DARK HORSE HEDGE
By Scott at Sabrient and Ilene at Phil’s Stock World
Tuesday marked the seventh consecutive day in which the S&P 500 has marched along its 200 day MA while managing to shed a total of four points in the process. The market gave what amounted to a yawn at the Federal Reserve’s “stimulus” announcement when the Fed indicated it would take small steps to “stimulate” the economy. The move is what is referred to as “quantitative easing,” where the Fed purchases government debt, and it comes at a time when the hope was that it would be rolling back some of the $2.3 trillion debt holdings as the economy improved.
"They can continue to buy Treasuries to keep borrowing costs down. But if the people who need credit don’t get it, it’s like knocking $50,000 off a Lamborghini. You’re still not going to be able to afford it," Dan Cook, an analyst at IG Markets said.
We agree with this analysis and continue to hold off on buying into the “rally”/uptrend that began on July 2, 2010, but appears to have flat-lined. We continue to watch the market closely for signs regarding whether we should alter the current BALANCED tilt of the Long/Short virtual portfolio. Last Friday the market staged a nice rally, seemingly shrugging off the weak jobs report, and suggesting we may need to reluctantly add more long positions.
So, what is the retail investor to do with all of this data? The answer is to do the same thing "professional" investors do and HEDGE. As we have discussed before, beta relates to the correlation between a basket of stocks, or in this case, your portfolio, and the overall market. A beta of 1.0 would indicate that for each 1% gain in the market you would earn 1% and likewise for each 1% drop in the market you would lose 1%.
No one, and we do mean no one (our apologies to all who claim they can), can predict short-term market direction to make money being on the right side of market swings all the time. It’s an extraordinarily difficult task and requires some degree of luck. As Ilene’s most recent fortune cookie stated "Luck is hard to recognize, especially for those who think they earned it."
This means that we need to get the beta in our portfolio as close to zero as possible while still generating acceptable alpha and sharpe ratios. We attempt to achieve this is by hedging using a long/short approach and supplementing that with Phil Davis’s Buy/Write option strategy that takes advantage of selling option premium on select positions. To achieve our objectives, we aim at identifying the best value/growth stocks for our long positions, and offsetting them with the worst, most overvalued, cash-chewing dogs for our short positions. We also attempt to tilt our balance towards the overall market direction when we can identify it more clearly–but as noted, no one is always right in predicting future market direction. Overall market direction changes, making our indicators always late at reversal points. Our mission is to use fundamental principles in building an intermediate to long-term portfolio that can achieve high alpha in any market.
DHH is currently balanced equally weighted 8 long/8 short positions and 60% invested (each position gets 7.5% of the overall portfolio). We have thoroughly evaluated all 16 positions and are still comfortable with all 16 for entry at current prices.
We are recommending a swing trade for Wednesday, August 11, 2010 which includes an option strategy using Phil’s basic Buy/Write method.
BUY MEMC Electronic Materials, Inc. (WFR) on Wednesday.
In our virtual portfolio, we bought we 500 shares of WFR at $10.31 (morning price) and sold 5 WFR Jan 2011 11.000 puts for $1.67 (WFR110122P00011000) and 5 WFR Jan 2011 11.000 calls for $1.02 (WFR110122C00011000). Thus, for each 100 shares of stock purchased at $10.31, we sold 1 put for $1.67 and 1 call for $1.02, collecting a total of $2.69 per share. This reduces our net cost basis to $7.62 (i.e. $10.31 – $1.67 – $1.02 = $7.62).
However, we have taken on two obligations which will play out differently, depending on which of the following scenarios take place:
Scenario #1: WFR is above $11 on Jan 21, 2011.
The sold call option will be exercised by the person who bought it, and for each sold call, 100 WFR shares will be called away at $11. (The sold put option will expire worthless to the holder.) The profit on that trade would be $0.69 (price appreciation per share) plus $2.69 (option proceeds) or $3.38 per share, against a purchase price of $10.31, or a 32% profit in five months.
Scenario #2: WFR is below $11 on Jan 21, 2011.
The sold put option will be exercised by the person who bought it, and for each sold put, we will be required to buy an additional 100 shares of WFR at $11, regardless of its current price. (The call option will expire worthless to the holder.)
Remember, we acquired our original 500 shares at net cost of $7.62/share (considering the two options sold), so buying 500 more shares at $11/share would give us a net basis of 9.31, which is about 10% lower than the current price of $10.31.
In summary, this trade is taking a hedged but bullish position in WFR, and taking advantage of selling option premium to offset the risk of the stock dropping from our purchase price. Our overall bullish position is based largely on the recent insider buying. (WFR’s rating in Sabrient’s system is a HOLD.) See Insider Zone here.>
The Sabrient Insider Sentiment Index (AMEX: SBRIN) identifies 100 stocks that reflect favorable corporate insider buying trends and recent earnings estimate increases by Wall Street analysts. This index is tracked by the Claymore/Sabrient Insider ETF (AMEX: NFO). We like companies that insiders are buying in significant quantities with their own money. Since August 3, 2010, six WFR officers have purchased over $1 million in stock on the open market between $9.51 and $9.91. We believe this is positive–that insiders have confidence the shares are undervalued, and perhaps know something we don’t.
DHH is going to follow the insiders and open a LONG position with potentially 10% of the portfolio on Wednesday. The position size will represent 10% if the put options are exercised and we buy 500 more shares of stock.
Before ending our update, we have a position note on our HUSA short. In the past 2 weeks, HUSA has made press releases explaining the move from the NASDAQ to AMEX as a positive, but from our view, it is just spin. We can’t think of a positive reason for the move. Yesterday, HUSA disclosed in the disclaimer of "BUYINS.NET Updates Houston American Energy SqueezeTrigger Report" that it pays $995 per month to BUYINS.NET to calculate the short squeeze price for its stock. We are wondering whether, if HUSA has its "eyes on the ball," which ball it is looking at. Is the company paying to target short squeeze prices rather than focusing on exploring for oil in Columbia?
Summary of DHH positions in the virtual portfolio
LONG: XRTX, WDC, GCI, IM, DLX, GME, FRZ, and TEO
SHORT: AIV, STI, HUSA, USG, CLDA, TEX, RAIL, and JOE
Read previous DHH actions and follow our latest portfolio moves here. >
