The Deal is Done

Monday morning, Sept 29, and the Deal is Done. We are going to get our $700B "bailout" of the American, if not world, financial system. But is this too little, too late to save the economy. This is what we have yet to find out.

There is no doubt in my mind, that if a deal hadn't been done by last night, we would have had an immediate devastation of the world stock markets. The backstop of the financial system will just allow the air to be let out of the balloon more gradually and less catastrophically. But the market is headed lower, maybe much lower, as the full effect of financial deleveraging and consumer angst is felt.

Another theme is developing: we will have many fewer banks in the next year, than we have had in the recent past. There is a deliberate effort by the Treasury and FDIC to consolidate banking assets to a few strong, or less weak, banks so that the crisis can be better managed. The "chosen ones" are apparently: USBank, Wells Fargo, JP Morgan, CITI and Bank of America. Goldman Sachs can also be added to the list as the only major investment banker left standing. I am somewhat vindicated in that I have long said (since last August) that I thought BAC and C would be considered "too big to fail" and would be protected by the Feds. I have to admit, though, that I have lost some money on this bet as even when I am right about their solvency, I have been wrong about the stock price.

All other banks are at risk. We know this because of the pattern that is developing. The FDIC just can't afford any more IndyMacs, which went bust in an uncontrolled way, leaving FDIC on the hook for $14B (or so) of insured deposits. FDIC only has around $45B of assets, so it can't afford to have all the banks go bust without some pre-emptive efforts. In the past week, it has overseen the dissolution of WaMu (assets only assumed by JP Morgan) and now, today, Wachovia (assets and liabilities assumed by Citi). Both banks were heavily exposed to the residential mortgage market.

On the investment banking side, Bear Stearns and Lehman have already been taken out with the help of Federal agencies. Morgan Stanley took itself out by selling itself off to Mitsubishi Bank.

What is next? The wave of banking failures is spreading around the world. Fortis and another less well know British bank were also dissolved over the weekend with assets transferred by European banking authorities. There is plenty of toxic exposure in China and other major Asian economies. The total effect of all this banking damage will be very negative for the world economy for many quarters to come. The markets must take a hit to reflect this reality.

Advice: it is too late to run for the exits, IMO. But, a little short side protection on existing positions is called for. I will buy SDS, the inverse and doubled short on the S&P500 index, in the next couple days. There may be an additional benefit of this action as I think when the Short Sale prohibition on many Financials comes off next week, that short positions may pop as a result of pent up demand into such a weak market.

Hold on for a Ride Up

Looking at the market before the open this morning, of course I wish I had a lot more Financial stocks than I do. The UYG and XLF will explode higher this morning. I had been short financials by selling the puts of SKF, a short fund. But I closed out my position yesterday because I hoped the actions that took place would happen. I closed it with SKF running very high on fear at $140. Today, SKF may open below $90. Boy, that was close. That would have been expenisve if I had not gotten out yesterday.

Meanwhile, the very large Goldman Sachs position I hold is looking a lot better. It was trading as low as $85 midday yesterday. I own it at $172 (actually, the options, but the loss would be the same). Today, it looks like it will open above $140 and could go to $160 during the day, getting me back close to even.

So, though I won't have a chance to get back into my long UYG position (the opposite of SKF), because it is soaring in the pre-market, I am happy for what I have. Hopefully you will also have a very nice market day with the action in front of us.

Be glad you are not a professional short seller with big short positions in Financials (hedge funds, Al Queda?) They will be wiped out if naked (not covered by equal long positions)

Sell Commodities Now

Yesterday it became apparent that the short term play was to short commodities, the more volatile the stock the better. By the time I was home from the office and had formed a strategy to implement the idea, the Extended Market was closed. I have not yet become so sophisticated (neurotic / obsessive) as to open a 24 hour account where I can play the foreign markets late into the night. But looking at Bloomberg around 10pm my time, it was obvious the commodities were accelerating to the downside with gold off 8% in Asia. BHP, FCX, GLD, OIL were all off by a significant amount as well, so it was a general commodty selloff.

So, this morning, with strategy in hand, I got on the laptop and started trading as soon as the Extended Market opened on ETrade at 7am my time. I quickly put in short sale orders on AUY (Yamana Gold), AEM (Agnico Eagle Mining) and SKF (Proshares Ultrashort Financials). As mentioned a few days ago, the Extended Markets are very thin with just a few other nutty players like me. So, it is a bit like trading with your neighbor. I put in an order on AEM at $67.25 between the Bid and Ask price at that time, and then saw the Bid and Ask move down below my order price. I changed my order down to get between them again, and the Bid and Ask moved down once more. Obviously, there was an after hours trader on the other side who was luring me down. So, I changed direction, raised my offer to $66.90 and waited. About 15 minutes later, the transaction went through. I was short AEM.

The Yamana went more smoothly, though I had to offer $1 less than the close yesterday, which is about 7%, or most of the overnight correction in Asia. I sold 500 shares short for $15.80. It had been as high as $19 a week ago. But having followed this stock a couple years, and played its options, I know it is high beta and can easily go down to $12 from here. As soon as the order executed I put in an order to cover at $13.13 on AUY and $60.10 on AEM. No reason to get greedy. A 10% plus return on margin in less than a week will be fine.

I tried the same approach with SKF, which I just hit for a 15% return in one day on Tuesday. I put in an order at $121 which was close to the ASK price. The Bid – Ask quickly moved down to around $119 as the counterparty saw some live bait. But I didn’t bite. Instead, I raised my offer to $121.80. It never hit by the market open. (Update: SKF closed around $106 on Thursday, March 20, so if the short sale had executed at $121 in the morning, it would have meant a nice $1500 one day profit on the 100 shares I tried to sell).

Right now the market has been open for 25 minutes. I am ahead on AUY which is at $15.59 and AEM which is at $65.59. Both opened quite a bit lower on the pent up demand to sell. Once again, the Extended Market turned out to be a better way to play the short side on these fast moving stocks. I will let you know how the trades turn out.

Trading Off the Bottom

I made a couple of trades this morning (Tuesday, March 18) before or at the open, based on the turn around in sentiment over night. Goldman Sachs and Lehman both reported better than expected earnings and revenue for the last quarter (ended on Feb 29). GS was up almost 100% on earnings estimates. A couple of days ago, these "beats" would not have mattered to the market. The market was selling on good and bad news. But today, with the moves by the Fed yesterday (Sunday-Monday) to back up even the investment banks with the discount window, lower discount window rates (3.25%) and acceptance of collateral as low as BBB rating (basically "junk"), the market psychology towards financials has done a 180. I was just shorting financials last Thursday and Friday. But, you know the old proverb "don't fight the Fed"!

Yesterday I doubled up on some options for January 09 expiration (sold another 5 put contracts on BAC $45 for $12.10). I also pushed out my WM $17.50 put options to April expiration, from March (this week) to give the market a little more time to get its footing on financials. Both these moves are already paying off today.

This morning, I sold short 100 shares of SKF, which is the 200% inverse ETF on the XLF financials index. The SKF goes up when the financial stocks go down, and vice versa. By doing this, I am able to take advantage of the move up in financials today (and probably the rest of this week) double the market return, and do so with borrowed money on my margin account. I will take this one off within 4 days because it is so volatile. I also bought another 5 Call contracts on the BAC Jan09 $50 for only $0.95. That is a cheap bet that BAC, which has acquired the assets of CFC, will get back close to where it was in late October. All the options and short moves are in my "speculation" accounts with less than 10% of my total portfolio, or my "Mad Money" to use the overused phrase of Jim Cramer.

Short Sale - Long Collar: the Perfect Hedge

This may be the perfect hedge: Short Sell a weak stock and then use a long collar to protect against it going higher.  I have been experimenting with this strategy and it is so far working very well. 

 

Here is how it has gone: on January 15 I sold short 300 shares of Radioshack (RSH) at 14.17.  RSH has shown weakness for over a year, though it did have a good spike the middle of 2007.  But lately, it has done poorly along with the rest of specialty retail.  Because the risk on a short sale is unlimited to the upside, I wanted to provide protection, so I bought (3) Feb $15 Call contracts for $0.75 each (each contract covering 100 shares).  To help pay for the Calls I sold (3) Feb $12.50 Put contracts for $0.40.  This left me some room to the downside to profit from continued weakness in RSH (14.17 - 12.50).  If the price of the stock continued to drop below the strike price of the sold put, I would realize a profit of $1.67 + 0.40 - 0.75 = $1.32 per contract (or $396 for all 3) when the put was assigned, taking out the short.  Over the one month time frame, this would provide an annualized gain of over 100% (using only margin, as shorts and sold puts require no capital).

 

But what would happen if the price of RSH rose in the meantime?  I just found out and am pleasantly surprised.  The fear of all short sellers is a rising stock price.  But using the collar, I guaranteed upside protection with the Call contracts.  I sold those contracts yesterday as the price of RSH had risen to $16.80 at the time of the sale.  Here is how the math has worked out on this transaction:  Call price on 15 Feb strike rose to $2  on Feb. 1, 2008 (it was at $2.70 earlier in the day but I have job and wasn't monitoring the contract price).  I closed out the Call contract for $2 and also closed out the short Put contract at $0.05.  My total gain on the Put and Call option contracts was (0.40 - 0.05 + 2.0 - 0.75) $1.60.  In effect, this raised the basis on my short to 14.17 + 1.60 = 15.77.  

 

I turned around and did another collar, though quite a bit higher, with a March expiry sold Put with 17.50 strike for $1.53 and a collaring $20 Call for a paid premium of 0.68.  The worse case scenario is a close below 17.50 on March 22 in which case the put option would be assigned and the Call would expire worthless.  In this case, the total possible loss is $17.50 - 1.53 + .68 = 16.65 - 15.77 (new basis) = 0.88 a share, about the same risk as for the Feb contract, so effectively rolling the strategy forward even in a market with rising prices.  But if it closes above 17.50, the sold put premium will be booked and will again increase the basis on the short position. 

 

Bottom line: this is a reasonable way to put in shorts against weak stocks while mitigating risk.  The weakness of this strategy is limited profits on a dropping stock price.  But it will do very well with flatish prices (renewing the collar will generate profits each month) and will provide protection with rising prices.  It might be possible with this short strategy even to profit with rising prices with good timing (which was not the case here as I gave up 0.70 in profit with bad execution on Friday). 

 

I will keep you posted to performance future months, and may add a couple more candidates, like Washington Mutual (WM), Garmin (GRMN) or CROX.