This just in from the holy shit department.

http://www.etfexpress.com/2009/11/17/kelly-capital-launches-100x-leveraged-etfs

100x leverage is insanity. This product is just looking to give ETFs a horrible name.  Now you're going to hear the news about Johnny Investor going broke because he used ETFs as a vehicle.  Naturally, the particulars of the ETF will be left out giving the whole ETF industry a bad name.  I suppose we all know that ETFs aren't going away and people who take the time to understand the products and avoid crap like this will come out ahead.

UPDATE: This appears to be a hoax.  http://www.jasonkelly.com/2009/11/first-100x-leveraged-etfs.html

Funny.

So far it's almost been like clockwork with this new trading system.  I mentioned that it averaged about a trade a month, and so far it's done that almost on the nose. Since this is a mean reversion system, the recent downdraft has flagged buys across the board. The averaging part of that statement should be paid attention to. Sometimes when the market is dive bombing, the system will flag a couple of days in a row as opportunities. Then in straight up mode, none for months. So I would consider this luck, so far. It could flag a trade or two this month.

So back to the trade at hand, SPY, QQQQ, IWM and DIA are all flagged. I reviewed all four and the credits on SPY and IWM were the best even though they weren't necessarily the most volatile. In fact, I would say QQQQ is probably the most volatile of the bunch but it yielded the worst credit. The second thing to consider is that the SPY NOV trade is still on, so do I want to expose myself to additional SPY risk? Well, IWM and SPY are pretty tightly correlated and the SPY has a little less volatility, so this becomes a pretty tough call. My plan is to take the IWM trade today and maybe the SPY trade tomorrow if we continue lower. Here's how they look.

 First IWM.

iwm-vertical-spread-dec-2009.png (43.70 kb)

And now SPY

spy-vertical-spread-dec-2009.png (45.00 kb)

Hopefully you're getting used to seeing the P/L structure of verticals. Each of these yield about the same credit and the distance between strikes is $2.00, which puts about $1.67 at risk.

Now the next trick is getting filled. The futures are pointing up slightly this morning, so a gap up may put these credits out of reach, but hopefully the market will rattle around enough today to fill. Things are changing rapdily as volatility has come back.

Will keep you up to date on the progress.

DISCLAIMER: This is not a recommendation to anyone to buy or sell.  I'm not a professional and I don't have much sense, so following me is hazardous to your finanical health.  The point of the post is to share ideas and hopefully get some feedback so that we can all improve our understanding of the subject.

A regional idea.  Georgia was under a "severe" drought over the last 2 or 3 years.  Yes, I put the severe in quotes because I wasn't a believer, but that's another debate for another day.  What was serious is that a mini-war amongst states began.  Alabama and Florida started bitching and complaining about Georgia not letting enough water down the Chattahoochee River which is their fresh water source.  This went to court and became front page news for many months until the ruling came down against Georgia.  We could not withhold water from the downstream states.

Fast forward to the last few months where we've seen floods and we're close to setting an all time rainfall record for the month of October.  Now we're talking "negotiations" and other civil means for dealing with neighboring states and water.  This was less than civil just a few months ago.

Rainfall averages are just that, averages.  Like the market, from time to time, they will deviate, sometimes wildly, but eventually the snapback will happen.  When the news here was that Atlanta could possibly be a desert, I wanted to be long rain.  If that were possible, I would be talking of my windfall at this point.

However, what if the trend changed permanently.  What if fresh water or water supplies were severely crippled or cut off in a region.  How could/would that be remedied? What sort of companies could provide relief in a serious situation? I know the water angle isn't new, but the water angle in the US is.  This has my eye on Claymore's CGW ETF.  Unfortunately, this is "global" in nature, but I suspect that a US water ETF is an idea for the future.  The next time there is a regional water crisis and the discussion turns to ghost towns in a major region of the United States, a good speculative play might be water.  High risk / high reward, for sure.

So we're back to arguing politics in the Atlanta area, not whether or not we're going to have to abandon our homes in search of H2O.  Forecast in Atlanta, rain showers, maybe some thunder, just in time for the weekend.

October expiration has passed, so it's time to analyze closed positions and think about new ones for November and December strikes.

Position Recap

The GE calls @ 18 expired worthless.  So I keep 100% of the 0.15 premium.  Not exactly juicy, but not too bad considering the stock hasn't done much but bounce around since I sold the calls in the middle of September.

The IWM trade flagged on September 2nd and taken on September 4th, brought in an 0.18 credit.  These options also expired worthless allowing me to keep the full credit.

November's SPY 92/94 vertical spread is well out of the money.  In fact, I tried to close this on Friday for 0.04, but didn't get filled.  With the original 0.31 credit, that would've been a fast move.  Usually things have to get way out of the money (since it's a spread) to be closed this quickly.  Well, the SPY has done so, but not enough for the market makers to give me 0.04 to close the position.  If there is another decent move up, I should be able to close it out, which would be nice.

The DEC XLF calls are showing a profit, but I'm getting less comfortable with these as time passes.  These calls were essentially a way for me to lock in some gains on my underlying XLF shares.  I felt pretty strongly that the financials were in for a set back.  Due to earnings, volatility shot up on the XLF and for a short time, the position was at break even.  The original credit was 0.41 when the XLF was around 15.35.  The XLF is now around 15.15 with the calls trading around 0.18.  I'm going to look to close this out around 0.10 and see if I can't catch a wave up and write some calls at 17 or 18 for December.  Stay tuned on that.

Looking Forward

Writing calls against GE is my top priority.  I don't like the credit offered for November at this point, I think the numbers weren't as bad as the market thought and shows some stability in the company. Maybe it won't happen this year, but I think people will slowly begin to buy up GE again. Hopefully it's next week and I can write a call or two.

The trading system that I write the verticals with isn't on a calendar, it's a mean reversion system, so it could flag trades at any time, but gets triggered on pullbacks. I'm comfortable enough with the wider strikes as I did with the 92/94 put credit spread on SPY. I'll stick with a 2 strike distance and see how that goes for awhile.  So far the trading system is 3 for 3.  Bill trying outguess the trading system is 0 for 1.  Imagine that.

And I'm still paying for the sin of writing puts against C back in 2007. If you weren't with us, my puts were exercised @ 22.50. That's not a typo. So with credits since, my cost basis is still somewhere around $21 which is obviously nowhere near the $4.60 C trades at today. I never bought any more C because I had little faith in the price and my original take was that Citi was big enough to absorb the losses without too much of a hit.  I was wrong and have been paying ever since. I decided that since I was wrong that I would not average a loser and held true to that. Now I feel that Citi is stabilizing in price and it's time for me to get some premium. I'll be looking at the $4 puts on another move down or a spike in implied volatility. The worst case is that I'm assigned at $4 which will lower my cost basis for C substantially and possibly get me out of this hole. It will be a happy day seeing C out of my trading account.

I spent a portion of the weekend getting caught up on older issues of Futures & Options Trader magazine.  If you're not a subscriber, you should be (it's free).  It can be downloaded from http://www.futuresandoptionstrader.com/.  Current issues are free, back issues are not.  I'm going to be referring to the May 2009 issue, so if you don't have it, I'll summarize the relevant bits.

Each month, the magazine has a feature entitled Options Trading System Lab.  The major players for the software OptionVue are the main contributors.  The feature takes a relatively well known strategy and runs a back test on historical data using the OptionVue software.  The results are usually disappointing. I don't mean that in a disparaging way.  If you've done backtesting for any length of time, you'll know that most of the ideas put forth are real stinkers.  In fact, I'd say over the course of many years, even before my days of working on RightEdge, I'd tested hundreds and now thousands of trading systems.  To this day, I use about 3 trading systems out of thousands tested.  There are some systems that have shown signs of promise in the lab and some that just plain stink, but I took an eye to May's Iron Condor results.

Strategy Summary

If you're not familiar with iron condor strategy, it's really just a fancy name for two vertical spreads put on in tandem.  It's basically an out of the money bear call spread and out of the money bull put spread. Both are credit spreads.  The P/L structure for an iron condor is below. 

spy-iron-condor.png (47.83 kb)

Most iron condor traders are looking to put the short strikes around one standard deviation.  In the P/L structure above, you can see that one standard deviation is marked by the vertical red dashes.  As a result, I put the short puts at 99.00 and the short calls at 115.00.  The long options can be placed anywhere you feel comfortable.

Risk

Now here's the catch on iron condors, my maximum reward is 0.44 less commissions.  My maximum risk is 4.00 - the credit.  This puts the risk/reward ratio at around 1 to 10.  That's not 10 to 1, that's 1 to 10.  This means that 1 losing month can wipe out 10 months of winners.  Couple this with the fact that one standard deviation means that it's probable the price has a 68% chance of staying within your shorts on either side, it sounds like a mathematical loser all the way around.  You need 90% winners in a case where statistically the price will only stay within your boundaries 70% of the time.

Backtesting the Strategy

Normally, this idea would be discarded especially with the pitiful risk/reward ratio.  Admittedly, it's not one of my favorite strategies, but let's see the results anyhow.

The test period started in January 2001 and ran through April 2009.  The starting capital is $10,000 and each month an iron condor was opened one standard deviation out.  They used 5 call and 5 put spreads. The system is always in the market and cycles the position (i.e. closes the current month and opens a new one for the next month) on the second Friday of each month.  The system had a 75% win rate with an average win of $763 and an average loss of $1,314.  What's noteworthy is the annualized return of 28.7%.  This would give you a return of 236% for the time period tested.  The S&P 500 had a negative return over the same time period.  Wow.

Discrepancies of Note

OptionVue constructs positions based on historical data.  I find the further out of the money the spread, the harder it is to get filled.  At best, the bid/ask spread on these positions is pretty lousy.  This probably wasn't accounted for.  Even dividing the bid/ask spread in half usually won't get you filled.  Second, the authors list the risk/reward ratio of 1 to 4.  I think that's generous.  I've seen in real life the ratio as poor as 1 to 12.

My Take

Given the discrepancies noted, if you were to consider putting on ICs, I strongly recommend using 1 contract positions and also putting them on the SPY ETF and not the big S&P 500 futures contracts (which are leveraged instruments).  Of course, never put on anything until you know what you're doing. Even in light of this impressive test, I'm still not very interested in iron condors because of the horrible risk reward.  I do, as most readers know, put on bull put verticals on the indexes when my trading systems flag them as a buy.  This has turned out to be successful so far in my first phases of live testing.

Update on the last post, I took the IWM spread trade and went with it live.  I got filled with a 0.18 credit per spread.  I figured at the very least, something fun to watch until October.

Looks like the latest round of dips got my newest trading system all hot and bothered.  Today a trade in IWM was flagged.  To recap, I have an ETF trading system that I'm using to flag option trades.  The ETF trading system is a low frequency/high probability setup and I add to my winning % by selling put credit spreads one standard deviation out of the money.  A standard dev for the IWM is about $51 (current IWM price is 55.80), so almost 10% out of the money.  If I put on a put credit spread 1 standard dev, here's what the P/L graph looks like over time.

(click to enlarge)

At the time of analyzing the position, I'm looking at a credit of 0.18, before commission.  This sets my maximum profit of the credit and my maximum risk being the distance between the two strikes - the premium (0.82).  I could do a few things, first, I could widen my strikes, if I did a 49/51 put credit spread, I could obtain a credit of 0.33 per spread but would also double my risk.  I could also move the short strike closer to the money.  If I did a 54/55 PCS for example, I would get a 0.39 credit, but if $55 was breached at expiration, the position would lose.  So higher probability of loss, but bigger credit.  Options are always a trade off and allow you to fine tune your position to what you're feeling.

I haven't decided if I'm going to go with real money or do another paper trade.  I don't recommend anyone put this trade on.  Doing so will likely be hazardous to your account value's health.  This is in testing at this point.

As usual, just sharing an idea and always welcome feedback.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aDSp1GtwaRpE

Yowch!  We've talked of tracking error before.  Tracking error seems to the worst in inverse and leveraged funds.  Couple that with futures and you have a recipe for serious tracking error.  20% is the new record.  So I ask, why would anyone want to trade these things?  They seem entirely unpredictable.  So now you have the unpredictable underlying asset coupled with the unpredictable nature of the way the asset is exposed through an ETF. I just don't understand who would trade something like this even for the short term.

A front page story, for whatever reason, on marketwatch.com is the gasoline ETF (symbol: UGA). It is touted as an ETF that does not invest in oil, but rather, refined gasoline itself. This ETF has the same problems as an oil ETF, most notably, tracking error. I'm not sure how tracking refined gasoline futures contracts is any better than tracking crude oil futures contracts, but if you think so, there's ETF for that.  Recently, there has been a bit of an outrage about the leveraged and short ETFs that also suffer from tracking error. This ETF is structured to suffer from exactly the same problems. You see, these ETFs do not buy the commodity itself, but rather, they invest in futures contracts that allegedly track the spot price of the underlying commodity. This is probably good for short term trading, and I mean a couple of weeks at the most, but like the leveraged and short ETFs, this ETF will suffer from contango and backwardation of the underlying futures contracts.

This probably sounds like a silly statement, but I love to understand what I'm investing in.  Leveraged, short and futures investing ETFs, I just don't get.  Stocks and bonds are straightforward, options are fuzzy to most and are quite complicated, but once you understand them, there are models that can pretty much tell you exactly how they're going to behave as the variables change.  Those variables are time, price and volatility. Leveraged, short and futures investing ETFs move to the beat of their own drum. I don't understand the price moves (and please enlighten me if you do).  They vaguely represent the move of the underlying.

Let's talk about tracking problems.  The current price for spot crude oil is 69.31.  This is represents a large price of what you pay at the pump. The price of crude on December 23rd 2008 was 30.28, which was the 'bottom' of the price range during the last fuel price run up during 2006-2008. This represents a price increase of about 120% during December until today. Assuming you had the wherewithal to purchase some USO, which is the oil tracking ETF by the same company, on December 23rd, 2008, would your gain be 120%.  Well, nope.  The opening day price of USO on 12/23/2008 was 31.06.  USO trades today at 36.05. This is a paltry gain of 16%. This is approximately 1/5 of the gain of the actual spot price. Is this a sufficient hedge? I would say absolutely not.

So given the numbers I've put forth, would you 'hedge' your price at the pump using UGA? I wouldn't. Would you hedge your price at the pump with USO, again, I can say unequivocally, I would not. If the S&P 500 ran up 120% and the investing public who bought a fund that tracked the S&P 500 gained 16%, I would expect blood in the streets, or at the minimum, I would expect this fund to be hung out to dry. While the tracking error for leveraged and short funds on equities may not be as significant, you get the point. I strongly believe that if the S&P 500 was as volatile as the price of a barrel of oil, we would see similar behavior.

My point, as its been in the past, is to understand what you're investing in. I do NOT invest in a fund, stock, ETF, etc that doesn't have a track record of at least 2 years (unless I'm just gambling) and I hope you'll consider the same. I hope you'll consider following a similar mindset.

Have a great Independence Day. 

The conventional wisdom is that closed ended funds, or CEFs provide a bit more volatile ride than open ended funds.  This is usually because they can trade significantly higher or lower than the net asset value.  The premium/discount of the CEF represents the value that it is above or below the net asset value or NAV. Typically, during bull markets, CEFs tend to run at a premium to NAV, during bears, a discount.  At the end of last year, CEF discounts were significant across the board.  I don't like to speculate on whether a discount represents value, which is one of the reasons why I don't do too much with CEFs.  However, the broad based discount was too much to ignore for a 'buy low' kinda guy like me.  In fact, I picked up some BEP in November and Decemeber when I felt asset prices were very depressed and add to that a decent discount to NAV on BEP which doesn't happen very often.

At the risk of monkeying around too much with long term holdings, my BEP holding has caught my eye for the same two reasons why I purchased it to begin with. Except for now I feel that equity prices are a bit rich short term and that BEP is at a high premium to NAV.

My calendar spreads (discussed here) have received very little drawdown up to this point.  It seemed like I damn near picked a top at SPX 920 (lucky), until today. The SPX never hit my original profit target of 850 and expiration is coming up in the next couple of weeks.  Reviewing the technicals, a reasonable profit target appears to be right around SPX 875.  Now that time has passed, this should offer me a reasonable reward and it's a reasonable pull back point.  What if it doesn't pull back?  Then I lose.  But I had my risk clearly defined and well established going in, so it's not a huge deal.  I also have a lot more eggs in the bull basket than the bear, so I'm happy to see up moves.  I'm in this to make money, not be right.  

On the upside, VWO is really moving.  It is up 18% from my cost and is the strongest performer in the portfolio.  My only regret is that I didn't get filled on a 19.99 GTC order late last year.  I'll settle for up 18% though.

And in trading system news, I believe I'm about 1 month away from testing another trading system.  I haven't figured out if I want to use options or just plain stock yet.  It's a quick "in and out" type trading system with a maximum hold time of about 10 sessions.  It may be tough to overcome the option spreads in so little time. This is what testing is for though.  I may test with both vehicles and see which one makes the most sense.  I'll share results here.

The DoD strategy is a popular one.  I talk about it here from time to time but don't actively practice it.  It's one of those things that's simply on my radar.  It does have a knack for outperforming the broader Dow index most of the time, but as of late, it has not.  In a previous Dogs of the Dow post, I outlined that the small dogs are nothing more than volatile stocks in the Dow.  As the market has surged upward over the last couple of months, I wanted to see if the DoD responded in kind. Let's compare the DIA vs. DoD and see. 

(click to enlarge)

This chart slightly resembles leveraged funds where the dips are pretty deep and the recovery fairly swift, but when all is said and done, it's still underperfoming a bit.  The point here is that volatility is most likely the reason for the DoD's outperformance in some years.  You're taking on more risk to get more gain.  If that's all it is, maybe you're better off diversifying using small or mid cap indexes instead.  So let's not be fooled into thinking that there's some sort of magic going on with the Dogs of Dow.  It's simply a more volatile sampling of stocks within an index, not the work of superior stock picking. 

Covered call ETFs are a relatively new product.  I've disclosed that I'm heavily in PBP.  In fact, most of my broad based U.S. holdings are divided between PBP and BEP (which is a CEF).  I find that historically they seem to offer the same returns with less drawdown (i.e. risk).  I've demonstrated in previous posts that these covered call funds are acting like they're "supposed to".  They were down less during the crash and are currently outpacing their tracking indexes year to date.

Sounds perfect, don't it?   It's nearly perfect except for one thing.  CC ETFs are long stock and short out of the money calls.  At least they're out of the money whenever the ETF establishes a position.  What happens in a 'crash up' when the market socks away solid gains?  Now is a great time to cherry pick a timeframe. The last two months have been up 20%+ on the S&P 500.  How did PBP do?

Today's blast up is nearly uniform.  This was after the first down week in over a month.  As I like to speculate, small caps lead big ones into the next up cycle.  So I've been paying special attention to IWM.  IWM was one of my last purchases on the way down because the smaller guys usually crash further and longer than the defensive names.  But what goes down, must come up.  Everything played out according to plan with the exception of the last downturn.  I expected that with the mid term trend being up and the short term trend (i.e. last week) being down, that the IWM may outperform (lose less) than the bigger boys.  Not so.

Here's the perf of IWM vs. SPY month to date.