Events Trader #20: The market is heading for a correction - here's how to profit

29th September 2009

The market is heading for a correction here's how to profit

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Welcome back. With September nearly over, the rally shows no sign of abating. The market has now risen for seven months in a row. Volatility is down, and back within its long-term range of 20-30 points.

Hostile takeovers have made a comeback along with the stupid comments of so-called experts who claim that the offer price is not enough and should be raised by 50% to fully value the company. Prices for target companies have started to trade above the value of the bid as speculators and traders with not many other stories to follow bet on endless white knights joining the bidding war and endlessly improving the price on the table (compare that with the discount we were able to take advantage of during the pharmaceutical mergers earlier this year). As you've probably guessed, I'm talking about the developing situation between Cadbury (LSE: CBRY) and Kraft (US: KFT) which we'll briefly look at later.

This market looks overbought here's why

But first, in my view this market is starting to look overbought. It needs to take a breather and retrace a bit. The big picture remains bleak. The economy will not return to 3%-a-year growth fuelled by consumers gorging on easy credit. This simple fact does not yet seem to be understood by investors.

Households will have to consume less and save more over the coming years to pay off their debts. So far government spending has replaced consumer spending and this has prevented GDP from shrinking further. But this extra government spending has come from - guess what - extra borrowing. This can't last forever. Sooner or later the government boost will have to stop and taxes will have to be raised to repay the extra debt incurred. We are already seeing this in the UK the political debate is all about what spending cuts will be made and where.

The alternative is simple: inflation. This will make us all poorer. And do not think that by buying real assets such as houses you can protect your savings against inflation, as it is very likely that nominal prices for real estate could stagnate or even fall for years to come.

How to profit from a short-term market correction

But anyway, getting back to markets. As you know, in late August I expected volatility in the market to rise following the summer break. So far this hasn't happened. Volatility has remained broadly stable as the market moved higher (though I think we should hold onto our volatility play see below for more).

In my view, the market needs to correct. Looking at short-term measures, we are in overbought territory. Markets are way above their 20- and 30-day moving averages. This suggests an October retracement could be on the cards. We can profit from this by buying a put option on a whole index or on a single stock, which thanks to the drop in volatility over the past few months, has become more affordable.

The main advantage of a put option over a short position is that your losses will be capped if the market continues to move against you, but you will reap the same reward if the market moves in your favour. There are many possible types and combinations of option you can purchase that will fit your portfolio or your trading style. I have chosen the two that I think will work best, but those of you with existing portfolios may want to look at other options as I explain below.

Strategy and scenarios

Options trade on a monthly calendar and expire on the third Friday of each month. This means that you have to choose the expiry which most suits you. I have chosen November as the expiry. Why? Because October options have only two weeks left, and after the November expiry I think the market will settle down for the New Year rally and the quiet period that generally happens around Christmas. Also, with the November scenario, you have a full six weeks in which you can wait for the retracement to happen.

The two options I have chosen for you are as follows:

1. Put options on the FTSE 100 strike 5,100 November 2009 which can be purchased for £1.40 each.

2. Put options on Vodafone strike 140 November 2009 which can be purchased for 6p each.

With these two options, if the market falls by 5% from its current level, you'll roughly double your money. If it falls by 10%, you'll near-quadruple your money. Of course if the market does not fall, you'll lose the premium of the option ie all the money you invest in the option - but your losses will be capped at this. You can't lose more than you invest.

More specifically, with these two options, you will make money if the FTSE 100 falls below 4,960 between now and 20 November; and if Vodafone falls below 134p per share. You will recover part of your money if the FTSE 100 closes between 4,960 and 5,100 and Vodafone between 134p and 140p; while you will lose everything if the index and the share close above the strike price.

The Vodafone options are for 1,000 share contracts (so the minimum investment is £60), while the index options give you greater leverage at £10 per index point (FTSE index at 5,160 = £51,620), so the minimum investment is £1,400. If the market falls before the expiry date, don't worry you can sell the options back in the options market and rake in your profit this way.

I would suggest that because of the riskiness of this strategy, you only invest a tiny part of your capital. To put it in perspective, you could allocate 15-20% of your portfolio to a risk arbitrage strategy, or 7-15% to distressed assets. But in this case, I'd suggest you only use 2-3% of your total funds.

Other uses for this strategy

Bear in mind too that this strategy could be used to protect your portfolio from a sudden fall in the market. Simply add the relevant put option to the stocks in your portfolio. In this case you will still enjoy the upside but you'll be protected from sudden swings.

There are options trading in all the FTSE 100 stocks and it would have been impractical to give you more than a couple of suggestions. The key point is that November put options are the best way to play a market correction. I leave it up to you to choose your favourite target stock.

How to trade options and where to get prices

Trading should be relatively easy. You can trade these with any major broker, but do check that you have the relevant paperwork because all brokers require a separate account and stricter procedures to allow them to offer derivatives. This is because the FSA regulates derivatives more tightly, as they are riskier than the corresponding shares.

As always do check the trading commission, which can have a sizeable impact on your entry price. Prices are easily available at https://www.liffe-data.com. All you need to do is register and you will be able to access all futures and options prices on the London market with a 15 minute delay.

Risks

The risks in this case are very simple. This is a strategy where you can double or triple your money on one hand, but you can also lose all the capital you have put in. That's why I recommend you only use a tiny amount of your capital should you decide to go ahead with this. Look at it this way if this strategy is successful, you will add a few percentage point to the performance of your portfolio, while if you lose you will lose some of your gains.

Cadbury and Kraft

As you probably already know, Kraft has launched a bid for the UK's best-loved confectionary company.

The offer is the usual mix of cash and shares, with the added complication that Kraft shares are traded in dollars. That means the value of the bid changes not only with the price of the shares, but with the exchange rate as well. Kraft (US: KFT) offered 300p plus 0.2589 of its own shares (listed in $) for each Cadbury share (LSE: CBRY)

This means the offer currently values Cadbury at:

300 + (0.2589 * $26.64)/1.595 [this is the dollar / pound exchange rate] = 300 + 432 = 732p

It was around 745p on the day of the offer, and since then has fluctuated between 700p to 745p due to changes in the value of Kraft stock and the pound/dollar exchange rate.

The Cadbury's share price reacted and is trading at around 800p, or 10% above the offer price, in the expectation that a white knight will come in and bid more. The UK's takeover panel has been asked by Cadbury to set a firm timetable for Kraft to make a firm bid.

To me this mentality shows that we have still not learned anything from last year's crisis. Until this sort of thinking is out of the market we have not reached the bottom - but that's another story.

Anyway unless the price drifts toward the offer price I do not think this deal is worth playing at the moment because the potential gains do not outweigh the risk associated with a bid failing. If Kraft decides to raise the bid it could be by 10-15% to between 800p and 840p. Meanwhile, the dozens of mooted white knight bidders remain thin on the ground. If for any reason Kraft decides to walk away you can expect Cadbury shares to slide back to around 550p.

Options on Cadbury are only available for December strike which is 10 weeks away and for this reason they are quite expensive. So for the moment we will only keep an eye on the situation and await developments then see if we can make money out of it.

A quick update hang on to our volatility play

While I was away, our Vix index volatility play (US: VXX) reached our stop loss of $50. However, I still think it's worth hanging on with this for a little longer. You know what my feelings are about the current market and it could only take a couple of bad days for it to return to break even. So let's hold on to this one a little longer, and see how things develop.

Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. The share recommended is denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. The value of your investment can go down as well as up. Your profit depends on the potential price increase of the underlying security. The potential loss is predetermined and limited to the premium amount paid, and can be as much as 100% of the premium initially paid for the put. Please seek independent personal advice if necessary.

Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.

Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.

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