November 2008 Archives

We have enjoyed two strong days in the stock market. On a pullback, one strategy you might wish to consider is to short puts on a stock that you like and do not own. This is called a naked put or uncovered put position.

Why short puts?

I am occasionally shorting out of the money puts on stocks that I do not think will go significantly higher from current levels and—this part is important—would be comfortable owning at the strike price. Because current volatility is high, options are relatively expensive. And, all options decay with time. That is, if the stock price were to remain at a stationary price, the out of the money put options would become cheaper as the expiration date approaches. And, if the put expires out of the money, I keep the entire put purchase price.

If the stock price moves upwards, the put options decrease in price. You can either buy back the put options to lock-in a gain. Or, you can continue to wait, hoping that the options expire worthless. What I decide to do is largely a function of how much the stocks have moved upwards and how much time remains before the options expire. For example, if recently I initiated a short put position with one month to expiration and we enjoyed a strong two day rally of over ten percent, I would close out my short put position to lock-in the gains.

If the stock price plummets such that the out of the money puts are now in the money puts, you have two options. One, you can buy the put options back for a reduced profit or loss. Depending on how far in the money the puts are, you might be in a loss position, but not necessarily. It depends on how deeply the puts are in the money. Or two, you can wait for expiration and be assigned the put. In theory, you could be assigned the put at any time the puts are in the money; however, with the current high volatility and low interest rate, the put holder is better to sell rather than exercise the puts.

Remember at the very outset, I determined that I would be comfortable owning the stock at the strike price. In reality, you would own the stock at the strike price less the initial short put price (plus commissions). For example, if you sold puts (naked puts) on stock ZZZZ for $5.00 with a strike price of $100.00, your effective purchase price is $95.00. One important thing to keep in mind is that your comfortable price today may change once the stock has defiantly punctured that floor price. In other words, you might be happy initially owning ZZZZ at $100.00. But on a sudden meltdown where ZZZZ plummets to $80.00, you will wonder how could you have ever been comfortable with owning ZZZZ at $100.00. The key point is that you must continue to monitor your position because your comfortable floor price might change with market or stock conditions.

Let us look at an example using Apple Inc. (AAPL). Assume that we believe that Apple's stock price will remain turbulent for the next several months. We do not believe that Apple will snap back to well over a $100 and stay there. So we want to sell out of the money put options to capture the premium. Please note, this is purely a hypothetical example. I am in not recommending this trade or investment. In other words, you must arrive at your own decisions.

Today, Apple closed at $92.95, up $10.37. Below is a one year chart of Apple. If you click through, you can view a larger image.

Assume that you are comfortable owning the stock at $75 under any conditions. Looking at Yahoo Finance Apple Option Quotes, we note that the December $75 options are bid $2.02 and ask $2.08, down approximately $2.95. Because we just experienced a strong two day rally, you decide not to enter the trade at these prices. Instead, you wait for a pullback.

Let us further assume that tomorrow morning the markets go down heavily. Apple reverses today's gain of $10.37, goes back to $82.58 and the put options prices go up $3.00 to $5.10. Now you execute the trade. Under this scenario, you gain $5.10 as long as Apple remains above $75 per share. If the stock is going to expire below $75.00, you will either be required to purchase the put option back prior to or upon expiration or be assigned the put option, meaning you will be forced to purchase the stock.

If the stock closes between $69.90 and $75.00, you win. You win because you effectively paid $69.90 ( = $75.00 - $5.10 ) for a stock that is worth $69.90 or greater.

If the stock expires below $69.90, you lose. For example, if the stock expired at $60.00, then you lost $9.90. Your initial premise, however, was that you were willing to own Apple at $75.00 under any conditions. If Apple were to expire at $60.00 in December, that would certainly test how honest you were with yourself.

By having a naked short out of the money put position, you are paid to provide insurance until expiration. If the stock remains above our strike price, you keep the entire put purchase price. If the stock is going to expire below the strike price, you will be forced to cover prior to or upon expiration or to purchase the stock.

What are some of the risks with this strategy?

One obvious risk is that Apple takes off over $100 and never looks back. While you keep the put purchase price of $5.10, that is a small consolation prize. If you had purchased Apple stock outright, your gains would be much, much larger. Again, our initial thoughts were that Apple would remain range bound for the next several months.

Another risk is that Apple expires at a low price, say $60.00 or lower. While you were initially content with purchasing Apple at $75, you now have buyers' remorse at having paid an effective price of $69.90.

Yet another risk is that you sold naked too many put options. You initially thought to yourself, how could Apple ever possibly go below $75.00 and sold a ton of naked put options? Much to your extreme surprise and disappointment, the unthinkable happened—the stock market crashed quickly taking Apple along with it. Now, you have too much expensive Apple stock sitting in your portfolio.

The three mentioned risks are the obvious ones.

Some people incorrectly believe that selling naked put options is extremely dangerous. The reality is that naked put options are very similar to a long stock and short call position. That is, if the stock rises dramatically, your gains are limited. If the stock just sits there and does nothing, you capture the price for the puts (or calls). If the stock tanks, you suffer the consequences. Where naked puts are dangerous is where you get over your head and short too many put contracts. This is the third risk that I mentioned above. Then, you have the potential to do major harm to your portfolio. Thus, before employing this strategy, you need to ask yourself, am I comfortable with owning the stock at the strike price (or more precisely at the effective price which is the strike price less the put price plus commissions)?

With volatility being high, I like this strategy for certain stocks. Please note, again, the Apple example is a hypothetical example only. You must decide which stocks, if any, are appropriate for you and at which strike prices you are comfortable. And, you should likely wait for a pullback before employing this strategy.

If option strategies interest you, I highly encourage you to read my friend Adam Warner's blog Daily Options Report. Adam provides much more detail and much more insight than I do in my high level discussion in this article.

Disclosure: I have no positions in Apple.

My photograph of Calgary at Night is hosted at Flickr. If you click on the picture, you will be taken to my Flickr account where you can see more pictures.

Recently I finished Dan Ariely's book Predictably Irrational: The Hidden Forces That Shape Our Decisions.

I have always been interested in the subject of decision theory, and was curious about the hidden forces that shape our decisions. Why do people make the choices that they do? Do they weigh the risks and rewards correctly? We all know that certain people are greater risk takers than others. Some people like to participate in extreme sports while others would never place themselves in harm's way. And some people are generally more adventurous than others. Thus, we know that each of us arrives at our decisions through our own internal vetting process. The book's title captured my attention because I was looking for insights on how we arrive at our decisions.

Ariely begins the book by describing how a horrific injury that, when he was eighteen years old, separated him from society and thus allowed him to become an acute observer of society. This unfortunate event started Ariely on his career and research path.

The book is broken up into thirteen bite sized chapters of about twenty pages each. Each chapter starts with some background information, which then set the stage for an experiment. Ariely then discussed the results of the experiments and how the outcomes differed from what we expected.

Because of the book's title, I knew to expect the unexpected. Thus, I was generally not surprised by the results with two major exceptions. First, in the chapter The Influence of Arousal, Ariely discusses how young males generally react within societal norms when feeling normal, but deviate wildly when feeling aroused. What we do not know from this chapter is whether these behaviors extend to males far beyond college age and to females of various ages. I will leave the specific details for you to discover. And second, I was surprised and dismayed by how dishonest we are. That is not to say that I am perfect and therefore surprised at how flawed everyone else is. I am sure that I am, like you, part of the ninety percent of the population who believes that we are comfortably in the top decile of honesty. Rather, I am surprised by how easily and frequently people cheat. After reading about our dishonesty, I am more able to understand how corporate chieftains backdated their stock options and engaged in other inappropriate activities. I am sure we can all find examples where we are disappointed by the others' actions.

The one series of questions that nagged at me throughout the book was, What about those individuals who did not act predictably irrational? Would those individuals not act predictably irrationally for all experiments? Are they always more honest and more rationale? What do we know about those exceptional individuals?

If you are looking for a book that heavily steeped in mathematics and utility curves, you will be disappointed. Instead, Ariely shows us how we often act in predictably irrational ways, some of which are fascinating and some of which are disturbing. Regardless of your background, you will find at least some portions of—if not the entire—the book interesting. I heartily recommend this book because it will provide a glimpse as to we often make irrational decisions.

My photograph of the Icefields Parkway is hosted at Flickr. If you click on the picture, you will be taken to my Flickr account where you can see more pictures.

I finished reading Benazir Bhutto's Reconciliation: Islam, Democracy, and the West a while ago. Although I thoroughly enjoyed her book, I do not think I learned as much as possible because of my poor background in history and religion.

I was initially attracted to Reconciliation for two reasons. First, I wanted to learn about Pakistan and Islam. Pakistan and Islam are playing important roles in international affairs, especially as NATO countries are involved in neighboring Afghanistan. And second, I was intrigued and inspired by a person who believed so passionately in her causes and beliefs that she should would risk—and succumb to—an assassination.

The challenge I had in reading her book is that my understanding of history and religion is weak. Throughout much of the book, Bhutto discusses history and religion and their affects upon Pakistan. I realize that every political figure uses all media sources to promote a message. As a reader, you should have sufficient background to be able to judge the reasonableness of that message. Unfortunately, my depth of knowledge did not afford that opportunity. As a consequence, I took everything she wrote at face value, realizing that there are those who would disagree with her.

Aside from the historical and religious references, I found two important themes that resonated with me: knowledge and information as well as hope.

On page 295:

Targeted economic development can help reduce poverty and violence in Muslim-majority states. Alleviating poverty is a fundamental responsibility of all Muslims, wherever they live, as part of the basic principles of Islam. It would be far more Islamic in its true sense to declare a jihad on poverty, illiteracy, hunger, and poor governance. That is exactly what I am proposing.

Islam's first generations produced knowledge and wealth that empowered the Muslim empires to rule much of the world. But now almost half the world's Muslims are illiterate. The combined GDP of the member states of the Organization of the Islamic Conference (OIC) is about the same size as that of France, a single European country. More books are translated annually from other languages into Spanish than have been translated into Arabic over the past one hundred years. The 15 million citizens of Greece buy more books annually than do all Arabs put together.

The World Bank comparison of average incomes demonstrates a disquieting pattern. In the United States, the average per capita income is almost $36,000; in Israel it is almost $20,000. Pakistan, on the other hand, has an annual per capita income that barely crosses the $2,000 mark. No Muslim nation that is a non–oil producer has an annual per capita income near or above the world average. I find this pattern, these statistics, unacceptable.

On page 271:

Technology and communication have changed our world and are influencing a global culture. The more one knows of people, the more comfortable one is with them. I believe that, even if Professor Huntington doesn’t. Chatting on the Internet with strangers all over the world builds relationships and friendships and understanding. The ability to “Google” information from anywhere in the world puts technology into the hands of even the most isolated rural communities in the developing world. The more people learn, the more they want to learn. The more they interact, the less likely they will be to fear the unknown. Just as democracy and educational exchange promote peace, the free flow of modern technology and communication promote peace.

Everything we learn about sustained trade between nations tells us that it promotes understanding between cultures and civilizations. Globalization may be the most fundamental element of conflict resolution that has developed. The more nations trade with one another, the more they have to lose by engaging in conflict with one another. And we know that as individuals are exposed to more options in consumerism, in products they can purchase and use and share, the more they want options in other elements of their life.

On page 264:

Contrary to the pontifications of many who are unashamedly contemptuous of Muslims around the world, democracy and Islam are congruent. The basic tenets of democratic governance are specifically and directly cited in Muslim teachings and are basic to religion of Islam. As I have discussed, history shows that democracies do not make war against other democracies. And democracies are not state sponsors of terrorism. Therefore, I conclude (and challenge others to give any evidence to the contrary) that if democracies can be nurtured and sustained in the Islamic world, the possibility of conflict between Islamic democratic states and Western democratic states, and the possibility of democratic state-sponsored terrorism by democratic Islamic states against Western targets, would be all but eliminated.

Given her strong determination and sense of purpose and passion, I am terribly saddened by the loss of Benazir Bhutto. I believe that she had much to offer the world, and especially Pakistan. I hope that her book continues to shed light and optimism and that we—all of us—learn more about one another so that further bloodshed can be one day eliminated.

I highly recommend Reconciliation: Islam, Democracy, and the West. As an aside, often when I am going to meetings, I bring along a book. While waiting for others to arrive, I read a chapter or two. When I brought this book along with me, complete strangers would often stop me and provide their thoughts and opinions on Benazir Bhutto or Pakistan or both. Her book is certainly a conversation starter. I know that if you read her book, you will be much better and wiser for the experience.

My photograph of the Lake Louise in Banff National Park is hosted at Flickr. This picture was taken on 8 November 2008, an usually warm November day with the temperature near the freezing mark. If you click on the picture, you will be taken to my Flickr account where you can see more pictures.

Addendum

I received an email from the Boston Review, which might be of interest to those who read the above article.

BostonReview.net now features a forum on “Democracy and Muslim Minorities” with essays by three religion and Islam scholars. Martha Nussbaum, noted American philosopher, examines the fate of Islamic liberalism, finding hope in Jamia Millia Islamia, a secular university inspired by classical Muslim values. She acknowledges liberalism’s tenuous future, and describes the pleas of secular Muslims in India: “You say you are a liberal, and that proves you are a radical Islamist.” John Bowen, author of Why the French Don’t Like Headscarves, discusses the spread of sharia law in England, and poses a critical question: “Do the tribunals provide a useful model for legally recognizing the equal standing of an immigrant community? Or do they threaten the integrity of law and democracy, and promise the unequal treatment of women in that community?” Finally David Mikhail, Research Associate with the Project on Middle East Democracy, details the detention of Shakir Baloch, a Muslim moderate detained after 9/11. Noting the “violent and enduring” effect imprisonment had on Baloch, Mikhail lays out the repercussions that such policy will have on American foreign policy in the Muslim world.

If this interests you, you can read more at Boston Review with the forum Boston Review — Democracy and Muslim Minorities.

Blue Nile, Inc. (NILE) held its third quarter 2008 conference call last week. I listened to the call and read the transcript at Seeking Alpha. We could dig into the facts and figures, but the reality is, I do not think the highly granular information matters right now.

The psyche of the consumer has been badly damaged, with October posting the lowest consumer confidence level on record. While our third quarter sales declined by 2.9% overall, published reports indicate that total Internet jewelry sales declined 11% year on year in the quarter. At Blue Nile we have seen our sales weaken in the past seven weeks, following the unprecedented events in the financial markets beginning in mid-September.

For the month of October, our sales were down 20% year on year. Given the events that have taken place in the global financial markets, consumers are understandably reluctant to spend. As the financial crisis has spread from the U.S. to other parts of the world, sales growth in our international business has slowed. Our international sales grew 53% year on year in the third quarter. Strong relative growth but down from our 179% growth rate last quarter.

The deteriorating global economy, coupled with the strengthening of the U.S. dollar, caused our international results to be more muted than those delivered in the first half of the year. With the buying power of currencies in our international markets declining roughly 20% versus the dollar, in combination with diamond prices increasing 20% year-over-year in dollar terms, consumers outside the U.S. saw extremely sharp increases in jewelry prices in Q3.

In addition, it’s important to note that the third quarter was the first full quarter in which we had anniversaried the May, 2007 introduction of our local currency websites for Canada and the UK. While we are experiencing some short term headwinds in our international business caused by global economic conditions and currency changes, we continue to be very enthusiastic about the future opportunity for our international business given the exceptional consumer value proposition that we offer.

Looking ahead, the economic climate remains extremely difficult. We are approaching the upcoming holiday season very cautiously. We will be sharp on price and value and will use this as an opportunity to enhance our competitive position. Current sales trends are very unclear. We don’t have a good picture as to how sales levels for the remainder of the quarter will compare to sales levels in the month of October.

While we would prefer to provide Q4 guidance, we have very little clarity as to how the economic environment will impact consumer spending patterns for the holiday season. For these reasons, we have decided that the prudent course is to not provide financial guidance for Q4.

What more do you need to know?

My view is quite simple. First, company met its guidance and enjoyed free cash flow, both of which are positive. Second, the company's model scales extremely well. That is, when times are difficult, it does not have brick and mortar stores and other high fixed costs to support. When times are great, it can expand rapidly. Third, much of their competition is getting their brains bashed out during this difficult economic climate. Fourth, economic times are extremely challenging and, as a consequence, Blue Nile is unable to provide guidance for the fourth quarter. And fifth, uncertainty and nervousness are extremely high.

So where does this information leave us in terms of share valuation?

Any analyst that ascribes a specific value for the proper share price is nuts. Given that the company is unable to provide guidance and that uncertainty and nervous are rampant, precise share valuation is meaningless. My intuitive guess is that is the low 20s is likely a buying opportunity and the high 20s is a selling opportunity. That is, buy the dips and sell the rips. I expect the stock market to remain volatile as we feel our way through this current mess. At times, buyers will feel confident and push share prices up. That is your opportunity to lighten up. And at other times, buyers will feel pessimistic and allow share prices to fall. That is your opportunity to purchase. If you like the overall business model, you can just sit back and enjoy the share price movement. When the economy shows signs of stabilizing (notice I did not say improvement, though that would be even better) and the share price is in upper 30s or higher, then you can buy.

A natural question is, if the stock is going to rise eventually, why not buy now? Many people will not be able to stomach the volatility that we might encounter. If we hit a particularly rough patch, the price might even dip into the teens. For most people, the anxiety would be too great.

There are many beaten down stocks that will rebound sharply once the economy shows signs of stabilizing or improving. Look for companies with low debt and an ability to weather the economic storm. Keep track of these companies and when the economy begins to turn, you can seize your opportunity. In the meantime, keep your powder dry and wait.

Disclosure: I am long Blue Nile stock.

My photograph of downtown Jasper is hosted at Flickr. If you click on the picture, you will be taken to my Flickr account where you can see more pictures.

Today is Remembrance Day (or Veterans Day in the United States) where we celebrate our freedom. The red poppies are to commemorate the sacrifices of those who served in the First World War. A Wikipedia article provides more background.

This past weekend while driving to Lake Louise, I came across this statue of a Ukrainian internee at a Ukrainian internment camp near Castle Mountain in Banff National Park.

During Canada's first national internment operations in World War One, thousands of immigrants from the Austro-Hungarian Empire, the majority of Ukrainian origin, some citizens of Canada, were imprisoned as "enemy aliens". Internment operations lasted from 1914 to 1920. This plaque is in memory of those held as Castle Mountain camp from 14 July 1915 to 15 July 1917.

Why?

Ukrainian internee at Castle Mountain

by John Boxtel

For those wanting to know more about Ukrainian Canadian Internment camps, you can read this Wikipedia article and another specific article on Castle Mountain Internment Camp.

My photograph of a Ukrainian internee statue located at the Ukrainian Canadian Internment Camp near Castle Mountain in Banff National Park is hosted at Flickr. If you click on the picture, you will be taken to my Flickr account where you can see more pictures.