Investoid

Some traders look for ‘high probability’ trades, based on mathematical assumptions about how stocks behave. Others look for arbitrage opportunities or other systematic deficiencies that can lead to a guaranteed (or nearly guaranteed) profit. One of the opportunities I find that presents a high probability and highly profitable trade is index changes.

Once in awhile, major indices will change the complement of stocks in their basket. Sometimes this is due to some companies going private, other times it is because a company has outgrown an index’s stated target (eg. a small cap index). In yet other instances a company is failing to meet listing requirements or is otherwise being halted from trading. Whatever the reason, when a company is added or dropped to an index it is a good trading opportunity.

Why? Because in today’s passive investing world, there are trillions of dollars dedicated to tracking various indices. This means that when a company is added to an index, index fund managers are obligated to purchase the stock reasonably quickly, or else their fund’s performance will begin to materially deviate from the underlying index. Furthermore, many actively managed funds are closet index funds, meaning they want to ensure they typically purchase the companies in an index to ensure they do not underperform their benchmarks.

This adds up to a lot of buyers chasing a relatively small amount of sellers. The Vanguard S&P 500 Index alone has $175 billion under management. Even if a new company takes up only 1/2000th of that index, that means the fund must purchase $87.5 million worth of stock in a company that probably has a market cap of about $10 billion, which represents nearly 1% of the company’s total shares outstanding. And that’s just for one fund, albeit the biggest. The opposite effect is true for companies that are dropped from indices. The larger the index (and the more followed it is), the greater the effect.

As a result, you typically see a sustained run in a company’s stock for anywhere from a few days to a few weeks. It is especially astute when the announcement occurs prior to the actual change: despite the fact that the stock will jump on the news, the true increase in price will only occur once the change happens and fund managers begin to buy the stock.

One recent example of this phenomena is Expedia (EXPE: Nasdaq). It was announced on Sept 24 that the stock would be added to the S&P 500 on Oct 1. The stock jumped about 5% on the news, but settled around that figure for the next several days. Since Sept 28 (the last trading day before Oct 1), the stock is up another 9.9%.

I played this news by buying a slightly in the money call option. I purchased the Nov $30 call option on Sept 26 for $3.20, and sold it on Oct 2 for $3.90, yielding a 22% gain (not including commissions). While I could have held on for hopes of higher gains (the option is now worth $4.90), but I had hit my target profit and needed to follow my strategy rules.

I have yet to find a specific site or news source that will let me know of upcoming changes to indices, so if anyone out there knows, feel free to leave a comment.

I was approached by Timothy Sykes, a trader who met with success while he was still in high school, to read a pre-release copy of his book, an An American Hedge Fund. I agreed to read it, not sure of what to expect.

After reading through it, I found that the book is an interesting look at Sykes’ life to date. He made the bulk of his money riding penny stocks during the dot com boom, and subsequently continued to increase his wealth during the bust by shorting the same type of companies he rode on the way up. Eventually Sykes decided to leverage his personal funds into creating a hedge fund. While Sykes goes into detail about how he made his millions, this book is not about the method. It is more of a biography that has some interesting thoughts and lessons for active investors/traders.

For me, the most insightful aspect of his book is how he keeps hammering home the mistakes he made and the psychological traits that were behind his trading decisions. I think this is a crucial aspect for anyone to understand in order to achieve long term success in active investing/trading. Sykes’ no holds barred confessionals made me feel like I’ve learned through his mistakes.

Sykes devotes the last part of the book to his trials and tribulations as a hedge fund manager. He becomes disenchanted with the hurdles that hedge funds face when trying to raise capital, and uses this as motivation to write the book. While I enjoyed reading the ending sequence regarding hedge fund regulations, I thought some more detail would be beneficial (although maybe just an egghead like me wants to know the specifics).

Overall, Sykes has written an engaging book that provides some solid lessons about trading psychology. He has a readable style that makes you want to finish the book as soon as possible.

For more info on Sykes’ new pursuit of investor education on the hedge fund industry, check out his website.

Disclosure: I will be receiving a complimentary copy of the book for my review of his work.

The big news on the Canadian financial stock front is that TD Bank (TD: TSX) has agreed to buy Commerce Bancorp, a regional US bank. As the Financial Post article indicates, TD is taking advantage of our historically high dollar to leverage their buying power in the US. Our banks have become relative minnows as financial institutions around the world have consolidated since the early 1990s. The big 5 in Canada have not participated in this wave due to federal regulations restricting mergers within our domestic banks as well as regulations limiting the amount of foreign ownership in Schedule 1 banks.

While Canadian banks have not kept up with global competitors in terms of size, they have exceeded the typical global financial conglomerate in terms of profitability and shareholder return. Since our banks face little competition on the retail banking side, they have been able to milk consumers for high profit margins. Meanwhile, global banks have faced stiff competition around the world as they begin to tread on each other’s turf. As a result, large firms such as Citigroup and Royal Bank of Scotland have underperformed our little banks to a large extent. Overall, our financial sector has outperformed similar US firms over the medium term.

While having Canadian banks eat up smaller US and other global firms may give shareholders and management a good ego boost, I wonder about the long term affect on the bottom line. Most Canadian banks have mixed records of integrating foreign assets into their operations, and rarely have any such assets ever met the same rates of return on capital that domestic operations have. Such acquisitions invariably reduce short term earnings, which may never become accretive. That said, I understand the trepidation that such banks face, seeing how small they have become.

Nonetheless, I am more interested in firms who are looking for higher growth areas than the US. For instance, Scotiabank (BNS: TSX) has a much more emerging market-oriented strategy, which I believe can produce similar rates of return (or at the very least similar absolute earnings growth) to domestic operations.

Make sure you evalute your Canadian financial holdings when they make foreign acquisitions. Depending on the size and scope of the deal, it may materially affect their performance for years to come.

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.

As I am becoming immersed in the option trading world, I have come across some pretty good blogs dedicated to option trading. Here are my favourites:

• Option Pundit: is dedicated to providing consistent income through option trading. Earlier this year Option Pundit (OP) started a paid newsletter that details his portfolio trades, which have demonstrated extremely strong returns. He now has a goal of achieving 100% annual returns, and is well on his way. OP uses a variety of option strategies, although he seems to favour credit trades (ie. initial trade causes him to receive money, instead of outlay money). While the English suffers at times, the quality of the content is unsurpassed.
• Option Addict: a blog run by Jeff Kohler, an instructor for InvesTools. He is mainly a directional trader, meaning he looks for strong 3-6 month trends or other technical indicators in individual stocks and then waits for pullbacks/bounces to enter options trades. I haven’t read through his blog archives in depth, so I’m not sure if he favours buying calls/puts or using credit trades like pull put and bear call spreads. He offers several companies to watch on a regular basis, although he rarely (if ever) provides specific trade information.
• My Traders Journal: is written by a person who works full time at AT&T while finding option strategies to augment his income. He mainly focuses on writing naked puts, which can be a risky strategy if you don’t want to own the underlying. Since this strategy is synthetically the same as a covered call strategy, he uses it as a way to lower his entry cost to a stock he likes in the worst case while getting a steady income in the best case.
• Option Strategies In Action is written by Canadian John Manley, who runs a research firm. He talks about specific trades and setups in stocks and indices, and goes through trade adjustments in detail. He also focuses on credit trades for the most part.
• Condor Options: is a blog that discusses market happenings, and details the trades post completion that they do for their paid advisory service. They focus on iron condor trades on index ETFs, and have a pretty good track records over the past year. Even during this turbulent time, they were able to be essentially neutral this past month, which is pretty good for a strategy that is market neutral and depends on little movement either way. Their service currently has a waiting list.

If anyone has others that they like, feel free to comment below. I’m always looking for more information and opinions.

As I’ve mentioned before, when you trade options you are working with a product whose value will change in a non-linear manner with respect to the underlying. When you are working with out of the money options, this means that you will experience very high percentage changes to the option value for every dollar change in the underlying asset. However, the farther along the option chain you go into the in the money options, the closer the change resembles the movement in the underlying asset.

Take for instance a ‘deep in the money’ (DITM) option. Let’s say you have a stock worth $50 and you buy a call option with a strike price of $40. That means that right now, the option is worth $10 + some time value (which depends on its expiry date). If the stock declined to $49 in one day, in theory the option value would decrease to $9 + time value. If the option has a far away expiry (at least 4 months, preferably 8-12), then it is likely the option value would only go down $1 since the daily time decay on such options is very small. Similarly, if the stock rose to $51 then the option is now worth $11 + time value. In option terms, the option’s delta is very close to 1.0.

Since these options behave very closely to the underlying, if you hold a DITM option you essentially have a long (or short) position in the underlying, until such a point that the stock has moved closer to the strike price (ie. against your position). When you’re buying a long term DITM option, you are making a leveraged buy or short decision against the stock. This leverage ratio can be greater than what your broker would provide you on margin, and does not have any interest to pay. It is an interesting strategy to use if you are bullish or bearish on a stock with liquid options.

Lenny Dykstra uses this strategy and chronicles his trades in his thestreet.com column. He has a pretty good track record when using this strategy, although as of yet it isn’t that long.

There are a couple of things you need to watch out for when using this strategy:

• Don’t buy these options at the ask price. Longer term options are relatively illiquid and will have bid/ask spreads of at least 20 cents. Place a limit order at a price you like and make sure you adjust it if the underlying moves significantly.
• Determine your stop loss and profit limits for these trades. Since you are highly leveraged, a small move in the underlying can make a big difference in your return. I haven’t used this strategy yet, but I’d be looking for a max risk of about 15% with similar upside (ie. risk reward ratio of 1).
• Look for options whose time value seems reasonable, meaning that implied volatility isn’t too high. Compare prices across expiry dates as well as strikes, to find a reasonable entry point.

I am thinking about using this play on a short basis against the US Real Estate Industry, via Dec 07 or Jan 08 put options on the iShares ETF IYR. Today the index was higher but gave up its gains. If another rally occurs without any material change in the fundamentals of the space, I’ll be looking to make an entry.