GSE bailout means interesting trading day

Financial stocks are going to be volatile on Monday following the Fannie (FNM) and Freddie (FRE) bailout. I am not whether this is good news or bad news but the S&P futures are up 3%+.

I don't think this changes anything so I am still going to be selling on strength in the financials. I am going sell some shallow in the money calls on positions like Wachovia (WB) or Bank of America (BAC) on the surge tomorrow. This is an opportunity to put on hedges at good valuations (despite implied volatility being low).

Shifted HD hedges to XHB

Yesterday, my GTC order to buy to close +HDCZ (HD Mar 32.5 call option) for 0.05 hit. This was a covered call I sold on some HD stock I was assigned from previous put selling at the 32.5-37.5 levels. At 0.05, it was not a good hedge and wasn't earning me much time premium. Given that HD reported today, I figured I'd want to get the upside if there was any. There wasn't and the reason I was able to close the options yesterdays was because other people already knew that and the implied volatility had fallen. Either way, I am just following my risk management plan.

I have been wanting to short some XHB for a while now but they are hard to borrow. So yesterday, I tried to sell some XHB Mar 21 call options naked at the ask but that didn't work. And for the first time in a while, luck was on my side. Despite more nasty economic numbers, we get another 6.4% gain in XHB lead by gains in HOV and LEN. So I sold a few front month call options naked at the 22 strike for around 1.50. This should give me a short position at 23.50 which is a little below the 200 day moving average. I haven't done much shorting before so I am just playing around. I figured that with my housing heavy portfolio (CBG, HD, BBBY), having a bit of a hedge on XHB couldn't be that bad.

I also tried to sell some April 65 FWLT puts (idea stolen from here) for 3.90 but it didn't execute. I like going long after a big drop but I have learned from experience. Stocks that fall hard tend to fall slowly afterwards. Often, you'll get another chance at the current price some time later or at a better price. So, I wasn't too eager to buy on an up day. But I will try again tomorrow, if it keeps dropping. 61.10 is an ok breakeven price for FWLT but not the sort of value I am looking for. For example, it is not as good of a value as AEO at 15.

I am practicing market discipline right now and keeping buying power high while hedging any of my positions that hit near term highs. I want to get out of as much stock as I can while maintaining positive delta. If EMC keeps going up, I am going to sell calls on my stock and start closing the puts I recently put on.

A naked put selling focused options trading strategy explained

Selling puts naked is a money making machine. You make money on most trades due to the positive theta and life is good. However, sometimes you bet wrong and you lose big. Winning in this game means we have to avoid the big losses while preserving the opportunity to profit. That requires risk management.

First, I want to say that I have no official system for this. No quantitative models, no portfolio insurances, nada. Just some gut feel. This is just my system. You could have a completely different system, and that would be fine. However, let me point out a couple pros and cons about this system.

Pro: Quantitative models and portfolio insurance give you a false sense of security. Equity issues are more correlated than ever and hedging correctly (without paying too much) is very difficult. Think LTCM.

Con: Basing large $$ decisions on gut feel makes it prone to emotions and mood swings.

Pro: This is how many traders operate. They make lots of money so they must be right, right?

Con: This is how many traders operate. They play with other people's money so it is easier to isolate emotions. Even then, we get an Amaranth Advisors once in a while.

My put selling focused options trading strategy is as follows:
1. Identify a good quality stock that I would want to own forever (or at least 5 years).
2. Identify a price at which I would buy right now. I usually do this by looking at fundamentals. I assume future earnings are either at or below the trailing twelve month (TTM) earnings. Given that, I low ball a P/E ratio based on historical lows of the stock or industry.
3. Take a quick look at technical support levels.
4. Try to pick a stock that satisfies the above and has high implied volatility relative to historical volatility (IV/HV).
5. Check that there is no news shocks coming up. This may include earnings reports, acquisitions, law suits, economic indicators, etc. Obviously you can't avoid all such outside factors but avoid the big ones. For example, do not trade RIMM on the day of earnings (at least in this strategy).

Take either track a or track b depending on how badly you want to own the stock now. Track a is good for a stock that I really want to own now since it maximizes theta. Track b is good for a stock that I want for the long term but not necessarily right now. I generally use track a for bottom fishing / knife catching and track b for long term Buffett style portfolio building.


6a. Write a near term at the money (usually front month ATM) put above a technical support but higher than my would buy right now price. The idea is to make money either from time decay or a drop in volatility. The front month ATM has the most theta and thus the most time decay. Since we picked something that had high IV, we benefit from a drop in IV.
7a. If I get assigned, I tried to sell a covered call on it such that the if the covered call is assigned, I would at least break even.

6b. Write a long term out of the money put such that if assigned, the cost basis is at or below than my would buy right now price.
7b. Sell a covered call if the stock becomes overvalued or is nearing near term resistance.

8. Repeat step 7 until stock is gone or if fundamentals shift greatly. Nothing says I can't change my mind and dump the stock. The above is the options trading strategy given that I like the stock.

Risk Management:

• Only sell options with enough time premium such that if I buy it back at 0.05, I can make a good return. Failing that, it must be close enough to expiration (I usually only do close to a week).


• Since I would not sell options for small time premiums unless they are close to expiration, I buy back options with small time premiums unless they are close to expiration. This is not a hard rule. Some times it does not make sense to only buy back an option that has huge unrealized losses. In that case, I usually either: give up and buy back the option (reduce my delta), roll the options down and/or out (maintain delta), write additional options (increase delta). That really depends on my outlook for the underlying.


• This requires a large amount of capital and is very high risk. The drawdowns will kill you. A more sane person would probably utilize stops. One of the obvious risks is that during a market downturn, you take assignment on a lot of stock and need to be able to carry that stock (either with cash or margin). To make things worse, when you are carrying stock during a down turn, you cannot make money by selling more options since you run out of buying power.


• This is just a strategy that I sometimes may follow. This is not a recommendation for you to use this strategy. In fact, it is a warning to those who choose similar strategies. It's feast and famine. When volatility is high and markets are range bound, it is all profit. In most other cases, it's not so happy.

This is the recipe for making my secret sauce. In theory, theory and practice are the same; in practice, they are not. Making money requires stock picking skill and trading ability. The key to this whole house of cards is step 1 which I gloss over.

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.