Email – #505

Market calls are always tough. Invariably, the exact reasons that prompt one to go long or go short the market are the same reasons another takes the opposite position… a true definition of a market.

However, we need some protection in this market. If it goes up, we’ll lose some cash in our shorts but make it up in our longs. Fortunately, with LEAPs, we have two things going for us. First, we have time; lots of it. And second, we know going in what our exposure is going to be if we lose on a position. There are no unlimited losses, just unlimited gains.

We just took some super profits on Motorola and Manitowoc. We’re sitting on huge gains in our Akamai position, sizeable gains in our Yamana position (although this one changes daily), and we are locked in to gains on our Natural Gas play.

Our USAir position (LCC January 2011 $7.50 CALL) is firmly in the black as well, up more than 30%. On USAir, place a MENTAL sell-stop at $1.40 to insure we do no worse than break-even on this position.

Why a MENTAL sell-stop? Because entering one into the system at your broker may prompt a market maker to take his bid down to $1.40 from the current $1.90 just to do you a favor. He can always leave his offer price much higher. Regardless of regulations and regulators, the market is not immune from unscrupulous operators.

Our Bank of America puts are weakening… it looked like they might have had a chance last week until the banks started to rally again. But this is a free trade for us and we have no loss exposure here since we took our entire investment off the table when we sold our Bank of America calls for a fat profit last year.

Our Pulte Homes play is in danger, though, since we have a strangle going. We are both long at short Pulte, but it is trading in a horribly tight range, neither breaking up or breaking down. We have lots of time left here, but we may close this position by July if there is no strong directional move.

On Citigroup, the 2012 $5 call options remain a buy here and they are cheap still at 45 cents. This is our “black swan” bet on the market. If it moves higher, this option will soar in value.

What We Have To Work With

So, let’s focus on the downside for a moment. The economic picture going forward is still not as rosy as the pundits would have you believe. Yes, it’s not as bad. But that does not mean it’s great either. There is strong anecdotal evidence to support both sides of the argument, but the side that is fueling the market gains is doing so on less than real economic growth.

The growth we are seeing is fueled by government spending and subsidization, not true consumer-led economic growth. Worse, there are still issues unfolding globally that could derail the market. Europe is a basket-case facing a myriad of issues that will keep it in slow growth mode for some time to come. It will be facing a devalued Euro thanks to its problem with member states that are in need of huge injection of cash to meet governmental obligations.

Now, we are seeing some structural issues in China as well. Across a range of cities, the average price of real estate is moving up at a clip of more than 5% per month. Sound familiar? Mortgage delinquencies are rising at an astonishing pace thanks to poor lending practices. And, now the government is beginning to tighten money supply, which could dampen speculation, but also lead to a property price collapse.

China has been injecting trillions of renminbi into its economy to keep it from falling into a recession – a recession in China is annual growth in GDP below 7% – But, it’s major customers are not buying as much and that will lead to unsustainable inventory growth and a production cutback. Of course, we could see a miraculous recovery in the US that is led by employment growth, but that is something that does not look like it will happen anytime soon.

So, we will take out some insurance that will allow us to gain if China or the US falls. If the US heads into a double dip recession, we will profit from this play. And if China continues to tighten in the face of rampant speculation, we will profit. We made this same play a couple of years ago and it paid us off very well, with some readers reporting triple digit profits.

Playing China Up And Down

The play will be to buy LEAP PUT options on the China ETF (FXI), which trades on the NYSE. It is the ETF that holds 25 Chinese companies and tracks their price movement. It has moved up more than 100% off its lows of last year before giving some back recently.

It has LEAP options and we are going to BUY The FXI JANUARY 2012 $30 PUT Options. These are currently trading at $3.45 on the offer. We are looking for a move down of between 10% and 30% in the next 12 months to clean up on this play. We DO NOT need the FXI to move down too much to profit if the move occurs early in the two year cycle.

Right now the volatility on this option is low, which is a good thing for us. If volatility picks up here or in China, the price of this option may increase in value regardless of the actual move in the underlying share price.

Again, BUY The FXI JANUARY 2012 $30 PUT Options. These are currently trading at $3.45 on the offer. Do not pay more than $3.55.

Karim