Monthly Cash Machine Newsletter, Friday, 03/11/2005 02:05:52 PM ET
HAVING TROUBLE PRINTING?
Stocks Tumble On Deficit Concerns!
The major equity averages retreated sharply Friday after the Commerce Department reported that the trade deficit widened to $58 billion in January. The dollar slid lower in the wake of the news and higher oil prices easily offset favorable consumer confidence data, causing investors to lock-in profits from the market's recent gains. The Dow closed 77 points lower at 10,774, while the NASDAQ fell 18 points to 2,041 and the broader S&P 500 index ended down 9 points at 1,200.
The widespread decline in stocks had little affect on the older positions in the MCM Portfolio, however one of the more recent plays has emerged on the "watch" list. Chiron (NASDAQ:CHIR) slid $0.55 to $36.51 and the move below a near-term support area at $37 is cause for some anxiety in the bullish spread. While the previous trading range ($33-$35) is fairly well established, we will need to monitor the issue on a daily basis to ensure that a timely exit or adjustment occurs in conjunction with any further downside activity. Our initial plan is to roll the spread down and out to the (short) JUL-$32.50 strike and since first test of CHIR's technical strength will occur near $36, we will use a trading stop slightly below that level to initiate the process.
We caution readers that this "roll-out" technique is simply one method of position management and it is not necessarily appropriate for every portfolio. The premiums in CHIR put options are robust for a reason - there is volatility expected in the underlying share value. Since no one can predict the success of the company's return to the flu vaccine market, it seems prudent to avoid losses where they can not be tolerated and that is certainly the case with some of the less experienced traders who subscribe to the MCM newsletter. If you are in this category, or if you simply don't favor the tenuous fundamental condition of the company, we recommend instead that you pursue another exit (or adjustment) strategy. Some viable alternatives include: a net-debit order to close the spread; a buy-to-close limit order on the short option; a closing order based on the underlying issue, where the price of the stock determines the exit point in the short option; or a covering order using (short) stock or (long) puts to offset the short option.
Murphy's Law is alive and well!
Our recent position in LM Ericsson (NASDAQ:ERICY) is not really performing as expected after we initiated the "call-covering" strategy. The stock initially retreated from recent highs, but now it has transitioned to the top of a near-term trading range. While this condition is fortunate for our adjustment, it presents a dilemma for readers in the original spread as there is simply no way to accurately forecast the current trend. From a purely technical viewpoint, it appears that ERICY is back in a "comfort range" near $30-$31 and without a major catalyst to drive it higher, the (relatively) lateral movement should continue in the coming week.
After reviewing ERICY's price chart, you should begin to understand the problems that can emerge with the "covering" technique (using stock) when the underlying issue does not have a clearly defined reversal point and directional trend. Not only must the risk from further upside movement be sufficient to justify the cost of the adjustment strategy, there must also be a high probability of continued (favorable) movement in the share value.
But what if there were a way to reduce the capital requirement for the "cover" and still achieve the same results? In fact, there is a technique that costs much less and it actually benefits from range-bound activity in the stock price. As one of our knowledgeable readers pointed out, you could simply purchase a longer-term call option instead buying the stock. This would create a calendar (time) spread.
For those of you who are unfamiliar with this position, a calendar spread, also known as a horizontal spread, involves the purchase of an option with one expiration date and the sale of an otherwise identical option with a different expiration date. The philosophy for using calendar spreads is that time will erode the value of the short term option at a faster rate than it will the long term option. A spread that is established when the underlying stock is at or near the strike price of the options used is a "neutral" spread (e.g. if the stock price remains relatively unchanged until the near-term option expires, the neutral spread should achieve a profit).
In this case, the calendar spread is not intended to provide additional gains but rather to reduce potential losses in an existing position. If the price of the issue is expected to remain in a small range, the strategy will likely be more appropriate than buying the underlying stock. Of course, it is also necessary to compare the risk-reward outlook of the two techniques and for this evaluation, we need to understand how a calendar spread profits from the passage of time.
We'll talk more about that subject next week, after we publish some new candidates for the MCM Portfolio.