Earnings Dilemma (Solved!)
by OptionSage - May 4th, 2008 2:39 pm
For many options traders, earnings season equates to trading dilemmas; should a straddle or strangle be entered before an earnings announcement to profit from an expected big movement afterwards or should iron condors or iron butterflies or even naked short options be entered to profit from the inevitable implied volatility crush after the news event?
If the stock doesn’t move much at all after the earnings report, the straddle and strangle strategies suffer from implied volatility crush while if the stock moves much further than expected the iron condors/butterflies and naked short options run into trouble. For the iron butterflies/condors, maximum risk is incurred if the stock moves beyond the long option strike prices. If naked short options were entered, the risk associated with the short calls is theoretically unlimited if the stock were to keep rising while the losses in the naked puts would continue to accumulate if the stock were to continue dropping.
In short, trading at earnings appears nothing short of gambling. None of us know (or at least should know) with certainty which direction a stock will move subsequent to an earnings report. As good as our estimates may be, a chance always exists that a stock will move opposite to our expectations. For example, we may have created a fundamental thesis that postulates a stock will drop at earnings based on what we project will be disappointing earnings or revenues figures. However, if management reports in a conference call that forward-looking guidance is considerably more positive than analysts’ estimates, disappointing results may quickly be disregarded by investors in favor of the rosy guidance. Even if we do manage to correctly assess the direction a stock will likely move, the magnitude of the move is certainly in doubt.
If we take a look at a history of how Amazon’s stock moved following earnings courtesy of www.optionslam.com we can see that sometimes the stock moved substantially post-earnings, but the final movement by the end of the month was considerably lower. Sometimes, it moved substantially and failed to retrace, and sometimes the stock failed to move much at all! So, while entering trades at earnings is fun and provides an adrenalin rush, it seems initially that betting on any given move is akin to gambling cloaked in sophistication.
But perhaps, we are too quick to dismiss! If we analyze a little further, we can spot…
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DiggFireworks and Fizzle!
by OptionSage - April 29th, 2008 12:48 am
Take a look the data due to be released over the next few days….
Tuesday: Agco (AG), Archer Daniels Midland (ADM), Arris Group (ARRS), Avon Products (AVP), Bemis Company (BMS), British Petroleum (BP), Buffalo Wild Wings (BWLD), Burlington Northern Sante Fe Corp (BNI), Corning (GLW), Countrywide (CFC), Daimler AG (DAI), Domino’s (DPZ), Energizer (ENR), Express Scripts (ESRX), General Cable (BGC), Medco Health Solutions (MHS), Office Depot (ODP), Panera Bread (PNRA), Under Armour (UA), US Steel (X), Valero (VLO), Waste Management (WMI).
Wednesday: Akamai (AKAM), Centex Corporation (CTX), Colgate-Palmolive (CL), Cummins (CMI), Dean Foods (DF), First Solar (FSLR), Garmin (GRMN), General Motors (GM), HESS Corp (HES), IAC (IACI), Ingersoll-Rand (IR), International Paper (IP), Kellogg (K), Kraft (KFT), Murphy Oil (MUR), National Oilwell Varco (NOV), OfficeMax (OMX), Proctor & Gamble (PG), Prudential (PRU), SAP AG (SAP), Starbucks (SBUX), Sunoco (SUN), Symantec (SYMC), Time Warner (TWX).
Thursday: Administaff (ASF), Annaly Capital Mgmt (NLY), Automatic Data Processing (ADP), BEBE Stores (BEBE), Burger King (BKC), Cabelas (CAB), Callaway Golf (ELY), Cardinal Health (CAH), Cephalon (CEPH), Chesapeake Energy (CHK), Cigna (C), Clorox (CLX), Comcast Corp (CMCSA), Comscore (SCOR), CVS Caremark (CVS), Dominion Resources (D), Dynamic Materials (BOOM), Eastman Kodak (EK), Expedia (EXPE), ExxonMobil (XOM), Investools (SWIM), Marathon Oil (MRO), MetLife (MET), Monster Worldwide (MNST), Noble Energy (NBL), Nymex (NMX), Sun Microsystems (JAVA), Tyco International (TYC), Wyndham Worldwide (WYN), Wynn Resorts (WYNN).
Now ask yourself if you really want to be fully invested without hedging with this plethora of data still to come!
At Stock and Option Trades, we made the easy money in April since our bottom call in the middle of the month, closing out all of our April trades profitably within days of opening them thanks to big moves and good timing in the FXI, EEM and FCX. And our latest trade is risk-free through May, yet can profit in any number of directions. Innovative and profitable strategies is what we strive for!
We’re not the only ones happy to have some cash built up through April. Phil is back to 70% cash in his Complex Spreads virtual portfolio. We fully expect this volatile Year of the Rat to continue to surprise when surprise is least expected. We do believe a little more upside is possible, but as April comes to a close, we’ll be sitting with a heavy cash pile while our remaining positions will be heavily hedged.
The chart…
Spotting A Breakout!
by OptionSage - April 27th, 2008 2:21 pm
By February 2006, Apple had increased approximately 6-fold in the space of two years. The stock made an attempt to rally above $72 but failed. A scary decline ensued as the stock fell to the $58 level, but ultimately found support at its 200-day moving average. Then it rallied sharply to the $72 region once again, before enountering stiff resistance. Another bounce back up in May 2006 resulted in an intra-day spike above the $72 region, but ultimately a close below $72. And that last failure for Apple was the start of an even more scary decline. For two and a half months in May, June and early July, the stock slid until its July earnings report catalyzed a bullish reversal.
Within weeks the stock had powered higher, but didn’t have enough momentum to reach the $72 level and retraced close to $62. Another surge higher and finally in September of 2006, the stock broke above long-term resistance at $72.
In both May and September, the stock price spiked above the $72 level. The difference between the spikes was simply that in May the stock spiked intra-day above the resistance level but ultimately closed below it, while in September the stock closed above resistance. Moreover, subsequent to the bullish September close, the stock re-tested the old resistance level, failed to close below it and began a surge higher. The breakout had indeed occurred!
Why discuss the movement of Apple in 2006? Well, a principle that can work very well is knowing that traders of a particular stock tend to trade it the same way again and again. By spotting the patterns of the past and recognizing similar activity in the future, a great deal of money may be made!
For example, the gang at Stock and Option Trades have been following Apple daily for many years now and had seen the pattern before. As a result, it was easy to call the breakout when the stock finally spiked above the $130-$132 range recently, where it had twice failed in February. Note the similarities between the failed breakout in late February plus the actual breakout in March and the previous action in 2006. In late February, the stock popped up above the $130 level intra-day, but significantly, closed below that level. In March, the stock closed above resistance, re-tested resistance just as it had done in 2006 and began its March higher.
Within days of the breakout, the…
Stand On The Scales (And Discover Your Nature!)
by OptionSage - April 20th, 2008 4:43 pm
"There may be a recession in terms of stock prices, but not anything in the nature of a crash" - Irving Fisher, leading US Economist, September 1929
"Stock prices have reached what seems like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from current levels, such as predicted. I expect to see the stock market a good deal higher within a few months" – Irving Fisher, October 1929
"The end of the decline of the stock market will probably not be long, only a few more days at most" - Irving Fisher, November 1929
The very unfortunate timing of these quotes from Irving Fisher serve to highlight how optimistic human nature can be! Not only were predictions of higher stock prices made on the eve of the 1929 depression, but when the predictions proved erroneous the downtrend was also believed to be only short-lived.
Are you an optimist or a realist? Jump on board some weighing scales and find out!
The optimist jumps on the weighing scales and sees a number higher than expected. What does he/she do? Jumps off of course! After all, the number disagreed with the expectation. Then the optimist jumps on board again to see if the number changed second time round. Moreover, if the number was better than expected first time around, the optimist jumps off the scales, delighted with the result. The realist, in contrast, simply accepts the information presented either way. The realist sees no need to jump on board the scales a second time because he/she trusts the data presented.
In the stock market, the natural tendency to be optimistic aligns with a self-serving bias. In order to move from optimism to realism, we must recognize that we have a natural proclivity to question information that disagrees with us and to accept data that aligns with our beliefs.
In the stock market, the same biases accompany trading decisions. For example, recent figures showed money market cash skyrocketed to $3.45 Trillion – 56% higher than the March 2003 low! So, with so much money moving to cash, what happened to the Investors Intelligence Sentiment Index for stocks in March?
It dropped, of course! Just as optimism is pervasive when market participants are bullish, so too is pessimism pervasive when positions have been sold and cash becomes a sanctuary. After all, market participants who sell MUST believe…
We Fought The Rat (And the Rat Lost!)
by OptionSage - April 15th, 2008 1:19 am
In a twist on I fought the law and the law won, we fought the rat and the rat lost! More on that later!!
IBM, Intel, Google, Caterpillar and Honeywell all report earnings as the VIX is perched slightly above its 200-day MA…the same 200-day MA that held as support in October and December. This most recent test of the 200-day MA almost broke through to the downside but failed to show much conviction and the danger is rising that support will be held again.
At Stock and Option Trades, we have been keeping a very close eye on the 1325 level for the S&P 500. If we disregard the panicked spike down in January, the 1325 level was quickly regained in January and held through much of February. Indeed it wasn’t until March that the old support level turned into a resistance level. This month that old resistance may well turn into support again and we believe that the next 24 hours will prove crucial.
We mentioned over previous weeks that we expected a surprise bearish dip and last Friday that occurred. Our internal models project strength over the next couple of weeks in the markets assuming the 1325 level can hold so Tuesday will be a very important day and we’re looking for anything above that key threshold level to signal high likelihood of a bullish follow through to the end of the month.
The NASDAQ moved too far too fast to the upside in late March and it was no surprise to see the doji followed by a reversal pattern bearish in April as predicted. The likelihood now is for a resumption of the bullish trend for a couple of weeks, starting either Tuesday or Wednesday.
The oil service holders index has had a phenomenal run since late March and, in our view, is overextended at these levels so we would be steering clear of any bullish plays at this point in time because the risk-reward ratio favors a pullback in the next day or so.
We hope that you have found all the efforts we have been making to improve our algorithms have paid off. Our models have been very accurate in navigating some of the choppiest waters out there over recent months and we’re looking forward to continued success in this volatile Year of the Rat! So far, we fought the…
Scaling In Or Averaging Down
by OptionSage - April 13th, 2008 2:24 pm
The thoughts of others
Were light and fleeting,
Of lovers’ meeting
Or luck or fame.
Mine were of trouble,
And mine were steady,
So I was ready
When trouble came.
- Charlie Munger
Investing in the stock market is as much about conquering oneself as conquering the markets. We consider greed and fear to be our arch-enemies, recognizing that both impact our ability to think rationally. Even those who hope to think rationally and who are aware that the best results in the stock market emanate from rational thinking often succumb to temptation and panic.
So how can we avoid acting irrationally and succumbing to greed and fear?
First, we must recognize that we tend to create the circumstances that lead to irrational behavior. Perhaps we decide to risk too much on a single trade, perhaps we over-leverage, perhaps we borrow from a home equity line of credit. Whatever the reason, an unexpected market event can lead to a decision between holding existing positions at the risk of experiencing continued losses or capitulating and banking losses.
Next, it is imperative that we are willing to hold cash in the absence of compelling investment opportunities. At Stock and Option Trades, we have been emphasizing a heavy cash position for almost 6 months. Indeed, in last week’s commentary we pointed out that we expected one last surprise before a spring/summer rally and last Friday’s big down move certainly appears to have taken most by surprise. In this week’s Market Commentary accompanying the Trade Alert, we will highlight when we believe the optimal buying opportunity is.
Another way of mitigating risk of surprise from a market event is to employ substantial hedging, which is another approach we have been advocating for many months on any positions opened. And one of the most important temptations to avoid is leverage. Too many examples in history have highlighted how excessive leverage leads to demise when unexpected events occur. Even the most conservative investors can become paralyzed by losses due to excessive leverage.
It is imperative to realize that the effects of a mistake do not necessarily stop with the mistake itself. A loss at one moment in time may diminish confidence and may result in one taking a smaller position on another investment that may be a great opportunity. This creates a chain reaction, whereby…
Discovering The Vision
by OptionSage - April 7th, 2008 1:16 pm
In most of these educational articles I discuss strategy, psychology, technical research and virtual portfolio management. In this article I decided to digress slightly to discuss more the fundamentals that affect business decisions. Why is it that some companies become great innovators while others fails to realize their potential? This has been the subject of great papers in the past by esteemed figures such as Stephen Kaufman and Clayton Christensen.
Before understanding how discounted cash flow analysis can affect business decisions, let’s understand the term itself. Discounted Cash Flow describes a method of valuing a company or financial asset using the time value of money. All future cash flows are estimated and discounted to give them a present value. The discount rate used is generally the cost of capital. Discounting a future stream of cash flows into a "present value" assumes that a rational investor would be indifferent to having a dollar today or to receiving some years from now a dollar plus the interest or return that could be earning by investing tthat dollar for those years.
A problem with discounting can arise when managers make an assumption that the present health of a company will continue into the future – indefinitely! When managers consider investments, they often do so in isolation. In practice, this can be dangerous as competitors disrupt the market place with new products or apply margin pressure or take market share. Essentially, managers and business owners must recognize that the market place is continuously changing and must not make business decisions in isolation.
Business owners often have a very hard time forecasting streams of cash from an investment in innovation, yet they have an even harder to time predicting how financial performance may deteriorate in the absence of investment in innovation.
Innovation may be stifled not only from flawed analysis of financial models, but also from assumptions of how Wall Street will react to certain actions. For example, business owners who believe equity markets will punish them for a write-off of obsolete assets may delay adopting new technology.
Another hindrance may be an excessive focus on earnings per share figures. When managers shift their focus onto earnings per share as the primary driver of share price and hence of shareholder value creation, innovation can suffer. Indeed Pete Petersen of Blackstone commented in a recent interview how private equity companies like his own were able to outperform over decades because…
Trading The Trends
by OptionSage - March 30th, 2008 3:12 pm
How many times have you traded stocks that you felt were oversold, but you just weren’t convinced the downtrend was over? How many times have you seen a stock or an index drop further before hitting a bottom and racing back up again? And how many times have you profited from such moves?
In this article, one of the many strategies that takes advantage of such expectations is discussed – the non-standard put calendar.
Before introducing the non-standard put calendar, let’s first review quickly the standard put calendar. In a standard Put Calendar, a long put option is purchased out-of-the-money, typically with 45-120 days of time value and a short put option is sold at the same strike price in the current month (expiration month).
The expectation when entering a put calendar is that a stock will remain relatively flat or ideally will drop a little in price. If the stock were to fall to – but not below - the strike price of the put options by expiration, then the short put would expire worthless and the long put would gain in value. Hence, both options would produce a profit.
More often than not, you will find when buying one option and selling another, that only one of the two options makes money. While this may be true also for the put calendar, if the stock remains flat (resulting in some loss in the long option due to time-decay and a profit in the short option as it expires worthless) or if the stock rises (in which case the long put loses value due to stock appreciation while the short put profits in such instances), the strategy offers the potential to make outstanding percentage returns if the stock should fall slightly.
The standard put calendar is structured such that the long put always protects the short put in the event that a sharp decline in stock price materializes. This is due to the fact that the long put is placed further out in time. The worst-case condition for a put calendar is that a stock moves up or down by a huge margin before we can take any action to modify the structure of the trade to the new trend. In short, gaps up or down are going to work completely against the strategy and much of the debit spent on the overall position is in jeopardy at such times.
While…
The Foundations Of Skyscrapers!
by OptionSage - March 23rd, 2008 5:46 pm
Marcus Cicero is famous for saying that the man who doesn’t know what happened before he was born goes through life like a child. Charlie Munger once commented on this with the following sage advice:
"If you generalize Cicero, as I think one should, there are all these other things that you should know in addition to history. And those other things are the big ideas in all the other disciplines. You have to learn these things in such a way that they’re in a mental latticework in your head and you automatically use them for the rest of your life"
These words from Munger have application to our own quest in the stock market. How can we generalize Cicero as Munger suggests in the context of stock market trading?
A first cursory step involves analyzing a stock chart. This doesn’t mean glancing at what happened last week and commiting capital this week based on a minuscule data set. Rather, it demands that we evaluate from a charting perspective how a company has performed over the past 3 months, 6 months, 1 year, 3 year, 5 year and 10 year timeframes.
Cramer likes to say that we don’t care where a stock has been, we care where it’s going. While much of the statement is true, it is helpful to know the historical patterns of a stock chart when gauging probable future movement. For example, we should have a clear understanding of how a stock reacts around earnings if we are planning to initiate any trades in April (when most companies report earnings). We should know which, if any, of the moving averages or exponential moving averages are most applicable to a company. It is redundant to quote a stock being close to its 200-day Moving Average if the 200-day Moving Average for the stock has never held as resistance or support or shown much impact whatsoever on the stock price!
Another application of generalizing Cicero is to review past fundamentals. While the current fundamentals are important, they often provide just a snapshot of recent performance. By reviewing a 10-year history, as shown here for Garmin, we see the context of a company’s performance.
From this analysis we can learn whether a company has consistently performed well or has ragged results. Stability is a postive. A company that reports fantastic numbers one year and disappointing numbers the next cannot be…
Paddy-Whacked!
by OptionSage - March 18th, 2008 12:51 am
What an ignominious end to a prominent investment bank founded in 1923 by Joseph Bear, Robert Stearns and Harold Mayer. Bear Stearns was nothing short of Paddy-whacked on St. Patrick’s Day!
Evidence of the scandal is in the numbers. At the close of business today, Bear Stearns was worth approximately $650M, a drop of over $3Bn from Friday’s close. Meanwhile, JP Morgan Chase gained $12.5Bn! Did the transfer to JP Morgan create a wealth multiplier of 4X? Last week, Bear Chief Alan Schwartz suggested the book value of the company was $84 per share! Joe Lewis, the billionaire British currency trader who is the main investor in the Tavistock Group and had a billion dollar stake in Bear Stearns, predicted shareholders would reject what he called ‘a derisory offer’. Indeed speculation is building that shareholders will threaten an assault on the company’s takeover.
The forerunner to exaggerated stock movements in Bear Stearns and Lehman over the past week have originated from options trading activity. Enormous put buying at strike prices way out-of-the-money have yielded massive returns. Today huge call contract volumes opened on Bear Stearns strike 5 options for March so this rollercoaster may yet have another surprise in store if the stock again follows the heavy derivatives bets.
As we reported throughout the night, volatility was reaching extreme levels with Asia, the dollar and the futures all down substantially. If you were to glance at the end of day figures, you would have missed a colorful story throughout the day because the volatility translated into confusion. The Dow dropped immediately to session lows of 11,756 before climbing back to breakeven by 11AM and turning positive! By 1.25PM the lows had again been revisited. Bulls then returned as the Dow climbed from being down 200 to up 100! In the last half hour, it again dropped, but remained positive and squeezed out a 21 point gain. The end result? The Dow moved almost 1,000 points today!! Now if it can move 1,000 points up AND down during the day, is there any reason to believe it couldn’t move up OR down 1,000 points in a straight line in a day?
A measure of volatility, the VIX, spiked substantially intra-day reflecting market concerns that the declines could snowball. The VIX reached an intra-day high of 35.60 before pulling back to close at 32.24, still outside its upper Bollinger Band.
Our Dow target of…
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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...
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