To begin, let's do a review of our open trades. With February options expiring this Friday, the timing is perfect.
1. We'll go back in time to a trade we opened in our May 11, 2010 issue, Banking Heroes and Bums, a zero premium trade that pitted local giant Wells Fargo (NYSE:WFC) against Spain's leading lender, Banco Santander (NYSE:STD).
We sold PUTS on Wells and bought them on STD, both for $2.20. STD expired worthless, but the WFC options increased in value, and we were underwater for awhile as expiry approached.
In mid-October we rolled out the WFC options to the April expiry (28 strike). The move worked out. As of today, those PUTS have lost a great deal of their value, standing currently at $0.25. We urge those of a conservative bent to take a loss here of $25 per option held and close the trade. WFC is now changing hands at $33.76. Risk takers who choose to hold until expiry, run the risk of greater losses should the market retreat from here.
2. The TLT/DBA zero premium trade we initiated back on January 10th has also moved against us. There's a reasonable chance the trade will still work out, at worst with both legs expiring worthless – if TLT advances a mere 0.6% from last Friday's close.
The trade will net a profit only if TLT advances and DBA pulls back more than 8% over the next week (less likely).
Given the probabilities, we feel it prudent to roll out the TLT side and leave the DBA to expire worthless.
Here's how we do it:
When we initiated the trade, we took in a premium of $0.23 (DBA was bought for $0.90 and TLT sold for $1.13). Currently the TLT February 90 PUTS are trading for $0.90. We're going to buy them back, leaving us with a net debit of $0.67. To cover the debit and gain some time, we're selling the TLT June 80 strike, also trading for $0.67.
We'll see what happens as the week progresses, and keep you posted of any relevant developments.
You bailed out too early, you jar-head!
There's no question we called the top early. Since our sell call went out in late December, the broad market has risen by 6.4%. And as of Friday's close the market hit new highs.
We're astounded, frankly. By all standard measures and indications the market should be ripe for some sort of retreat. But it hasn't happened. Some oversimplify and say it's a matter of not 'fighting the Fed', as if there were never retracements during periods of easy money. The crash of 2008 was not caused by a tightening of the Fed Funds Rate; the Fed didn't touch rates for nearly two full years before the Lehman blowup.
Others say Fed-induced liquidity is responsible for the rise in equities. 'Some of that money inevitably has to find its way into the market,' they say. No doubt. But at some point, sellers take over temporarily and profits are taken. Markets never move in straight lines, even during asymptotic blowoff tops.
Our BGZ CALL purchase will also likely expire worthless as result of the market's relentless climb. It's something of a stain on what was a rather strong record coming into the New Year, and we admit it has, at times, made us a little gun-shy about bellowing our bearishness.
Yet we see little reason to reverse our position at this stage. What? Based on the notion that there's a lot of money out there that could eventually end up in stocks? That low interest rates make straight-line, bull markets inevitable?
Sorry.
Put Away the Big Guns
We are going to engage in a somewhat less aggressive strategy going forward but, we repeat, we're not changing our posture. At the risk of turning into a contrary indicator, we remain bears. Pandas, maybe. But bears nonetheless.
The trade we're putting on is one we believe better accounts for the current market dynamic, while still enabling us to remain negative on the market. It's a bearish calendar spread whose near leg expires this Friday and whose second leg winds down in April.
But first a word on calendar spreads in general.
Calendar spreads are, in essence, purchases and sales of current and future volatility. What we're hoping for when we set up a calendar spread is that our near term option (which we sell) will expire out-of-the-money, allowing us to pocket the premium in the short term, and then profit from the longer term option as volatility increases and price moves in our favor.
The most basic form of the trade is executed by simultaneously buying and selling the same strike PUT or Call on the same underlying instrument but with different expirations. So, for instance, if we believed the market was going to fall over the next three or so months, but that it was currently pausing or consolidating, we might sell the near month PUTS for, say $1.00 and buy the same stock's three month PUTS for $3.50. Our total cost for the trade is $2.50.
We make the most money when the near month option expires worthless and the market subsequently tanks. But we can also cash in on the spread. As the near month expiry draws near, the short PUT might decrease in value to, say, $0.20, while the longer dated PUT maintained its worth, trading for $3.35.
In that case, closing out the trade would net the trader $3.35 - $0.20 or $3.15, less the initial purchase price of $2.50. Total profit for the trade, $65 per pair traded.
Risk/Reward for the Calendar Spread
The calendar spread also allows traders to sell near month options against their long position every month – something like a covered call, except the long position is an option rather than stock.
Best yet, maximum losses are known (the initial cost of setting the trade), and gains are unlimited, once the initial option expires.
We're trading the cash-settled SPX PUT options this week, selling the near month, and buying April. The details are here:
Wall Street Elite recommends a bearish calendar spread, selling the February SPX 1330 PUT for $6.90 and buying the April SPX 1330 PUT for 32.20. Total cost for the trade is $25.30 per pair traded.
With kind regards,
Hugh L. O'Haynew,
Analyst, Oakshire Financial
