The window dressers ran out of cash and weakness appeared. Is it just a dip before the normal first week fund money rally or is it a preview of things to come?
Grab a cup or glass of your favorite beverage because this is going to be a long commentary. I researched well over 500 stocks this weekend as I tried to determine if my bias for an early January dip was on track or in error. I came away with an even stronger conviction that we are going to see some volatility soon. Maybe not in the first couple days of January but soon.
The vast majority of all the stocks I researched were looking very tired after a strong run in December. The chart of Gardner Denver is an example of what I saw. After a very nice run in December the window dressers could not hold it at the highs and the sell program on Friday was simply too much pressure for the bulls. It is not that there was a ton of selling in GDI and others but there were no buyers once the funds completed their December push.
Chart of Gardner Denver
In order to profit from a correction, either minor or major, in a newsletter devoted to writing naked options about the only method is to sell calls either naked or in a bearish call spread. Since very few readers have naked call writing permissions that means either a spread or while nobody is looking we buy a few puts.
I have a personal dislike for spreads as too limiting on the profit side and too expensive if the desired move never comes. It is one of those cases where you are risking $5 to make $2 and although I have used them in the past I have never been a fan. It is probably my type A gunslinger personality that always wants to go big or go home. That is dangerous in the market and I fight the impulse constantly.
Of the 500+ stocks I researched I came up with a list of 60 potential candidates that will likely drop hard if the market decides to take profits. I had to split the graphic below into two sections so it would fit on a normal computer screen. The 60 stock list was sorted by price and split into two sections.
I analyzed the news on each, checked the open interest on option strikes and tried to determine the potential decline targets. I looked for stocks with lower volume that would move dramatically if the selling accelerated. I looked for stocks with big moves for the year and big moves over the last 30-45 days that would probably mean current gains are un-captured. Remember, they are not profits until you close the position.
Some stocks I had to rule out because the open interest on the in the money calls was too small to provide adequate cover from the market makers. If the open interest is 10 and it suddenly jumps to 100 on Monday the market maker will just exercise the calls at the close to equalize his positions. Some market makers, even though they are supposed to make a market in every strike, refuse to let new naked positions remain open. Basically if you sell a call $10 in the money the $10 premium you collect is the market makers money. If he is running a tight ship he does not want you holding his $1,000 per contract for the next three weeks and he will exercise the call and yank the money right back the next day.
If there are 10,000 contracts in open interest on a strike that is $10 in the money then the odds of your new calls being exercised are minimal. Those market makers are actually providing a market instead of squashing the market. Always look for the strike with the biggest open interest when possible.
Some stocks were ruled out because the strikes did not fit the expected support points to make it worthwhile to take the risk. Some grossly overextended stocks struck out on multiple points. In the top 60 list below there are some great potential trades and anyone willing to take a little risk and actively work their entry can make a lot of money. I am showing you the top 60 list so you can chose other stocks that better fits your risk profile.
For a newsletter where we have to pick stocks and entries the day before it is like throwing darts blindfolded. Every stock has certain pressures on it when the market opens and it can gap up or down several points before deciding on the trend for the day. It is basically a crap shoot when I pick entry targets because as we saw in December we can had a 100 point market move at the open that is erased by 10:30 and be moving in the opposite direction. It is like crossing a freeway blindfolded. You can get hit from both directions and knocked for hundreds of yards but if you are lucky enough to get across without getting hit you really only moved 100 feet.
In a market situation like we have today there are two options. Write a call that is $5 out of the money for $1 and risk $5 to make $1. Or, you can write a call that is $5-$10 in the money and risk the same $5 to make $5-$10. The risk is almost the same except that the out of the money call inflates slower than the in the money call if the stock goes against you. Same if it goes in your direction. The OTM call deflates slower than the ITM call. It all boils down to risk management. If you write ITM then your stop has to be closer. Say you are willing to risk $3 to make $10 then you write the $10 ITM call with a stop $3 above the entry price. On the OTM call for $1 the most you can make is $1 but you can have some breathing room on the stop.
I am not going to get into the margin discussion here but obviously if you are going to write OTM then you want a low priced stock otherwise you a putting up $50 in margin to make a buck. Again that gets back to the risk reward ratio.
Out of the 60 candidates I chose about 10 to either write calls or buy puts. My preference is for the higher dollar stocks because they move faster when the market corrects. Plus, fund managers had been putting money into stocks with higher share prices because generally they are more liquid and you don't have to buy/sell so many shares to move a lot of money. As the clock turns over to 2010 those same fund managers should be taking money out of the higher dollar stocks and spreading it around on the small caps in hopes of catching some doubles and triples in 2010. This makes a large stock price a liability over the next few weeks.
I want everyone to understand this is a lottery play. I expect the market to decline at some point next week but that expectation and $4 will get you a cup of bad coffee at Starbucks. This is a lottery play. As such I am not going to account for them in the official Option Writer track record. If we make a lot of money that would be great but it is not going on the record.
Another reason is that I am giving you 10 choices for plays. I know that NOBODY is going to play more than one or two of them. Some may not be chosen at all. I did the research for those who want to roll the dice. Hopefully we will get lucky.
If we do get a big dip then I will go on the record with some put writes as we exit the January options cycle and head into the Q4 earnings cycle, which begins around Jan-22nd. I believe the market will pause in whatever it may be doing at the time to move higher during the first couple weeks of earnings. That will give us the chance to write some puts.
Here are the top 60 candidates. The yellow lines are the ones I selected as the best potential to decline and include all the factors I listed above. Good luck!
January Short Candidates page 1
January Short Candidates page 2
We did not get an entry on the TSL and IOC naked call positions last week and those recommendations are still open.
We entered the DIA Short Call, long put position on Thursday. That position is active with a stop at $106.05.
If you have not taken advantage of the Option Investor End of Year Renewal Special here is the link to the offer. This is the cheapest rate we offer for the entire year. Nobody can get the core newsletter package at a better rate.
Click here for the 2009 Renewal Special Details
I am foregoing the normal description of the company and just listing the plays.
Naked Call Candidates
Long Put Candidates
December Recommendation History
Click here for November Results
Click here for October Results
Click here for September Results
Click here for August Results
We do not sell out of the money puts for a few cents and then hope the market does not correct and cost us a fortune to exit. I don't like to risk a dollar to make a quarter.
The concept for Option Writer is to find solid momentum plays with enough volatility to inflate the option premiums. We will sell in the money naked puts ahead of the stock price and let the stock rally to our strike.
Selling in the money puts allows us to capture nearly dollar for dollar the movement in the stock price.
Because we are selling in the money that same dollar for dollar move can go against us as well. For this reason we establish tight stops to take us out of the play for a loss of a few cents rather than let the losers grow and "hope" they rally again. In a typical month we could get stopped out of twice as many plays as we close for a profit but those stops will be minimal and the winners worth the trouble.
If you do not have the ability to sell options you can turn the plays into spreads by buying a lower strike put. This will decrease your margin requirements but it will also decrease your profits.
There are several different formulas for determining margin requirements for naked put writing. These are normally broker specific and some can require larger margin requirements than others.
Here is the most common margin calculation for naked puts.
100% of the option premium + ((20% of the Underlying Market Value) - (OTM Value))
For simplicity of calculation simply use 20% of the underlying stock price and you will always be safe. ($25 stock * 20% = $5 margin)