At 2:PM on Friday the Dow was nearing positive territory when the Bear Stearns CFO said this was the worst credit environment in the last 22 years. That was all the market needed to hear and the Dow took an immediate -150 point plunge. Just when traders had begun to think it was safe to venture back into the market the evolving news in the financial sector came back to haunt them. BSC shares fell -$9 almost instantly but recovered some before the close.
Dow Chart - Daily
S&P-500 Chart - Daily
It was not a bad market until the Bear Stearns comments. The morning's economics headlined by the nonfarm payroll report were market positive. 92,000 jobs were created in July and while that was well below the 130,000 estimate it was considered right in the middle of the Goldilocks range. Not cold enough to fear an economic slowdown and not hot enough to wake up the Fed. There was also a change in the revision trend. Jobs in the prior two months were revised downward by a total of -8,000 jobs. The trend for many months has been for strong upward revisions. The unemployment rate rose slightly to 4.6% and the highest rate since January. Average hourly earnings were flat with the recent average at +0.3%. The 3rd quarter appears to be starting slowly and with new job creation declining to a level not seen since February the outlook is not positive. The impact of the housing sector on the U.S. economy is growing and the employment outlook for future months is dropping. A continued slowdown in housing will impact hiring in construction, financial, building materials and retail sectors.
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The housing induced slowdown was already evident in the ISM Services number, which came in at 55.8 in July. This was a significant drop from 60.7 in June and there were declines in nearly every component. Only order backlogs showed a material gain from 46.5 to 53.0. The Manufacturing ISM on Wednesday also fell from 56.0 to 53.8. There is definitely a downturn in progress in the U.S. economy and the Fed will have plenty to discuss when they meet on Tuesday.
The Tuesday FOMC meeting is the only major economic event next week. Given the breakdown in the financial sector and the buyer boycott for any manner of credit instrument the Fed is faced with another situation similar to the LTCM crash and the Russian debt default in 1998. One commentator was calling this financial crisis as 1998 in slow motion.
Friday was full of financial news and none of it was good. It started with S&P changing its outlook on Bear Stearns from stable to negative and warned that problems could impact performance for an extended period. S&P said Bear Stearns was one of the nations largest underwriters of mortgage securities and had significant exposure to the downturn in the mortgage market. This downgrade came after BSC said it was preparing bankruptcy filings for its hedge funds currently in default. That is not a good sign for investors even if BSC is not specifically liable for their defaults.
At 2:PM Bear had a conference call when they should have been hiding from analysts. On the call the CFO said the credit markets were in the worst shape in 22 years. There are no buyers for any type of paper and billions in loans are going unsold. Bear said they were canceling their stock buyback to "preserve capital" for future problems. That is not what you want a major financial institution to disclose. If preservation of capital is a major concern then there may be serious problems we don't yet know about. The CFO said revenue was under significant pressure in July but they did expect to post a profit for the period. That could be the first cautionary statement in a string of warnings to come.
Bear could be approaching levels where a takeout is possible. JP Morgan CEO James Diamond has previously expressed interest in BSC but could not make the numbers work at the values BSC was trading at in the past. Now that BSC is 40% cheaper than it was in Jan-2007 the door may be open for a JP Morgan acquisition. Bear is in serious trouble but not in financial trouble. It will not be able to sell any future hedge fund participations after having three of their funds blow up so visibly in the public eye. With their inability to sell commercial paper today they need an outlet for the billions in loans they have hung on their books. Left alone Bear will eventually extricate itself from this problem but it will be years before their reputation has healed. In the financial sector reputation is a key asset that allows a firm to attract and place those large deals and profit from monster fees. Bear now has two black eyes and there could be more problems ahead.
Bear Stearns Chart - Weekly
American Home Mortgage Chart - Weekly
I wrote about American Home Mortgage on Tuesday and after a rebound on Thursday things got a lot worse for investors and employees on Friday. AHM said it was firing its 7000 employees and would cease most operations. A bankruptcy filing is expected next week. This was the 10th largest U.S. mortgage lender originating $59 billion in loans last year and primarily lent to people with good credit not subprime loans. What killed them was the lack of a bid on mortgage loans in the secondary market and a rising default rate. Once they were unable to continue closing loans it was a quick trip to bankruptcy. They left nearly $1 billion in loan commitments unfunded leaving homebuyers scrambling to find another mortgage on the eve of their real estate closings. Without credit lines AHM could not cover the margin calls from loans going into default and the house of cards came tumbling down. Several states revoked their license to do loans after the company failed to follow through on loan commitments. The founder and CEO owned 9.47% of AHM shares on Monday but had 2.97 million shares liquidated at $1.72 per share due to margin calls. He had pledged his shares in Oct-2005 to secure a revolving margin loan. They were worth $35 each at the time. Ouch!
This has not been a good week for financial stocks, builders or homebuyers. In the last 72 hours rates for home mortgages have spiked significantly reflecting the risk to lenders in reselling the loans. Wells Fargo raised the rate on a $425,000 loan from 6.78% to 8.0% with 20% down. Rates were also rising at Greenpoint to 7.875%, Chase 7.25%, and Citi 7.5%. No doc, low doc and no down loans have disappeared from the scene replaced with full qualification, full doc loans at rapidly rising rates. The Indymac CEO said "the secondary loan market has ceased to function." Without a secondary loan market those still writing loans will quickly fill up their short term credit lines and cease taking applications. Wachovia said they were halting all but the best loans.
There is also a move in congress to legislate loan requirements and it is being called the lock out bill because it would lock out 50% of borrowers from qualifying. 14 million people closed on a mortgage loan in 2006 and more than 7 million of them would not qualify under the new rules. Reportedly those are the same 7 million that may lose their homes when those loans reset over the next 18 months. The peak of the $1.2 trillion reset will occur in October 2007. With home prices falling, loan rates rising and loan requirements increasing the odds are very good many who are currently making payments on time will end up being forced to sell by year end.
Is there no hope for the financial sector or is it all in the spin being produced for your benefit in the press. Larry Goldstone, CEO of Thornburg Mortgage (TMA), was interviewed on Thursday regarding their delinquency problem. He said he did not have a problem. Thornburg only writes prime loans and has 38,000 on the books with an average loan amount of $630,000. Their delinquency rate has doubled over the last year. Doubled to 57 loans out of 38,000. Yes, only 57 loans are in 60-day default. That is 0.21% and not even worth mentioning. It is not even a footnote for them that defaults rose from 27 in 2006 to 57 in 2007. Larry said it was all in the definition of prime, alt-A and subprime. Industry wide lenders claim a default rate on prime ARMS of 2.3%. That is more than 10 times the rate at Thornburg. The Mortgage Bankers Association says default rates on true prime loans are "virtually unchanged" from 2006. Larry claims the problems came from banks that wrote loans to customers who could not qualify at the full rate. They were making so much money from fees they continued to come up with creative ways to qualify individuals with no verifiable income and no down payments and then repackaged these "liar loans" as alt-a or prime using their own grading rules and package structures. Those loans are the ones that are defaulting not the true prime loans. Since Thornburg has the stats to back up their prime default rates I believe this financial crisis may not be as bad as it is being represented. Unfortunately many lenders did write millions of those liar loans and those will be flushed through the system over the next 12-18 months.
The current credit crunch may have originated with the subprime problem but it has spread to every area of the financial spectrum. In the last 30 days 46 LBO deals have been pulled from the market totaling over $60 billion. Unsold loans are piling up at major banks according to Dealogic. According to Dealogic there are $269 billion "hung loans" in the US and $208 billion in Europe with over $500 billion worldwide. Three banks admitting unsold loans last week were JPM $17.4B, RBS $18B and Barclays $16.2B but that is just the tip of the iceberg. There are increasing worries that there are bigger problems ahead. As each deal blows up or gets postponed that causes other banks to withdraw a little further into their shell and retract any outstanding bids. Nobody knows what is going on and nobody wants to get stuck holding loans if the music stops. This buyer boycott has paralyzed the market even though there have not been any defaults of those deals. It is simply a prime example of gridlock while everyone waits for the smoke to clear. With news of closures or bankruptcies nearly every day there is no rush to venture back into the loan market.
The Fed meets Tuesday and right now all eyes are focused on the Fed announcement as the light at the end of the tunnel. Almost everyone expects the Fed to come to the market's rescue by changing their bias and putting calming sentences in their statement. Since Bernanke has already said it was not the Fed's job to rescue the equity markets I think we are facing a disappointment. I am sure they will change the statement but it may not be what the market is hoping for. It is commonly thought that the Fed is the backstop for the market and that is where the we got the term "Greenspan put." With the weakness in the housing market, a slowing in the ISM manufacturing and services and slowing job growth the Fed should be thinking about a rate cut. Most feel it won't happen until 2008 and that is creating a scenario similar to Nero fiddling while Rome burned. Some analysts feel that by not cutting rates now Bernanke is fiddling while the U.S. housing sector goes down in flames.
In the stock news Network Appliance fell -20% to $22 after warning that corporate customer spending had slowed. NTAP is now forecasting 19-20 cents where analysts had been expecting 25 cents. That number had already been adjusted lower from 31 cents when NTAP guided lower back in May. Bear Stearns said two quarters of soft sales could be a harbinger of deeper problems and cut them to an under perform. Citi upgraded NTAP to a buy saying the dip was a buying opportunity. The Citi analyst said bookings were up +30% year over year and he expected a sizeable buyback program soon. I would think a drop to a 2-year low would be a good opportunity to buy back stock.
Apple Inc (AAPL) lost another -$4.64 despite expectations for a new Macintosh computer line to be announced next week. The move is just in time for back to school and the holiday shopping to come. Apple sold 1.76 million Macs in the last quarter, a +33% increase over the year ago quarter. The patent infringement suits have started with several different companies claiming the iPhone violated their patents. Most will probably be frivolous in the hopes Apple will pay them to go away. There was also a warning that a power failure in a Samsung flash memory factory could cause a shortage of iPod and iPhone components. That report was quickly squashed when research firm iSuppli said production could be restarted as soon as this weekend.
Take-Two Interactive said it was delaying the next installment of Grand Theft Auto (IV) until 08Q1 and miss the entire holiday shopping season. TTWO fell -2.75 on the news. TTWO is now expecting a large loss for the next quarter instead of a profit. Activision (ATVI) gained +50 cents in a very bad market after reporting strong sales of Guitar Hero II, Spiderman 3 and Shrek the Third.
Rent-A-Center (RCII) continued its plunge with another -5% drop after warning of lower earnings on Monday. Rent-A-Center customers are those homeowners and renters that cannot afford to buy furniture. With that sector of the population undergoing severe stress from rising mortgage/rent payments and higher gasoline prices it only makes sense that RCII would take a hit on revenue. I would not expect that business to improve before mid 2008 or later.
Cerberus Capital completed its acquisition of 80.1% of Chrysler despite multiple restructuring problems. Cerberus had to put up more capital and several banks had to eat their loan commitments but the deal got done. DaimlerChrysler, now just Daimler AG, will continue to hold a 19.9% interest. Chrysler was acquired by Daimler nine years ago in a $33 billion merger. It was a stormy marriage and now divorced for $7.4 billion Chrysler is free to "make the long term investments with laser-like focus" according to CEO Tom LaSorda. Chrysler still faces $18 billion in long-term retiree health care costs and Cerberus has agreed to assume that burden. What in the heck were they thinking?
Oil prices fell sharply to settle at $75.20 after hitting an intraday high of $77.36. The nearly $2 drop closed a week that saw a new historic high at $78.76. That 4.5% drop was prompted by many factors. OPEC continues to say global supplies are more than adequate and will not discuss increasing production until September. They repeated their claims that $65 was a fair price when oil was over $78. That took some strength out of the rally. Secondly the hurricane forecasters cut their estimates of hurricanes to only 15 named storms for the year with 8 in the Atlantic/Caribbean region. With no storms around the gulf to date and none on the radar the lowered forecast prompted additional profit taking. September 10th is typically the peak of the season so still plenty of time for some trouble to appear. Gasoline production continues to increase with gasoline prices barely clinging to the $2 support level. Once that $2 level breaks we could see oil back under $70. Oil stocks were particularly week with the Oil Service Index losing -6.2% for the week. That was only exceeded by the broker index losing -7.6%.
Crude Oil Chart - Daily
The markets are not healthy and several analysts attributed much of the selling
to hedge fund redemptions. Reportedly they have been very strong over the last
couple weeks due to the blowup at the three Bear Stearns funds and the -50% loss
and closure at Sowood. Investors are very skittish despite enormous profits at
those funds that bet against the subprime slime and the equity markets. Some of
those funds are up +40-60% for the year but they are in the minority. I reported
weeks ahead of the decline that short interest and margin loans were
at record highs and trouble was brewing. It appears to have come to a boil.
The Nasdaq finally closed under its 100-day average but is still holding up better than the other indexes. The Nasdaq-100 is still the strongest of all. The chip sector was a major drag after the Semiconductor Industry Association said chip sales fell -2% from the prior quarter. Shipments were actually up +7% but deteriorating prices kept sales growth in check. Silicon Image (SIMG) lost -1.78 after reporting a decline in earnings and warning that Q3 would miss estimates. Analysts feel margins for chipmakers will continue to shrink as global competition increases. The SOX declined to an 8-week low at 487. Major resistance has appeared at 500 over the last three days.
Nasdaq 100 Chart - Weekly
The S&P-500 fell significantly below its 200-day average at 1450 to close at 1433 and a new 4-month low. This is a major sell signal for funds and that suggests next week could be trouble, especially if the Fed doesn't say something market friendly on Tuesday. If the decline continues the S&P could test major support at 1375. That would be just over a -10% drop from the record closing high at 1553 on July-19th.
Most of the major indexes with the exception of the Russell 2000 still need about another -3% drop to hit full correction status. The table below shows the drop from the recent highs for all the major indexes. The Dow has suffered the least despite its high profile moves with the broker/housing sectors correcting the most. It is interesting that energy has already corrected more than 10% as well.
The Russell-2000 closed at a new 9-month low on Friday at 755. This is only a small step away from minor support at 750 with major support well below at 675. Since the Russell has already corrected more than the rest of the majors I would be looking for a bounce attempt at 750. If that fails we could be in serious trouble. The Russell is well below its 200-day at 805 and uptrend support at 770. There is little to prevent another major flush if 750 breaks. I still view the Russell as the sentiment indicator for mutual fund managers and based on this indicator the market has not yet found a bottom.
Russell-2000 Chart - Weekly
I would be very cautious next week. The Tuesday Fed meeting will be the focal
point and unless Bernanke has changed his spots over the last couple of weeks I
am not expecting any major concessions to the market. Other news of other
financials in trouble will also keep the pressure on stocks. Because of the
alternating triple digit days we have been seeing I would also expect investors
to be shy about throwing money at the market. Trimtabs said investors took $11.3
billion out of mutual
funds in the week ended July-25th with $5.5 billion coming
out on Tuesday alone. That was the second highest withdrawal this year with
Feb-27th being the highest at $6.5 billion when the Chinese stock market
crashed. For the week ending on Wed-8/2 there were $9.5 billion in outflows.
Those are some strong redemptions from individual investors and that gives you
some idea of the problem the hedge funds are having to deal with. With four
funds blowing up in the last two weeks there
are some major players taking money
out of their hedge fund investments. This will continue to keep pressure on the
market until something happens to change the market sentiment. It could be a big
new LBO deal announced or possibly a major concession from the Fed or just the
passage of time without any new problems. We won't know for sure the bottom is
behind us until we can look back from the safety of a much higher level to see
an obvious low. I would maintain a bearish bias until
proven wrong. I am already
compiling a list of stocks I want to buy once that bottom is behind us. I
suggest you do the same.
Play Editor's Note: We are also keeping an eye on MHO, MON, PX and TNP as
potential bearish candidates.
Avalonbay - AVB - cls: 109.77 change: -4.62 stop: 115.26
Why We Like It:
BUY PUT SEP 110 AVB-UB open interest=41 current ask $6.20
Picked on August 05 at $109.77
Bank of Amer. - BAC - cls: 47.00 chg: -0.78 stop: 48.51
Why We Like It:
BUY PUT SEP 50.00 BAC-UJ open interest= 1866 current ask $4.00
Picked on August xx at $ xx.xx <-- see TRIGGER
ITT Educ. - ESI - cls: 102.22 change: -4.13 stop: 107.51
Why We Like It:
BUY PUT SEP 105 ESI-UA open interest=208 current ask $6.30
Picked on August 05 at $102.22
MSCI Brazil iShares - EWZ - close: 60.90 chg: -3.29 stop: 64.15
Why We Like It:
BUY PUT SEP 65.00 EWZ-UM open interest=14519 current ask $7.00
Picked on August xx at $ xx.xx <-- see TRIGGER
FMC Tech. - FTI - cls: 88.22 change: -2.19 stop: 92.51
Why We Like It:
BUY PUT SEP 90.00 FTI-UR open interest= 11 current ask $5.60
Picked on August 05 at $ 88.22
Allegheny Tech - ATI - cls: 102.40 change: -3.32 stop: 98.49
The last couple of hours in the market on Friday were very ugly. We are definitely expecting more broad-based weakness ahead and that should make readers think twice about opening new bullish positions even this one in ATI. Shares of ATI lost 3.1% on Friday and look poised to fall toward what should be support near $100.00 and its rising 200-dma. We are going to stick with the strategy for now. Markets and stocks don't normally move in a straight line so there is still an opportunity to buy a bounce in ATI but this is becoming more speculative and higher-risk given the environment. Currently we're suggesting traders buy calls on ATI if the stock dips into the $100.50-100.00 range. The better play would be to wait for the bounce to begin first after ATI tests the $100 level. If we are triggered then our target will be the $104.85-105.00 range, which is an adjustment from our original strategy. More conservative traders may want to use a tighter stop loss.
BUY CALL SEP 100 ATI-IT open interest=409 current ask $8.40
Picked on July xx at $ xx.xx <-- see TRIGGER
Lam Research - LRCX - cls: 54.82 chg: -2.41 stop: 53.90
On Friday the Semiconductor Industry Association (SIA) said that semiconductor sales slipped last quarter. This news contributed to the weakness in the sector and the SOX index slipped 2.5%. Shares of LRCX under performed its peers with a 4.2% decline and a breakdown under short-term support at $56.00 and again at $55.00. We had been suggesting a trigger to buy calls on a dip into the $55.10-54.00 range so the play is now open. However, if you're looking for a new entry point we would wait. The SOX looks very weak and is heading lower toward what should be technical support at the rising 200-dma. This will probably pull LRCX toward the $54.00 level. LRCX does have potential support at its 50-dma around $54.15 so we would wait for a dip into the $54.25-54.00 range before considering new bullish positions. Although in reality we would hesitate to open any bullish positions at this time. Now that our play is open we're going to focus on just the one target in the $59.75-60.00 range and disregard our more aggressive target.
Picked on August 3 at $ 55.10
PACCAR - PCAR - cls: 80.66 change: -3.09 stop: 79.70 *new*
Watch out! The bounce in PCAR is already failing. The market's widespread sell-off on Friday afternoon pulled PCAR to a 3.6% decline. The stock is headed lower to retest support near $80.00. We are inching up our stop loss to $79.70, just under the July 26th low. If PCAR breaks down under $79.50 then nimble traders may want to consider buying puts and targeting a decline around $75.00 and its 200-dma. We are not suggesting new bullish positions at this time.
Picked on July 26 at $ 82.87
Penn National Gaming - PENN - cls: 57.19 chg: +0.01 stop: n/a
We have two weeks left before August options expire. Right now the situation looks grim. The stock should be trading near its buyout price around $67. The fact that it's not would suggest that the market doesn't believe this deal will get done - at least not in its current form or price. PENN's 45-day window to solicit a higher bid has expired. We're not suggesting new positions at this time.
Picked on June 17 at $ 62.12
Sears Holding - SHLD - cls: 131.58 chg: -4.94 stop: 127.49
Friday was a very rough day for the retailers. The RLX index lost 3.9% closing at 468. The bad news is that the RLX doesn't appear to have any support until the 450 region. Meanwhile SHLD continues to plunge. We see some support near $130 and have been suggesting that readers buy a dip into the $133.00-130.00 range to capture any oversold bounce. The stock is extremely oversold with a three-month fall from the $190 region and a $40 drop in just the last four weeks. On Friday SHLD hit our entry zone so the play is now open. However, we strongly suggest that readers looking to open new positions wait! SHLD closed on its low for the day and that suggests more weakness on Monday. Odds are very high that SHLD will trade near $130 on Monday. Wait and watch for a bounce near $130 before considering new positions. Our target is the $139.50-140.00 range.
Picked on August 3 at $133.00
Terex - TEX - cls: 82.40 change: -4.06 stop: 79.74 *new*
The situation is not looking good for TEX. The stock under performed the markets on Friday with a 4.7% decline on big volume. All of last week looks like a big bearish reversal. Most of TEX's technical indicators have turned bearish. More conservative traders may just want to abandon this play early. The only reason we're hanging on is because TEX should have support near $80 and its rising 100-dma. We're inching up our stop loss to $79.74. If TEX hits our stop loss then nimble traders might actually want to jump into bearish put positions and target the $72.50-70.00 region. We're not suggesting new call positions at this time. The stock has already hit our first target in the $89.50-90.00 range. Our second target is the $94.00-95.00 range.
Picked on July 26 at $ 83.87
Baker Hughes - BHI - cls: 75.84 change: -2.22 stop: 80.05*new*
Oil and oil service stocks dropped sharply again on Friday. BHI closed with a 2.8% loss on big volume. The intraday low was $75.30. Our target is the $75.25-74.00 range. We suggest that readers prepared to exit. We are adjusting our stop loss to $80.05.
Picked on July 29 at $ 79.43
Harley Davidson - HOG - cls: 55.20 change: -1.77 stop: 60.26
HOG sank more than 3% on Friday and broke down from its recent $58-56 trading range. Shares closed at their low for the session, which is a bearish sign for Monday's open. We're not suggesting new positions at this time. More conservative traders may want to tighten their stops toward the $58.00 level. Our target is the $52.50-50.00 range. The P&F chart already points to $42.00.
Picked on July 23 at $ 57.75
Lubrizol - LZ - cls: 59.94 change: -1.43 stop: 64.15 *new*
LZ hit another relative low and broke down under its rising 100-dma on Friday. Shares also closed under what could have been round-number support at the $60.0 level. We are adjusting our stop loss to $64.15 as the $64.00 level should be overhead resistance. Our target is the $57.00-55.00 range. $57.00 is near the top of the April gap and $55.00 is near technical support at its 200-dma. If you want to aim for the $55 region then this looks like a new entry point for puts.
Picked on July 29 at $ 61.62
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
DaimlerChrysler - DCX - cls: 89.12 chg: -2.06 stop: n/a
Shares of DCX spiked midday on Friday as news hit the wires that the company had completed its sale of Chrysler to Cerebus. The rally was very short-lived and the stock eventually closed with a 2.2% loss. DCX is still trading in its $88-92 trading range but we suspect the stock will break down to new relative lows soon. We are not suggesting new strangles on DCX at this time. The options in our suggested strangle were the August $95 calls (DCX-HS) and the August $85 puts (DCX-TQ). Our estimated cost was $3.70. We want to sell if either option rises to $6.45.
Picked on July 22 at $ 89.75
Celgene - CELG - cls: 59.46 change: -0.96 stop: 57.49
The bounce in biotech stocks appears to be rolling over much like the rest of the market. CELG is still out performing its peers but the rally is struggling and the stock has closed under what should have been support near $60.00. There is chance that support near $59.00 and $58.00 will continue to hold. However, given the market's widespread weakness and where we are on the calendar we are suggesting an early exit. We'd rather cut our losses now and wait for a potential dip in CELG near technical support at its rising 200-dma, which could be a new bullish entry point. More aggressive traders may want to stay with it.
Picked on July 27 at $ 61.25
Lexmark - LXK - cls: 37.76 change: -2.17 stop: n/a
Target exceeded. It was a good day for LXK puts. The stock plunged more than 5.4% and closed at new multi-year lows. The put side of our strangle was the August $40 LXK-TU put. Our estimated cost was $0.75. Our target to exit was $1.50. The LXK-TU put hit an intraday high of $2.70 and is currently trading at $2.45bid/$2.75ask.
Picked on July 22 at $ 45.43
When my daughters were in their early teens, a new fashion surfaced. Dresses, blouses and sometimes even sweatshirts were festooned with lacy collars. Those collars were wide enough to extend all the way to the edges of the thickly padded shoulders that were also in fashion. I couldn't help but think that their class pictures were going to end up looking as ridiculous as mine from the sixties.
Collars have their places, however, and they may be coming into fashion again: in the stock market, not on shoulders.
Imagine that by Monday, July 30, 2007, you had decided that the sell off from the previous week had been overdone, especially in the financials. You thought you might buy 1000 shares of Merrill Lynch stock, then at $76.12.
Annotated Daily Chart of MER on the Afternoon of 7/30:
You intend this as an intermediate-term buy to be held for several weeks, perhaps, not a long-term investment, but still you're not quite certain about your decision. You don't buy MER just yet. News from overseas shows that the implosion in the U.S. mortgage market is beginning to impact other banks. Britain's HSBC reported just that morning that it was going to increase its reserves because of the impact of the credit crunch. You want some protection.
Selling a covered call provides some, you know. By the time you've pulled up an options chain, MER has already risen a penny, so your purchase price has now risen to $76.13. These options prices were found at Brokersxpress when MER was at $76.13 that afternoon.
Near-the-Money Call Prices with MER at 76.13 @ 1:09 pm on 7/30:
You believe that MER will encounter resistance at about $83.00. You see that you can sell an $85.00 strike call for $0.50. If you decide to buy the 1000 shares of MER, you could sell 10 contracts, reducing your basis in MER to $75.63. (Note: For the purposes of this article, we'll ignore commission cost, but they shouldn't be ignored in real life. In fact, one brokerage I once used charged fees so large that it was not possible for me to employ collars. I didn't stay with that brokerage too long.)
Reducing your basis to $75.63 assuages your concerns some, but what if markets plunge overnight some night and you wake up with MER gapping below $70.00? You'd like a bit more protection. As it turns out, as we know from our end-of-week perspective, that protection was going to be needed.
What if, instead of using that call premium to reduce your basis, you spend it on extra protection? What if you use it to either pay for or reduce the cost of an out-of-the-money put?
Near-the-Money Put Prices with MER at 76.13 @ 1:09 pm on 7/30:
Unfortunately, you find that the recent volatility has pumped up put prices. Puts are so expensive that your $0.50 sold call premium wouldn't offset the price of those puts much. It would be too expensive to establish a collar.
What if you sold the $80.00 strike call for $1.40 instead and used that to buy the $70.00 put at $0.95? You'd reduce your basis in MER to $75.68 [$76.13 MER cost - ($1.40 credit for sold call -$0.95 cost for purchased put)]. You'd be able to participate in gains only up $80.00, the strike of your sold call, but, unfortunately, you'd have risk all the way down to $70.00, the strike of your long put.
Is that a good risk/reward scenario, risking $5.68 ($75.68 basis - $70.00 strike) to participate in gains up to $80.00? Maybe that wouldn't be such a good risk for some people.
However, that depends on how strongly you feel about MER's bounce potential and your view on the timing of any potential climb. For example, if you believe that MER will climb surely but slowly while the VIX declines and options cheapen, you might benefit from an increase in the stock price without the stock being called away.
Let's think about an imagined scenario. What if MER has risen to $78.00 four days before option expiration? What if volatility in those options, at 43.29 on 7/30, dropped to 30.00 as it rose into opex week? As of 7/30, when these calculations were being made, my brokerage calculates a theoretical value for that sold call at $0.31 if MER has risen to $78.00 four days before opex. You would have several choices. Perhaps you're grateful in the current environment for have chosen a stock that gained, but now you've had enough excitement and want out. You could buy back (buy to cover or buy to close) that sold call for $0.31 and then sell the stock for $78.00. This transaction would net you $77.69. Since your basis was $75.68, you've gained $2.01.
Maybe, in this supposed scenario just before option expiration when MER has risen to $78.00, you're still reasonably confident that MER will move higher. Instead of buying back the AUG 80 call, you decide to roll up and forward into a September call. My brokerage calculates the theoretical value of a September 85 call (moving up a strike) at $0.90 four days before August opex with MER at $78.00. Theoretically, then, you could roll out of the August 80 call and sell the September 85 for a $0.59 gain (buying to close the AUG 80 at $0.31 and selling the September 85 for $0.90), although I'd figure a little less because you're going to be splitting bid and ask prices at an advantage to the market maker, not you. Imagine, however, that you could roll into that September $85.00 strike for a $0.50 gain. Are you going to use it to again reduce your basis or to collar the stock price again?
If MER had theoretically risen to $78.00 four days before option expiration as the implied volatility in MER's options dropped to 30.00, in our imagined scenario, my brokerage calculates a theoretical value for that Aug 70 put at 0.01. Selling to close that put isn't going to garner you anything to help with the purchase of a September put. You have only the $0.50 that you gained from rolling into a September call to spend on a protective put. My brokerage calculates the theoretical value of a September 70 put at $0.45 under our imagined conditions. You have more than enough to buy that put, but that keeps your risk down to $70.00, when that long put's protection kicks in, and the stock has risen, in our imagined scenario, all the way to $78.00. A September 75.00 put would cost you $1.60, significantly more than the $1.60 you garnered by rolling forward and up into a September 85 call.
Of course, we know now, as of about 10:20 on Friday, August 3, as this article is completed, that MER didn't bounce. Continued bad news from financials pummeled this financial along with others. As of about 10:20 that morning, MER was at $70.90. Let's see what would have happened to your option prices. Would that collar have helped you?
MER's Near-the-Money Call Prices on Friday, August 3:
MER's Near-the-Money Put Prices on Friday, August 3:
With MER at $70.90, you could buy to close your 80-strike call for $0.40, sell-to-close your MER stock, and sell-to-close your 70-strike put for 2.05. You would net $72.60 [70.90 + (2.05 put credit - .35 call debit to close)]. Your basis, if you remember from the earlier discussion, was $75.68, so your total position has suffered a $3.08 loss ($75.68 - $72.60). That's a loss of 4 percent from your original basis, but it's certainly less than the 6.9 percent loss you would have suffered without the collar.
Whether a 4 percent loss is the maximum you're willing to take depends on your account-management practices. Whether you'd exit the play at this point depends on those account-management practices and your outlook for the stock. I can't answer those uncertainties, but I can say this with certainty: although the high volatility had plumped up options prices, making conditions for the establishment of a collar less than optimal, that collar ameliorated the losses that otherwise would have occurred.
Can you imagine a condition under which it wouldn't have helped as much? Sure. How about if MER languished between $70.25 and $71.25 for the next two weeks, settling on option expiration day back at $70.90? The sold call would expire worthless, but so would your protective put, and there you would be with MER at $70.90, and you having purchased it at $75.68 (the basis with the collar). Although your 6.3 percent loss would still be less than the 6.9 percent loss if you hadn't had a collar, when the basis was $76.13, I'm thinking that small difference might not have been a huge comfort.
Another concern exists, of course, one that did not confront you in this week's action: what would have happened if MER had risen quickly and that sold $80.00 call had gone in the money? You would have had danger of assignment, then, once the extrinsic premium of the call dropped below about five cents. That shouldn't be a problem since you do own the stock, but that should be considered.
Collars prove helpful attire, then, but they're not going to magically get you admitted into the environs of the big money people, either, if you don't know all the secrets about collars. Spend some time studying them. Right now is a great time to run a few scenarios like this one, pricing out a collar using both front month (AUG) and next-month (SEP) options, and seeing which works out best or if they help at all.
While you're add it, compare the tactic with your gains or losses if you just purchased a protective put without going through the collar business. The supposed benefit of the collar is that the sold call pays for much of or all of the cost of the protective put, but decide, after running some of those scenarios, if you agree.
Keep in mind that collars are not going protect you from all losses, but run
some real-world scenarios to get a feel for them. They certainly have a place in
your trading repertoire.
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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