Sponsored By:

Bernanke Gets His Bazooka

March 23, 2009


Dear Fellow Options Traders,

Fed Chairman Ben Bernanke may have more in common with Eric Carle, author of the children's book "The Very Hungry Caterpillar," which sold 29 million copies, than might appear obvious at first glance.

In 1935, in what may be viewed as one of the worst management decisions of all time, the Carle family moved from New York to Stuttgart, Germany. With the breakout of World War II, Carle's dad was recruited by the German Army and ended up in a POW camp in Siberia.

Back at home, the family passed time in the cellar with bombs exploding 20 feet away. On the rare days they emerged from the cellar, they would get their exercise dodging 50-caliber bullets from war planes strafing all pockets of resistance.

When Carle was about 10, a Nazi official told his mother it was time for him to come down to the train station and get his bazooka. In his mind, this was a positive development. During this dark time, a bazooka looked like a darn good idea.

With the relentless pounding of falling asset values and strafing of endless economic bad news, Bernanke thought it was time to try a bazooka. Out of nowhere, our academic Fed Chairman fired a $1.15-trillion round right into the credit market. On Wednesday, he announced a plan to buy $300 billion of Treasuries and spend the remainder on Fannie Mae and Freddie Mac guaranteed mortgage-backed securities; 30-year mortgage rates dropped to all-time lows of 4.94% in a single day.

In the wake of this blast, investors are trying to sort out how much Bernanke likes his bazooka.

If this is the start of the Fed's surge campaign, it may be a game changer for the market that will take us much higher over time. M2 (a measure of money and close substitutes for money), after remaining unchanged for five weeks, rose by $69 billion during the past two weeks, coinciding with a 17% run in the S&P 500 (SPX).

On Friday, investors worried that the use of a financial bazooka could cause deflation to immediately change to inflation, and there was more consternation about how you can't fight debt with debt. With the Fed acting as the only significant buyer of credit, it is unlikely inflation will grow in the near-term, and thus it may become too painful to stay short as each new round is fired.

Today the bazooka was fired again as the Treasury announced how it will spend as much as $1 trillion on troubled mortgages and related assets. The general idea is to have the Treasury and FDIC invest side-by-side with the private sector through special purpose investment partnerships designed to create leverage of government dollars by having the private sector co-invest. The private sector should provide extra bang for the buck.

Our Take

We have just had a powerful market bounce. It wouldn't surprise us to see a 50% retracement from the highs of the latest bounce as inflation fears play out, and we continue to see concentrated negative economic news flow. (This week, we'll get figures for existing and new home sales, final Q4 GDP, February durable goods orders and the March Michigan Sentiment.)

Some of the expected pullback occurred on Friday, and there may be more to go. Once the pullback is complete, we believe we may see a significantly larger rally develop in the intermediate term. The big question is when.

Big M0

As we mentioned M2 earlier in this issue, but at Options Trader, the formal name for the money supply number we care most about is M0. M0 is the term used by the Fed to describe currency. Big M0 is about putting coin in our collective pocket.

We know from your e-mails and comments that you prefer trading simple put and calls, and so do we. But sometimes the implied volatility of a trade is such that it is well worth the extra effort to turn the trade into a spread trade in order to significantly increase our odds of success.

Citrix: Pay Me Now, and Pay Me More Later

And there are times, like our Citrix Systems (CTXS) trade from Thursday, when it is fine to go either way with the trade.

Let us explain the benefits of the spread trade using two examples -- our recent CTXS trade and the Ivanhoe Mines (IVN) spread we opened on March 3. Both trades are winners, but there are differences.

On Friday, we gave you two ways to trade Citrix Systems based on the big money activity we saw in the CTXS options. Because the implied volatility was in line with the historical volatility (see chart below), we recommended going long calls outright.

CTXS Daily Volatility Chart (3 months)




Additionally, because of the valuation of both the stock and options, we recommended a second trade whereby we sold puts to pay for the calls and collect a net credit.

The single-call trade puts you in position to take advantage of any movement related to M&A action that seems to be gaining momentum right now, and that's certainly a great place to be.

The credit spread trade, however, gives you a net credit after you open the positions, putting you in positive territory from the start. Trades with a little more complexity require more work, but you get the payoff from the lower entry price for the trade (or in CTXS's case, a credit to your account). We believe selling the 20 put is a safe bet. Shown below is a one-year CTXS stock price chart. You can see that $20 is the low end of the trading range.



Best of all, you have the same upside opportunity as the single-call buy because you also own the call. Both trades have unlimited upside, but by selling the put, you have increased the odds of making money significantly. This has been one of our preferred strategies lately, but we've also seen success with a covered-call trade.

Ivanhoe Mines: Covering All the Bases

For several trading sessions leading up to March 3, we saw huge buying volume in the April and June 5 calls for Ivanhoe Mines Ltd. (IVN). The volumes were four- and five-times larger than any prior extreme level of IVN call buying. We couldn't let this opportunity pass us by.

Take a look at the chart below from the International Securities Web site that shows both options volume (a) and the options implied volatility (b) price spike versus historical volatility.



On March 3, we recommended establishing a covered call by buying IVN stock for $4.45 and selling the IVN June 5 Calls for $1.35. This effectively made our entry price into the stock $3.10 ($4.45 stock price less the $1.35 options premium collected).

Between March 3 and March 19, the stock ran up 24.5% (c). The stock was a winner.

What about those option buyers? This is what is amazing. On March 3, option investors paid 90 cents for the IVN April 5 Calls and $1.35 for the June 5 Calls. On March 19, after an almost 25% advance in the stock, an option investor could have sold his April 5 Calls for 85 cents for a 5-cent loss and the June 5 Calls for $1.35 -- or no gain -- because volatility collapsed (d).

With our recommendation where we went long the stock and short the calls, our profit, if expiration occurred on March 19, was more than 61%.

Just as we thought, the IVN options on March 3 were too expensive. We would much rather have just gone long the calls but that method of trading is often not working when volatility is priced too high.

We will continue to seek out attractive straight long call and put trades but may also continue to recommend selling volatility while it continues to sell for historically high prices.

REVIEW OF OPEN POSITIONS

There are a lot of open trades at Options Trader. To provide you with a clearer view of what we are strongly recommending right now, we are adding a section called "Top Trades Now" directly following our review of trade actions of the prior week.

We want to make sure you know what trades we are most excited about, given the latest market moves. The trades that are not included in "Top Trades Now" may continue to be attractive, but don't provide the same "hot" opportunities given their recent price action.

But first, let's review our busy week.

Positions Closed

Schlumberger Ltd. (SLB) -- On Thursday, with oil spiking higher on the Fed liquidity injection announcement, we recommended you buy to close half of the SLB April 35 Puts (SLBPG) for 40 cents or less, and sell to close half of the SLB April 50 Calls (SLBDJ) for $1.05 or more. We had opened this position on March 12 by collecting a credit of 95 cents. With prices spiking on Thursday, we collected an additional credit of $1.85.

SLB is typical of many of the trades we are currently putting on. We are collecting a credit and then collecting profits on the back-end. How do you calculate the return-on-investment of an investment where you were paid to put it on and paid when you sell? If it were a riskless trade, the mathematically correct answer is infinity return. We know one thing for sure, the answer is something substantially larger than just a money doubler.

Supertex (SUPX) -- Also on Thursday, we recommended buying to close our short SUPX March 25 Puts (SQOOE) for $3.20 or less. On Jan 6, we opened this trade for a recommended price of $2.75 or better but had received better pricing based on favorable market conditions. Essentially, this position was closed at breakeven.

United Parcel Service (UPS) -- On Feb. 18, we recommended selling to open the UPS March 40 Puts (UPSOH) for $1.40 or better. Last Monday, we closed this position for a 93% profit.

In addition to the trade activity shown above, a number of positions expired in March that were victims of the 25% market sell-off this year. These included: Vasco Data Security International (VDSI), PowerShares WilderHill Clean Energy ETF (PBW), Red Hat (RHT) and Ametek Inc. (AME). MSCI Inc. (MXB) was a March 15 Put position that went into and out of the money in the past couple of weeks. At expiration, the stock was above the $15 strike price.

Positions Opened

Wright Medical Group (WMGI) -- On March 17, we recommended buying to open the WMGI Aug 15 Calls (QWMHC) for $1.25 or less and sell to open the WMGI Aug 12.50 Puts (QWMTV) for $1.90 or more to collect a credit of 65 cents. This gives us a "lottery ticket" if WMGI appreciates above $15 per share. Currently, both sides of this trade were profitable.

Microsoft (MSFT) -- On March 17, we recommended buying the MSFT October 22 Calls (MSQJN) for 60 cents are better. They traded today around 95 cents. We really like this trade but would not add to it unless we see pullbacks to the 60-cent level.

Citrix Systems Inc. (CTXS) -- On Thursday, March 19, we recommended you buy to open the CTXS June 30 Calls (XSQFF) for 65 cents or better. For those interested in being paid to do this, we also recommended selling the June 20 Puts (XSQRD) for $1 or more to collect at least a 35-cent credit. CTXS has not traded below $20 per share during this recession. We continue to like this trade.

TOP TRADES NOW

The open trades in this section are the group of trades we would actively add new money based on Friday's closing prices. The full details of each trade are shown above and below and on the Options Trader Web site. We've updated some of the opening guidelines to take advantage of price fluctuations in our direction.

Wright Medical Group (WMGI) -- Put on the position all the way down to a net credit of 55 cents or more.

Schlumberger (SLB) -- With the sell-off on Friday, we recommend adding to this position for a 30-cent credit or more. SLB has never traded below $35 per share.

Citrix Systems (CTXS) -- On Friday, CTXS was hit by a valuation downgrade by an investment bank and a down market. You can now open this trade for an 80-cent credit or more.

Aerospace (BEAV) -- The stock is about $7 and the company reiterated its earnings forecast of $2 per share for this year. The credit on this trade now stands at 55 cents , and we continue to like this trade. If you would like to add to the position, you could substitute the BEAV April 10 Calls (BQVDB) in place of the April 15 Calls and you should continue to collect a credit. However, we will continue tracking the $15 strike calls on our Open Positions list.

GigiMedia (GIGM) -- On March 13, we recommended you buy the GIGM Oct 7.50 Calls (GBUJU) for 80 cents or better. We recommend adding to this trade on any pullbacks whereby you are able to buy the calls for 75 cents or less.

Research In Motion (RIMM) -- You can sell the RIMM June 25 Puts all day long. We call this free money.

Rackable Systems (RACK) -- Take a flyer on the RACK June 5 Calls, and buy for 15 cents or less.

The remainder of our open trades are:

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. During the market pull back over the past several weeks, the CSIQ July 10 Calls dropped to about 10 cents. On March 12, we recommended you buy to cover the CSIQ July 10 Calls for an 80%-plus gain and remove the upside limiter from this trade.

Yahoo! (YHOO) -- On March 12, we recommended you "sell to open" the YHOO April 11 Puts (YHQPK) for 32 cents or more, and "buy to open" the YHOO April 17 Calls (YHQDR) for 22 cents or less. This position has run quite a bit in our favor and we recommend sitting tight to see if we capture further gains.

Ivanhoe Mines Ltd. (IVN) -- On March 3, we recommended you buy shares of IVN for $4.45 and "sell to open" the June 5 Calls (IVNFA) for $1.20 or more, effectively making your entry price $3.25. IVN had a strong week and now the stock is above $5 per share.

Alcon Inc. (ACL) -- On March 4, we recommended you sell to open the ACL May 70 Puts (NOZQN) for $3.10 and buy the ACL May 105 Calls (ACLEA) for 45 cents. With this trade, you collect premium while we wait to see whether Novartis AG (NVS) acquires the company for north of $105 per share. ACL is a high-quality company selling at a very discounted price that may see rapid appreciation in the near term. We continue to like this trade but would not add unless we saw a significant pull-back in price.

Perrigo Co. (PRGO) -- On March 6, we recommended you "sell to open" the PRGO May 17.50 Puts (IQPQW) for $1 or more and "buy to open" the PRGO May 25 Calls (IQPEE) for 35 cents or less for a net credit of 65 cents or more. This is another opportunity that we're getting paid to see if we capture incredible upside profits on a company exposed to secular growth of "store" labels over branded products. PRGO had a good week and traded near $23 today. We continue to like this trade but would not add money unless we saw a significant pull-back in price.

Novell Inc. (NOVL) -- On Jan. 19, we recommended using a spread order to simultaneously "buy to open" the NOVL Jan 5 Calls (WNNAA) for 50 cents or better and "sell to open" an equal number of the NOVL Jan 2.50 Puts (WNNMZ) for 25 cents or more, for a net debit of 25 cents. We continue to like this trade but would not add unless we saw a significant pull-back in price.

Grupo Televisa SA (TV) -- On Jan. 23, we recommended buying the TV April 15 Calls (TVDC) for $2 or less. They closed the week at 20 cents. We are now fighting time. Do not add new money to this trade as we are approaching expiration.

Shaw Group (SGR) -- On Nov. 26 we recommended selling the April 12.50 Puts (SGRPV) for $2 or more. We covered half the position on Jan. 29 for 25 cents or better. Given the continued strength of the stock, we feel there is no rush to clear the entire position. This position last traded at 4 cents. Do not add new money to this trade, as it has already moved substantially in our favor already.

Cadence Design Systems (CDNS) -- On Jan. 9, we recommended buying the CDNS May 5 Calls (CDNEA) for 60 cents or less. This position opened at 15 cents. We like this trade although the stock has not done much and the clock is ticking. We would not add new money to this position.

PARTING SHOT: WHERE THERE'S SMOKE, THERE'S FIRE

With or without Big Ben's bazooka, o ne possible market catalyst is corporate mergers and acquisitions.

For corporations with large cash reserves and a belief that someday the economy will once again grow, now may be the buying opportunity of a lifetime. If you are in the business, the ratio of the market price of tangible assets to the cost of replacement strongly favors buying such assets in the equity market rather than through cap-ex investing.

Corporations are one of the few serious buyers of equities today. Individual investors continue to flee the market en masse -- and private equity, leveraged buyout (LBO) and hedge funds have spent their capital and are afraid to increase risk exposure. Corporations buying corporations shows how ridiculously low equity valuations are.

IBM's announced offer to purchase Sun Microsystems (JAVA), a critical component of our Internet "cloud" computing infrastructure, for two-times cash seems like a low bid. What is incredible is that two-times cash is a 100% premium to Sun's value just prior to the announcement.

The corporate merger and acquisition wave began to build with Merck agreeing to buy Schering-Plough (SGP) for close to a 34% premium. The IBM/JAVA announcement followed.

We are hearing active takeover rumors about Yahoo (YHOO), Alcon (ACL), Citrix (CTXS), SanDisk (SNDK), Hershey (HSY), Humana (HUM), Expedia (EXPE), Advanced Micro Devices (AMD), Foot Locker (FL), NetApp (NTAP), Brocade Communications (BRCD), F5 Networks (FFIV), EMC Corp. (EMC), Health Net (HNT), SalesForce.com (CRM) and Sina Corp. (SINA). If this wave becomes a tsunami, it could lift the entire market.

The point is, when the guys in the business believe valuations are so low they can afford to pay big premiums to current trading levels and still make good returns, it is likely we all should be looking hard at getting long equities. Our advantage is that we have the leverage inherent in options to make really big returns in this undervalued market, especially with our positions in M&A targets YHOO, ACL and CTXS.

Have a great week trading.


Nick Atkeson and Andrew Houghton
Editors
Options Trader


P.S. Free Investment Training at the Las Vegas Money Show.

Mark your calendars for May 11-14, 2009, and join us at the Las Vegas Money Show at the Mandalay Bay Resort & Casino.

We'll focus on helping you invest in this turbulent market to reach your financial goals. Tickets are free so click here to sign up today.