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The real answer is that the “answer” varies by investor.

December 1, 2008


Good morning. I hope everyone survived the Thanksgiving Holiday and was able to do whatever shopping was necessary without any undo problems, like being trampled. The question now is whether the wait in line for the once-in-a-lifetime bargain produced a prize to be kept or sold on Ebay for a profit.

Anyway, the market had a nice week. We went from a low tick on the SPY of $74.34 on 11/21 to a close of $90.09 last Friday, a gain of over 21%. The VIX also came in some, with a close on Friday of around 55, way below some of the recent numbers. For those able (and smart enough) to buy stock, buy call spreads, or sell put spreads that would represent a very profitable week. For those already in the market the huge percentage gain only returned the market to the levels of Nov. 13, still down 7% on the month. This morning (early) stock futures are down sharply reflecting several reports worldwide showing serious manufacturing contraction in several countries. So far we may have to put last week in the Bear Market rally category.

What does this all mean for prudent investors, and for those in the Protected Index Program? Let’s start with those currently in the PIP. Most of those clients with investments in the SPY’s have the 95 puts as protection against their long SPY’s, meaning that we had fairly deep in the money puts as the market declined very rapidly. The high volatility levels, and some widening of option bid-ask spreads due to decreased liquidity, made it difficult to “roll those puts down” at a price we would have liked as the market was moving very rapidly. That is OK, however, as we just maintained the protection and did not sell any calls that might have been a problem with a serious “bounce back” rally (which did happen). We finally did sell calls on Friday morning, after the market looked a little extended. So the people in the program continue to seriously outperform the market with less volatility in their account balances. With the sell off this morning we may have a chance to buy those calls we sold in at a profit rapidly, and still find the right repair strategy to give us a strong end to the year.

What about new people? A lot of recent clients (and some older ones) have no doubt noticed that they have a lot of cash in their accounts. That is true for two reasons. The first is that the market still does not look very healthy, despite the sharp (Bear Market?) rally of the last week. I have had positions for people all planned out on literally tens of days, only to have the market look fairly sick. It was easy to say, “I think I will wait a day” only to have the same thing happen the next day. Obviously I am not going to commit anyone’s capital if I do not think that the market level, coupled with the price of the corresponding puts and calls, gives them a reasonable chance of success.

That leads me to the next reason for hesitating to commit capital, the price of the puts (insurance). Remember when the market was healthy? When the SPY’s were trading at $150, we were paying roughly $13-14 for the $150 put with around 30 months to go. That is around 9%, and we actually did some in the 6-7% range. When the SPY reached roughly $75 on 11/21 the $75 put with now only 25 months to go was around $18-19, or roughly 24%. Tough to pay that price! First of all, despite all the fear (bordering on panic) we see around us, the SPY does not need as much insurance at $75 as it did at $150. Your 5 year old car worth $10,000 should not cost more to insure than it did when it was new and worth $20,000, even if it is raining. At the $19 price the SPY’s would have to go to $56 (a 25% move) just to break even on the cost of insurance, possible but very pricey. The good news is that the calls are also at extremely high levels, so we may be able to “cover” those put prices over time, but still a tough task going in.

So what’s the answer? The real answer is that the “answer” varies by investor. I have never seen a program that is as effective at forming the cornerstone of most clients’ investment strategy as the PIP, but right now even the PIP has to be evaluated with every new client as to whether it matches his or her investment goals. For example, many clients, if the recent market problems have left them in still good financial condition, may be able to insure some, but not all, of the current SPY price and have it appropriate for them. For example, this morning the price of the SPY (Friday’s close) is $90.09. The $90 put expiring in Dec. 2010 is roughly $19.40, or 21.5%, still a very high number. If we decide to only insure part of the downside, say to $45 (another 50% move from here) we could buy the $90-45 put spread for around $15.80, or 17.5%. With an initial sale of the Dec. 95 calls at $2.10 we knock that down further to $13.70, to 15.2%. Can we go lower than $45 in the SPY? Sure. Is it likely? No. Still, this adjustment to the PIP strategy should only be considered for those who could still hang in there with the SPY’s trading $35 for a while.

What about those who have been hammered by the market so bad that they really have very little risk tolerance form here, surely not the 21.5% further risk that the outright put purchase would assume. For these clients it probably would be sound to stay primarily in cash, with some call spread initiated that neutralizes the high volatility and gives some participation should the market begin a sustainable recovery. Like I said, it depends on the client.

How does someone who is relatively whole, and with a high-risk tolerance take advantage of the high volatility? They could go, and we have done some of these for selected clients, with some covered strangle writes in selected stocks or indices. For example, we may think BAC (Bank America) is a good buy at $16.25. We could just flat out buy 1,000 shares at that price and put out $16,250. Or we could go about it another way. We could buy 500 shares at $16.25, and also sell 5 of the May 20 calls at $2.10 and sell 5 of the May 12.5 puts at $2.30. The puts are not naked, as we have the remaining cash in the account to buy the other 500 shares. We have obligated ourselves to buy another 500 shares at $12.5 and to sell the 500 shares we just bought at 20. Counting the proceeds of the put and call we have just sold we would by buying (if forced to) the additional 500 shares at the effective price of $7.10 or selling our 500 share we did buy at $25.40. Not bad, but what if we had done this with the market down 15 or 20% on the year. Not so good. If it works, however, the return is terrific.

For now we are spending lots of time talking to clients about their risk tolerance, and any changes to their situation the market moves (or the job market) may have brought. If you are a new client with cash in your account, and you hear me on your voicemail, that is probably what it is about. If you feel comfortable doing the put spread at this level instead of the outright put buy, please call or email me to that effect. Let’s hope we hang on to some of last week’s gains.