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Bold Trades, Big Gains, and Controlling Risk

 
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PostPosted: Sat Sep 23, 2006 3:58 pm    Post subject: Bold Trades, Big Gains, and Controlling Risk Reply with quote

This week, a detailed trading plan will be presented in this category. These trading plans are generally reflected in the Option Trading Log, Top Stock Picks, or other member categories each day.

On Wednesday, the FOMC gave a more dovish statement, while the Fed Funds Rate was left unchanged at 5.25%. On Thursday, the Philadephia Fed manufacturing report was weaker than expected. Consequently, the stock market fell Thursday and Friday on uncertainty whether the Fed will achieve a "soft-landing" or if the country will fall into recession. However, the price of oil fell below a multi-year support level, which indicates oil will likely stabilize around 60 or fall further.

Bond and stock prices generally rose together over the past two months. However, after the Philadelphia Fed report, bond prices rose, while stock prices fell, and the yield curve inverted further, increasing expectations of slower economic growth. When the 10-year bond yield, for example, fell below 4.75% (or 50 basis points below the Fed Funds Rate) that triggered a threshold of lower stock prices, and suggested a potential recession. Consequently, future economic growth data will be important determinants of bond and stock market directions.

Below is a five-year daily chart of TLT (long-bond ETF). RSI (above price chart) is above 80.8, which is extremely overbought. The gray arrow represents when RSI reached its all-time high at 85.4 in May 2003. At that time, TLT topped at 80.40, pulled-back to 78.00 in two days, and then rose to 81.55. If TLT follows a similar pattern in the current period, then it'll rise roughly two points in five days, and then pullback about 2 1/2 points in two days.

The following are (roughly) current TLT put option prices: Dec 86 0.40; Dec 88 0.95; and Dec 90 1.80. TLT closed at 89.60 on Friday. December puts are used, because if the short-term trade doesn't work out, a longer-term trade may. If TLT rises slightly Monday, TLT Dec 88 puts may be bought below 0.90. However, only one-half of a position should be bought initially, with the rest in cash, in case TLT continues to rise, to buy more puts cheaper.

A bold trade can earn big gains. Also, other options can be used to control risk. SPY (S&P 500 ETF) Nov 132 puts and VIX (S&P 500 Volatility Index; symbol: $VIX.X) Nov 15 calls can be used to partially hedge TLT Dec 88 puts, since TLT and SPY are moving in opposite directions (from the threshold effect), and VIX and TLT are now moving in the same direction. If volatility increases, gains can be made on VIX. Also, volatility or directional changes can eventually make gains on all three.

So, with a $100,000 portfolio, for example, $30,000 can be set aside for TLT Dec 88 puts with a $15,000 initial purchase. If TLT rises enough next week, it may become a $30,000 trade. However, initially, $5,000 may be used for SPY Nov 132 puts, and perhaps some for VIX Nov 15 calls. It's likely less than $30,000 can potentially be lost. Also note that if TLT rises after the initial $15,000 purchase and then pulls-back before the entire $30,000 is used, some puts can be sold to lower average cost, while keeping most of the puts for a potentially large gain.

Nonetheless, the main trade is the TLT puts with the objective of a 50% to 100% gain within one or two weeks. If the short-term trade doesn't work out, the odds are high most or all of the amount at risk will be recovered on the first pullback. Also, if the other half of the position is used at lower prices, then a lower stop loss can be set (although, the stop loss has to be low, because of leverage). This is a high risk trade with the potential for a big loss (which should be recognized and accepted if the trade is taken), although the potential gain is higher, and the odds of making at least a small gain are high.

Some economic reports next week are: Monday--Existing Home Sales, Tuesday--Consumer Confidence, Wednesday--Durable Goods Orders, and New Home Sales, Thursday--GDP and its Deflator, and Friday--Personal Income and Spending, and Chicago PMI. Perhaps, Durable Goods Orders is most important, since it's a leading economic indicator. Most of the other reports are coincident indicators. The Chicago PMI is a large regional manufacturing report, similar to the Philadelphia Fed. Consumer Confidence hasn't been an accurate predictor, although a leading indicator. The price of oil will also be influencial.

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