As recently reported by IndexUniverse.com, in the last few months the yields on Treasuries have been rising, while yields on corporate bonds have been falling, signaling a shift from Treasuries to corporate bonds. But does this imply that investors are no longer worrying about the economy and therefore don't feel that they need the safety of Treasuries? Are investors simply sector shifting into corporate bonds? Closer inspection shows that while investment grade corporate bond yields have fallen recently (junk bond yields have fallen more), investment-grade corporate yields have actually remained relatively steady over the last year as Treasuries prices fell and their yields increased. Furthermore, even with the recent sell-off of Treasuries, the spreads between investment-grade corporate bonds and Treasuries is still above historical averages, signaling that there are still better deals in investment-grade corporates and that the sector shift is not complete. Rotation is also being suggested in part due to a belief that if Treasury yields do continue to rise, prices could fall much further and change much quicker than corporate bonds on average given that Treasury yields have been down so much in the last year, suggesting prices have gotten ahead of themselves.

UBS is projecting that crude oil will have a yearly average of $156 a barrel by the year 2012, with the price rising steadily over the next four years, even though they see oil averaging $115 a barrel this year, about $10 less than the recent highs. This is a reversal from earlier coverage which predicted a pullback in oil prices as demand fell in the face of a potential U.S. recession. UBS has also stressed that it believes the increase in prices are mainly due to demand growth (not met by equal supply growth), rather than speculation.

Who does UBS see as benefiting from this increase in oil prices over the next four years? As to the major oil companies, UBS believes Chevron (CVX) will benefit, in addition to Occidental Petroleum (OXY), Apache (APA), ConocoPhillips (COP), and Exxon Mobil (XOM), all of which have buy recommendations. In addition to the major oil companies, UBS has also initiated coverage of oil service, drilling, and equipment firms. Current buy recommendations include Transocean (RIG), Diamond Offshore Drilling (DO), Noble (NE), Ensco International (ESV), Atwood Oceanics (ATW), and Rowan (RDC).

Of the group, the oil services and equipment analyst at UBS prefers Transocean, a recommendation that is due in part to the recent news of Petrobras locking up 80% of the deep water rigs, while also attempting to extend contracts with Transocean for over three more years (see earlier post). Current daily rates are topping over $600,000 a day for leasing deep water rigs, almost three times the average rate of $219,700 just a little over 6 months ago. A number of analysts are also picking up on this story.

Bloomberg is reporting how Petrobras (PBR), the state-owned Brazilian oil company, has leased around 80% of the world's deep water offshore drilling oil rigs. The rigs can drill in water approaching 10,000 feet in depth. Currently, the world has a supply of 21 such rigs that are capable of such depths.

Given the need for increased supply to meet current demand (which is slightly outstripping supply), producers are moving to more deep water exploration. While placing rigs under contract can be expensive, it can also give Petrobras a strategic advantage. Not only will they have more ability to tap resources that may end up being extensive, the company is also forcing competitors to pay higher rents for available rigs, in some cases as much as $50,000 more per day. The contract rates Petrobras currently has in place range from $410,000 to $580,000 per day. Truly amazing. Who is the big winner? Possibly Transocean (RIG), the world's largest offshore driller. Petrobras is attempting to extend its leases with Transocean 3 years beyond current expiration dates.

The rumors are true. Carl Icahn will be making a play for the Yahoo! board. In hindsight, this makes sense. Icahn loves situations where both the current retail investors and big shareholders are dissatisfied. It does not hurt if management is also not appearing to listen to shareholders. Having options, such as buyers or potential merger partners, also helps. In this case, Icahn has all three.

Of interests in the recent news is how Icahn is planning to nominate a full slate of directors, up to 12 in total (Update: Looks like it will be 10). At first blush this looks risky, and potentially less successful, but is also probably a wise and typical Icahn move. If the board is approved, then Icahn can essentially do what he wants with the company, including removing Yang and selling the company to the highest bidder. On the other hand, if the move fails, because shareholders were not that dissatisfied as originally expected, then Icahn can walk away, and hopefully sell shares at or slightly above what he paid for them, letting Yahoo fix its own problems.

Of course, trying to nominate a full board could simply be a strategy to get some, but not necessarily all of the board after a series of negotiations with the current board and management. Nonetheless, he probably needs at least half to influence a board that is seemingly in the pocket of its management, and who at this point appears unwilling to negotiate and accept a reasonable price for their company.

What also may be more important is not the shareholder vote and number of board seats, but whether Icahn can convince Microsoft to come back to the bargaining table. If he can accomplish this, I suspect the large shareholders he needs, along with enough retail support, will fall into line and make the proxy contest successful. But getting Microsoft on board will be tricky. While still probably wanting Yahoo!, Microsoft has publicly stated their intention to move on, and Ballmer is not know for wavering. Furthermore, Microsoft has to think about whether they want a vocal activist in their corner, and whether they want this same activist to eventually own a small, but significant portion of their stock after the sale - assuming cashing out is not part of the deal.

Merrill Lynch is apparently now going to require stock analysts at their firm to issue underperform ratings on at least 20% of the companies they cover. Right now, Wall Street analysts on average only give about 5% of companies an underperform rating. Merrill will also limit buy ratings to 70% of the companies covered, as well as limit neutral ratings to 30%. Analysts at Merrill now recommend sells on about 12% of the stocks followed.

Beyond making few sell recommendations, understanding exactly what underperform means has also be inconsistent between brokerage houses. As a result, Merrill Lynch has also further defined its ratings. Now, underperform will be the lowest rating and will apply to stocks that are expected to have a negative total return over 12 months, or gain the least among stocks in the same industry. Neutral stocks are projected to return up to 10% (doesn't sound neutral to me), while a buy rating will apply to companies that are expected to return more than 10%.

What does this mean? Essentially, 1 in 5 companies that Merrill covers will be a dog. A full 20% of the analysts covering stocks will be looking for the companies that don't quiet make the grade. So why is Merrill Lynch making these changes? Are they bowing to the pressure put in motion by Eliot Spitzer back in 2003? Is John Thain being influenced from his experience at the NYSE? Maybe, but more than likely it is about money, and not just lawsuits. During any volatile market, especially one that has the overhang of housing, credit, and inflation issues, not to mention the potential recession talk, investors and traders are interested in what to sell. Buying is easy, selling is harder. Sell guidance is valuable, especially in our current environment.

But can Merrill make money letting clients know what to sell, especially if those same clients were already advised by the company as to what to buy? Certainly valuable to the client, but probably not as value adding to Merrill. Yet, recent data from Bespoke Investment Group showed that over 10% of the shares available for trading are sold short. Given that over 1/3 of all stocks fall each year on average, providing sell data could be profitable for those willing to paying up for it - i.e., hedge funds. Of course, providing sell data is not without its own cost. Investment banks in the past have been opposed to providing too many sell recommendations, worried that they may offend potential or current clients that they hope to do business with. As such, while being potentially profitable for sale to hedge funds, expect the sell recommendations to also be filtered somewhat, avoiding upsetting the investment banking apple cart.

Yahoo! shareholders have until the end of the day Thursday (10 days after the announcement last week of the date of the shareholder meeting) in order to nominate candidates for Yahoo!'s board of directors. As discussed earlier, this short time was no accident, and puts the pressure on shareholders to get together and get organized, or find an high level investor willing to take the lead. If one were to take the lead, it would need to be someone with a large position, someone with the potential to make it larger, and someone not shy about stating their intentions? Who could it be? Any whales fit the bill?

Both CNBC and the WSJ are reporting that Carl Icahn may in fact be the vocal whale that disgruntled shareholders are looking for. Apparently Icahn is considering fighting for control of the company's board, with sources stating that Icahn may have acquired as many as 50 million shares of Yahoo!, or over 3.5% of the company. And of course, Icahn has the capital to acquire more if he wanted to. Again, the timing of the purchases is not totally clear, but it would explain somewhat how the stock has been propped up over the last few weeks.

This of course begs the question: Why does Icahn want control of the board? Does he really think that Microsoft will come back and offer $33 a share once again? Can he convince them to come back? Is there another strategic partner waiting in the wings? Does he want to integrate Yahoo! with Blockbuster and Circuit City? Just kidding about the last one ..... at least I hope. Seriously, other than Google or Microsoft, who could really partner with Yahoo! and add value, and would either Microsoft or Google, even if they were to partner, even pass anti-trust reviews? It is possible that there is a Time Warner / AOL connection, but again, the ability to add value is probably limited. It is really hard to see what his motivation is, other than believing he can get Microsoft back to the table with a +$30 offer, making a nice 20% or so profit in his shares. Otherwise, if it is not Microsoft, it is hard to see other integration possibilities that add value, just as it is hard to see how integrating Blockbuster and Circuit City together builds synergy. But then again, he is Carl Icahn, and he currently has a couple billion or more reason why he knows better than I do. Time will tell.

Reuters and other outlets are reporting that a House of Representatives committee has started considering opening up a formal investigation into energy market speculation. Hedge funds and investment banks are expected to take the most blame during the investigations. Word is that some representatives are discussing the possibility of changing the margin requirements for crude oil and other energy commodities as a way to curb speculation. As with most things Congress gets involved in, the best we can often hope for is that they consider the unintended consequences of any new laws and/or regulation. Even something as simple as raising margin requirements would have the effect of reducing the amount of leverage available to speculators, causing some to move to greener pastures, but it could also have the unintended consequence of making it more costly for companies that truly need to hedge their energy cost exposure. Not only would higher margins potentially tie up more capital for these companies, keeping it from being deployed for more useful purposes, but the increase could also have a negative effect on liquidity - after all, someone needs to take the other side of the trade. It is true that speculators can overtake and artificially drive a market, but they are also necessary to help provide a market for those looking to take a hedging position. As price fluctuations increase, margin requirements should reflect sustained increases in volatility. Nonetheless, simply increasing margin requirements in a hope to eliminate speculation may do nothing more than drive out those who need the market the most.

Bloomberg recently reported how hedge funds run by both Jon Wood and Eddie Lambert are down for the year, in part due to the concentrated nature of each fund. Wood's fund is expected to only invest in no more than 40 companies, but was recently hurt as U.K. Bank Northern Rock Pic and California mortgage company Countrywide Financial suffered losses. Lampert's fund has been hurt by its large stake in Sears Holdings, for which Lambert is chairman.

For many, both investors and managers, concentrated funds are both an opportunity to strike it rich, but also provide the potential to implode quickly. For fund managers, who are often compensated on a 2/20 setup, the potential for 20 percent of a big winner is often too tempting to ignore. If the fund implodes, management will often close up shop given that it will be difficult to get above high water marks anytime soon. Those managers that want to continue on have to worry about investor redemption, unless the fund has long-term lockup provisions in place. Even then, it may still be unattractive for high profile managers to continue on with the existing fund given that their track record may be good enough to raise fresh capital as a new fund is initiated. Yet many investors don't seem to mind, given their knowledge of the risks and track record of the manager. Many of the same investors will follower a manager as he or she closes down one fund and opens up another.

There are just a few links and summaries this week. Sorry for the short list. More promised next week. I spent additional time with students last week (it was finals week), and traveling to see Mom this weekend. Happy Mother's Day! It's summertime, and the living is easy ......

Commodities

Are Commodity Funds a Long-Term Bet?
Daisy Maxey - WSJ
* Discussion of commodity-focused mutual funds, and whether the above-average gains for these funds can continue. In general, yes. Returns have been high, but demand remains strong for raw materials, which makes it likely these funds will continue to do well in the long-term, even if there are short-term corrections.

Commodities: Bubble or Not?
David Enke - SeekingAlpha.com
* Sorry for the blatant self-promotion, but if you enjoyed my recent commodity bubble discussion post (here and at seekingalpha.com), or did not enjoy it and/or felt I was way off-base, then you might want to check out the comments at the seekingalpha site. It has generated a lot of additional discussion, some of which is worth reading - pro and con.

Derivatives

Credit-Default Swaps: Weapons of Mass Speculation
Jonathan R. Laing - Barron's
* Barron's discusses the Credit Default Swap (CDS) market. A short primer on what a CDS is, followed more extensively about how they are being used for speculation. The article includes the typical mention of how hedge funds are making a killing, but then talks more about how regulators and on-air personalities may have contributed to the movement of CDS prices every time they discuss whether the monolines would be downgraded. Again, not a detailed article on the CDS market in general, and the purpose it serves, but interesting in how it is being used to profit from rumors and speculation, as with other markets.

Hedge Funds

GLG star's exit could cost $4bn
James Quinn - Telegraph UK
* Another article about what happens to investors that try to leave a hedge fund once the fund manager departs. Redemptions fees get increased or waived, based on your loyalty.

Private Equity

Wharton Private Equity Review: Harnessing the Winds of Change
Wharton - University of Pennsylvania
* The spring review discusses changes in the private equity arena. In particular, there is discussion of how since the credit markets have shut down, it is more difficult to obtain the lifeblood of private equity - cheap money. As such, PE funds are looking for other opportunities. Many are finding that they are needing to hook-up with strategic buyers and corporations, or consider going back to a previous mainstay - distressed investing. Some funds are also considering more international opportunities, some of which may be driven by changes in the tax code, or anticipated changes in the tax code. There is also a nice round-table discussion of the challenges with starting a new private equity firm.

Quantitative Finance and Financial Engineering

A Trader's Perspective on 130/30 Funds
Christopher Holt - SeekingAlpha.com
* Interesting article of 130/30 investment funds from the perspective of a trader. What is the conclusion? Despite the academic discussion of the pros and cons and general rationale for the strategy, a 130/30 strategy is nothing more than a simple short-selling strategy. In fact, there is nothing magical about the 130/30 fund. The amount of short-selling and subsequent leverage could be quiet different, given different circumstances. The article goes on to give some general 1X0/X0 mechanics as a starting point for those interested in developing their own long-short strategy, as well as what is and is not practical - such as whether the short funds can be properly and fully redeployed.

Trading

Boom in 'Dark Pool' Trading Networks Is Causing Headaches on Wall Street
Scott Patterson and Aaron Lucchetti - WSJ
* Article on the "dark pools of liquidity" that are multiplying by the second. The dark pools are simply secretive electronic trading networks that match buyers and sellers anonymously, allowing them to distribute big blocks without displaying their intentions, or moving price. The problem is that there are probably too many, and they are getting more notice. Nonetheless, hedge funds and others that need to move big blocks are using then extensively. Of interest is how securities firms and their clients are expected to increase their use to about 20% of their stock orders by 2010. This is certainly worth considering for those considering technical analysis. A further problem is that users of the dark pools obviously know about extreme buying and selling pressure that is about to affect the stock, in a sense having quasi-insider information. Depending on the size, they can shop around to get the best bid or ask. Of course, this has gotten the SEC's attention. The traditional exchanges and OTCs, on the other hand, such as NYSE and Nasdaq, are looking to get a piece of the action.

FedEx warned Friday afternoon, cutting its fiscal Q4 earnings forecast for a second time this year (it warned earlier in March), citing increases in fuel prices, which had increased by 7% ($100 million) since giving its last estimate. The company now expects earnings for the quarter ending in May to be in the range of $1.45 to $1.50 a share, compared with previous forecast of $1.60 to $1.80 per share. Not surprisingly, the shares are down in Friday after-hours trading.

A few observations. First, for those that follow FedEx, this was somewhat to be expected given their earlier warning, but troublesome nonetheless. Furthermore, anytime a company warns on Friday afternoon, when they expect that everyone will be home with family or in The Hamptons, this is also sometimes a tell that the company is in trouble. This again is certainly not encouraging.

So what does this mean for the overall economy? Just recently we discussed how the Dow Transports were making a small rally earlier in the year, even as the Dow Industrials were relatively flat. While not a perfect indicator, the transports have at times been a leading indicator for the industrials. From a previous post we discussed why:

The logic behind the indicator being that if product is being shipped from supplier to retailer, than retailers are experiencing lower inventory and increased demand, eventually resulting in both the supplier and retailer booking revenues and earnings. The leading transportation indicator occurs since the transports are the first to signal demand, with the transportation companies also being the first to actually get paid for their services, resulting in higher valuations and stock prices. Both the suppliers and retailers have to wait a few months before seeing increased revenues at the retail level, or increases in accounts payable at the supplier level. As a result, increases in the transports can at times signal future revenues and stock prices for the industrial companies.

A current comparison of the charts for the DJIA and DJTA gives us no real conclusion:


As expected, there was a nice breakaway in transports in late January, followed a few months later in March by the industrials. The recent moves this week in the transports, while down, are still above the current uptrend line. Nonetheless, the industrials have appeared to roll over slightly. Certainly higher oil prices and recent new developments (i.e., problems) with some financial companies are most likely having some impact on the broader market.

Of course, FedEx, and even the over the road shipping companies, such as YRC Worldwide, may no longer tell the whole story. Given the strength and demand of the once maligned rails, it will be important to see results from companies such as Union Pacific, Burlington Northern Santa Fe, Canadian National Railway Company, and Norfork Southern before we can declare that shipping and transportation are weakening, and that lower demand will result in lower profits for the production-driven industrials. With the rails it is also important to see what is being shipped, given that recent agricultural and energy demands have seen an increase in business for moving coal and crude oil, along with wheat, corn, soybeans, and fertilizers. The energy commodities in particular, along with higher levels of corn production, will provide an increase in freight levels, while at the same time signaling pressure on the energy consuming industrials, thereby weakening the significants of the DJTA indicator.

Tickers: FDX, BNI, UNP, NSC, CNI

To read a little more detail regarding the Berkshire Hathaway selling of index puts, check out this post at the Financial Crookery Blog. We have recently discussed this issue, but this article goes deeper into the ramifications, in particular looking at the impact of vega and dividends when writing puts with long expiration dates. Nice read and well worth the time.

Tickers: BRK.A, BRK.B

Recently there has been a lot of discussion as to whether the run-up in commodity prices is a bubble or not, or whether there is a fundamental factor at work, primarily a sustainable supply-demand imbalance.

A recent WSJ survey found that 51% of those surveyed said that demand from China and India was the prime factor for high energy prices, with 41% blaming demand for rising food costs. Supply constraints were listed by 20% as causing higher food prices, while 15% felt that supply was resulting in higher energy prices. Only 11% felt that a speculative bubble was in the works.

So what should we take of this? Those surveyed felt that the supply-demand imbalances were the major cause of higher commodity prices, and not speculation. Furthermore, demand is driving the growth and higher prices, and not simply lower supply. This is something often debated, but those surveyed felt differently on average - we have enough for now to go around, people are just demanding more of it. This makes sense to me, given that China and India are continuing to increase their energy needs to grow their economies and increase the standard of living for their citizens. This higher standard of living is putting further pressure on food commodities, no only to consume directly, but also to feed livestock as the demands for protein-based foods increases in these areas of the world. Supply may eventually become more of an issue, but demand appears to be driving prices.

As with any survey of economist and analysts, there were "two-handed" inconsistencies. The same survey group felt on average that the price of crude oil would fall to about $105 by the end of next month, and to about $93 by the end of 2008. Demand is high, supply in check, but prices will fall? Possibly, and this course is the argument surrounding the falling dollar. But this is not what the responses feel. Only 15% believed that currency (i.e., dollar woes) were causing higher energy prices, and only 7% felt they were contributing to higher food prices. This is somewhat surprising given the amount of talk recently about how weakness in the dollar is contributing to the high cost of crude oil, with some estimates showing nearly 50% of recent price increases resulting from the falling dollar.


In the end, even with the discussions of crude oil prices being too high, and pronouncements of $150-$200 a barrel prices in the next 6-24 months (bringing back images of Internet valuation calls in the late 1990s - where a yearly price target was raised one day, only to see the stock move to that new level a few days later), it is still difficult to foresee a complete collapse of commodity prices, at least a sustained collapse over the long-run. Will there be sell-offs and short-term corrections? Yes. Will there be volatility? Absolutely. Will there be adjustments as the dollar strengthens? Most likely. But will there be a total collapse in demand? It is doubtful. Demand destruction is always a worry, but people will always want to eat, and emerging countries will need energy to continue their growth, just as the United States has in the past, and will continue to in the future.

So as commodity investors, in particular energy investors, what do we do? The safer investments may still be in the "consequence" plays, i.e. the seed and fertilizer companies for the food commodities, and natural gas for the energy plays. The Potashes of the world still have tremendous demand and pricing power. Natural gas, while also having a nice run-up recently, is still trading at a lower BTU multiple than crude oil. Using historical comparisons, natural gas still has room to move to the upside, even with crude oil leveling off. If crude reverses its upward trend, this lower than historical multiple may also cushion the fall of natural gas if crude oil was to begin selling off.

The moves in energy have no doubt been sharp, and the prices do seem high, but this may in fact be the issue that we struggle with when considering investments in commodities. We have not seen $125 crude oil before, and the recent spike does seem over-extended, so it certainly seems scary. Of course, if crude oil was a stock, and the company had the same level of demand, pricing power, growth forecast, future supply issues, and strong technicals, many of the same investors might be jumping into the stock, while at the same time shying away from crude oil. Of course, commodities and stocks are very different animals, and stocks also top and end badly, or at least have large corrections, even for good companies (i.e., Google), but the analogy is not totally lost. The key is to eliminate the emotion as much as possible and examine the fundamentals and technicals for what they are. When they change, they change - and this could happen today, tomorrow, or next year. But when they are in place, they are hard to ignore. Right now they look pretty good.

Tickers: POT, AGU, MOS, MON, UNG

We tend to only focus on private equity in the U.S., but private equity investment is increasing across the globe. As for the four BRIC countries (Brazil, Russia, India, and China), India is leading the pack in the amount and number of deals being done. In U.S. dollars, there was $7.4 billion of private equity investment in India last year, compared to $2.1 billion in China, $3.2 billion in Brazil, and $924 million in Russia. As for the number of deals, India was also at the top with 119 deals completed last year, compared to 73 deals in China, 17 deals in Brazil, and 19 deals in Russia. Reports also have 42 private equity deals so far this year in India, worth approximately $1.1 billion. As a comparison, through Q3 of 2007, 295 U.S. private equity firms had raised $199.4 billion, which was more than the $154.1 billion raised by 232 firms in 2006. Still a long way to go, but private equity is on the move internationally, and surely will see increased growth as sovereign wealth funds look for places to put their new found commodity wealth.

Now that the Microsoft's takeover attempt of Yahoo! is over, Google does not appear to be as willing to move so fast in setting up a partnership with Yahoo!. Apparently, Google executives are now divided as to whether to pursue an advertising deal with Yahoo, and also divided as to what benefit it does for Google to help prop up a competitor. Microsoft is also continuing to move away from the Yahoo! discussion, and is now talking about possibly striking a deal with Facebook - although Facebook is apparently not excited about selling the entire company. Microsoft bought a 1.6% stake in the company last year, valued at $240 million. If their valuation stays the same, Microsoft would need roughly $15 billion to takeover the company, and probably a little more to get the deal done. If offered, it will be interesting to see if Facebook CEO Mark Zuckerberg takes the same approach as Jerry Yang and the Yahoo! board. A $15 billion valuation would be hard to turn-down.

Tickers: YHOO, MSFT

Yahoo! announced yesterday that its annual shareholder's meeting will be on July 3rd. The announcement also states that:

"Under Yahoo!'s amended and restated bylaws, notice of a stockholder's nomination of persons for election to the Board of Directors of Yahoo! at the 2008 annual meeting must be received by the Corporate Secretary at the principal executive offices of the Company no later than the close of business on May 15, 2008."

Therefore, by 1.) announcing the meeting details right after the Microsoft fiasco, and by referring to their recently amended bylaws that only gives shareholders 10 days to put a new slate of directors together for consideration at the board meeting, and by 2.) having the annual meeting the day before the July 4th holiday, when may shareholders will have other travel plans, Yahoo! is once again showing total disregard for its shareholders.

I would not be surprised to see the current board start to get nervous and begin making outside comments, or at least hear current shareholders rattle the cage a little. As with many poison pills and shareholder rights provisions, the provisions themselves often come back to hurt the very shareholders they are suppose to help.

Ticker: YHOO

Nice article at the Daily Options Report about why you should not trade VIX calls as a way to trade volatility. Check out the whole article, but as a highlight:

Primarily because the guy on the other side of the trade understands them better than you do. Particularly if he is running a big derivatives portfolio with all sorts of variance risk, while you are seeing the recent VIX poundage and want to speculate that has gotten overdone. And you don't fully understand the bet you are making here. Which is absolutely nothing to be embarrassed about; it's an extremely confusing product masquarading as something not so complex.

In a sense, the VIX is an estimate of the volatility of SPX options. As such, the VIX options are therefore derivatives of a derivative, making the analysis more complicated than most of us want and need to bother with. You are better off using the VIX as an indicator of overall market volatility, and then trading options on other assets off this information.

Nice article at the Crossing Wall Street blog about shorting puts to acquiring stocks at cheaper cost. The basic idea is that if you want to buy a stock, why not just sell puts against it, receive the put income, and then wait. If the stock goes up, you at least get the put premium as income. If the stock goes down, you capture the stock at a lower price. Of course, the immediate risks are that 1.) the stock goes up and you do not get to participate in the upward gains, other than the put premium income, and 2.) the stock goes down a great deal below your written strike price, forcing you to buy a cheaper stock for a higher price. For 1, you do give up potential gains, but are not adding negative downside risk. For 2, this certainly does involve downside risk, but if you bought the stock, you would also incur a loss, possibly more, since you probably bought at a higher price and also did not gain any option premium income to offset your purchase price. Buying the stock and placing stops would involve less risk, but given a gap down at the open, you would also not see the benefits of the stops, and would have similar risk as the put position. If the move down is slow, then monitoring of the option can reduce some of the same risk, but not all. Of course, the strategy works when long-term options are written in order to generate more income, and is obviously more profitable when the implied volatility of the option is high.

Furthermore, as mention at Crossing Wall Street:

"What makes this technique so effective is that it exploits the fact that option prices do not reflect the expected long-term growth rates of the underlying equities. The reason for this is that standard option pricing formulas, used by option traders everywhere, do not incorporate this variable. With short-term options, this doesn't matter. With long-term options, however, this oversight often leads the market to overvalue premiums. Taking advantage of this mispricing is the foundation of my strategy."

As mention in 1 and 2, this is not without risks, but in some cases the risk amounts to the same as buying the stock (without stops) on the downside, or not buying the stock as you wait for it to go lower, only to have it move higher without you taking a position. The strategy is worth considering, but of course, requires a little more monitoring than a simply buy-and-hold type strategy. Also, if you are looking to reduce/eliminate your downside risk, but still participate in any upward movement, call options might be a more manageable position.

Crude oil futures contracts are trading above $120 a barrel. Meanwhile, Goldman Sachs is stating the oil may incur a "super-spike" and reach $150-$200 a barrel over the next 6 to 24 months as growth in supply fails to keep pace with increased international demand, especially demand from developing nations. The moves in both crude oil and natural gas should be interesting to watch over the next few months as we enter the summer driving season. The effects of the dollar, which recently staged a short-term mini-rally before giving back some gains, should also be watched.

Jim Cramer and Joe Kernen discuss the change in the uptick rule once again (See the CNBC video here). Cramer has been on this issue for a number of months now, but Kernen does offer some counter-point as to whether this is any different than ganging up and driving a stock higher. While there are different volatility studies that don't conclusively point to higher volatility as a result of changes in the up-tick rule alone, the change in the rule does certainly allow traders to get into and out of a short position much easier. In the past it may have taken a longer time to build a short position, so you were less likely to give up the position unless you were certain the stock was going higher. Now you can move into and out of the position with more ease. To Cramer's point, it also appears that less effort is made to insure the stock can be shorted, and that shares can actually be borrowed, but this is not really an uptick issue. If you are naked shorting - shorting shares you did not borrow - then you are violating the law, regardless of whether you shorted those shares on an uptick or downtick.

Every three months after the release of quarterly data, we start to hear Congress talk about how Big Oil is making too much money and how we need to initiate some kind of windfall profits tax. Of course, when you look at the data, you see that profit margins for oil companies on a percentage basis are not stellar, or at least not exceedingly high. Compared to other industries, they are quite average. To see the data, check out Mark Perry's blog at Carpe Diem, or do a simple sector/industry sort at Yahoo! Finance.

I do sometimes wonder how many of our leaders talking about windfall profits are even looking at the data (or care to). I also wonder if they realize that when you tax something you tend to get less of it. The issue is obviously more complicated than this, but it is important to also make sure we consider the unintended consequences of our actions and decisions. Ethanol is a good example. Right or wrong, it is affecting commodity and food prices. Of course, as a trader or investor, what is important is not only noticing the obvious, but also considering the consequences. In doing so, one can use their insight to hopefully profit from the changes in the regulatory, tax, or program mandated landscape.

Just recently, those investors and traders that realized fertilizer companies would do well given the need for more corn production, or that chip makers would benefit from tax breaks to solar companies, or that the railroad companies would do better given high trucking fuel cost - along with the need to transport increased commodity production, have all profited from their knowledge and foresight. Looking out for the next "consequence" can sometimes make us profits, while easing the additional burdens we may be incurring in the rest of the market and economy. In a sense, smart investing and trading can allow us to act more like a hedge fund by increasing our returns while reducing our overall level of exposure to the market and those that control prices and policy making.