Option Investor

Daily Newsletter, Saturday, 03/03/2007

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap


Tuesday's dip was supposedly an external event caused by a drop in Chinese markets. OK, no harm, no foul. Back to business as usual on Wednesday. Oops! A -200 point drop at the open on positive economic data shocked quite a few traders but the sharp rebound was thought by many to be indicative of a climax bottom. The correction is over now that 12100 has been tested and Thursday should be the beginning of the rebound. Oops! Thursday also started ugly with an even deeper test of 12100 and another sharp rebound. Traders were now convinced the double dip was the end of the selling and were being urged by respected analysts to go shopping for stocks. Oops! Friday failed to produce a rebound and the markets closed at the lows for the day. This is not a positive scenario and the outlook for next week is questionable at best.

Dow Chart - Daily

Nasdaq Chart- Daily

Friday's economics consisted of the final Consumer Sentiment report for February. It fell from 93.3 to 91.3 but nobody was watching. Those who were watching failed to care. Volatility had captured the attention of everyone still in the market and it was rising to close at the high of the week despite Friday being a relatively calm day. The VIX closed at 18.61 and less than a point below Thursday's intraday high at 19.40. After eight months of negligible volatility it has returned with a roar and if the charts are right there are rocky times ahead.

It won't be economics that captures attention early in the week with the only really important report, Nonfarm Payrolls, not due out until Friday. After last week's heavy calendar this week will be positively boring. Wednesday's Fed Beige Book may attract attention but Bernanke has already blessed the recovery so the report will only be informational not major news. On Friday the February jobs report is expected to show a gain of +100,000 jobs, which would be a slight decline from the +111,000 added in January. I think the more important informational tidbit here is the falling consensus estimates over the last couple of months. Last fall estimates had risen to 133,000 but that number has been in decline for several months despite a constant upward revision in the actual numbers. Analysts are becoming concerned that the jobs situation is growing less positive as the months pass. The slowdown in housing and the continued layoff news at the automakers is reducing expectations. Personally I don't think Friday's number matters unless it drops below 50,000 or suddenly spikes over 150,000. Without a major surprise it is just going to be another economic report worth slightly more than 15 min of airtime.

Economic Calendar

The crisis for the week is going to continue to be subprime loans. The sector took another hit on Friday when the Federal Reserve and four other Federal agencies called on lenders to exercise caution in making subprime loans and strictly evaluate the borrowers ability to pay. They proposed stiffer guidelines that if formally adopted by the agencies and followed by lenders would result in significantly fewer subprime loan approvals. In 2005-2006 nearly 17% of mortgage volume was subprime loans or nearly half a trillion dollars. Add in Alt-A loans, those just slightly better than subprime, and that number rises to something in the 23% range. Remove that mortgage volume from the market and the housing sector is going to tank even further.

The proposed guidelines were similar to the Freddie Mac announcement earlier in the week. Basically every subprime mortgage product now comes with much stricter requirements that will prevent many subprime borrowers from qualifying. The agencies said they wanted to make sure that borrowers could repay the loans without refinancing and without flipping the property. According to once analyst I heard on Friday the delinquency rate is continuing to rise with 19% of Countrywide Financial's subprime loans are currently delinquent. This rising default rate is expected by many to eventually cause problems farther up the financial ladder. These defaulting loans are like millions of termites eating away at the financial foundation of the banking system and unless the problem is addressed very quickly those foundations could crumble.

Fears of an impending announcement by a major institution in subprime trouble have helped pushed the yields on the ten-year note to 4.5% and better than a two month low. On Friday credit default swaps tied to brokerages traded at their highest level in 19-months as fears of a default rose. Goldman Sachs default swaps are up +30% since the subprime problem began. Merrill Lynch stock is under pressure because two subprime lenders they financed over the last two years have filed for bankruptcy and they bought a subprime lender, First Franklin, for $1.3 billion. All the major brokers package and securitize subprime loans. As part of the deal they keep a portion of those loans for themselves. Reportedly Bear Stearns has loans equal to 13% of their capital, Lehman 11% and others don't disclose the numbers. These firms are not in trouble because of their exposure to subprime defaults but those defaults will impact profits at some point in the future. GM disclosed this week that it had $67 billion in subprime loans in its GMAC subsidiary. We could see hits to GM earnings when they are released sometime in the next couple weeks. 27 subprime lenders have closed their doors in the last year. Quite often when loans default the initiating lender has to buy them back from the investors. This puts severe stress on the cash flow at the initiating lender and this has forced many to close their doors.

New Century Financial (NEW), the second largest subprime lender, announced after the close on Friday they will likely breach a major lending covenant with its financial backers. This poses new questions about the potential for its survival. Their stock price fell another -10% in after hours trading to close at $13.15. NEW said minimum profit requirements to remain in compliance with its loan covenants would not be met for the two quarters ending in December. NEW said it had received waivers from six of the 11 lenders but had not been able to get the waivers from the remaining five. If the waivers are not received the lenders have a right to walk and this could force NEW to shutdown operations. The company's auditor KPMG said without the waivers their ability to continue as a going concern was doubtful.

China may have recovered from its Tuesday meltdown but the US markets failed to attract any real buyers. I could understand the dip on Wednesday and chalk it up to margin selling. Outstanding margin loans rose to a record $285 billion in January. This was higher than the prior record levels of $278.5B we saw back in March 2000 just before the crash. I could easily understand how Wednesday morning's dip was related to margin calls. That does not explain the rest of the week.

There was a major change in sentiment from buying dips to selling the rallies. The bulls tried several times to buy the dips and were successful in the very short term but sellers continued to appear as each bull run began to run out of steam. The resulting decline pushed the markets to their worst weekly performance in the last four years. The Dow ended down -535 points or -4.24% for the week. The Nasdaq lost 147 points or -5.85% with the NDX losing -6.13%. The brokers were the hardest hit with a -7.61% drop followed by the transports at -7.30%. This is only the result of one week of selling. Several of those indexes started declining several days earlier. As of Friday's close the Transports were down -8.2%, Russell -6.6% and Dow 5.4% from their highs. The S&P has been down 7 of the last 8 days. According to Merrill Lynch weakness in the financial sector accounted for 31% of the market drop with tech stocks accounting for another 19%.


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Greenspan's comments about an impending recession in the US last weekend weighed heavily on the markets. So heavy that he was quoted later in the week as saying the prospect was "not likely" as he tried to smooth over the reaction to his original comment. Bernanke also tried to cool the frazzled nerves when he spoke and his positive economic comments had immediate impact with a sharp rebound. That rebound was short lived. In the case of Greenspan you can take back the words you said or try to spin their meaning but it is much harder to make investors forget the initial shock.

About the only entities that benefited from the market decline was companies with a stock buyback program in place and those buyout firms with takeover targets in their crosshairs. Thomson Financial said there were $56 billion in stock buybacks announced in February and that was the 2nd highest month on record. Those contemplating a buyout are said to be lowering target prices after this weeks decline. Thomson also said that 731 deals were announced in February for a total of $161.4 billion. It was the best February on record for M&A and the 12th best month ever. The decline in the markets should accelerate that trend.

For next week the outlook has turned negative. The failure of the market to rebound from Tuesday's China event is a major red flag. Chalk some of it up to margin selling but that is only a temporary pressure factor. The lack of bargain hunters at Friday's close suggests the bulls are in shock. After buying the dip three times last week and seeing their rebound quickly blunted they may have paused to reconsider their trading plan. In point terms Tuesday's drop was the 8th largest one-day point drop in history. However, it was only the 237th worst percentage drop. It may have been a big news item but it was not really a material move. There is an average of 8 one-day -2% drops per year. It had been about 160 trading days according to Ned Davis Research (32 weeks) since we had one of those drops. We were way overdue.

When the market does not rebound from an external event like China's 9% sell off it suggests a dramatic change in sentiment. That is also normal after a long run. Historically a market event that is not quickly dismissed tends to lead to several weeks of higher volatility and large point swings. Basically the drop is a wakeup call for millions of investors. The quick rebounds on the following days are similar to hitting the snooze alarm. Buy the dip and go back to sleep expecting the same rebound we have seen on every dip for the last 8 months. After repeating this process several times with an unsatisfactory result investors finally wake up to the realization that maybe this time is different and quit hitting the buy/snooze button.

With investors now wide awake and staring at some really ugly charts the reality of a sentiment change begins to take hold. Positions they loved for months and where sizeable profit had been accumulated are now giving back those gains on every successive drop. Investors probably added to those positions on the first drop and maybe even the second dip. Now all those positions are underwater or heading there fast and investors have to make a decision. It is no longer a question of capturing remaining profits but of rescuing shrinking capital. This is how a 4% dip becomes a 7% dip or even worse. The farther we fall the more stops get hit and a larger correction becomes a self-fulfilling event.

The charts are clearly indicating more negativity than they did when the smoke cleared on Tuesday. The Nasdaq has broken below strong support at 2400 to close at 2368 and appears to be targeting 2325 for its next support test. The Dow closed right at support at 12100 and looks very weak. We could easily test 12000 on Monday and a break there has trouble written all over it. 11250 will become the next target. The S&P-500 dipped to 1380 on Thursday and rebounded +30 points before tanking once again. Friday's close at 1387 is right on critical support. The 100-day average at 1408 has been broken and is now substantial resistance. The break of the 100-day average typically indicates a secondary correction ahead. All internals are negative and getting worse. 457 S&P stocks declined on Friday compared to only 36 with gains.

Tuesday was the all time record volume across all markets at 8.3 billion shares. Wednesday and Thursday rank 2nd and 3rd with 7.17B and 7.39B shares respectively. A 5% loss for the indexes spanning the top 3 volume days ever is never a good sign. Friday's volume was a paltry 5.66B shares but that would have qualified as heavy only a week ago. It definitely appears there has been a change in sentiment. Whether that sentiment is temporary or lingering is still undetermined. Bank America warned investors on Friday that the time was not right to put fresh money to work saying cheaper valuations were possible.

S&P-500 Chart - Daily

On Tuesday I recommended buying dips to 1385/2400/12000 but cautioned to run for the exits if those levels broke. The Nasdaq closed at 2368 on Friday as the first index to break critical support. With the S&P at 1387 the odds are good it will be the second index to crumble. I still suggest buying the dip over those levels but reversing to a short as those levels are broken. Obviously with the Nasdaq already failing I would be extremely cautious about any dip buys on the other two indexes. At this point I would probably not commit capital to the long side of the market until we see if those levels are going to hold. The key for the markets next week will be Thursday's low on the Dow and S&P. If those lows break it would indicate another leg down and that leg could be steep. Professional traders would like nothing better than a washout early next week. They would like a textbook climatic drop to clear the rest of the margin holders and weak stomachs. Note the Russell-2000 came to a dead stop at very strong support at 775. This is a critical level and a key inflection point for gauging fund manager sentiment. If this level fails then funds are fleeing the market rather than buying the dip. TrimTabs said fund withdrawals on Mon/Tue alone were $3.2 billion. If that snowball is still growing then funds will be forced to sell positions to raise cash for withdrawals.

The economic outlook may have improved slightly in the short term and that is market positive. In light of the subprime problems and the market dip the Fed may be tempted to move to a neutral position when they meet in two weeks and that would be very market friendly. There is the potential for another quarter in Goldilocks mode before the fall 2007 housing worry really begins to take hold.

Dow Transport Chart - Daily

Russell-2000 Chart - Daily

I believe this is going to be the straw that eventually breaks the markets back. Depending on what statistic you read the impact of the new mortgage rules could take 15-20% of homebuyers out of the market as of Sept-1st. With delinquency rates rising and foreclosures soaring we could see an additional 20% of homes purchased over the last three years come back onto the used market through forced sale or foreclosure. My son lives in an affluent suburb of Denver where starter home prices average about $365,000. There are 109 homes in the foreclosure process within a 2-mile radius of his house. These will all be on the existing home market soon and there are probably many more headed for that process. Multiply this by all the metropolitan areas in the country and that is a lot of homes coming to market. I believe the spring selling season will be frantic as subprime borrowers race to buy before the new guidelines shut them out from purchasing another home. Once September 1st arrives it will be a true buyers market and only for those who can pass the tougher rules. Home prices will fall sharply until supply and demand return to balance. Some estimates I heard this week suggested declines in the 15% range. Consumer sentiment will plummet and builders will face another round of cutbacks. Greenspan may have been right about the potential for a recession in late 2007. I believe it would only be a mini recession if it occurs and we should rebound in 2008. I believe this subprime cancer will continue to eat away at the economy and the market and this was the real reason for the market drop last week. China may have accelerated the process but the subprime problem has been quietly eroding the economic outlook for months. Last week the supports finally began to crumble.

New Plays

New Option Plays

New Option Plays
Call Options Plays
Put Options Plays
Strangle Options Plays
None ASH None

New Calls

None today.

New Puts

Ashland Inc. - ASH - cls: 65.82 chg: -1.19 stop: 68.25

Company Description:
Ashland Inc., a diversified, global chemical company, provides quality products, services and solutions to customers in more than 100 countries. (source: company press release or website)

Why We Like It:
ASH has spent the last two months consolidating sideways with a bearish trend of lower highs. Shares spent a week failing to breakout over $70, which was followed by a week failing to breakout over $69. Now last week's market weakness has fueled a bearish breakdown under support near $66.00. Meanwhile the weekly chart shows ASH failing to breakout against its trendline of lower highs (see below). The P&F chart is still bullish but ASH could see a sharp pull back and still maintain a bullish P&F chart pattern. We are suggesting put positions with ASH under $67.00. Readers can choose between opening positions now or trying to catch a failed rally on any oversold bounce under its 10-dma. Our target is the $60.50-60.00 range. FYI: More conservative traders may want to consider a tighter stop in the $67.00 or $67.50 region.

Suggested Options:
We are suggesting the April puts. With all of our suggested plays it is up to the reader to choose which month and strike price best suits their trading style and risk.

BUY PUT APR 70.00 ASH-PN open interest=567 current ask $5.70
BUY PUT APR 65.00 ASH-PM open interest=296 current ask $2.25
BUY PUT APR 60.00 ASH-PL open interest=384 current ask $0.65

Picked on March 04 at $ 65.82
Change since picked: + 0.00
Earnings Date 04/25/07 (unconfirmed)
Average Daily Volume = 770 thousand


Bausch Lomb - BOL - cls: 50.63 change: -0.68 stop: 52.51

Company Description:
Bausch & Lomb is the eye health company, dedicated to perfecting vision and enhancing life for consumers around the world. Its core businesses include soft and rigid gas permeable contact lenses and lens care products, and ophthalmic surgical and pharmaceutical products. The Bausch & Lomb name is one of the best known and most respected healthcare brands in the world. (source: company press release or website)

Why We Like It:
BOL's pattern of higher lows and higher highs over the last several months may not be quite as bullish as it looks. The stock has created a bearish wedge-shaped consolidation pattern. The recent sell-off has brought shares of BOL precariously close to breakdown down through the bottom of this pattern in addition to round-number support at $50.00 and technical support at its 200-dma. We are suggesting that readers wait for the breakdown to occur before considering new positions. We are suggesting a trigger to buy puts at $49.49. More aggressive traders may want to jump in early with a drop under $50 while more conservative traders may want to wait for a decline under $49.00 to lessen the risk that we'll be triggered on an intraday spike lower. If we are triggered at $49.49 our target will be the $44.00-42.50 range. FYI: BOL has been extremely late on its SEC filings and recently announced it will file its 2006 10-K on April 30th, 2007. BOL also plans to release news about its preliminary 2006 results in mid-March. This last comment raises the risk level for us since we do not know what's in the announcement or when they will announce it. One might presume that any earnings comments will be negative as the company tries to recover from its eye-infection fiasco last year.

Suggested Options:
If triggered at $49.49 we are suggesting the April puts.

BUY PUT APR 50.00 BOL-PJ open interest=5527 current ask $1.80
BUY PUT APR 45.00 BOL-PI open interest=1747 current ask $0.50

Picked on March xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 00/00/07 (unconfirmed)
Average Daily Volume = 678 thousand


Chicago Merc. Exch. - CME - cls: 540.25 chg: -4.98 stop: 554.25

Company Description:
Chicago Mercantile Exchange Holdings Inc. became the first publicly traded U.S. financial exchange on Dec. 6, 2002. The company was added to the Russell 1000 Index on July 1, 2003, and to the S&P 500 Index on Aug. 10, 2006. It is the parent company of Chicago Mercantile Exchange Inc., the world's largest and most diverse financial exchange. (source: company press release or website)

Why We Like It:
Before we begin we have to warn readers that CME can be a very volatile stock and traders should consider this a high-risk, aggressive play. The stock peaked under the $600 level over a month ago and has spent the last few weeks consolidating early January gains. The recent sell-off has pulled CME under support near $550, its 50-dma and couple of supporting trendlines. The oversold bounce on Wednesday and Thursday got a boost after CME announced that February volumes soared nearly 27% over a year ago. The exchange witnessed some record-setting volume last month and probably early this month. Yet the news on record volumes (which means higher profits for CME) was not enough for the stock to breakout over broken support near $550. The Thursday-Friday trading has produced a failed rally under what now appears to be resistance at $550. We are suggesting put positions with the stock under its simple 10-dma (currently $548). Our target is the $511.00-500.00 range with the upper end of our target range placed near last week's lows. FYI: shareholders are expected to vote in early April on CME's proposed $8 billion acquisition of rival CBOT. The merger is still awaiting government agency approval.

Suggested Options:
We are suggesting the April puts.

BUY PUT APR 550 CNM-PJ open interest=225 current ask $29.20
BUY PUT APR 540 CNM-PH open interest=389 current ask $23.90
BUY PUT APR 530 CNM-PF open interest=291 current ask $19.50

Picked on March 04 at $540.25
Change since picked: + 0.00
Earnings Date 05/01/07 (unconfirmed)
Average Daily Volume = 631 thousand


Harman Intl - HAR - close: 97.49 change: -1.97 stop: 102.01

Company Description:
Harman International Industries, Incorporated is a leading manufacturer of high-quality, high-fidelity audio products and electronic systems for the automotive, consumer and professional markets. (source: company press release or website)

Why We Like It:
It might seem like we're late adding HAR as a put play now with shares down seven out of the last eight sessions. Odds for an oversold bounce are pretty good. However, short-term the stock has just produced two failed rallies near the $100 level, both under its 50-dma and 100-dma and shares closed near their lows on Friday, which is bearish for Monday's open. Plus, the weekly chart shows HAR reversing under its longer-term trendline of resistance (see chart). While we would consider new put positions here more conservative traders may want to wait for a bounce and watch it fail before initiating positions. Should share rebound we would watch for a failed rally under the 10-dma (currently near $101.90). Our target is the $92.50-90.00 range near its simple 200-dma. FYI: The P&F chart points to a very bearish $80 target.

Suggested Options:
We are suggesting the April puts.

BUY PUT APR 100 HAR-PY open interest=2328 current ask $4.70
BUY PUT APR 95 HAR-PS open interest= 690 current ask $2.30

Picked on March 04 at $ 97.49
Change since picked: + 0.00
Earnings Date 04/26/07 (unconfirmed)
Average Daily Volume = 614 thousand

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Allegheny Tech. - ATI - cls: 97.06 chg: -3.62 stop: 93.95

We have reached the "moment of truth" with our ATI play and strategy to buy the dip near support. The markets continued to sell-off on Friday and shares of ATI slipped almost 3.6% and dipped toward rising, technical support at its 50-dma. We were suggesting that readers buy calls on a pull back into the $97.50-96.00 range. Most quote services will list the intraday low on Friday was $95.95 but this looks like a bad tick (check an intraday chart). We see ATI closing near its lows for the day just under $97.00. Our official entry point was at $97.49. More conservative traders may want to watch for a bounce before initiating any bullish positions. If the 50-dma fails to hold as support ATI appears to have additional support in the $96.00-95.00 zone. More conservative traders may want to tighten their stops toward $95.00. Our short-term target will be the $104.00-105.00 range. More aggressive traders can aim for the $109-110 zone. FYI: This play is probably not for the faint of heart. Technical traders will note that the weekly chart for ATI has produced a very large bearish engulfing candlestick pattern. These types of patterns are normally seen as a bearish reversal!

Suggested Options:
We are suggesting the April calls. Our suggested entry range to buy calls is in the $97.50-96.00 range above its 50-dma.

BUY CALL APR 95 ATI-DS open interest=2552 current ask $7.60
BUY CALL APR 100 ATI-DT open interest=2745 current ask $5.10
BUY CALL APR 105 ATI-DA open interest=2196 current ask $3.20

Picked on March 02 at $ 97.49
Change since picked: - 0.43
Earnings Date 04/25/07 (unconfirmed)
Average Daily Volume = 2.7 million


Cigna - CI - close: 141.01 chg: -1.68 stop: 134.35

CI has produced another short-term failed rally near $143 and its simple 10-dma. The stock closed near its lows on Friday and definitely looks poised to move lower. Nimble traders might actually want to try and scalp two or three points while we wait for a dip into our suggested entry range to buy calls. Currently the plan is to buy calls on a pull back into the $135.00-137.50 range. Shares of CI appear to have support near $137.50 and again near its rising 50-dma around $135. Our official trigger to open plays will be $137.49 but we strongly suggest that readers wait for the dip to end and signs of a bounce to begin before opening positions. If triggered our target is the $145.00-146.00 range. We are suggesting a stop loss under the 50-dma.

Suggested Options:
We are suggesting the April calls. Our suggested entry range to buy calls is in the $137.50-135.00 range above its 50-dma.

BUY CALL APR 135 CD-DG open interest=1663 current ask $ 9.00
BUY CALL APR 140 CD-DH open interest= 634 current ask $ 5.50

Picked on February xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/09/07 (unconfirmed)
Average Daily Volume = 759 thousand


Freeport McMoran - FCX - cls: 54.63 chg: -1.59 stop: 51.99

Friday's pull back looks like another entry point to buy calls. However, it's also a crucial test of its new trendline of support. We admit that this looks like a dangerous spot to buy calls given the bearish breakdown under its simple 200-dma and the big bearish engulfing candlestick pattern on its weekly chart. More conservative traders may want to sit this one out and just wait and watch. We are looking for a bounce near $54.00 but if you feel it's necessary some traders may want to tighten their stops toward $53.00 or near the mid-February lows. It's worth noting that another analyst firm upgraded FCX on Friday. This is the second upgrade for the stock in the last week. Deutsche Bank raised their rating to a "buy" with a $69 target. FCX is in our suggested entry range to buy calls but we'd strongly suggest waiting for a bounce first. Our target is the $62.50-65.00 range. We do not want to hold over FCX's mid-April earnings report. FYI: The April calls have seen a huge increase in open interest in just the last few days.

Suggested Options:
We are suggesting the April calls. Our suggested entry range to buy calls is in the $55.25-54.00 range.

BUY CALL APR 55 FCX-DK open interest=5738 current ask $3.60
BUY CALL APR 60 FCX-DL open interest=6364 current ask $1.75

Picked on March 01 at $ 55.24
Change since picked: - 0.61
Earnings Date 04/17/07 (unconfirmed)
Average Daily Volume = 6.5 million

Put Updates

MarineMax - HZO - close: 22.32 change: -0.51 stop: 23.75

Friday's decline (-2.2%) and the late afternoon failed rally in HZO has temporarily renewed our faith in the stock's bearish trend. We would still wait for a breakdown under short-term support at the $22.00 level before buying new put positions but that opportunity could come as soon as Monday. The P&F chart continues to point to a $2.00 target. Our target is the $20.25-20.00 range. FYI: It may be worth noting that HZO has a high amount of short interest. The latest data (February) puts short interest at almost 24% of the stock's 16.8 million-share float. That definitely increases the risk of a short squeeze should the stock unexpectedly rally and breakout higher.

Suggested Options:
We would wait for a new decline under $22.00 before considering new positions. We like the April puts. More conservative traders may want to tighten their stops. Note - we currently don't see an active bid or ask on the puts. This may be a temporary (weekend) quote error.

BUY PUT APR 22.50 HZO-PX open interest= 8 current ask $ ?.??
BUY PUT APR 20.00 HZO-PD open interest= 3 current ask $ ?.??

Picked on February 11 at $ 22.59
Change since picked: - 0.27
Earnings Date 04/26/07 (unconfirmed)
Average Daily Volume = 300 thousand

Strangle Updates


Dropped Calls


Dropped Puts


Dropped Strangles


Trader's Corner

Wash Sales, Mark-to-Market, and Section 1256: Tax Stuff

If you don't know what a wash sale, Section 1256 trade or market-to-market election is, you need to figure it out right now. The IRS expects you to know about wash sales and Section 1256 trades, and it's not going to clue you in on the possible benefits of the mark-to-market election unless you go searching for the information yourself.

You get the disclaimer right up front. I'm not an accountant or a tax attorney. This article is not meant to provide tax advice, but rather to warn you when you might need to seek the advice of such a professional.

First, the wash-sale rule. The wash-sale rule was created to make the lives of active traders as miserable as possible.

Not really. It just seems that way, of course. It did to me when I calculated my taxes after my first year of trading. I discovered that, mathematically inclined as I was--once being able to handle nuclear physics with aplomb--my brain was tied up in knots performing all sorts of convoluted calculations. That happened because that first year, I had concentrated my trading on one company's options. It turns out that if you sell and take a loss in a stock or an option you've held and then buy back "substantially identical stock or securities" within 30 days, you can't take that loss (IRS Section 1091. Loss from wash sales of stock or securities). You have to roll that loss into the cost basis for the repurchase. When you're an active trader, you can imagine the headache this might cause, especially when you go through one of those inevitable periods of one losing trade after another.

The headache gets worse. Imagine what might happen with the calculations if you don't always sell and then buy back the same number of shares or option contracts. For example, imagine that you owned 1000 shares of MSFT and sold them at a loss. On day 2 after that, you bought back 300 shares of MSFT and sold them for a gain. Then, on day 4, you bought back 1000 more shares, but sold them at a loss that same day. You folded 7/10 (700/1000) of the original loss into the cost basis for that day 4 purchase. When you're ready to buy 500 shares of MSFT again on day 5, you will have to fold 1/2 (500/1000) of the day 4 losses into purchase of the 500 shares. Your Schedule D can end up having more branches than the most complicated of family trees.

"Aha," you're thinking. "I trade options, and I'm always buying different strikes." Uh-uh.

Remember that "substantially identical" clause from the IRS code? Other language and legal interpretations of that code clarify that it doesn't matter what strike you're buying, you're going to have to use wash-sale rules if you're dealing in options on the same underlying. One day, you can buy a deep-ITM call on MSFT and take a loss, and then 20 days later, you can buy a far-OTM call on MSFT, and you're going to have to follow wash-sale rules and fold that original loss into the cost basis for the purchase of the far-OTM call on the second purchase.

Stinks, doesn't it? Options traders know that we're not buying something "substantially identical," but don't argue with the IRS.

The convoluted mathematics prove cumbersome, but some have found ways around that. One method is to use software that makes those calculations for you. Many use Turbo-Tax (R), but some people have reported that Turbo Tax's (R) wash-sale computations fall apart when you're buying and selling different amounts of stock or options contracts. That's not something I've verified for myself, so don't take my word for it before you reject Turbo-Tax (R) for these computations. Another software that I'm investigating for my personal use is TradeLog, found at www.armencomp.com.

So far, I can report that the software proved so easy to download that I accomplished that task, uploaded my brokerage account's activity sheet for the entire year, and produced a Schedule D-1, complete with wash-sale computations, all in the time my husband was showering. What I can't yet verify is that all the computations are accurate, as I've just produced that Schedule D-1 as I was drafting this article and haven't gone through all those wash-sale computations line by line. I can, however, verify that trader support is wonderful with this group. I asked a question and the tech support changed the program to meet my need and had it ready for me to reload within an hour. I don't think I've ever had another trade-related software support staff that provided service like that! Furthermore, the support staff says that you shouldn't spend more than 15 minutes trying to import your trades or reconcile your 1099's before calling them for support. Support is free.

If you're interested, the site provides a 30-day trial, but it limits the upload to 20 records. That's understandable, since otherwise, everyone would sign up for the trial this time of year, run their tax forms and not sign up for the full service. If you want to try the trial, upload a batch of records that would include a wash sale.

I sound like a commercial again, and some subscribers do not like any mention of specific software, but others appreciate learning about other traders' experiences with software that might or might not be helpful to their trading experience. I have no connection with this company other than my connection as a paid (and brand new) subscriber.

Of course, you can also pay an accountant to do these wash-sale calculations for you, but don't assume that your accountant knows about wash-sale rules. Through the years, I've talked to several traders whose accountants have been filing their reports for years and not making any wash-sale rule calculations at all. Make sure your chosen accountant understands these calculations.

A third hope is that your brokerage calculates these for you. Mine doesn't. It defers me to TradeLog and several other software sources, including GainsKeeper's software, which also reportedly automates wash-sale calculations and downloads them directly from the account. When I tried GainsKeeper many years ago, it did not properly recognize options trades, but that was at least six years ago. I suggest that, if you're examining several potential software sources, you check this out for yourself, as the company was reportedly working on providing bookkeeping for options traders when I tried them many years ago.

Many of these software programs also allow you to export the forms that you've compiled into popular tax-preparation software such as Turbo-Tax (R). TradeLog's documentation warns, however, that Turbo-Tax (R) may not be able to handle the complicated wash-sale calculations necessary if you're an active trader who trades different amounts each time. TradeLog offers suggestions for handling this problem, but warns that there is no true workaround since the problem lies with Turbo-Tax (R). Again, this is not a problem that I can verify.

Available software programs such as these allow you to perform wash-sale rule calculations with some ease, but you still might have a problem. If you trade straight through the year and into January, trading the same security every few days, and have a loss toward the end of the year, buying that security back again within 31 days, you're not going to be able to take that loss. The wash-sale rule forces you to roll it into the basis for the January trading you're doing.

That can be painful. That can be doubly painful if you've had a losing year in which you're trading constantly, losing frequently, so that one wash sale blends into another right through the end of the year, into January. If you have had that kind of year, you won't be able to take the loss that you've incurred that year, at least not that year.

What's even worse would be if you had a winning spurt the first of the year, but end-of-year losses wiped out the gains from earlier in the year, and you keep trading in and out of that security every few days right through the end of the year and into January. In that case, wash-sale rules might result in all your losses being delayed until the next year while you pay taxes on your purported gains for the year, the gains you accrued the first of the year!

Do you see why I said at the beginning of the article that wash-sale rules were created to make the lives of frequent traders as miserable as possible?

Don't panic as I did when I first heard about the wash-sale rule. The loss isn't gone, as I somehow believed after hearing about the rule the first time. It is rolled into the basis for the next year's trades. You are taking it.

Is there any way around the wash-sale rule entirely? Yes, and I'll discuss that tactic later, after discussing a couple of other quick-fix tactics various articles have suggested. I've heard these ideas batted around for many years, and Armen Computing Ltd. also discusses them on its website. First, if you have losses in December, some websites advise you to avoid buying back the same security for 31 days. For example, if you have been trading MSFT almost exclusively this year and take a loss sometime in December, this work-around suggests that you not buy MSFT again for 31 days. You can trade. Just trade something other than MSFT.

Another suggested tactic is to close out any open positions that have wash-sale losses attached to them by the end of the year and don't buy back that security again for 31 days. The 31 days don't have to begin on December 31. You can close those losing positions December 14, for example, and then buy them back 31 days later.

Here's a question that troubled me, however, when first reading about these tactics many years ago. Did getting out of all positions with wash-sale rule losses attached to them at the end of the year and not buying them back for 31 days mean that I could just list my trades for the previous year in matched pairs and not do all those wash-sale rule calculations? Since no wash-sale losses were being carried over into the next year, the gains and losses figures would be identical whether all those complicated computations were made or not. An article suggested that the wash-sale computations wouldn't need to be made.

However, I'm a stand-up kind of woman or maybe just a cowardly woman, and I wanted to make extra, double sure that this was okay with the IRS. I called the IRS. The IRS representative to whom I spoke proved less than helpful when I asked whether, if I took a December vacation from trading, if I had to do all those complicated wash-sale computations for any losing strings I'd had earlier in the year. Could I just list the transactions as normal on my Schedule D? "I guess you could do that" and "that sounds okay" were the answers. That was far from satisfying. However, since I knew I was paying the proper tax, I attached a note to my Schedule D noting the details of my conversation and did not include any wash-sale rule computations. I would recommend that you talk to an accountant, a tax attorney, or, perhaps less satisfyingly, call up the IRS and ask them before adhering to the hesitant confirmation I received when I called the IRS all those years ago.

Another way to avoid the whole wash-sale rule computations is to elect the mark-to-market method for accounting for your trades. This is more than a quick fix. No wash-sale computations are needed. Ever. In addition to doing away with the wash-sale rule accounting, the mark-to-market method treats all your trading-related gains as ordinary income and losses rather than capital gains and losses. That method also allows you to deduct all your losses in the year they're incurred rather than limiting you to $3,000 in a single year, and you can even carry losses back two years, if you have no other income that offsets that loss, amending the previous two years' tax returns. Who knows? You could end up getting a refund for those previous years.

Another difference, the one from which the name derives, is that any securities held at the end of the year are treated on paper as if you've closed them out and then bought them back at the beginning of the next year. They're marked at the market price that last day, so that your trading books are effectively closed on the year and then opened the next year with that same trade. I don't want to be putting words in the mouth of the IRS, so I'll quote from IRS publications on the mark-to-market method of accounting for your trades:

"A trader in securities or commodities may elect under section 475(f) to use the mark-to-market method to account for securities or commodities held in connection with a trading business. Under this method of accounting, any security or commodity held at the end of the tax year is treated as sold (and reacquired) at its fair market value (FMV) on the last business day of that year."

It's not always easy to elect mark-to-market status. With some exceptions, it's too late to do so for 2006, for example. According to IRS Publication 550, if you'd wanted to elect the mark-to-market method for 2006, you would have had to file a statement with the IRS saying that you wanted to do so by April 15, 2006. If you're considering it for 2007, you would have to file a statement with the IRS saying that you wanted to do so for the 2007 year by April 17, 2007. The statement should be attached to your individual income-tax return or to a request for an extension of time to file that return, if that's what you're doing. Publication 550 sets out the requirements for what must be included in that statement.

Some believe that electing the mark-to-market accounting method also confers more rights to deduct trading-related expenses. However, I'm not certain about that. Being able to deduct all trading-related expenses such as charting programs, books, subscriptions and seminars depends on qualifying as a "Trader in Securities," and, as far as I can ascertain, that's a separate consideration from the election to use mark-to-market accounting methods. The IRS quote above does include the phrase "in connection with a trading business," so I'm on shaky ground, but I'll discuss my reasoning.

IRS Topic 429 (http://www.irs.gov/taxtopics/tc429.html) sets forth the qualifications a trader needs to meet to be considered a "trader in securities," able to take those deductions. They include substantial trading activity, an effort "to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation," and a regular and continuous carrying on of your business as a trader, among others.

If you meet the standards for a trader in securities, sometimes difficult to prove to the IRS, the Topic 429 sheet allows for both mark-to-market accounting methods and the more typical method. It goes on to explain that the "tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election . . . to use the mark-to-market method of accounting." It continues to explain what method would be used if that election had not been made.

So does electing the mark-to-market accounting method automatically confer status as a "trader in securities" or does the trader have to meet the other standards the IRS sets out for that qualification, before deducting trading-related expenses? I don't know. Check this out with your accountant or tax attorney. Or, if you used to be proficient at deciphering Greenspeak, you might try reading the IRS publications for yourself. Perhaps you'll be able to muddle through them and come to appropriate conclusions. The link at http://www.irs.gov/taxtopics/tc429.html includes lots of information, and it's actually clearer than most of the descriptions found in IRS publications.

However enticing that mark-to-market status might sound, traders should be aware of some elements of this election. First, once you've made the election, it's difficult to undo it. Some literature suggests that, since the IRS seldom lets traders go back to regular accounting methods, traders would have to set up a new account and a new trading business in order to do so. Verify this with your accountant or tax attorney. Whatever you learn, it's apparent that electing mark-to-market status should be given serious consideration before proceeding.

Some traders rush to this election, not understanding another aspect of this election, one that's especially important to those who trade the broad-based indices as I do and as many others who trade credit spreads a la Mike Parnos do. Under Section 1256 of the IRS code, all capital gains on these broad-based indices, such as the S&P 500 or its options, are split 60/40, with 60 percent of the gains considered long-term gains, and taxed at a more favorable rate, and 40 percent being considered short-term gains. However, when you elect the mark-to-market method, all gains are taxed as ordinary income, and that favorable split is lost.

Since I trade the broad-based indices almost exclusively, I've chosen not to elect the mark-to-market method because I would lose that favorable split, but if you're trading a lot of equity stocks or options, or options on narrow-based indices, you might not make the same choice. This information should be verified anyway with . . . you guessed it, your accountant or tax attorney.

Which indices qualify for that Section 1256 trades and which are considered narrow-based indices? The IRS sets forth rules describing the various types, of course. One source says an index would be considered narrow based if they "contain nine or fewer component securities, if a single component security comprises more than 30 percent of its weighting, or if the aggregate of the five highest-weighted component securities comprise more than 60 percent of its weighting" (www.twenty-first.com/exchange-traded_index_options.htm). That link also provides a listing of indices and their classifications as either broad-based or narrow-based indices. Rules appear to have been changed or clarified in November of last year, and some indices that previously were not considered broad-based ones now are, at least according to that www.twenty-first.com link. For example, the SOX was not previously considered a broad-based index, I don't believe, but the site now lists it as one. Some other securities, such as bonds, commodities or currencies fall under the Section 1256 rule, too, according to www.armencomp.com.

Gains and losses from Section 1256 securities are reported on IRS Form 6781, rather than Schedule D. I've read conflicting information about whether you need to detail each trade on that IRS Form 6781 as you do with a Schedule D. Most sources note that the gains and losses are taken straight from your brokers' 1099s and plugged into the appropriate lines on IRS 6781. Then the 60/40 split is made as directed on the form, without any need to document each trade.

However, many--and maybe most--brokerages do not include options trades on 1099s, and the instructions accompanying the IRS Form 6781 state that that you should "[l]ist separately each transaction for which you did not receive a Form 1099-B or equivalent statement," so I would quibble with the advice that each option trade wouldn't need to be listed separately. Once again, however, I'm not an accountant or a tax attorney and my interpretation could be wrong.

Whether you're considering the mark-to-market method of accounting for your trades or anticipating qualifying for status as a trader of securities or doing neither of these, you need to know that all Section 1256 securities must be marked to market at the end of the year. This Section 1256 requirement does not relate to the accounting method you choose. It doesn't matter which accounting method you've decided upon or whether you meet the qualifications for a trader of securities or any of that. This requirement relates to the type of security you trade. Despite the similarity in names, electing the mark-to-market method for accounting for your trades is a separate consideration from the need to mark to market your Section 1256 trades.

A Cornell Law School website defines a Section 1256 contract and also suggests that such a contract would be "treated as sold for its fair market value on the last day of such taxable year," if you'd like to read their interpretation. It can be found at http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00001256----000-.html

I once was surprised by some of these considerations, and I don't want our subscribers to be similarly surprised. These topics are discussed for the sole purpose of alerting traders to matters they might discuss and clarify with tax professionals. I do not claim to be such a professional, and it's possible that the information here is wrong or outdated. Don't rely on it. Use it as a starting point for the discussions you need to have with people more knowledgeable than I am.

Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.


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