Stocks Reverse Course After Touching 3 Yr Highs….”Thanks A Lot Bin Laden”. Oh and And A Sell in May and Go Away Structure for AAPL Holders

by Dan May 3, 2011 7:25 am • Commentary

While I am very glad to hear of the unpleasant demise (shot in the eye!) of the above mentioned evil-doer, as far as the markets go, I do find the whole thing a bit anti-climatic. Heck, I still have my “Wanted” insert of him from the NY Post, circa 2001, hanging in my closet.  The markets weren’t quite sure what to make of it. They have all but forgotten what to do with the “we got Osama rumors” that were very prevalent in late 2001 to sometime in 2003 and would cause a 50 bps to 1% surge in the major indexes, just to have them quickly retrace the move on the official denial.  Bare with me this morning as I engage in a bit of a think piece, BUT I PROMISE THERE IS AN AAPL TRADE STRUCTURE BELOW….

The SPX‘s reversal yesterday from the highs, even though it was only less than 1% (peak to trough) may signal that we are about to enter a cooling off period…..lets think about where we have been and what we know and we we are headed fro…..

1. In March, as most market participants anxiously anticipated Q1 earnings to confirm their bullish views, Japan was hit by an unthinkable disaster causing many to take pause….global markets acted in a very rational and orderly fashion after a little 6% draw-down and have since made new multi-year highs…..

2. Those very earnings results that are in for more than 60% of the S&P500 have demonstrated fairly strong earnings trends, but lack the revenue growth necessary for a sustained recovery (in my humble opinion).  Most companies are managing costs well in an effort to fight higher input costs and passing through costs to consumers where possible, but they are generally not hiring, they are buying back stock or buying other companies which are helping their stocks and could result in more job cuts.

3. The diligent inflation slayers at the fed have successfully got the markets convinced that the end of QE2 won’t really be the end and that they will be able to deliver the soft landing as they head into a regime of tighter fiscal policy…..chances of that are slim to none…exhibit A. and B. the last 2 asset bubbles caused by the fed in the late 1990s and the early to mid 2000s…it is unavoidable and they know it…..fun parlor game is just speculating on what the next bubble will be?? (best Onion article ever)

4. Geopolitical stuff is picking up some steam in the background, as the situation in Libya rages on, new Egyptian coalition instigating situation with Israel and a recently politically realigned Palestine, Syria slaughtering hundreds of their citizens in the streets and a bunch of other situations still brewing…..the markets cared about this at one point this spring and may do again when we get a slow news cycle…….

5. GDP….hmmm, the dollar, commodity prices, housing (uck), continued sluggish employment……Trump for President……ok sorry that was a low blow, but a lot of things point to me to a slower 2nd half and with the major indexes up ~8% ytd we could see the markets start to anticipate this…..As for earnings guidance, there is no reason why you should believe these company’s, they have every reason in the world to ALWAYS offer the rosiest picture they can get away with, (see RIMM from last week) and usually they do.

So I obviously remain bearish, there are just too many headwinds for the markets near-term, but in an effort to brief I just listed the ones that are bugging me this morning…………I promise I will continue to look for opportunities on the long side when I see them.  For now I believe portfolio protection is of utmost importance…..It is easy to become complacent after a period of strong gains……re-evaluate why you own things and for what time horizon, if you cant remember then consider lightening up…..the markets are not going to just go straight up and close on the highs of the year….we will have another test from a high that could be 5-10% peak to trough.

TRADE EXAMPLE TO PROTECT GAINS IN A CONCENTRATED LONG POSITION.……EVERYONE HAS THAT STOCK THAT THEY WILL NEVER SELL….IT’S GONNA PUT MY KIDS THROUGH COLLEGE”…..WELL YOU CAN CERTAINLY LOOK TO BE TACTICAL AND ANTICIPATE VOLATILE PERIODS IN THE MARKET AND LOOK FOR PROTECTION THAT STILL OFFERS UPSIDE.

Lets use AAPL as an example (we get a lot of questions about this name)…….say you have enjoyed gains in stock and you find yourself nervous through the summer…..you got a little “Sell in May and Go Away Fever”.  You could look to collar your gains, offering continued upside, but also offering some downside protection.

-stock is up 7% ytd and almost 45% from Sept, 1 2010.  Maybe you see the situation around Job’s health, continued competition in the tablet space and the potential of a push out of an iPhone 5 to early next year as a short term reasons to be cautious.  Consider protective structures against a long position.

AAPL (stock ~346.00)  SELL the AUG 380 Call to BUY the AUG 340 / 315 Put Spread for about.30

-Sell the Aug 380 Call at 8.60

-Buy the Aug 340 Put for 18.00

-Sell the Aug 315 Put at 9.10

Break-Even on Aug Expiration Against a Long:

Upside: btwn 346 and 380 (at the money to up ~10%) enjoy gains in the stock less the .3o premium that you paid for the structure.  Above 380 your long stock is called away up about 10%.

Downside: btwn 346 and 340 (have up to 6.00 losses in the stock plus the .30 premium), btwn 340 and 315 (down ~1.7% and 9% your long stock is protected)…..BELOW 315 you have no further protection, but you have mitigated 31.00 of losses and paid very little for it…..

TRADE RATIONALE: The stock that you will never sell but get nervous about from time to time is the perfect name, especially if a concentrated position for your portfolio to employ such a strategy with, but to be used tactically.   The biggest risk to this sort of structure is that the stock rallies more than 10% btwn now and August expiration and your stock is called away…..REMEMBER, IF THIS HAPPENED BECAUSE YOU SOLD A CHEAP CALL AGAINST YOUR LONG STOCK THEN SHAME ON YOU, BUT IN THIS INSTANCE YOU USED THAT PREMIUM TO BUY VERY NEAR THE MONEY PROTECTION, INTO A PERIOD THAT YOU THOUGHT COULD BE VOLATILE……..THIS IS A RISK MANAGEMENT TRADE, IN PLACE OF AMBIEN TO HELP YOU SLEEP AT NIGHT.