Thursday, January 28, 2010

Microsoft Earnings Play 1/28/10



Microsoft reports earnings tonight after market close.  It is quite remarkable that Microsoft implied volatility in the front month is elevated to highest level in 52 weeks.  At-the-money $29 straddle is going for $2.10.  This is huge because if you really believe the straddle is cheap, then you expect Microsoft to make a monster 7.2% move in either direction.  Given its large market cap and weighting in Nasdaq, you bet a move like that would move the index significantly tomorrow.  


Looking at the daily chart you can see, Microsoft did make an almost 10% move to upside on excellent report last time they reported.  Last quarter, they beat earnings by nearly 25% (40 cents vs. 32 cents consensus).  I expect another monster quarter from Microsoft and beat on both top and bottom line.  While I certainly have a bullish bias, the move in the stock might be a bit subdued or muted due to general market sell-off we are currently under.  


With that said, I think the straddle is overpriced and I want to be a seller of elevated implied volatility.  Specifically, I like the following double diagonal calendar spread:


- Buy to open March $28 calls
- Buy to open March $31 calls
- Sell to open Feb $28 calls
- Sell to open Feb $31 calls


As of this writing, the whole spread is going for a debit of $0.42.  Currently, Feb IV is at 35 and March at 29.  Tomorrow morning, I expect both Feb and March IVs to collapse and settle around 25, which actually might be conservative considering that the VIX is elevated as general market continues to sell-off.  


If you adjust the IV to 25, the hypothetical P&L chart on the trade shows break even points of $27 on the downside and $32 on the upside.  I like the odds.


Good luck!

Wednesday, January 27, 2010

Buffalo Wild Wings (BWLD)

One sector that hasn't been getting much press despite performing well in 2009 is restaurants.  I have already suggested a trade on Chipotle Mexican Grill (CMG), but here is another one.  


Until two years ago, this used to be a great momentum stock due to its consistent performance in top and bottom line.  But as valuation got overextended, the stock has been digesting gains for past two years.  The stock currently trades at slightly less than 22 times 2010 earnings, which are expected to grow 22% YOY.  This compares to 23 times earnings for its peer group, which is expected to grow 14% YOY.  So, on a valuation basis, the stock is certainly cheap.  


From a technical standpoint, $45 used to be stiff resistance going as far back as early 2008.  After long consolidation from July to Dec 09, the stock finally broke out above $45.  The only caveat is it did so on decent but not impressive volume.  I can't call this a bullish breakout or a bear trap, but the longer it spends time above $45, the stronger the chances that this is about to fly.  


Recent actions and opinions:
- Jan 22, 2010 Stephens initiated the stock with an Overweight and $60 price target
- Jan 14, 2010 MKM Partners upgraded the stock to Buy
- Jan 11, 2010 the company reiterated expectations for 20% EPS growth in 2010
- Jan 11, 2010 Morgan Keegan upgraded the stock to Outperform


Earnings come out on Feb 8 and I think we could see sparks to the upside just like we saw with Panera Bread recently.  The volatility skew is already starting to build up, but it could be even better as we get closer to earnings date.  Nevertheless, I like June/Feb calendar spread:


- Buy to open June $50 strike calls
- Sell to open Feb $50 strike calls


The trade is going for a net debit of $2.10.  I want to buy the long options in June as it buys me a little more time if it is a failed breakout.  It also allows me to see one more earnings reports in April if I decide to hold longer.  Feb IV is currently at 44, while June is at 37.  


Good luck!

Tuesday, January 26, 2010

Gold (GLD) and Rangold Resources (GOLD)

I am bullish on gold long-term.  I don't think we're in a deflationary environment and I believe all this money printing by Obama administration will eventually show up in prices of common household items, food and other non-discretionary names.  That is, I expect rising inflation as the administration tries to inflate their way out of this recession.  


I also think the recent run-up in US dollar is nothing more than a dead cat bounce as perceptions are starting to surface that the Fed may very soon start withdrawing some liquidity measures that were put in place during the crisis.  With unemployment at 10% and still rising (albeit slower pace) and housing market still deteriorating, I just don't see how the Fed could suddenly change its lenient monetary policy.  I expect US dollar to resume its downward slide after this brief correction. 


It also wouldn't surprise me to see that as US dollar resumes its downward slide, more emerging markets join in along with India to diversify a portion of their foreign exchange reserves into gold.   


Fundamentally, all this is bullish for commodities.  From technical side, attached here is a long-term weekly chart of GLD.  After breaking above the converging triangle in Oct'09, GLD was off to the races and now have retraced and settled back around $107.  Despite the recent sell-off, the long-term rising trend line is fully intact.  I am watching area $103-105 and as long as this area holds, the rising trend is still intact.  


Now, lets look at the long-term weekly chart of Rangold Resources with symbol GOLD (not to be confused with GLD which is the commodity ETF).  There is a beautiful long-term rising support trend line fully intact since Oct of 2008, and today the stock closed right at this support line.  As in the past, I expect a bounce from here, but as a trader you have to be nimble because if the stock breaks down below $70 support, all bets are off.  


So, given my bullish outlook, and Rangold and the commodity itself near or at rising long-term support line, I think now is the time to play some bullish option trade.  I like the following trades:


GLD Vertical Bull Spread:
- Buy to open March $108 strike calls
- Sell to open March $112 strike calls, for a net debit of $1.50


GOLD Bull Put Spread:
- Buy to open March $65 strike puts
- Sell to open March $70 strike puts, for a net credit of $1.85


The P&L charts of both trades are attached. Just a quick note, my long-term followers know that most of the time I try to do option trades that benefit from time decay, i.e. trades have position Theta.  That's true, but the reason I am interested in doing a vertical bull spread for GLD above is because gold volatility which goes by symbol GVZ is at near all-time low.  Buying options to bet on a directional trade on gold is as cheap as it could be in last two years (see attached GVZ chart for reference).  


Good luck!

Monday, January 25, 2010

Amazon (AMZN)



This is not about whether you love or hate Amazon.  This is about making the most out of your money given Amazon earnings coming up on Thursday, Jan 28.  The stock has certainly enjoyed its run in past 12 months.  


Going forward, I think the stock is going to pause within the channel defined in the attached daily chart.  The implied volatility in Feb is elevated at 55 while March is currently at 48.  This is not a significant volatility skew, but it is enough to provide an opportunity to place a calendar spread trade.  At-the-money straddle is selling for $13.50 which implies almost 12% move in the stock by Feb expiration.  


Given my expectation that the stock is likely to pause here, I think the straddle is overpriced.  As such, I like the following calendar spread: 


- Buy to open March $125 strike calls
- Sell to open Feb $125 strike calls


The spread can be done for $1.70 as of this writing.  The break even points are $112 on the downside (about 7% cushion) and $139 on the upside (about 15% cushion).   


Good luck! 

Citrix Systems (CTXS)


On Sept 24, 2009, Goldman Sachs added Citrix Systems to its Conviction Buy list with $45 price target.  At the time the stock traded at $37.  On Oct 21, Citrix beat earnings expectations by 4% and alluded to 8-9% revenue growth in 2010.  Since then at least 5 analysts have come out and upgraded the stock with price target of $45 or higher.  


The reason why Citrix is catching my attention today is that earnings come out this Wednesday, Jan 27 and while the stock is slightly down, some large blocks of call buyers are showing up at Feb $45 strike.  The implied volatility in Feb is elevated to 45 and a total of 14,000 contracts have exchanged hands vs. 5,800 open interest, clearly implying opening positions.


This might be a straight speculative earnings play as $45 has been a strong resistance since Oct, 2009.  The implied volatility in March is around 38.  Taking advantage of the volatility skew, I like the following calendar spread going into earnings on Wednesday:


- Buy to open March $45 strike calls
- Sell to open Feb $45 strike calls


The spread can be done for a net debit of $0.35.  Given the volatility skew, the spread provides nearly 4-to-1 profit if CTXS closes at $45 on Feb expiration.  Potential P&L and daily charts are attached. 


Good luck!

Friday, January 22, 2010

Looking for a Bounce in First Solar (FSLR)



Ever since the rumors hit that Germany may cut solar subsidies by 15%, all solar stocks along with general market have fallen off a cliff. News from Germany may very well be legit, but I am not sure the extent of subsequent drop in solar names is warranted.


The attached daily First Solar chart shows very strong support right around $110-115 where it is trading at today. We have seen this level several times since Sept'09 and every time the stock has bounced from here. I think we can play for a bounce here on the long side.


I like selling the following Bull Put Spread:


- Buy to open Feb $100 strike puts
- Sell to open Feb $105 strike puts


The trade can be done for a net credit of $1.05 as I write this note. This provides 21% return by Feb expiration if the stock stays above $105. Notice you have 9% cushion on this trade to make 21% return, i.e. even if the direction of the stock continues downward, it can fall another 9% from here and you will still make money by Feb expiration. I like the odds.


Good luck!

Bearish on US Treasuries



It is not a surprise that any time when fear returns to the market, investors sell stocks and flock to US Treasuries for safe heaven. When bonds rally, yields go down as they're willing to accept lower interest rates. That's exactly what we have seen in the past 7 days. If you haven't understand me from posts yet, you should that I mostly like to play contrary to the market, unless the story is solid.


The yield on 10-year note has fallen from 3.85% to 3.6% in past seven days as fear has ramped up (check out VIX). I think now it is time to bet the other way. Morgan Stanley believes that by the end of 2010, yields on 10-year note will rise to 4.5% and I fully agree. Banks have been paying back TARP and Fed's commentary going forward will continue to raise questions about how and when to start pulling out liquidity measures such as backstopping banks' losses and 0% interest policy.


Attached is a daily chart of TLT which tracks US 20-year bond performance. It is not there yet, but it is real close to hitting the upper band of well-defined resistance line. I think it will stall there and go right back down. TBT is 2x inverse of TLT. I like to play long TBT with the following calendar spread:


- Buy to open Mar $50 strike calls
- Sell to open Feb $50 strike calls


The whole trade can be done for a net debit of $0.39 as of this writing. This creates a range of $47.50 and $52.50.


Good luck!

Thursday, January 21, 2010

Google (GOOG) Earnings 1/21/10



Google report earnings today after hours. The stock has fallen about 5% in last two weeks ever since Chinese started the scare. The attached chart shows a very well defined pattern that has been in tact since March 2009. I am willing to bet that earnings will be good and the pattern will remain in tact. However, given the negative tape in the market, after some knee jerk reactions, the stock is likely to just stay range bound between $550 and $600.

Given the rise VIX today, I believe the IV of high beta stock such as Google will remain elevated in outer months. Thus, I want to do the following Double Diagonal Calendar Spread:

- Buy to open Mar $550 strike puts
- Buy to open Mar $600 strike calls
- Sell to open Feb $550 strike puts
- Sell to open Feb $600 strike calls

The whole trade can be done for a net debit of $9.50 as I write this. The attached hypothetical P&L chart shows break even points at $525 on the downside and $630 on the upside. I like the set up.

Good luck!

Goldman Sachs (GS)



Goldman reports fantastic and it gets no love in the market. Let me just remind my readers that Goldman earned $8.20 vs. $5.20 per share in 4Q09. They're well on their way to earn $25 in 2010 if you have even a mediocre recovery in the economy. That puts a forward P/E multiple of 6.5x. Even during the worst of financial meltdown when Goldman traded as low as $40 in spring 2009, Goldman never traded below 6x forward multiple.

The only reason for sell-off today is constant negative rhetoric coming out of D.C. I wouldn't be surprised if Goldman gets together with Buffett's of the world to take the company private to stop bashing by our politicians.

From technical standpoint, Goldman's daily chart shows strong support at $157. A close below that could quickly take us to $150. And if we get to $150, the forward P/E will shrink to 5x, a historical low. I don't believe we will see below $150 and I want to take advantage of today's sell-off. I'd love to own Goldman below $150 and with that said, I like the the following Bull Put Spread:

- Buy to open Feb $145 strike puts
- Sell to open Feb $150 strike puts

The trade can be done for a net credit of $1.20, which produces a profit of 24% as long as Goldman stays above $150 by Feb expiration. I like the odds and I love the name. P&L and daily chart are attached for reference.

Good luck!

Apple Earnings on Monday (1/25/10)



Apple reports earnings on Monday. Ever since IBM reported earnings, traders have taken tech stocks to the woodshed. I think Apple will report a blow out number and given how bad the tape has been for two days, I'll take the other side and play on the long side with the following conservative play.

I like the following Bull Put Spread:

- Buy to open Feb $190 strike puts
- Sell to open Fen $195 strike puts

The trade above will produce 26% return as long as the stock stays above $195 by Feb expiration. If it falls below $195, the whole vertical spread can be rolled over to Mar or I would love to own Apple below $195. The potential P&L chart and daily charts are attached.

Good luck!

Wednesday, January 20, 2010

Resting Period for Freeport-McMoran (FCX)?

All commodity stocks are pulling back 2 to 3% today on the back of news from China that they might withdraw some of their economic stimulus. For now it is just news and the chatter on the street. More than 80% of the time, I take all the chatter on CNBC with a grain of salt.

Anyway, FCX is one of them that is pulling back. They report earnings tomorrow, Thursday, morning before the market opens. After fantastic gains in 2009, I think FCX is ready to pause and digest some of those gains. I also believe this "pause" could last many months to come.

Looking at the daily chart and support and resistance lines, I expect FCX to stay within its 52-week high of $90 and previous double bottom in mid-Dec of $75. So, I want to establish a trade that benefits the most if the stock stays in this range. I like Double Diagonal Straddle Swap:

- Buy to open Mar $90 strike calls
- Buy to open Mar $75 strike puts
- Sell to open Feb $85 strike calls
- Sell to open Feb $80 strike puts

The whole trade can be done for a net credit of $1.00. As with all my other trades, I always favor a set up that has positive Theta and this FCX trade is no different. The attached P&L chart shows $75 and $90 break even points. I have also marked this range in the daily chart.

Good luck!

Rambus (RMBS) Calendar Spread


Yesterday, after the market closed, RMBS announced $500 million settlement with Samsung related to DRAM rights. The stock is up 13% today. You would think that now the news is out so the implied volatility should collapse, however, the Feb IV is still elevated at 70%. Investors want to know who is next. Samsung has set a high bar and now Micron, Hynix and even Nvidia are in focus.

I believe the IV will remain elevated. Feb $25 strike straddle is going for $4, so traders still expect 10-15% move by Feb expiration. Assuming we get that kind of move, the stock is still likely to stay range bound with $20 and $30.

I like the following Double Diagonal Straddle Swap trade:

- Buy to open Mar $30 strike calls
- Buy to open Mar $20 strike puts
- Sell to open Feb $25 strike calls
- Sell to open Feb $25 strike puts

The whole trade can be done for a net credit of $2.05. The theta is in your favor as long as Mar IV holds ground, which I think it will given further anticipation of settlements with other companies. The hypothetical P&L chart is attached.

Good luck!

Tuesday, January 19, 2010

United Health (UNH)



The entire group of health insurers rallied on Monday based on favorable outcome of MA Senate elections. Leaving all the political bickering aside, purely from a technical standpoint I think the stock is a bit overextended here and a pull back towards $30 is reasonable. There is heavy support at $30 which should hold. Long-term weekly chart is attached. I like the following calendar spread:

- Buy to open Mar $32 puts
- Sell to open Feb $32 puts

The trade can be done for a debit of $0.30 as of Monday's closing prices and provides nearly 3-to-1 return if the stock drifts lower to $32 by Feb expiration. In case the upward momentum continues, I would exit the trade if the stock breaks $38, which is current resistance, on greater than daily average volume.

What Does Future Hold for Garmin (GRMN)?

I have long argued going back to 2006 that Garmin's product line has reached a saturation point. Coincidentally, just as I was making my case, several hard core Garmin longs were arguing quite the contrary that Garmin product lines have reached the inflection point to appeal the masses like iPod did once. In old days, I shorted the stock just above $100 and carried it all the way to $36 before finally closing out.


So, what now? I still firmly stand by my arguments. Garmin has blown every possible chance they had to make Nuviphone even a remote hit. That was the only product that could've carried the momentum further, however well after Garmin's announcement we've had Palm, HTC, Samsung, Motorola and now Google all crawling into that space with Apple taking the lead.


I will refrain from repeating plethora of fundamental research I have done in the past to arrive at my judgement. For those interested, you can search on Yahoo! message boards under spoiler79 going back to 2006. Instead, lets look at the short-term trading opportunity here.


Garmin fell off a cliff on 10/28 and again on 11/14 in 2009 based on poor earnings guidance (anyone surprised?). Garmin stated that 4Q09 sales will be softer than 4Q08. Here is a short summary from Reuters:


"Garmin, which posted a surprise rise in third-quarter profit, now expects to sell fewer units in the key holiday season quarter than it did last year, indicating that it expects weak demand. Shares of the company dropped almost 14 percent to as low as $27.14 in afternoon trade on Nasdaq after the weak forecast. They had risen about 10 percent when the company posted a profit that blew past market expectations. "The (third-quarter) beat, as impressive as it is, will likely do little to ease investor concerns about the sustainability of the PND business in a world of free Google mobile navigation," analyst Yair Reiner of Oppenheimer & Co said. "Against that backdrop, some holders may use any strength this morning as a pathway to a clean exit."


From a technical standpoint, Garmin shares are rallying today on rumors of potential buy-out by Microsoft. Nice try market makers!! The stock has almost entirely closed the gap from 10/28 and now forming a double top on daily chart (see attached). There is tremendous amount of congestion between $38 and $40 and with no earnings expected before Feb 23, it will take a lot of buyers support to clear that congestion if it were to rally further from here. I am going to use today's rally to build the following neutral-to-bearish Skip-Strike Butterfly. Specifically:


- Buy to open 20 contracts of Feb $40 strike puts
- Sell to open 30 contracts of Feb $38 strike puts
- Buy to open 10 contracts of Feb $37 strike puts


The whole position can be done for a net debit of $2.10 as of this writing. The position remains profitable as long as the stock remains below $39 (see attached) by Feb expiration. The position size can be changed as long as the combination of contracts remains unchanged to maintain the same P&L profile.


Good luck!

Is Hartford Financial Services (HIG) undervalued?



Hartford Financial provides investment products, individual life, group life and group disability insurance products, and property and casualty insurance products in the United States. On Jan 12, HIG pre-announced 4Q09 core earnings of between $1.45 to $1.60 per diluted share. This was significantly higher than consensus of $0.83. But the pre-announcement includes about $0.26 gain related to after-tax DAC unlock benefit. Even without that one time gain, HIG easily beat the estimates and after an initial spike to ~$28.50, the stock has settled below $28.

On the fundamental side, here is an excellent piece by Credit Suisse regarding this announcement:

"In terms of valuing HIG, it currently trades at just 6x the high end of its normalized 4Q09 guidance, and 7x the low end, below both the life insurance (8.5x) and P&C peer averages (8x) using 2010 as the base case. We suspect the high end of this EPS range of $4.00 and $4.60 won't be viewed as relevant for forecasting future EPS though due to what likely to be an unsustainable level of P&C results. If we further examine peer multiples and consider that HIG closest competitor on the life insurance side, LNC trades just below an 8x P/E and some of the larger peers on the P&C side that aren't repurchasing shares (ALL and ACE) trade below 8x and 7x, respectively, we think an 8x P/E is too high, though a 7 to 7.5x P/E makes sense. Adding all of these variables together, we are sticking with our price target of $29, despite the increase in EPS estimates."

Despite the fact that the analyst didn't change the target price, there are two positives to be considered. One, the analyst community is bound to increase forward EPS estimates for 2010. Even without expansion in P/E ratios, the raised EPS should put a floor under the stock. Secondly, I expect HIG will provide in near term its plans to pay back $3.4 billion TARP through equity raise or by other internal means. As CS points out, that will actually be accretive to EPS as preferred dividend of 7.4% after tax will be eliminated.

Bottom line is I believe the stock is cheap relative to peers considering potential upside in EPS, below industry-average P/E and only 0.7x book value vs. industry average of 0.9x. The company reports earnings on Feb 8 and I believe the management will provide further clarity into 2010 which could follow analyst upgrades.

I will be a buyer going into earnings on Feb 8. However, I want to do this with a conservative option play. As such I like the following Skip-Butterfly trade:

- Buy to open 20 contracts of Feb $25 strike calls
- Sell to open 30 contracts of Feb $27 strike calls
- Buy to open 10 contracts of Feb $28 strike calls

The whole trade can be done for $2.20 debit as I write this note. The potential P&L chart for this trade as well as the daily chart of the stock is attached. The trade assumes that $26 will hold through Feb expiration as that was the level before HIG pre-announced. Additionally, the trade remains profitable if the stock stays here or goes further up.

Good luck!

Potash (POT)



As I write this note, POT is selling off in a good market this morning, now trading down just under $114. I would be a buyer in this weakness. First a quick recap:

- On Dec 18, Scotia Capital went positives on Ag names on the back of raised estimates for China potash prices to $400/ton.
- On Dec 20, Barron's put out an article stating that Mosaic shares could rise 40% as arable land continues to decline and world consumption of food continues to go up.
- On Dec 21, Goldman Sachs upgraded POT to its Conviction Buy List. Specifically, Goldman said a "near-worst-case" scenario on 2010 potash pricing is reflected in potash valuations and that they continue to expect a fundamental potash demand recovery in 2010. GS price target is $138.
- On Dec 22, National Bank Financial upgraded Potash to Outperform.
- On Dec 23, Belarusian Potash said it expects the American potash market to improve and that it is getting positive demand signals from Asia, according to Bloomberg. It also sees interest from Brazil for January potash.
- On Jan 5, Credit Suisse upgraded Potash to Outperform on the same thesis as Goldman Sachs with price target of $135.
- On Jan 6, Mosaic in its earnings report suggested increasing potash sales in 2010.
- On Jan 8, Bloomberg reported that the competitor K+S to increase potash prices by at least 10% Euros after Feb.
- On Jan 14, Barclays initiated Potash with Overweight rating and price target of $137.
- On Jan 15, RBC Capital raised price target of $150.
- Today, On Jan 19, Broadpoint provided positive commentary on potash demand.

So, that's plenty of positive commentary on the street. However, the reason why POT has taken a slight hit since last week is because Dec crop inventory report was weak and Citigroup and UBS used that as a proxy to go neutral-to-bearish on Ag names. But as other Tier 1 analysts have suggested, this story is about 2010 and not about what happened in 2009.

From technical standpoint, the daily chart gives us a great set up. There is a rising trendline that is nicely intact since early Nov. The support is clearly right around here at $114. I would be a buyer of POT at this level with a tight stop at $113.

If you want to do it through options, I like selling the following Bull Put Spread:

- Buy to open Feb $105 puts
- Sell to open Feb $110 puts

The trade can be done for $1.60 as I write this which provides approx 32% return by Feb expiration as long as the stock remains above $110.

For more conservative traders, a similar Bull Put Spread can be done using 100/105 puts which gives you more cushion to the downside and still provides approx 18% return by Feb expiration.

Good luck!

Monday, January 18, 2010

Chipotle Mexican Grill (CMG)


I love this growth story and their food. As of the end of 2009, CMG operated 900 restaurants with more than 90% of them in the US. A few highlights from the last quarter:

- 3Q09 revenue rose 14% y/y to $387.6 million and same-store sales grew 2.7% driven mostly by 6% increase in menu prices. This contrasts with declines at other casual dining chains. Earnings grew 83% to $1.08 in 3Q09 from $0.59 in 3Q08.
- Management reiterated its goal to ultimately open 3000 restaurants in the US and worldwide with expansions in London, Toronto, Germany and France already under way. The company also expects to introduce lower-priced kids menu, soups and salads to boost revenue going forward.

CMG has consistently performed at 25% growth easily surpassing the industry average of 13%. Currently, CMG shares trade at 21.5x FY2010 earnings estimate vs. industry average of 22. Given its growth rate and PE relative to industry, I believe CMG is trading at a very reasonable valuation.

On Jan 8, 2010, Morgan Stanley upgraded the stock to "Overweight." Here is the link: http://finance.yahoo.com/news/Chipotle-shares-jump-on-apf-2628739333.html?x=0&.v=1

Three days later, on Jan 11, 2010, Deutsche Bank upgraded the stock to "Buy." Here is the link: http://www.marketwatch.com/story/chipotle-panera-ruths-upped-by-deutsche-bank-2010-01-11?siteid=yhoof2

Then three days later, on Jan 14, 2010, Wells Fargo upgraded the stock to "Market Perform." Here is the link: http://finance.yahoo.com/q/ud?s=CMG

Given all these upgrades, the stock is on the cusp of breaking out. A break above $100 on above average volume could take it quickly to $120 which is prior resistance going back to early 2008. MACD, Stochastic and RSI are also slightly turning to the upside. Attached here is a long-term chart.

I like to play it to the long side with the following calendar spread:

- Buy to open Jun $110 strike call
- Sell to open Feb $110 strike call

The trade can be done for a net debit of $3.05 based on Friday's closing prices. The long open is far out in June so it gives us several more months to roll short options in case it doesn't pan out in Feb. The hypothetical P&L chart is also attached.

Good luck!

Bank of America (BAC) Earnings 1/20/10


Bank of America is scheduled to report earnings this coming Wednesday, Jan 20. I am going to leave much of the fundamental picture out of this discussion and instead just reference my earlier post regarding JP Morgan's earnings. Overall I expect mediocre to slightly bearish earnings at best.

From technical standpoint, BAC has nicely held $15 support line since late July 2009 with the exception of late Oct sell-off for a few days. Also, much of potentially negative reaction (if there is going to be one) may already be priced into the stock now as JPM earnings is already behind us. Therefore, the best trade here is sideways reaction in my opinion. Bank stocks cannot continue to rally with shrinking balance sheet and unemployment at 10%.

I like the following Double Diagonal Swap:

- Buy to open May $18 strike calls
- Buy to open May $15 strike puts
- Sell to open Feb $17 strike calls
- Sell to open Feb $16 strike puts

The whole trade can be done for a net debit of $0.53 based on Friday's closing prices. Two things I like about this trade:

1. Currently, at-the-money straddle is selling for $1.44, which means market participants expect about 8-9% move in the stock by Feb expiration. However, as the attached P&L chart shows, the trade would remain profitable for up to 11% move on the upside. On the downside, the break even is $15.25 which is close to 6-month support line.

2. Since the long options bought are far out in May and VIX is at 2-year low, any return of fear in the market should see the Implied Volatility rise benefiting the long option. Lastly, Feb options could be rolled over to Mar and then to Apr based on the risk preference towards the end of Feb expiration.

Always remember that you must know the reasons for getting into a trade and you must understand the reason for staying in it longer than desired time frame. I will return back to this trade after BAC reports to re-evaluate those reasons.

Sunday, January 17, 2010

So, What Did We Learn From JP Morgan Earnings?

I will cut the obvious from headlines all over the internet about JP Morgan's earnings and go straight to the most important aspects as they apply to other banks when they report this upcoming week:

1. The Retail Banking revenue was flat q/q and y/y as the re-pricing of higher rate deposit accounts and increased debit card income was offset by lower deposit related fees, time deposit balances and investment sale revenues. There is probably nothing to worry here, but in larger scheme of things a truly robust and improving economy should see rising banks' deposit base. But that was not clearly evident in JP Morgan's earnings. I don't see how Bank of America, which has the largest consumer business segment of any banks, would be any better than JP Morgan.

2. Consumer Banking sector was negatively affected by higher credit costs of $4 billion which includes an increase of $1.5 billion in loan loss reserves. Again, at least in the mindset of investors, JP Morgan is supposed to be the best of breed, yet there is still no end in sight when it comes to increasing loan loss reserves. Two years ago, an increase of $1.5 billion in loan loss reserve would have sent investors to the exit doors in a panic. But we have become accustomed to that. To add more fuel to fire, here is current thinking by Credit Suisse:

"Going forward, production and run-offs in the Home Lending Portfolio could result in a 10-15% decline (or estimated $240 billion in 2010 and $200 billion in 2011) which would reduce 2010 net income by approx $1 billion. Our 2010 forecast contemplates mortgage revenues down by 20%."

No matter how you try to milk this, it does not portray good for Bank of America, which also has the largest home loan portfolio through its acquisition of Countrywide.

3. Total Investment Banking business revenue was down 34% q/q. Specifically, lower revenues were attributable to a q/q decline in fixed income which went from $5 billion in 3Q09 to just $2.7 billion in 4Q09 due to lower volume and tighter spreads. It is important to note that 40% of all Goldman Sachs revenue comes from fixed income trading. If JPM had such a bad quarter, there is no reason to assume Goldman was simply eating JP Morgan's lunch. I would argue that it was industry wide as spreads across all products have in fact tightened. This does not bode well for Goldman and hence the reason why Meredith Whitney has been busy taking down estimates for Goldman for last several weeks.

The bottom line is JP Morgan managed to beat expectations when it reported earnings on Friday despite lower revenue. And it did so on sharply lower manageable operating expenses. If I take a page out of JP Morgan's earnings, I see Goldman's results will be soft due to sluggish Investment Banking, and Bank of America's earnings will be soft due to shrinking balance sheet, still deteriorating home loan portfolio and poor Consumer Banking business. The shrinking of balance sheet to me is most concerning. This should not be the case if there was true underlying improvement in the economy.

In my mind, the banking sector is the back bone of our economy. Leaving aside short term and temporary discrepancies in pricing in the market, in general the market just cannot rally without help from the banking sector. Given the plethora of banks' earnings coming out this week, I expect mediocre to slightly bearish results at best. And with this stance, I'll be presenting my trades for certain bank stocks going into their earnings.

Stay tuned!!