Friday, I’m in love with you

Relentless bad news

Right now, investors have to get used to a relentless torrent of bad news. One minute its weak Chinese data. The next its the possibility of the Greeks exiting the Euro. Or Spanish bond yields climbing over 6%. In the past few years we’ve really witnessed all kinds of trials … from tsunamis and volcanic ash clouds to debates over raising the US debt ceiling and talk over bailouts ….  The mood is definately subdued and financial press is continuously “glass half empty” (in Australia that is … watch US financial TV and you will find hopium is everywhere .. but that’s another story).

The Aussie market gets the wobbles

Most Aussie investors know that we take the lead from overseas – historically the US, but now also Europe and China. And for whatever reason, the worst news of all seems to be delivered over the weekend! So in a risk averse environment (now), Friday is often a dud day on the ASX as “the market” anticipates various weekend crises. Come Monday, the market can see a good “catch up” rally if the anticipated bad news doesn’t occur.

So I’ve turned my mind as how to profit from these situations using options. There are a couple of strategies. I’ll work through an example now.

Case study – BHP on Friday 18 May

On the Thursday 17th of May, the US market was weak, with the S&P 500 closing down 1.5%. Following this poor showing, and anticipating further carnage over the weekend, the ASX was down 2.7%. One of the worst stocks was BHP, which closed at $31.46 (- 4.0%).

The chart below shows BHP with the relevant data highligted. Click on the chart to open it in a new window.

The effect of this drop was that volatility increased significantly. The composite implied volatility for BHP rose from 30.3% to 36.5%. As can be seen from the chart below, volatility over 30% is relatively high (but certainly not unprecedented).

Suggested trade

In order to exploit this increase in implied volatility, one strategy is to sell a strangle. I chose to sell $35 call options and $26 put options for a combined credit of 54c per contract, excluding brokerage. Based on 50 contracts, this resulted in a credit of $2700 to my account, before brokerage and fees of $30. I required $17,000 available margin to do this strangle. The diagram below shows the payoff at expiry on 28 June 2012. More technically minded readers will note that the implied volatility for the put is 54% and for the call is 33%.

Summary of this trade

A credit of $2670 is received when initiating this trade. At expiry, the full credit is kept provided BHP remains within the range $26 to $35. So in essence when we initiate this trade we want two thing to happen:

  • Realised volatility to decline. Simplistically this means we want the stock to go “sideways”. Of course “sideways” is a relative thing … but as a rule of thumb if the stock ranged between $30.50 and $32.50 in the two weeks following the trade, that would be fine
  • Implied volatility to decline. If the market become less anxious, and the stock moves sideways or increases, implied volatility will usually decline. As an option seller this is good for us. Lower implied volatility means that the options will depreciate.

Trade mangement

This is not a “set and forget” trade. When we set out to do the trade, we had in mind a desire that the stock move sideways and implied volatility decline. If either of these things don’t happen we will have to take action. One thing we can do is buy back both the options and close the trade. One guide as to when to buy back the options is when either option doubles in value. So in this case we received 27c per option. A good guide is to consider corrective action when either option is over 54c.

Outcome

Its impossible to know what will happen to this trade, since it expires on 28 June 2012. However, one week later the results have been very good. Composite implied volatility has dropped from 36% to around 30%. BHP was relatively stable over the week, closing at $31.61 (+0.5%). As a result the spread has depreciated by about 60% to around 22c. We can book a profit of $1540 if we buy back the options. Or alternatively hold the position and hopefully accrue further gains.

Happy investing!

Ed

PS Option trades can involves losses. Please read the site disclaimer.

Excellent Opportunities in ETOs

Introduction

Current market conditions give great opportunities for options traders. Recent volatility, as well as the fear prevailing in the market means that volatility (historical, forecast and implied) is high relative to recent levels.

Today I’m looking at a calendar spread on BHP. This is a bearish play (aligned with my view on the market and BHP) with limited risk.

The trade

I’m looking at buying 100 $28 puts expiring on 26 July 2012 (76.5c) and selling the same number of puts expiring on 28 June 2012 (52.5c). Each option contract is over 100 shares in BHP. Total cost is $2,400 plus commission. My risk is limited to my initial investment so there should be no margin requirements. My expectation for placing this trade is that BHP will decline and trade around $28 during June. I’ll look to close the trade on or before expiry of the June option.

Profit potential

Below is a graph showing the estimated profit on 28 June 2011 (when the short option expires) for a range of BHP prices. Ive assumed $60 brokerage (the cheapest discount brokerage available). Click on the graph below to open in a new window.

Maximum profit is c.$9,000 is BHP is exactly $28 at expiry. The spread is profitable for BHP prices between $25.25 and $31.50. More technically minded reader might note there is a potential edge from buying the July option on a volatility of 41.1% and selling the June option on a volatility of 44.6%.

Advantages of this trade

  1. Limited risk of $2,460 with potential profit of up to $9,000.
  2. The spread is profitable over a wide range ($25.25 to $31.50). So even if I’m wrong on my opinion of BHP I still might do OK.
  3. BHP options are amongst the most liquid so I’m more likely to get fair prices when entering and exiting the trades.

Follow up

I’m going to treat this trade as a paper trade, and will conduct a post-trade analysis after it closes.

Ed

PS Please read the disclaimer before trading any action.

Postscript

On Monday 21 May following this post the spread was trading at c.21c. This will form the entry price for the purpose of tracking the trade and undertaking post-trade analysis.

ASX Macro View Week Ending 18 May

Since my last review in Feb, the S&P/ASX 200 (XJO) has slumped after attempting to break out to the upside though the 4400 level. For much of this period the market was in a slow grind, with little impulsive price action (positive or negative).

Since peaking at 4449 on 1 May, the XJO has sold off aggressively and is currently at 4047.  In the week ending 18 May, the market was down 5.6% in broad-based selling. Only the utilities sector escaped the carnage (+2.12%), however this was aided by the takeover offer for Hastings Diversified (HDF), up 12.8% for the week. Biggest loser among the largecaps was Toll Holdings (TOL) down 23.2%.

Why the drop?

The market has caught the nerves due to uncertainties in Europe (again). In addition, admission of over $2bn in trading losses by JP Morgan has not assisted confidence.

It should be noted that May and June are historically weak months, as 3 of the big 4 banks have gone ex-dividend and underperformers are typically aggressively sold as investors realise tax losses.

Where to from here?

I see weakness with an approximate target of c.3800 by 30 June. A lot obviously depends on the resolution (or lack thereof) to the European problems.

I think rallies will be short lived and could be viewed as selling or shorting opportunities.

Chart

Below is a weekly chart of the XJO since the market peaked in 2007. We are still in a secular bear market with the rally from the March 2009 lows essentially stalled and the market remaining approximately 40% off its all time highs in November 2011. Click on the chart to open it in a new window.

Ed

PS Please read the disclaimer before taking any action.

Dividend Stripping

What is it?

Dividend stripping is the process of buying a stock and selling it after it goes ex-dividend. The objective is to capture the dividend with the objective that the dividend (plus franking credits) exceed the losses incurred in holding the stock. Of course the stock makes a profit that is a bonus!

Example

On 19 Dec 2011 I buy 1,000 TLS @ $3.23. Total cost $2,230 + brokerage.

On 13 Feb 2012 the stock goes ex a 14c dividend.

On the same day I sell my stock @$3.23. I’ve broken even on the stock, collected a dividend of $140 and collected $60 of franking credits which will reduce my tax when I lodge my return (note to get the franking credits I’ve had to meet the ATO’s 45 day rule … google for details). I’ve ignored costs in the is example. Note a breakeven is not guaranteed (YMMV).

Easy!

In the good old (pre-GFC) days, dividend stripping was easy …. a rising market meant that the stock could be often be sold for about breakeven, leaving the dividend as pure profit! Given that some larger stocks can yield up to 10%pa including franking), this meant an easy profit of about 5% in 45 days (or 40% annually) with minimal risk!

What about now?

Unfortunately dividend stripping in general no longer works particularly well … it was a definitely a strategy for a bull market. A reasonably analogue is flipping residential property … most of the profits come from the rising market rather than the renovation itself. There are a couple of reasons why its stopped working but the most obvious that in a secular bear market (i.e. the current market), most of the return (actual and expected) is from the dividend. This applies particularly to high yielding stocks. In plain English, this means a lot of people are pretty stoked to get a total return of say 10-13% and gains above this level are arbitraged away.

My next post will look at how to trade for profit around dividends in the new environment.

Ed

PS None of the above is financial advice. Consult a professional before investing or speculating.

Investing in gold and silver

Recently there has been a fair bit of publicity from Warren Buffet, Charlie Munger, Bill Gates and others as to whether gold was a worthy investment. They all answered in the negative. However this misses the point. Gold is not an investment. Its savings – an alternative to cash. Its not designed to be productive. Its designed to maintain its value regardless of the political or monetary conditions of the time. It is thus a kind of insurance. No you can’t eat it, but you can generally exchange it for food or other items of value!

How to invest in gold

A couple of alternatives.

  1. Buy bullion (e.g. Perth Mint, ABC Bullion amongst others). Store it with them or at another location.
  2. Invest in a security listed on the ASX that tracks the price of gold (e.g. GOLD or PMGOLD).
  3. Invest in a company which mines gold (e.g. Newcrest Mining).

It is worth pointing out that the price of gold mining companies does not necessarily track the price of gold and is subject to all the exploration, operational, fiscal and political risks of  running a mining company.

What about silver?

Silver is sometimes called “poor man’s gold” since it is of much lower value (about 55 times less at time of writing).

Silver is likely to maintain its value in all situations, however historically it has not been as stable as gold.

Aristotle defined money has needing to have several qualities – durable, portable, divisible and consistent. Gold in my opinion has all these qualities. Silver has most of them – I would not currently regard it as portable. If I sold my home I could easily transport its weight in gold. Silver – not so easy.

So, silver is currently less like “money” than gold. In certain situations it may become more “moneylike”. If its low risk savings and / or insurance you’re after, gold is the better choice in my opinion.

More later!

Ed

Note: Nothing in this post should be construed as investment advice. Consult a professional before investing in any security mentioned.