-- Posted Sunday, 24 June 2007 | Digg This Article
| Source: GoldSeek.com
Rick’s Picks
“Phenomenally accurate forecasts”
After Friday’s dispiriting performance on Wall Street, we’re starting to think something actually has changed. But has it? Have we entered a bear market? We asked that question here two weeks ago but decided that any attempt to answer it would be premature. Give it another six months, we said, and maybe we’ll have a better handle on things. But with each passing week, as our borrow-to-consume economy lopes toward recession or worse, we can’t help wondering whether the answer is solidifying before our eyes.
Regardless, we must confess that we’ve been in there buying the dips aggressively, just like the many whack-jobs on Wall Street whose intelligence and discernment barely exceed that of leafy photosynthesizers. Pondering a global economy that has teetered for years on the edge of a deflationary abyss, we see ominous thunderclouds where the “smart money,” aka private equity capital, evidently sees only sunshine and rainbows.
But there we were on Friday nonetheless, licking our chops at the prospect of scooping up some Merrill Lynch shares at the Hidden Pivot bottom of a predicted swoon. To say that we were confident of success would be an understatement. In fact, we stated explicitly that the trade looked like a terrific opportunity for Rick’s Picks subscribers to recoup the cost of a year’s subscription. (The actual recommendation is reprinted below.) And get this: With the Dow off 185 points on Friday and sinking like a brick at the final bell, we still like the trade. Some kind of permabear, eh?
Catch the Falling Piano
Concerning Merrill, our forecast called for the stock to plunge by a whopping $3.28, to $84.02. Although we didn’t foresee this happening in a single session, we were nonetheless prepared to buy the dip on Friday by acquiring July 85 calls. We came close, but the order ultimately went unfilled. Merrill dove to an intraday low of $84.20 in the early going, a mere 18 cents from triggering our bid for July 85s. Naturally, we can’t wait to try again on Monday, notwithstanding our respect for the old Wall Street adage, “When attempting to catch a falling piano, always wait until it has bounced three times.”
One effect of Merrill’s weakness was to push call-option premiums into the stratosphere. This is simple physics, since call options cannot remain cheap when put-option volatilities are soaring. (Were it otherwise, constructing hedges in which stock is shorted against puts would yield outlandish risk-free returns.) Originally, we had estimated that the July 85 calls would sell for around 2.10 if the stock fell to the 84.02 target. In fact, they were hovering near 2.40 when MER first approached the target.
Game Has Changed
Given this dramatic increase in call volatility, we could not have hoped to make much money on a bounce in Merrill shares unless it were an extremely powerful one. That’s because our calls would tend to shed volatility on the way up much as they had picked up “juice” on the way down. What this suggests to us is that conditions may have worsened for those who, for a time, had mastered the art of buying the dips. Until a few months ago it was possible to buy call options at swing lows and make easy money on the rallies that followed. Now, it would seem, at least in the shares of Merrill Lynch, a key financial bellwether, mere perfect timing will not suffice to produce fat profits for put-and-call buyers. This is because any rally would need to surmount not only the normal, considerable drag of time decay, but also the increasingly severe swings in volatility that even in the most advantageous of circumstances tend to beggar retail customers and bedevil trading professionals.
We may be premature in inferring from this that a major change has occurred in the stock market. But it certainly hints of one, as does the fact that rallies of minor degree are failing to reach their Hidden Pivot targets, even as pullbacks increasingly are overshooting theirs. In our experience over the last fifteen years, the opposite should hold true if the bull trend is truly dominant – i.e., rallies should reach or exceed their ABCD targets while corrections fail to attain even the midpoints of their C-D legs. In plain English, rallies have been waning as pullbacks have waxed. While it is still too early to say conclusively that we have entered a bear market, evidence is growing that this is so.
Not-So-Easy Money in Merrill
** The following recommendation for Merrill Lynch appeared in the Touts section of Fridays newsletter. The update was added around mid-session:
“MER (89.55): “The 84.02 downside target that I gave here earlier is not only still valid, it is as succulent a morsel as we have seen in a long while -- just the thing, perhaps, to help defray the cost of a year's subscription to this service. Since I want as many subscribers as possible to get in at the low, I'm going to hold off for now on the details of how to do so. We'll probably want to buy some July 85 calls (MERGQ), but it is difficult for me to estimate exactly how much they'll be selling for if the stock comes down to our price today (unlikely) -- a Friday. My guess is that 2.05 for the calls would be about right (see inset, a snapshot of my calculator), if a little on the niggardly side, so if you want to simply leave in a bid for two calls at that price, you can do so today, good through Monday. If the stock comes down to the target, the risk in this instance is that we will get shut out of the trade because the options will be priced a tad richer than we've estimated. I've determined fair value by using a 27.7 volatility, and that is correct as of Thursday evening, but it is not uncommon for near-the-money calls to pick up volatility, or "juice," as a stock falls. This doesn't mean they will gain in absolute value, only that they will shed value less precipitously than one might have expected had volatility remained constant. Note that I have plugged in Monday's date -- as well we should when buying options on a Friday. Time decay will be working against us from the instant we acquire this wasting asset, so we should price the options with the recognition that, when we awaken on Monday, they will have sat inert in our account, wasting away, since trading ceased at the final bell on Friday. _______ UPDATE: Merrill is getting schmeissed this morning, falling to the target more quickly than I'd anticipated. A result is that the call options have gotten ridiculously pricey in the manner anticipated by my analysis. I am still recommending that you try to buy the options, predicated on the stock's reaching the target nearly exactly. The so-far low at 84.20 is close, but I'm holding out for a low that is within two cents of where'd I'd forecast. This being a Friday, I will pull the order if it goes unfilled by 2 p.m. EDT. I estimate that the calls will be selling for around 2.35, but the price could come down by 5-15 cents as the week's activity winds to a close.”
***
Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers’ initials will be used unless express written permission has been granted to the contrary. All Contents © 2007, Rick Ackerman. All Rights Reserved. www.rickackerman.com
-- Posted Sunday, 24 June 2007 | Digg This Article | Source: GoldSeek.com
