Pair Up Option Trades for a Double Dip

by Michael Shulman | May 9, 2011 5:13 am

Pair Up Option Trades for a Double Dip

Jobless claims numbers rose “unexpectedly.” Job creation data is “light.” GDP came in 1.8% in Q1 — and it will be revised downward for sure. Why are people surprised? And how do options trading [1]investors trade the reality and the surprise?

First, the economy. My view is that a double dip recession will arrive not later than Q1 of 2012 and that, in the rest of the world, the recession never really left. Every recession since World War II was fixed by the Fed lowering rates and housing coming back. Not this time. The Fed cannot lower rates any further and housing won’t come back until 2014-2015. Why not? Look at the numbers:

- 7 million foreclosed or to be foreclosed homes to hit the market;

- 25% of mortgage holders under water, another chunk having less than 10% equity in their homes;

- 25% of Americans with a credit score not good enough to buy a lollipop on time.

That means no housing rebound, no exit from the current stagnation and that eventually leads to recession.

Second, the markets. They have been buoyed by a flood of liquidity from the Fed along with corporate profits. Both the expansion of liquidity and the sharp rise in corporate profits is over. So the S&P 500 Index may hit 1400, but it will be followed by a sideways market then a slow to moderate decline. Along the way, good stocks will outperform, bad stocks will under perform, and that’s something that has not happened since Bear Stearns went away.

Paired Option Trades – Good Guys/Bad Guys

You trade this market with smart stock picking and by using call options that expire long after real stagnation becomes more evident.

I like to use paired trades — this approach makes the most out of one idea. Go long with calls on a great company and short through puts on a lousy company.

What company did best during the first Great Recession? Apple (NASDAQ: AAPL[2]) of course. But now the stock is stuck so it’s time to take a look at another great company.

Glass supplier Corning (NYSE: GLW[3]) is not stuck. The maker of Gorilla glass (no kidding) is building a base at $20. If you go with calls look at out-of-the-money strikes with expiration dates in the fall, and GLW has November options. Who loses? Dell (NASDAQ: DELL[4]). Apple’s computer sales were up 28% in Q1. Those sales had to come from somewhere in a flat market. Look at out-of-the-money puts that expire in 2012 on Dell.

I also like a paired option trade in the medical arena. Amedisys (NASDAQ: AMED[5]) is dependent on Medicare spending, and despite Republicans pulling back their plan, Medicare cuts are coming, so look at longer term puts on AMED. On the long side who could not like Teva Pharmaceuticals (NASDAQ: TEVA[6]), the world’s largest generic drug maker, an industry benefiting from cost cuts. Take care as TEVA has been hit due to geopolitical events – it is based in Israel — and it is an aggressive acquirer, having just announced plans to buy Cephalon (NASDAQ CEPH[7]) for $6.8 billion. For TEVA, consider out-of-the-money, long-term calls, 2012 or beyond.

Find more option analysis and trading ideas at Options Trading Strategies[8].

Endnotes:
  1. options trading : http://investorplace.com/options-trading/
  2. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  3. GLW: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLW
  4. DELL: http://studio-5.financialcontent.com/investplace/quote?Symbol=DELL
  5. AMED: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMED
  6. TEVA: http://studio-5.financialcontent.com/investplace/quote?Symbol=TEVA
  7. CEPH: http://studio-5.financialcontent.com/investplace/quote?Symbol=CEPH
  8. Options Trading Strategies: http://investorplace.com/category/options-trading/trading-strategies/

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