The Dow Jones Industrial Average closed the week having made two new all-time highs. Factors weighing into the bullish sentiment were a plunge in oil, further evidence of the Fed on pause and a huge week for tech on the heels of Apple's (AAPL) introduction of the iPhone on Tuesday.The bulls were further enthused by a strong start to earnings season with stronger-than-expected results and/or guidance from Alcoa ( AA), Genentech ( DNA) and Sears Holdings ( SHLD) most notably. Once again, RealMoney's bloggers were all over the market action, and we'd like to share the best of their commentary this week with readers of the 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 whether you have to like a stock to trade it, Cody Willard on "the place to be" in the markets, Steve Smith on option trades for takeovers and Tony Crescenzi on oil and the consumer.
The excitement over the iPhone makes me cringe, and I dislike the fact that the stock has a fanatical following. But that doesn't stop me from buying the darn thing when I think the time is right for a trade. I believe the market is very extended and going to start to roll over next week as earnings hit. That doesn't mean I'm holding shorts and sitting on piles of cash. In fact, I'm long and buying stocks today. Just because I don't share the love that some have for the market doesn't mean that I don't respect the fact that the bulls are in control. I've often found that the attitude of buying while I hold my nose works very well for me because it ensures that I don't overstay my welcome. I like to say that there are no good stocks or markets. They all are out to get us at some point, and we better keep that in mind as we consider them each day. So yes, I'm cautious and fail to have any great love for this market while at the same time I'm buying. That is what I do, because that is what has always worked for me. If you need to have your bullish view of the market confirmed by wild emotions and proclamations of wonderfulness, I'm not the guy you want to read.
As I've been saying since early last year, when I first
started talking about the potential for an echo techo bubble for 2007 and 2008, I think tech and Vista-related names will be big beneficiaries of this macroeconomic and monetary setup. On the flip side, the economy might get going again and the Fed will have to hold rates steady. Such a scenario would probably be healthier for the economy and the markets in the long run anyway, as it would help preclude the Fed from continuing its roll in inflating new bubbles. And I expect tech would still lead in 2007 and 2008, in large part because of Vista and a continuing broader Internet boom. The biggest hope for the bears is that energy takes back off and inflation gets spiky as the broader economy softens further. And they have to hope that the Fed would actually show a backbone in fighting inflation in such an environment. I'm not sure that's a good bet, even though a profligate Fed in such an environment would really create bigger problems for the broader economy sooner than any of us would want. So what's the point? This top-down risk/reward analysis sure points us toward thinking that tech is the place to be in 2007 and probably in 2008. At the time of publication, the firm in which Willard is a partner was net long Microsoft, although positions can change at any time and without notice.
A better bet is to focus your attention, and dollars, on companies already in play, such as Harrah's ( HET), or those that are courting suitors, such as Foot Locker ( FL). It might mean lower returns, but it offers a much higher probability of turning a profit. And the last time I checked, consistent hitters Cal Ripken and Tony Gwynn are heading to the Hall of Fame, while home run "king" Mark McGwire will be riding the pine of shame into retirement. The obvious lesson is don't swing for the fences. Be patient and wait for a situation that offers not only a reasonable risk/reward, but also a quantifiable edge.
It's crucial, and advantageous, to understand what happens to the option prices on a company once it agrees to a merger/takeover/buyout: Once a deal is agreed to, the implied volatility, or time premium, collapses. That is, options that are out of the money will be essentially worthless, and in-the-money options will be priced at their intrinsic value. Remember, the bulk of an option's value stems from the right to buy or sell a stock at a set price -- the strike price -- during a given time period defined by the expiration date. Once terms of a deal are agreed upon, those variables are eliminated, and so, too, is the price premium awarded to the options. Jan. 9 video, one of the best ways to play the possibility of a takeover is to sell a calendar spread. The video used Gap ( GPS), which recently hired Goldman Sachs to explore a sale, as an example. In this case, I suggested buying the March $22.50 call for 40 cents and simultaneously selling $22.50 calls with a January 2008 expiration for $1.50 per contract. This gives the position a $1.10 net credit for the calendar spread. Because talks are still in very initial stages the longer term, or LEAP, options still retain a significant amount of time premium. But if Gap does agree, or even hone in on the terms of sale before the March 16 expiration day, then expect the implied volatility or time premiums to collapse across the board.
The result will be that the value of the March and the January 2008 calls will trade at nearly equal values, meaning the value of the calendar spread will contract or flatten out. This will be true regardless of the price of the deal; if price is only $20, then both options will be worthless; if there is a 30% premium to $26 per share, then both call options will be worth $6 per contract. In each case, the value of the spread will be close to equal, allowing you to collect that $1.10 premium, which represents the position's maximum profit. The risk, especially in a case like Gap, which is still in the early exploration stages, is that the timing, terms and pricing are far from set. In fact, the company might consider spinning off certain units. That means if no deal, parameters or even intentions are clarified by the March expiration date, the position will be exposed to incurring a loss. The 2008 LEAP options that you've sold short will maintain their time premium and potentially increase in value while the near-term March options you own will expire, possibly worthless. To avoid winding up with a naked short position, it is imperative to close the position before the March expiration or roll those long calls into a later month. My advice in Gap would be to wait and see if some more details emerge regarding any potential deal. Even after a proposal is put on the table, it is not too late to benefit from this sale of a calendar spread strategy. The key to the trade is establishing the position in the window between when a deal is still just a proposal and its consummation.
The position I established consisted of buying the February $35 calls and selling the August $35 calls for a net credit $1 for the calendar spread. If a deal is agreed to prior to the Feb. 16 expiration, the time premiums should collapse, the spread will contract and the position will earn the $1 profit of the net credit collected. If no headway is made by the second week of March, I'll close the position to avoid ending up naked short the August calls and at the mercy of a rising IV or stock price. But at the moment, with the firm proposal on the table, I like my odds of squeezing out a profit during the time period of very limited risk.