Million Dollar Challenge - 11/20/2008

The Short Candidates for Tomorrow

I’ll be watching the below stocks/ETF’s tomorrow for my shorting pleasure.  Here they are for you to follow along.

Alcoa (AA)

Will be a big victim of lower consumer/industrial demand.  It is headed in a downward spiral and should continue to follow its shorter term trendline tomorrow.

Alcoa (AA)

Citigroup (C)

Citigroup broke an important $5 level today.  Institutions should start dumping this stock soon.  Barring some sort of additional “free money” from the Feds this stock is going to tank.

AK Steel Holding Corp (AKS)

This is another metals/industrial play.  Its getting thrown out and should revert back to its trend line and reach sub-$5 levels.

AK Steel Holding Corp (AKS)

UltraShort Consumer Services ProShares (SCC)

Another great way to play the weak economy is to play the weak consumer.  The SCC is an ETF that aims to return twice the inverse daily performance of the Dow Jones U.S. Consumer Services Index.  This index tracks consumer spending in various services and is an easier way to play the broader weakening of consumer spending.

UltraShort Consumer Services ProShares (SCC)

UltraShort S&P500 ProShares (SDS)

This one is a little tricky.  After today’s trading I think it can still go down tomorrow, but there is a possibility the downward move may not materialize.  In fact we may see a short-term bounce.  I would keep this trade on the backburner, but this might be a good place to go long.  When you buy SDS you are buying an ETF that aims to return twice the inverse of the S&P 500.  By going long SDS you are in effect betting against the S&P 500 index.

UltraShort S&P 500 ProShares (SDS)

Follow My Trades

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CNBC Million Dollar Challenge - daxdesai.com doing quite well

Follow My Trades

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The market had its 7th straight trading session of decline and is now at a low it has not seen in 5 years down 39% from its year ago peak.  All 30 Dow components were down today.  Bad news continues globally as the financial issues are showing up in Europe and Asia.

As Americans sleep the Japanese Nikei index is opening down 11% and Iceland had to nationalize its largest bank.

What Now?

Don’t panic.  Don’t sell at a bottom or what maybe near a bottom.  Yes you are seeing bad news everywhere and it is hitting everyday America hard.

“I lost $20K in 1 day.  I did all the right things.  I forwent driving a nice car and living in a nice house for my future.  I am losing money faster than I’m earning it.”    -colleague in my office building

It is tempting to remove your money from the market to stop the pain.  Timing the market is a difficult thing.  You probably saw losses in your retirement and other investment accounts down 20-30% over the past 3 months and you think you’ve got to sell.  Right?  Wrong.  Some such as TV personality Jim Cramer will tell you to sell everything if you need money in the next 5 years.  This is dangerous advice for a few reasons.

Cashing Out Your Retirement Accounts is Expensive

Depending on the type of account removing money from your retirement account can be expensive.  

Some Penalties/Taxes You May Have to Pay:

• 10% penalty on ALL withdrawn funds
• The distributions will be taxed as ordinary income.
• Loss of compounding tax-free.  Money withdrawn can’t be put back in later.  For example if you earn 10% in a tax-free account, you’d have to earn 14.2% [10%/(1-.30)=14.2] in a taxable account to get the same return (assuming a 30% tax bracket).  If you read my post - The Rule of 72, 114, 144, you’d see how powerful and important this is.

Depending on your tax bracked you could be left with just 60 cents on the dollar after penalties and taxes.  In addition you’ll lose the power of compounding tax-free in years to come.  I know you’ve felt alot of pain in the past week, but the odds are that most of the pain has passed.  Their could be more, but if you time it wrong you could miss out on short-term rallies and sell at the bottom. 

Be Patient

You may be thinking we’re in a recession (you’re probably right) so you should get out of the market.  The past few days of torment and losses don’t help.  The fact is that since the end of WWII, each recession has lasted about 10 months.  Each subsequent expansion has lasted a little over 5 years.  The beginning of a recession is never really pinpointed until the economy is already somewhere in its cycle.  They also end without warning.  You don’t want to take your money out towards the end of a recession and a subsequent expansion.  In other words, you could mistime it and miss the big gains.

The chart below illustrates mistiming by investors.  It shows the market decline and subsequent bull market.  As you can see investors withdrew their funds and hoarded it in cash.  Those investors missed out on half of the subsequent bull market and were cashing out near the market bottom.

Money Market Funds vs Total Fund Assets

On average the market has given around 10% return annually.  That factors in down years as well.  You must endure the bad to reap the good.  Moving your money into cash or bonds could leave you growthless after taking inflation into account.  By all means move in and out for trading, but not for investing.

The Fear Factor

The Volatility Index or VIX is at an all-time high.  The VIX is often seen as a “Fear Index”.  It has an inverse relationship to the market.  See the chart below.

Looking at the above chart, what do you suppose might happen when volatility comes back to more sane levels?  We would expect that their would be a bounce in stock prices as volatility subsides.  It may not make it back to the all-time high 1 year ago, but you would expect some big gains from this level.  The downside risk from this level is relatively low as we maybe in an oversold market.  The big drops are probably behind us even if there are some more drops.  If you need the money near term, wait until you get some spikes and the VIX comes back down and sell into short-term rallies.

My Strategy

Besides my trading account, I’m all cash and gold.  I will be selling some gold as I think the “fear factor” is going to start coming down sometime in the next month or so.  My cash is short-term.  I will be putting it back into the market once I see the volatility (VIX) come down and see some more buying volume.  At that point I will be double-down long in the market.  

Sometimes you have to be brave and calm when trading.  I bought a foreclosure house close to (if not at) the bottom of the housing market when others were afraid to do so.  Time will tell, but that decision probably added the most to my net worth in recent years than anything else I’ve done.

Keeping things simple I’m going to focus on the below ETF’s:

• SSO     Double Long   S&P500
• UWM   Double Long   Russell 2000
• SAA     Double Long   S&P Smallcap 600
• DZZ     Double Short  Gold Double Short

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And of course a chart…

We are now trading above that dangerous 200 day moving average and MACD seems to indicate we are reversing an oversold condition.  The stock could make a dramatic move from this point.  Any progress in union talks will only accelerate the uptrend.

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Last week I felt the wrath of being tagged as a “Pattern Day Trader.”  Last Tuesday I had a few good trades selling some Potash for some small, but respectable gains.  I was watching Freddie Mac (FRE) and decided to buy on Wednesday.  I entered a buy order for Oct 08 $6 strike @ $250/contract.  That same contract is now trading at $500 just three trading days later!  That’s a 100% missed gain!  That’s a lot of lunch money.  My trading account was just a tad bit under the $25,000 mark which caused this missed opportunity.

Free to Trade Again

So today I had available trades without being tagged as a PDT.  What did I do?  I bought 2 more contracts of Dec 08 $210 Calls @ $34.10.  If you are watching Potash you know that the union voted in favor of a strike against Potash Corp.  This is some scary news.  No miners, no product.   Well I’m not as concerned.  I’m convinced a strike will be averted.  Last November, another Potash seller – Mosaic settled with unions and their workers agreed to a new contract 8 months ago.  At that time potash was selling under $400/ton.  Today it is near $900/ton.  Something tells me Potash Corp can afford to settle with the union and move forward given the high price it is able to command for its product.  That’s my rational and that’s why I saw this as a buying opportunity.  The moment they sign a new agreement, the stock will bounce back.

Oh and that missed FRE opportunity

I revisited my Freddie Mac calls.  I put in an order for a few Oct 2008 $10 Calls @ $2.25.  I missed it by a dime.  I wish I would have got in my FRE Call trades in.   I would have had a nice intraday trade, but I wasn’t able to watch my orders today.  Later in the day it would have been up 20% had I changed my order.  I don’t always chase a stock, but sometimes I may change my order if its just a dime or two and I believe in the move.  I’m beginning to wonder if FRE is another Apple for me.  I always tend to mistime Apple.

Financials Tomorrow?

Overall I think tomorrow may offer a short-term perhaps day-trade opportunity to short the XLF.  It has had quite a run and I think the general trend is still down longer term.  The XLF has had quite a run the past week.  I see some consolidation before the next move.  Near term – tomorrow I see a downward move.  If you have some guts I’d short it for a day-trade.  That makes my Freddie Mac call position questionable doesn’t it?  Well I think I may be watching it tomorrow.  I’ll have to see what the price action looks like tomorrow.  I’m leaning towards buying a Sept $11 Call.  I still believe Freddie has plenty of support from the government and it is grossly oversold.  I expect to see the $14 level within month.  That’s the level it was trading when it fell off the map with huge volume to the downside.

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You may be wondering if I bailed on my position. Nope. I stood by my reasoning on my trades. Partly out of greed, but mainly out of my belief in my past trades and POT’s resiliency. I really didn’t see the big volume capitulation that would drive this stock lower and lower longer term. That’s not to say I wish I had. In an ideal world, I would have sold at a small gain and bought back at the bottom. I didn’t, but it isn’t a perfect world. I was fully invested in the market so I didn’t have the cash to add to my position. I was salivating at the downward move as a missed opportunity to build more position.

Yes POT went from $227 down to the $197 level. Over 2 weeks it went down and is back up to $221 and was as high as $224. That’s only down $3-6. Sometimes you have to stand your ground. Yes my position is still negative, but more in line with a normal intraday loss. It is a minimal paper loss right now.

I wait for confirmation on uptrends. I also wait for confirmation on downtrends. This time I didn’t feel the strength was there to take this stock down. Considering the broader market moves, POT held up quite reasonably.

As a side note I noticed my readership drop during this 2 week period. Now it is going back up. Just like stocks, I never got the volume drop confirmation in my readership and now it is approaching normal levels. To you traders following me and sticking with me… Bravo. To you other guys… stick around. I may have a few more trades you don’t want to miss.

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Deep in-the-money (ITM) options will for the most part be unaffected. This is because deep ITM options have little time value. It is the time value or extrinsic value of an option that is effected by changes in implied volatility.

So that is my reason. I’m not trading the volatility per se. There are many volatility trading strategies.

For example if your stock price expectation of a stock is flat and volatility is higher than normal (market expects strong price movement), you could sell some deep out-of-the-money (OTM) options with the expectation that volatility will drop. A drop in volatility will reduce the price of the OTM options. This is one potential volatility trading strategy.

Another way to trade volatility is to trade ahead of earnings. Below is a chart of Apple’s volatility. You could buy options a few months before earnings when volatility is relatively lower. As earnings approaches the options volatility tends to spike as high as 20% (circled in chart). During those spikes option premiums go up. Of course you must balance your time decay against your gains from volatility so you’d want to have a longer term option if you use this strategy. You could buy during low volatility a few months ahead of earnings and sell near earnings.

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I Expect POT to hit $240 by Wednesday and $260 within 2 weeks. The DOW is points away from confirming a bear market. It sort of like a recession. You feel the pain long before you get confirmation. Stocks that work should continue to work. Stocks that are for discretionary goods should continue to be battered. Driven by fundamentals the ag plays should do well, particularly the fertilizer stocks. POT is the best valued in my opinion, but feel free to do your research and look at Agrium (AGU) and others. Monsanto could be another good Ag play if you want some further diversification in the ag space.

Below are the positions I’ve opened:

• Dec 08 $210 POT Calls @ $40.00
• Dec 08 $165 POT Calls @ $72.60

Both positions are pleasantly to the upside. There is much more room. I would build up your position at this level as I see a $30 run from this level.

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Disclosure: I have sold all my POT Puts today as the stock fell to my $220′ish goal.

Happy trading

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Now that I’m in the shorting mood, I added one more short position.  I purchased Jan ‘09 $17.5 FITB Puts @ $8.6.  So far that position is down 9%.  I’ll have to wait a 3-4 weeks for that move to play out.

I also opened Jan ‘09 $20 WB Puts @ $5.30 this morning.  Wachovia has a juicy 8.6% dividend at this level.  I believe their sub-prime exposure will force them to cut it, driving down the stock price.

My 2 financial short positions are prone to headline risk.  Bills to save people from foreclosure tend to give some small pops on these stocks.  Also any interest rate news can move them.  Conversely you can play the pandemonium.  When one stock craters sometimes other financials follow sometimes without reason.  Some banks are in good shape.  Others are not.  If you wait for another regional bank to report bad news you’ll get the pop.

Sell into those pops. Don’t get greedy. This is a trader’s market right now.

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