Explaining the Covered Call

Why did I do this? I see a lot of volatility and that is translating into premium pricing on calls.

There are 3 possible scenarios: stock advances, stays flat or declines.
I paid $3.75 and then rented out these shares for $0.40. The renter has until May to buy my shares at $4.

First of all, that's 11% for a 7 week period - an enormous rate for such a short time.
This is due to the implicit volatility and the market's expectation that >$4 is very, very likely. In fact, it hit $4.20 last week.

Let's assume that it is option expiration day:
Scenario #1: ETFC >$4
The call will be exercised and I will get paid $4. That is $0.25 gain on the stock and $0.40 on the call. Total gain = $0.65 or 18%

Scenario #2: ETFC $3.40~$4
The call is unexercised. I still have the stock and my cost basis is $3.35 ($3.75-$0.40). I am ahead and can write another call or sell or hold.
I am protected at least 11% downside by the $0.40 I received for the call.

Scenario #3: ETFC <$3.35 The call is unexercised. I still have the stock and my cost basis is $3.35. I am at a loss, but I can write another call and further reduce my cost basis. So in 2 of 3 scenarios I am ahead. In the 3rd scenario, I am down. The stock hasn't closed below $3 in 10 weeks, which is saying a lot. But it did see $2.25 in early January. The trick is in choosing a stock that I feel is trending up, not down. 1. Business is up since January and they have an additional $1B in assets 2. They dumped their mortgage exposure last quarter 3. The recent Fed moves will lower investment companies costs while raising their profits. 4. ETFC is down 90% from June when they were $25 5. They are still profitable (ignoring the write-offs last quarter) So what might occur between now and May expiration? Lets say it is April 30th. Scenario #1: ETFC >$4
The call will most likely be exercised and I will get paid $4. That is $0.25 gain on the stock and $0.40 on the call. Total gain = $0.65 or 18%.
I could buy bcak the call, but I'll be paying more than $0.40. I would do this only if I thought that ETFC was about to zoom higher. Possibly a merger with TD Ameritrade. In that case, I would be trading the likelihood of an 18% gain in 7 weeks for some hoped-for higher return

Scenario #2: ETFC $3.40~$4
Anything is possible. I could buy the call back (close it out) and probably pay much less than I earned because options erode in value over time.
For example, if ETFC is $3.75, I would estimate that the May $4 call would be ~$0.25. So I could close out the call and sell the stock and net $0.15 or 4% in 1 month.

In a Bear market, 4% in 1 month is good. If my options go unexercised, I would see 11% in 2 months or 5.5%, just above this 4%. So it's pretty good for 2nd place.

Or I can keep the stock, take the 4% net on the call, and see what happens. I can always write another call.

Scenario #3: ETFC <$3.35 Anything is possible, but the stock is clearly breaking down and re-visiting short term lows. After all, that is at least 11% below my purchase price and 25% below it's recent high. In any case, the $4 May call is probably super cheap: ~$.10. If i think the stock could crash further, I could sell the stock, I could close the call option and sell the stock, or I could close just the option and assume that this was a short term drop and that the stock will rise again. The key assumption here is that the stock isn't going down more than 15%~20% for any length of time. That is a VERY dangerous assumption and very risky. I am mitigating that risk (I hope) by carefully choosing a stock that seems to have bottomed. One last thing, I am deliberately writing short-term calls: 1 or 2 months at most. This gives me a good return while also retaining some flexibility. I actually hope for 1 of the following 2 scenarios: 1. ETFC >$4 in May. Lock in 18% in 7 weeks.
2. ETFC $3.35~$4. I would write another set of contracts, hopefully also for 11%.
My hope is that eventually the options are exercised and someone takes my stock. But not after I yield 11%+ a few times.
If I do this twice and drop my cost basis to ~$3 and then sell >$4, that's a nice 33% return.

Buying

Following on my last post:
Buying 2000 shares ETFC @ $3.75
Selling 20 contracts, covered calls, May $4 $0.40

What I am doing

There are several stocks that I want to buy
CF
ATW
WLT
MVL
ETFC

I am being cheap and hoping for a pullback that has yet to come.

What I may do is buy a bunch and then write the covered calls. For example, CF ~$110. Buy 100 shares and then write the covered call May $120 for $7.80. I do expect them to hit $120, so that would net $17.80 or ~16% in 2 months.

I think it's time to migrate what I've been doing personally into LiveRocket.

Market Rises Today, but Trends are Negative

The market is moving up today despite bad news.
* Corporate earnings continue to disappoint: JC Penny expects far lower results, Lennar sales were down 60% and KB Homes missed earnings completely.
* February consumer spending was flat at 0.1% (excluding food and fuel). This is very bad news – with inflation running high and taking more out of the wallet, a 0.1% rise is really a reduction in spending. Folks are buying less but paying more.

In the past, markets would get excited because bad news implied future rate cuts. In practice, the Fed doesn’t have much more room to cut.

What is exciting the markets is that personal incomes rose 0.5% and there are hints that inflation is moderating.

INFLATION
These are the moves of hope over experience. The economy is slowing down and will continue to slow down. Usually, economic slowdown is deflationary and prices are coming down in some places like housing. But in key areas like food, consumer goods, and energy, prices continue to surge.

No amount of economic slowdown will reduce those prices because global demand is driving demand for food and fuel. In addition, the US is facing a long term trend of a weak dollar.

While the Fed can play games with how inflation is measured, the reality is that the US consumer is going to spend less and save more. Fewer goods will be purchased. Layoffs will pick up. The vicious cycle will pick up.

PERSONAL INCOME
I don’t understand how incomes can be up when 63,000 people were laid off in February.
http://www.bls.gov/news.release/mmls.nr0.htm
I also don’t understand how unemployment was reported flat at 4.8% in the face of these significant layoffs.

The issue of personal income is around spending and inflation. If you can pay more and inflation remains low, then that is not a problem. And if you can pay more, then spending can go up. Except that consumer spending in fact went down. This supports my thinking that, however it gets measured, spending is going down.

One last point. January saw a reduction in saving which reversed in February. I wouldn’t read too much into that. January dissaving was just paying the holiday bills. February saving is probably tied to Tax season and the need to get ready to pay taxes.

It's a pause before another drop

The question was asked: isn't it a positive sign that the market has shrugged off all of the recent bad news?

Yes, but the market strength needs to be understood.
2 weeks ago, when I compared this cycle to previous market cycles, I showed that there were some rally points along the way. Dead cat bounces. It's a normal part of financial behavior.

But this particular one has some legs because the Fed is lending free cash to investment firms, not just banks. And the loans are due in ~2 weeks.

Clearly fundamentals are working against the market really rising:
* Corporate profits are falling. http://www.marketwatch.com/news/story/gdp-unrevised-06-weakest-us/story.aspx?guid=%7B3B6DDF46-888D-49CA-B53C-0183A4614A02%7D
* IT spending is slowing as evidenced by Oracle's earnings release
* Housing continues to weaken
* Manufacturing continues to weaken

The point is that I am not going to get pulled into this. Maybe there are some short term moves up, but I am not really looking to capitalize on them

Time to make some puts/calls

In general, the market looks ready to ease again. Good time to buy some quick puts to sell off by Friday.

I love the stocks that we were Stopped out of. Would be worth buying some calls. But right now, I'm more bearish than bullish

I'll be buying Wednesday am.

Hospitality under threat

As the recession begins to bite, the hospitality industry will be affected by cutbacks among two traditional customers: business and blue collar workers. Whether family cruises or business meetings, there will be fewer expenditures.

I just booked a trip to Puerto Vallarta at a major resort hotel in peak season. My rates are ridiculously low ($100 per night including taxes) AND the operator has told me that the hotel is very far from full.

Cruises – Both luxury and fun getaways, these have been especially big for folks looking to splurge. While there are elegant cruise lines, the bread and butter money comes from more down-market clients. Costs are not cheap – a typical cruise will start at $3300 per couple with airfare included. But those costs are competitive compared to a week visiting two destinations: $2500 per couple for 1 week room, board, and island hopping. That’s about equal to 1 week in San Francisco with a side trip to Napa Valley. (hotel = $1400, food = $700, drinks and entertainment = $300, car to Napa = $100)
Many people budget that much for vacations. I suspect that, in fact, discretionary vacation spending will drop and shift to a mix of time at home and time on the road. Hey kids, lets drive to see the Grand Canyon!

Recently, Carnival Cruise Lines announced that all was well and that fuel costs were being managed thru fuel surcharges. But most cruises are big events, so they are booked well in advance. If there is going to be a slowdown, it won’t be seen for a few months as cancellations mount (better to be out $300 and not $3300) and as vacationers stay away. The cruiselines will respond with various discounts and gimmicks, all of which will hit the margins. They will respond by delaying refurbishings, squeezing their vendors, and various cutbacks. But there isn’t a lot that they can do. I bet those fuel surcharges don’t last, either.

Hotels – Buoyed by international travelers but hit by a loss of business travelers and conferences. A lot of cancellations are happening as companies trim costs by cutting back on extravagant business meetings and holding them locally. Or not at all. One large corporate meeting for 100 people is $100K for a hotel. If every Fortune 500 company cancels one such event, that’s a lot of money not being spent.

International hotels benefit from the weak dollar – Starwoods, for example, does 50% of business overseas, so that’s an automatic 20% profit increase on 50% of the business.

I could see more low-end hotels doing well as folks move down market and focus less on accommodations and more on destinations. Choice hotels would be a good long play for that. But a forward 22 P/E looks high. Still, they could steal business and stay ok

In general, I would beware going bearish on hotels

Casinos – Fun fun fun. And Vegas is good at running specials like free or almost free rooms. But the concept of gambling is more appealing to those with money or those desperate to get some. Vegas can be a place for cheap thrills, but not as much as it used to be. And if more gun shy visitors come and don’t gamble, margins get squeezed.

CRUISE LINES
Down only 20% in 1 year – ready for a deeper crash
CCL – The budget travelers choice. Revenue was up ~15% last quarter but profits are sagging. Sure gas prices have an effect, but costs are just up. The only shining light is the $2B+ in short term debt that will benefit from falling interest rates. But that’s a lot of debt. In any case, they seem fairly valued for slow growth, but I think bookings and onboard spending continues to droop.

RCL – Revenue is up 30% Year over Year, as is profits. Although not as debt loaded, they face the same problems.

CASINOS
In addition to Vegas, casinos are looking to Macau for Chinese gamblers and to condo and timeshare sales in Vegas. The former is great, but the latter is a money pit.
Business is off - I'd short al lof them

MGM – Performance doesn’t justify the 30 P/E. Not much growth last quarter
Las Vegas Sands – Very dependant on potential Chinese market. And that market is raging.
Wynn – Hugely successful but overpriced. I would buy in the 80s. But they are not exposed to the timeshares and condos.

False Rally Continues

Do not mistake this for anything except a pre-earnings move up, with a touch of the Fed juicing the market.
It is short term (measureable in weeks) and will sucker money in before crashing below 11,400 by the Summer.


The good news is really not good news - it's more like saying the compound fracture is only 8 breaks not 9. It doesn't matter: the patient isn't walking anytime soon.

Excited that Bear Sterns is worth a lot more than $2? Maybe even $10? Tell that to folks who bought it 2 months ago at $80 or 2 weeks ago at $30.

Keep perspective.

* Manufacturing is down
* Housing is down. The Fed doesn't have enough money (it needs $3T) to buy all the dud loans and derivatives
* Cash is scarce.
* Unemployment is rising and will continue to rise.
* Retailers are struggling. The consumer is tired

I don't think a $1,200 check is quite enough to forget all of these woes.

Yes, our puts are down, but I'm not worried. Plenty of time