Options Trader: Monday Outlook

What a wild ride!

To think the S&P 500 was at 666 back in March and here we are, less than 6 months later with the S&P finishing last week at 1,026 (up 54%), just a point off Friday’s high and up at levels we haven’t seen since the first week of October, when we lost 800 points in just 5 days (see 10/3 weekly wrap-up). At that time, I cautioned members not to be led into temptation to buy the S&P 500 at 1,000, warning:

Keep in mind that governments are doing everything they possibly can to prop up the markets. As I said a couple of weeks ago, this is very much like the government throwing sandbags behind the totally inadequate levees in New Orleans ahead of hurricane Katrina - it may look like they are doing something but if the storm hits us, all these efforts will quickly wash away like sandcastles in the tide.

My protective picks at the time were real portfolio savers: SKF Jan $100s were $19 and caught the move up to $200 in early January (up 420%), DXD Apr $55s at $14.20 caught the spike just a week later to $110 (up 674%) and SDS March $77s at $9.95 also caught the move on Oct 9th up to $130 (up 1,200%). At the time, I set danger levels on the Dow at 10,650, 1,135 on the S&P, 7,400 on the NYSE (I was ignoring the Nas and the Russell as indicators as they were too volatile at the time - now we are used to the volatility so we watch them too).

We were not surprised by the downturn in October - we were prepared for it as we had been skeptical of the stimulated rally from the start. The reason I went down memory lane was to remind myself this weekend what it is that we fear now - in this "new bull market." It is very difficult to keep buying covers when those covers keep failing and it’s extremely tempting to take a bite of the apple and try to run with the bulls, even if you feel you are a little late to the party.

This weekend we initiated a new $100,000 Portfolio with the goal of creating a $2,500 monthly income as a way to supplement a more conservative base of investments. I pointed out to members that if $600,000 is returning 6% ($3,000 per month) then taking $100,000 out drops the core return to $2,500 per month but, if we can hit our goal and leverage that $100,000 to return another $2,500 per month, then we have increased the total return to $5,000 per month, a 66% increase in returns on the overall portfolio. When push came to shove we did, in fact, target the sale of $7,310 in options in our first month with $27,785 at risk.

There are only 8 trades involved at the outset, 6 bullish plays and 2 bearish covers. I had considered the other ultras, which is what led me back to my October posts, which was the last time I had this creepy feeling that all was not right in the markets and, in the end, we used FAZ as one of our covers but let’s discuss using our old reliable plays as covers for our other bullish trades. Our last major bull blocks were back on August 9th when we had Pharmboy’s Phavorites (part 1, part 2 came out this weekend) as well as my latest edition of the Long Shots Portfolio, which featured bullish plays on BHI, UYG and C (which is already up 40%) so we have plenty of longs to protect and, while our usual DIA covers are adequate, the ultra covers we used in October can be downright fun if they pay off even half as well as they did back then.

The original protective picks were made on October 1st in "Hedging for Disaster," also a good read if you have time are still good selections today but we are starting at much lower levels in our ultra-ETFs but we have a lower VIX so let’s see what works as current "Disaster Protection." The idea here is not to bet the house on the bear plays but let’s say we’re concerned about that "double dip" in the markets and we want to protect against a retrace of 50% of the recent gains.

XLF is up 31% since July 10th and up 141% since March. A 15% pullback in XLF would be a 30% gain in SKF, which is currently at $27 so figure $36 would be our target. Jan $29 calls can be bought for $4.10 and Jan $33 calls can be sold for $3.10. That’s $1 on a $4 spread with a 300% gain if we hit our $36 target. If you are concerned that your overall portfolio will drop 40%, you only have to commit 10% to this type of cover to protect you from most of the drop. It’s not an all or nothing play, as you fall out of the money you can expect to lose about 15% of your cover per $1 drop in the S&P and hopefully the 90% of your portfolio is making more than the 2% it would need to offset that drop as the XLF rises 2.5% (which causes SKF to drop $1).

DXD is the ultra-short on the Dow and is down from $50 to $37 (down 28%) since July 10th as the Dow climbed from 8,146 to 9,505 (up 16%). Of course the Dow is up 46% off the March lows but let’s assume just a small move that sends DXD back to $43. October $36 calls make good protection at $2.95 and we would plan to roll out of that position, back to the Jan $35 puts for $2 more if DXD breaks below $36. Then we would be free to sell some front-month covers (the Sept $38s are now $1.35) while we wait to see if we are in for another late September sell-off.

SDS is more liquid and has fallen further, down from $60 on July 10th to $43.28 on Friday. With $51 as our retrace target, the Dec $39 calls ($4 in the money) can be bought for $7 and the Dec $44s can be sold for $5. That’s $2 for a December call 10% in the money (S&P would have to gain 5%, to 1,077, to put you under) with a $5 payout (up 150%) if SDS gains .72 (1.7%) from here into the winter.

Jeremy Grantham of Boston asset-management firm, GMO who, like me, encouraged people to buy in March also agrees with me now in saying the S&P 500 has zoomed right past what they consider fair value of about 880, based on earnings estimates and historical price-to-earnings ratios. Mr. Grantham sees "seven lean years" of a sluggish market ahead, to atone for what the firm believes was a long era of overpriced stocks, according to his newsletter. "The past 12 years have seen two bubbles that were really good for corporate profits," says Ben Inker, GMO’s director of asset allocation. "Now things are unlikely to be anywhere near as good as people have gotten used to, because we’re not going to have a bubble to help us."

We are going to continue to go with the flow but let’s keep an oar in the water, just in case we spy obstacles ahead. Barry Ritholtz had a great article this morning about what BS the home sales numbers are - something we discussed in Member Chat last week and you know how I feel about China’s nonsense recovery so we can continue to enjoy the ride as long as we are ready to jump off before we head off a cliff. These are not the super-aggressive covers we took in September, at that time we already had confirmation that things were breaking down - these are just our early positions, the "just in case we wake up tomorrow and the floor drops out" sort of positions and I’m very pleased to see the market holding up to give us good entries this morning. You may not be able to fight the Fed but you can’t fight Mike Tyson either - that doesn’t mean it isn’t worth putting on head gear if you do have to, right?

Why then, should portfolio protection be any different? The Hang Seng is back over 20,500 and the Nikkei gapped right back over 10,500 to finish at 10,581 for the day’s session, erasing all of last week’s losses. The Hang Seng still has a way to go to get back to 22,000, where it topped out on Aug 4th, but 100% of this session was a pre-market gap up that was sold into all day so fake, fake, fake and we’ll be picking up some $10 FXP calls if the US markets are red for a quick ride back to $10.50 or higher if we have even a hint of pullback.

Europe is being less silly than Asia with half-point gains across the board at 9am. EU Industrial Orders were a huge improvement in June but we know June was good, it’s July we’re worried about. We’ll see what this week’s data will bring but, for now, let’s take a few extra covers (and, if we have momentum, we can take the buy side of the above spreads and wait for a better price on the options we sell) and see what shakes out. We have a lot of data coming in, starting with Case-Shiller (but it’s June) and August Consumer Confidence, which has low expectations considering the "booming" market. Wednesday is real (as in real scary) data with Durable goods at 8:30 and New Home Sales for July at 10am followed by Crude inventories at 10:30 - all three have the potential to disappoint.

Thursday we get our Q2 Preliminary GDP report and Friday is all about Personal Income and Spending with a little Michigan Consumer Sentiment thrown in for good measure. So no major data reasons to turn back until Wednesday but the momentum is slowing and a 55% gain off the bottom for the indexes is a pretty big load for the bears to carry. CNBC is working overtime to convince you that money is on the sidelines, shorts are getting squeezed, fund managers will be fired if they don’t buy no matter what the values say… whatever it takes to keep GE afloat for another week!

It’s going to be interesting to say the least but please, be careful out there!