Slope of Hope Blog Posts

Slope initially began as a blog, so this is where most of the website’s content resides. Here we have tens of thousands of posts dating back over a decade. These are listed in reverse chronological order. Click on any category icon below to see posts tagged with that particular subject, or click on a word in the category cloud on the right side of the screen for more specific choices.

Speculative Options Buys

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Hey fellow Slopers,

With volatility continuing to hover near two-year lows, I’ve been spending more time looking for speculative option buys. I’ve been looking to place bullish and bearish bets, so I’ll have a better shot at making some money whatever direction the market takes in the next several months.

While doing this, I’ve been keeping in mind a few points Tim made in his book, “Chart Your Way to Profits.” On p.474, Tim offered a few common sense guidelines about speculative options buying:

  • Start small (since options often expire worthless).
  • Avoid out-of-the-money-options (instead, try to get ones with some intrinsic value)
  • Avoid nearby expiration dates (to avoid theta burn and give your position more time to work out)

I’ve been following each of those guidelines in my recent speculative options bets, and I’ve added a fourth one to boot:

  • buy options at a discount to model estimates of their fair market value.

For the bearish bets, I’ve been starting by scanning for relatively lightly-traded (average daily volume over the last month of 150k-200k shares or less), optionable stocks  that look weak technically and fundamentally. The idea behind looking for relatively thinly-traded stocks is that the options traded on them are more likely to be thinly-traded, which increases the chances that they might be inefficiently priced. Then I look for in-the-money puts on them several months out, and compare the current bid-ask prices for them with the estimated fair market value of them via the Black-Scholes model.

If I find one where the most recent bid is significantly below the Black-Scholes fair market value estimate, I’ll place a small limit order for it, with the limit price set at a 25%-30%+ discount to the fair market value estimate.

For the bullish bets, I’ve been doing the reverse: scanning for stocks that look strong technically and fundamentally, and looking for in-the-money calls priced below the Black-Scholes estimates of their fair market value.

After the close Wednesday, I placed 10 limit orders (5 for calls, 5 for puts) on options that met all the criteria above — if I’m lucky, I’ll get a fill on a few of them Thursday. More on those below, but first a quick clarification, since I’ve written about options in the context of hedging in recent posts: the trades for which I placed these limit orders are speculative directional bets, not hedges.

Hedging versus Betting

If I were hedging, I would enter the symbol of the stock or ETF I was looking to hedge in the “symbol” field of Portfolio Armor (available on the web and as an Apple iOS app), enter the number of shares in the “shares owned” field, and then enter the maximum decline I was willing to risk in the “threshold” field. Then Portfolio Armor would use its algorithm to scan for the optimal puts to give me that level of protection at the lowest cost.

On rare occasions (I’ve seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases though, they will be out-of-the-money. Since I’m making directional bets in the cases below, though, and not hedging, I placed limit orders on in-the-money options that were close to the current prices of the underlying stocks. This makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost).

I placed limit orders for in-the-money calls on these five stocks: AEG, SVN, SUP, ASMI, and COHR.

And limit orders for in-the-money puts on these five stocks: CPIX, LOJN, HIL, PNCL, and MDS.

To keep this post from getting too long, I’ll just highlight one of each of those orders below.

A Bearish Bet

Pinnacle Airlines Corp. (NASDAQ: PNCL) is a regional airline holding company that was once a top pick of hedge fund manager Mohnish Pabrai (I’m not sure if he still owns it).

According to Short Screen, PNCL has an Altman Z”-Score of 0.55 (Z”-Scores below 1.1 indicate financial distress).

PNCL closed at $5.40 on Wednesday, and the bid-ask on its $7.50 strike, December 2011 puts was $0.20-$4.70.  The Black-Scholes estimate of the fair market value of those puts was $2.32. I put in a small limit order at $1.60.

A Bullish Bet

Superior Industries International, Inc. is an auto parts supplier manufacturing aluminum wheels.

Short Screen shows an Altman Z-Score of 4.77 for SUP. Z-Scores of 3 and higher indicate financial strength (Short Screen automatically applies the five-term Z-Score to SUP, and not the four-term Z”-Score, because SUP is a manufacturing company, unlike PNCL).

SUP closed at $25.34 Wednesday, and the bid-ask spread on its $22.50 strike, October 2011 calls was $3.00-$4.40. The Black-Scholes estimate of the fair market value of those puts was $4.54. I put in a small limit order for them at $3.20.

Q1 GDP Advance (by

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The first look at GDP for Q1 2011 came in at 1.77% in real (inflation adjusted) terms, a decline from 3.11% in Q4 2010 and 3.72% in Q1 2010.

Below are the highlights.

A big drag was government that actually contributed a negative 1.09% to growth driven mainly by state government and national defense.

Inventory bounced back slightly and contributed 0.93% from a prior quarter contraction of 3.42% but clearly the inventory build cycle is declining.  Should retailers grow concerned about business conditions it is probable inventory will contract in Q2.

Trade was flat at negative 0.08% from the prior quarter where it actually contributed to growth by 3.27%.  The trade deficit contracted in Q4 2010 but the first two months of data in 2011 showed this trend reversing and thus highly probable to be a larger drag on GDP in Q2.

Looking forward to Q2 2011 GDP contraction is very possible and at risk due to government, inventory or trade.  This assumes consumers stay relatively strong as in this current report although a big portion of consumer income growth was from the government.  As government austerity becomes reality the Federal government will be a big drag on future GDP and very likely a cause of the next recession.

The next recession is the scary one when you consider labor is already in a difficult position and the government will be even harder pressed to stimulate or face the risk of rising bond yields.  This is when things get scary and I am of the opinion that Q2 could in fact be the next negative GDP print.

Charts below for your viewing pleasure.





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Further Look at Energy Sector (by Leaf_West)

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A further look at the energy sector after my blog post from yesterday … just as an aside, I started a short on the XLE etf at yesterday's HOD this morning at $79.50.  I did it via the 2x Proshare "DUG" at $26.33.  I plan to monitor and add to this trade if it works like I think it will.

Another Energy component is the oil service sector … much like the XLE chart that I posted yesterday, OIH is lagging the break higher that the markets are having here.

OIH_April28, 2011_Daily

With triangle patterns, it is best to wait for the pattern to break either higher or lower instead of trying to guess which way it is going to go.

One stock that seems to be in a confirmed move is TranOcean (RIG) …

RIG_April28, 2011_Daily

RIG_April28, 2011_30min

While keeping my eye on the OIH, I plan to try and short RIG on any push into that 50EMA area on the 30min chart ($72ish). Cheers … Leaf_West

Hedging Macro Trend Risk

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Hey fellow Slopers,

My largest long position is an Australia-based nano cap I've mentioned in the comments on occasion, Alloy Steel International (Pink Sheets: AYSI). AYSI uses a high tech, proprietary process to manufacture protective wear plates for mining equipment. Essentially, the company is a picks & shovels play on the mining industry (particularly iron ore and coal mining). As such, it has the potential to benefit from the macro trend of Chinese demand for those commodities.

As is typical of nano caps, there are no options traded on AYSI, so it's impossible to use options to hedge against AYSI's idiosyncratic, or stock-specific risk — some of which it has exhibited over the last week, as the stock dropped 25% after reporting a sequential drop in earnings in its fiscal Q1, following its release of record Q4 and annual numbers in February:

The way I try to manage AYSI's idiosyncratic risk is by keeping my cost basis low (e.g., by buying more when the stock tanked to the low .40s last year, and not buying more when it spiked to $1.89 earlier this year, after releasing its 2010 numbers). How to hedge against its macro trend risk though, i.e., a big dropoff in Chinese commodity demand?

One way is to look for an optionable stock that's exposed to the same macro trend risk. BHP Billiton (NYSE: BHP ) fits that bill here (and is also a good fit for another reason: it's one of AYSI's largest customers). If you've got a position in AYSI, you could look at an equivalent dollar amount position in BHP and consider buying optimal puts on it as a hedge against macro trend risk. Using Portfolio Armor (available as a web app and as an Apple iOS app), you could simply enter "BHP" in the symbol field, your dollar-equivalent number of shares in the "shares owned" field, and the maximum decline you're willing to risk in the "threshold" field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost. What number should you use as a maximum decline threshold though? 

In previous posts on hedging, I mentioned that I often use a 20% decline threshold when hedging (i.e., I hedge against a greater-than-20% loss), and that I got that idea from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

I wouldn't use a 20% threshold in this case though. If there's a big dropoff in Chinese demand for iron ore, I'd expect a much bigger decline in BHP's share price. How much of a decline? Take a look at the 5 year chart of BHP below. 

The lows of late '08 could be attributed to the general end-of-the-world atmosphere post-Lehman, so I'd start with BHP's share price in Q1 '09. By the end of Q1 '09, some of the immediate panic of the global financial crisis had lifted, but there were still fears about a dropoff in Chinese commodity demand. At its lows in Q1 09, BHP was trading at about 10x its trailing earnings. Currently, it's trading at about 16.5x its trailing earnings (of $6.13). So if BHP's valuation dropped to 10x its trailing earnings today, the stock would be trading at $61.30, about a 40% drop from BHP's closing price Wednesday of $101.16. So I'd use 40% as my threshold if I were looking for optimal puts on BHP as a hedge against the macro trend risk of a dropoff in Chinese iron ore and coal demand.

Checking Portfolio Armor now, the cost of hedging against a >40% drop in BHP over the next seven months, using the optimal puts for that, is 0.86% of your position value. I may pick up a few of those optimal puts this week, while the VIX continues to hover near its two-year lows.