Options Trading: Use an adviser or go it alone?

This is a fundamental point. I’ll present the arguments for both cases.

Use an adviser

There are a few very good reasons for using an ASX-accredited advisor:

1. Trade Selection. An advisor will typically contact his clients periodically with trade recommendations. The quality of these recommendations can of course vary, but an experienced advisor is likely to come up with much better ideas than an inexperienced beginner. From a learning perspective, this can give the client a few ideas to focus on.
2. Execution. Advisors can assist with placing orders into the market, which can itself be a little complicated for new traders (particularly if a trade has multiple “legs” i.e. two or more options are being simultaneously traded). Advisors who know their stuff will be aware of the nuances involved in getting the best price. Advisors will require clear instructions from the client but from there they take responsibility for any errors.
3. Monitoring. Advisers will monitor the trade and recommend the optimimum time to close it to book profits or manage losses. In addition they can advise the client on managing their trades around dividends or corporate actions.

There are of course a few disadvantages of using an advisor. The most obvious is cost. Keep in mind that brokerage on options is typically higher than for shares. Use of an advisor increases the cost further.

Go it alone

An alternative is to use an online broker. The primary advantage of using an online broker is cost savings.  These savings can ultimately lead to a better bottom line, enabling better market timing (cost effectively scaling and out of trades) as well better risk mangement by cost-effectively hedging using additional options trades or stock. Discount brokers can also potentially offer research, information and portfolio analytics (e.g. calculate the option “greeks” for a particular position).

Disadvantage is obvious. You’re on your own.

 

A few thoughts on gold 6 April 2013

Introduction

If in 1900 you bought an ounce of gold for USD21, you would have made 75 times your money. That’s a return of 4% pa, or approximately the same as inflation over the same period (i.e. terrible). By comparison the All Ordinaries total return was approx 13.3%pa. This occurred despite the period containing many negative events – several wars, the great depression, the 2008 financial crisis etc.

My point is that gold, being absolutely the safest asset around (having thousands of years history of holding value) has a very low expected return in the absence of a severe economic crisis. However, if such a crisis occurs, it is invaluable (ask anyone who has lived through the many hyperinflations of the last 113 years).

The Economic Crisis of 2008 and the aftermath

A result of the economic crisis is that major too big to fail banks (i.e. the large US and European banks) are effectively insolvent and can only limp along with the benefit of actions taken by governments. The effect of ZIRP and QE is that asset prices are inflated which masks the impairment of the bank’s assets. While interest rates remain at near zero banks can gain a healthy profit borrowing at low levels and buying bonds which have continued to increase in price. The chart below shows the US 10 year bond yield. Lower yields = higher price.

The US federal reserve targets bond rates through QE. The purpose is to inflate bond prices, generating profits for banks and underpinning their ability to operate. In addition low interest rates supports price of risky assets (eg residential real estate and stocks) which makes people feel wealthier and more likely to spend. The chart below shows the S&P since 2008.

Clearly, its working. However, in the medium to long term the risk is that people question the value of the US dollar with all this money being printed. The key barometer of this risk is the price of gold. The chart below shows the price of gold since 2008.

Put simply, its vital that public perception of gold be kept at low levels. If gold is exploding then it is a sign that the US dollar is failing. In that circumstances the bond market, and the stock market, will fall. The gig is up. So far, the government are doing a great job through a number of means, one being manipulation of information. I will post at a later time more comprehensively, but suffice to say that the mainstream media is relentlessly negative on gold. So much so was that in a recent seminar of high net worth US investors, all but one raised their hand when asked “is gold in a bubble?”.

Conclusion

Those interested the markets typically pay attention to stock prices. However I would argue bond prices and gold prices are of equal or greater importance. It is vital for the future of the economic system that gold prices do not rise at a parabolic rate nor do they rise in a way where there is excessive levels of public participation. Either occurance brings into question the value of the US dollar and the ability of the US to continue its low interest rate policy.

Weekend action 9-11 June: implications for Australian investors

Over the weekend a rescue was announced for Spanish banks. China also released data that was interpreted by the markets as broadly ambiguous (eg inflation data indicated that the economy may be cooling more than expected).

After the obligatory bounce reality set in. All key risk markets reversed eg the S&P (ES futures) moved from +1% to -1.5% on heavy volume with major US financials dropping 5-7% from open. Oil moved from +3% to -3%. EUR gave back all of its 180 pip rise and more. The S&P Volatility Index (VIX) closed at 23.56, +2.33 but not as high as a week ago.

Charts

Implications for Australian investors

Generally, the market has welcomed bailouts (with good reason – the punchbowl is being passed around so the party can continue). The extremely negative response to ‘good’ news is concerning. My opinion is that, ‘risk’ is going to underperform until there is some definitive progress made in Europe (read: massive coordinated intervention on a scale required to deal with the problems). It is also likely that the newsflow will be unsympathetic (eg I expect on other countries to demand assistance without austerity, which in the first instance is likely to be rejected).

I do believe that defensive, low beta equities (utilities, property trusts, and defensive industrials ) will continue to outperform as investors seek lower risk income and defensive characteristics in an environment of declining cash rates.

I also believe that gold priced in AUD is likely to outperform over the medium term (1-3 years). Currently markets are only holding together because of of a belief that the central banks will intervene if required (i.e. the Bernake Put). Action over this weekend strongly implies that words alone are not going to have the desired affect for too much longer and actions, on a significant scale, are required to stabilise markets. This is positive for gold.

Happy investing

Ed

PS Please read the site disclaimer.

ASX market comment 1 June 2012

May was a bad month on the ASX, with the market down 7.3% (worst month since May 2010 … May strikes again!). I’m sure many investors are keen to turn the page into June!

Yesterday the market put in a decent showing with the XJO down a measly 12 points (-0.3% to 4064). Hardly significant or meaningful. However what got me thinking was some comments I received that the market “felt” a lot worse than it actually was. So I decided to examine the performance of the most liquid stocks (average value traded per day of over $5m). There are 111 such stocks. I then looked at the performance of the 20 “riskiest” stocks (measured by beta) vs the 20 most “defensive” stocks. The results summarise in the chart below:

Fairly remarkable. On a day when the market was essentially flat, risky stocks returned -2.9%, while defensives were unchanged. (Outperfomers included TLS and the banks).

Reasons I can suggest for this:

1. The macro environment is obviously poor (negative headlines everywhere, Chinese data at 11am was also perceived negatively).
2. The equity market is pricing in further interest rate cuts. In this environment defensive stocks will outperform handily.

I would suggest defensive stocks could be accumulated on weakness. On my watch list are property trusts and utilities that pay quarterly or semi-annual distributions in the last week of June (most of them but not for example WDC). I will also be looking at liquid industrial stocks that pay dividends in August and early September (eg TLS, CCL, WOW, AMC, ANN). Its important that the stock should be very defensive … this excludes mining, mining services, energy, consumer discretionary and media stocks for example.

I won’t be rushing though – last night the S&P 500 was -2.5%, the worst performance in 7 months. So there’s probably time to get set …

Happy investing

Ed

PS Investing and trading involves risk. Please read the site disclaimer.

Excellent Opportunities in ETOs

Introduction

Current market conditions give great opportunities for options traders. Recent volatility, as well as the fear prevailing in the market means that volatility (historical, forecast and implied) is high relative to recent levels.

Today I’m looking at a calendar spread on BHP. This is a bearish play (aligned with my view on the market and BHP) with limited risk.

The trade

I’m looking at buying 100 $28 puts expiring on 26 July 2012 (76.5c) and selling the same number of puts expiring on 28 June 2012 (52.5c). Each option contract is over 100 shares in BHP. Total cost is $2,400 plus commission. My risk is limited to my initial investment so there should be no margin requirements. My expectation for placing this trade is that BHP will decline and trade around $28 during June. I’ll look to close the trade on or before expiry of the June option.

Profit potential

Below is a graph showing the estimated profit on 28 June 2011 (when the short option expires) for a range of BHP prices. Ive assumed $60 brokerage (the cheapest discount brokerage available). Click on the graph below to open in a new window.

Maximum profit is c.$9,000 is BHP is exactly $28 at expiry. The spread is profitable for BHP prices between $25.25 and $31.50. More technically minded reader might note there is a potential edge from buying the July option on a volatility of 41.1% and selling the June option on a volatility of 44.6%.

Advantages of this trade

1. Limited risk of $2,460 with potential profit of up to $9,000.
2. The spread is profitable over a wide range ($25.25 to $31.50). So even if I’m wrong on my opinion of BHP I still might do OK.
3. BHP options are amongst the most liquid so I’m more likely to get fair prices when entering and exiting the trades.

Follow up

I’m going to treat this trade as a paper trade, and will conduct a post-trade analysis after it closes.

Ed

PS Please read the disclaimer before trading any action.

Postscript

On Monday 21 May following this post the spread was trading at c.21c. This will form the entry price for the purpose of tracking the trade and undertaking post-trade analysis.

ASX Macro View Week Ending 18 May

Since my last review in Feb, the S&P/ASX 200 (XJO) has slumped after attempting to break out to the upside though the 4400 level. For much of this period the market was in a slow grind, with little impulsive price action (positive or negative).

Since peaking at 4449 on 1 May, the XJO has sold off aggressively and is currently at 4047.  In the week ending 18 May, the market was down 5.6% in broad-based selling. Only the utilities sector escaped the carnage (+2.12%), however this was aided by the takeover offer for Hastings Diversified (HDF), up 12.8% for the week. Biggest loser among the largecaps was Toll Holdings (TOL) down 23.2%.

Why the drop?

The market has caught the nerves due to uncertainties in Europe (again). In addition, admission of over $2bn in trading losses by JP Morgan has not assisted confidence.

It should be noted that May and June are historically weak months, as 3 of the big 4 banks have gone ex-dividend and underperformers are typically aggressively sold as investors realise tax losses.

Where to from here?

I see weakness with an approximate target of c.3800 by 30 June. A lot obviously depends on the resolution (or lack thereof) to the European problems.

I think rallies will be short lived and could be viewed as selling or shorting opportunities.

Chart

Below is a weekly chart of the XJO since the market peaked in 2007. We are still in a secular bear market with the rally from the March 2009 lows essentially stalled and the market remaining approximately 40% off its all time highs in November 2011. Click on the chart to open it in a new window.

Ed

PS Please read the disclaimer before taking any action.

Dividend Stripping

What is it?

Dividend stripping is the process of buying a stock and selling it after it goes ex-dividend. The objective is to capture the dividend with the objective that the dividend (plus franking credits) exceed the losses incurred in holding the stock. Of course the stock makes a profit that is a bonus!

Example

On 19 Dec 2011 I buy 1,000 TLS @ $3.23. Total cost $2,230 + brokerage.

On 13 Feb 2012 the stock goes ex a 14c dividend.

On the same day I sell my stock @$3.23. I’ve broken even on the stock, collected a dividend of $140 and collected $60 of franking credits which will reduce my tax when I lodge my return (note to get the franking credits I’ve had to meet the ATO’s 45 day rule … google for details). I’ve ignored costs in the is example. Note a breakeven is not guaranteed (YMMV).

Easy!

In the good old (pre-GFC) days, dividend stripping was easy …. a rising market meant that the stock could be often be sold for about breakeven, leaving the dividend as pure profit! Given that some larger stocks can yield up to 10%pa including franking), this meant an easy profit of about 5% in 45 days (or 40% annually) with minimal risk!

What about now?

Unfortunately dividend stripping in general no longer works particularly well … it was a definitely a strategy for a bull market. A reasonably analogue is flipping residential property … most of the profits come from the rising market rather than the renovation itself. There are a couple of reasons why its stopped working but the most obvious that in a secular bear market (i.e. the current market), most of the return (actual and expected) is from the dividend. This applies particularly to high yielding stocks. In plain English, this means a lot of people are pretty stoked to get a total return of say 10-13% and gains above this level are arbitraged away.

My next post will look at how to trade for profit around dividends in the new environment.

Ed

PS None of the above is financial advice. Consult a professional before investing or speculating.