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What's the Trade?   August 15, 2012

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This Week's Education Tip

Short Puts: Many retail traders use short puts to generate income in their accounts. Short puts can also be an excellent way to acquire stock. This is a widely used strategy and is considered one of the most conservative options strategies. The position is very similar to a covered call. Learn more in our free Education section.
Sometimes, a stock has been beaten down so much that it seems destined to hit $0. But even if we are eventually right about that direction, it can be very difficult--if not outright dangerous--to attempt to profit from such situations before they go bust.

One of the big issues is the inherent risk short-selling low-priced stocks. Even when stocks seem to be in a death spiral, they still have theoretically unlimited potential upside.

Dendreon is one that comes to mind, as I have watched it pop from single-digit prices on more than one occasion over the years. I remember seeing the pharmaceutical firm trade around $4 with huge short interest while waiting for a regulatory decision on one of its proposed drugs.

You can guess what happened: The ruling was positive, and the shorts got squeezed as the stock jumped above $20. It happened in March 2007 and again in April 2009, when shares eventually ran up to $57 from a low of $2.55.

Of course, one alternative in approaching such names is to use options. Buying puts is a limited-risk way of betting on that $0 price target, but the problem there is the cost. When stocks get very cheap, the volatility is usually very high, making the option premiums a poor choice.

We saw an example of this just this morning in Zynga. With the stock at $3.08, someone was selling the March 2.50 puts for $0.42.

The trader may end up obligated to buy the stock if it trades below the $2.50 strike, but the effective purchase price would be $2.08. If the trader is hoping only to make money on the puts and not get long, however, the stock price would need to be below that level at expiration for the options to profit.

We have seen more extreme examples in stocks that were rumored to be near bankruptcy. The implied volatility of Bear Sterns puts went as high as 700 percent.

But those two cases highlight the big issue with stocks that are struggling in the low single digits: the potential takeover.

Publicly traded companies have value to someone, regardless of how low their stocks go. And bargain-hunting suitors will find such names even more attractive as their share price descends.

So just when a stock seems to have no hope, that may actually be the optimum time for it to reverse higher--perhaps in a very big way, especially if the acquirer offers a generous price.

Mere rumors of a buyout often catch short-sellers off-guard, lifting an otherwise "worthless" stock if only in intraday trading. So from a simple probability standpoint, you are almost always better off selling puts in such cases rather than buying them.

Moreover, if you think that a stock is going to $0, you probably aren't alone. And whenever you share the consensus opinion, it is usually more difficult to make money.

Remember, the best opportunities come when you think that the market is wrong about something and have a thesis based on your research. Otherwise, you're just gambling.
Back on July 6, I recommended two emerging financial names to readers of our InsideOptions Pro premium service. Since then, both have significantly outperformed the S&P 500 and probably have plenty more upside in store. This is especially true because they remain barely known and could rally as their stories attract a following.

The companies are Nationstar Mortgage (NSM) and Ocwen Financial (OCN), which service mortgages held in large pools. Before the crash of 2008, major lenders such as Bank of America and Countrywide Financial focused on originating mortgages and treated servicing as an afterthought. This is one of the reasons that such confusion occurred when delinquencies and foreclosures shot through the roof after the bubble broke.

Banks are essentially retail institutions, focused on selling products. Their loan officers are compensated by origination, not the performance of a mortgage years down the road. That's why they never anticipated the kind of problems that eventually occurred.

The result is a giant opportunity for NSM and OCN. By selling the servicing rights, banks can stick with their core retail business while shedding a major headache. And investors get pure-play stocks focused on a business that was never independent before.

Based on the results so far, these stocks are major winners. They have been rapidly growing their loan portfolios and often stand to make more money when they successfully rehabilitate delinquent mortgages and prevent foreclosures. Even better, they are emerging at the sweet spot of the credit cycle as borrowers increasingly make payments on time and home prices recover.

NSM has another trick up its sleeve. Because it has access to more than 1 million borrowers, it is perfectly positioned to originate new loans through refinancing. That gives it a big advantage over most lenders, which must advertise to gain refis.

In other words, banks pay NSM to service loans. It then uses that opportunity to compete against the very same banks in the refinancing market.

Lender Processing Services (LPS) and Corelogic (CLGX) are riding a similar wave. They are not loan servicers, but also providers of data and software to companies in the industry. Both have beaten expectations in recent quarters and made bullish comments about the future.

Another reason I like these companies is that skeletons continue to fall out of the closets at the big banks such as JP Morgan and Citigroup. Whether it's Libor, robosigning, credit-default swaps, or even questionable dealings with foreign governments, the megabanks still remain under a cloud. Mortgage-servicing companies give investors direct exposure to the improving mortgage market without any of those legacy issues.

Most of these stocks are up pretty big recently, so it's probably smart to wait for a pullback. But they seem to be in the midst of a real bull market and could offer many trading opportunities in the next year.

Three other companies seem to be following a similar trend. One is Fortress Investment Group (FIG), which owns 75 percent of NSM. Second is iStar Financial REIT (SFI), which owns a basket of commercial mortgages. It trades for about half of book value and has a big short interest.

Lastly, Portfolio Recovery Associates (PRAA) is a collections agency that has been catching fire recently as debtors increasingly pay back overdue accounts.




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