Does lightning strike twice? It sure does in the financial markets. On September 4th Sage wrote:
“… Victor Niederhoffer rose to fame in the 1990s. In 1997 "The Education of a Speculator" was published and acclaimed Niederhoffer – who just a year earlier had been ranked the #1 Hedge Fund Manager in the world!
In the book, Niederhoffer regales the reader with stories of near disaster and his escapes that ensured he survived another day. He amassed great wealth in the process. Niederhoffer proudly boasted that he "never used stops". He regularly violated one of the primary rules of the book "Reminiscences of a Stock Operator" – Do not average down on a losing position.
Soon after the book was published, George Soros’s warning that a tide might ‘overwhelm’ Niederdhoffer became prophetic, when bets on the Thai currency market went against him causing huge losses that forced brokers to issue margin calls against him. Although hours later the positions had returned sufficiently that he would have been just fine, the triggers had been pulled and it was too late for his fund. The damage was so extensive he was forced to re-mortgage his home and he effectively lost everything.”
Victor Niederhoffer rose from the proverbial grave and was incarnated in the form of the “Matador Fund”. The name alone is disturbing. From my way of viewing bull-fighting, the bull only needs to win once to defeat the matador and effectively ends his career! I sure would not want my money tied up in a fund which had a similar risk profile i.e. the fund would blow up if one bet went wrong. And I sure wouldn’t trust it to a guy who made that same bet in the past and lost!
Well lightning did strike twice! Niederhoffer’s Matador Fund lost 75% of its value this year and closed its doors in September. One of Niederhoffer’s former students, Peter Hansen, commented that Niederhoffer’s approach, though pioneering in many respects from a statistical standpoint, was not systematic. That absence of a system is sufficient to doom any trader!
Each of us MUST trade with a system. For example, we have had a heck of a run with an FXI bear call of late and we’re not out of the woods yet. But we are sticking with the system that has proven successful for us in every market condition because we evolve to market conditions.
We started with a 200/210 bear call in October when the FXI was trading at $180. As the FXI increased to $200 we knew that the risk of holding the position was substantial and, in the event of a big run above $200, the opportunity to adjust the position would have been very low because expiration was so close (therefore little extrinsic value existed on the options). As a result, we adjusted to a 220/240 bear call in November – a position we still hold. (As an aside the FXI did move substantially above the $200 mark soon after the adjustment). Today’s move down on the FXI gives us some breathing room on the trade. The FXI may still rise back up to $220 over the next 9 trading days to expiration but for now the adjustment is looking like a real winner. Even if a further trade modification was required we would simply follow the rules until we ultimately made money.
The lesson is to STICK with a system that works for you. An ideal trading system would be correct 100% of the time. Since nobody has a Trillion dollar bank account yet, my guess is the holy grail has never been developed. So, the next best thing is to find a system that has the potential to profit in every market trend and evolves to the market through trade modifications.
Well let’s move onto trading opportunities. Sage was scanning options chains today for credit opportunities with just 10 day trading days to expiration. These final 10 days are VERY lucrative because theta decay is substantial and increases exponentially day by day over the course of the expiration month. Opportunities present themselves every day but the one that stood out for Sage today was the strike 850 Nov short calls on Google for $0.70 credit intra-day.
Google was trading around $723 at the time. For the trade to run into trouble, the stock would have had to increase from $723 to $850 in just over 9 trading days. That’s a run of approximately 18% or almost 2% per day. While this may be possible, it is improbable and the trade benefits from two additional features. The first is theta-decay, already mentioned. The second is implied volatility. As the stock reverses direction, which is very likely to do on at least one of the next 9 trading days, the premium associated with call options will reduce simply because the direction of the stock will be in the opposite direction. Further analysis, excluding the effects of theta-decay highlight that the position would be down just $0.50 even if the stock rallied another $40! And it would have to run another $90 or so for the trade to run into trouble by expiration. Factoring in theta decay it portends a profitable trade in a short period of time.
All in all, the trade proved compelling. It is not, however, a low risk trade. In fact, a much lower risk trade is a bear call spread, which comprises an additional long call option placed at a strike price above the short call. This would limit the loss on the position, whereas the naked call is potentially subject to much more significant losses should the stock continue rising. Of course, the answer to “what should we do if the stock does rally $130 to $850 in the next 9 trading days? “ is to roll the options next month. Not even Google will rise to infinity!
In stock news, the Wall Street Journal reports that Alibaba.com IPOed successfully, up 122%. The most amusing comment of the report was made by Francis Lun, general manager of Fulbright Securities in Hong Kong: "I think Alibaba’s share price is way ahead of its fundamentals; I think the best advice is to get out as soon as possible”. We can all benefit from a regular refresher on the power of sentiment in the markets and this seems to be a classic example of a manager focusing solely on fundamentals and ignoring sentiment.
We will soon see if Yahoo benefits from its stake in the company but even if a move does not occur right away, there is no reason to be too concerned. It took a considerable amount of time for Cypress to ramp up even though SunPower was vaulting to new highs regularly. EMC reacted slowly despite VMware bolting out of the gates subsequent to its IPO. Many professionals like to enter a long-short play which constrains the “parent” stock (Yahoo in this case) because the pros short the “parent” stock while “buying the “child” (Alibaba in this case). It’s a nice arbitrage that works quite well but has the effect of keeping the “parent” restrained while the “child” races free. It’s a nice reverse on human relations!
Have a fantastic week!
Stock & Option Trades
