Two Interesting Drops: Whole Foods Market (WFMI) and Otter Tail (OTTR)

During the day, Otter Tail (OTTR), a wind energy play, is down 20% and back to reasonable valuations after an earnings miss. Possible slow down trend in days to come as the Cramerica crowd get nervous. After that, it's a good put selling stock. High dividend payout means that there is some pricing support (and it's great to carry the stock while selling calls against it). I am looking at selling some longer term options.

Don't know much about OTTR. Did a rush read through the annual report during the day. They are a bunch of diversified businesses. So I am going to add some delta and then see where it heads. I like dividend stocks in interesting industries.

With the new lower multiple, it might be interesting to pair trade OTTR and FPL (i.e. short FPL and long OTTR).

Whole Foods Market (WFMI) misses and guides down. WFMI is down 20% after hours. I am short some Aug 24 calls against some naked Nov 25 puts. Looking to increase delta at these levels through a combination of events. Let the Aug 24 calls expire. Buy back the puts and the stock (artificial assignment). Then sell some more out of the money puts.

It wasn't hard to guess that WFMI would miss and guide down. High end groceries in a consumer led downturn. It's a matter of whether the news is priced in. On a huge rally day, the news seems particularly bad.

So, the interim plan is: Sell covered calls on banks (WB, BAC, BCS); sell front month naked calls (as a way of initiating a short position) on credit risk plays (COF, FNM, FRE); sell long term out of the money naked puts on commodities (CHK, FCX, VLO, TSO, FTO).

General Electric (GE) gets hit by an earnings miss

From GE investor relation: GE announced first quarter 2008 earnings from continuing operations of $4.4 billion with $.44 per share, down 8% from first quarter 2007.

As they say, "the market has a paddle big enough to give anyone a spanking". Nothing could be more fitting when the second largest company in the world by market capitalization (eclipsed by XOM due to the recent rise in crude). GE is down a whopping 14.66% or 4.70 to 32.05.

Not long ago, Jeff Immelt all but promised 15% growth this year. GE hasn't missed a quarter in years and even when it did in 2003, the miss was a penny. A 7 cent miss is huge for GE.

This is another example of the long tail of equity pricing. Stock prices do not follow a normal distribution; they have long tails. This is also known as Taleb's Black swan theory. Every options trader should be very comfortable with the idea that substantial moves happen more often than predicted by models. Such rare events is what makes naked options more dangerous than the statistics would predict.



Now back to GE. Industrials were strong due to currency and rest of world demand. Appliances down due to housing crisis. Financials down due to mark downs. Healthcare down due to lower demand for capital diagnostic equipment. None of this is surprising, per se. I don't know why analysts didn't bring down estimates.

I was slightly long GE before this (long the stock, selling calls against). I see this as an opportunity for me to pick up for shares for a great price, 15x trough earnings. I am selling at the money puts for June and September. The options markets are not increasing the implied volatility. This is bad since it means I get less time premium. This is good because it says that options traders are optimistic. Either way, I am reserving extra capital to handle a dip (since I am at the money) and in case of a volatility spike (since IV is low).

USEC (USU), an interesting Uranium / nuclear energy play

With oil hitting new records, everyone is looking towards other energy sources. Natural gas is no help, that's expensive too. In fact, the reason we have so many natural gas power plants is because we thought it would stay cheap. For an example of how difficult it is to predict natural gas prices, look up the Amaranth Advisors disaster. Coal, solar, and nuclear plays are all being bit to new highs.

I think most of this is irrational. Energy prices are high due to a speculative bubble and market manipulation (by OPEC and others). Stocks in those sectors are also incredibly expensive. Take Exelon Corporation (EXC), a nuclear plant operator. It is in a great position because no nuclear plants are being constructed. However, I do not like owning any utility at a P/E of 20. That's just silly.

While doing some research on nuclear energy, I did find an interesting little company called USEC (USU). It is the owner of the United States Enrichment Corporation. USEC (USU) was privatized over a decade ago. It currently operates a gas diffusion enrichment plant which is barely breaking even. (Enrichment is a part of the process that creates fuel for nuclear power plants). It also performs some contracting services for the United States Government.

A company with only one operation that's barely breaking even -- that doesn't sound very good at any price. However, the story behind the stock is that it is building a new gas centrifuge enrichment plant. It is expected to use 95% less energy than the current plant (rising energy prices is why the current one is barely breaking even).

So, why is the stock in the dumps? Well, the project is 50% over budget and likely to be behind schedule. There are lots of other companies doing the same thing. In this credit environment, a small player like USEC (USU) may not be able to get funding to finish this plant.

So, why buy the stock? Well, recently President Bush passed a series of bills that includes loan guarantees for nuclear companies. USEC (USU) is likely to qualify. Its competitors face difficulty in placing their new plant due to NIMBY (not in my back yard). USEC (USU) has two properties on lease from the DOE for this purpose.

With the current price, there is a lot of upside for moderate downside. I've been picking it up since the 6.50 level and will continue to accumulate. I am also looking at selling some puts at the 5.00 strike.

Lots of risk, but if you believe in the nuclear renaissance, USEC (USU) is definitely a ticker for the watch list.

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.

Added delta to SIRF and WB amid market freefall

Another day with blood in the streets. Institute for Supply Management (ISM) non-manufacturing survey results are out early and they don't look good. Survey says: Recession. Panic ensues and we get another 3% drop across the board.



Keep in mind that this is a survey and if everyone is flooded with recession news, they will believe that a recession is coming. This is also known as anchoring bias.

The hedges that I put on a week ago seemed dumb at the time (and a bit early) but they drastically cut my losses today. Without hedges, I am about ~4x leveraged and with them, I am about ~2x leveraged. However, some of my hedges are running out of premium (probably a good time to buy the calls back). In general, my portfolio has a naked put / covered call profile where I am long delta with negative gamma. So as the prices decrease, I am getting more delta. This fits well with my value based strategy. As prices decrease relative to value, there is a better risk/reward tradeoff and I am willing to take on more delta.

I have been reluctant to buy after the rally last week since I've turned more bearish while the market sentiment turned more bullish. I also could not understand why prices should go up given the constant stream of bad news. The rationale that bad news => fed cut => financial recovery is silly. It's like saying mortgages are good cause the government gives you a tax break on the interest. Rate cuts are weakening the dollar and causing a rise in commodity prices which are increasing costs for businesses. On the other hand, rate cuts are not increasing consumer spending due to constrained credit (i.e. banks are do not want to lend at these lower rates since they would rather use it themselves as capital). The 'consumer led recession' is leading to demand destruction. When supply decreases (due to higher inputs) and demand decreases (due to lower income), equilibrium output decreases (i.e. GDP decreases). And GDP decreases define recession. So, recession, here we come. But the word doesn't really mean much to me per se. I see it as an opportunity to pick up more assets at a lower cost. Capitalism at its best. I actually hate bull markets because it is hard to make a living as a put seller since I try to have enough discipline not to chase stocks. On the other hand, I love to sell insurance for quality companies at low prices and high premium (thanks volatility).

SIRF gave really bad 2008 guidance. 6+ brokerages smacked it with downgrades. Stock is down 55%. GPS technologies are good, but consumer electronics are bad. Niche analog semiconductor companies are good, but semiconductors are bad. Basically, I see SIRF as a good growth company hit with bad macro trends. However, I think they will do ok in the coming slow down. GPS devices are so competitive that the price reductions will be hitting the device manufacturers hardest. Sure things are bad but not 7 a share bad. SIRF has never traded at this level before. Although they have been issuing shares and diluting shareholders, it isn't that bad. Take a look at the past annual reports. I checked the current ratio and did a few quick solvency tests and they seem to be able to whether the storm. I doubt they will continue to issue shares at these prices (if they do, the management need to be replaced). We might even see a share buyback. The 1.4 a share in cash also doesn't hurt.

I sold a bunch of Feb 7.5 puts at around 0.5 and a bunch of Mar 7.5 puts at around 1.25. That would give me an average cost basis of approximately 6.75. Backing out the cash, that means I'd be paying 5.35 a share for a growing business in a great segment. That's me rationalizing my purchase; it could turn out to be stupid but analyst downgrades always make me over confident.



I also sold some Mar 30 WB puts as I have been doing for the last couple of months.

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.