RealMoney's Best of Blogs

As always, RealMoney's bloggers were all over the market action this week, and we'd like to share the best of their recent commentary with readers of TheStreet.com. These posts best capture the intent of these blogs, which is to provide intelligent discussion on the issues each writer sees as most pressing that day.

Let's take a look at Rev Shark on the questionable reasons for a continued rally, Steve Smith on a different use of leverage and Tony Crescenzi on durable goods and a rate cut.

Click here for information on RealMoney.com, where you can see all the blogs -- and readers' comments -- in real time.

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Rev Shark's Blog: Ripe for a Pullback
Originally published on 8/23/2007 at 8:08 a.m. EDT

He has not learned the lesson of life who does not every day surmount a fear.
-- Ralph Waldo Emerson

The market continues to quickly surmount the fears of credit issues that caused some outright panic just a week ago. This morning news that Bank of America (BAC Quote) is investing in Countrywide (CFC Quote) is causing the market to gap up yet again. The Nasdaq has now bounced nearly 7% off the intraday lows of last week and the attitude as we start the day seems to be that it is that it is clear sailing from here.

The action the last couple days has certainly been quite positive, but what you really have to wonder is whether all those things that caused so much fear last week are now mostly contained and of little real consequence as we move foreword.

The bullish spin is that the market overacted to the lack of liquidity and subprime news. With the Fed ready to jump in to save us, should problems crop up again, we are back to business as usual. Why should we worry about these credit issues when the economy is still strong, especially internationally, and we have the Fed ready to cut rates?

If the economy really is as strong as many think it is, would the Fed be cutting interest rates? We really are at a juncture right now where the bulls are having it both ways. Either the problems out there won't matter because we have the Fed ready to act, which will support the market, or the problems out there are minor and we don't need the Fed to support the market. The whole market seems to be supported by two simple ideas right now -- that we know all or most of the bad news and that the Fed is going to cut rates very soon. The bulls are not expecting any new negative developments and are confident the Fed will act.

That logic for why the market has to go higher from here seems very suspect to me, but more important, the technical condition of the indices at this point is practically begging for a pullback. We are very short-term extended and the gap up this morning is making us even more so. We are heading for some key resistance levels on this open. For example, the Q's (QQQQ Quote) is indicated right now to open just below its 50-day simple moving average at $48.11. I've been building a little QQQQ short into this strength this morning and am looking for a quick trade.

We certainly can continue to act like none of those issues of last week matter and move straight back up, but my trust level is very low. We are ripe for a pullback, so proceed with caution. The shorts have been squeezed and the momentum investors are busy, but when we bounce as big as we have, the siren song of locking in some gains grows louder.

Short QQQQ.

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Steven Smith's Blog: Using Leverage to Reduce Risk
Originally published on 8/22/2007 at 5:00 p.m. EDT

In Scott Rothbort's recent article on how to handle market stress, he recommends getting rid of leverage by paying down any margin balances in your portfolio.

He explains his reasoning by writing "leverage is a wonderful thing when the markets are going your way. However, during periods of increased volatility and declining markets, leverage can work against you ... and erode your portfolio much faster than if you did not employ leverage at all."

And he is absolutely right. Don't become a deer stuck in the headlights -- take some action to avoid being flattened.

He Who Hesitates Is Lost

I certainly agree that leverage is a double-edged sword, and traders who "lever up" in an attempt to boost returns must realize the magnitude of potential losses also increases.

But it's worth keeping in mind that you can use leverage to reduce risk before volatility increases and positions turn against you. This, of course, could be accomplished by including options as part of your positions or portfolio to control losses from the outset.

The simplest strategy is the purchase of put options to limit the loss incurred if the price of the underlying asset declines. This is known as a married put. Like most insurance, it comes with a cost that will have a drag on returns. But thanks to the leverage of options, a small amount of money can buy you a lot of coverage.

The cost, like insurance, will, of course, depend on several factors. For example, the term or amount of time, because the longer the policy, the lower the annualized cost. Also, the condition of the asset being insured must factor in.

Rothbort suggests avoiding high-beta stocks, as these are thought to carry more risk. An analogy would be a house sitting on a fault line or a pack-a-day smoker, both of which will have higher insurance premiums. Finally, you must decide what size deductible or out-of-pocket loss you are to willing to accept.

An Apple Today

Let's use Apple (AAPL Quote) as an example, as it has a relatively high beta of 2.24. That means if the market at large or, say, the S&P 500 rises or falls 1%, shares of Apple should experience a 2.24% change in price. So, as a stock that is expected to move or produce returns, profits or losses, more than twice that of the broad market, one can consider it fairly risky, and therefore, its insurance will be relatively expensive.

With Apple currently trading around $131 a share, you can buy the April puts with a January 2008 expiration for $15 per contract. Assuming you owned 1,000 shares of Apple, a reasonable amount of coverage might involve buying 10 of these puts, which would cost $15,000, or nearly 16% of your investment.

What do you get for that 15 grand? First, understand that currently the delta of these puts is around 0.50, meaning that for each $1 move in the price of Apple shares, you can expect the value of the puts to move 50 cents. So, at the moment, your deductible on any initial decline in the stock price is around $7,500, or 5.7% of the investment.

But since delta moves on a slope, meaning it increases as the options move further into the money, your full coverage -- or where the value of the 10 put options will increase on a one-to-one basis for each dollar decline in Apple stock -- will begin at around $115 per share.

A Pre-Emptive Strike Price

Now how does that compare to simply selling off shares to reduce your margin requirement? Selling 1,000 shares of Apple at $115 will result in the same $15,000 loss as buying those puts, but it still leaves 900 shares, or some $103,000, exposed to further losses.

The leverage provided by the put option prevents incurring any further losses over the next eight-month period. Also, you still own that full 1,000 shares, meaning you retain the same upside potential should Apple resume its rally.

For a stock that has gained more than 160% from $50 to $131 over the past 52 weeks, this seems a reasonable price to protect this investment. Let's face it, like that house sitting on a peninsula in the middle of hurricane alley, it takes only one small squall -- such as a problem with the iPhone batteries or a backlash against the contracts that offer a limited choice of carriers yet long-term commitment -- to knock down what underpins the high growth projections.

On the flip side, if it all lives up to its promises and the iPhone and other Apple products have blowout holiday sales, the stock could easily rise above $200 by next April, a 53% gain.

Now no one wants to give away nearly 25% of that profit -- remember the purchase of these puts moves your effective cost basis or purchase price up to $146 a share -- but it's a lot easier to be magnanimous knowing you stand to gain 25% or more while your losses are limited to just 15% of your original investment. The lesson: That while leverage has its downside, by applying it in a pre-emptive fashion, you will be well positioned to reap the advantages of its upside.

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Tony Crescenzi's Blog: Durable Goods Lessens the Chances of a Cut
Originally published on 8/24/2007 at 10:07 a.m. EDT

Durable goods orders increased 5.9% in July, the largest increase since last September and much larger than the consensus forecast for a gain of 1.0%. Excluding transportation orders, durable goods orders increased 3.7%, the most since August 2005 and well above forecasts for a gain of 0.6%.

There are a variety of reasons to discount today's strong report on durable goods orders for July, but the report will nonetheless increase doubts over whether the Federal Reserve will lower interest rates again.

The Fed wants to be seen as responding to weakness in the economy, or at least the likelihood of such, rather than be seen as responding to volatility in the financial markets. The durable goods report hence weighs on the side of reducing the chances for a Fed rate cut, even with the many caveats for the report's strength.

The biggest reason to discount the durable goods report is recent events. Not only will the financial market volatility reduce business confidence, it has also boosted the cost of capital, owing to sharply increased costs for capital.

This will discourage the purchase of capital equipment, not only because costs on an outright basis have increased, but because the increased costs will be seen as too high relative to the rates of return that could be generated on new investments. In other words, increased costs of capital are colliding with what many will see as decreased rates of return related to what could well be a much different economic climate.

The Fed would rather cut rates in response to signs of weakness in the U.S. economy, or at least signs that it is headed toward weakness, which makes today's report a negative from the standpoint of the likelihood of Fed rate cuts. The report won't be enough to quash hopes of a cut, of course, as many other data points are enroute.