Despite most of our positions being well above the strike prices and will potentially expire worthless I am skeptical about the current rally and suggest exiting some positions.
The markets appear to be in breakout mode and may not show weakness until January but I am cautious. When things appear to be going too well it is time to start looking over your shoulder.
For instance Interoil (IOC) is up +10% or nearly $8 from where we entered the play. Currently at $77.95 and the strike we sold at $65 it would appear that there is little chance of the put not expiring worthless. However, the market internals over the last six-weeks suggest that money managers are just passing time until January so they can cash out some positions in a new tax year. If that is the case then the momentum stocks like IOC could come crashing down very suddenly once the music stops.
Last week's rally was a jam job of titanic proportions. Managers took advantage of extremely low volume to punch through resistance and trigger textbook short covering. Volume from the prior Friday declined from 11.3 billion shares to Monday 7.0B, Tue 6.4B, Wed 5.6B and Friday 2.2 billion shares. With only two billion shares traded any decent sized mutual fund could have pushed prices higher at will. This was window dressing at its finest.
What fund managers were likely trying to accomplish was to push the indexes significantly higher so they could trigger short covering and hopefully give them enough volume in future sessions to exit their positions in January pretty close to their recent highs. The trick will be to keep the indexes pinned to last week's highs for four more days. Then IRA and 401K money will provide that one last boost the first week of January and funds can cash out in the new money volume.
I am not saying they are going to dump all their positions. Far from it. They will probably only exit those with the most gains. For instance, if they bought Interoil last November at $9 then they are probably going to take profits at $78 and count themselves very lucky. There are hundreds of stocks just like Interoil with 200%, 300% even 500% gains but as we all know they are not really gains until they are sold.
If every fund manager has the same plan then there could be a race to the exits in early January. I want to avoid giving back our current profits by exiting before year-end. That way we will have plenty of cash to put to work in January.
I plan on going against my own bias against selling naked calls and recommend some on companies like Interoil for the first week of January. If we do get a market drop it could be sharp and provide us with some quick money and graceful exits.
So, the following are the exit targets I am suggesting for each of the plays next week. If you can exit at these targets we should be happy. Pigs get fat, hogs get slaughtered. Waiting for the last nickel to bleed away could find us headed for the slaughterhouse.
Trina Solar - short Jan $45 put TSL-MI target 25-cents.
Akamai - short Jan $25 put UMU-ME target 25-cents.
Foster Wheeler - short Jan $28 put UFB-MK target 20-cents.
Russell 2000 IWM ETF - short Jan $60 put DIW-MH target 30-cents.
Hornbeck - short Jan $22.50 put HOS-MX target 20-cents.
Interoil - short Jan $65 Put IOC-MM target 50-cents.
I also updated stop losses on several positions.
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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)