Downgrade Portfolio - End of October Status

Overview

Readers will recall that about the time S&P downgraded US debt, CCI put some dry-powder to work on the simple assumption of “buy when others were fearful”. As October comes to an end, it seems like a logical time to report on the status of those trades.The specifics of those trades and update status can be found at this google doc and are described below. 

Overall this basket of nine diverse positions is up just over 5%. Of course the S&P500 is up about 11% in that same time frame. So the reader can judge for themselves if the glass is

• half-empty – it would have been much better to just “buy the market” or buy with some leverage
• half-full – the timing of the call to put more capital to work was very good. While the positions taken did not match the market performance,  they did go up.  Further,  almost all were hedged in such a way that they would not have lost as much if the market had not cooperated.

CCI “unbiased” opinion is that the glass is half full. It is not all that easy to overcome the fear of the moment that existed at the downgrade time to put money to work. The easy course of action would have been to do nothing and make nothing, or worse panic sell and miss the opportunity. While the option based hedged positions put in place damped the gains, they not only reduced risk, but helped make it psychologically easier to invest at a time of fear.

Trade Status

Let's start with the worst position. Bank of New York (BK) is down 7% along with the overall financial sector. The stock and sector had bounced some based on last weeks alleged positive European news, but that faded away likely in sympathy with the noise related to MF Financial bankruptcy today. CCI continues to believe this is somewhat a unique play in the financial services industry and read the charts to say it can get back over $23.  So we continue to hold and may sell some calls against this position on a bounce.

Three long positions and associated covered calls

Ford (F) - Bought a lot of stock at $10.18. Sold and then subsequently covered a lot of $11 Sept calls against the position for a gain of $.35. Established another $11 covered call position in November for a credit of $.79. The stock closed today at $11.68. If the stock stays above $11 through November options expiration the position will close with a gain of 19%. Conversely, with all the premiums taken in the stock would have to fall to $9.04 before loosing money. Still generally bullish on Ford so it if does pull back we would likely skim the profits from the option position and hold for better days to re-establish yet another covered call position.

Waste Management (WM) - Sold Aug $30 puts for $.70, and the stock was put to us at an effective price of $29.30. Closed today at $32.90. Over the past months we sold calls against the position for a $.63 gain and collected a $.23 dividend. Overall the position is up 16.5%. I would plan to exit the stock if it nears $35 but in the interim, I am Ok owning this for the dividend and possibly another round of covered calls on a bounce.

Utilities ETF (XLU) – Originally bought the etf at $31.72 and sold Jan $32 calls against it for $1.23.

The intent was for this conservative group of utility stock to stay stable through the end of the year and pocket both the option premium and two dividend cycles. The etf close trading today at $34.85. The original plan remains in place. We plan to hold through the dividend cycle and assuming it is still trading above $32 will likely exit the trade at near a 7% gain.

Four short puts trades were made. Three are closed for a profit, and one is still open and showing a gain.

• Japan ETF (EWJ) $9 put – closed for a profit of .9% in a little more than a week.
• Health Care Sector (XLV) Jan $29 puts – closed at $.39 for a gain of 4.6% in about 2 months
• Bank of America(BAC) – first the Sept $7 puts and then the $6 puts for a gain of 5.5% in about 2 months.
• Corning (GLW) – Initially sold Oct $13 puts for $.75 cents. Those expired worthless and put the same trade on for $13 puts in November for $41 cents. The stock is currently trading at $14.20 and the options at $.18. Looking to harvest a little more of the premium before closing the trade.

The final trade was on the materials ETF (XLB) – Initially we sold the Dec $31 puts and used those proceeds to buy the Dec $34 calls. Zero out of pocket costs. When XLB was trading higher we were able to finance the covering of the short Dec $31 puts by selling the Dec $37 calls. Received a very small credit. In option language, that was starting with a risk reversal and converting it to a vertical call spread. In common sense language that was risking less ($31) to now have a can't lose shot at making $3 or about 10%.It is nice to be sitting in a place where we are now essentially playing with the houses money. XLB ended the day at $34.45 so the spread is barely in the money. However, as stated we just need for this volatile etf to bounce back toward $37 anytime between now and December expiration and the position will turn nicely positive with nothing at risk now.

Time to Shorten Portfolio

Markets surged today apparently on what appears to be good news on the financial situation in Europe.

CCI looked at this up move not so much as an opportunity to take profits, but more as an opportunity to look to add some short positions to the portfolio.   One hedging action take today was to short Lululemon (LULU).   They manufacture and sell high-end athletic apparral often associated with yoga.  (No, CCI does not own any yoga clothes.)  They are "the hot" retail concept opening some 140 retail outlets.   The main driver to shorting this stock is their forward p/e of 39 and trailing p/e of 54 which means the stock is kind of priced for perfection.  Shorting this stock  is not an original idea as short interest was shown as 18.5%.  The stock moved up over 7% today and I'd assume some of that move was caused by a short squeeze to those already short.  CCI wanted to get some short exposure for the overall portfolio so we shorted just below $57.  It is always risky being short as irrationality can continue longer than my patience, but we are hoping either

a). this stock backs down to retrace the large gap in the chart and towards it s moving averages  in the short term and we can scalp a few dollars off the trade possible to re-invest in a bearish option strategy on the stock.
b).  Holiday sales for this high-end product may not meat expectations causing weakness in the stock be early next year.

Of course, it is also possible that we could just be wrong and become the next victim of the next move up.  However,  the overall long bias of the portfolio will probably perform very well if the market continues to move straight up, so this trade can be rationalized as an overall hedge.   Stay tuned.

Generating Income via Put Selling of November Options

With volatility in options still very high by historic standards, CCI continues to believe it makes sense to pursue the generate of income via put selling.  The past two months CCI has picked 2 option plays for the next month's expiration.  A recap of those trade and this months selections are discussed in this article at seekingalpha.com.

One of these trades is the next step in managing the Alpha Natural (ANR) position previously established by CCI.  The other is another round of selling of Corning (GLW) $13 puts.  

FYI, since that article was written earlier in the week, GLW reported positive earnings and moved up a few percent.  This already makes the GLW put sale profitable.  If those gains in price hold, and the reduction of perceived risk by the passing of the earnings release drops option volatility, CCI will likely cover this position and look to deploy the capital on another put sale in  stock with more option premium.  

Xerox - Q3 Earnings

Xerox (XRX) reported earnings on Tuesday beating q3 estimates by a penny and confirming full year estimates of $1.08 to $1.11. Nothing spectacular, but steady.  The main thing I liked about their earnings was the consistency. This is at least the 4th quarter in a row they beat estmitates by just $.01  which I interrupt as they have a solid handle on their business and are able to mange it to expectations now.  Their announcements says that 83% of their revenue is annuity business, and over half is now services revenue.  I suspect that number might have some positive spin associated with it, but never the less it does indicates a potential high degree of predictability in the future business.  I'm not aware that the company has set expectations for 2012, but average analyst estimates are $1.19.  With the stock trading just over $8 that is a forward pe of just 7.

At Oct. option expiration date, CCI was assigned a fourth lot at a cost of $9.  We now have a full position of shares at an average cost of around $10.   Still thinking the market will pin a more normal multiple on this company as it becomes more comfortable with its transition to a services business.  Hence CCI still has a  "price target" in the low teens and will hold for awhile longer.  However, if the stock does not move by year end we will consider selling some shares to harvest tax losses.

3m (MMM) - Earnings

MMM reported earnings today.
Not to say I told you so...but they guided down for q4.
However, CCI was surprised that they also missed q3 numbers.  The stock pulled back to $77.

From a trading perspective, the weekly $80 calls plunged on this news.  Hence the $80 weekly calls sold a few days ago plunged towards zero making that a profitable hedge. 

As mentioned above, CCI was not surprised to see MMM lower expectations (they seem to do that a lot) but the q3 miss was surprising and concerning to me.  I looked at just closing the position, but decided that the volatility was probably not out of this stock yet, and even lower expectations of $6 EPS this year should provide some floor for the  stock.

So we rolled the profitable weekly option position out and down.  Specifically we covered the Oct $28 call and sold the Nov $75 call for $3.30.   Scenarios if held to expiration are
- Stock falls below $75 and CCI remains long one lot of shares.  Those shares were purchased at $80 but we will have collected nearly $7.00 in option premium so the effective break even is down to $73.
- Stock stays over $75.  The stock will be called away at $75, but having collected $7.00 in premiums the portfolio would have made $2/share on the trade.

However, as the market digests these results, there is potential additional volatility in the stock so CCI may trade out of this position before expiration.

3M (MMM) - Covered Calls

MMM crossed back over $80 today.  CCI continues to believe this is blue chip company.  Not sure that means it will soar, but do think that may limit its downside.  However, earnings are next week and CCI believes it is likely MMM will continue in its tradition of  performing OK, talking down expectations, and the stock price falls back.  With option volatility still historically high,  CCI sold the $80 OCT 28 (weekly) calls today for about $1.50. Nearly 2% for 1 week holding.

(As an aside.....yes, there are now weekly options.  Hard to see how weekly options are absolutely critically important  to the success of the world,  but it sure does seems like yet another trading vehicle created by our friends on Wall Street to encourage speculation.  Isn't that what we have come to expect from Wall Street......so......if that is the world we live-in....we might as well play the game!)

Scenarios:
- If I'm right about MMM pulling back next week, I'll pocket this premium and that will drop the break even point on this lot to  below $77.  We can then consider November option plays against the position.
- If I'm wrong and MMM rises from here, the lot will be called away capping gains at a modest, low risk, 4.4% over 2 months.
 
Stay tuned

Cisco - Rolled Covered Calls to Nov.

Cisco  (CSCO) has continued moving up. 

CCI rolled the Oct. $16 covered calls forward to Nov.  for a $.24 /share credit.  Earnings are Nov. 9.  That should create some volatility in the stock and may present the opportunity to trade around these option positions still with the intent of closing this trade.

3M (MMM) - Covered the Short Puts

With MMM trading over $79 this morning,  CCI covered the lot of puts sold 2 weeks ago. 
This lot returned 2.5 % in just over 2 weeks.   There was only about  .015% left in premium and it did not seem worthwhile to take the risk of holding the position for another week until expiration for such a small remaining return.

Obviously catching the stock near its short-term bottom is a good/lucky thing, and in this case just buying the stock 2 weeks ago would have returned more.  However, the premium received, and lower strike price for this option,  meant this trade had about a 5 % downside protection if the market had not moved in our direction.  

Going forward, MMM reports earning on 10/25.   Part of CCI's trading thesis on MMM is they are the master of UPOD. (under promise and over deliver).  Hence if the stock runs up over $80 before earning, CCI will consider selling covered calls against the remaining lot in the portfolio. This is in anticipation that their earnings will be fine, but they will talk down expectations, and the stock will stall for a short while.   In that event, that trade would generate more income and also set up to put the short put trade back on.  

Intel - Over $23. Covered Calls Sold

About a year ago in  this article CCI  provided rationale for a position in Intel.  The article concluded by suggesting buying Intel if/when it was near $20.  CCI has built a full position in Intel with an average cost just over $20. 

As INTC went over $23 today, CCI sold one lots worth of Nov $24 calls against the position for $.45.

 In Intel reverses in the short term of after it reports earnings  (it has rallied into earnings only to fall back after earnings several times in the past) CCI will try to harvest some/most of this 2% option premium. If Intel  breaks out over $24, one lot will be called away at an effective price of $24.45.  That would be a 22% gain plus a 3+% dividend for a total of a 25% gain on this lot.  

UDC Portfolio Q3 Results

At the end of this turbulent third quarter, CCI must report that the Utility Dividend Capture fund (description here) lost 2.0% this quarter. This is the first loosing quarter in the funds 9 quarters of existence, and hence the first time the fund has failed to meet its absolute return objective of 0% per quarter in down markets and 3% in up markets. 

The fund once again generated significant dividend income (6.85%), as planned. Unfortunately, this is the first quarter that the anticipated capital loses were not able to be kept less than the dividend income (-8.89%).

Of course the S&P 500 was down about 13.9% (fter dividends) over the same period, so the draw down was much less than that traditional benchmark. However, the utility sector ETF (XLU) still managed to eek out a 1.4% gain this quarter. Hence that would have been a better, simpler way to go this quarter.

While the fund failed to meet its idealistic, arbitrary quarterly objective (maybe I should change the objective to -2% in down quarters, ...lol) it still obviously avoided a big down draft which is perhaps the most critical element to achieving good long-term performance. Additionally, UDC is the least volatile of these three funds. (as measured by SD).

CCI plans to continue with this approach both for its return profile and to illustrate how disciplined approach might work. Below is a lot of performance data so the reader can judge for themselves the merit of this approach.

RETURNS	UDC DIV.	UDC CG	UDC TOTAL	XLU	S&P500 (DSPIX)
2009 q3	7.73%	-2.86%	4.87%	6.26%	11.43%
2009 q4	8.22%	-4.29%	3.93%	7.02%	6.02%
2010 q1	8.10%	-5.93%	2.17%	-4.38%	5.36%
2010 q2	7.98%	-7.89%	0.09%	-3.68%	-11.39%
2010 q3	5.53%	1.08%	6.61%	12.16%	11.24%
2010 q4	5.62%	-3.25%	2.37%	1.05%	14.80%
2011 q1	5.95%	-3.34%	2.61%	2.69%	5.90%
2011 q2	5.96%	-0.39%	5.57%	6.10%	-2.10%
2011 q3	6.85%	-8.89%	-2.04%	1.44%	-13.89%
Compound Return			29.09%	31.24%	25.74%
Standard Dev			4.4%	4.9	9.1

Correlations between these three funds are shown below.

• udc/xlu .74
• udc/spy .67
• xlu/spy .43

TRADE STATS	Trades	Wins	Loses	Win %
2011 q3	20	13	7	65.00%
Total	165	122	43	74.00%

"When the facts change, I change my mind. What do you do?"

Bespoke Investment Group provides a large amount of interesting, thought provoking market data.  On Wednesday 10/5 they had a post about recent market volatility.  You can read their whole post and better see their conclusion graphically at their website here . However, the key bit of info CCI found interesting was the following:

"Up 8.31%. Down 7.34%.  Up 5.34%.  Down 5.68%.  Up 7.38%.  Down 8.70%.  Up 7.34%.  Down 10.14%.  Up 6.65%. Those are the swings the S&P 500 has seen over the last thirty trading days."

That nets to a little over a 1% loss. Of course that was published before Thursday's 1.8% gain in the market. WOW. That is an exciting way to achieve .........nothing. 

I think this type of data should make an investor question their theory on equity investing.  Modern (circa 1952) portfolio  theory is based on many assumptions including that equity performance will be something like an annualized 8% gain with a standard deviation of 15.  I wonder what the SD for this zero return of the last 30 days might be? Perhaps this volatility is just unique past 30 days.  However, I'd guess ( not audited) that over the past 12 years the S&P has had something like an average return of zero with a standard deviation of 20.  So perhaps this is not really that unusual any more.

So why do so many investors blindly believe the advice from the financial services industry that says:  traditional passive portfolio theory is "good" and more active trading is "bad".  

Paraphrasing the famous quote from the title of this post:

When the underlying assumptions change this dramatically,  I change my approach to investing. 
What do you do?

HPQ - using options to trade the range

CCI is long and wrong two lots of Hewlett Packard.  CCI developed a strategy to manage this loosing position in this article.  One of the main premises of that article is that HPQ's valuation is providing some base for the stock, but it will meet strong selling resistance in the high $20s for a long while.  In an attempt to repair some of the damage from this trade and exit the position,  the article describe an initial option trade. The trade is built around the assumption that the stock would  bounce around a lot in a range between the low and high $20s. CCI has had one round trip using this strategy.


Recent volatility saw HPQ trading below $22 earlier in the week and $25 today.  (Once again an example of those "efficient and rational" markets ...lol). CCI was able to buy a lot of $24 Nov options late last week and this week sell 2 lots of Nov. $28 calls. This basically mimics the original trade described in the article.   With the high implied volatility of the options and the 2:1 ratio, the trade was established for a net credit of $.22/share.  

In "option speak" this would be considered a 1x2 ratio spread which can also be viewed as the combination of a $24-$28 vertical call spread and $28 cov calls.  From a more common sense perspective the following scenarios are in play.

- Pullback - HPQ falls back below $24 - CCI keeps the $.22 (just under 1%) to lower the losses of the position and will still own two lots of shares that are deep underwater.
- Sideways - HPQ moves mostly sideways over the next weeks ending at $26.  CCI will make $2 on the call spread and keep the option premium from the covered call and still have two lots of shares that are less underwater. .

- Rises over $28 - CCI makes $4 on the call spread, keeps the premium from the covered call, and one lot of shares is called away at $28. (My target price)
- Volatility continues and CCI will be able to leg out of  (and maybe even back in) to these option positions

Stay tuned.

Cisco - Coverd Calls......Again

CSCO hit $16.50 this afternoon. Yes, that is right. In less than 24 hours Cisco went from $15 to $16.50.  Gee...I wonder if the "value" of the company change by 10% in the last 24 hours? 
You really have to love those efficient markets that factor in all available information to identify a "true" price. ...lol
.
In any event, CCI sold the  Oct $16 calls for $.78 this afternoon against our long Jan 12 option position.
Yes, that is the same trade that we just closed  on Monday.  If it worked once, why not again!

CCI still thinks Cisco is a "value" stock, but now that the overall market has moved down,  there are a lot of "value" stocks to choose from.  Some of them likely have greater growth potential than Cisco.  So we are content to have this last lot called away at Oct expiration for an effective price of $16.78, and redeploy  the capital to another trade.  Conversely, if the stock decides to retrace some of its 10% recent pop, we will also be content to skim some short-term premium off this trade......again.

Q3 Results for EEM2

Near the beginning of the year, CCI was looking for ways to more globally diversify the portfolio.  I described a portfolio of three ETFs that I felt would diversify away from the US markets but have less risk than choosing a popular emerging market ETF such as  VWO or EEM .   A portfolio of 3 small cap, international ETFS all of which focus on the emerging consumer while trying to be less dependent on China than standard emerging market etfs was developed.  The portfolio, called EEM2, is described in the article here.   It consists of a wide ranging emerging consumer etf econ and small cap etfs for Brazil brf and India scin .

Diversifying away from the US to emerging markets around the beginning of the year was a bad idea.  The emerging market etf VWO is down 25.6% this year.   Far worse than the US market.  The Chinees ETF fxi is down more, about 27.3% including dividends.  EEM2 performance was similar, but better. Down 24%. 
The performance of the Brazil and India etfs were both large drags on performance, both down well over 30%. Econ performed better (less bad) and CCI still likes the make-up of the fund.  It seems to put a focus on companies that might serve the emerging middle class in a wide variety of countries.   CCI plans to stick with this portfolio for now.  However, it is possible that we may add to the ECON position and close the Brazil and India portions for tax losses in q4.

Q3 Results for GSPY

Near the beginning of the year, CCI was looking for ways to more globally diversify the portfolio.  I described a portfolio of four ETFs that I felt would diversify away from the US markets but have less risk than choosing an emerging market ETF such as  VWO .   The portfolio consisted of country etfs from Brazil ewz, Canada ewc, South Korea ewy, and Switzerland ewl.  I called that portfolio globalized SPY (S&P500) or GSPY and rationale for those specific countries and how they might work together is described at the original article here.

Let's start with the bad news...ok really bad news.   Diversifying away from the US markets to almost anywhere else in the world as of the beginning of the year was a bad idea.   Seems like the US is viewed as a safe-haven...imagine that.

The following data includes dividends. While the S&P 500 is down around  8.7% for the first three quarters, the emerging market etf VWO is down about 25.6% .  OUCH.   The "good" news is that GSPY is down only 21.2%.  OK that's not really good news.  However,  if the objective was to move away from the US and perform better than the emerging markets then the portfolio has met its goal .  Additionally the monthly standard deviation for GSPY is 6.3 vs. 7.3 for VWO (still volatile, but less volatile). Correlation of GSPY with VWO is .98. (real high).

GSPY performance was hurt badly by its acknowledge overweight in the materials sectors of the market, and the pegging of the Swiss Franc by the Swiss government.  CCI is sticking with the portfolio for now, but will be considering adjustments and/or  tax loss selling in the fourth quarter.  

Cisco - Covered Calls Removed

With CSCO trading back down around $15.30 along with the market, CCI bought the Oct $16 calls for about $.33 after commissions to close the option position.   These calls were sold for a little over $1 about two weeks ago. The portfolio made about $.67 or 4+% on this transaction.  There was "only" about 2% left on this trade.
A small bit of green in a sea of red in the portfolio the past month.


CCI would still like to exit the CSCO position, but I think/hope there might get a chance to exit closer to the top  of Cisco's trading range.  Hence, a similar  covered call position might be reestabslished if the stock moves back up in this volatile market.