actually just $1,755 with an ordinary margin account), the return is still and attractive 22% but, as I said, over 1,000% on the actual cash commitment and 500% on cash and ordinary margin).  

Trades like this can help you keep your virtual portfolio mainly in cash while you wait PATIENTLY for the market to clearly show which way it is heading.  That is our current game plan.  It is BORING and we amuse ourselves with day trading but we are not, on the whole, day traders – merely active market participants who know better than to commit too much capital in uncertain markets.  Warren Buffet has been known to wait a decade or longer before committing his capital – we've been waiting since November!  

This is how we trade uncertain markets.  It can even be argued that I'd rather get assigned 500 shares of AAPL at $43,750 than get my "consolation prize" of $10,000 if the markets move up – that would be the Buffett way.  Two Tuesday's ago I asked if we were "Topping or Popping?" and we discussed our many, many long-term bullish plays as well as a dozen other bullish trade ideas we were working on besides AAPL and, of course, we still have our "Secret Santa's Inflation Hedges for 2011" and XLE, XLF, DBA and even XHB are all still playable as the markets still haven't gotten away and these are long-term plays but they are long-term plays with the potential to make HUGE amounts of money so, no matter how cynical you are about the current market moves – it's worth considering at least some hedging to the upside – in case this thing really starts to pop.  

Now that we have discussed the bullish premise, which is A) Inflation B) An improving economy and C) The Psychotic Fear Global Governments Have of Letting the Markets Decline and we have discussed (in the links) dozens of long-term upside trades that will make HUGE money if the market go up – we can move on and discuss a few shorter-term downside hedges and why I think we still need them.  

Back to our AAPL example – I KNOW if the S&P rises 10%, I will make $10,000 and if AAPL justifies $300, I will not see much increase in my $1,755 margin requirement.  Assuming my commitment was to make AAPL 10% of a $500,000 virtual portfolio ("worst case") then I still have oodles of cash to play with in the short-term.   Where is my risk?  I don't really lose anything other than my $800 cash if the S&P doesn't hold 1,250 for the year.   My danger is in AAPL selling off hard.  Since AAPL is now close to 25% of the Nasdaq, it's very logical to use the Nasdaq as our short-term downside hedge.  

QID is the ultra-short on the Nasdaq and has been brutalized at this point down to $10.96 and even lower at the open.  It's a 2x ETF so if the Nasdaq drops 5%, QID should go up 10% but be wary on ultra ETFs because they experience decay and tend not to give you the expected returns over time.  Nonetheless, for AAPL to hit $175 we would expect a catastrophic drip in the Nasdaq of at least 25% and that should bump QID up to $15, right?  We are mainly worried about the market between now and April.  If we keep going higher through earnings and the Fed keeps dumping money on the markets then we should be well on our way to S&P 1,350 by April and less worried about a correction than are now.   

QID's April $10/13 bull call spread is just .92 and is, of course .96 in the money.  You can buy as much of it as you want for a straight 3:1 pay-off if QID goes up 20% (Nasdaq falls 10% back to about 2,400).  Now, if the Nasdaq drops 10%, what would I like to buy?  How about DECK?  DECK is down a bit at $80 and they get pretty attractive at $70 and VERY attractive at $60 and did you know there is a guy who is willing to pay is $3 today in exchange for our promising to buy DECK from him for $60 in June (selling the June $60 puts for $3)?  This is the "Wimpy Strategy" we discussed in last week's Weekend Reading.  Well OK to that!  So let's say we're willing to own 500 shares of DECK for $30,000 and that would be, at worst, $15K of margin but about $3,000 in an ordinary margin account for selling the puts.  

We collect $1,500 and buy 15 of the QID April $10/13 bull spread and those will pay us $4,500, which is another 15% off the potential assigned price of 500 shares of DECK if the Nasdaq drops 10%.  Is it possible for DECK to fall 25% to $60 without the Nasdaq dropping 10%?  Sure it is – these hedges aren't perfect.  We just look for logical combinations of stocks we don't mind owning and trades that give us good index protection.   

So we are in cash with very small margin commitments and we've decided we're willing to spend $43,750 on AAPL and $30,000 on DECK as potential long-term virtual portfolio holdings if they go on a massive sale.  If the market goes straight up, we won't own them but we will get $10,000 in cash from the S&P.  If the market goes down, we'll get a bonus $4,500 in cash from the QIDs towards our possible purchase of AAPL and DECK and, if the market does neither – then we didn't miss anything and we continue to watch and wait for bargain opportunities using our "How to Buy Stocks for a 15-20% Discount" Buy/Write Strategy, that pays us whether the market goes up or not.

As I also said recently in Member Chat, this is a "Ty Cobb Strategy," we are swinging for average, not for home runs.  As long-term investors, average trumps home runs every time and even Ty Cobb accidentally hit a few home runs once in a while.  He won the triple crown in 1909, leading the league with 9 home runs while batting .377 with 107 runs batted in.  That's the goal of a hedged investing strategy – always look to improve our average and the home runs will take care of themselves and we'll pocket those 20% gains one by one all season long.  It's the kind of trading that works under almost any market conditions.  

Ty Cobb was asked once how he thought he would hit against modern hitters and he thought about it for a moment and said "I think I would hit about .300."  Why so much less than your lifetime average, asked the reporter.  "Well," said Cobb, "you've got to remember, I'm seventy-three now."  If you want to be a successful investor when you are 73, take the time to learn to hedge your virtual portfolio now – it's a valuable skill that will serve you for the rest of your life.  

We don't need to look at the news today.  Everyone is rescuing Europe and it's all about Russell 800 again.  I think until we get past this week's bond auction in the EU we have no right to be as complacent as the markets are indicating and, of course, next week we finally begin to see some earnings so, again, why are we swinging so hard when we haven't even seen the pitch yet?  

The move up on low volume, especially in the thinly-traded futures, smacks of desperation on the part of the manipulators more so than a genuine rally.  We will continue to favor the short-term short plays and oil finally hit our $90 target where we are thrilled to jump in on the short side there.  WYNN ($119), NFLX ($190), AMZN ($185), FCX ($120) BIDU ($107) and PCLN ($440) are all overpriced and ripe for a fall, despite all of Cramer's button-pushing, so we'll be looking for short option plays on them as well as our QIDs (already in) and DIA (already in) short positions.   

It's fine to pick up long positions in good companies that you don't mind buying more of if the market falls 20-30% but try to stay out of momentum stocks – even AAPL as we are stretching the rationale of any kind of bullish positions until we have more solid evidence, not just speculation, that these companies deserve to have higher values now than they had in 2007, when earnings were higher and we thought there was no possibility of Bank Failures, Sovereign Defaults, Deflation, Inflation, a Housing Collapse, a Flash Crash and the World's 6Bn people were $18Tn less in debt ($3,000 each!) and 10% more of us had jobs!  


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