Wednesday, August 26, 2009
Email – #492
** Bet on a Recovery… For Less than $1!
I recently received an e-mail from a member who commented on the number of bull spreads in our portfolio. He correctly observed that you can’t do bull spreads in retirement accounts.
(A bull spread is where you buy one option and sell another against it to lower your cost and risk.)
I wrote back that we don’t really do many bull spreads or bear spreads, but we will LEG into a spread once we have achieved enough profits to get a free ride. So, we may enter a bull/bear spread AFTER we have taken a long or short position.
Most of the spreads you see in the portfolio were actually long call or long put positions at one time, where we have taken our money off the table and are looking for triple and quadruple digit gains.
In some cases, like Motorola, we’re being paid to be in the trade because the option we sold netted us more than we paid!
But that doesn’t mean we won’t do spreads at all. Why let an opportunity slip by?
If you can’t do it in your IRA, either wait for the next trade, or open an account where you can do it. Call our Pillar One Partner Greg Long at Gunn Allen, and he will take care of you and charge you a “special” 400 Report Member rate.
So, before I get into today’s recommendation, let me give you the rationale for doing a bull spread.
Bull Spread Basics
We take spread positions when we’re looking at a trade that would otherwise be too expensive, and exceed our parameters… no more than 15% of the underlying share price for a one-year option and 20% to 25% for more than a year.
So far, more than 90% of our trades have met these parameters.
If you recall when we made money off Petrobras and Freeport earlier this year, we had to use spreads because the options prices were too high thanks to the volatility. The other choice would have been to pass on the trades and let triple digit profits slip through our hands.
The vast majority of our picks will NOT be spreads, so if you can’t do this trade, sit tight and wait for the next one…we just did a non spread trade a few days ago with FITB.
How To Make 5 Times Your Investment… If We Recover
Single dip or double dip? L-shape, V shape or W-shape?
You hear all of these terms bandied about but it’s pretty simple really. We’re either going to witness a global recovery soon, as commodity prices are foretelling, or we are going back down and going down hard.
We are going to be well positioned either way with our strangles. If we do recover though, you’re going to want to be in high beta and high volatility names: Companies that can fly based purely on the fundamentals of a recovery.
One fundamental piece of any recovery is transportation of goods, especially raw materials. And the one company in this sector that has tremendous leverage to this type of a situation is DryShips (NASDAQ: DRYS), a former high flyer that reached $74 last year before falling to single digits.
Dryships owns a fleet of drybulk carriers and transports goods all over the world. When times were good, the company printed money. When the global economy fell off the cliff, so did DryShips. And, in order to bulk up its finances, it had to sell stock and restructure its debt.
That led to a massive decline in share price. And we’re not going to see $74 again for this company. But any recovery could see the price double from current levels.
So with that in mind, we’re going to shoot for a 5 to 1 return on this play by entering into a bull spread that expires in 2011. Of course, we can always get out of the trade earlier if we choose to.
The current price of DryShips is $5.75. If we used our 20% limit on the price we want to pay for the option, it would restrict us to buying the $10 calls, which would make little sense since our target price is $11 to $12.
So we have to get a little creative.
Here is what you should do:
* Buy the Dryships January 2011 $7.50 calls (ZDU AU) currently trading for $1.85
* Against this position, sell the Dryships January 2011 $12.50 calls (ZDU AV) currently trading at $0.95
The equation is as follows:
You buy for $1.85 and you get $0.95 back for selling the higher strike option giving you a net cost of $0.90. Your profit potential is the spread between the two strike prices or $5 (12.50 minus 7.50) for a chance to net $4.10 on the trade ($5 spread minus $.90 cost).
Only execute this trade if your net cost of the spread is no more than $1. That gives you a 10-cent per contract leeway to get filled.
This is a speculative trade since it is a one sided bet on global recovery. Do not let the “cheap” entry price fool you and position size accordingly. For those of you who are not familiar with position sizing, it means that you should not overweight any single position in your portfolio.
If you cannot do spreads with your broker, get one who will let you do spreads. I mentioned Greg Long above and you can call him with any specific questions.
Karim