Reasonably Thinking

This week, I’ve seen a few mentions that volatility is low.  The implication is that investors are complacent.  This contradicts with my general bearish views given the potential economic pitfalls.  Betting on increased panic, or volatility can be accomplished by trading VXX.  Today, I purchased 65 shares of VXX at $21.12.

Here is a historical view of how the CBOE volatility index has contrasted to the S&P500.

(image from MarketWatch)

A month ago, Chile, the world’s largest copper producer, was rocked by an earthquake.  At the time, I was willing to bet that continued chaos, impairments to infrastructure, and aftershocks would hinder copper production more than initially expected.  The trade has not played out to its full potential, so I exited my position today.

Today was an ideal exit point since copper inventories on the London exchange fell, boosting the price.  Strategically, I like having some hard asset exposure, but a position should be sold with a broken thesis.

I have yet to post anything from Todd Harrison on this site, but I found today’s article as an interesting perspective.

…a lot depends on how we navigate a multi-linear dynamic that includes currency readjustments, the evolution of credit, $500 trillion of global derivatives, two-sided regulatory reform, the shifting social mood, geopolitical fragility and trade relations.

http://www.marketwatch.com/story/ten-reasons-why-this-is-not-a-bull-market-2010-03-24?pagenumber=1

Hussman’s weekly article is short and sweet.  One really only needs to look at the graphs to get a sense of future mortgage pain… but I definitely recommend reading the article.

http://www.hussmanfunds.com/wmc/wmc100315.htm

…it is an event that has just begun to occur with loans now hitting their resets…

I remain concerned that we could quickly accumulate hundreds of billions of dollars of loan resets in the coming months, and in that case, would expect to see about 40% of those go delinquent…

http://www.hussmanfunds.com/

Quote from John Hussman on Monday:

Many investment professionals have developed a habit of forming expectations based on nothing more than extrapolation of short-term trends in the data, even when those extrapolations are inconsistent with market history or well-established economic relationships.

Quote from Laszlo Birinyi on Thursday:

If the market is continually picking black, picking red is not necessarily a good idea.

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I’m bearish on the stock market because I believe the US economy has the potential to encounter hardships in the near future, and valuations are too high.  Even though some advisors continue to play the momentum game (Birinyi above), I would like to believe that a little a leg work will be rewarded.

To execute this line of thinking, I sold three bull put spreads on SDS (-33+26 Sep10).  SDS performs 2x the daily direction of the S&P 500.  Since I believe that the S&P 500 will go down, SDS would then go up.

Dissecting the put spread…

Sold SDS 33 Sep10 P @ $4.22

Bought SDS 26 Sep10 P @ $0.74

Possible outcomes:

• If the market falls only slightly by September, SDS will close at $33 or higher.  In this case, both options would expire worthless, and I would then keep the proceeds of today’s trade:  $1,028.97.  This is the difference between the sale of the $33 strike option ($4.22) and the purchase of the $26 strike option ($0.74) minus a commission.  (Remember that each option is worth 100 shares, and I sold 3 option contracts; $3.48*100*3-$15.03 = $1,028.97).  Even if the market tanks and SDS significantly increases, my maximum gain is $1,028.97.
• Perhaps my thesis is wrong (the trade moves completely against me), and SDS falls below $26 in September.  I now owe the difference between the $33 strike that I sold and the $26 strike that I purchased ($700 for each spread, meaning a total of $2,100).  The $2,100 loss would be offset by the $1,028.07 already in hand, so my maximum loss is $1,071.93.
• Now, let’s say that SDS ends up somewhere in between $26 and $33.  I could win or lose depending on where it ends up.  My Breakeven point is $33 – $3.48 = $29.52.  Now add a fraction to account for commissions to make the breakeven $29.57.  So above $29.57 I make money, below $29.57 I lose money.

Welcome back!

Since there have been many new (and returning) visitors to the site recently, here is a quick guide to some recent investments:
Bearish on housing
My favorite utility stock
Uncertainty in Chile
 
And for the ambitious crowd, here is a dissection of Bill Gross’ February Investment Outlook.  My analysis was featured Tuesday morning on the front page of Seeking Alpha.
Pricing the Ring of Fire
 
Finally, here are some introductory articles on how options work:
Basics
Income Producing Strategies
Neutral Strategies
Spreads

My broker failed to maintain adequate inventory of ITB shares today, so I was forced to cover my ITB short position by 200 shares, at $13.84.  I replenished this position by purchasing three ITB 17.50 Jul10 Put options at $3.90; these are options that I have purchased before.  Even though I am down somewhat significantly on this trade, I remain steadfast that housing is overvalued, as evidenced by my continued financial backing.

I haven’t posted a third party article in a while, so Hussman’s weekly commentary is a good place to pick back up.  Hussman presents a bearish view, but he is not a perma-bear.  Rather, he bearish because the prevailing conditions have resulted in negative returns.  Here is the link, followed by some excerpts.

http://www.hussmanfunds.com/wmc/wmc100308.htm

Over the past decade, it has been an uncomfortable lesson to accept that investors can be relied on to behave in ways that are ultimately unsustainable and destructive to their wealth, as long as market internals are temporarily supportive…
Many investment professionals have developed a habit of forming expectations based on nothing more than extrapolation of short-term trends in the data, even when those extrapolations are inconsistent with market history or well-established economic relationships.

I admit, there is still some uncertainty to this trade, but I bought copper today.  Here is my thesis…

An 8.8 magnitude earthquake bellowed Chile on Saturday.  The magnitude was about 500 times that of the first quake in Haiti, yet might have less damaging effects as it was located offshore and deeper in the ground.  Emergency crews are still swirling around cities, and from what I’ve gathered, looting has not been contained.  The focus of Chile’s citizens is focused on the basics–food, water, and safety.  In some areas, many are sleeping in the streets for fear that their structures will collapse; this problem has the potential to be amplified if aftershocks occur.

The economic impact is potentially global in nature.  Chile is the world’s largest copper producer, accounting for 1/3 of the world’s output.  Reasonably thinking, one can imagine that when the supply of copper is reduced, the price will rise.  Now, some copper mines have and will reopen, but impasses still remain.  Some mines are closed due to power outages, and highways to transport copper are impaired.  Besides, if I am Chilean citizen, I’m more worried about ensuring my safety more than exporting copper.

(image from BBC news)

Pricing this trade was an issue.  I read reports of copper prices soaring 5-8% on the news.  However, JJC, the Copper ETN, was only up about 2% at the open and stayed relatively stable throughout the day.  Obviously an investor would want to own the commodity before a supply shock.  Here, I’m betting on continued chaos, power/transport impairments, or aftershocks.

From an allocation perspective, I have been eager to add commodity exposure since I’m a little light in that area.  As for JJC, I owned (and sold) it years ago, but am always cautious with an exchange traded note.  The trade:  Bought 30 shares of JJC at $45.70.

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Last night I published an introductory piece on how options work.  It is written for the novice stock trader.  Feel free to take a look.