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 Marketwatch.com)

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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Cover your Calls and Sleep Well.

Trying to make money in this current market is a daunting, confusing task. The S&P 500, the benchmark index representing a broad scope of the market, is down over 10% since October and over 7% since the last two weeks of December.

Are we bottoming? Transitioning to a bear market? Is this a hiccup in the 5-year bull run? I surely don't know.

But I can recommend one strategy that can increase gains, lower cost bases, and minimize losses in a volatile, unpredictable market; write covered calls.

In this market, I like to use it to enter risky positions, in essence, at a lower entry-point. Here's an example of how to do that.

A year a go, Merrill Lynch (MER) was trading at $100; today it sits at $56. You believe that Merrill is a great company, and that it'll eventually get its act together. However, due to write-downs, the continuing housing crisis, and the possibility (or probability) of recession, you don't know if this is the bottom. But you would rather enter now than miss any upside.

A share of stock can be bought for $56. You go ahead and buy a lot of 100 shares for $5600. (We're excluding commission for this exercise; if you trade at a discount broker like Tradeking, commission is negligible anyway).

Cost= $5600

Right now, a contract of January 2009 calls at the $65 strike price is selling for $5. Once you own 100 shares of stock, you can write one contract of those calls that are "covered" by your shares (hence the term "covered calls").

If you go ahead and do that, you'll take in $500 right away. You can look at this money many ways; you can think the trade like you bought the stock for $51/share, or right now, your investment automatically made you 10%.

Here's the great thing about a contract like that; it's a win, win, lose-less situation.

• Win: Say that the economic clouds blow over, and Merrill recovers to $75 next year. Your options will be called away, and your stock will be sold for $65/share, not $75/share. However, you still made a 30% return (20% stock move plus initial $500 credit for calls), only missing out on another 5% of upside.
• Win: Merrill is approximately flat in 12 months. With the stock at $57, your gains would have been negligable just holding the stock, but by selling calls, you made a handsome 10% as the stock price remained stagnant.
• Lose, but less: OK, this isn't the bottom. Merrill is $44 next January. But because you sold calls, taking in $500, your losses were less extreme than if you hadn't done so.

As you can see, the only bad thing about covered calls is that it can limit upside potential. However, as long as you have extra cash (or margin in your account), you can simply buy more shares if you like the company and your shares are going to get called away.

The amount of money you can take in depends on expiration and strike price. Sticking with this MER example, if you think that performance will remain poor, you could write Jan 2010s @ $65 strike and take in $8.30/contract, or take in the same $5/contract for the $75 strike price.

You can, of course, write covered calls on positions you already own, or as I displayed, they can be used to open new positions, too. Since the only shortcoming is the limitation of upside potential, it's a great time to write calls now as the market looks like it may move sideways, if not worse, in the near future.






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Follow up to COP/OPEC trade

Just to follow up, (and for the sake of full disclosure),

I closed my Strangle trade yesterday. ConocoPhillips (COP) moved up, the calls increased in value, and I sold the calls, netting a 16% gain in three days, including commission costs. I still hold the puts (which are now nearly worthless at 11 cents), which I could have sold to make another 3% gain. (I'm holding just so that, if COP falls, I might milk a little more money out of this trade.)

16% doesn't sound like much, but annualized, it was a 1920% return. (Also, if I would have traded more contracts, commission costs would have been lower per contract and the percentage gain would have been slightly larger).

This was a sort of experiment for me, and my "long strange" worked as planned. If you see the potential for volatility in a stock, this is a good strategy to consider.

Strangle OPEC, Make Money.

The fluctuating, inflated price of oil has held the attention of businessmen and lay people alike. Oil's price run-up has certainly been impressive; from a low near $10/barrel in the late 1990's, oil flirted with $100 just last week. This dramatic increase was only rivaled by the price spikes after the oil embargoes and crises in the 1970's and 80's. Just this year, oil is up 30%.

The cause of this increase is debatable. Sure, the incredible growth in China, India, and other emerging economies will strain the production capabilities of the world. But did it really merit such a dramatic increase?

I'll let professional economists and commodities experts argue over the causes and effects of $100 oil. But I think that the average investor can profit off of the volatility in oil.

Oil has retreated from nearly $100 to about $90 per barrel. But where will oil go from here?

Wednesday may be the day that clearly defines a trend. Two defining events will happen this December 5th. First, the weekly oil inventory report will be released, and this week's numbers could be effected by the pipeline explosion late last week. If inventories significantly declined at Cushing, the delivery point for the Nymex contract, that could be a catalysts for a pop back to $100.

The more significant event will be OPEC's meeting in the United Arab Emirates on the same day, this Wednesday, December 5th. Much of the developed world is looking for OPEC to increase production quotas to ease prices. However, with the recent 10% decline in the price of oil (the steepest and quickest in years), OPEC may not be motivated to hike their output. Unless a major event occurs tomorrow, I see oil staying stationary into the two announcements yesterday.

So two possibilities exist:

• On one extreme, US inventory was steady (or even increased) and OPEC decides to increase production. If those happened together, the price of oil may plummet.
  
• However, if inventories are pinched and OPEC deems current production sufficient, then the price of oil could be back near record territory, considering the market is already pricing in a production increase.
  

I don't know what's going to happen, so I chose to be insulated either way.

I set up a "Strangle" options scheme, using my favorite oil stock, ConocoPhillips. When the stock was trading around $80 today, I bought $75 puts and $85 calls. The calls were about half as expensive as the puts, so I bought twice as much. (Also, I have a tendency to expect upward price movement simply because the oil stocks have declined considerably recently.)

The puts were $63/contract, and the double-strength calls were $78 for two. The at-the-money calls and puts both trade for around $2/contract. So, as long as Conoco moves $5 either way, the transaction will be profitable. (If it moves to the upside, which I made a slight bet on, It'll be a little more lucrative).

Using a "Straddle" (at-the-money calls and puts with the same strike price) or a "Strangle" (out-of-the-money calls and puts at opposing strike prices) can allow a trader to profit off of the volatility of a stock, no matter which way it may move.

Since my crystal ball is out of order, I don't know if oil is going to be up, down, or flat on and after this Wednesday. But as long as something happens and oil moves in one direction, this trade should profit from an unpredictable market.