The Tycoon Report

Don't Get Caught Trading Options Naked

Monday, August 24, 2009 | Barbara Cohen



As you all know by now, I am a proponent of trading E-Mini futures.  It is an excellent trading environment for smaller investors because the Chicago Mercantile Exchange (CME) makes it a level playing field for one and all.  No matter how many contracts you trade, getting filled is still FIFO (first in / first out), which is not necessarily so with the New York Stock Exchange or the Nasdaq.  And there is only one exchange for each instrument, so there is only one price.  Again, not necessarily so with stocks or Exchange-Traded Funds.

I know that a lot of you use options in your portfolio but you haven't yet taken the plunge to integrate futures into your overall trading strategy. Today I have a way that you can use both to put your money to work while protecting your capital.

The Way the 'Big Guys' Trade

Trading E-Mini futures is not just for smaller investors.  It is also used by larger investors to protect their trades.  How does this work and, more importantly, how can you use E-Minis to protect your options positions?

If there were one word that could describe trading options, that word might be "insurance." 

If you look at many of the option strategies, they are designed so that, in some way, you invest in both calls and puts to protect your investment.   Trading just one side (either up or down) is considered risky.

When you short a call option, for example, but don't own the underlying instrument, the option is described as "naked" -- or "uncovered" by a long position to protect you if the position moves against you.

Why would you short (or "sell to open") a call or a put? Many investors do this because you receive a credit upfront. That is, you receive money at the outset of your trade, with the goal being that the option value decreases over time, allowing you to keep most (if not all) of the money you collected. This strategy depends on the underlying security moving in the "right" direction, or not moving at all.

But what if the position does not go your way? With stock options, you can typically exit your option trade at any time, so you don't have to be stuck in a position that's not working for you. But when the market, and the underlying stock, moves very quickly, it's important to have a safety net to "cover" your position.

Brokerages frown upon investors trading uncovered options.  If the price of the underlying asset moves in the opposite direction than you expected, meeting your financial obligation might result in substantial loss to you.

But if you have to purchase some kind of an "insurance policy" for every option trade (i.e., buying a call in the opposite direction against the put you already own), it provides a layer of much-needed protection. However, buying protection can cut into your profitability.

Another Way to Hedge

Enter the S&P 500 (SPX) E-Mini futures.  Here's an insider's tip on what the big boys do to cover their potential losses.

Since the middle of July, the Chicago Board Options Exchange (CBOE) put/call ratio has been plunging.  It is now down at its lowest levels since March.  March is when the S&P 500 moved up considerably. 

The CBOE equity put/call ratio demonstrates the trading volume of put options vs. call options.  When the put/call ratio is low, market sentiment is very bullish.  Because the market has been flying back up, larger investors have been capitalizing on the run by purchasing SPX call options.

However, on the remote chance that the market does pull back, these investors are placing SHORT STOP LIMIT orders on the S&P 500 E-Mini futures.  The stop limit says, don't execute this trade unless the price falls so far that it hits the lowered limit price, at which time, execute my short trades. 

Since the market has been steadily climbing, the short limit orders have not been getting executed, so it hasn't cost the big boys anything to buy call options.  By placing short stop limit orders on the S&P 500 E-Mini, if the value of their call options goes down due to bad economic influences, their short positions on the S&P 500 E-Mini will make their trading a wash. 

While they won't make any money, at least they break even.

How do we know this is true?

Normally, Monday mornings tend to bring light trading in the S&P 500 E-Mini.  After all, it is Monday.  But on Aug. 17, 2009, by 8 a.m., more than 400,000 contracts had already been traded, and the S&P 500 E-Mini was down 22 points. 

Why? 

Japan's Nikkei Stock Index plunged 3.1% on poor economic earnings announcements, taking the Shanghai Composite (down 5.8%) and the Hang Seng (down 3.5%) with it.  The CBOE Volatility Index (the VIX, also known as the "fear index," as it is used as a measure of trader sentiment) shot up 14.9% to 27.89.

Because the Asian markets fell so heavily, they triggered the S&P 500 E-Mini to be down 22 points.  Those larger investors saw their short Stop Limit Orders get executed.  It was the first time in a long time that Short Limit Orders were hit.  And a lot of money was lost!

The bottom line? Anything can happen in the markets, and you must be prepared for it. Not every trade is going to be a winner, but with the right protection in place, you can walk away from the losers without losing everything.





Barbara Cohen
Contributing Editor
The Tycoon Report



TUESDAY, AUG. 25

10 a.m. Conference Board Consumer Confidence

    * Importance (A-F): This release merits a B-.
    * Source: The Conference Board.
    * Release Time: 10 a.m. Eastern on the last Tuesday of the month (data for current month).
    * Raw Data Available At: http://www.tcb-indicators.org

The Conference Board conducts a monthly survey of 5,000 households to ascertain the level of consumer confidence. The report can occasionally be helpful in predicting sudden shifts in consumption patterns, though most small changes in the index are just noise. Only index changes of at least 5 points should be considered significant.

The index consists of two subindexes -- consumers' appraisal of current conditions and their expectations for the future. Expectations make up 60% of the total index, with current conditions accounting for the other 40%. The expectations index is typically seen as having better leading indicator qualities than the current conditions index.

Highlights

    * The Conference Board reported the Consumer Confidence Index dropped to 46.6 in July (consensus 49.0) from 49.3 in June.  The July report marks the second-straight monthly drop in this particular confidence reading, which tends to revolve a great deal around labor market conditions.

    * The Present Situations Index retreated to 23.4 from 25.0.

    * The Expectations Index dipped to 62.0 from 65.5.  It would be remiss not to mention that the Expectations Index is up from 27.3 in February and the year ago level of 42.7.

    * The number of respondents saying present business conditions are "bad" rose to 46.3% from 45.3%, but those saying business conditions are "good" ticked up to 9.1% from 8.1%.

    * Notably, 63.1% of respondents think business conditions will be the same six months from now versus 58.7% in June.

    * A lower number of respondents (9.5% vs. 10.1% in June) thinks their income will have increased six months from now.

    * Given that this survey was mailed out around the time of the June employment report, it is little surprise to us that those claiming jobs are hard to get increased to 48.1% from 44.8%

Key Factors

    * The back-to-back monthly declines suggest the stock market may be putting the recovery cart before the consumer horse.

    * Weak income growth expectations aren't a great portent for a meaningful pickup in consumer spending nor is the realization that plans to buy a car, a home, and major appliances within the next six months were all cut back from June levels.

Big Picture

    * Consumer sentiment indices get way too much attention.  The simple fact is that sentiment does not correlate strongly with consumer spending and thus has little predictive value.  Consumer spending correlates more closely with income.  Sentiment tends to reflect well known factors such as unemployment rates and gas prices more than it predicts future spending patterns.


WEDNESDAY, AUG. 26

8:30 a.m., Durable Goods Orders

    * Importance (A-F): This release merits a B.
    * Source: The Census Bureau of the Department of Commerce.
    * Release Time: 8:30 a.m. Eastern around the 26th of the month (data for month prior).
    * Raw Data Available At: http://www.census.gov/ftp/pub/indicator/www/m3/index.htm

The durable orders release measures the dollar volume of orders, shipments, and unfilled orders of durable goods (defined as goods whose intended lifespan is three years or more). Orders are considered a leading indicator of manufacturing activity, and the market often moves on this report despite the volatility and large revisions that make it a less than perfect indicator. These problems can be minimized by looking at the breakdown of orders. The total number is often skewed by huge increases in aircraft and defense orders. An increase based solely on strength in one sector tends to be discounted, while the market is more impressed with broadbased increases in orders.

Highlights

    * Durable goods orders declined -2.5% in June (consensus -0.6%) while the May number was revised down to a 1.3% increase from an originally reported 1.8% increase.

    * A -12.8% drop in transportation equipment orders, which followed two consecutive monthly increases, fueled the June disappointment in the notoriously volatile report.

    * Excluding transportation, orders increased 1.1%.  That was well ahead of the consensus estimate of 0.0% and it followed a downwardly revised 0.8% increase (from 1.1%) in May to mark the second straight monthly increase in that series.

    * The other ray of business investment light was the nondefense capital goods, ex aircraft, number, which was up 1.4% in June after a 4.3% increase in May.  This number is viewed as a proxy for business investment spending.

    * Total shipments declined -0.2%, which extended the negative streak there to 11 months (the longest on record).

Key Factors

    * The June shipments number left the Q2 average at $170.0 billion, which is down slightly from the average of $171.0 bln prior to the June report.  This will be a negative factor as it relates to estimates for the advance Q2 GDP report.

Big Picture

    * Durable goods orders trends were very weak in late 2008 and early 2009.  That reflected a collapse of confidence in the business sector and poor credit market conditions.  The rate of decline has eased and there has been some intermittent increases of late that suggest the worst of the downturn is over.  Still, the business investment outlook can be considered weak.


THURSDAY, AUG. 27

8:30 a.m. Gross Domestic Product

    * Importance (A-F): This release merits a B.
    * Source: Bureau of Economic Analysis, U.S. Department of Commerce.
    * Release Time: Third or fourth week of the month at 8:30 a.m. Eastern for the prior quarter, with subsequent revisions released in the second and third months of the quarter.
    * Raw Data Available At: http://www.bea.doc.gov/bea/dn1.htm

Gross Domestic Product (GDP) is the the broadest measure of economic activity. Annualized quarterly percent changes in GDP reflect the growth rate of total economic output. The figures can be quite volatile from quarter to quarter. Inventory and net export swings in particular can produce significant volatility in GDP. The final sales figure, which excludes inventories, can sometimes be helpful in identifying underlying growth trends as inventories represent unsold goods, and a large inventory increase will boost GDP but might be indicative of weakness rather than strength. The broad components of GDP are: consumption, investment, net exports, government purchases, and inventories. Consumption is by far the largest component, totalling roughly 2/3 of GDP.

Highlights

    * The advance Q2 GDP report showed the economy contracted at an annualized rate of -1.0%.  That was much improved from a downwardly revised -6.4% (from -5.5%) in the first quarter and it was also better than the expected -1.5% decline.

    * Personal consumption expenditures, which are the main driver of the economy, fell at an annualized rate of -1.2% and subtracted 0.88 percentage points from the change in real GDP.  In the first quarter, PCE added 0.44 percentage points to real GDP.

    * Real final sales, which exclude the change in private inventories, decreased -0.2% in the period versus a -4.1% decrease in Q1.

    * Government consumption expenditures added 1.12 percentage points to Q2 GDP after subtracting -0.52 percentage points in Q1.

    * The biggest drag was gross private domestic investment.  It subtracted 2.64 percentage points from real GDP. 

    * The change in private inventories subtracted 0.83 percentage points.

    * The bright spot so to speak was net exports.  They added 1.38 percentage points to the change in real GDP as global trade rebounded from the extremely depressed base of the first quarter.  Imports were the swing factor there, adding 2.14 percentage points while exports subtracted 0.76 percentage points (which wasn't as bad as the minus 3.95 percentage point contribution in Q1).

Key Factors

    * The disappointing PCE number was a reminder that the economic recovery will be an uneven affair, quite simply because the U.S. consumer isn't what he/she used to be in the face of rising unemployment and falling home values.

    * The government spending has been necessary, but it, too, provides a reminder that activity in the private sector continues to be lackluster.  Even with the positive contribution from government spending, real GDP was still down -1.0%.

    * The change in private inventories was the sixth time in the last seven quarters that the change in inventories has been negative, so the market will presume this component should shape up in the near future with inventory restocking.

Big Picture

    * The trends in the economy were moderately poor through the summer of 2008.  Then, in September, the trends tanked along with the stock market.  Some tech firms noted a significant dropoff in demand right after the mini-panic of mid-September.  These worsening trends were readily apparent in the fourth quarter GDP numbers, and in the first quarter 2009 GDP numbers as well.  Consumer spending is weak and will only take a significant turn for the better once the declines in payroll moderate.   Business investment is weak, too.  A lot now depends on overall psychology and perceptions of how well the government responds to the financial market and other problems such as exist in the auto industry.  The economic outlook is now as much a function of government action as it is of the traditional correlations and trends among macro-economic variables.


FRIDAY, AUG. 28

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. Eastern on the second Friday of the month (data for current month); Final: 10 a.m. Eastern 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 preliminary report on consumer sentiment for August from the University of Michigan caught the market by surprise and not in a good way.  The index dipped to 63.2 from 66.0 in July.  The consensus estimate was 69.0.

    * The current conditions index dropped to 64.9 from 70.5.  The August reading here is unsettling, considering it is below the level seen in February when the stock market was much lower and the unemployment rate wasn't as high.

    * The economic outlook index fell to 62.1 from 63.2.  That is the lowest reading since March when this category measured 53.5.

Key Factors

    * Ultimately, it is income that drives spending, but the weak confidence measure is a sobering reminder of the psychological (and real) effects of a weak labor market that has been accented by a growing mass of workers (1 out of every 3 unemployed) that has been unemployed for 27 weeks or longer.

    * The economic data overall might suggest in the months ahead that the recession is over, but this confidence report goes to show it will feel like a recession for a lot of people a lot longer than some production data says it should.

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