Cadence (CDNS) - Decision making in the face of uncertainty

Today was one of those days that I hate. Everything is up and by a lot. As an options trader who makes money from selling time premium, this isn't my thing. Sure, I make money since I am generally positive delta and negative vega. (I will probably explain all the option greeks sometime -- mostly to help myself gather my thoughts learn them better. I mostly only use delta and I am trying to learn to use vega.) However, I write options expecting them to expire. So a market rally just helps to speed up that process a little bit. However, I ran out of margin a while back during the big dip and thus do not have many open positions for March. If the market is up, then it is hard for me to find a good risk/reward balance in options to write since I am mostly selling puts naked. So the ideal market is one that is perfectly flat (historical volatility of zero) while having a high implied volatility. That's what I dream about. Of course, the markets aren't so nice.

So I was looking for options to sell and noticed that CDNS (Cadence Design Systems) was down 33% to 10 a share. Cadence makes CAD (computer aided design) software for the electronics industry (some people call it EDA -- Electronic Design Automation). CDNS is to semiconductors as ADSK (Autodesk) is to buildings. Brought up a maximum length chart on Yahoo finance and saw:



CDNS is basically back to 1996 levels. Always a good sign. I like things that are at long term lows (that's my style of investing most days).

Took a look at the AP bulletin which was pretty useless. I am convinced that they are written by robots (or people playing robots). It calls CDNS a "semiconductor manufacturing equipment maker". Never a good sign.

Basically 4Q '07 was ok but guidance for 2008 is bad. 1Q is going to be a loss and full year guidance is down to non-GAAP EPS of $1.11 to $1.19 (GAAP EPS tends to be lower since EDA companies take write-offs for their acquisitions). The current Street consensus estimate $1.53 a share. With earnings potentially down over 28%, the price drop seems reasonable, right?

I disagree. I think the bad new was already mostly priced in. I am more than happy to go long this company at P/E of 10 (after lowered guidance, even better!). I sold a bunch of Mar 10 puts at 0.85 which would give me a basis of 9.15 if assigned. Otherwise, I get about an 8% return on maximum risk or a 50% return on initial margin (for 50 or so days).

I also feel good about the fact that 53 million traded out of 268 million outstanding. Combine that kind of volume with the flat intraday price action, it smells of major buying. There was a floor around 10 all day and a volume spike and the end of the day. We might see an SEC filing some time soon.

We'll see what happens. It could prove really dumb to try to catch this falling knife. Sometimes, there is no time for analysis, and it's mostly gambling with an estimate of the odds.

Tried to grab some EMC, got greedy and missed it

The EMC options did not hit my target price when it opened (just like the model said). I slowly lowered by limit order and chased it all day. Didn't execute. Will try again tomorrow. FOMC statement coming out. It could go either way. If they cut big, then they are panicking and Bernanke put will be in the news. If they don't, people will whine. Either way, it could be up or down but probably volatile.

I noticed that VMW kept dropping during the day while EMC recovered. It was mostly due to the positive earnings report from EMC this morning. However, it does confirm (maybe confirmation bias) my theory that EMC is a fundamental play whereas VMW is a momentum play. Although I am not going to try to short VMW.

I am also going to try to grab some positive delta on Yahoo by selling out of the money naked puts. Today after the close, it reported earnings and wasn't too good. The main problem was that a part of the call was quotable. Everyone is talking about the 'Substantial Headwinds'. Down 9+% to 18.90. Also, laying off 1000 people. The cost cutting should be good for Yahoo to focus on their core business. Google isn't as great as people say and Yahoo isn't as bad. Reversion to the mean happens. I need to do some more due diligence but it's on my watch list (so I must have already looked at it before). We'll see how it trades tomorrow.

Also noticed LEN and other homebuilders at short term highs and overbought. Very tempting to short XHB (Spiders Homebuilders ETF) via options. Shorting the index is probably less risky than shorting individual companies. I am going to wait to see if there is an opportunity to deploy capital in EMC or YHOO. If I have the excess margin, I might get my feet wet. I like collecting premium so I'd probably sell a naked call rather than buy a put.

VMware earnings report - a case study in pricing

VMware shares are down 26% to 61.18 in after hours trading following its earnings release. But what exactly did they do wrong? Was it the tone of the conference call (I haven't heard it yet)? They posted an 80% rise in 4Q revenue but missed by 1% ($412M instead of $417M). Their earnings were 0.19 versus the consensus estimate of 0.24 but this included -0.07 of non-recurring line items.

From all metrics, this company is executing well. The problem is that they missed expectations. This is where risk vs. reward trade-off analysis comes in. At a price of 125 (the 52 week high), VMW was incredibly risky because all the upside is priced in. That doesn't mean it can't go higher in the short term. But in the long term, it's hard to see VMware (as it is now) as a $48B company. Some day, valuation ratios will come into play.

As I am sure everyone is already aware, there's a famous Benjamin Graham quote that goes "In the short run, the market is a voting machine, but in the long run it is a weighing machine."

Another interesting thing about the VMware drop is the correlation with the EMC drop. I have seen many articles about using EMC as a way to get VMW cheap. The argument usually goes as follows. Each share of EMC owns 0.155 shares of VMW. With VMW at 85, it accounted for 13.18 of EMC's price.

So with EMC at around 17, you would expect to see 78% of the move in VMW in EMC. But today, EMC dropped 13% while VMW is down 26% (about 50% correlation). So what's wrong?

This is where the Graham quote comes in; in the short term, the market is a voting machine. The market price for a share of stock is the price necessary that balances the number of buyers with sellers. It doesn't necessarily correspond to the long term value of the shares.

At any given time, there are many who are willing to sell, but only at a price above the market price (otherwise they would have sold). This is why most takeovers, LBO, etc. clear at 40% premium to the market price before the deal (or the rumor). This also explains why Countrywide Financial (CFC) dropped after the Bank of America (BAC) offer. It was below the market price.

The bid price is only valid for the bid size and the ask price is only valid for the ask size. To assume otherwise would be foolish. The market capitalization is a poor valuation metric. Stock being heavily sold will dip below the long term price and stock being heavily bought will go above the long term price. This is the same reason why technical indicators work. By looking at price action, you get a view of the supply and demand imbalance.

I think EMC is a good deal at these prices. The stock is supported by their core business. EMC has traded at a high of 14 for years. EMC was at 14 when they bought VMware for $635M of cash in December, 2003. Their business has gotten stronger as they acquired other franchises (like Mozy and Documentum). They are ready for the future reality of managed storage. If VMware is any indication, they are good at buying businesses.

VMware on the other hand is a risky proposition. Their business has great potential but there are also many competitors emerging. They promote the model of paying for licenses once whereas many other software companies are moving towards SaaS (Software as a Service). But the part I worry about trading short term options is that we are going to see a lot of selling pressure from EMC and other holders. EMC's cost basis in VMW is about 1.95 (if we ignore the money the put into it after the purchase). It's hard to compete with them. I may think that VMware is a good stock at 30 a share. For EMC, it's completely different. They need to sell (at least some) to raise cash for other acquisitions. They also need to diversify their assets while focusing on their core business. Buying VMW before EMC starts selling is dangerous. Profitable maybe, but dangerous.

EMC dragged down by plunging VMWare

As TheNetFool pointed out in a comment to my previous post, EMC was down 13% to an after hours low of 14.70 before recovering to around 15.



My position in +EMCNR (Feb 17 put) was at 0.85 before the close. My Black-Scholes model says it's going to open at 2.14. This is unreliable since any number of things could happen at the open. EMC can gap lower, it can go up early and then come back down, or it can go higher. I don't know. Implied volatility will also change (either higher to reflect the increased historical volatility or lower since this unknown event is out of the way). Even though it is unreliable, the model gives us a good estimate to work with.

The same models say the Feb 16 put will open at 1.33 and the Feb 15 put will open at 0.69. I am seriously considering selling the Feb 15 put for 0.75 instead of trying to sell the Feb 16 put for 1.75. Since EMC is at 15 right now, I maximize the time value of the option by selling the at the money. I am still going to stick with my 14.25 target price.

VMW earnings could be opportunity to pick up EMC

VMW (VMWare) reports earnings after the close today. It could be a surprise either way. If there is a surprise down, it will probably drag EMC down in trading tomorrow and could be an opportunity for me to implement the plan described in a previous post.

Shanghai composite nailed over the weekend

The SSE Composite Index is down 7.19%. I don't know much about technical chart wizardry but looking at the 1 yr chart, even I can see the lower highs and lower lows.


But if you invested when valuations were reasonable, you are still so far from your cost basis that you have nothing to worry about.


There might be some opportunity to trade this by going long FXP (UltraShort FTSE/Xinhua China 25 ProShares) but I don't have the capital right now and the option spreads are too big.

Considering selling front month EMC puts

I have been looking at EMC for a while now. Not only does it own the majority of VMWare, its storage franchises are also the ones to beat. ZachStocks' recent post about VMW (VMWare (VMW) - A Creative Way to Own the Stock) explains the VMWare situation really well so there's no reason for me to do repeat it. I have been looking at selling some front month puts in EMC at the 16 and 15 strikes. In particular, I would be delighted if I could sell the Feb 16 for a credit of 1.75. That would give me a cost basis of 14.25 should I get assigned. Given my (dumb) propensity to hold assigned stock, I'd probably hold this for a while until the general market turned around.

From the 3 month daily chart, we can see that EMC has been trending down but has been finding some support at the 16 level. So this could either work really well or we could see EMC start another leg down. Nothing like trying to catch a falling knife for some excitement.

According to the Yahoo options tables, +EMCNQ (Feb 16 Put) traded at a high of 1.40 and is now trading at 0.53. We'll see what the market does next week. If we get a week like last week (entirely possible given the expectations for another rate cut), there is a good chance of hitting my target.

Welcome to Options Strategery

Welcome to yet another blog about stock options, trading them, valuing them, swapping them for stock (i.e. exercising them), and using them to fulfill the risk seeking (or averse) side of your inner trader. I am going to look at mostly equity options but will expand my horizons and I learn from my readers. Hopefully, in the long term, I will even develop some options strategies, for now, you'll have to settle for strategery. I hope to better understand volatility (it's a bit like magic to me) and branch out into some exotic options like currency options or commodity options.