Breakout Defense Part Deux – 5 More Trades that Make 500% in a Rising Market (Members Only)

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Here we are again!  

The last time I wrote a Breakout Defense article was back on December 11th when I said: "Wow!  I mean wow! Will this market ever go down? My mother called me this morning and she’s raising her GDP outlook for 2011 too – that’s how crazy things have gotten out there. I’m just waiting for the Pope to come out and tell us to buy CMG and Netflix and THEN we’ll know it’s a sign."  Clearly, my Mom and the Pope nailed it as the the Dow is up another 500 points (4.3%) since then and CMG made a comeback yesterday and is a bit higher than Dec. 10th’s finish at $238.22 and NFLX is well above $194.63 so the infallibility streak continues for the pontiff!  

As with last time, I would urge you to spend some time reading (and now viewing) David Fry’s market commentary over at ETF digest.  Dave’s take on the IWM, which we have been playing this week, is that it is still rolling over and that investors should not be fooled by the Dow.  I’m not here to debate the points – this is an article about what we can do to make sure we don’t miss the rally train if it does leave the station and, like last time, it’s very easy to set aside a small amount of capital into highly leveraged trades like this, which can make excellent returns on even small rises in the market.  On the whole, I remain cautious and still believing that we may be in a blow-off top but we have plenty of bearish short-term bets and we need some balance – just in case… 

We had just a 4.3% gain since our December picks and check out this performance on those already:

• FAS Apr $20/25 bull call spread paired with the sale of the April $21 puts for net .15, now $3.98, up 2,553%. 
• DBC Apr $27 calls at $1, now $2.05 – up 105%
• 4 DBC Jan $22/27 bull call spread paired with the sale of the 3 USO 2013 $30 puts for net $170, now $740 – up 335%
• DBC Jan $26/30 bull call spread paired with the sale of the $22 puts for net .30, now $1.50, up 400%
• SSO Jan $30/June $42 diagonal call spread paired with the sale of and SPX LAST Jan $1,185 put that already expired worthless for net .40, now $10.85, up 2,613%.
• GE Jan $17.50/20 bull call spread paired with the sale of the 2013 $12.50 puts for a net .15 credit, now $1 – up 766%.  
• 50 HOV 2013 $5/7.50 bull call spreads paired with the sale of 10 2012 $5 puts for net $650, now $1,250 – up 92%
• BA Jan $45 puts, sold short for $2.50, now $1.10, up 56% (alternate funding suggestion).

We have more than our target 5,000% worth of gains already and the year has hardly begun.  That’s pretty good!  Keep in mind these are highly leveraged trades based on the idea that you REALLY don’t mind having the underlying stock you sell puts against put to you (hence the BA alternative example in the post).  In other words – If FAS had fallen below $21 (the November low) we have to be willing to either roll the puts along in hopes they expire down the road or to accept a long on the ultra ETF.  Since we felt that QE2 gave us a firm floor on the financials, we would not have minded going long on a dip (plus, of course, we would have then hedged that anyway).  

I said in the December post, if you commit just 2% of your portfolio’s sideline cash (more in margin) to a spread of trades like this that makes even just 2,000% – that’s a 20% boost to your ENTIRE portfolio.  Even The Bernank hasn’t been able to devalue the dollar that fast – yet.  My comment in early December on the market was as follows:  

That’s the key now, we’ve been watching Dow 11,500, S&P 1,220, Nasdaq 2,600, NYSE 7,750 and Russell 725 for a very long time and, other than the Dow, our indexes have now smashed through that upside resistance and look like they are heading to the moon – especially the Russell 2000, which is up 25% for the year! Small-caps may not be hiring or making a lot of profit and they may not have the ability to get loans from the bank and their customer base may be hurting but BOY, just look at that performance!

And, as I’ve said before, once you break the orbit of a fundamental market, then "Stock Market Physics" no longer apply and there is no limit to the madness that lies ahead of us when (and if) the Dow breaks that 11,500 line. With the Russell up 25% and the Nasdaq up 17%, the Dow, NYSE and the S&P are looking kind of pokey hanging around the 10% lines, aren’t they?

We only had a couple of more days of pokey behavior, with a nice little dip that gave us fabulous entries on that Wednesday (Dec 15th) and then Santa Clause came to town and we were off to the races.  Of course we lost a little money running short-term protection along the way but the idea of short-term plays is to protect your long-term plays.  Otherwise it would be madness to watch them go up 100%, 200%, 500%, 1,000%… – without taking any off the table, wouldn’t it? 

Keep in mind we had not only these trades coming off our pretty much all cash position we were getting bored with, but then we had our less aggressive but also POMO-minded, "Secret Santa’s Inflation Hedges for 2011," which actually weren’t a secret at all as it was Christmas Day and I decided to give the World (especially Phil’s Stock World) some good money-making ideas for Christmas.  

Usually we don’t publish our portfolio trades for the general public but it didn’t seem like there was anything that was going to stop The Bernank from destroying the Global Economy with inflation so, it made sense for us to hold our own bags out if Uncle Ben was going around handing out money to the top 10%, right?  Those trades were far more conservative, so appropriate for larger bets as we looked to hedge our still 75% cash positions against various kinds of inflation (see post for details).  Those trades were:

• 30 XHB 2013 $15/18 bull call spreads paired with the sale of 20 2013 $14 puts for net $800, now $1,940 – up 142% (on track to $9,000)
• 2 XLE Jan $55/60 bull call spreads paired with the sale of 1 2013 $50 put for net $120, now $700 – up 483% (out of 733%, this one is done with risk now outweighing reward 2:1 and a whole year to go).  
• 6 DBA Jan $26/29 bull call spreads paired with the sale of 4 2013 $25 puts for net $380, now $1,100 – up 189% (on track to 373% but high enough to urge caution already).  
• XLF Jan $12/13 bull call spread paired with the sale of the Jan $11 puts for net .40, now .68 – up 70% (on track to 150%)

One of the things I’ve been getting upset with is how fast our inflation hedges are making money.  Perhaps that’s why I (and other Members) are a little more sensitive to what BS the Fed’s money-printing policies are as we see the effect on our own meager holdings and that makes it very easy for us to imagine the many Billions that are being funneled into the IBanks, who are playing trades like these right along side us and funneling that money out of the pockets (and mouths!) of the non-investor class, which is really 99% of the people in the World if you don’t count mindless 401K contributions and retirement funds.  

So we make money and we complain about it.  Is that really so strange?  I often say to Members – "We don’t care IF the game is rigged as long as we can figure out HOW the game is rigged and place our bets accordingly."  It’s a bit cynical and, if I felt that our participation in this scam was perpetuating it, then I’d have a real moral dilemma…  But it’s not.  We are but fleas on the ass of Goldman Sachs, et al. and they are going to do what they are going to do.  To go against the forces of the market is like betting that a star in the event horizon won’t get swallowed by a black hole, just because we don’t want it to.  You COULD bet against it, but I doubt your find any Physicists who are willing to bet with you.  

Speaking of science – in the December post I made a comment about the plunging VIX, then 17.61, which was: "I have a theory that all the lithium from all the rechargeable batteries has seeped into the water supply and made it impossible for investors to worry about things."  That theory has been holding up all too well with the VIX at 15.93 at Friday’s close!  Be afraid, be very afraid that nobody else is!  Here’s a look at the multi-chart as we ignore, well – everything that is going on in the World – for the last six months:

Wheeee!  This is fun!  Now keep in mind that most of the punditry is telling you that they EXPECT to do this again in the next year.  As Eddie Murphy said in Trading Places when the rich guys told him he was getting a mansion, servants, a job etc. "Yeah, I’m cool with that because stuff like this happens to me all the time!"  He was being sarcastic but there’s not even a hint of irony in the expectations of the vast majority of investors and that makes me very, very nervous.  On the other hand, there’s not a hint of irony in a wildebeest when they are stampeding, either, and it’s not a good idea to go against that herd.

We’re testing 20 and 25% breakout levels from the August lows and, as I have long been saying, it is now "safe" to go back in the bullish water if we remain over our major breakout levels of Dow 12,000, S&P 1,300, Nasdaq 2,750, NYSE 8,250 and Russell 800.  As we stay above them, they begin to give us firmer and firmer support, which means the plays we take here (at the lines) that are designed to withstand 20% drops, will look as safe as our last set of December upside trades do now.  Note also, the way the chart was on December 11th is the way the chart is now and, like December 11th, we begin with our breakout defenses and we will move on to plays that we are willing to commit more capital too once we have a little more comfort and experience over those lines (maybe end of this month if all goes well). 

We have plenty of downside covers in place so now it’s time to give ourselves something to cover but it’s all about holding at least 3 of 5 of those levels – anything below that and we can consider it a bearish turn for the market!  TZA is our lead cover (see yesterday’s post) along with EDZ.  As I mentioned last time, there are several stocks we should always look to pick up when they are "on sale" and that’s:  BA, GE, VLO, XOM, MO, WFR, UNG, PFE, MCD, KO, JPM, FDX, HPQ, GS, GOOG, AAPL, DIS, T, VZ and AA off the top of my head.  Please use the comments below to make suggestions and identify opportunities, especially as I’ll be out for a few days so any research you guys have time to do would be much appreciated and I can concentrate on making plays out of them.  Thanks!  

And, Finally, Some New Trade Ideas:  

Since there is APPARENTLY no risk in owning equities, then there should be no risk in owning ultra equity ETFs either and I think we can start with a play on SSO, which is a 2x track of the S&P that is surprisingly reliable over medium amounts of time (12 months). I like the 2012 $44 calls at $11.30, covered with the June $50 calls at $4.70 for net $6.60 on the $6 spread (and, of course, you can roll the caller if things go well) that can be offset by selling an SPX March 1215 put for $6, which has a high premium of about $17K (to get $1,000) but it’s offset by the fact that your margin is released on March 18th if things go well and that leaves you in a net .60 2012 bullish play on the S&P that has an easy 1,000% upside if things go just a little well.

The SPX is currently at 1,310 so the S&P would have to fall 7.25% to put the puts in the money. If that should happen, it would, of course, be a good idea to slap on a downside cover if you don’t already have them. Hopefully, with the new market breakers, we aren’t likely to drop 5% in a day and, for example, SPY March $125 puts are just $1 so 10 of those slapped on real quick would take a lot of the sting out, as would rolling. Keep in mind, these are upside HEDGES at the moment, we go bullish on stocks, not 10:1 paying ETF plays! These are for protection on bearish positions as well as for small bets so you don’t feel like you’ll miss out on the rally. As I pointed out last Friday, if we have a FAS play that makes 3,233% by April and we commit just 1% of our portfolio to it, that’s 32% gained on the whole portfolio on that one play – that should keep you up with even The Bernank’s wettest dreams of hyper-inflation without over-committing your cash!

Also, keep in mind, this is where those substitutions come into play.  Why are we selling the SPX March 1,215 puts?  To get $6!  We like it because we don’t think the S&P is too likely to drop 7.5% in 45 days and, if they do, we can roll ‘em to the June 1,025 puts (also $6 at the moment) and then on to the Dec 800 puts ($6.70). If you think the S&P is going to fall below 800 or fall so fast you won’t be able to roll – THEN WHY THE HELL WOULD YOU BE TAKING THIS AGGRESSIVE UPSIDE PLAY???  There, in a nutshell, is the logic of these kinds of positions!

So, where was I?  Oh yes, substitutions.  So if the idea of playing SPX makes you squeamish, the thing to do is find something else you REALLY want to own that will pay you $6 instead.  Try to make it something that you REALLY, REALLY want to own long-term and are willing to commit to now so that, even if the stock falls 20% below your strike, you would still be thrilled to have such a bargain and, if the stock falls 20% more below your strike to 40% off your entry, you will be THRILLED to double down and be in 2x at an average of 20% off.  

AAPL is always a good example – I would love to own AAPL for $250.  Unfortunately, it is at $346.  Yet, amazingly, there is someone willing to pay me $8.90 to promise to buy his Apple stock for $250 in January (selling me the put).  Why does he do this?  Well, from his point of view, maybe he is worried Steve Jobs will die or the Droid will wipe out the IPhone or NFLX will come out with a Pad computer and he wants to limit his potential losses to 27% and he’s willing to pay $8.90 (2.5%) – whatever, it’s not our problem.  All we have to do is say: "Sure, you give me $8.90" and I will buy your Apple stock for $250 in January if you ask me to.  That’s what a short put is.  Since $250 is 27% lower than the current price, the margin on my TOS ordinary account says net $2,500.  Not a bad deal for letting giving me $890 in cash now.  

This is our famous "Wimpy Investing Strategy" as we get paid today for promising to buy something tomorrow.  If I REALLY, REALLY want to buy 100 shares of AAPL for $250 a share ($25,000) and I would REALLY, REALLY be thrilled to buy another 100 shares 40% lower at $150 ($15,000) so I would own 200 shares of AAPL for $40,000 when they are down to $30,000 because I would be confident enough to hold them LONG-TERM and wait for a comeback – then why not take $890 now against $2,500 in margin?  

Again, keep in mind, it does not have to be AAPL – it can be any of the stocks I listed above at 20-25% off and it can be any stock you REALLY want to own at the strike you sell a put at.  This is an ideal strategy when we have a lot of cash on the side that we would like to deploy on a dip but, we also don’t want to miss out on a big move higher.  Even if we margined 50% (because when you buy the stock it’s only 50% margin) for the trades and allocated 50% of a $250,000 portfolio to 10 short AAPL Jan $250 puts, we’re still collecting $8,900 cash while we wait, which is 3.5% interest on our entire balance.  Better than putting it in a CD, right?  

Another thing people say, especially those with 401K accounts that have restrictions on short puts selling, is can we just take the suggested bull call spread?  Of course you can!  Generally, I’m looking for bull call spreads that are very likely to double and then offsetting the cost by selling puts that reduce the net cost of the bull spread by 75% of more to turn a 100% return into a 700% return.  So, if you can be satisfied with "mere" 100% returns – the bull call spread alone is fine and, of course, set stops if we break down – which is really easy to do as we’re right above our major levels.  I would caution against applying this strategy to any old thing though – although I liked the above SSO play do do it again, I generally look over 40 or 50 trade ideas that I reject before one of them makes these portfolios.  It is VERY painful when they go the wrong way so it’s important to be very selective in your picks as well.  

I still love my Financials because that’s where all the POMO goes.  XLF was only $15.76 when I made my 12/11 picks and now just $16.61 so we didn’t miss too much of a move.  Financials are lagging the market and probably for good reason with however many bank closings per week but, still, clearly the top of the heap, that make up the bulk of the XLF, is certified by the Government as "too big to fail."

FAS is always a favorite because it has very attractive spreads.  The July $28/35 bull call spread is $2.10 and we can offset that by selling 3x the C 2013 $3.50 puts for .40 ($120).  I like C as a TBTF bank and also, in TOS, the margin requirement is net $144 to collect $1.20.  So this trade obligates you to buy 300 shares of C at $3 ($900) and you toss in another $90 in cash fro the bull calls spread and you have a $700 upside at FAS $35, with FAS at $31.12 today.  Of course, you won’t net out the $700 until/unless C finished over $3.50 in Jan of 2013 but you will make $490 CASH at $35 and you can quibble about the value of the trade over a very nice steak dinner.  Another thing about a trade like this is, if successful, you can re-load and re-load and re-load – as we are doing right now off our last set.  

HOV just came down in price as they sold a little stock to raise a little cash.   Home builders are THE place to be if inflation works its way back to real estate as they are sitting on huge piles of land (and unsold homes) that are already highly leveraged so, what looks like a bad thing now can turn into a very good thing very quickly.  So think about betting on HOV, and possibly TOL later on, as speculating on the speculators – their leverage can make for astounding gains if real estate prices inflate.  Also keep in mind they are just as likely to collapse and that’s why I like HOV, who have already written off their asset values tremendously.  

HOV 2013 $5 puts can be sold for $2.  The most you can lose is $3 – simple enough?   If you are willing to lose $600 you can sell 2 contracts.  With that, you can buy 6 2013 $5 calls for $1.10.  That’s another $60 out of your pocket and you control 600 shares at $5 and make every net penny above $5.10.  That’s not complicated, right?  Why do I like this trade?  Here’s a chart of what happened to HOV the last time they were at $5 and there was a housing boom:  

Let’s say HOV "only" gets to $10 in 2 years.  What do we get?  We get the net of $5-$20 ($15) x the 600 shares we control for a $9,000 reward on our $600 risk.  If you simply run a trade like this every two years, we would have to go 30 straight years without once getting the 300% run we’re looking for AND you would have to be wiped out ALL 15 times to not break even on this trade.  It is rare that we get an opportunity to buy into a cyclical industry so near the bottom.  If we do get wiped out on HOV (they go BK), then I can assure you that in January of 2013 I will be telling you what a great opportunity it is to invest in whatever other beaten-down builder looks good because the ones that are left will likely be even cheaper then if the market is so terrible that it bankrupts HOV.  

So consider a play like this scaling in.  Maybe set a $300 stop-loss on the short puts on this one and then we go in with another $600 attack once the dust clears on whatever it is that forces us to stop out of this one.  Speaking of beaten-down and out-of-favor sectors.  How about shipping?  The BDI, which is the rate shippers charge, is down at just over 1,000 on the index.  It was only below 1,000 between October of 2008 (down from 12,000) and January of 2009 – after which it went back to the 4,000′s, which it held through last June and then down and down they went.  A shipper just went bankrupt and there probably is too much capacity but, if the global economy is really recovering (and that’s the premise to this portfolio), then 1,000 will not last long again.  

DRYS is attractive, mainly BECAUSE they are right on the $5 mark.  That makes their contracts a little better for us to sell at the moment (as people bet off key levels in both directions, increasing the implied volatility for the stock) and, with a low VIX, we need all the help we can get!   This is a judgement call but I’m looking for BDI to bottom here and turn up on Q2 earnings (again, assuming the bulls are right) and that should power them towards $10 in the summer.  

The June $4/5.50 bull call spread is .79 and is already .21 in the money (options are funny that way) with a potential for $1.50 (up 90%) and then it’s just a matter of paying for that with anything you REALLY want to own between now and then but let’s say we do REALLY want to own DRYS long-term at a 30% discount, so we sell the 2013 $3 puts for .40 and that’s net .39 on the $1.50 spread with a $1.11 upside (285%) and our WORST CASE is that we own DRYS for net $3.39, which is 32% below the current price.  

These are not meant to be complicated ideas.  If you like the idea of shipping and you are a long-term investor and DRYS appeals to you.  Then you can set aside $3,390 (for example) to buy 1,000 shares, right?  On the whole, it doesn’t matter whether or not you make money on the short-term bull spread because all you are doing is setting aside $3,390 to buy DRYS.  If, by some happy accident, DRYS finishes at or above $5.50 at June expiration.  Then you will be handed $1,500 for your 10 contract spread.  That means, the net possible cost of having DRYS put to you in 2013 would drop to $1,890 or $1.89 a share.   If you do not buy DRYS in 2013 because it never comes back down to $3, then you paid net $390 to collect $1,500, which is a $1,110 profit.  Even with no margin at all, that’s a nice return.  

DRYS can, of course, be played more aggressively and, for that, I’d go for selling the 2012 $5 puts for $1 and buying 2x the $5/7.50 bull call spread for net .60 so that’s net .10 per $2.50 spread with a 2,400% upside if DRYS can finish over $7.50 next January.  That’s another one of those fairly low net margin plays (about $1) so really fun if you have a margin account.  If I have a $100K portfolio and I’m willing to own $5K of DRYS then I can allocate $2,400 to selling 6 of the 2012 $5 puts on the assumption that I can roll those back to the 2013 $4 puts (now .85) even.  Of course we can roll again and again but I like to assume we’re stuck after 2 years.  

So let’s say DRYS is $2 by then and I have 600 shares at $4.  Well, if I then take the $2,600 that’s left of my $5K allocation, I can buy 1,300 more contracts at $2 (obviously assuming we still like it based on 2 years of new information) and that would leave me with 1,800 shares for $5,000 or $2.77 each with the stock at $2 so down a little over 20% after a 60% drop in the stock.  If I decide I can live with that, then on THAT basis, I am deciding to allocate $600 in margin to take $600 in cash today for selling 6 2012 $5 puts and applying that cash plus another $200 to buy 12 of the $5/7.50 bull call spreads.  

If all goes well, DRYS finishes above $7.50 and I collect $3,000 (1,200 x $2.50) against my $600 of margin and if all goes horribly wrong, I own 1,800 shares of DRYS at net $2.77.  THAT’s how I’m thinking of a position when I tell people not to worry about them sometimes and I apologize if I come across as flippant about it but, in this trade, for example, think how silly it seems to worry if DRYS dips down to $4.50.  If you are looking ahead to your $2.77 entry because you REALLY want to own DRYS long-term – then this doesn’t bother you at all because you’re not going to get your price unless it gets a lot cheaper than that!  

The $2,800 you make on this play is a consolation prize.  It’s what you have to settle for for NOT getting your 1,800 shares of HOV at $2.77.  I WANT, REALLY, REALLY want a portfolio that is filled with LONG-TERM positions like DRYS at $2.77 and GE at $11 and AAPL at $250 etc.  I want a portfolio like that that I can sell calls against for the rest of my life for a nice little monthly income.  You’d better pay me not to take it!  

Develop that attitude, and you will become a much better, much more relaxed option trader!