Performance Update (January and February)

Two months into 2006 and here are our fund's results on pure trading basis:

Best account: +7.4% YTD
Worst account: +5.7% YTD

These figures are net of commissions and exchange fees. No adjustment has been made for management and performance fees charged to the accounts. So, this is trading P&L only.

Why does our performance vary between accounts? The short answer is: it depends on the size of the account which affects our ability to diversify across strategies. Since diversification can lead to better or worse results, depending on market environment, the returns will vary. In general, all of our managed accounts will post very similar results by the end of the year, regardless of their size.

Cheers,
/Dmitry

Disclaimer: The above is not a solicitation or offer of any services. This information provided is for educational purposes only.

Buy Premium! (Part I)

Unsurprisingly slow Friday. I don't have much to report as far as our fund's activities are concerned and I'll use this opportunity to share an educational post. Below is the first part of the article:

As some of my readers know one of the key strategies at Cadence Capital is premium selling. I love the strategy for many reasons but one of the drawbacks that always leaves a bitter taste in my mouth (even after making money) is its capped return. Granted, you can be the best options seller but 5% a month on your capital is probably the best you can hope for - with any sort of consistency. By the way, before I get bombarded with "I can do 15% a month, no problem" type of emails, keep in mind that this 5% is calculated on your entire account capital, not a particular monster trade that you did that month.

So, how does one position for a higher return? The only answer I have is "buy premium". I realize it may be funny that a net seller is recommending to buy options but there is really nothing strange about this: you have to diversify across strategies (read my earlier post on this topic) if you want consistent returns with a high Sharpe ratio (volatility of P&L your client can stomach)

Naturally, being long options can be for two basic reasons (aside from more exotic ones):

1. You have a volatility view
2. You have a directional view

I like to buy premium for either reason but ultimately, it's best to do it for both.

If you're going long vol you'll buy options and stock (assuming puts) and scalp gamma in either direction. Your bet here is that realized volatility of the underlying will outpace theta of the options. You'll make money if the underlying moves up and down in a proximity of the strike. You'll make money if the underlying moves strongly in one direction (here you'll have to exercise staying power to not "cover" too early).

This strategy (by the way, this is often called a "synthetic strangle") works well with implied vol being on the downside and technical positioning of the underlying spelling a high probability of movement. Recently, Oil stocks served as excellent examples for this sort of play.

If you going long direction then you'll buy options the way you'd normally buy stock. Naturally you'll still have to pay attention to implied volatility (you don't want vol crush to decimate your profits even when you get the direction right). However, there are several other key considerations that need to be taken into account (and they are the ones that make long options so much better than stock) before initiating a long premium position. Yes, leverage is one of them, but it is by far the least significant one on my list. We'll cover the art of buying premium in detail in Part II of this article.

Cheers,
/Dmitry

Capture The Bounce

Down and up and down action - in sum, we are nowhere index-side but we are certainly seeing action in specific sectors. Often, a mindless grind in the broad indices will bring out definitive action in beaten down or overbought parts of the market. Today it appears to be working and we're seeing the following:

• Oil is bouncing smartly and near-strike long April exposure is paying off well. As an example, one of the things we were doing to take advantage of this was buying into 27.5 April call strike in PTEN on the way down. Today is the right time to liquidate this sort of position as the oversold condition is being worked off.
• Housing is doing the same except that it is trailing Oil in its bounce. I feel that another day or two of upward retracement is in the cards so if you're long (we like RYL, KBH and LEN) give yourself a chance to gain some deltas.
• Semiconductors sector is the final example of this. The difference is that it was never really oversold (unless we decide to judge the oversold condition but the likes of KLAC a week ago). Since the sector is rallying strongly my feel is that it is going to continue may even lead the tech market higher. (CSCO is through 20 and that means quite a bit)

Keep in mind that Oil and Housing are in an overall downtrend so while capturing the bounce is where the money is at the moment, it is just a moment nonetheless.

Stay on your toes!

Cheers,
/Dmitry

Cub, Then Bear

Today's rally is really frustrating the bears. The rally really shouldn't be, so it angers them and the bears cover their positions to wait for colder weather. But the bears are wrong!

What's a bear?

A bear is someone with a distinctly negative outlook for future prices. A bear is someone who backs up his outlook with money and gets short the instrument. A bear is someone who is going to get really hurt if his outlook proves to be wrong.

So, why are the bears wrong?

Contrary to the obvious, it's not because we have a rally. The bears are wrong because they can't afford to stay right.

It's really simple: You want to be a bear? Become a cub furst. Then grow some claws and teeth and gain some size. With time you get bigger and you become more like a grown bear. By the time you reach maturity you're growling and likely collecting dividends for having grown up.

And if you don't make it to full age, you shouldn't have been a bear to begin with. No harm done.

Lesson? Position sizing, risk management, asset allocation. You don't make money only when you are right. You make money when you can afford to be wrong.

Cheers,
/Dmitry

Analysis: MACD/RSI divergence?

It's 10:30 pm and I am agonizing over SPX. Normally there are greater things in my life than worrying about the next tick, but right here, right now is a point of potentially outsized profits - only if we get the direction right.

So, how does one get it right?

Often, traders use indicators derived from price series, such as MACD and RSI, to estimate future direction. One of the more common and allegedly reliable "setups" implying high odds for the directional outcome are represented by divergences between the oscillators and the actual underlying price series.

Over my years as a stock trader (before options suddenly made a lot more sense) I came to watch these divergences. I saw a lot of them. In fact I saw so many that eventually I saw just as many that "worked" as the ones that didn't.

Today I am seeing both MACD and RSI show such a divergence with respect to SPX and my gut tells me that this just has to work. But, regardless of what it tells me I know one thing: this is a lesson in the making. This is the time to use your brain and do the right thing as a trader, not a compulsive speculator who thinks that MACD, RSI, ROC, or some other squiggly is somehow superior to the very price series they are all derived from. Folks, understand that I don't want to knock these as I know a lot of people swear by them, but if you've seen enough price charts, MACD and friends won't tell you anything radically different from the price itself. In fact, these divergences can be spotted without bringing in MACD or RSI at all!

In case anyone still thinks otherwise, let me state with the utmost degree of conviction that there is no way to tell the future. All one can do is make sensible bets and employ proper asset allocation techniques (or some other form of risk management) to enable yourself to take advantage of this situation. I promise you, noone knows whether this is a top until it becomes (painfully) obvious.

That's why it's a just a carefully measured, calculated bet and that's the only right way to look at it. And so my agony over SPX is over.

Cheers,
/Dmitry

Buying Premium

To reiterate I am not an official bear but I am putting our fund's money into long SPY April puts right here. To quote a master sci fi story teller Bradbury, "Something wicked this way comes".

Note that I am making a minor commitment here as I don't like selling tops on broad indices. Also, I am looking for a very short term bounce in Oil and Housing that could be actionable from a long call perspective.

Dismal action in Biotech and I am watching 195 level on BBH as a tell. So far it's a retracement among overall weakness, but it easily get worse. If the market gets weaker but this level holds I'll look to add to our short put positions.

Stay tuned.

Cheers,
/Dmitry

Relentless and Right

Smart action this morning with the indices spiking straight down in a kind of a relentless, unmerciful way. Given the weakness of yesterday's rally this move is welcome and my hope is that it starts a new wave down that takes us out of the range we've been stuck in for the last three months.

I scanned the news this morning (my readers know I don't read news, but I do scan them for a sentiment read) and I find two interesting things:

• Everyone is talking about Housing bubble imploding. I think this is now bordering on hype and while I am a Housing bear a bounce is in the cards at these levels. We're still looking to sell more calls in this sector but we'd like to see a rally to make the sales worth it.
  
• There is still lingering bullish sentiment on Oil and that tells me that it's heading lower even at these "beaten up" levels. The vol is fairly rich here so selling calls is excellent from both directional and vol perspectives.

So, am I a bear on the overall market? I know I'd like to be but more action is needed to really get me to growl. For now I am looking for oversold conditions to buy calls into or rallies to sell same. Getting long SPX puts has crossed my mind several times but this morning is exactly when one should be careful about chasing an index.

Cheers,
/Dmitry

What We Are Doing

My gut feeling proved right and the market moved. Not reading too much into this action as the "breakout" that everyone has been waiting for came on a dismal volume. In fact now Nasdaq-100 looks like it corrected up and is positioned to start a leg down. Not calling anything here - this is merely another observation.

A few actionable things happened today:

• Retailers (RTH) are strong and we are long deltas via stock and April calls. I don't think owining vol is great here but I like calls because they automatically get you bigger as the sector moves higher.
• Biotech peaked my interest even though I think I missed the meat of the move (somehow I haven't been watching this sector for a while). We're looking to sell puts on BBH with any weakness and are buying calls in a couple of names.
• Oil is weak as expected and after selling call spreads on midday strength we let them rest easy.
• Housing is all over the news but the action is non-exciting. Regardless, we're sticking to our bearish strategy and are selling calls in KBH, RYL and other names.
• Gold seems to have caught the "lack of inflation bug" and that's why people think it's down. To us it doesn't matter. NEM is our vehicle of choice and we're short call spreads here. Again, once the sector sells off, we will be selling puts as well as our view for the next few weeks is neutral.
• Finally, we like the Drug sector with LLY and ABT being among the favorites. I broke down and advised our fund to just buy stock.

This about wraps it up.

One last thing - I am personally getting long ITF (Japanese fund) as I like the technicals a lot. This has nothing to do with our fund (for now) but I thought I'd through this out here.

Cheers,
/Dmitry

An Option Trader's View

I always said to a head trader of an options firm I used to work for a long time ago: "Take a view". Why? Because focusing on just capturing the bid/asked spread in an often illiquid (options) market isn't a worthwhile game. I'll explain this at some point in detail.

Naturally, there are more than one kind of a view. At Cadence Capital I condone either a volatility view (essentially an arb play between realized and implied) or a directional view. Often I combine the two.

Personally, directional views is where I like it the most. Maybe it's because I've done a lot of stock in the past (before my re-incarantion in the options world) or maybe it's because delta is the ultimate money maker.

So, here is where I am putting our money from a directional perspective:

• I am a bear on Oil for at least the next month. At this juncture we will sell any rallies that may follow today's action. The reason for us not getting short outright right here is that there is also a great possibility that the spot will consolidate in this range for a while before moving lower. Thus I'd like to sell the highs, not the lows of the range.
• I am neutral on Gold in the short term. It doesn't have to break hard, but I do think it's done here. We will sell rallies and buy breaks. From an options perspective a ratio strangle (with the calls outweighing the puts) is the play. We want to sell more calls because I see the buying interest still lingering here with weak rallies giving us better prices.
• I am a bear on Housing. KBH, RYL, BZH should be heading lower and we are getting short credit call spreads on any strength. Now, keep in mind that I am not a long term bear on Housing and I don't subscribe to the usual "interest rates/bubble/recession" rhetoric. I just don't care. I am not an economist, I am trader.

I have other views as well but the three above are the most defined. As far as the overall market is concerned, I like the strength today (NDX-100 traded through my majic 1682 number and hopefully stays above it), but I am not finding anything actionable on this level.

I will update everyone later in the day with "What We Are Doing" post as far as our fund's activities are concerned. Good Trading Week to all!

Cheers,
/Dmitry

Gut Feeling

Oil is heading lower this morning. Not calling a reversal here and not suggesting a trade just yet as I feel the near futures contract can move to 66 before reversing in a meaningful manner. If one is itching to do anything, then a long gamma stance in OIH may be sensible. At Cadence we aren't taking this sort of a position on right now as we don't see the odds we need.

Semiconductors also present an intersting picture with SMH looking ready to breakdown and separate issues such as TXN and LLTC drawing a perfect technical setup to get short. We aren't taking the plunge on this either as the overall market isn't providing a "get short tech" sort of context now. If anything, I'd look to fade any breakdown.

Overall, I have a feeling the market will move today. Yes, it's mostly a gut feeling, but often that's all we have going for us!

Cheers,
/Dmitry

CNBC: Fundamentals and Daytrading?

I just happened to come across a video of CNBC blurb that featured Barron's Michael Santoli and DayTradeteam.com's Andy Swan talking about the recent Google decline. It's the usual CNBC tactic of stuffing a bull and a bear in the same cage and giving them a story to fight over. What's notable though is that they take Santoli's fundamental view and pit it against a daytrader's opinion, thereby forcing Andy to put on his "fundamental" hat and do his best in combatting Michael's arguments.

CNBC certainly achieves its goal of providing an entertaining show but fails miserably at educating the investor. In retrospect I find it entirely laughable: it's similar to handing a soccer player a hockey stick and throwing him on the ice. Probably just as entertaining and at the same time utterly lacking in any other value.

The above isn't meant to undermine Andy's abilities. Bet let's face it - he is a daytrader and I'll bet he is very good at picking his battles when it comes to short term directional trades. In fact, his bullish view on the stock (GOOG was trading at 344 at the time) proved to be correct (the stock is at 377 as of last Friday). Roughly ten percent up. Excellent call if you ask any trader.

So, does that mean Andy's fundamental arguments (about Google's expansion of product lines, growing ad space, etc) have proven true? Or are we to believe that Google isn't going to 250 as suggested by Santoli?

No, all this proves is that a trader is a trader is a trader. Either the folks at CNBC still don't understand or they deliberately ignore this important fact. In either case, this is just another proof that when taken seriously, the show is dangerously misleading to the investor.

TV is entertainment only, folks. CNBC is one of its best kinds.

Cheers,
/Dmitry