Sponsored By:

The Pareto Principle

January 26, 2009


Dear Fellow Options Traders,

Italian economist Vilfredo Pareto once observed that 80% of the income in Italy went to 20% of the population. This became known as the "Pareto Principle."

As is often the case, we Americans like to import what is attractive from abroad (e.g. pizza) and customize it to better match our tastes (e.g. Hawaiian pizza delivered to your home in 30 minutes, or else you don't pay). We renamed the Pareto Principle the "80/20 rule" and mostly use it to describe how 80% of companies' sales often come from about 20% of the clients.

The 80/20 rule, with some degree of twisting, may also be used to describe the current problems with our banks and why we may be finally moving to the end of the crisis in the financial sector collapse.

A little more than a year ago, financial stocks made up more than 22% of the value of the S&P 500. Today, their value is under 9.7%. A large part of the shrinkage has been caused by mark-to-market accounting rules.

Bank assets that are paying out at rates of at least 80 cents on the dollar, if held to maturity, are trading at 20 cents on the dollar, if sold today, because of the immense supply of assets for sale relative to the buying demand.

If we simply relaxed the mark-to-market accounting requirements and valued the assets on a discounted cash flow basis if held to maturity, the balance sheets of the financial sector would rapidly re-inflate and a huge amount of liquidity would be restored to the system. What has blocked this apparently simple fix is the fear of losing transparency during a time of illiquidity.

Bouncing Banks

Stuff that is bouncing goes up and, by definition, down. Bank of America (BAC) and Citigroup (C) behaved like the original Wham-O SuperBall this past week with price oscillations of 20% to 30% from day to day.

How hard can it be to calculate the residual value of the equity and eliminate the manic pricing movement from these stocks?

The answer, according to some very knowledgeable bank experts, is close to impossible.

The reason is that at the drop of a hat, the U.S. government might step in and nationalize our largest banks, causing the bank equity to go the way of Fannie Mae/Freddie Mac. No longer is the risk of nationalization of private commerce an investment consideration found only in communist or small developing countries in the control of extremist leadership.

The radical daily-bank-stock-valuation changes have been setting the market's tone for the past two weeks. With this uncertainty raging, the S&P 500 is trading 11% above its old lows. We continue to see the relative resilience of the rest of the market as a bullish indicator.

Knowing the Price of Everything and the Value of Nothing

Driven by Sheila Bair, chairperson of the FDIC, the Obama team is reportedly moving rapidly toward a comprehensive solution to the 80/20-nationalization problem of our banks.

It appears there is a good chance Obama will unveil a plan to create a huge "bad bank" that essentially buys up all of those bank assets trading at 20 cents on the dollar that may be worth 80 cents if held to maturity with a new trillion-dollar bailout fund. The U.S. government may be the only market participant capable of "hanging in there" during the long term to capture the value embedded in today's discount prices.

Such a program is not materially different than what former Treasury Secretary Hank Paulson was attempting to do with TARP. What is expected to be different is its clarity of purpose and focus of execution.

We will wait and see. We suspect that such a proposal will come to pass and it will greatly alleviate one of the major uncertainties of the market, namely what is going to happen with our banking system. Reducing uncertainty is an essential element to restoring liquidity and private sector capital flows in our economy.

Banks to Main Street

We have devoted much of our discussion this week and last to talking about the banks. The reason is that our economy is dependent upon debt financing.

The entire financial crisis started -- and will end -- with how we lend money. Today, we're seeing the beginning of the end of the crisis in the banking sector. Structural changes are being made that will stabilize our lending system and restore some reasonable level of private sector capital flows.

The credit crisis, however, has clearly triggered a chain of events that extend well beyond the banks and into the heart of Main Street.

Of the 170 companies that have reported earnings through the end of last week, 45% beat estimates. Surprisingly, this makes the fourth quarter of 2008 the worst in more than a decade.

On the other hand, it is surprising that it was not worse, as it felt in many ways that the economy had come to a dead stop in October and November. Investors may also be anticipating the $825 billion stimulus spending program that must be spent before the end of 2010 that Obama is trying to fast-track through Congress before the Feb. 13 recess.

Bad, but Not So Bad

With the banks moving closer to structural repair, it will be the crisis on Main Street that determines whether the stock market retests its November '08 lows.

This week, the earnings season begins to accelerate with a wide range of important corporate earnings reports. We will see the December Leading Indicator number (expected to show a slowing decline from November), January Consumer Confidence figures, December Durable Goods results and the fourth-quarter GDP report.

Additionally, the Fed ends its two-day meeting on Wednesday and will potentially make market-moving comments. With interests effectively at zero, we do not anticipate much rate-change activity.

So far, the market's reaction to earnings (e.g., Apple and Google better; Microsoft, eBay, Intel and General Electric worse) has been to say "bad, but not-so-bad" and move up slightly after posting the worst Inauguration Day performance in history.

With the CBOE Volatility Index (VIX) starting and ending the week at about 48, it appears that the "new normal" is alive and well. As time passes, the economy heals -- although it may require a walker for some time to come.

Keep the Guard Up

From reading our trading landscapes during the past few weeks, you may have the impression that we are becoming more complacent with the market. Nothing could be further from the truth.

We do see structural changes that are encouraging, but we still lose sleep at nights because of the condition of the credit market, as well as the fact that many technicians predict the S&P 500 will hit 600 before we finally establish a hard bottom. So far during this crisis, the credit market indicators have been the most reliable of all indicators of stock market direction.

With the clear and present possibility of another market collapse from current levels, our options strategy is to be nimble, balanced and watchful. We are likely to clear positions faster if profits emerge, and make investments in options where expiration dates give us plenty of time to benefit from market volatility.

REVIEW OF OPEN POSITIONS

This past week, we put on two and a half positions and closed one of those positions almost immediately.

Darden Restaurants (DRI) -- On Jan. 20, we recommended you buy the DRI Feb 22.50 Puts (DRINX) for $1.50 or less. On the morning of Jan. 21, the company reiterated its earnings guidance and the stock began to rally. Eventually, the big-money options investors we followed into the trade may be proven right but we believed, given how far the stock would have to pull back, that it was a better bet to cut our losses early. On Jan. 21, we recommended closing this position for 90 cents or better.

Phase Forward (PFWD) -- On Jan. 21, we recommended you buy a half position in the PFWD Feb 15 Calls (UTOBC) for $1.30 or less because we believe option investors are making a directional bet based on the company's Feb. 5 earnings announcement. We normally do not like buying in front of earnings announcements, as they contain less proprietary information (as it is public information the company will report on Feb. 5) than other generally unknown catalysts. But, we made an exception in this case because of the persistence and magnitude of the option signals. We are hedging our bet here by recommending only a half-position.

Grupo Televisa SA (TV) -- On Jan. 23, we recommended buying the TV April 15 Calls (TVDC) for $2 or less. For most of the day, these options were available at about $1.90 to $1.95. They closed the week at $2.12.

The remainder of our trades are:

NBTY Inc. (NTY) -- On Jan. 14, we recommended buying the NTY Feb 15 Puts (NTYNC) for $1.15 or better. On Thursday of last week, the stock rocketed higher from about $14.80 to above $16 per share on no news. The company reports earnings this week on Jan. 29, which may serve as a catalyst to change its direction. These options closed the week at 80 cents. This position may have a rapid gain or loss based on earnings this week. This is a trade for the more aggressive investor.

Canadian Solar (CSIQ) -- On Jan. 15, we recommended using a spread order to buy the CSIQ July 5 Calls (GQAGA) for approximately $1.85 and simultaneously sell an equal number of the CSIQ July 10 Calls (GQAGB) for approximately 60 cents, for a net debit of $1.25 or less. The stock had a tough week until Friday when Jon Najarian noticed unusual options flow in CSIQ and, in turn, discussed it on CNBC. We thank Jon for his commentary, as the stock enjoyed a rally on Friday as a result. The spread position closed the week at $1. We continue to like this trade.

CBRL Group (CBRL) -- On Dec. 10, we recommended buying the CBRL March 20 Puts (CBQOD) up to $3.50. We closed half the position on Jan. 14 for $4.80. The stock reached a point of technical support, which we expect it will eventually break. However, prudence dictated that we take some money off the table.

It looks like prudence was the right move in the short term. CBRL benefited from competitors DRI's and Brinker International's (EAT) positive announcements on Thursday, which hurt our put position. We are staying with this position, as CBRL has about $36 per share of debt and may not be as well-managed as DRI and EAT. These options closed the week at $3.70.

Supertex (SUPX) -- On Jan. 6, we recommended selling to open the SUPX March 25 Puts (SQOOE) for $2.75 or more. These puts closed the week at $2.90. We continue to like this trade.

Rackable Systems (RACK) -- On Jan. 8, we recommended you buy the RACK June 5 Calls (RQOFA) for 95 cents or less. These options closed on Friday at 45 cents, as the stock was hurt by a negative earnings preannouncement. We continue to like this trade given the company's $5.88 per share in cash and no debt.

Shaw Group (SGR) -- On Nov. 26 we recommended selling the April 12.50 Puts (SGRPV) for $2 or more As this option position approaches a greater than 80% return, we will be looking for optimum times to close the position. On Jan. 12, we recommended closing half of this position for 30 cents or better. The option closed the week at 40 cents. Time is on our side, and we will continue to wait for the easy money to be made before closing the position.

Novellus Systems (NVLS) -- On Jan. 8, we recommended buying the NVLS Feb 15 Calls (NLQBC) for 75 cents or less. This position closed the week at 44 cents and we continue to like this trade.

Wal-Mart Stores (WMT) -- On Jan. 8, we recommended selling the WMT Feb 47.50 Puts (WMTNW) for $1.45 or more. These puts ended the week at $1.65. The stock has been buffeted by downgrades and reiteration of "Buys" from the analyst community this past week. We continue to like the trade as we would not mind taking ownership of WMT in the mid-$40s if required to do so upon expiration.

Cadence Design Systems (CDNS) -- On Jan. 9, we recommended buying the CDNS May 5 Calls (CDNEA) for 60 cents or less. This position closed at the end of the week at 40 cents and we continue to like this trade.

Hain Celestial Group (HAIN) -- On Oct. 21, we recommended you buy the HAIN Feb 25 Calls (QQHBE) as part of a bull-call spread for $3.40. HAIN was badly damaged by the market crash. We are hopeful to recover more than the current 10 cents from this position but we do not recommend adding new money to this trade.

Pool Corp. (POOL) -- On Dec. 10, we recommended buying the POOL April 17.50 Puts (QCLPW) for $3.80 or less. These options closed on Friday at $3.30. We continue to like this trade.

MSCI Inc. (MXB) -- On Dec. 11, we recommended you buy the MXB March 15 Puts (MXBOC) up to $2.50. These puts closed the week at $1.25. With the financial sector melting down, we wonder how much longer MXB will defy the trend. We continue to like this trade.

Vasco Data Security International (VDSI) -- On Nov. 4, we recommended buying the VDSI March 15 Calls (QFNCC) for 95 cents or better. This position closed the week at 10 cents. Unfortunately, the company had a negative earnings pre-announcement that halted the positive upward trend the stock was in the process of establishing. Although the stock has pulled back, the original signal is still valid and we are staying with the trade. However, we would not add new money to this position.

PARTING SHOT

The first year of a U.S. president's term has historically been a tough year for stocks. Since World War II, during the year of inauguration for first-time presidents, the median move of the Dow was down 5%

We should take heart in the observation that important history is being made almost daily. We are all veterans of one of the worst market years on record and, after what we have seen firsthand, it would take a lot to shock us now. With Obama, we cannot deny that things may be different.

The willingness of the Senate to accept a head of Treasury who did not pay his taxes and was slow to correct the entire problem shows a willingness to allow Obama a free pass to move ahead with his aggressive agenda. As we mentioned last week, fighting spirit is hard to measure but has been an important economic force in the past.

With a bank bailout, stimulus package and other Obama programs on the way, we stand ready to support and contribute to our president's interest in prosperity for all of us.

Have a great week trading.

Nick Atkeson and Andrew Houghton

Editors

Options Trader