The Tycoon Report

1 Powerful Strategy: 2 Ways to Profit

Monday, November 30, 2009 | Ron Ianieri

Over the last several weeks, my articles have tried to zero in on one particular theme: being prepared for the downside.

As I stated before, it is not bear markets or sharp sell-offs that kill investors’ portfolios. It is the lack of preparation by the investor in reading the signs of an upcoming problem and an inability to strategize and execute a plan, if and when the potential problem comes to fruition.

Going forward, investors will need to be even more prepared for these types of market situations, as they are likely to occur more frequently as the markets become more and more globalized.

This latest financial crisis, as confirmed by the recent news from Dubai, shows exactly how much the world markets and economies are interwoven.

This means that our economy and markets here in the United States will be more and more influenced and affected by international situations.

A World of Crisis ... and Opportunity

We have all known for a long time that overseas markets and economies have been influenced by us.  Now, it seems like the opposite scenario is starting to show signs of balancing out.

We are starting to see events like the situation in Dubai occur more often but, more importantly, how they have bigger and more-direct effects on us.

We have talked about how to defend ourselves from these types of situations. We’ve talked about a simple way of getting on the offense and making money off the downside after first protecting ourselves and what we already have.

But, between the amount of money you have invested in your portfolio and the cost of protecting it, many of you do not have enough capital remaining in your account to then take advantage of the downside using the strategy of simple stock replacement via purchasing puts.

Remember, you can start to reconstruct your portfolio using the stock replacement strategy, which would allow you to keep your same-size position, decrease your risk, and increase your cash position. For those of you who have embraced this concept, cash will not be an issue.

For those of you who just have to own stocks, then cash will be a problem. And the stock replacement puts, which would have allowed you to make money on the downside, could very well be too expensive.

Yet Another Way to Replace the Stocks in Your Portfolio

Obviously, it is never too late to reconstruct your portfolio and do it the right way. However, for those of you who just can’t do it for whatever reason, thus leaving you without enough cash for stock replacement, you will need another way to take advantage of the downside.

This way is a strategy known as the vertical spread.

For the record, the vertical spread is probably the most-versatile of all of the option strategies:

• It is extremely cost-effective.
• It features a limited-risk scenario.
• It can be used to play direction.
• It can be used to collect premium.

And it can be constructed in two different ways.

I have been asked many times what my favorite options strategy is, or what's the best strategy to use.

Where I would never willingly admit to having a favorite strategy, due to the fact that -- depending on the situation -- there are many different strategies that could be the right one at that time, I would have to say that the vertical spread is a viable strategy more often than any of the others in most situations.

So, when I am asked about my favorite strategy, I always say that my favorite strategy is the right one for the specific occasion. More than any other strategy, the vertical spread is in my list of possibilities.

While I cannot properly teach the vertical spread in the depth required in a brief article, I can show you why you should seek to learn more about the vertical spread. First, we need to know what a vertical spread is and how it is constructed.

1 Strategy: 2 Ways to Profit

Vertical spreads involve the simultaneous purchase of one option and the sale of another in the same month in a 1-to-1 ratio. The vertical spread will consist of all calls or all puts.

An example (but not a recommendation) of a vertical spread may be purchasing an IBM Dec 120 Call while selling an IBM Dec 125 Call at the same time. Another example would be purchasing an IBM Jan 125 Put while selling an IBM Jan 120 Put.

Now that you understand the construction, let’s take a look at the advantages of the vertical spread.

The first advantage, and the most-important one in the scenario discussed above, is the cost-efficiency.

Using IBM as an example, let us say that we believe IBM is going to trade down and we would like to take advantage of that opportunity. We could short the stock, but then we would have to come up with the margin requirement -- which is 50% of the price of the stock or, in this case, about $63 per share.

If your portfolio is reasonably allocated, there won’t be much cash available in your account, and probably not enough cash to cover the margin to short enough shares to matter even if IBM goes down.

Instead, you could decide to buy a short stock-replacement put. The ideal put will in this example would be the Jan 135 Put, which would cost you about $10 per share per contract. (An option contract represents 100 shares, so $10 per share times 100 would cost you $1,000.)

This strategy could also be too expensive.

If it is, here is where the cost-efficiency of the vertical spread comes in.

The Cost Advantage of the Vertical Spread

Say you were to buy that IBM Jan 120-125 Put spread, as described above. You purchased the Jan 125 Put and sold the Jan 120 Put in a 1-to-1 ratio. You would have paid approximately $3.40 for the Jan 125 Put and you would have sold the Jan 120 Put for around $1.80.

Your total cost would be $1.60 ($3.40 paid out minus $1.80 collected), times 100 (amount of shares per contract), times the amount of spreads you choose to buy.

In this case, if you were to buy 10 spreads (buying 10 Jan 125 Puts and selling 10 Jan 120 Puts), your total cost would be $1,600 … a lot less than the margin requirement needed to short the stock.

If IBM closes below $120 on January expiration, the spread will be worth $5 (the difference between the two option strike prices, or $125 - $120).

You paid $1.60 for a spread that is now worth $5. You have made $3.40 on your $1.60 investment with the stock trading down around $6. From a cash standpoint, looks like a pretty good alternative to shorting the stock.

Less Money on the Table, Less Risk

The second advantage is the limited-risk scenario. When buying the vertical spread, the buyer can only lose what they have spent. You spent a total of $1,600, $1.60 per share per spread. So, the most you can lose is that $1,600 with the opportunity to make $3,400.

The limited-risk scenario is very important, as we already have risk to our portfolio. The last thing you need is an open-ended risk in addition to the risk you already have.

This is not true if you have shorted the stock. In that case, you would have unlimited risk if the stock went up.

The pure put purchase, the short stock-replacement put, would have a limited-risk scenario also. But the difference in the amount of risk is still considerably more than in the vertical spread … almost 10 times more!

Access the Power of Premium Collection

Another advantage is the fact that the vertical spread can be purposely constructed in such a way so that it is not only a directional strategy, but also a premium-collector strategy.  If the option you sell has a theta that is higher than the theta in the option you buy, then your spread will benefit with the passage of time.

(Theta tells us how much our option's price will lose in one day. We teach you about this important "Greek" in the Options GPS educational course.)

This leads to an increased chance or probability of success of profitability.

Now, the spread will not only benefit from the stock moving in your direction, but also if time simply passes by with the stock staying still.

Another Example

For example, say we set up a different spread. Instead of buying the Jan 120-125 Put spread for $1.60, we chose to buy the Jan 125-130 Put spread.

In this case, we would buy the Jan 130 Put for about $6.20 and sell the Jan 125 Puts for $3.40 for a total cost of $2.80 with the stock trading at $125.70.

If the stock were to finish right at $125.70 at January expiration -- totally unchanged -- then the spread would be worth $4.30. This would leave you with a profit of $1.50 ($4.30 minus $2.80) without the stock even moving! This profit is brought to you courtesy of time decay.

Vertical Spreads Offer a Bounty of Opportunities

As you can see, the vertical spread is a powerful strategy that can really help investors, not only in this specific scenario in the current market but also in many other situations.

There are several other advantages that the vertical spread offers to investors. There is also much more to the mechanics and selection process of the vertical spread, not to mention finding an opportunity where the vertical spread is a viable option. 

In order to be in a position to take advantage of all the vertical spread has to offer, you need to first be educated in option theory and in the workings of the vertical spread itself.

When educated in how to use the vertical spread properly, increased profits and decreased risk are within the scope of all investors!




Ron Ianieri
Contributing Editor
The Tycoon Report



MONDAY, NOV. 30

9:45 a.m. Chicago Purchasing Managers Index

    * Importance (A-F): The Chicago PMI merits a B.
    * Source: Kingsbury International Ltd. and Institute for Supply Management-Chicago, Inc.
    * Release Time: Typically the last business day of the month at 9:45 a.m. Eastern

There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region. The New York and Philadelphia Fed's surveys are the first each month, followed by the Chicago purchasing managers' report on the last day of each month.

These surveys can be of some help in forecasting the national Institute for Supply Management data. The Chicago PMI index, which is released on the last business day of the month (with data for the same month), has an impressive 91% correlation with the national ISM.

Highlights

    * The Chicago PMI index jumped over the 50-point threshold for the first time since September 2008 as the index grew to 54.2 in October. The consensus expected the index to increase slightly to 49.0 from 46.1 and to remain in the contraction phase.

    * The production index increased to 63.9 from 47.2 and orders rose to 61.4 from 46.3.

    * Inventories continued to contract and have gotten worse over the last month as the index declined to 32.2 from 38.9.

    * The only other sector that continued to contract was employment, which declined to 38.3 from 38.8.

    * Other components of the index showed the manufacturing sector strengthening, including order backlogs (which increased to 41.9 from 36.7) and prices paid (which declined to 48.6 from 51.3).
      

Key Factors

    * The entire index showed signs of a sustainable expansionary cycle.

    * Unlike last month's national index, where production grew on the anticipation of new orders that never came in, production and new orders posted strong growth and entered an expansionary phase in the Chicago region.

Big Picture

    * The Chicago PMI has little overall economic value, and is only watched by the financial markets because it is usually released one day in advance of the similar national ISM manufacturing survey.  A significant move in this regional survey will therefore sometimes be seen as having predictive value for the ISM index.


TUESDAY, DEC. 1

10 a.m. Institute for Supply Management

    * Importance (A-F): This release merits an A-.
    * Source: Institute for Supply Management
    * Release Time: 10 a.m. Eastern on the first business day of the month for the prior month.
    * Raw Data Available At: http://www.ism.ws

The ISM report is a national survey of purchasing managers, which covers such indicators as new orders, production, employment, inventories, delivery times, prices, export orders and import orders.

The total index is calculated based on a weighted average of the following five sub-indexes, with weights in parentheses: new orders (30%), production (25%), employment (20%), deliveries (15%), and inventories (10%).

The ISM is one of the first comprehensive economic releases of the month, typically preceding the employment report. Though it covers only the manufacturing sector, it can often provide accurate hints regarding the tone of subsequent releases.

Highlights

    * The ISM index reported a faster rate of expansion than expected in October as the index increased from 52.6 to 55.7. The consensus expected the ISM index to increase to only 53.0.

    * The rate of production rose as the index increased from 55.7 to 63.3 and backlogs maintained the same rate of expansion as last month.

    * Surprisingly, prices posted its fourth-consecutive month of expansion as the index increased from 63.5 to 65.0.

    * Inventories continued to contract as manufacturing inventories increased 4.4 points to 46.9 while customer inventories declined 0.5 to 38.5.

Key Factors

    * The data from the sub-indices were interesting in the fact that new orders expansion slowed from 60.8 to 58.5 while employment showed its first sign of expansion in 14 months.

    * One would expect orders would have to continue to strengthen in order to drive demand for new labor. The jump in employment may be temporary as firms bring back some furloughed employees to maintain a new production schedule through the end of December. If consumer demand does not continue to rebound beyond then, manufacturers could return to smaller workforces.

    * If production continues to increase without a significant boost to new orders, backlogs will begin rapidly falling over the next few months.

    * Given the heightened unemployment level and slack in the manufacturing capacity, theory suggests prices should be facing more deflationary pressures than inflationary.

Big Picture

    * This is a highly overrated index.  It is merely a survey of purchasing managers.  It is a diffusion index, which means that it reflects the number of people saying conditions are better compared to the number saying conditions are worse.  It does not weight for size of the firm, or for the degree of better/worse.  It can therefore underestimate conditions if there is a great deal of strength in a few firms.  The data have thus not been either a good forecasting tool or a good read on current conditions during this business cycle.  It must be recognized that the index is not hard data of any kind, but simply a survey that provides broad indications of trends.


THURSDAY, DEC. 3

8:30 a.m. Employment Cost Index

    * Importance (A-F): This release merits a B-plus.
    * Source: U.S. Department of Labor, Bureau of Labor Statistics
    * Release Time: 8:30 a.m. Eastern, near the end of the first month of the quarter for the prior quarter.
    * Raw Data Available At: http://stats.bls.gov/news.release/eci.toc.htm

Since the employment cost index was mentioned by Fed Chairman Greenspan in July 1996, it has risen into the upper echelon of economic reports in the eyes of the bond market. Its lagging nature still leaves it as a less-timely indicator of employment cost trends than the monthly hourly earnings data in the employment report.

But the ECI does add something to this picture: an adjustment for shifting employment between industries, and a look at benefit costs. These additions typically do not alter the view of the employment cost picture, which was left by hourly earnings. ECI will be much less closely watched during periods when wage inflation is not a serious market concern.

Highlights

    * For the second-consecutive quarter, employment costs rose only 0.4% in Q3. While the rate of the increase was expected, it still remains the lowest change in prices in the history of the index.

    * Wages and salaries, which make up approximately 70% of compensation, also maintained its 0.4% growth rate in Q3. Benefits rose 0.4% after increasing 0.3% in Q2.

    * Year-over-year employment costs increases slowed for the fifth-consecutive quarter and only increased 1.5%.  Last year, at this time, employment costs rose 2.9%.

    * Wages and benefit increases have also declined for the fifth consecutive quarter and now stand at 1.5% and 1.6%, respectively.

Key Factors

    * Employment costs are a double-edged sword. One one side, firms can take advantage of lower employment costs by receiving higher profit margins. However, lower employment compensation growth prevents the consumer from paying more for goods and increases deflationary risks.

    * Employment costs will be constrained in the future as high unemployment forces workers to compete for jobs. This will push down potential wages.

Big Picture

    * Employment costs are the major component of business costs.  The trend in these data therefore have important implications for cost-push inflationary pressures and for profit margins.  In recent quarters, the trend has been relatively steady to lower.  The year-over-year total increase in the ECI is now below 2.0%. Weak overall demand in the economy should keep the ECI cost index on the current trend.  At 1.5% this does not represent much inflationary pressure.


10 a.m. Non-Manufacturing ISM: Institute for Supply Management

    * Importance (A-F): This release merits an improved B-.
    * Source: Institute for Supply Management
    * Release Time: 10 a.m. Eastern on the third business day of the month for the prior month.
    * Raw Data Available At: http://www.napm.org

The non-manufacturing ISM report is a national survey of purchasing managers that covers new orders, employment, inventories, supplier delivery times, prices, backlog orders, export orders, and import orders. Diffusion indexes are produced for each of these categories, with a reading over 50% indicating expansion relative to the prior month, and a sub-50% reading indicating contraction.

The index should be far more indicative of the broader economy, given its inclusion of service-producing as well as good-producing sectors outside of manufacturing. However, the short history of the index dates to only July 1997 and doesn't provide the insight of a longer period inclusive of varied economic climates.

Highlights

    * The ISM non-manufacturing index pulled back slightly in October as the Purchasing Managers Index dropped from 50.9 to 50.6. The index remained above the 50.0 threshold and represented the second-consecutive monthly expansion.

    * The consensus expected the index to have grown to 51.5.

    * Business production increased by only 0.1 to 55.2, but the change was faster than what occurred in September. New orders posted a much stronger gain of 1.4 to 55.6.

    * Inventories have contracted for 14 consecutive months and in October the contraction sped up as the index fell from 47.5 to 43.0. Inventory sentiment increased by 1.5 to 63.5 and signaled that firms still believe they have too much inventory on hand.

    * Employment levels contracted for the 18th consecutive month as the index fell from 44.3 to 41.1.

    * Prices remain volatile and entered an expansion phase as the index increased to 53.0.

Key Factors

    * The decline in the ISM non-manufacturing index isn't too worrying as the two main components, production and new orders, posted positive increases.

    * As long as production and orders continue to increase, we should expect to see expansion in the sector.

    * Inventories remain a problem and a rebound doesn't look too likely in the near future. Inventory sentiment is directly related to expected consumer demand, and until firms truly believe demand will increase sentiment will remain too high. Fortunately for the economy, increases in inventory sentiment rarely lead to an actual change in inventory levels.

    * Deflationary pressures continue to outweigh inflationary concerns and the price index should fall over the next few months.

Big Picture

    * The market generally doesn't pay much attention to the services index because the service sector is less cyclical than the manufacturing sector. During the current recession, the service index held steady around 50.0% through September 2009 before bottoming at 37.4% in November 2008. Since then, the service index has slowly risen back and finally broke the 50.0% barrier. In contrast, the manufacturing index, with the exception of January 2009, stayed below 50% from December 2008 through July 2009 and bottomed at 32.9% in December 2008.


FRIDAY, DEC. 4

8:30 a.m. The Employment Report

    * Importance (A-F): This release merits an A.
    * Source: Bureau of Labor Statistics, U.S. Department of Labor.
    * Release Time: First Friday of the month at 8:30 a.m. Eastern for the prior month
    * Raw Data Available At: http://stats.bls.gov/news.release/empsit.toc.htm

The employment report is actually two separate reports, which are the results of two separate surveys.

The household survey is a survey of roughly 60,000 households; this survey produces the unemployment rate. The establishment survey is a survey of 375,000 businesses; it produces the nonfarm payrolls, average workweek and average hourly earnings figures, to name a few. Both surveys cover the payroll period that includes the 12th of each month.

The reports both measure employment levels, just from different angles. Due to the vastly different size of the survey samples (the establishment survey not only surveys more businesses, but each business employs many individuals), the measures of employment may differ markedly from month to month. The household survey is used only for the unemployment measure -- the market focusses primarily on the more-comprehensive establishment survey. Together, these surveys make up the employment report, the most timely and broad indicator of economic activity released each month.

Highlights

    * The unemployment rate broke above the 10% barrier and jumped 0.4 percentage points to 10.2% in October. This is the highest rate of unemployment since 1983.

    * The consensus did not foresee the unemployment rate moving nearly as high and predicted a more-modest 0.1 percentage points increase to 9.9%.

    * Payroll declines continued to moderate as only firms only shed 190,000 jobs in October.

    * In the private sector, goods producing payrolls declined 129,000 jobs as the construction sector shed 62,000 jobs and the manufacturing sector lost 61,000 jobs.

    * The service-providing sector shed 61,000 jobs, but the news wasn't all bad. Professional and business service sector gained 18,000 jobs due to a huge jump in rehiring temporary workers. The education and health services industries increased their workforce by 45,000.

    * The average workweek held steady at 33.0 hours and hourly earnings increased 0.3%.

Key Factors

    * The knee-jerk thought to the rise in unemployment was that it had to be due to workers re-entering the workforce. However, that was not the case. The labor force declined by 31,000 people as 259,000 workers left the workforce over the last month.

    * The jump in the unemployment rate was solely due to an increase in the unemployed. It was not from any statistical manipulations.

    * However, the decline in payrolls would have been much worse if companies didn't start hiring temporary workers. Temp jobs increased 33,700 in October and other employment service jobs increased by 2,300. Without the massive increase in temporary workers, the drop in payrolls would have increased from September.

Big Picture

    * Weekly claims for unemployment have to drop below 400,000 before payrolls will stabilize.

    * Limited wage growth and declining payroll levels are a recipe for very poor consumer confidence and sluggish consumer spending.

Source: Briefing.com