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November 30, 2007

"How long a minute is, depends on which side of the bathroom door you're on." -- Zall's Second Law

Dear Fellow Options Trader,

Time is indeed a precious commodity. Although technically we do not trade time, it is indeed part of every trade that has ever been made.

Systems like the ones we employ to find unusual activity in stocks, options and futures exist because time is important. They help us find what happened in this millisecond, and what stretched into the next millisecond. That information, in turn, helps us to select the best opportunities to trade and which ones to leave behind!

Time is part of the calculation of every derivative trade -- how long a particular options contract, oil future, index option, bond, etc. will be in place helps to determine the value beyond the intrinsic value of that contract.

The calculation for pricing is determined by the time that contract will be in effect, multiplied by the applicable interest rate, multiplied by the price of the asset, divided by the number of days in a year.

Thus, the December futures contract for crude oil, trading at $92 per barrel, would be determined by:

$92 x 34 (days) x 0.044 (interest rate), divided by 365 = 37 cents, which means that the December contract should trade for 37 cents more than the cash value.

As you can see, time is a critical factor in trading, but we've only scratched the surface of its importance. Any of you who have traded know the fantastic high, or the crushing low, that you feel when you either sell at precisely the right moment, or at precisely the wrong moment.

If we each had a dollar for every time a trader said, "If I'd only been locked in a closet for 10 minutes, I wouldn't have been stopped out for a loss; I'd be selling for a killer profit," -- we'd all be very wealthy.

Bottom line: Time, whether too much or not enough, can be a killer.

One other example of time and how moments can make a massive difference is to a scuba diver. The diver goes down, but runs out of air moments before he or she can get to the surface. The consequences can be disastrous, but the example does point out the difference that time makes to the diver.

Not dissimilarly, you can see the difference that time made to both E*Trade (ETFC) and Citigroup (C). Both financial stocks were on their last breaths, meaning their respective tanks were nearly out of air.

So, they did what they had to do to get those last precious breaths that would allow them to make it back up to the surface. Both companies paid a dear price to get those extra moments, but it may be enough to save them.

CITIGROUP (C)

Citigroup's (C) struck a deal with the government of Abu Dhabi for the Arab nation to invest $7.5 billion in convertible bonds paying 11% that can be converted into a 4.9% stake in Citigroup's equity. Whether or not it was a brilliant move or a portent of things to come for the company and/or other ailing financials, it gives Citi the chance to work on staying afloat and ultimately recovering from the hit it has taken in the subprime shakedown.

E*TRADE FINANCIAL (ETFC)

You might have thought that, by heaving that $3 billion anvil of mortgage debt from its chest, ETFC would be moving toward similar valuations of its peers, and that its shares would be on the launching pad. But, not so fast!

While they did trade the $3 billion to Citadel Investment Group this morning, they have to take a $2.2 billion charge to reflect its loss on the sale. That will make for one ugly quarterly report in January!

I'll liken this to the coyote that has to chew its leg off to get out of the trap. The animal escapes, but it can no longer run with the pack!

Don't misinterpret what I'm saying. E*Trade may still be a great brokerage platform, but chewing their way out of that trap cost them dearly, as that $1.75 billion of secured paper is due to pay Citadel 12.5%, and the hedge fund also gets 84 million shares. The dilution to existing shareholders is massive, and this secured paper at 12% is chokingly expensive in an environment where the 10-year bond trades for 4%!

Thus, we're not sounding an all-clear for ETFC just yet. Sure, their peers may have values ranging from $3,000 to $5,500 per account, but our worry is just how many accounts ETFC has lost during the past few tumultuous months.

If the percentage lost tops 10% of all accounts, we view that as negative. Less than 10% will be viewed as a victory of sorts.

To quote Michael Hecht in a note to Bank of America (BAC) clients, "Xmas comes early for Citadel; shareholders get a lump of coal."


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader