SURVIVING THE GAME
NOVEMBER 13, 2008
VOLUME 1 NUMBER 18


The unthinkable has occurred. The model portfolio has gone negative. Some may think that down 3% is not much given the circumstances but I will tell you that it INFURIATES me. What it means is that I must work even harder to protect capital while extracting small gains from extraordinary option volatility.

The indexes are testing the Oct 10th lows and may penetrate as early as today. Dow is holding up better than S&P and Nasdaq. I still believe we are bottoming and will bounce from here. With that in mind, we will adjust the portfolio to capture gains from a bounce while not adding much to risk.

Just after open today, assuming we are flat to down, execute the following trades.

1) Buy back 15 DIA NOV $92 calls. Closed at .40-.49
2) Lower stop on GE to $15.00
3) Lower stop on NUE to $26.00
4) Buy back GE MAR 09 $23 calls. Closed at .73
5) Buy back BNS APR 09 $50 calls. Closed at .86
6) Roll DIA DEC $91/91 straddle down to $88/88 straddle. Buy back both $91 call and put, sell both $88 call and put. Should cost approx $100 per position
7) Buy 20 DIA DEC $100 calls at $45 or less

What does all this do. It eliminates the upper side of our DIA NOV $92 straddle which positions us for large gains if we rally but adds only $675 (total cost to buy back $92 calls) of risk if we continue to sink. We own the DIA NOV $80 puts so we now have a $92/80 spread which will increase slowly in value if we fall but shrink quickly in value if we rise. Shrink is good as we make money if value drops. These options expire next Friday, the 21st so we won’t have to wait long to see.
Lowering GE and NUE stop to give a bit of breathing space.
Buying back GE calls with plan to re-sell after decent rally.
Same with BNS, re-sell if get decent rally.
Moving the DIA DEC $91/91 straddle down to make it a more neutral position. Doesn’t cost much at this point so take advantage of it. Buying DIA DEC $100 calls as upside protection for $88/88 straddle.

Now it is time to get long. How? With options of course. I’m fairly certain not one of you are in the mood to just pile on with uncertain downside risk so we will implement some basic option strategies to get long while limiting our downside exposure.

The most basic “ getting long “ option strategy is to by call options. Eg We could buy the DIA NOV $83 call. DIA closed at $83.09 Wednesday. It costs us $340 each. Well that means that we need to rise $3.40 points above $83 to break even and then away we go to the upside. $83 on the DIA is like 8300 on the DOW. We closed today at 8282.66. Can we make money on that trade? Yes, if we are right and it happens quick. You see, the NOV options expire next Friday so we only have 7 trading days to get it right. We could buy ourselves more time and buy the DEC $83 calls instead of the NOV. Problem is, they cost $590 each, meaning we would need to rally to 8890 to break even, then we make money. The benefit of this strategy is defined risk. The max risk is whatever you pay for the option, never a penny more. The downside is that you must get both the direction and timing right. If we were to rally the day after the option expires, you get nothing. For those reasons, as well as the fact that prices are extremely high right now, I will pass on this strategy for the indexes.

The second simplest strategy is an option spread. This is buying one option and selling another option against the first. Essentially one offsets the other with a price difference. A slightly more advanced version is called a butterfly. We currently have a butterfly on Encana. This is the strategy I will employ to “ get long “. If you have been watching the ECA butterfly this will make sense.

Purchase 20 DIA DEC $85 calls, sell 40 DIA DEC $95 calls, buy 20 DIA DEC $105 calls. This will cost approx $270 per set or total of $5400. This trade unfolds like this. I am looking for the DOW to rally above 8500 between now and Dec 19th, but not rally much above 9500. We will make the maximum profit at 9500 on Dec 19th. It looks like this.





DOW $85call $95call $105call Profit/Loss
X 2
8500 or 0 0 0 -5400
lower
8770 270 0 0 0
9000 500 0 0 4600
9500 1000 0 0 14600
10000 1500 -500 0 4600
10230 1730 -730 0 0
10500 2000 -1000 0 -5400
or higher

So, we want to see the DOW end up between 8770 and 10230. Anywhere in that range we make a profit, outside, we lose. BUT, we can only lose $270 per trade as a maximum while we can gain up to $730 per trade or a 2.7:1 risk:reward ratio with a high chance of success. We will exit his position if the value falls to $120 or less, risking $3000 maximum.

If we rally 500 pts on the DOW soon, this position will move from $270 to approx $325. If we sink 500 points it will move from $270 to approx $200.
It will ebb and flow up and down as we move closer or away from 9500 on the DOW. As we get closer to expiry on DEC 19th, it will move much higher if we get close to 9500. eg The NOV position with exact same options is now worth $217, even though we are 1200 pts below 9500 with only 7 trading days left. The NOV 75/85/95 position, which is almost exactly in the middle, is worth $500 with 7 days left. If we were to close here at 8282 next Friday, the NOV 75/85/95 would be worth $782 each.

I am looking to do a similar trade on the Nasdaq using the QQQ’s and on oil using the USO. The oil trade looks especially nice. 6:1 profit potential. Will keep you informed. This type of trade is also possible on the Toronto index, the i60. If anyone wants to do the i60 trade, email me at davidknight7@shaw.ca and I will send you my best recommendation for the Canadian market.

I also want to get short the $US. The rally Wednesday failed to make new highs. The safest way to do this is again using options. We will use options on the UDN. UDN is an ETF that tracks the $US. It rises as the $US falls. It trades in the US. Buy 30 UDN MARCH 09 $25 calls at $80 each or better. This will cost $2400. UDN closed yesterday at $24.28. The $25 is called “ at the money “ meaning it is the closest call to current price that is not “ in the money “ or below current price. UDN has fallen from the $30 range in July to current price. I do NOT believe this rally in the $US is sustainable. I will risk ½ the premium paid or $1200 on the position. If the $US declines, we will profit above $25.80 on UDN. This is a straight call option purchase because the volatility in the $US is much lower than the stock indexes, making option purchases possible. I will sell ½ this position at $200 each and reassess other ½ at that time. Each $1.00 rise in UDN with net us approx $2100 in profit.

I am still watching the Gold/Platinum spread. Closed below $100 yesterday. Was as low as about $90 and now at $121. Remember, this spread was $1200 earlier this year. I am research historical data to determine best course of action.

It may seem to many that I am executing a lot of trades. You would be correct. Normally I would expect to do 2-5 trades per month, mostly selling more options on open stock positions as old options expire worthless. Believe me, I would like nothing better than 6 months of nice quiet sideways to up action to sooth everyone’s nerves. Trades like the DIA straddles will almost always be a staple of the model portfolio, especially when volatility is high. Trades in individual stocks and one off trades like the $US and Oil come and go periodically. There may be times like this where there are opportunities left, right and center, the problem is finding the best ones. And, months may tick by with no new opportunities at all. A trade like the one I am looking at in Gold/Platinum may occur once ever 20 years, it just happens to be now!!

These are unprecedented times and I will continue to do my best to try and point you towards profitability.

Dave Knight
Editor
Surviving The Game