Off the bat, some trading advice.
On May 23rd of this year, we recommended a zero premium
trade that pitted the Royal Bank of Scotland (NYSE:RBS) against
J.P. Morgan (NYSE:JPM). Our thinking at the time was that Royal
Bank of Scotland had tremendous exposure to Greek debt while Morgan had (almost)
none. If there was further trouble, we expected RBS to drop faster than JPM.
That week's letter, 'Playing Relative strength with American
Banks', also explained that RBS's exposure to Greece was as much
as 12% of the firm's value.
Two month's later we're cashing in. On a trade that cost no money but
commissions to initiate (the purchase and sale of the PUTS were offsetting),
we're taking out $100 per pair traded. JPM's August 38 PUTS now sell for $0.55,
while RBS's August 12.50's are fetching $1.55. Our advice to all who opened the
trade is to close it out immediately. And congratulations.
How Deep Can You Go?
A slightly longer word now, on our three time recommendation to
purchase long-dated, deep-in-the-money SPY CALLS.
A deep-in-the-money (DITM) option is one that possesses no time value.
It trades for precisely the difference between the strike price and the value of
the underlying security.
The purpose of such a purchase is a) to minimize inevitable time-value
losses that accrue if the option is held over a long period, and b) to spend
less than an outright purchase of the underlying security itself. We buy these
options as a substitute for stock and, in so doing, maintain a higher cash
balance in our accounts to deploy if and when other opportunities
Options, however, whatever their stripe, are leveraged investments, and
magnify both our gains and losses when the underlying climbs and drops. This
reality requires us to take two further items into consideration. The first is
money management. The second is hedging risk.
How much money should we allot to any given trade? Since trading
options is manifestly riskier than trading the underlying security, the answer
is always less far less. Volatility is what accounts for the increased risk
(whether you're long or short) and money can be lost in a hurry.
Precisely because of this, we're never happy speculating more than 1%
of our total portfolio on any given options trade, and we recommend our readers
use this as a guideline for themselves. That is, on a total cash hoard of
$100,000, an options bet of more than $1000 is generally
Why, then, have we gone ahead and recommended the SPY options not once,
but three times knowing full well that DITM options are also
more expensive than their at- and out-of-the-money brethren?
Glad you asked.
As you know, we are bullish on this market. The S&P500 has been
rising since March of 2009, putting on over 100% since that time, and still
fundamental measures of the market are anything but outlandish. The P/E on the
Dow, for instance, is 14.16, and its dividend yield is 2.42 anything but
overblown numbers by historical standards.
Now have a look at the Dow's monthly chart for the last five years.
Most important here are the RSI and MACD indicators, the latter of
which confirmed the former's bullish break above the waterline back at New
Year's. Since then, the monthly chart has been unequivocally bullish. The
salient moving averages are just now unfolding and the price action is well
above them all, adding further heft to the bullish read.
The weekly chart, too, speaks to more buying ahead. Here it is for the
same time period:
Here, too, we have the price action located above all the moving
averages, not all of which have unfurled, but which are
all trending upward. RSI and MACD, too, have held above their waterlines for
better than eight months save one three week period in June. In short, the
weekly chart also commends a bullish reading at this point.
Here's the daily chart for the last year. Mind the strong
bullish indicators here, as well:
The read here is similarly strong: