Option Trading Idea of the Week
Trading Options After a Stock Split
When EEM split 3-for-1 on July 24th, two series of options became available. The pre-split options had strike prices around the $130 level (and strikes at $5 increments) while the post-split option series had strikes around the $40 level (and strikes at dollar increments).
The immediate implication was that market professionals all jumped into the new option series and totally disdained the old pre-split series. Our new portfolio suffered for several reasons:
Our graphing software did not work, so it was difficult for us to see where we stood. The Analyze Tab at thinkorswim was no better - it showed 70% gains coming our way in two weeks across a huge range of possible stock prices. Option prices in the pre-split series fell considerably. Traders did not want to deal in options that did not easily translate to the current stock prices.The bid-asked spreads increased by a large margin, making it impossible to get decent prices when either buying or selling. This problem relates to the general issue that market makers just don't want to deal in the old series, and they make it expensive for anyone who wants to trade there.For the above reasons, we recommended that subscribers get out of the old series as soon as it was practical. For us, this meant waiting until the August expiration week when we would normally be buying back soon-to-expire short options and selling the next month out. Rather than continuing to trade the old series, we advised closing out all the pre-split options and starting over with the post-split series.
This policy would result in some costly bid-asked spread penalties and commission costs, but it is a better choice than continuing to trade in markets that have bid-asked spreads large enough to drive a truck through. Sometimes it is best to take your lumps and move on to better things. We expect that our EEM portfolio will be our worst-performing portfolio this month, and may even lose a little. Thankfully, 3-for-1 splits don't come along too often.
Andy's Market Report
It was an incredibly volatile week for the market. With the exception of Friday the market moved at least 1% every day. Indecision was palpable and it was purely evident by the end result - a narrowly mixed market. Basically we are right back where we started.
For the week the Dow, S&P, NASDAQ and Russell 2000 finished the week mixed at -0.4%, 0.2%, 0.8% and 0.0%, respectively.
The week began with a sharp 4.5% decline in the financial sector after news of the collapse over the weekend of two more regional banks. First National Bank of Nevada and First Heritage Bank in California were taken over FDIC after running short of money late last Friday.
The FDIC action comes two weeks after the agency took control of IndyMac. A total of seven banks have failed this year as the credit crunch and housing correction continue to take a toll on the economy.
The overall decline in the financial sector led to a scare in some of the nation's biggest banks, most notably Merrill Lynch which dropped 11% on the news.
Late on Monday, the investment bank stated that it would write down $5.7 billion and raise $8.5 billion by selling new stock. As a result of the bad news, several analysts widened their loss view for Merrill Lynch.
However, the sharp decline could have been far worse if it were not for the sharp decline in oil early in the week
"The oil price drop is tremendously helpful. I think people view it as relieving a major strain on the economy, combined with a feeling that Merrill is working its way through its problems, and combined with consumer confidence, that was a little better than expected," said Jim Awad, chairman of W.P. Stewart Asset Management in New York.
Much like the overall market, crude experienced 1% moves every day this past week. The price of a barrel of oil traded as high as $128.60 and as low as $120.80 a barrel only to end the week up 1.5% or $125.10.
More relief came to the financial sector after President Bush signed a massive housing bill intended to provide mortgage relief for 400,000 struggling homeowners and stabilize financial markets.
Much of the bill was focused on the temporary relief to troubled mortgage companies Freddie Mac and Fannie Mae.
As a result the financial sector ended the week higher 4% and Wall Street began the discussion of a bottom in financials.
"People are saying financials have been battered and battered and battered. They're looking to find value," said Bob Andres, chief investment strategist for Portfolio Management Consultants, a unit of Envestnet, which manages $45 billion in Chicago. "We're going to get out of this, but it's going to be very slow. We're still grappling with a slowing economy." Economic reports were mixed which also led to the market indecision this past week.
Early in the week it was reported that U.S. consumer confidence edged higher in July, which halted a six-month slide and offset data that showed U.S. home prices plunged at a record pace in May.
Thursday, the Commerce Department's reported that GDP grew 1.9% in the second quarter which disappointed investors. Economists had expected growth of 2.4% in the broad measure of the economy's health. Revised numbers also revealed for the first time that the economy shrank in the fourth quarter last year.
On Friday the Labor Department stated that jobs fell for the seventh straight month in July by 51,000, less than expected, but that the unemployment rate rose to a greater-than-expected 5.7%.
"It reinforces the idea that we're seeing a steady, but not dramatic, decline in employment, which is likely to last for some time," said Michael Sheldon, chief market strategist at RDM Financial Group in Westport, Conn.
Technically speaking the market is right back where it started the week which is firmly in a neutral state. However, over the last ten years the first two weeks of August have been notably weak with an average return of 1.1%. Only 3 out of the last 10 years have witnessed an increase. Seasonal biases are little more than food for thought and (at least in my humble opinion) should never be the sole reason to place a trade.
As I stated last week, when probability is not on my side I wait patiently until the market gives me an edge and right now I just can't find one.
Overbought/Sold Condition Report
Overbought/Oversold for August 1, 2008
Major Benchmarks - Dow (DIA) - 44.8 (neutral)
- S&P 500 (SPY) - 48.9 (neutral)
- Russell 2000 (IWM) - 55.9 (neutral)
- Nasdaq 100 (QQQQ) - 61.9 (neutral)
Emerging Markets (EEM) - 44.1 (neutral)
Testimonial of the week
"I just went onto my Think or Swim account, and they are trading the "Mini-Russell". Would you believe that the account is up 6% in one month? Keep up the good work." Fred 8/1/08
