Who Else Wants Better Returns, for Less Money?
Thursday, January 28, 2010 | Bob De DeaRating:
Investing in sectors (i.e., specific industries) can be a very lucrative way to build up your portfolio. There are nearly a thousand Exchange-Traded Funds, representing dozens of sectors, that can help you to play a group of stocks in specific industries in just one transaction (by buying or shorting an ETF, which is a "basket" of representative stocks) -- instead of spending a lot of time and money, picking multiple individual stocks to leverage a coming move.
Not all ETFs are created equally, though. Just like many stalwart, blue-chip stocks that haven't moved in 30 years, there are some "slow and steady wins the race" ETFs out there.
And while you might look at some of those for long-term holdings, there are plenty of sectors out there that are practically always on the move .. and some of those moves can be big.
Even with the ones that don't have huge runs (or drops), you can capture those "smaller" moves and turn them into a potentially much-bigger ones by trading ETF options.
Today I'm going to walk you through my process when I'm initiating an ETF trade -- from looking at a potential opportunity to identifying the way to play it that sets me up with the best reward for the lowest-possible risk.
A Real 'Steel'
Active stocks and sectors can open up some amazing opportunities for you.
But how do you spot them and position yourself for profits?
Steel/iron is one of those very volatile sectors. It's not uncommon for there to be wild swings from overbought to oversold and back again.
Back in April 2009, I wrote about "2 Sectors Poised to Provide Serious Trading Profits," and this segment was one of them. Once the sector Bullish Percent Index (BPI) crossed below the 70% line, that was a significant level because the sector was now on a sell signal. (Its BPI was at the time at around 64%.)
(For a primer on the BPI and Point & Figure charts -- which we'll examine in today's discussion -- see my series starting with this article.)
Typically, once this particular sector hits resistance, it drops like a rock. In fact, a month later, the sector posted another exception to its "typical" behavior.
Here's a current chart with the period circled in green:
The head-fake that took place in April 2009 was followed by a move above the 90th percentile.
Another head-fake at the top, and it plummeted again, to just below 30%.
Then up it went again, down below 50% and so on until its recent move this month back to Os, at a little above 78%.
(The Xs on the chart represent demand and, thus, price increases; Os signify supply taking over and, accordingly, price drops.)
Investing With the Flow -- Rather, the Curve
According to the U.S. Industry Bell Curve (one of my absolute favorite tools, courtesy of Investors Intelligence), steel is currently in a precarious and uncertain position:
(click on the image to view it full-size)
It's in a bull trend in an overbought range (between 70% and 80%), but in a column of Os. (On a sector BPI chart, the P&F buy signal is not as important as the last column position that the chart shows -- in this case, Os.)
Is now the time to short this puppy?
It's too early to tell. If the BPI dips below 70%, the sector will be on a sell signal again. The only thing we can observe from the history of the BPI chart above is that the down moves tend to be either short or long; there are only a few middle-of-the-road columns of Os.
The sector is still outperforming the broader market, however, so any contrary move would be against the long-term trend.
How to Play the Sector
Knowing what we know about this sector makes me cautious.
I could buy a stock and hope for the best, but I'm much more comfortable purchasing a diversified instrument that will spread the risk across the sector.
That's why I like to use ETFs.
There are two ETFs associated with steel/iron:
1. The SPDR Metals and Mining ETF (Symbol: XME). As the name might suggest, it's not a pure steel/iron sector play, since it contains gold and coal securities in its portfolio. It only has six holdings in common with the constituents that make up the Investors Intelligence sector BPI, which is limited to steel producers and steel special alloys.
2. The Market Vectors Steel ETF (Symbol: SLX), on the other hand, shares 14 of the BPI's 23 constituents, and does not have any precious metal or coal miners among its holdings, making it the ETF of choice for the sector.
Thus, today we'll take a closer look at the SLX. Let's start by examining its BPI chart.
SLX had a pretty good 2009, after a devastating 2008. If you compare the two time periods, you'll see that the uptrends in SLX correspond to the columns of Xs in the BPI, and vice versa for the downtrends.
(See, for example, the start of the uptrend in March 2009 -- signified by the red "3" at the bottom of the column of Os near the middle of the chart -- and the recovery from the third column of Os to have reached zero on the BPI.)
When the market turns around -- that is, when the NYSE BPI turns back to a column of Os, when the steel/iron sector BPI confirms its downward trend, and especially when the sector starts underperforming the broader market -- that would be the time to seriously consider shorting this security.
(Doing so at present while the sector is outperforming the broader market is certainly possible, but should be treated as a short-term strategy and not a long-term play.)
Preparing (and Hoping) for the Worst
If you were on the other end of this trend and got in at around 25 smackeroos, you'd be sitting pretty and happy to have taken advantage of the movement upward.
Let's pretend for a moment, however, that it all goes to hell in a handbasket. (What does that mean, anyway?!)
The trader who had no problem buying the ETF at 20 bucks may have a harder time when he or she considers shorting the ETF at $65.
But there are other options. Errr ... options!
Directly shorting a stock or ETF carries a tremendous amount of risk. Instead, you can simply purchase a put option to make a bet on the security, in this case the SLX, taking a tumble.
Buying the right put option positions you for profits as a security loses value, and your only risk is what you spend to enter the position.
I'll step you through my own selection process as I choose a put option to buy when the technical indicators I follow are in alignment to short SLX.
1) Look at the current price. (It's $64.61 as of the date of this writing.)
2) Look for options with a maturity date at least two to three months out. So, we'd consider buying puts with an expiration date of April or May.
3) Look for an in-the-money option. This simply means that, with a call option, the strike price of the option is less than the current market price of the ETF. And, with a put option, the strike price is greater than the current price.
Since we're looking for puts, I'll be looking for a strike price of between $70 and $80. (Again, a put is in-the-money if the security's price, which is around $64 in this case, is below the strike price.)
Get a detailed lesson on in-the-money options from Ron Ianieri by clicking this link.
4) Look for an option with a fairly high delta. "Delta is the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of an option contract."
If you don't know what that means, you obviously haven't read Chris Rowe's definitive series on the topic (from which I lifted that definition), so go here now, read it, and come back. I'll wait.
"Leavin' on a jet plane, don't know when I'll be back again. Oh, babe, I hate to go."
You're back -- great! Let's go on.
4) Your online broker probably shows you the Greeks -- most show you the deltas, and some even show you other important Greeks like theta, vega and gamma. Why do you need to know about the Greeks? Because they quantify the potential risks of an option position before you even enter it.
And who wouldn't want to know how the trade might turn out ... before ever spending a dime of money on it?
The puts with April and May expiration dates aren't available to trade yet, though, so here's a list of puts with a June expiration date in our strike-price range:
2) Look for options with a maturity date at least two to three months out. So, we'd consider buying puts with an expiration date of April or May.
3) Look for an in-the-money option. This simply means that, with a call option, the strike price of the option is less than the current market price of the ETF. And, with a put option, the strike price is greater than the current price.
Since we're looking for puts, I'll be looking for a strike price of between $70 and $80. (Again, a put is in-the-money if the security's price, which is around $64 in this case, is below the strike price.)
Get a detailed lesson on in-the-money options from Ron Ianieri by clicking this link.
4) Look for an option with a fairly high delta. "Delta is the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of an option contract."
If you don't know what that means, you obviously haven't read Chris Rowe's definitive series on the topic (from which I lifted that definition), so go here now, read it, and come back. I'll wait.
"Leavin' on a jet plane, don't know when I'll be back again. Oh, babe, I hate to go."
You're back -- great! Let's go on.
4) Your online broker probably shows you the Greeks -- most show you the deltas, and some even show you other important Greeks like theta, vega and gamma. Why do you need to know about the Greeks? Because they quantify the potential risks of an option position before you even enter it.
And who wouldn't want to know how the trade might turn out ... before ever spending a dime of money on it?
The puts with April and May expiration dates aren't available to trade yet, though, so here's a list of puts with a June expiration date in our strike-price range:
It's 1 a.m. here in Seattle, so that's why there's no volume registered.
And one caveat: We'll limit ourselves in this example to those options which have open interest. (In other words, somebody is already selling/buying them.)
I've highlighted the deltas in this screen shot. Since we want an option with a delta in the 70s or so (or, because it's a put option, in the negative 70s, as puts have a negative delta because they are a "short" instrument), the first three are too low to meet this criteria.
This leaves us with three options. (And, oh, yes, the pun was definitely intended, you betcha!)
For the sake of this example, I'm assuming that we are able to buy the option at $3 more than the "Last" price. With that in mind, we would pay $14.70/share for SLXRX with a strike price of $76; this option has an intrinsic value of $11.39 (strike price minus current price) and an extrinsic value of $3.31 (cost of option minus intrinsic value).
Likewise, we would pay $15.60 for SLXRY with an intrinsic value of $12.39 and an extrinsic value of $3.21; and we would pay $16.70 for SLXRB with an intrinsic value of $15.39 and an extrinsic value of $1.31.
Notice that, as the delta gets higher, the intrinsic value also increases.
Since I'd be buying put options for as far out as June, I would go for the $80 strike price, even though it's more than $5 to $10 in-the-money.
I would spend $1,560 for one options contract -- that's a lot less scarier than shorting 100 shares outright.
But, remember, I'm not giving advice here. (I'm not legally allowed to.) This is a hypothetical situation we're talking about, since we haven't yet seen the movement in the ETF or in its sector that would signal our entry into a short position on SLX.
The Beauty of it All
The greatest thing about using options with ETFs is that you limit your risk in so many ways -- by choosing a diversified instrument, by limiting your exposure in the first place -- and, yet, you have great leverage with options because they allow you to do things you can't do unless:
1) You have loads of money that you don't care about risking, or
2) You have loads of money that you don't care about risking.
You get my point. With options, you can keep the majority of your cash safe in some interest-bearing account while you risk only a small portion of your portfolio.
Or, if you have limited resources, as discussed last week, you can use options to build your profits little by little, step by step, dollar by dollar.
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Bob De Dea
Guest Contributor
The Tycoon Report
