Thursday, September 30, 2010

Renewable Energy: The US Secretary of Energy is Onboard!

As you know, I'm away in Los Angeles this week.  My company actually sent a coworker and me to attend a laser conference, ICALEO, that's taking place here.  There was an awards ceremony today and the US Secretary of Energy, Steven Chu, was the recipient of one of the awards.  He was a recipient of the Nobel prize in 1997 for his work on trapping atoms with a laser (how cool is that?!).  It's not everyday that you're in a room with a Nobel laureate (actually, there were 2 of them, the second being Charles Townes, who invented the maser [precursor to the laser]).

Anyway, I digress...what I wanted to talk about was Dr. Chu's speech.  The first half of it was essentially about how he got to where he is today.  It was a very interesting story, but I won't go into it.  The second part was about America's future.  He talked about global warming and he said that there is overwhelming evidence of global warming, but many people remain unconvinced.  He compared this to how for many years people did not believe that smoking cigarettes was harmful to the body.  Well, they were wrong there...and the unbelievers will be wrong again.  I absolutely agree with what he says, but even if he were wrong, there is something to be learned here.  Here is the US Secretary of Energy talking about the risks of not doing anything to stop global warming.  What policies do you think will result from his stance?  I can bet that he will be pushing for development of renewable energy.

It has become apparent that our world is shifting to one that embraces renewable energy.  If you were a politician, the right thing and the popular thing to say is that you are green and will endorse the shift away from oil and carbon-based energy.  The megatrend has begun!  Don't miss out on this excellent investment opportunity.  By investing in renewable energy, you'd be fulfilling your responsibility as a steward of the Earth.  Don't know where to start?  Go to one of my recent posts on solar energy!

I will leave you with a Native American saying that Dr. Chu quoted in his speech, "Treat the earth well: it was not given to you by your parents, it was loaned to you by your children."

Saturday, September 25, 2010

S&P500 Reverse Head and Shoulders in Action

I'm going on a business trip to Los Angeles for a week, flying out tomorrow morning.  So, just a quick one before I leave...

The above chart is that of the S&P500 index.  A reverse head and shoulders pattern has just been confirmed, with the index breaking above the "neckline".  You can expect the index to reach 1230 points as a target.  Note that this is a purely technical indicator and has no fundamental basis, whatsoever.

So, how does it work?  Technical analysis is loosely connected to behavioural economics.  From behavioural economics, we know that people tend to conform to the general populace and is loss averse.  In the case of technical analysis, since investors believe other investors look for technical indicators, they would not want to miss out on this great run, and decides to jump back into the market.  Therefore, the pattern is almost a self-fulfilling prophecy because this new money flowing in drives the prices up further.

Depending on what your outlook on the overall market is, it may be a good time to either jump back in (if you believe the past few months has been a correction), or to take profits/cut losses (if you believe a double-dip is in the works).  What do I think?  I'm undecided until I see the S&P500 breaks above the 1220 point resistance.  Proceed cautiously!

Friday, September 17, 2010

Shorting a Bear Leveraged ETF: A Sure (But Impossible) Win

Some say that the stock market is like the casino...and I say they are right (in some cases)!  I can show you how you can be the house and have the odds stacked in your favour.  Just a small note: you can't actually execute this strategy...sorry!  Unfortunately, there's no free lunch.

Bear ETFs
In recent years, ETFs or Exchange Traded Funds have emerged as very popular instruments.  Traditionally, there were stocks and then there were mutual funds.  With stocks, it was possible to execute orders in a matter of seconds.  Literally, you could jump in and out of the same stock hundreds of times a day.  On the other end of the spectrum, you have mutual funds, which you buy from the company that runs that mutual fund.  If you wanted to buy or sell shares of that mutual fund, the transaction usually take a few days to show up on your account.

ETFs have bridged the gap between the two.  ETFs trade almost identically to company stock shares.  Orders can be executed in a matter of milliseconds and there are even options of ETFs.  However, as the name suggests, ETFs are funds, pooling investor's money to buy a number of securities, whether they be stock, options, swaps, etc.  Usually, ETFs will try to mimic the movement of a certain index (e.g. SPY with the S&P500).  To satisfy the market's demand for shorting stocks, bear ETFs have been created.  It mimics the underlying index, but inverses the return.  For example, SH is an inverse ETF of S&P500.  If S&P500 goes up 2% for a particular day, SH goes down 2%.

The Key Characteristic to Bear ETF - Imperfect Imitation
The normal index ETF, such as SPY, mimics the index almost perfectly.  If S&P500 goes up 2%, it goes up 2%.  If it goes down 1%, it goes down 1%.  Over the long term, the performance of SPY matches S&P500 pretty closely.  You can go to Yahoo Finance and plot SPY and ^GSPC (symbol for S&P500), and you will see that they essentially lie on top of each other.

For bear ETFs, they don't work as perfectly.  In the chart above, I've plotted ^GSPC and SH together.  In the ideal case, a bear ETF should have exactly the opposite performance as its underlying index.  The blue line is S&P500.  From 2006 until now, it has returned approximately -10%.  You would think that SH should return +10% because it is the inverse of S&P500.  However, it returned almost -30%!  What?  Isn't this a bear ETF?  Should it not make money if the underlying index falls?  Yes and yes.  The problem lies in the mechanics of a bear ETF.

Let's use a hypothetical case as an example.  Imagine that the American economy suddenly recovered, unemployment drops to 3%, and the market skyrockets.  S&P 500 moves from today's 1125 to 2360.  That is a 110% move.  Since SH is the inverse ETF, it should move the same amount but in the opposite direction. So, it should move -110%...but wait a minute, an ETF can't go negative, can it?  No, it cannot.  Therein lies the problem...or shall we say opportunity?

What actually happens with a bear ETF is that it inverses the daily performance of the underlying index.  All bear and leveraged ETFs behave in this way.  The fund company rebalances its portfolio daily such that the daily move mimics the move of the underlying index.  Look at the table below.  I have made up some data to illustrate this effect.  On the first column is the underlying index.  On the second is the daily moves in percentage.  The last column is the inverse ETF.  As you can see, even though the underlying ETF moves back to its original value of 100, the inverse ETF does not.  This is called time decay.  The more volatile the index is, the bigger effect time decay becomes.

Underlying Index
Move (%)
Inverse ETF

Leveraged Bear ETFs
In more recent times, leveraged ETFs have surfaced.  These ETFs simply multiply the daily movement of the underlying index by a multiple.  For example, the BGZ is an ETF that provides -3X of the daily move of the Russell 1000 index.  As you might imagine, the time decay effect is multiplied as well.  Since the direction of the stock market is generally up over the long term, bear leveraged ETFs are bound to lose its value, and very quickly.

From its inception in November 2008, BGZ has lost about 85% of its value.  If we look at the period from Feb 1, 2010 until Sep 17, 2010, the Russell 1000 index has returned just below 0%.  BGZ, on the other hand, lost almost 20% of its value.  In less than a year, the ETF has lost 20% of its value purely from time decay.

The Opportunity
As I was thinking about this just a few weeks ago, I wondered whether I could short a bear leveraged ETF.  It's almost a sure win.  All I need is for the stock market to remain steady, let alone going up, and I'd be making 20% + gains in a year.  Now, that's a market beating strategy!

I also thought about shorting ETF pairs, or basically the bull and the bear ETFs for the same underlying index.  For example, I would short both BGU and BGZ.  The reasoning behind it is that since the ETFs provide both 3x and -3x movements of the Russell 1000 index, the position would be a sure win in the short term because of time decay.  I got really excited and started talking to my close friends about it.  My cousin, who works in  TD bank's mid-office (ticker: TD) of its securities group, was skeptical, because if something was a sure thing, people would have taken advantage of it already.  In short, he was saying that I couldn't be so smart as to come up with this ingenious idea.

Too Good to be True
He was right!  Darn!  I googled some more on this and found that there had been some chatter on this topic on forums.  Most people were skeptical, but could not provide a real argument why this would not work.  Finally, I found out the real reason why this could not work.  It was not because the theory was flawed.  In fact, I was right on the money.  Most brokerages, I found out, would not allow shorting of leveraged ETFs, especially bear leveraged ETFs.  Even if they did, they would retain the right to call the shares back at any moment.  This leaves the investor vulnerable to huge losses.

An alternative to this strategy would be to buy put options on the bear leveraged ETFs.  However, these options were very expensive the farther out they were.  The market prices these accordingly because most people are aware of the time decay characteristic of bear leveraged ETFs.

Did You Just Waste Five Minutes of My Time?
So, what was the point of all this, if there was no way this theory could be executed?  For one, I was hoping I could share with you what goes on in my head from time to time.  I was quite excited about all this for about 18 hours, until I burst my own bubble, with the help of my cousin.  However, more importantly, I want to encourage all of you to try to think outside the box.  With tools like options and ETFs, there are quite a number of things that can be done that could not have been possible with traditional stock shares.  I'm not trying to get fancy or anything, but I try to keep my mind open for hidden gems that are waiting to be exploited.  Of course, this should all be done within our own moral code.

Before I close, I'd like to thank all of you who completed my short survey.  I've read all of your comments and appreciate them very much.  I will take note of your suggestions and try to address them in the future.

As you know, it's September, so school has started for me again.  I will try to keep up my writing as much as possible, amidst all of my readings and assignments.  Please keep me in your prayers!  God bless!

Tuesday, September 7, 2010

Would Love Your Feedback!

Hi Everyone!  I can't believe it's been more than a year since I first started this blog!  I've been doing much of the talking here and now, I'd love to hear from you!  Could you please kindly fill out this very, very short survey?  If you are so inclined, drop me an email as well at felix [at]  God bless!

Don't Be Afraid of Options - Part 6: Fancy Options

If you have read all of my posts on options, your knowledge of options would hopefully have increased.  In this post, we are going to look at some of the fancier option strategies that are used by investors/traders.  Without further ado, let's get started!

Strangles and Straddles
A few factors affect the price of an option.  Without going too much into the Black-Scholes model that is widely used as a pricing model of derivatives, let's look at what might make an option more or less expensive.  We know that an option is all about what might happen in the future.  When I buy a call option, I'm betting that the underlying stock price will rise to a certain point in the future, before the expiry of the option.  There are several factors that affect the likelihood of this happening.

Volatility is one of these factors.  If you expect the underlying stock to fluctuate a lot (i.e. increased volatility) because of some future event (e.g. earnings or announcement of a new product, etc.), then it is possible to use strategies to capitalize on this.  Two examples are the strangle and the straddle (please don't ask me how they came up with the names).

For both the strangle and the straddle, you buy both a call option and a put option of the same stock.  The goal is for the stock to move either up or down so much that you end up making money on one of the option that it covers for the losses of the other and then some.

The Straddle

A Straddle

The straddle is a strategy where you buy a call and a put with the same strike price, that is closest to the current price of the stock.  The example we'll use today is the Canadian potash maker, Potash Corporation of Saskatchewan (Ticker: POT).  There has been recent news of a potential hostile takeover and the stock has almost doubled in a matter of 2 months!  This is extreme upside volatility for a company that has a market capitalization similar to that of Ford!  Anyway, POT is trading at $148.50 at time of writing.  For the month of October, there are options available at $150 strike price.  The call option costs $4.85/share and the put costs $6.60/share.

You can see in the above figure the behaviour of this position for the different stock prices at the time of expiry.  If the stock moves below $138.55 or above $161.45, then the position would start to become profitable.  At $161.45, the put option would be worth nothing since the strike price allows you to sell the stock at $150, and who would want to do that when he/she can sell it for $161.45?  The call option, on the other hand, would be worth $11.45, because the stock has risen $11.45 above the strike price.  So, you initially spent $11.45 on the 2 options, and now the call option covers that cost.  Once the stock moves higher, that difference would go right into your pocket.  In the same way, the put option would be worth $11.45 if the stock dropped to $138.55.  The lower the stock moves, the more the put would be worth.

The absolute worst case for this strategy is if the stock moved to $150 and stayed there until expiry.  Both options would expire worthless, and you would have lost $11.45/share.

The Strangle

A Strangle

A strangle is very similar, except that both the call option and the put option are out-of-money.  So, if the stock price is at $148.50, I would buy a call option at $150, and a put option at $145.  The call option would cost me $4.85/share and the put, $4.05/share.  The total cost is $8.90/share.  So, if the stock moves up or down $8.90 beyond the higher/lower strike price, respectively, the position would become profitable.

The strangle is a lower cost option over the straddle and it also becomes profitable more quickly than the strangle.  The maximum lost, in our example, is $8.90/share versus $11.45/share for the straddle.  The price range between the 2 strike prices (i.e. from $145-$150) is where your maximum lost occurs.  The strangle is probably a better bet all around.  I see no real advantage of buying a straddle over the strangle.  Having said that, both strategies requires a large fluctuation in stock price in order for you to profit.  The strangle, for example, requires a movement of $8.90, which is 6% of the current stock price.  Sometimes, the stock doesn't even fluctuate that much in a few months, nevermind 1 month!  I also did not include commissions cost in this analysis.  By entering into a strangle/straddle, you have to buy 2 options, which doubles the cost of the position.  If you decide close the position before expiry, you'd have to sell 2 options, incurring commissions costs again.

It is not uncommon for either of these strategies to be used when an unusually long period of inactivity has elapsed.  If a certain stock has traded within a narrow range for a few months, it is likely that increased volatility is just around the corner.  And since volatility of the stock has decreased recently, the price of its options may also have decreased in value.  As such, it would be an opportune time to enter into a strangle/straddle position.  Just keep the commissions cost in mind.

Another concept that is popular is called spreads.  The idea is to buy and sell a combination of options to create a semi-bullish or semi-bearish position.  The semi-bullish position is called the bull spread, and the semi-bearish one is called, surprise, the bear spread.  If you create a bull spread position using call options, it is further defined as the bull call spread.  Let's look at one right now.

A Bull Spread

In the figure above, we have the behaviour of a bull call spread of POT.  To create this position, a call option is bought with strike price at $145, while another call option with strike at $150 is sold.  Here, the October $145 call costs $7.60/share, and the $150 call can be sold for $4.85/share.  Therefore, we spent a total of $2.75/share to open this position ($7.60 - $4.85).

We all know what buying a call option at $145 gives us, which is limited loss and unlimited gains if the option rises above $145.  What happens when we add selling a call option at $150?  When we have sold a call option at $150, we give the right to buy 100 shares of the underlying stock at $150 to the buyer.  If the stock price remains at or below $150, nothing happens.  The option expires worthless and we get to keep the premiums.  If the stock rises above, $150, we have to give our shares away for $150/share.  Now, if the stock rises to, say, $155, the option is exercised, and our shares are called away.  But we don't have 100, what we do is use our $145 call option to buy 100 shares at $145, and then give the shares away for $150.  Thus, we pocket $5/share, but we need to take away our initial investment of $2.75/share.  Our profits are $2.25/share.

The advantage of a bull spread is that the initial cost is lower than a plain call option.  Let's compare.  With a bull spread, if the stock rises to $150, we make $2.25/share (like above) on $2.75/share investment.  That's 82% gains.  For a plain call at $145, we have to pay initially $7.60/share for the option. That's the first thing, higher initial cost.  Then, when the stock price rises to $150, you make $500 by exercising the option to buy 100 shares at $145 and then immediately selling them for $150.  The gain is $5/share, which is only 66% profits.  So, on a percentage basis, the profits are decreased.

The disadvantage of a call spread is also precisely what it was designed to do, limit upside potential.  Once the stock price rises beyond $150, your profits are capped off and you make only $2.25/share, even if the stock price goes up to $1000!  Therefore, this position is semi-bullish, because you make money if the underlying stock price goes up, but your gains are capped if it goes up beyond the strike price of the higher option.

A bull put spread has essentially the same outcome, except that you buy a put option with a lower strike price, and sell a put option with a higher strike price.  For bear spreads, the concept is exactly the same, but the position is profitable if the stock price decreases.  I'm sure you are knowledgeable enough now to work out what options you need to buy and sell to make that happen.

Anything Else?
Heck, yes!  If you can imagine a combination of buying/selling calls/puts, chances are people would have thought of it and have given it a fancy name already.  If you want to do further research, start with butterfly spreads, calendar spreads, and ratio spreads.  I typically like the KISS principle (Keep it Simple, Stupid) and avoid anything with more than 2 options.  You really don't need to get that fancy to make money.  Also keep in mind that if you sell uncovered calls/puts, you would need to have a margin account.

In the next and last post of this series, I will make available a spreadsheet that I have built to evaluate the various option strategies out there, and even ones that you make up yourself.  Stay tuned!

Thursday, September 2, 2010

Don't Be Afraid of Options - Part 5: Let's Get Naked (with Options)!

Please excuse the title of this post...I had to! :)

We have learned about buying call options and put options, and also writing a covered call option.  Let's continue with writing an uncovered or "naked" option in this post.  Why is it called "naked"?  This term has been coined because the seller of a naked option is left exposed to unlimited risk (in the case of a naked call).  Recall that when you buy a call option, the most you can lose is the amount of money you have spent buying that call option.  Also recall when you sell a covered call, when the underlying stock price rises above the strike price, all you have to do is hand over the shares that you already own of the underlying stock, and you're done.  Not so with naked options.

Naked Calls
For a naked call option, what you do is exactly the same as a selling a covered call, except you don't own any underlying shares.  Let's use an example to illustrate this.  You think Ford (Ticker: F) at $11.71 is priced too high and predict that it would fall by January 2011.  So, you sell a call option with a strike price at $12, set to expire in January 2011.  You get paid a premium of $1.10/share, which is what this option is trading at currently.  If the stock stays below $12, the option expires worthless and you get to keep the $1.10/share premium.

However, if your prediction was wrong and the stock rises to $14, the buyer of the option exercises his right to buy 100 shares at $12.  Who would sell him those shares?  YOU!  Since you sold him the right to buy 100 shares at $12, you have the liability of fulfilling that contract.  And since you don't actually own any shares of Ford, you need to buy 100 shares in the open market at $14/share and give them to the owner of the call option for $12/share.  So, you earned $1.10/share in premiums, but lost $2.00/share because the buyer exercised the option ($14/share you paid - $12/share the option owner paid you).  You netted -$0.90/share.

This is if you were lucky!  If Ford had skyrocketed to $22, you would need to pay $22/share in the open market and sell them to the option owner for $12/share.  You stand to lose $8.90/share ([$22 - $12] - $1.10 premiums).  The higher the stock goes, the higher your losses.  That is why your losses are considered unlimited.  As long as the stock goes up, your losses go up.  Therefore, I absolutely do not recommend writing a naked call.  By exposing yourself to unlimited risk, you stand to gain only a fraction of what you could lose.  This is the wrong side of the bet!

Naked Puts
Naked put options, although appearing similar to naked calls, are a completely different beast.  For one thing, your losses are not unlimited.  Say you sold a put option of Ford with a strike price of $11 and expiry date of January 2011 for $0.89/share.  You essentially have sold the right to sell shares of Ford for $11 at anytime before the expiry of the option to the buyer.  This is a bullish position.  If shares remain higher than $11, then the buyer would not want to exercise the option, because he can sell it for more on the open market.  However, if Ford tanks and goes to $10, the buyer can exercise that option, and you would have to buy the shares at $11.  If Ford totally went bankrupt and the shares went down to $0, you would still need to pay $11 for those same shares.  That's too bad...but that's the worst it can get.  The share price cannot go into negative territory.  Your maximum loss is simply the strike price of the option minus any premiums that you had received when you sold the option.

When Should I Write a Naked Put?
As I said, writing a naked put option is a bullish position.  It is especially useful when you are trying to accumulate a certain stock.  By writing a put option, you can potentially increase your returns and lower your risk (wait a minute, aren't those two polar opposites?  Keep reading...).  Let's use an example...I like examples, they make things easier to understand.

So, real life example...if you have followed my trading history, you would know that I've been accumulating True Religion stock.  I began buying when it was $29.31.  In merely 5 months, the stock has shed more than 35% of its value.  It's trading at $18.75 today.  This is one volatile stock!  No worries, I kept buying as it came down.  Lately, I've been thinking about writing naked puts (thinking only, because I need to "upgrade" my account, more on that below).  I checked out the prices of TRLG's put options and were quite surprised at how much people were willing to pay.  I looked at one with a strike price of $16 and expiry in April 2011, and people were asking for $1.95/share.  That's more than 10% of the stock price!

So, if I can successfully upgrade my account, and sell that same put option, I would immediately get $1.95/share for it.  If the stock goes down to $16 and the option is exercised, I simply buy 100 shares per each contract that I have sold.  Is that bad news?  No, not at all.  If I had not sold the option, I would still have bought the shares.  So, why not make $1.95/share while I'm at it?

In fact, by writing a naked put, I have lowered my overall risk.  Compare this...if I were to only buy the shares when TRLG dropped to $16, and the stock fell some more to $15, I would have lost $1.00/share. However, if I had sold that option, I would have been paid $1.95/share for it, and as a result, I'm still up $0.95 (the shares costed me $16/share - $1.95/share of premiums = $14.05/share)!  Now, that's having your cake and eating it too!  So, please, don't listen to the industry's seemingly intuitive and believable lies, "if you want greater returns, you have to take greater risks."  Selling naked puts when you are trying to accumulate a stock is what I call prudent investing!

The Catch
Yes, yes, there is a catch.  Not a big one though.  In order to be able to write naked calls or puts, you need to have a margin account, because after your initial transaction, you can still rack up additional losses.  Depending on your broker, they would likely limit how much risk you are exposed to.  So, chances are, they probably would not let you write too many risky naked options if you did not have the cash to back them up. You may either need cash sitting around in your account or the appropriate collateral (i.e. you may be required to sell your holdings) if the trade goes against you.

What Now?
I don't know about you, but I'm going to get my account upgraded!  When I talk with friends and such, most tend to think of options and margin accounts as very risky things, without really knowing what they are all about. It's sort of like a gun.  If a gun falls into the hands of an irresponsible person, it can be very dangerous and no one should allow that to happen.  However, if on the other hand, the person in question is a trained police officer with years of experience, we would feel much safer if he had a gun in his possession, compared to if he had not.  And so, that is the case with options.  Learn to use the tool and don't be afraid of it.

I've almost exhausted all of the things I can talk about options, without going into really fancy stuff, but wait, the best is yet to come.  I will give you a tool that can enable you to evaluate various option strategies, even those I have not talked about.  Stay tuned!