Chasing The Bull

In the last week my market trend prediction has changed from showing a reversal back to a bull market being in July of 2009 (which is what it has been predicting since it was created in November of 2008) to not happening until August of 2009.

I've been waiting for a good time to get into some GE. Today there was an oportunity to pick some up and reduce the risk by buying the stock and selling call options. This is an example of a simple option strategy referred to as a "covered call".

Here is the trade:

Buy GE stock at $6.70 per share.
Sell April $8.00 Calls for $0.81 per share.

This effectively yields a position in GE at $5.89 per share with the downside being that if the stock should be above $8.00 per share on April 18, 2009, it will be called away and one would be forced to sell at $8.00 (thus missing out on the gain above $8). In this case - selling the calls effectively lets the seller endure a 12% decline in the stock price and not loose money (thus limiting risk compared to just buying the stock and not selling the call options).

Here are the possible outcomes (not considering trading costs) - if on April 18, 2009, GE stock price is:

Greater than $8: In this case the shares will be called away - thus sold at $8 for a gain on the trade of 35.8%.

Between $5.89 and $8: The calls will expire worthless and the net gain will be whatever the difference is between the stock price at that time and $5.89.

Less than $5.89: The calls will expire and there will be a net loss of whatever the difference between the current price and $5.89 is.

I was recently asked what my opinion was regarding leveraged ETFs with respect to the 'unexpected' results of holding them for long periods of time. Here are my thoughts:

Part of this issue is that people aren't paying attention to what these funds are designed to do (or have a false expectation about what that implies for the long term). These funds usually track the 'daily' change in the index. Some people have been buying them thinking that over the long term they will get the double return (or inverse return) of the index -- i.e. If the index goes down 10 percent over the next year then the double short fund will be up 20%. The problem is that because of the day-to-day compounding action that happens - there is a certain amount of random drift introduced into the overall return (which can cause the end result to be either higher or lower depending on how the random day-to-day fluctuations in the market play out). I would note at this point that it isn't just the 'short' funds that have this issue - the leveraged long funds have the exact same drifting issue (I've seen some discussion that makes it sounds like only the 'short' funds will drift).

Just to show how this works I did a quick example of a hypothetical 10 days of fluctuations in an index. Here I show the index results, the double long results, and the double short results:

As you can see the double long would have seen an overall gain of 23.34% -- which is not the 22.68% (that is 2 X 11.34%) gain one might have expected if this drifting issue didn't exist. For the double short of the same index that gain is -20.63% and not the -22.68% one might have falsely expected.

Now there are actually two things that can cause these leveraged funds to have unexpected long run differences from their base index:

(1.) The 'drift' caused by compounding that I just discussed.

(2.) The inability of the fund to achieve the 'daily' result that it is shooting for. All of these leveraged funds use futures and other derivative contracts to achieve there results. Because of illiquidity and other 'friction' type issues in these markets there can be times when the relationship the fund is supposed to maintain with it's corresponding index isn't exactly maintained.

A lot of times when people are talking about this issue they invoke the experience of the FXP (double short china) fund. While the index was down like 50% over last year (looking at FXI - the normal 'long' of this index) - the results had you held the double short FXP fund would also have incurred about a 50% loss (where people were expecting a return of 100% in this situation -- thus a 150% difference from expectation). Using FXI -- you can model the behavior that this fund would have had if it were only subject to #1 above. When you do this -- you see that just from the 'drift' you would have seen a return of +22.4%. So in this case ... it can be concluded that the difference between getting that +22.4% return and the -50% return the FXP fund turned out is from reason #2 (and I believe but haven't confirmed that the reason for this big difference is because the futures/derivative markets for 'china' have a lot more 'friction' than the futures market for say the S&P 500). On further examining this situation it appears that a lot of the reason for the big #1 problem here was because of the huge swings in the underlying index (there were many days with a +/- 10% change -- and some with over a 20% swing).

It appears as though leveraged ETFs like SSO & SDS (double long & short of the S&P 500) have less of a problem with #2 than some other ETFs (like FXP). It has been my experience that holding these funds (SSO & SDS) for periods of several days to several weeks is not necessarily a problem IF it is understood that there will be some random 'drift' in the overall performance compared to the performance of the base index (specially in cases where the index is making unusually large swings from one day to the next). Holding such funds for months or longer can be a real problem however as you will essentially end up with a 'random' overall return.

I did a wordle of the stimulus bill - after removing some of the extraneous words it came out like this:

I find it interesting that 'health' was the most common word. I haven't actually read the document, but poking around it there seems to reference 'health information technology' quite a bit... I notice that CERN and MDRX are both up for the week (while the market is down by around 5%).

Disclosure: As of writing I have no position in CERN or MDRX.

Here is a story about how after 24 years (I can't believe it has been that long) Coke is finally dropping the 'Classic' from their labeling. This brings back memories of the 'New Coke' ad campaign featuring Max Headroom (I recall being really into that TV show at the time).

I saw a nice graphic of the job loss rate in this Time article. It actually doesn't look as bad as I would have expected it to... however we'll have to wait and see how the whole thing turns out.

I saw this article online today... although I don't know that I entirely agree with it I found the parting sentiment kind of funny:

"Remember, it ain't what you invest in, but when you invest."

It reminds me of something my financial adviser has said about a dozen times, something to the effect of:

"Time in the market is more important than timing the market."

Which has always made me a little skeptical because it is one of those things that is passed off as wisdom because it rhymes. It's funny that for just about every piece of market 'wisdom' you encounter you can find someone passing along the exact opposite 'wisdom' with just as much conviction.