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My Darden Puts were heading into expiration this week and I elected to close out the position with a decent profit.  I sold for $2.85 and bought for $2.25 for a gain of $60.  The profits were not enough to cover the loss on the Nasdaq Puts, but I learned many valuable lessons, which I will share below.

There are several reasons why I decided to take my gains last Friday and not get greedy:

  • Even though I am still bearish, I feel uncomfortable spending money in a market that is as distorted and manipulated as our current one.  There are too many examples to go into right now, but there are excellent examples of overt manipulation here, here, here and here.
  • Maximum Pain dictated that I sell before expiration and lock in my gains.   In the option market, wealth transfer between option buyers and sellers is a zero-sum game. On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group.
  • Technical analysts were broadcasting a head and shoulders pattern break (see below), which leads me to believe a lot of CNBC followers (non-institutional investors) are piling onto the short side for the “easy money”.  It makes sense to bet against the “easy money” crowd and not expect a decline.  On Monday, the market rallied very sharply.  Glad I got out.
Head and Shoulder - DJIA
Head and Shoulder – DJIA
  • My price target had been hit and the price was unlikely to go much lower.  Darden filled in the “gap” between $29 and $33 like I thought it would.
Darden Restaurant Group Chart
Darden Restaurant Group Chart
  • As a wise man told me, you never go broke taking profits!

Epilogue:  I have decided not to continue buying options since the market is clearly not a normal, healthy one.  Unrealistic balance sheets, excessive program trading and monetary manipulation have turned me off from the market.

Options buying is extremely difficult since it involves both forecasting the market and timing it.  I am proud I made money on the Darden trade, but I realize I got impatient with my Nasdaq trade.  Overall, a great learning experience.

Since capital gains are difficult to lock in without being an active trader, I am considering doing covered call writing on certain stocks.  If I decide to buy some shares and write calls on them for income, I’ll post it here.

I will continue to add to my RWM position, which I feel comfortable holding for the long-term.

The market has been on a tear lately and it looks like my Nasdaq options will expire worthless.  From this outcome, I have learned a few things.

  1. It is idiotic to “time” the market based on your gut.  Yes, the case for bearishness remains (see below), however, Getting a Piece of the Action (GAPOTA) is a moronic way to trade.
  2. Respect the chart.  Charts show us trends, consolidation, breakouts and the majority opinion.  It is foolhardy to go against the crowd.  I need to exercise discipline and wait for the top to form and develop before trying to rush things.  Let the chart tell me when the market is tired out and has exhausted its supply of buyers.
  3. Trying to score big is foolish. Investing is a marathon, not a track meet.  Invest with the long-term fundamentals in your favor and have some patience.  It will greatly improve my “win” rate.

As a result of these revelations, I am taking a slightly different, longer-term approach.

I have added significantly to my CEF holdings in my IRA and I’m going to be accumulating a larger position in one or more reverse ETFs.  A reverse ETF will allow me to hold my short position in the market indefinitely, rather than being forced to time a drop in the market, like I would have to do with an option.

I lose the upside of leverage that an option provides, however, it is far too difficult for me to time the market perfectly.  As you can see from this Nasdaq chart, markets can go parabolic (like they did in 1999) and throw reason right out the window.  The market went from 2,500 to 4,700 in a few months!  That’s an 88% move in five months on horrible fundamentals!

If the market keeps rising now due to irrationality, I will be more than happy to keep buying inverse ETFs each month since they would be getting cheaper and cheaper (more and more valuable).

From a fundamental perspective I am not buying the bullish argument for a second.  There are plenty of events which have not fully manifested:

  • GM Bankruptcy - The ripple effect has now begun.  Suppliers/Creditors will get haircuts and pass those losses down the line.  Visteon and Metaldyne, two large auto suppliers, have already declared bankruptcy and other large suppliers will eventually have to realign with decreased demand.
  • Municipal bankruptcies/insane pension obligations are still looming.
  • Credit cards are tapped - The consumer has limited purchasing power.
  • Geopolitics – Chinese students LAUGH at Geithner when he says purchasing power of the dollar is solid.

“Chinese assets are very safe,” Geithner said in response to a question after a speech at Peking University, where he studied Chinese as a student in the 1980s.

His answer drew loud laughter from his student audience, reflecting scepticism in China about the wisdom of a developing country accumulating a vast stockpile of foreign reserves instead of spending the money to raise living standards at home.

  • Jobs are still being lost – Job losses ultimately lead to declines in the housing market as well as consumer spending, the engine of our “growth”.
  • Insane P/E ratios – S&P has the Q12009 PE ratio at 60!  60!!  Historic bear market bottoms typically occur with single-digit P/E’s.  Obviously this isn’t a perfect indicator, but it shows how far removed we are from stocks being cheap.

I remember the bubble of 1999 and how exciting it was to see stocks soaring and thinking how easy it was to buy tech stocks and sell them for huge profits.  I remember buying five shares of Yahoo in a fake portfolio for $205 a share (before a 2:1 split) and learning the lesson that bubbles can crash painfully and never come back.

There is no shame in “missing out” on returns in the stock market.  There is great shame in not learning from your mistakes.

Takeaway:  I lost on the Nasdaq options trade, but I realize that it is foolish to ignore the charts and risk capital when there is no need to do so.  I am coming around to the fact that I should be happy to not hit a home run with a juicy options trade, but rather accumulate quality positions at good prices.  I plan on adding more CEF and RWM in the days ahead.

Thanks for reading.

For the Trading Log, click here.

A picture is worth a thousand words.

8 large rallies and 8 large drops. 

This is what a panicking market can look like.

Prepare accordingly.

November 2008 – March 2009 DROP: -54%

March 2009 – May 2009 RALLY: 31%

Takeaway:  We can expect a lot more of this bumpy ride.

The option trades I put on a few weeks ago have been doing ok.  One has worked out real well, the other has not.  Since it has been a few weeks, I am posting an update to share what I have observed and learned so far.

Darden:  Things are looking good for this trade.  The stock is currently trading right at the strike price, and if the indices continue to decline over the next two months, this trade should do very well.  This option has, at one point, almost doubled, however, I am reluctant to sell since this option does not expire until the third Friday in July and the price can still go much lower.  In my earlier post, I mentioned that the stock should fill in the gaps around $30 – $32, so if the price gets down that low, I will consider placing a trailing stop.

QQQQ:  Argh!  This trade was a mistake to put on.  I didn’t follow the chart and, as a result, the Nasdaq has moved higher and more or less maintained its ground.  I was banking on a quick pullback, however, I am getting hit on both sides:

  1. This option expires the third week of June.  As that date approaches, the stock needs to move quickly downward, or it will expire worthless.
  2. This option is still far out of the money.  Since this option has no intrinsic value, every day the stock remains above the strike price, the more worthless my option becomes.

If the option hits breakeven, I will set a trailing stop.  If not, I will lose the money invested ($86 * 2) and learn from my error.

Takeaway:  It is easy to fall into the buy and hold mentality, however, there are numerous reasons why we could be facing a Japan style deflation or plunging stock market.  Intelligent options trading (both buying and selling) can allow investors to make money in up, down and sideways markets.  While I am a novice at trading, I believe it is helpful to learn these skills now, while I am young and make my mistakes early.

I am also thinking about how I can learn lifelong skills (like trading) now… skills like public speaking, patience through volunteering, and meditation are worth learning and now is the time to learn.

For the trade log, click here.

The Nasdaq keeps rallying and hurting a trade which I put on last week (same time as I put on the Darden trade).  I bought two June 2009 31 Puts on the QQQQ’s (Nasdaq index) at 0.86 ($86 dollars each).

Rationale: My rationale for this trade was very ill-conceived and emotional.  I literally could not believe the market was rallying so strongly and felt I had to “Get A Piece Of The Action”.  While I do not have to call a top perfectly with an option trade to be profitable, it is still foolish to trade emotionally or based on gut-instinct.  I bought these options thinking the market would sharply turn down, so I bought June options which will be due on June 29th.  Like a fool, I failed to study the chart and I was disconcerted by what I found once I looked at it.

Here is the chart of the QQQQ’s:

qqqq

There are two things that jump out at me:

  1. There is an obvious double-bottom which is a very bullish indicator.  It is nearly a textbook double-bottom, which, despite the fundamentals of the Nasdaq, makes a compelling case for putting in a short-term bottom.
  2. A common trading rule of thumb is that tech stocks lead the rally.  Meaning, the Nasdaq would be the first place any sign of strength would first appear.  As such, if the other indicies (S&P, Dow) aren’t confirming a bottom, this isn’t necessary since the Nasdaq would be the first place strength would appear.

Below is a chart of the Dow, which displays a weak, V-shaped bottom, which is clearly far weaker than the Nasdaq (shown above).

_dji

Comfort Level

I am not very comfortable with this trade, especially since the market has done so well despite news of Swine Flu and the bankruptcy of Chrysler.  To feel at ease with your trades, there are certain rules you must obey.  Feeling like you need to “Get A Piece Of The Action” is probably the stupidest way to trade I can think of.  I have done this numerous times after seeing, reading, or hearing something provocative.  Just like you cannot let an errant comment from a co-worker provoke you or cause you to react erratically, you must also exercise this self-discipline and control when trading.

Feeling like you need to “Get A Piece Of The Action” is the triumph of emotion over reason.  With reverse ETFs, option strategies and leveraged ETFs, there are ways to profit in up, down and sideways markets and you should never have a need to jump in without carefully weighing the pros and cons of a trade.  It is better to paper-trade and learn, rather than risk losing hard-earned cash, especially if you don’t have a huge account (like me).

Again, there will ALWAYS be opportunities to make money in up, down and sideways markets.  Never get into a trade just because you feel you are missing out or you want to feel like you have something at stake in the market.

Compared to the Darden trade, the Darden trade looks much better given that it is not a market leader, has more time to show weakness, and has rallied even more sharply/irrationally.

Exit

My strategy with this will be to set a trailing stop if and when the value of the options double.  A trailing stop will allow me to exit the position if the price drops below my stop price, but if the market keeps moving in my favor, it will raise my stop, allowing me lock in even more of the gains.  I have never used trailing stops, but hopefully I will get a chance to use them and learn with this trade.  Since the total cost of these options were less than $200, I am comfortable holding them until expiration and seeing them expire worthless, if the Nasdaq does not decline strongly.

Takeaway

I try to resist GAPOTA trades, but I sometimes succumb to the temptation to risk a little bit of cash when I see such a parabolic rally.  Hopefully, the Nasdaq will turn around and I will get to exit gracefully, however, I’ll learn from this trade either way.

DISCLAIMER:  All opinions expressed on this website are solely my own and do not reflect the opinions of anyone else. You should not treat any opinion expressed on this website as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinion. My opinions are based upon information I consider reliable, but I do not verify its completeness or accuracy, and it should not be relied upon as such. I am not under any obligation to update or correct any information provided on this website. My statements and opinions are subject to change without notice.  Past performance is not indicative of future results.  Risk of loss exists in futures, options, equities trading.