The Tycoon Report

Turn a Losing Trade into a Winner in One Easy Step

Monday, November 9, 2009 | Ron Ianieri

When we left off last week, we had been talking about the addition of the rolling technique to the stock-replacement strategy.

We examined how the use of options, combined with the rolling technique, gives the individual investor an advantage that is simply not available in any other type of asset class.

The advantage is the ability to lock in profits and decrease risk while at the same time maintaining the size of the position. Using call options to replace long stock positions and put options to replace short stock positions (stock replacement) offers many advantages to individual investors.

We have discussed several of these advantages during the last few weeks, and today, let's talk about another advantage ... flexibility. Options are extremely flexible and one of the ways we see this flexibility is with another technique called morphing.

How to Turn a Losing Trade into a Winner

Morphing is a technique where an investor turns their entire position around with the addition or subtraction of just one element.

Morphing has a relatively sophisticated pre-requisite concept in option theory called “synthetics” that must be learned before you can begin to morph your position.  (Synthetics are positions that you can create to mimic the performance of a different instrument, such as using a combination of calls and puts to behave exactly like stock.) Although this concept may be over your head now, with a little bit of work it won’t be over your head for long.

The idea in today's article is to show you what is possible so that you will be able to appreciate the benefits of learning the ins and outs of options and come to appreciate how that knowledge can help you in the future.

'Righting' a Position Gone Wrong

Back to morphing.  You apply the morphing technique when the underlying stock moves adversely to your position putting you in a ”wrong position.” 

A “wrong position” occurs when you are in a long position expecting the stock to go up, and it unexpectedly goes down. Or, in the case of the example we have been discussing with our short position in the banks, the stock unexpectedly goes up.

In that case, with our position consisting of a long put, we would be in a losing position by owning puts. As the stock went up, our puts lose value. With the stock going up, we would not want to own puts -- we would want to own calls instead!

To rectify our losing situation, we would want to sell out our puts to prevent further loss and buy calls, which will allow us to gain with the stock trading up.

The problem here -- and it is really only a little problem -- is that, in order to get out of our puts and into calls, we would have to execute two trades. This means we would have two commissions and, more significantly, two bid/ask spreads to contend with.

Wouldn’t it be nice if we could instead accomplish our goal of getting rid of our put position and adding a call position without the added expense of needing two trades to get it done?

Well, actually there is a way of doing just that.

2 for the Price of 1

Instead of exchanging our put for a call, we can turn our put into a call!

As I said, it is necessary to learn about synthetics first but, the ability to turn a call into a put, or a put into a call, allows us to avoid incurring that second trade. We escape the second commission and the second bid/ask spread expense!

In our example with the banks, we would morph our long put into a long call if and when the stock turns and begins to trade up. Remember, this is going to be done with only one move.

We will need to add something to our position or subtract something to our position. In this case, we are going to add something. We are going to add the purchase of the stock. We are going to buy the stock in a 1-to-1 ratio. That is, for every put we own, we are going to buy 100 shares of stock.

The combination of the 100 shares of stock along with the long put creates a position that will mimic the put’s corresponding call identically. The new position is called a synthetic call. Its risk/reward profile will match that of the real call approximately 100%.

Didn't Bet on a Bounce? 'Call' for Reinforcements!

Let’s look at a quick example. We believed that JPMorgan (Symbol: JPM) was likely to go down, so we bought five Dec 50 Puts. We chose to purchase stock-replacement puts (around 80 deltas) and we rolled them down once as the stock traded down.  We did that in order to lock in profits and decrease our risk. At this point we are in the Dec 45 Puts with JPM trading at $43.50.

In our opinion, the stock seems to have bottomed out at a support level (as determined by technical analysis) and is beginning to bounce back up. Based on that educated opinion, we decide to morph our position into a call.

In order to do so, we need to buy 500 shares of JPM against our five long Dec 45 Puts. With the stock in the fold and matched with the puts in a 1-to-1 ratio, our position is the equivalent of owning the Dec 45 Calls!

When the stock trades up, we no longer are losing money by owning puts; we are making money owning calls. In actuality, we do not own real calls; we own synthetic calls.

Many of you might say that this position is not possible for you because you do not have enough money in your account to afford the stock purchase.

Well now, don't fret! There is an alternative!

There's Always Another Way

We have been speaking about and learning of the stock-replacement strategy, which allows us to use options in place of the stock. So, we have an easy fix. Simply buy a front- or second-month, cheapest 100 delta call instead of the stock and you can achieve the same result and spend less money!

Obviously, there are many, many possibilities with options when you use them properly. Make sure that you spend the time necessary to learn this vital and powerful tool prior to using it.

For those of you interested in learning about what options can do for you and how to use them in the proper way, learn more about our new option-education system, Options GPS.

You have now had a quick look at the stock-replacement strategy over my last three articles. If you are good at trading stocks or any other underlying security, then you will be in a better position by learning how to use options in the stock-replacement strategy and by applying the rolling and morphing techniques to juice up your returns!





Ron Ianieri
Contributing Editor
The Tycoon Report



THURSDAY, NOV. 12

8:30 a.m. Initial Claims

    * Importance (A-F): This release merits a C-plus.
    * Source: The Employment and Training Administration of the Department of Labor.
    * Release Time: 8:30 ET each Thursday (data for week ended prior Saturday).
    * Raw Data Available At: http://www.dol.gov/opa/media/press/eta/main.htm

Initial jobless claims measure the number of filings for state jobless benefits. This report provides a timely, but often misleading, indicator of the direction of the economy, with increases (decreases) in claims potential signalling slowing (accelerating) job growth. On a week-to-week basis, claims are quite volatile, and many analysts therefore track a four week moving average to get a better sense of the underlying trend. It typically takes a sustained move of at least 30K in claims to signal a meaningful change in job growth.

There are two other statistics in this report -- the number of people receiving state benefits and the insured unemployment rate; neither is watched closely by the market. Some analysts track the number of people receiving state benefits from month to month as a guide for job growth, though this series has a poor track record in predicting the monthly employment report. The insured unemployment rate changes little on a weekly basis and is never a factor for the market.

Highlights

    * Initial claims broke free of its last equilibrium lower bound and dropped to 512,000 new unemployment claims for the week ending Oct. 31. Initial claims were expected to decline from 532,000 claims to 522,000 and remain within the 520,000 to 535,000 range.

    * Continuing claims fell from a newly revised 5.817 million workers to 5.749 million workers for the week ending Oct. 24. The drop was exactly in-line with the consensus expectation of 5.75 million workers.

    * The market reaction to the drop in claims will be limited as the more important national unemployment numbers for October are released on Friday.

Key Factors

    * It's way too early to tell if the drop in initial claims represents a growing downward trend or if claims are merely looking for a new equilibrium range. In the past few months, whenever the claims level fell below its previous range analysts were quick to predict a long-term downward trajectory.

    * Given that a long downward trend hasn't happened yet, we are leaning more on claims trying to settle somewhere between 500,000 and 525,000 for the next few weeks.

    * That said, an initial claims level above 400,000 will continue to push the unemployment level higher.

    * The drop in continued claims does not mean more workers are finding jobs, but is due to the unemployed running out of their unemployment insurance. Approximately 7,000 unemployed workers lose their unemployment benefits every day.

    * The Senate just passed a new bill that would extend unemployment insurance 14 weeks for all states and 20 weeks for states with unemployment rates above 8.5%. The extension should halt the steady decline in continuing claims for the next few weeks. The House passed a similar measure about a month ago and is expected to ratify the new Senate bill.

    * Republican lawmakers have already begun campaigning that this will be the last extension of unemployment benefits, but if the job market doesn't pick up tremendously over the next 3-4 months, there will be enormous pressure to extend benefits before the midterm primaries.

Big Picture

    * New claims have finally broken free of their 550,000-600,000 bounds, but they are still well above the peak of 400,000 during the last recession. As major companies finish their labor restructuring, many of the newly unemployed are coming from smaller businesses. This tends to cause more hardship on Main Street as many of these workers are unprepared for their job loss.


FRIDAY, NOV. 13

8:30 a.m. International Trade

    * Importance (A-F): This release merits a C-plus.
    * Source: The Census Bureau and the Bureau of Economic Analysis of the Department of Commerce.
    * Release Time: 8:30 ET around the 20th of the month (data for two months prior).
    * Raw Data Available At: http://www.census.gov/foreign-trade/www/press.html

The trade report is most widely watched for trends in the overall trade balance. But trends in both exports and imports of goods and services bear watching as well. The export data in particular are important to watch for indications that a strengthening competitive position at home and/or strengthening economies overseas are boosting U.S. growth. Imports provide an indication of domestic demand, but given the severe lag of this report relative to other consumption indicators, it is not particularly valuable for this purpose.

The volatility in the monthly trade balance can play an important role in GDP forecasts. Net exports are a relatively volatile component of GDP, and the trade report provides the only early clues to the net export performance each quarter.

Highlights

    * The U.S. trade balance deficit tightened by $1.2 billion to $30.7 billion in August. The drop in the deficit was unexpected as the consensus forecast the deficit to rise to $33.0 billion.

    * Exports remained virtually flat in August. The entire tightening in the trade balance was due to a decline in import demand.

    * Imports also decreased in industrial supplies and materials ($1.0 billion); consumer goods ($0.7 billion); other goods ($0.4 billion); and foods, feeds, and beverages ($0.1 billion).

    * Exports saw a decline in capital goods ($1.3 billion) and consumer goods ($0.1 billion). Export demand increased for industrial supplies and materials ($0.9 billion); automotive vehicles, parts and engines ($0.5 billion); and foods, feeds, and beverages ($0.1 billion).

Key Factors

    * The drop in the deficit was not necessarily good news for the U.S. economy as it shows the U.S. consumer is still holding back on increasing their spending.

    * The depreciation of the dollar against all major currencies was expected to help U.S. export growth. We saw evidence confirming that a low dollar value would boost exports in 2007 Q4 and 2008 Q2.

    * Unfortunately, global demand for U.S. goods remains extremely weak and the relative price gain for U.S. importers was not enough to spur an increase in purchases.

    * The drop in imports was unexpected. The latest wholesale and retail sales reports suggested the consumer was rebounding and beginning to make more purchases. The decline in imports confirms the opposite is true as the consumer remains in a state of limited consumption.

    * The lack of correlation between the sales reports and imports is strange. Auto sales came in as expected as the Cash for Clunkers stimulus program boosted demand for imported vehicles by $1.2 billion. However, petroleum imports posted a massive decline of $1.2 billion which does not correlate at all with gasoline purchases.

Big Picture

    * The trade deficit can be thought of as a Catch-22 situation for the US economy. A drop in the deficit has resulted from import demand declining at a faster rate than the decline in export demand. The result was an increase in GDP growth without any actual increase in output. The recent rise in the deficit was the result of both exports and imports growing, but with imports outpacing exports. We are now experiencing an increase in output, but GDP is negatively affected. The trade-off of more production for negative GDP growth is better than the reverse and we'll take the increasing deficit as a signal of a stronger economy.


9:55 a.m. University of Michigan Consumer Sentiment Index

    * Importance (A-F): This release merits a B-.
    * Source: The University of Michigan.
    * Release Time: Preliminary: 10 a.m. ET on the second Friday of the month (data for current month); Final: 10 a.m. ET on the fourth Friday of the month (data for current month).

The Michigan index is almost identical to the Conference Board Consumer Confidence index, though there are two monthly releases, a preliminary and final reading. Like the Conference Board index, it has two subindexes -- expectations and current conditions. The expectations index is a component of the Conference Board's Leading Indicators index.

Highlights

    * The final revision to October's University of Michigan Consumer Sentiment showed a slight increase in sentiment from the middle of the month. The sentiment index rose to 70.6 from 69.4. However, sentiment is still down from September's reading of 73.5.

    * The consensus expected the final reading to increase to 70.0.

    * The expected sentiment indicator rose from its preliminary reading of 67.6 to 68.6.

    * The current sentiment indicator spiked to 73.7 from 72.1. Current sentiment rose above September's reading of 73.4.

Key Factors

    * It is slightly disappointing that, even though the final revision was better than the preliminary reading, consumer sentiment declined from September's reading.

    * Sentiment is strongly correlated with gasoline prices, employment and media reports. With the exception of oil prices, the employment numbers have been getting better and news reports continue to talk about how well the economy is recovering.

    * Given the correlation, sentiment should have posted a much stronger increase.

    * Please note, changes in consumer sentiment does not necessarily translate into changes in consumption spending. The main drivers for consumption are current/expected income and available credit. The consumer still faces constraints in both sectors which will make future consumption growth difficult.

Big Picture

    * Sentiment readings are a reflection of a variety of events rather than an accurate tool for forecasting consumer spending.  Gas prices and political events can have an outsized impact on sentiment.  In general, these data are of very little economic value.

Source: Briefing.com