Exposure to falling oil prices

It turns out, I don't have the authorizations in place to trade options in my account like I thought I did. Very frustrating, but that is not your problem. I bring it up because I tried to place an options order this morning and thought I should share my reasoning.

I tried to buy puts on USO, which is an Oil ETF. Specifically I was looking at the January expiration Put with a 33 strike price. The pricing was not as favorable as I hoped, but I was still planning on making the trade.

Why? I was trying to give myself exposure to two separate outliers (at least to conventional wisdom). First, if the Iranian protests succeed in bringing about change in Iran, that change could be a more moderate, less belligerent power in the middle east. My point really, is that I see the possibility of a much more stable middle east in the next six months. This is the macro outcome that I wanted some exposure too. I don't have any crystal ball here, but I know there is a catalyst in place right now, which means the potential for real change is there.

Second, almost everyone in the investment community I talk too is very worried about inflation, usually with comments about printing money and debt to GDP ratios attached. I have a contrarian streak so this one-sided consensus has really been getting my attention. The fear of inflation has been driving investors into commodities such as gold and oil. My view is that oil is dramatically overvalued right now considering the weakness of the global economy, but is being pushed up by inflation hedgers. While I do not have much confidence that Obama's long-term spending will cease to be an issue, I do have a lot more confidence in the Fed than many investors. In my view, the Fed will be able to shrink the monetary base to compensate for the eventual increase in velocity of money. Also, I think consumer spending will be anemic for quite awhile, which leads me to be less worried about an overwhelming spike in the velocity of money. And of course, Fed Funds are basically at zero, so they have a lot of room to raise rates when the time comes. (As an aside, I do not think it is time to raise rates yet and am annoyed at investors who are calling for immediate rate increases to calm their own inflation fears)

In light of all that, I thought I would be able to buy some puts at very good prices. Unfortunately, the implied volatility in oil is also very high right now which makes oil options in general more expensive. My base case assumption was a 30% decline in oil by January 2010. Under that scenario I would have made 130%. To break even, oil had to decline 20% which was a lot more than I was expecting. Ultimately I was prepared to make the trade, but pricing made it less attractive than I thought it should be. I could just short the ETF but that gives me unlimited loss exposure and I like the idea of a fixed downside in this case.

Options trading is not for everyone (evidently not for me either according to Schwab) but mostly I wanted to share the thought process. If you make a trade like this, understand that you will lose the entire upfront cost (100% loss) if oil doesn't go down so this needs to be money you can afford to lose. That is probably obvious, so I'm sorry I insulted your intelligence.

Taking a Pass on E*Trade

Normally I wouldn't write up a stock I'm passing on, but I've been thinking about it a lot and decided to pass along my thoughts.

E*Trade is a discount retail stock brokerage firm that has had a horrible run. It bought an internet bank in the early part of this decade (I can't remember the year off hand) and somehow the CEO of that internet bank ended up being CEO of the E*Trade. This is important only because E*Trade blew up by making really bad decisions in its banking operations which you would think a former bank CEO would have avoided. They had a good strategy that was poorly executed.

They were able to raise a lot of deposits from their customers, which was a good thing, but could not make enough loans to those customers to put those deposits to work. Their choices were to plow those deposits into a conservative investment portfolio until they could make good loans, or be more aggressive. They were more aggressive. They purchased a large loan portfolio, which means they didn't have anything to do with the underwriting of those loans, and they bought a riskier level of securities. Not only did they purchase mortgages, they purchased home equity lines of credit, which have a bad habit of being worth zero if the borrow stops paying because they are the second or third lien on the underlying property. Their timing was clearly bad in retrospect, as the housing market crashed and non-performing assets skyrocketed.

That is the history, leaving out a lot of detail about Citadel stepping in etc. So why am I interested at all? Because despite my earlier expectations, retail clients don't seem to care that E*trade has imploded financially. I assumed they would start bleeding clients and assets as the news came out. That has not happened. They continue to attract new accounts and assets! Amazing! Couple that with the idea that the sentiment on this stock is very poor, and I thought there might be an opportunity to buy the stock now and wait until normalized earnings power shows up.

The punch line is that I would pass on E*Trade. Under a rosy outlook, not exuberant, I can come up with $0.12 in 2011 EPS after taking dilution into account from the equity and bond exchange being offered today. If the market will pay 15x for that at the end of 2010, then the stock could trade at $1.85. I need at least a 30% cagr to get me interested in this stock which puts me at $1.25 today. The stock is at $1.42 this morning. And I need to repeat that $1.25 is the most I would pay; realistically, I would like to pay $1 so that I don't have to assume a 15x multiple.

Citadel is reported to be planning to convert $600m of their 12% coupon debt into zero coupon convertibles and buy $50-$100m of the equity offering, but I am baking that into my numbers. If E*trade gets very good terms on the equity and convertible swap, I will reconsider.

I really wanted to buy this stock, and you can tell a pretty compelling story about why it makes sense, but I do not think the potential returns are enough to compensate you for the risk in this case.

If nothing else, this has been a very interesting story to follow.