Monday, March 30, 2009

Unconventional Way to go long Financials

Once-proud financial-service companies have been humbled, and currently trade at lowly prices usually reserved for unknown, unremarkable companies.

Citi (C) ended at $2.31 at Monday's close. American International Group (AIG) closed below a dollar. Both stocks are up roughly 250% off of all-time lows, but the future of the shares (and companies) are hazy at best. Risk-adverse investors don't necessarily want to gamble on such risky companies, especially while daily price fluctuations are so extreme. At the same time, however, bullish investors may want to be exposed to potential upside in shares of such trampled companies.

Rather than owning the shares of stock, investors could gain exposure to upside movement by selling naked put options.

Selling "naked" puts refers to selling puts without actually being short shares of the stock, which would sometimes create a riskier situation for the seller. However, with C shares so close to $0, even the worst-case scenario is very clear.

When puts are sold, the seller's account gets credited with the amount of the sale and an outstanding obligation shows up. If shares do move lower, the size of that obligation increases as the puts increase in value, and the seller essentially loses money. If shares increase in price, the size of the obligation gets smaller, and the seller enjoys some paper gains.

Below is a table of C January 2010 puts (courtesy of

Though there is little to no volume in the far in-the-money puts, the bid and ask spreads remain reasonable and transaction costs do not inhibit using this strategy. Options close to the current share price retain time value, providing a bonus for the seller.

At the $2.50 level, options traded hands yesterday at roughly $1.25 (we'll take the bid), implying that investors expect C shares to be worth no more than $1.25 in January of 2010. If shares close below that level, the put seller will lose money. If shares became completely worthless ($0) before then, the put seller would essentially owe $250 per contract while he was only credited $125 at the time of sale. However, if shares only appreciate 10% (to over the $2.50 strike price) within the next 10 months, the seller will get to keep the entire credit at the time of sale.

Utilizing this strategy with in-the-money options changes the risk and reward involved. If a seller sold $10 puts for $8.05, he has a possibility of making $800 per contract (if shares close above $10 in Jan '10) while only potentially losing $200 (if shares go to $0).

Selling even farther OTM puts exaggerates the risk/return profile further. Selling $40 puts in the bid/ask spread at $38 seems possible, even though its highly unlikely that C shares will see that share price within the foreseeable future. However, the trade can still be made. Again, downside risk is limited to coughing up $200 if shares hit $0 (which means repaying $4000 compared to an initial credit of $3800), while profit potential remains intact (a $10 share price close would net the seller $800 of profit, essentially). And with C, AIG, BAC, and many other companies trading relatively close to $0, this strategy can be employed for an entire portfolio of companies.

Requirements for selling naked puts differs based on broker, and the strategy isn't for everyone. Like owning shares, downside risk is limited (paying the entire difference between strike price and $0) if the shares become worthless, but gains are capped too (at the initial selling price of the contract). But this strategy may offer an interesting way to expose one's portfolio to the possibility of bullish performance without sacrificing too much capital.

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Wednesday, March 18, 2009

More Positive ETFC News

Since I wrote about ETFC last week, shares have crept up from $.66 to $1 (in pre-market action this morning; last night's close was $.91).

The Wall Street Journal put out a little article this morning discussing a few monthly updates that ETFC released today. The article may (or may not, depending on if it's subscription-based) be seen here.

Not only did trading volume stay steady, but more importantly, loan delinquencies among its portfolio are on the DECLINE. "The company said Wednesday delinquencies of 30 to 89 days have fallen 16% in the first two months of the current quarter, while delinquencies of 30 to 179 days are down 1%."

That is obviously wonderful news for ETFC. They have already provided loss provisions far beyond realized losses, so if things are bottoming (or improving) now, they might not have to increase provisions anymore, allowing them to return to profitability. This may sound a little crazy, but maybe write-ups are hiding in the not-too-distant future.

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Monday, March 16, 2009

From Laggards to Leaders

Monday's market action was volatile and interesting, with a couple surprising underlying themes.

The S&P 500 opened higher, peaked midday while up about 2%, and ended up closing marginally lower. Many of the previously worst-performing stocks (financial) had daily charts that resembled the S&P's movement, albeit with supercharged movements.

As AIG made news by listing important counter-parties and declaring that it planned to pay bonuses, the shares exploded higher.

Shares logged a few trades at $1, which was an 100% daily move. Even as trades ticked lower with general market weakness at the end of the day, shares still logged a 66% daily gain. Though the percentage gain is obviously impressive, it pales in comparison to the enormous wealth that was lost as AIG fell from real-company valuation to penny-stock territory. But theoretically, an investor that plowed some money into shares at $.33 recently would have been very pleased with this recent performance.

Some other examples of beaten-up stocks that outperformed today:

E*Trade (ETFC): +9% today (read my recent article about ETFC shares here)
Citi (C): +31% today
Bank of America (BAC): +7%
Freddie Mac (FRE) +21%

Obviously all stocks mentioned are ultra-risky, and some may ultimately be worthless. But such extreme movements are heartening for investors who own shares of said companies, and if any major development in the market or indivual stocks (like ETFC getting TARP money, or the alteration of M2M rules) happens, shares could explode higher. But "investing" in any of the five companies I named (I own shares of ETFC and AIG) is still more like gambling than rational, careful capital allocation.

People courageous (or stupid) enough to invest will continue to see gains or losses that are characatures of the general market.

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Sunday, March 15, 2009

This Week Crucial to Investor Emotion

Though I'm currently being taught that many scholars and businesspeople believe that stock market prices represent the entirety of all available information, I disagree. I see the stock market as a much less rational creature; along with true facts and information, fear, emotion, rumors, and expectations share responsibility for driving prices and creating price swings.

The major markets (S&P 500, Dow, NASDAQ, and most international markets too) have endured wild fluctuations over the past year and a half as they shed 50% of their value. Below is a chart of the S&P 500 over just the past six months, after the index had already lost a significant portion of its value.

After establishing a new multi-year low late last week, the S&P 500 had a spectacular rebound, rising roughly 80 points - adding more than 10% to the index's value.

I was on spring break this past week, which allowed me to waste plenty of time lounging around watching CNBC. While I don't take too much from that channel to heart, watching the various personalities, traders, and interviewees provides a good sense of sentiment on the street. At the end of the week, the depressing fog certainly seemed to be clearing and some people seemed downright cheerful. A few actually resented the steep rise as they had hoped to initiate some long positions at better prices.

The week was kind to the general markets, but certain beaten-up stocks did even more exceptionally well. GE bottomed at $5.87 last week, but recovered to nearly $10 by Friday's close. General Motors (GM) more than doubled from an intraday low of $1.27 last week to close at $2.72 on Friday. PNC, a bank of national (and moreso local, due to my Pittsburgh roots) significance, began the week under $18 and closed at $28.

Last week's rally may have been caused by any different number of factors. Some scary unknowns became known; both GE and Berkshire lost their AAA ratings, but credit outlooks were reset to stable, allowing investors to feel a little relieved and reassured. Mark-to-market rules are under review, and any suspension or alteration of them would likely lead to writeups and increased capital cushions at virtually every financial institution. Other commentators think that some sidelined money may have flowed into the market, and after the gains began early in the week, additional investors threw even more tinder on the financial fire.

Some people are less optimistic. Considering the depressed, pathetic pre-rally prices of stocks like GE, GM, and many others, some people argue that much of the reason for the rally this week was short covering.

No matter the reason for what is now history, the market action this week may stifle and reverse, or enhance, the movements of this past week. The S&P 500 now sits at approximately its November low; it may not be able to cross that resistance level, but if it does, it should have a new level of support. (Note: I'm not a technician and I don't believe too deeply in technical trading, but because enough investors do, it sort of becomes a self-fulfilling prophecy).

Disregarding any technical indicators, simple emotional sentiment is hinging on the first few trading days of this week. After a 10% gain, many people want to believe that the market has turned a corner; they may be willing to commit more capital or cover any outstanding shorts if they see a little more proof that the markets will continue skyward. On the contrary, the good feelings of this week will be forgotten if markets stutter early in the week, as investors are inches away from writing off any gains as a bear-market rally in a formerly-undersold market.

Various nuggets of news will likely drive sentiment this week. FedEx (FDX) reports earnings, and they are often considered to represent the general economic environment; a positive report will reassure jittery investors, while a bleak one may estinguish existing goodwill. Nike (NKE) and Oracle (ORCL) also report earnings, while GE will provide some information about their financing arm. A spattering of other economic news and company reports will augment the aforementioned ones.

I don't have any fresh capital to invest at this point, but I'm eager to see how the markets will move. On one hand, I too share the opinion that I don't want things to go up too far, too fast - I'd like to buy some good companies at the current firesale prices! However, I think many stocks are currently oversold, and an extention of last week's rally doesn't seem irrational to me. Only time will tell...

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Thursday, March 12, 2009

E*Trade: Worth Ten Dollars or Ten Cents?

E*Trade (ETFC) shares have suffered one of the greatest declines of all (non-bankrupt) financial service companies - a whopping 97% from pre-meltdown levels. (From the start of 2006 through the first half of 2007, ETFC was a $20+ stock.)

The verdict remains out on ETFC. Obviously the possibility (or probability?) of bankruptcy is priced in, as shares changed hands at $.66 on Thursday. However, the core brokerage business remains strong... if only management had had the foresight to have avoided banking and investments over the past five years.

Shares slumped Thursday amid the strong rally after a Citi analyst slapped a "sell" on the stock this morning. The Citi analyst provided a price target of $.25/share. However, along with that bleak statement, he pointed out:

"E*Trade is a tale of two companies. On one hand, the retail brokerage operation is steady. The segment has averaged over $500M of annual operating earnings and 41% margins over the past five years. The institutional business, however, remains an albatross as a result of its $25.5B loan portfolio. While we believe current management is doing all they can to address the company's legacy balance sheet issues, the long-term viability of the company remains in doubt, in our view."


There are about 500 million ETFC shares outstanding, so theoretically, the brokerage-only component would be making $1/share per year and trade at $10-$20.

However, the institutional component, which focused on investing in mortage securities, threatens the viability of the company. ETFC hasn't reported a profit since 2007 as mark-to-market writedowns of assets have forced ETFC to take losses. However, management has proactively dealt with the losses and associated need for increased capital; they sold E*Trade Canada for over $500 million (after taxes) and sold a portion of their asset portfolio to private buyers.

They now seem well capitalized, and a recent stress test confirmed that conclusion. (Read the article here.) The analyst concludes that while ETFC would need more capital in a (harsher than realistic) immediate full-writedown scenario, it would be able to maintain a Tier-1 capital ratio if the writeoffs happen over a few quarters.

The wild card that could still significantly change things is ETFC's still-outstanding request for TARP funds. ETFC requested $800 million, which would cover all losses even in the aforementioned analyst's doomsday scenario.

The bottom line is that ETFC will do one of two things - go bankrupt, or go way, way up.

When it comes to the financial services sector, the most important thing now is survival. For the past year (or more), companies have written down assets repeatedly thanks to mark-to-market accounting. Assets have to be written down to prices they'd fetch on the open market, while in reality, many instruments have intrinsic value (based on interest payouts, etc.) above their current marked values. Eventually, these assets will be written up. Some firms will fail or be bought out before they have the opportunity to do this; others, whether due to good management or the government's good graces, will survive until the day they report a gain on their held assets.

Even ignoring any writing-up of ETFC's assets, if they can survive to the day that their non-brokerage business no longer impairs their results, the shares will skyrocket - eventually back to double-digit (dollars, not cents) territory. (Note: Seemingly ridiculous claim is based on $1/share brokerage-component earnings). However, current market pricing indicates that most investors don't think that will happen.

I find buying ETFC a bet worth making - The slim possibility of a 10- or 20-bagger makes the probability of bankruptcy worth betting against. I currently hold some shares, but I'm planning to add to my position if shares stay at current levels. ETFC shares are not for everyone, and I'd almost classify going long as closer to gambling than true Buffet-like investing... but I'm young and I like taking risks. I'm hoping that management can continue to bail water out of this sinking dingy until the storm clouds have cleared.

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