Weekly Wrap - This was from our weekly wrap...thought you might find it interesting...Didnt really have time to clean up the lesson today or yesterday but i thought it was good enough to send. All you English perfectionists, lets have some slack! <GG> Hopefully next week is a better one for those long.
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Weekly E-Wrap
Topics Included in this Newsletter:
1. From The Trading Desk
2. Lessons from the Trenches
3. Yamner & Co., Inc. Managed Portfolio Program
4. Yamner & Co., Inc. Online yamner.com
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1. From the Trading Desk -
8/26/98 3:14:32 PM
First off, we are proud to announce that while our Daily E-Letter subscription has grown to more than 290, our Weekly Wrap, today's mailing, is being delivered to more than 4900 subscribers.
An incredibly volatile week left the markets shaken but not yet stirred. When rallies early in the week did not materialize and were defeated by constant selling pressure, it was inevitable that the markets would pull back. We felt as such and as indicated in the mid-week letters and last weeks' letter, were selling on all rallies. Political and economic turmoil, if there is a difference between the two, compounded the already-jittery markets. Russia collapsed economically and politically and concerns are that the country may revert back to communistic behavior. Nothing like the threat of communism to shake the world's market.
German markets tanked as they are heavy investors in Russia as well as South American markets. Asian markets, already beaten down, got crushed. And what happens to the rest of the world, doesn't escape us. The US markets suffered its third greatest loss every on Thurs. , down 357 points, closing at its lows. Unable to sustain a 110 pt. Gain on Tues., the markets dropped 87 on Weds and got hammered for 4.1% on Thurs. The futures today opened down 11 yet were up 12 near the open, a tremendous reversal. The Dow was up more than 100 in the first hour of trading, yet concern and profit taking brought the markets down and by the close we were off triple digits.
There were few stocks that were not effected by this sell off. Drug stocks, oil stocks, industrials, technology, as well as retail stocks were especially hard hit. AOL was down 10 today, while BBY was down 4 3/4, Travelers down 2 1/2, and Citicorp down 6.
An interesting statistic was that on Thursday only 39 stocks were hitting new highs while more than 2300 stocks were hitting new lows. I think most would agree that outside the world's leading companies, the GE's, the Dells', etc., this bear market has been occurring for some time. It would be accurate to say that ANY sales prior to Friday were insufficient and any purchases were premature. Nonetheless, we know you can not pick bottoms but must pick reasonable times and places to acquire your issues.
Having raised our cash position over the past few quarters to its highest levels in several years, we did in fact put some of that cash to work late in Thursday and Friday's session. Coming into the week, 40% of our portfolio was cash and we put about 25% of that cash to work on Thurs and Friday, picking up some Ford, TMAR, CS, WDC, DO,
It is very likely that we see a rough open on Monday. Monday's are historically ugly and given today's selling at the bell, we could expect some additional pressure on Monday as investors digest these corrections. Yet, there is a feeling we are approaching an over-sold condition. I might take issue with that given the incredible levels at which this market current trades, relative to historic levels, but there is enough pessimism out there already.
We'd expect an ugly open then some rallying and perhaps an end to this near term downdraft. Always prepare for the worst and you wont be disappointed.
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2. Lessons from the Trenches - Hedging - Covered Call Writing
This week's lesson involves a strategy that played out quite well a number of times during the past week. The strategy involves hedging. Hedging involves the minimization of investment risk through investments in strategies opposing the primary strategy.
There are many ways to hedge a portfolio. A basic example of a 'hedge' might be a portfolio that is long 4 technology stocks and short another leading tech firm. In the event the 4 longs move lower, it is likely that the other tech stock which the client has shorted will decline as well, offsetting, hedging, the losses in the long positions.
Today I will discuss the use of options to hedge positions. Options are a very complex and volatile investment product that should only be employed once an investor has fully researched and understood the risks and rewards of such a product. It is quite easy to incur large and umlimited losses if you aren't comfortable with the particulars of the product. As you will note, this explanation is somewhat lengthy and can easily lose someone without a basic understanding of options. This is simply the tip of a massive iceberg. Please visit the CBOE's website at cboe.com. Also, please take the time to speak with your broker about the fine points of options. Your broker should be at best, a liscensed Option principal, and at worst, full knowledgeable in the specifics of various options strategies.
Equity options offer investors a multitude of ways to play the markets. While the possibilities are only limited by the creativity of the trader, they can be categorized into one of three major categories:
1) speculative 2) protection and 3)income-oriented.
While most investors are attracted towards options for speculative investments as a result of their leverage, we primarily utilize options for protection and income/hedging strategies. Let me present how we might utilize this product and then I will present three examples of recent hedges to discuss how the strategy has played out.
Often, we become reluctant to sell a good position when we have achieved a sell target or have a position that may have gotten ahead of itself. We like to keep losses marginal and let winners run. We hedge the position by writing calls that are out of the money. Calls are option products that allow a call buyer to buy stock at a fixed price, called the strike price, up to a particular time, called the expiration date. The call buyer buys the option for an amount called premium. The other side to the party is the call writer who is obligated to deliver the stock , at the strike price, up to the expiration date, and receives the premium as consideration for writing the contract.
The term out of the money indicates that the strike price on the call you are writing is above the current market price of the stock. An example: A client buys XYZ at $12. The stock advances and at $18, a 50% gain, the client may decide he would like to protect profits or possibly hedge the position. Yet often clients are reluctant to sell and take complete profits as they feel the stock may have more upside potential. Yet we often suggest hedging the position in a number of ways. One way is to write an out-of-the money, or nearly in-the-money call.
Using our example, with the stock at $18, the client could sell a call option against the position. Lets use some hypothetical numbers: The client is able to sell a Call option, with an excise strike of $20, and an expiration 2 months in the future, call it October, for a price of $2. That is, the client sold and someone bought the right to buy the stock at $20, for the next two months. The buyer wants the stock appreciate and is betting that it will even though the stock is currently $18.
The client sells the call. If the stock moves higher, the client is obligated to deliver stock at 20 if the stock appreciates above 20 and the call buyer exercise the option. Thus the client will have an effective sale at 20. Yet, the client has now reduced his cost basis by $2, essentially giving him a sales price of $22. If the stock falls back, the client has $2 additional dollars to offset any pullback, providing the hedge.
So what did the position provide?: if the stock moves higher, the client will lose the stock at $20 PLUS the $2 he received for writing the call. If the stock stays below $20, the client keeps the stock and the $2. The $2 on an $18 security is a very nice return over the 2 months, 11.1% for the two months, or 66% annualized. Many would be content with $2 additional dollars on $18 if in fact the stock moves higher and is called away. As you can see, writing premium-rich calls can be a great way to generate income. But there are risks as well.
3 things can happen:
The stock can sit tight and not move anywhere. The optimal place for the stock for the call writer would be just below the strike price, essentially remaining flat, thus allowing the option writer to maintain the stock position, collect 100% of the premium with no liability and sell the stock at the same price as the strike price. In this regard, the client keeps the stock, keeps the options and can rewrite more calls for additional income or simply sell the stock, essentially having earned 2, or 11% on the stock while the stock did nothing over the period.
The stock can move lower. This offers the greatest risk associated with covered call option writing. Lets assume you have a $50 stock and you have made $10 on the stock. Now appreciated, you write calls going out 2 months, with a strike of 55, for $4. You just received $4 for 2 months, or approximately 8% over the period, or 48% annualized. Not bad, but if you are not comfortable with the position, or if the stock sinks below 46 ($50 market price at time you wrote the $4 options) then you would have been better off selling the stock outright.
Lastly, the stock can exceed your expectations and continue moving higher. In this event, lets assume the stock moves to $26. The call writer must deliver stock at $20, clearly an inferior price to the $26 available in the open market, even when factoring in the $2 the client received for the option. Rather than simply delivering stock at $20 (effective sale of $22), now with the stock higher at $26, the client could buy back the calls written and roll-out to a subsequent month, a later expiration date. Yet by rolling out, buying back the originally written call at a short term loss and selling another further out in time, the client is able to maintain position in the stock, and has moved out the expiration date for the options, gaining additional time in which the stock may pull back and leave the option worthless. As well, in buying back the short option and selling another with a longer expiration, the option writer will likely pickup additional time premium adding to the $2 already received.
Let me present an example to clarify: The client sells a OCT 20 calls when the stock is $18 for $2. The stock doesn't pull back moves higher and in October, the stock is $26. The calls which the client sold for 2 are now 6 (26 market price - strike price=intrinsic value, no time premium on last day). The client would buy back the calls at 6, thus having short term loss of $4, yet now has stock at $26 and would simultaneously sell a January 20 call for, lets say 6 3/4. The Jan. calls would be 3/4 more than the current OCT 20s because of the additional time premium. Thus, compared with the original calls for 2, the client now has another 3/4 points premium for rolling out. At very least, if the stock continues to move higher, the client has at minimum collected another 3/4 points or 2.88% over the 2 months, or 17.3% annualized. Here the investor has to analyze this return on investment relative to risks associated with maintaining the stock and relative to other possible investments.
Yet the greater reward from rolling out comes if the stocks backs down to the strike, thus allowing the client to collect the balance of the premiums written. There are a number of risks such as the way option prices do not move tick-for-tick with stock prices and variances get even larger as they approach the strike prices, as well as the risks associated with the potential for a large, non-linear, correction in the stock.
In sum, so for the option writer who, in retrospect, was premature in writing the option, can consider rolling out the option, postponing the delivery of stock, and leaving open the opportunity of a pullback to recover missed gains.
Three examples:
1) WDC . We bought WDC at an average cost of 17 1/4 and watched it run nicely to 21. At 21 we wrote calls for 1 3/4 average hoping the stock would sit tight. It didn't and correct down to a close today in the mid-nines. We didn't need the 1 3/4 that bad and in retrospect would clearly have been better simply selling the stock. Yet we're glad to have the 1 3/4 lowering our cost to under 16.
2) HD. We HD with an average cost of 31. At 41, we sold the 45 calls out of the money for 2 1/2 dollars. The stock has remained within a few points of that strike thus permitting us to keep the premiums in full.
3) Fore - We bought FORE with an average cost of 15. When it ran to 19, 20, we sold JUN 20 calls for an average of 2. As the stock ran higher, we rolled out to AUG collecting another dollar in premiums, content with the percentage return on investment if the stock continued to soar. The stock didn't. It fell hard this week from 26 to 21, our calculate max profit number and we sold the stock and bought back the call, maximizing our return, giving us an effective sale of 21 plus 3 in premiums or 24, a beautiful execution but risky given the volatile nature of the stock over the past few days.
The strategies are complex. They involve varying risks that can not be encapsulated in this particular lesson. This less is not an endorsement of any particular strategy but a presentment of some opportunities out there. You should understand options inside and out before even considering them as an investment vehicle. But properly mastered, they can provide a wealth of opportunity.
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