Be on the Lookout For Crazy Deals

As panic sellers and shorts drive the market lower, be on the lookout for pricing craziness on deep in the money LEAP calls on stocks that are especially volatile. It may be possible to buy a stock and sell a deep in the money covered call for a very small net debit or even a net credit.

How would this work? Check out ESLR. As I'm writing, it's trading around $3.08 a share. The January '10 2.5 call's bid is $2.10, and the ask is $3.30. Writing a covered call for a net credit (i.e., money being deposited into your account) is unlikely here. However, a small net debit is possible. For example, if I buy 100 shares for $3.08 and sell a covered call for $2.50, the entire transaction will cost me $0.58 a share, or $58 (plus commissions). If ESLR trades for $2.50 or higher at expiration in 2010, the shares will be called and $250 will be deposited into my account. So, max loss here would be $58 plus commissions. Max gain, about two years out, would be $192. That's more than tripling the money I put at risk. I think it's worth it, and have an open limit order for a net debit of $0.6 a share.

If you think this is worthwhile and wish to try it yourself, please consider that there's a strong possibility that you'll lose all the money you put in. So, if you decide to play, risk only a small amount.

Don't try to buy the shares and then sell the call (this may get you a better deal--and is the only way to get a net credit--but you can also end up having a larger debit than you planned). Your broker should give you the ability to both buy shares and sell calls at the same time--you just have to specify the net debit from your account. If your broker doesn't have this function, you should switch brokers.

ELSR is just one example. Be on the lookout for others.


Evaluating Portfolio, Waiting For a Decent Rally

I sold GE on Monday for around a 36% loss (it's a little less because of dividends). I wrote numerous times how I thought the company was unfairly punished by the market. Some people called GE "an unregulated bank." They were right. I was wrong. I sold because I think the stock will continue going lower. I also think there's a possibility there will be a dividend cut.

Another thing that motivated me to sell was the CEO coming out on CNBC to say that things were going well, considering the current economic environment. He talked up the stock. A few days later, GE announced a $12 billion share offering and a $3 billion loan from Warren Buffett with 10% interest. Immelt had to have known about this when he went on TV to talk up his stock. There goes my trust. New rule of thumb: whenever a CEO goes on TV to say things aren't as bad as they appear, things are probably worse (think Bear Sterns). That said, I'm looking to buy GE back later this year or next year, probably for a lower price. If anyone benefits from the eventual recover, it'll be GE, supposing it survives.

JNJ and PG: They were doing just fine until this week. I'm keeping these guys for now. They might go lower, but I think they're great companies with bright futures. I'm a little worried that Cramer keeps recommending them, though. That's rarely a good sign.

ESLR: This is one volatile stock. I'm looking to buy back my calls for lower than I sold them. I'm also looking to sell my October puts, perhaps rolling them farther ahead. If this company survives, I think it'll turn out to be a great investment.

CPSL: Why do I own this piece of crap? Great earnings growth, and it's in a country that will be the world's economic superpower in the future. CPSL is also very volatile, and I bought it to write covered calls. When it was trading in the $4 range, the 5 strike calls a month out went for $30 to $50. So why is CPSL trading below book value now? There's the general sell off. Also, CPSL is in the steel industry, which is certainly out of favor. Chinese stocks are particularly loathed right now as well. Lastly, the company has negative cashflow. That's never good. If it survives, I think it'll be a great investment. The company is boosting production and has a decent order backlog. I'm looking to buy back my calls for a lower price, wait for a rebound, and sell the calls again for a higher price.

PM: While its share price is down significantly, my favorite tobacco company is expected to post good earnings on October 22. We'll see if people around the world started smoking more because times are tough. The firm's European sales will probably be poor, because of the Euro's weakness against the dollar and lower sales volume. Although I may change my mind, I want to keep this company for as long as possible. As long as there aren't any dividend cuts, I'm probably not going to sell. I might pick up a few more shares, depending on how much further the stock falls.

I've been making some decent gains with puts in the last few weeks. I'm waiting for a rally to buy some puts on SPY and QQQQ. We haven't had a sustained rally (that's longer than a couple of days) in quite some time. Below are charts of the Dow from 1929 to 1933 and the NASDAQ from 2000 to 2003. There were a few pretty good rallies during the huge drops.

I'm pretty sure the general direction of the market will be down for some time. That's why I'm not buying calls. I'm being careful with puts as well, because I don't want to buy just as a rally gets underway. While I'm waiting for a rally, I'll by trading the SPY 72 March put. My plan is to buy it around $1 and sell around $2 a couple of more times.

I'm also looking to buy puts on companies that will probably go out of business if the economy continues to suffer and the credit markets remain frozen. I'm thinking of companies with massive debt, low margins, and a reliance on the consumer. RHD is a great candidate, but I'm too late to this one. Avis (CAR) is an example of companies that I don't think will survive if times get tougher.

I'm also watching Whole Foods (WFMI). It's got obscene evaluations. I think the stock should be trading at $10 a share. I'm looking to buy puts four to six months out if WFMI rebounds to $20 a share or higher.

My investment portfolio is about 40% in cash at the moment. I keep track of my trades in the lower right portion (under "free stuff") of this blog.


A Few Ways to Play UST, BUD

A few weeks ago, I wrote about UST (UST) as a stock to watch. It was supposed to be purchased by Altria (MO) before year's end for $69.50 a share. UST closed at $64.90 a share on Friday, after Altria announced that the deal may be put off until 2009 because of the deepening credit crisis. Altria will pay UST $300 million if the deal does not close by January 7, 2009. (Shareholder and government approval are required for the purchase agreement to close.)

Let's say you anticipate that the deal will go through as planned, and you buy UST for $65 a share. You can potentially make $5.13 a share, or 7.89% if there's a $0.63 UST dividend payment in December [$69.5 - $65 + $0.63 (possible December dividend) = $5.13 max gain].

If the deal falls apart, UST will most likely drop. The question is how low the stock will go. UST traded between $50 and $56 in the few months leading up to the announcement of the deal. Shortly before Altria's buyout offer, UST traded around $54 a share. It seems likely that if the deal falls apart, UST will drop back to that level, or go lower. So let's say the max loss would be $15 per share minus any dividends received, if UST falls to $50. Unless you're very comfortable with risk and are very confident the deal will go through, buying at $65 is probably not worth it.

There's a safer way to play this, though with a smaller potential reward. The UST Jan '09 65 strike put's last ask on Friday 10/3/08 was $2.45 (it can probably be purchased for a lower price). If you buy UST for $65 a share, and get one Jan '09 65 put for every 100 shares at $2.45, your max gain will be $2.05 a share ($2.68 if there's a $0.63 dividend in December). That's not a bad couple of months' gain in a bear market. Ideally, you can buy the 65 puts below $2.45 and UST shares below 65.

If the deal falls apart before the January 16, 2009 expiration, the most you can lose is your put premium (plus broker commissions), as you'll have the right to sell your shares for $65. If UST pays a dividend in December and you close your position after the ex-date, your loss will be offset by the dividend amount.

This trade is worth it if you're willing to risk $2.45 for a reasonable chance (analysts think there's a 70 to 80% chance the deal will be consummated) to gain at least $2.05 and maybe $2.68 (minus commissions).

Another trade if the deal falls apart (but this one is much riskier and you'll have to watch it very closely) is the following. You buy UST shares and puts as described above. If the deal is canceled, UST starts falling, and you think it'll fall further, you might consider selling your shares for market price and keeping the puts, to sell later for a higher price. This would possibly offset losses more, and may even result in a gain, depending on how early after the deal cancellation you sell and how low the stock drops afterward. (For example, you'll make money if you sell UST at $60 and sell the puts later when the stock drops to $50.)

Yet another possibility is if the deal falls apart, but you think UST is a good long term hold with a decent dividend, sell the put when you think the stock won't fall further and keep your shares.

If you're a speculator who thinks the deal will fail, consider buying puts. Your potential gains will depend on which strike you buy and how low UST goes. Your maximum loss is the put premium.

All of the above assumes that the deal will either fall apart or be closed before January 7, 2009. That is, I assume the deadline won't be extended.

Similar things can be said about Anheuser-Busch (BUD), my other stock to watch, but I don't think it's worth pursuing. The brewer is supposed to be bought by InBev for $70 a share before the end of the year. BUD closed at $65.10 a share on Friday. Its January puts are much more expensive. The deal's price tag is almost five times bigger than Altria's, and at least three of InBev's financiers are experiencing problems.

The market is full of bargains right now, and investors are starting to nibble. But as no one knows where the bottom is and the market can go much lower, consider buying long term puts when you go long a stock. If it's a great company selling for a bargain basement price, the additional cost of a long term at the money put is a reasonable expense. You'll curb your potential gains somewhat (though they will still be potentially unlimited), but you'll know exactly how much you can lose.

If you own stocks that you're thinking of selling because you can't bear the possibility of more losses, see if it's worthwhile to buy puts on them instead.

Disclosure: I hold no positions in the securities mentioned above.