Investoid

Today the Fed did the (slightly) unexpected and dropped their target rate by a half percent. The market has subsequently rallied a couple percent off this news.

I was listening to BNN and watching the DIA options closely. Once the news broke, DIA went up about one dollar and hit resistance around 136. Meanwhile the 136 Sept call option was only up to an 0.80 ask price, so I thought that was a good exit point for this option given the potential upside on the Dow. I decided to hold onto the 138 option to see if DIA would break the resistance and if I could use my defensive measure to reduce the loss. A short time later the stock began to increase above 136. I looked at using my stated defense, but found that it was best to exit the trade entirely since the gains from the 138 option were greater than selling a 139 or 140 option, given that I’m not sold that this rally will last beyond the close. The 138 option could have been sold for 0.30-0.35 cents, depending on whether one took the bid price or went in the middle of the spread. The net exit for this trade was a 0.45 to 0.50 debit.

In the worst case this trade would have lost 0.10 per contract (before commissions, which are an important factor the smaller your lots are), which isn’t that bad given that the underlying went in the wrong direction. It was a good learning opportunity and made me reconsider whether I should stop looking at speculative trades and start focusing on more ‘income’ style plays that other option traders look for. The journey continues…

The Wall Street Journal has reported that PIMCO is starting a $2B fund to purchase distressed debt on the cheap. To me, this is a very good sign that the capitalists are coming out of the woodwork and are taking advantage of the collective fear out in the credit markets. I expect we’ll hear more such announcements in the coming weeks.

Hopefully the Fed is looking at such actions and will take into account the vast financial sums still on the sidelines, which can do a far better job of fixing the issues out there than a rate cut would. For years we’ve been hearing how much cash has been sloshing around looking for investments to fund. For awhile the private equity groups were receiving this money, but now that cheap credit is drying up I suspect that distressed debt funds and other vulture funds will start to get attention. The market will work through this, provided the structural monetary issues are handled by the Fed. Hopefully they will tighten money supply and keep the dollar from collapsing by holding rates steady.

Let’s see what Tuesday brings!

I’ve been looking at this trade for the past couple of days, based on my belief that the Federal Reserve will not cut their rates more than 25 basis points next Tuesday. As a result, I expect the markets to be disappointed, or at the very least muted based on the Fed’s decision. Even if the Fed gives the market a half percent cut, this has already been priced into futures prices, and thus I doubt there is much upside regardless.

As a result I am looking to take out a bear call spread on the Dow Jones Industrials ETF, DIA. I want to open a 136/138 bear call spread for a 0.40 cent credit per contract or better. I plan on holding until after the Fed decision, but not until expiration. Based on current option prices, I want to fill this at 55 cents and 15 cents respectively for each option.

If the Dow does start to go up and gets close to or goes through my short option strike, and the market looks like it will continue to climb, then I have a defensive adjustment planned. I’ll be looking to buy back that option at a loss and sell some 140 or higher options, turning the trade into a bull call spread. My thinking is that if the market continues to go up I can partake in the upside a bit and eke out a profit, but if it goes back down I’ll capture the additional funds from the higher options that I short, thus limiting my losses.

Note: I will only be paper trading this strategy, since my current broker forces you to go long first and then short on option spread trades. Since the short contract has a dime spread on it, I don’t want to risk that the market will move down while I’m holding the long position while waiting for the short position to be filled. This is really frustrating and as a result I’ll be moving brokers right away. I am thinking about OptionsXpress, but if anyone has comments on it, Interactive Brokers or others who are good for option trading, please let me know.

I will update this trade next week once we’ve seen what the market does.

Note 2: This is not a recommendation for anyone to perform this trade. Please see my full disclaimer.

As I mentioned in my last post, the US Federal Reserve is under pressure from the financial markets to cut their funds rate by a quarter to half a percent. As a result of an increase in sub-prime mortgage defaults, higher risk debt issues are becoming quite illiquid. This has caused a credit crunch for some firms who rely on junk bonds and the like to finance their operations, while various hedge funds and purveyors of collateralized debt obligations are feeling the pinch from low prices and no buyers.

The fear is that this housing calamity is spreading to the rest of the US economy, thus affecting overall growth and strength in important areas such as consumer spending and business investment. A rate cut would not only spur on these areas, but would re-invigorate the credit markets. With inflation within (or close to) the Fed’s target range, they can afford to cut rates. So, why not do the ‘right thing’ and keep the economy going? In fact, with the market pricing in a half percent cut, wouldn’t keeping the rate the same just be punishing investors already spooked by the recent downturn?

Not so fast. Just because a sub-sector of the credit markets is in trouble, doesn’t mean that the whole system requires stimulus at this point. As this Financial Times articles notes, “this is far from the greatest credit correction of all time”. We are far from a wide-scale crisis at this point. Furthermore, I believe that in our financial markets one person or company’s pain is another’s opportunity. If credit markets are seizing up, it’s because the typical buyers aren’t willing to buy anymore. That doesn’t mean that the securities being peddled are worthless, just that they aren’t in vogue right now. But in these capitalistic markets there are always someone trying to get an edge. I suspect that many hedge funds and other large investment houses are re-pricing these phantom ‘AAA’ rated securities. In fact, there are several companies openly saying that this crunch will be good for business in the long term. Canadian banks also seem to think this is a good thing.

I’m not going to harp on about the Fed being in a moral hazard situation, but if you’re a Mad Money fan get Cramer to answer this: does he really think even a percentage point cut to the Fed rate will save people from losing their homes? Just because the prime lending rate goes down doesn’t mean that high risk rates will go down as much, or even at all. In fact, I would guess that such rates will increase, regardless of what the funds and prime rates do, because of the higher perceived risk of default. And if a person who’s in an adjustable rate mortgage whose teaser rate is about to end and his new rate will be prime + 3% or more, do you really think that a 100 basis point cut will really matter in terms of his monthly payment? Assuming that the person has a $200,000 mortgage on a 25 year amortization and had a teaser rate of 4%, they would have paid $1047 per month. Assuming their new rate is prime + 3%, then at current rates their monthly payment is going to be $1918, while their payment with a percentage point cut would be $1795. Either way, if the person wasn’t ready to pay 90% more in monthly housing costs, I doubt they’re going to be ready for a 70% increase either.

The bottom line is that capitulating to the financial markets desire for continuing cheap money does nothing to wring out the excesses currently in the system. By prolonging their existence, they are more likely to cause long term harm, as we have seen in Japan’s sclerotic economy since their own real estate bust. Because Japanese banks weren’t able to go out of business or even fully disclose their bad loans, the excesses were never fully brought to bear. Only in the early 2000’s did a special task force make Japanese banks own up to their bad debts. Despite their 0% interest rates for many years, their economy has continued to stagnate. I’m not suggesting that this is the only reason for Japan’s continued growth lag, but it is a contributing factor.

I don’t expect the Fed rate to remain at 5.25% on Sept 18, but I think there is a strong case to be made that it shouldn’t be reduced. If the board of governors decides to only cut by 0.25%, expect to find many bargains around the world that day.

My apologies to the Canadian Capitalist (who uses this phrase for his weekly miscellaneous column), but this title seemed apt for this post.

I have been posting very infrequently during the summer. Part of the reason is that I’ve been fairly busy and haven’t found time to think deeply about what’s been going on in the markets. But I’ve also not wanted to discuss in detail my option trades. I’ve had quite mixed results, and didn’t want to put my failures on display. Instead I was writing in a personal trading journal so I could reflect on what I did right and wrong. While this has been instructive, I think it would be more helpful to talk about more of the trades in the open, so I’ll write more about my thinking on future trades. Right now I am not actively looking for setups, and am going to focus on doing some statistical analysis on index ETFs so I can determine the value of trading iron condors or calendar spreads on such stocks.

Also, I found out quite belatedly that the Globe and Mail published an interview they did with me last Saturday. For those who have found this site through that article, welcome. I’ll scan the article and put it up as soon as I can get a copy.

Over the summer the markets have faced a lot of turmoil. The credit markets have blown up and fear is prevalent. The commercial paper market is particularly sclerotic, which if it continues can materially affect the ability for many companies to function. This can be traced to the sub-prime mortgage mess in the US, which is based on the fact that hedge funds and the like would buy highly rated debt that was merely the collection of poorly rated debt (wonder if the ratings agencies will face more government regulation as a result).

As a result of this financial crisis, the market has been howling for a rate cut in the States. The Fed is keeping their true intentions close to the chest, although they have said they will reduce the funds rate ‘if necessary’. The market has priced in a guaranteed rate cut on Sept 18, and are now speculating on when the next cut will be. I am not certain that the Fed will bow to pressure from the financial community. If for some reason the Fed does not cut on Sept 18, expect a large drop in the US markets and around the world. As a result, I’m waiting for this event to pass before I look to make any short, medium, or long term trades.

If things do go south as a result of Fed inaction, I’ll be looking to pick up a lot of solid companies at a discount, particularly Canadian financials, income trusts, and energy companies that pay a healthy and stable dividend.