When we left off last Monday, we were discussing a concern I had about the banks.

I had recommended late the prior week (Oct. 22 to be exact, on "Morning GPS," a daily before-the-bell commentary for members of Options GPS), to sell off any long positions in the banks and to get a little short, as a pullback seemed likely.

Those who felt the same way are in a pretty good position. But, many still have profits and principal still in the market and at risk.

So You Have a Profit ... Now What?

For those who are sitting on profits in your long puts, your job is only half-done! Locking in profits, lowering your risk, and maintaining your position still need to be accomplished.

This is where the true power of options comes in to play. This is what separates options from all other forms of investment in the financial markets ... the rolling technique!

In this weekly column, we've been looking at doing things in a different and, I think, better, way ... using options instead of the underlying securities (i.e., stocks, indexes, Exchange-Traded Funds).

I started by introducing you to the advantages of using options -- buying calls instead of stocks to create a long position, and buying puts instead of shorting stocks -- which is called, quite appropriately, "stock replacement."

Last week’s article offered a way to safely, smartly and cost-efficiently play a potential downside movement in the banks.

Now that the position is on, it is time to manage it.

In this type of position, there is an extremely important technique that goes hand-in-hand with the stock-replacement strategy called the "rolling" technique.  Now is the perfect time to discuss this important "next step" in managing successful (and successfully managing!) positions.

Rolling is a continuation technique. Our goal is to stay with the strategy that we are currently in but just rearrange the options we are using in order to stay as optimal as possible. 

The definition of optimal, when applied to a position, is that the position is cost-effective, quickly profitable in the sense that there is a lot of bang for the buck, and the risk is defined and acceptable. 

In order to attain this goal of constant, consistent optimization of the position, we must use the rolling technique!

'Rolling' With the Profits

There are several types of “rolls,” with each addressing a slightly different concern. 

• There is a horizontal roll, where we move our option from month to month in the same strike.
   
• There is a vertical roll, where we move our option from one strike to another in the same month.
   
• Finally, there is a diagonal roll, which combines the characteristics and virtues of both the vertical and horizontal rolls.

In the stock-replacement strategy, normally, the vertical roll is the one that is most frequently used and most important.

As stated, the vertical roll allows you to lock in profits and lower risk, while maintaining the same position size. By addressing the concerns of profit and risk, you'll have a much easier and better opportunity to follow the full run of the stock without risking the profits already built up in the option.

With the roll technique, your fear of loss is ameliorated and controlled, allowing you to be much more comfortable following the stock and, thus, much more patient playing the entire length of the movement.

Rolling Returns on Buckling Banks

The vertical rolling technique is actually quite simple to use. An investor sells out their current option position and buys the same amount of another strike in the same month.

In the case we have been discussing with the banks, our position would start with a purchase of a stock-replacement put. The purchase of the put will substitute for our short stock position. If we did this on Oct. 22 or 23, then right now would probably be a perfect time to roll our long puts down to the next strike.

Let’s take a look at a couple of possible trades we could have made on that day.

On Oct. 22, JPMorgan (Symbol: JPM) was trading at around $46. At that time, a perfect stock-replacement put would have been the Dec 50 Puts, which were trading around $5.10 with a delta of 75.  (We cover delta in-depth in Options GPS.)

So, instead of selling the stock short, if your broker even allowed it, you would have purchased the Dec 50 Put.  And, for the purpose of this example, let’s say we bought five contracts.

The ownership of these five put contracts would give us the right, but not the obligation, to sell 500 shares of JPM stock at $50 to someone else prior to or on expiration day in December.

The past week of trading in the market produced some down days. Now, here we are about to start another trading week and JPM is trading down at $41.77.

Our puts, the ones we are long -- the five Dec 50 Puts -- are each now worth $8.60 with a delta of 89.  We are currently sitting on a $3.50 profit. That is a 69% return!

Take the Money and Run ... or is There More to Come?

A very good argument can be made for just taking the profit now. However, a strong argument can be made that JPM has a lot more room to go down. 

Hmmm, what to do, what to do? I know, let’s do BOTH! Let’s have our cake and eat it too. Let’s roll!

In order to roll, I must determine the proper option to roll to. Remember, we started out this position by purchasing an option that had a 75 delta and a price around $5.10. Currently, our option is trading at $8.60. We are going to sell out the five contracts at $8.60 and simultaneously purchase another December put ... namely the Dec 47 Puts trading at $6.10 with a delta of 76.

Now, we have closed out our Dec 50 Puts and are now in the Dec 47 Puts. Take a good look at the Dec 47 Puts. They are trading at about $6 with a delta of 76. They sure seem very similar to the position you started with in the Dec 50 Puts. By moving into the Dec 47 Puts, we are basically moving back into the same position we originally started with.

However, the trade we just made, the roll, was actually executed via a vertical spread. We sold the five Dec 50 Puts and bought five Dec 47 Puts.

We have simply executed a credit spread. We took in a credit in the amount of $2.50. This credit that we received is actually part of our profit we made in our Dec 50 Puts when the stock dropped from about $46 down to about $41.75.

Further, instead of having all of our $3.50 profit in the market and at risk, we only have $1 of our profit in the market at risk. The other $2.50 of our profit is in our pocket (i.e., in our account in cash) and out of harm’s way via the credit we received from our roll.

We have locked in the majority of our profits and have decreased our risk of exposure to an adverse movement of the stock!

We can continue to do this rolling technique for as long as the stock trades down.

A Professional's Secret Behind When to Roll

You may be asking yourself when you would know to execute the roll technique. Well, there is a rule of thumb. Take special note of the delta in the option you start with. 

You roll once the next strike’s delta matches the delta of your original option.

For instance, if you start with a 75-delta option, you roll once the next strike up (if buying calls in a rising stock) or down (in the case of buying puts in a dropping stock) reaches 75 delta.

Here lies the power of the option for all to use in the stock-replacement strategy combined with the rolling technique. 

Next week, I will show you how to adjust this trade if the stock turns against you in a simple-to-use technique called morphing!




Ron Ianieri
Chief Investment Officer
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MONDAY, NOV. 2

10 a.m. Institute for Supply Management (ISM)

    * 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 that 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. During periods of inflation concerns, the prices paid and vendor deliveries indexes often determine the bond market's reaction to the report.

Highlights

    * The ISM manufacturing index declined 0.3 percentage points to 52.6 in September. The index came in well-below consensus expectations of a jump to 54.0.

    * New orders fell to 60.8 from 64.9, but are still well-above the 50.0 threshold for an expanding market.

    * The inventory cycle continues to be a problem. The contraction in manufacturing inventories has slowed down as the index increased to 42.5 from 34.4. The increase bodes well for suppliers of raw materials. However, customer inventories remain depressed as the index failed to move from last month's 39.0 reading.

    * Other components of the index were mixed:

1. The employment reading declined to 46.2 from 46.4 and have been contracting for the last 14 months.
2. Supplier deliveries increased 0.9 percentage points to 58.0, which correlates with the increase in inventory levels noted above.
3. The price index declined to 63.5 from 65.0.
4. Backlogs continued expanding as the index increased to 53.5 from 52.5.
5. Finally, both the import and export sectors are in an expansion phase as imports increased to 52.0 from 49.5 while exports declined to 55.0 from 55.5.

Key Factors

    * Even with the slight disappointment in the September reading, the national manufacturing sector looks much better than the Chicago region.

    * The new-orders ISM index contradicts the data just released by the Census Bureau. The Census Bureau reported that new orders for durable goods had dropped significantly over the last month. If the ISM release is going to correlate with the complete factory new-orders report, we will need to see a strong showing in the non-durable manufacturing sector.

    * Once consumer demand picks up, we should see an increase in customer inventory levels and, as a result, an increase in production as manufacturers rush to replenish the stock shelves.

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.


WEDNESDAY, NOV. 4

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 which 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.

The seasonal adjustment of the index didn't begin until January 2001 with only 3 of the 9 components seasonally adjusted as of April 2001. The lack of historical data and lack of a tight correlation to the non-manufacturing economy leaves the relatively poor "B-" rating compared to the "A-" rating of the well-respected manufacturing ISM index.

Highlights

    * The ISM non-manufacturing report soundly beat the consensus forecast (50.0) in September as the index jumped to 50.9 from 48.4.

    * The data from the service sector looks strong.

    * Business activity/production increased to 55.1 from 51.3 and expanded for the second-consecutive month.

    * New orders, which was one of the biggest reasons for the slight decline in the manufacturing ISM report, surged to 54.2 from 49.9 and entered an expansion phase.

    * At the same time, backlog of orders rose to 51.5 from 41.0 which should give the industry strength as we move into Q4.

    * Employment remains a concern as the employment index crept slightly higher to 44.3 from 43.5. Employment has contracted for 17 consecutive months.

    * Deliveries were essentially unchanged as the index increased to 50.0 from 49.0.

    * Prices continue to be highly volatile and swung into a deflationary phase in September. The index dropped from 63.1 to 48.8. We continue to believe prices will moderate further as unemployment rises through the middle of 2010.

    * The biggest problem area continues to be in the inventory sector as the index increased from 43.0 to 47.5.

Key Factors

    * The latest report confirms the market's suspicion that the service industry had entered an expansion phase after 11 consecutive months of contraction. Since services represent 66% of total personal consumption, the ISM numbers suggest strong consumption growth in the near future.

    * However, due to the way the diffusion index is created, the ISM reading only concretely states that the number of service related firms posting positive growth has increased over the last month compared to the numbers firms posting negative views.

    * The ISM non-manufacturing index does not differentiate between between size of firms or value of output. It is very possible that many small firms pushed the index high through increases in activity whereas the larger firms, which produce most of the output, continued seeing declines. In this case, the higher reading will not correlate well with an increase in consumption.

    * While the inventory contraction has slowed, the cycle has entered its 13th-consecutive month. To make matters worse, inventory sentiment continues to be way too high as the sentiment index remains well-above 60 at 62.0. Until inventories decline, business activity in both the non-manufacturing and manufacturing sectors will be limited.

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% 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, NOV. 6

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 really two reports -- the household survey and the establishment survey. These two surveys contain a wealth of timely information that justify this report's status as the most-important economic release of the month.

Highlights

    * The consensus expected the labor situation to improve and projected payrolls to decline by only 175,000.

    * Instead of an improvement, payrolls fell 263,000 -- worse than even the ADP employment report projected.

    * The unemployment rate increased 0.1 percentage points to 9.8%, exactly what the consensus was expecting.

    * Total private weekly hours worked declined 0.1 hours to 33.0, below the consensus expectation of 33.1. Further, hourly pay only increased 0.1%, also below consensus expectations. Looking at the payrolls a little more closely, there is no sign of an improvement in employment in the near future.

    * Government payrolls declined 53,000 as state and local government budget cuts forced out workers.

    * Construction and manufacturing employment declined by a combined 115,000.

    * Service-providing firms shed 147,000 jobs as retail trade lost 39,000 jobs, business and professional service lost 8,000 jobs, and leisure and hospitability employment declined 9,000.

    * Only the education and health service sector posted positive employment gains, but the increase was extremely small with only 3,000 new jobs.

Key Factors

    * The employment report came in well worse-than-expected in September.

    * The unemployment rate is very misleading. The civilian labor force declined 571,000 in September compared to an increase in the labor force of 73,000 in August. If the labor force held steady in September, the unemployment rate would have increased to 10.2%!

    * The drop in hours worked and the lack of a strong increase in pay pushed weekly earnings down 0.2% and will lead to lower consumption from people who have maintained their jobs over the last month.

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