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August 1, 2010
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6/8/05
TREADING WATER
June 08, 2005
The market basically treaded water last week, but that's not bad news given the tremendous rally we've enjoyed since the April 20 bottom. There's no doubt that the standout performer among the major indices has been the Nasdaq, which has nearly doubled the S&P 500 during the past five weeks. Through yesterday, the Nasdaq was up 11.25% since that April bottom against the S&P 500's 5.4% move.
I don't want to talk politics, but I will say that President Bush's nomination of California Rep. Christopher Cox to head the Securities and Exchange Commission could well be a strong catalyst for the bulls, as Wall Street seems to universally like the president's pick. Traders I've spoken with liked Mr. Cox's links to Ronald Reagan and think he will be an SEC chair who can preserve recent reforms enacted in the wake of the financial scandals, while understanding their impact on business and applying "measured" enforcement.
A huge majority of those I've talked to do not believe Mr. Cox will roll back the anti-fraud Sarbanes-Oxley provisions, but they do think he is likely to re-interpret some SEC rules in a much more business-friendly way than did his predecessor. That predecessor, Bill Donaldson, was viewed by many as being much closer to Eliot Spitzer, the fiery New York Attorney General who has grabbed headlines for his relentless pursuit of mutual fund timers, stock market analysts and former NYSE Chairman Dick Grasso.
WHAT THE OPTIONS MARKETS ARE TELLING ME
Despite some violent moves last week, the Dow Jones Industrial Average finished with a "whopping loss" of just 7 points. The Chicago Board Options Exchange's market volatility index (the VIX) finished exactly where it began, at 12.15%. To put this in perspective, a year ago this same index registered a 16.78% reading (28% drop) and one month ago it was 14.05%, from which the VIX has slipped 14%.
CATCHING THE CHANGEWAVE -- ALL THE WAY TO THE BANK
Independent credit-card companies may be going the way of the dodo bird. One week ago, it was Citi buying May and Federated's credit card biz, and this week it's WaMu (Washington Mutual Inc.) announcing its intentions to buy Providian in a cash-and-stock deal valued at $6.45 billion. The catalyst here is the slowdown in the growth rate of the credit-card business, which is putting pressure on card issuers who focus mostly on the business of peddling plastic.
I've been trading in and out of a number of these "mono-line" companies, such as Capital One, MBNA Corp., Metris and Providian Financial Corp. But unusually heavy call-option activity in MBNA Corp. (KRB) tells me this might be the next one to be gobbled up! Three times in the past two weeks, I've seen very active accumulations of the out-the-money calls in MBNA and, just this morning (Wednesday, June 8), my computers showed 4,000 of its July 20 Calls trading for $1.70. That in and of itself isn't crazy, but the fact that 96% of these calls were trading on the offer means that someone was getting pretty aggressive.
In addition to its massive credit card biz, the company makes other consumer loans, including installment and revolving unsecured loan products, mortgage loans, insurance premium financing loans, aircraft loans and other specialty lending products to consumers, as well as commercial loans, which include business-card products, professional practice financing loans and other specialty lending products to small businesses.
To make some cash of our own, I recommend buying the KRB Sept 20 Calls (KRBID) for $2.10 and selling the KRB Sept 22.50 Calls (KRBIX) for 65 cents, for a net debit of $1.45 for this $2.50 spread. With MBNA trading for $21.65, this spread is in-the-money by $1.65, so we're entering under its intrinsic value!
To make a limited-risk investment in MBNA Corp., I recommend buying the KRB Sept 20-22.50 bull-call spread for a net debit of $1.45.
TRADE DETAILS
All information is based on prices as of 12 p.m. Eastern on Wednesday, June 8, 2005.
* NOTE: This example follows the most current prices available to us at the time of publication. You can still enter the trade for up to $1.45 for the KRB Sept 20-22.50 bull-call spread through Wednesday, June 15, as long as MBNA shares trade for $21.20 or higher.
Here is the information you need to know to buy our MBNA Corp. bull-call spread for profits:
Underlying Stock: MBNA Corp. (KRB)
Current Stock Price: $21.65
Trade Type: Bull-call spread
Options to Trade: The specific trades to make are in the table below...
| Action | Quantity | Option | Strike Price | Ticker | Investment | |
| Buy | 1 | KRB Sept 20 Call | $20 | KRBID | -$2.10 | |
| Sell | 1 | KRB Sept 22.50 Call | $22.50 | KRBIX | +$0.65 | |
| Net Cost | -$1.45 |
*A minus sign (-) indicates an amount you pay; a plus sign (+) indicates an amount you receive.
Making The Trade:
If you give this trade to your broker at a net debit of $1.45, then it doesn't matter which prices your broker pays for the individual parts of the bull-call spread. Thus, our net debit would be $1.45, or $145 for each spread. (For those of you who are do-it-yourselfers and are making the trade online, an order to buy the KRB Sept 20 Calls (KRBID) for $2.10 while simultaneously selling the KRB Sept 22.50 Calls (KRBIX) for 65 cents puts you in the trade with a net debit of $1.45.)
Our loss is limited to the $1.45 that we are paying for the spread. If, on the other hand, MBNA Corp. rises above $22.50 on September expiration, then we make $1.05 on our $1.45 investment!
SUMMARY
With MBNA Corp. trading for $21.65, a 1,000-share position would tie up $21,650. However, with our trade you'll be able to put just $1,450 at risk and have a potential gain of $1,050 if MBNA Corp. rises to $22.50 or higher.
Here’s why:
* Our net investment on that bull-call spread is the difference between what we paid for the KRB Sept 20 Calls ($2.10) and our credit on the KRB Sept 22.50 Calls (65 cents), or a net debit of $145 per contract.
* With MBNA trading at $21.65, a 1,000-share position would cost us $21,650.
* Instead, if we buy 10 of the KRB Sept 20 Calls (KRBID) for $2.10 ($2.10 each times 100 shares = $210 per contract), or $2,100 and ...
* Against that purchase, we sell 10 of the KRB Sept 22.50 Calls (KRBIX) for 65 cents (65 cents each times 100 shares = $65 per contract), or $650.
* Thus, on a 10-contract spread we have only $1,450 invested, so that's all we can lose!
* If you follow these guidelines, this means your broker can pay no more than $1.45 and you avoid the risk of "legging the spread" -- that is, buying one side and waiting to sell the other.
* NOTE: Keep in mind that nobody knows your risk tolerance or financial situation better than you. A single bull-call spread in this example will cost you $145 plus commissions. As long as you maintain the ratio of one contract purchased against one contract sold, you can ramp up this strategy as big, or make it as small, as you’d like.
* Remember, you can pay up to $1.45 for this spread trade through Wednesday, June 15, as long as MBNA shares trade for $21.20 or higher.
TRADE PROFITABILITY ANALYSIS
Here’s how we figure out how much money we can make on this trade:
To illustrate how and where you will make money on this trade, I have included a payoff diagram at the start of this section. You can use this chart to follow along with my explanation below:
If you look at the shaded areas as they compare to the horizontal axis that tracks the price of MBNA shares, you can see that the trade becomes profitable (green area) when the underlying stock crosses the $21.45 level. Likewise, while the stock is under $21.45, we are below the axis (red area) where the bull-call spread registers a profit.
As with any 1-to-1 bull-call spread, our risk is limited to what we pay for the spread -- in this case, $1.45.
Breakeven: $21.45
The breakeven is $21.45 because, as in any bull-call spread, the breakeven is determined by adding the net cost of the spread ($1.45 in this case) to the strike price of the call you are buying. Again, because we paid $2.10 for the KRB Sept 20 Calls and took in 65 cents for the sale of the KRB Sept 22.50 Calls, our net out-of-pocket is $1.45. You add that net to the strike price we’ve purchased ($20) and you get your breakeven of $21.45.
Max Profit: $105 per spread ($1.05 x 100 shares)
The max profit is determined by taking the difference between the two strikes of the bull-call spread, which in this case is $2.50 ($22.50 – $20 = $2.50) and subtracting the amount we paid for the spread ($1.45) and is therefore $1.05. Thus, if MBNA is $22.50 or higher on expiration, then the spread will achieve that $2.50 max and, because we paid $1.45 for the spread, that would leave us with a $1.05 profit, or 72.4%. On a 10-contract spread, that would translate to a profit of $1,050!
*This analysis does NOT include the cost of commissions while executing your trades.
BUY LIST UPDATE -- JUNE EXPIRATIONS
Several of our options spreads are expiring on Friday, June 17. While we were fortunate that our Cree Inc. (CREE) and Valero Energy (VLO) June spreads managed to rally quite nicely during the past couple of weeks to yield us some decent gains, we've been less than impressed by results from IMAX Corp. (IMAX), Audible (ADBL), Companhia Vale do Rio Doce (RIO), Synaptics (SYNA) and Silicon Image (SIMGE).
We are watching and, yes, hoping that one or more of these can make a move prior to expiration, and we'll send you updates if that happens, and we'll also review their performance in next week's newsletter if things don't play out in our favor.
JOIN ME AND THE CHANGEWAVE TEAM IN THE NATION'S CAPITAL, WASHINGTON, D.C.
I want you to be my guest at The Money Show in Washington, D.C., on Aug. 11-13, 2005, at the Wardman Park Marriott in Washington, D.C.
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The ChangeWave gang will be on-hand, including Toby Smith and Bryan Perry, and we will talk about stocks and trading with you throughout the show.
Here is the ChangeWave adviser schedule:
THURSDAY, AUG. 11, 2005
FRIDAY, AUG. 12, 2005
SATURDAY, AUG. 13, 2005
The Money Show in Washington, D.C., WILL book up quickly, so call 800-970-4355 now and don’t forget to mention priority code 004074.
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