Merrill Lynch Sold, Lehman Brothers Bankrupt, While AIG And WaMu Totter

The financials are falling! The financials are falling!

We awoke this morning to the cry of Chicken Little, only this time our poultry little friend is not over reacting.

Lehman Brothers tried to avoid bankruptcy over the weekend by negotiating a buy out with Bank of America and Barclays. Henry Paulson, Secretary of the Treasury, had told the market not to expect the tax payers to bail out Lehman Brothers and there was none.

With no government guarantee to protect them against losses, Barclays and Bank of America walked away from a potential sale, prompting Lehman Brothers to file for Chapter 11 Bankruptcy protection earlier this morning.

When Bank of America walked away from Lehman Brothers, they walked over to Merrill Lynch and negotiated a price to acquire the firm.

AIG is scrambling to raise capital to avoid what would be a devastating downgrade of its credit rating. The company rejected a couple of deals that would have injected needed capital, but at the price of control shifting to those capital investors.

An AIG deal may require Fed participation and it is presently unclear whether the government is willing to take on more now that they have a $200 billion bail out to finance off the tax payers' back following the take-over of Fannie and Freddie.

Washington Mutual is now seeing as much as 45% of their Payment Option ARM loans, which were written by the thrift from 2004 to 2007, heading into default.

Today's market open is going to be rough. Minutes prior to the open the DJIA futures are down 370+ points, the S&P 500 futures off more than 45 points, and the Russell 2000 showing 23 points to the downside.

We could talk about how you could have made a small fortune playing these falling financials to the downside. While that is true, it feeds into the sort of greed and lack of risk management that has lead Lehman, Merrill, and perhaps AIG and WaMu to their demise.

Risk management is an absolute necessity, if you hope to survive and even prosper during what will be remembered as the worse financial crisis to hit Wall Street since the market crash of 1929.

Christopher Smith
TheOptionClub.com

Lehman Heading For Bankruptcy

Bank of America and Barclays were Lehman Brother's best, and probably last hope for a deal to unload the faltering 158 year old financial firm. According to reports over the weekend, that deal is falling apart.

Understandably, Bank of America and Barclays do not want to take on the risks being carried by Lehman Brothers without some form of government guarantee. Those guarantees appear to be in short supply now that the U.S. taxpayer has already signed up to bail out Bear Stearns, Fannie Mae and Freddie Mac.

The bailout of the two GSE's alone are expected to cost more than $200 billion.

Lehman's History

Lehman Brothers got its start about 158 years ago as a cotton trading firm in Alabama, and then grew itself to a financial giant. It was the third largest U.S. brokerage, behind Goldman Sachs and Morgan Stanley. The firm's mortgage business was wildly profitable during the recent housing boom, but proved to be the firm's Achilles' heal in the ensuing credit debacle.

Bankruptcy Filing By Lehman Brothers Expected

With Barclays and Bank of America taking a walk and the apparent absence of any willingness by the government to finance a bail out, it appears increasingly likely that this firm will be forced into bankruptcy. The risk of a forced sale or bankruptcy is that Lehman's bad assets will effect the still performing assets of other firms.

More Financial Firms Likely To Fall

Other potential victims of this credit crunch? Concerns seems to be rising with regard to Washington Mutual.

Also, on Friday, insurer AIG, which may see its rating cut by Standard & Poors, said that it is reviewing its business and that "everything is on the table." The popular theory is that the insurer is looking to sell off portions of its business to raise capital and avoid what would likely be a crippling downgrade.

How To Protect Yourself From This Broadening Debacle

This credit crisis is broadening, boys and girls. If you're in this market without a sound exit strategy you may find yourself joining these troubled financial firms.

Risk management is critical to our success in these markets. Yes, we need to learn about the markets and learn about options and how to use them to effect our plans in the market. Just as important as that foundation, we must also learn how to structure our trading portfolio to avoid being over leveraged and to design our trading plans and systems to adjust or exit our positions when the trade is not working out as we had planned.

Free Trading Videos Reveal Common Mistakes Being Made By Traders

The person who taught me the importance of risk management and how to apply it in the context of a trading system is Bill Poulos, a 30+ trading veteran.

In appreciation for what he taught me and for those who could also benefit from his guidance, I put together a Squidoo lens that provides free video interviews featuring Bill speaking on the subject of risk management.

Tumultuous markets always present trading opportunities. Spotting those opportunities is only part of the solution to prospering in tough times. Another key element is avoiding the mistakes so many others make.

Bill Poulos Trading Interview Videos

Take the time now to view these five videos, now...

Christopher Smith
TheOptionClub.com

August Options Expiration, Trading Plans & Trading Psychology

August’s expiration is now behind us and we can turn our eyes toward September. Before we do, I thought it would be helpful if we turn our eyes back and review what happened between July 15th and August 15 in these rather volatile markets.

On July 15th, the DJIA hit a low of about 10,828 and rallied from that point to close friday, August 15th, at 11,660. That was an 832 point run, or a nearly 7.7% rise over a 30-day period. Impressive.

The lumbering S&P 500 marked a low of about 1,200 on July 15th, then rallied from there to close at 1,298 on Aug. 15th. A nice 8% pop!

How about the NASDAQ? Well, NDX had a low, also on July 15, of 1,761 and rallied to 1,957. That amounts to 196 points, or an 11% gain. Holy mackerel!

Get this, though. The RUT notched a low of 647 on July 15th and closed Friday at 753, for 106 points of upside gains. That’s more than 16% in 30 days!

Great news, right?

Well, before we continue our celebration I want to share with you what I’ve read in e-mails and posts from our message board. A lot of our members like to trade vertical credit spreads and/or iron condors on the indexes. I happen to be one of them...

There have been a lot of reasons to be bearish this month. I recently read in IBD, for the first time since I’ve subscribed to the paper, the word “stagflation” being used in the present tense. The dreaded condition of a stagnating economy and rising inflation, that we have not heard since the 70’s...

Jobless claims are up, consumer sentiment is low, the economic stimulus tax rebates are now memory, Georgia and Russia in open warfare, and the Chinese have more gold medals than us...signaling the decline of U.S. dominance in the world. The point is that if you were thinking about selling bearish call spreads a month ago, there was plenty of bad news out there to support your thinking.

Now, when the market began to rally the initial thought we all likely had was that this was that this was going to be another bear market rally off a relative low. To be expected, no doubt. A great opportunity to sell (more) call spreads!

Did I sell call spreads? Sure, I did.

But then the market kept on rallying. No matter, because there was little positive news out there supporting this rally so it will reverse any day now, taking pressure off my short calls. Sound familiar?

Yet, the market kept pushing higher...

If you had sold those call spreads without first establishing a defined trading plan, it is likely that you had an internal debate with yourself for much of the last 30-days. It probably went something like this...

July 23 - Wow. My short strikes are really under pressure. Should I roll? This rally can’t continue. I’ll hold on, wait for a pull-back and let theta do its job in the interim. Hmmm.

July 24 - Ah hah! We’re selling off. I knew I was right to hold on, and now we’ll head lower and I’ll keep my credit.

July 28 - Another down day. I knew that rally wasn’t going to hold. I should have sold more call spreads before it rolled over.

July 30 - Hey, yesterday took back all of those losses and today we’re up again. We’re supposed to be going lower. I hope that this market stays put because I really don’t want to have to roll my 740/750 call spread.

Aug. 4 - Oh, good. Selling off...

Aug. 6 - Oh, no. Another two up days. I’m no less than 15 points from my short strike. Maybe I should roll up, but I can’t get enough credit at the higher strike to offset the cost and I’d have to take a loss this month. Hmmm. I know this market is going to roll over and when it does I’ll have already taken the loss. Maybe I’ll just watch things because I know this market is going to start selling off.

Aug. 7 - Yes! We’re down, going down, oh yeah! Tomorrow’s Friday, it will be light, I’m sitting on this over the weekend and Monday I bet we’ll see it sell off some more.

Aug. 8 - Yikes. This can’t be right. Just 6 points away from my short strike? Okay. Um. Roll? Geez, why can’t this market just sell off for a couple days and give me a break here. This spread is far to expensive to buy back right now. It’s Friday. The weekend is two days, which means I just have a few days to survive next week until expiration. Theta is going to really be sucking on this spread. Oh, man. Maybe I should just buy it back. I’ll think about this over the weekend...

Aug. 11th - Oh, crap! Two big up days. I’m in real trouble, now. My spread is now in-the-money, where I never expected to be. I should have adjusted when I had the chance. What do I do now? Well, this market has to pull-back now. Maybe that was a climax run and it will all roll over tomorrow...

Aug. 12th - We’re down, just a bit, but at least we’re down. Still a little in-the-money, but with a little more selling tomorrow this whole trade might turn around for me.

Aug. 13th - Started lower this morning, but closed a bit higher. Just two days until expiration. This is a big mess. How’d I ever let my spread go in-the-money. Why didn’t I roll when I had the opportunity. Maybe if I post on the OptionClub message board, one of those guys could help me out...

“Dear Discussion Board, I sold an August 740/750 call spread on the RUT and it’s now at 747. What should I do?”

...I hope someone can help.

Aug. 14th - not much help on the discussion board...they just keep replying to tell me I should have had a plan...follow the plan...too bad, so sad... I need the market to reverse. Today’s the last day I can trade. Should I sell the spread and just take the loss? Maybe we’ll sell off in the afternoon. Let’s see... Oh, no! The RUT’s now above the strike of my long contract...my spread’s totally in-the-money! I can’t get out. I can’t afford a max loss. Maybe there’ll be some selling at tomorrow’s open. Yeah, I bet a lot of traders will want to take the profits before the weekend, so tomorrow’s open will be lower and the RUT will settle lower. Maybe it’ll even gap down a bit, maybe there’ll be some really bad new before the market’s open. It could happen. Man, I hope something happens...

Aug. 15th - Oh, no. The RUT’s settlement value is in...765! Disaster...

This chronology was a little work of fiction on my part, but for some, perhaps even you, it sounds uncomfortably familiar.

What went wrong?

The problem that occurred had nothing to do with the market, or even the selection of the 740/750 strikes for the vertical spread. It had a lot to do with that internal conversation our fictional trader had with them self, rationalizing their way out of taking a loss when the market rally materialized, instead hoping for a reversal to save their trade.

There are very few people who can make well reasoned decisions under pressure. That is why athletes, the military, law enforcement, etc., all train and respond according to predetermined plans of action. If X happens, then I do Y...

It also had a lot to do with a fundamental failure to understand what was happening with that vertical option spread. Once the credit spread was sold, theta was the primary driver behind our profitability. That positive theta needs to be balanced against negative gamma, though.

Holding the position into the days leading up to expiration, with the market closing in on our short strike, left our trader in a very vulnerable position. They were no longer in control of their risk, but relying on hope and prayer that the market would "give them a break."

This is where options tend to get a bad name. Someone puts on a large short position and gets bush whacked by the market. Let's blame the options. They're too risky.

Options are not risky, though!

It's no different than blaming the hammer for clobbering your thumb. So, hammers are dangerous? They are if you use them carelessly. Otherwise, they are very useful tools.

So are options. In fact, options were created to reduce risk in an investment portfolio. The problem we faced above was that our trader was so focused on earning an easy profit, they forgot about the risk and then failed to take steps to manage it once the trade started going against them.

Tools, hammers and options included, can be dangerous when you do not know how to use them properly. Understanding how options work, understanding option "greeks", understanding things like synthetic and embedded positions, becoming adept at position adjustments, etc. These are all part of trading options and if you're a little uncertain about one or more of these subjects, then it would really pay to spend some time studying those areas where you have questions.

You might consider taking a few moments right now to watch a video that demonstrates how options can be used safely, intelligently, and effectively for investing and trading.

Tale Of Two Traders Video

Trade well,

Christopher Smith
TheOptionClub.com

A "Loser" Stock Option Trade On Starbucks, Inc. (SBUX)

As promised, I want to share a trade with you from my new membership site. Most folks would show you a trade that has worked out wonderfully well, producing significant profits. I am not going to do that in this post.

Instead, allow me to show you a trade that has not worked out according to plan. This stock option trade was opened as a double diagonal spread on Starbucks, Inc. (SBUX), following their earnings announcement. My opening position consisted of a long July call and put, with June options sold against both, as follows:

BTO July Call 35
BTO July Put 27.50
STO June Call 32.50
STO June Put 30

For a .50 CREDIT

Waiting for earnings to be released avoided a subsequent drop in the implied volatility of this position, which is a risk with double diagonals. The one other risk is a directional move outside of the break even points. Above, you can see a price chart with the break even points displayed as two red horizontal lines.

There is a double bottom visible on the chart, which is a bullish sign. The earnings news had not been bad, but there apparently remains a good deal of concern that SBUX will not be able to continuing growing its business at a pace sufficient to push the stock price higher. This could be good news for a range bound strategy, such as this double diagonal. However, if investors sell the stock to look for green pastures we could see it break through support.

Today, SBUX was looking weak. While it had not violated the price channel signified by those red horizontal lines, the gamma for this position is fairly high. A high gamma is not a good thing if the share price is near the strike of your short option. The bottom line is that my comfort level with the stock has waned and rather than tempt fate, the position was adjusted this morning to accommodate the perceived weakness in the stock's price.

The adjustment was simple. I simply closed the put diagonal portion of the double diagonal spread. The trade was executed for a .50 debit. That closing debit offset the prior credit, so I now own a call diagonal spread for no cost. The risk graph of the new position is posted below.



The green line represents the value of my options position as of the June expiration date. The white line represents the current position value. The horizontal, dashed white line represents break even. You can see that SBUX can lose all value and I will still see a small profit on the trade. The important thing is that the downside risk is completely eliminated.

This is important!

You can open 10 trades each month. Some will make money. Some will lose money. The trick is to lose as little money as possible when trades don't work out for you. Staying in a losing position "hoping" things turn around is a loser's game.

Now, if SBUX heads higher I can lose money on the call side. However, I already have a trading plan in place that will deal with that possibility. In fact, even though this trade has not worked out as originally envisioned, I still don't plan on losing money on it. I can't tell you how much, but this "loser" may still put some cash in the account before summer begins.

Too many options trading services harp on their big winners. I have a "dirty little secret" that I will share with you. The professional traders don't stand around on the exchange floors talking about returns. They talk about managing risk.

You see, the real "holy grail" of trading is not about the big wins. The big winning trades are nice and we all like them, but they're not what keep you in the black. Knowing how to reduce loses, manage risk, and keep yourself from suffering the big loss is how the game is won.

With that in mind, I decided to share with you one of my trades that was not working out real well. The several other trades I opened earlier this month are all looking good and I just opened a new position on Apple, Inc. (AAPL) today. All of the positions are fully documented on the private membership site with trade alerts having been issued before I placed any trade.

Good trading!

Christopher Smith
TheOptionClub.com

Private Stock Options Site

A few people want to know what I mean by my "private site."

For the last couple months, I have been hard at work putting together a private membership site. I call it TheOptionClub Trading Room or, TOC Trading Room, for short.

In most every profession, a certain amount of education and training is required before you are turned loose to practice on your own. Imagine someone deciding that they want to be a surgeon, enrolling in a weekend seminar, then booking patients for Monday's surgical schedule! It is absurd. Even after four years of academic training in medical school, a new doctor is not turned loose in an operating theater. It is only after years of additional training in internship and residency programs that they become credentialed.

Lawyers learn their profession, not from law school, but by following other lawyers. Pilots fly solo only after supervised flights. Plumbers must apprentice. Yet, retail traders routinely jump into the market with little or no experience behind them.

Professional traders are not turned loose on the trading floor on their first day of work. They must complete training programs and demonstrate to their employers that they are up to the task. They learn by watching others trade.

Retail traders face a difficult hurdle. Trading is a very lonely activity for most of us. It is simply you, a computer screen, and perhaps the talking heads on CNBC. Who's shoulder do you look over to learn?

Some subscribe to trade alert services with the idea that they will follow those trades and learn how the "professionals" do it. I have not seen that work out well for most.

The idea behind the Trading Room is that you will be granted a seat in my "virtual" trading room. All of my trades are posted as I enter my order tickets. I trade mostly on an end-of-day basis, and my positions are typically designed so that intra-day management is typically not necessary. This should fit into the schedule of anyone working during the day.

The Trading Room is not yet open, but is still being tested to make sure it functions properly, but it should be online in the very near future. It will be a paid service because of the time commitment involved on my end, as well as the cost involved. Pricing information is not yet available, but my intent is to make it sufficiently affordable so that someone with a $5,000 account can pay for the service from trading profits.

If you're interested, keep following along here or subscribe to the e-mail newsletter. When the Trading Room opens, it will be announced through both the blog and on e-mail.

In the meantime, I'll post some trade update of the positions that are currently open and will try to provide you with information as to new positions that I open.

Good trading!

Christopher Smith
TheOptionClub.com

High Probability Stock Option Trades

Happy Cinco de Mayo!

You may have been wondering why I have not been posting as frequently to this blog. What's happening is that I have been working on a private site, documenting all of my income trades. The SPX is part of it, but I have also been posting every income trade I have made over the last few weeks.

So, over 1,500 on the S&P 500! Another psychological milestone reached. The bulls keep nudging this market higher, no matter what the news brings.

A June iron condor has been opened on the SPX, using the 1,420 - 1,430 - 1,580 - 1,590 strikes. That was opened for a $1.25 credit. Even with the continued upside move, the spread continues to maintain a primarily neutral market position.

What are the other positions I am trading? I am about close an April bull put spread in the DIAmond for a 25% - 30% return. A calendar spread on IWM is doing well, but will need to be adjusted if there is continued upside movement.

One of the more bullish plays has been an out-of-the-money call calendar on NRG Energy, Inc. It is poised right now to return in the neighborhood of 40% to 50% in the first 40 days, with room for continued profitability in the months to come.

The most recent trade I opened is a double diagonal spread on Starbucks. They reported earnings and investors are somewhat "ho hum" about it all. If the stock sits still for the next 30-days it should do very nicely, but there is also a plan in place to deal with moves outside of the expected trading range.

Each these trades have several characteristics in common. They include: 1.) When opened, they each had a relatively high probability of being profitable and, as such, the odds of each trade were squarely in my favor; 2.) Each trade has a defined, limited risk which means that I know precisely the maximum loss I can sustain on each position so that there are no surprises; 3.) Each trade has a specific plan for managing market risks going forward.

I will try to add more detail to the concepts behind my trading in future posts and keep you updated as to my progress. Questions are welcome, so feel free to leave them in the comments section.

Good trading!

Christopher Smith
TheOptionClub.com