CASH: Yes and no. In this business, there needs to be a critical mass of quantity… but the quality of the deal is important, too. You and I talk poker from time to time, and the way this week is shaping up reminds me of a key concept from Texas Hold ‘Em.

JL: Speaking of which, did I mention that I took down a large-field poker tourney 10 days or so ago? There were 180 players total, and I cut a path through 177 of ‘em. Dodging, bobbing, weaving — it was a beautiful thing. So we were down to three at the final table… me and two other guys, one a grinder and the other a full-time pro…

CASH: Um, yeah you mentioned it. You told me the story last week, remember?

JL: I did? Oh, right. Silly me. I’ll just have to gin up more stories by winning another one then. Meanwhile, I think I might know what you were going to say regarding poker analogies and this week’s IPO action.

CASH: Practicing your mind-reading skills, eh? Let’s hear it then.

JL: Well, the similarities are pretty clear. In poker, hand values are only the beginning. It’s just as important, if not more important, to have a clear bead on the competition. If your opponent is any good, he (or she) knows this, too. The game is so much more than numbers and statistics; the subtleties of human nature change everything. Greed and fear dominate the picture, too. That’s a big reason why I fell in love with poker in the first place: It stemmed naturally from my love of trading and investing.

CASH: Gosh. I must say, that was very insightful and well put. Too bad it has nothing to do with what I was getting at.

JL: Yeah yeah. I never claimed to be Miss Cleo. So fill us in then, wise guy. What were you getting at?

CASH: Well, in No Limit Hold ‘Em, as you know, there is a “dealer” button that gets passed from player to player in clockwise rotation. Before each hand begins, the two players sitting left of the “dealer” are required to ante up a fixed number of chips, known as the “blinds,” in order to seed the pot.

JL: Sure. There’s usually a big blind and a small blind, and the reason they call ‘em “blinds” is because the chips have to go in before the cards get dealt. The blinds help ensure there’s something to vie over in terms of pot size, and represent a voluntary cost of playing the game. In other words, you can’t just sit and wait for good cards without contributing in turn. You’ve got to pay to play.

CASH: Exactly. So that’s what this week is shaping up to be for me… It’s my turn to pay out some blinds. We’ve had some great cards dealt to us over the past two months, we’ve pressed our bets and made some nice bank, and now it’s time to contribute.

JL: Hmm. Methinks you’re reaching a bit with this analogy, but go on.

CASH: I think it’s a relevant parallel. The dealer is now on my right, and I’ve got to chunk some chips into the pot. Part of my bargain with the underwriters is keeping them happy, as you know. I participate in the bad deals along with the good, and use my trading skills to make the difference. To keep giving you my insightful backroom view of the IPO process, Cash is gonna have to take one for the team this week.

JL: I get it… You’re not a big fan of the deals going down this week, but you have to take some shares to keep your guys happy. This is like paying the blinds in that you do it to keep a seat at the table, with future opportunities in mind.

CASH: Yep, now you’re catching on. You know what? I don’t care what everyone says. In my book, you’re pretty sharp.

JL: Thanks, man, I appreciate tha– Hey wait a minute!

CASH: [snicker]

JL: Okay, I’ll give you that one. But when you least expect it… Anyway, back to the topic. So I guess the question now is, what kind of chips are you putting on the table? Red, green or black?

CASH: I’m trying to keep the blinds as low as I can, obviously. There’s a delicate balance between taking a big enough position to keep the underwriters happy, and keeping the position small enough to minimize impact on P&L.

JL: And by P&L, you mean profit and loss, of course.

CASH: What else would it be — power and lighting?

JL: Man, are you gonna get it…

CASH: I’m sure I will. I’m quaking in my boots here. But anyway, to give you a little more color on the stocks: The first IPO is American Capital Agency Corp (AGNC). Interestingly, the IPO is the beginning of the company. They’ve never done business before, and the founders actually have a pretty neat idea. They plan to raise a bunch of capital in the IPO offering, and then use the money to buy assets linked to residential mortgages.

JL: Oh, that sounds like an absolutely brilliant idea — buy toxic waste for 40 cents on the dollar and sell it for 50 or 60 cents, right? I suppose there could be some good money there… if the players are savvy enough and if they know how to play the vulture game without getting cute.

CASH: Right. The argument is that mortgage problems are now so widely publicized, and investor disgust so widespread, that the prices of these securities have the distress priced in. If these guys can pick up assets at 40 or 50 cents on the dollar as you say, and end up collecting 60 or 65 cents, that’s a 30%-plus return.

JL: And I would imagine with those kind of gains, they could absorb a few dud issues and still book double-digit profits. Worth a look, I guess — but I’m confused. You sound pretty upbeat on this idea, and I thought we were talking about deals set to flop.

CASH: Well, this isn’t the first “pass through” company. (That’s the lingo for their business model — that I’ve seen come through the deal pipeline.) And it seems like every time this type of structure is introduced the stock drops on the first few days of trading. Investors are savvy enough to realize that their initial IPO capital will be diluted by the expenses of the firm, the salaries and bonuses that must be paid to executives, and plenty of other little things like rent, maintenance, legal costs, technology costs and so on. All of this is taken out of the IPO capital raised before the first mortgage security is bought.

JL: So if, say, the company raises a cool $250 million, they might only have something like $230 or $240 million for investment proceeds, because a portion of that capital is already pre-committed.

CASH: Yes, that’s exactly how it works. And the stock price tends to reflect this dilution, too. So if they price it at $20, you will probably see it trade at $19.50 until investors start getting information that the capital has been put to good use, or the mortgage security prices are rising. Then the stock starts to trade on the future expectation of profits.

JL: A time delay of sorts?

CASH: That’s a fair way to put it. And so we don’t want to be long the stock until the “time delay” is worked through… and also until we get a sense of how management will actually be spending the IPO money.

JL: Gotcha. So what’s the other new issue that has you wincing in pain this week?

CASH: The second one is Verso Paper (VRS). This company supplies paper to catalog and magazine publishers.

JL: Interesting. I’ll have to check with the back office and see if we use any of their products. The publishing business still uses a lot of paper — but more and more, the Internet is starting to play a bigger role. Sending physical newsletters is obviously a bit more costly and time consuming than digital fulfillment. Not to mention the advantage of real-time delivery via the Web for more timely communications.

CASH: That long-term trend — away from paper and towards the Internet — is exactly why this IPO is going to go south. The business isn’t dead by any means, but it’s hardly thriving. There are only so many major consumers of this type of paper, and margins are getting squeezed as manufacturers like Verso compete for pieces of a shrinking pie.

JL: Doesn’t sound like all that profitable a niche.

CASH: You can say that again. The company lost $100 million last year.

JL: Yikes! And they’re going public why exactly?

CASH: Oh, management is spinning a big fat yarn about engineering a merger, needing to pay off debt, reorganizing the company to increase profitability, yada, yada, yada. So they expect to use the proceeds from the IPO to pay off their debt… and then we’re supposed to believe that they’ll get their act together and start making money.

JL: Do I detect a hint of cynicism?

CASH: Hey, it pays to be cynical in this market. Besides, you would be a grump too if you knew you had to take a long position with a 95% chance of going down the next day.

JL: True that. But, looking at this from our readers’ perspective, this seems to be an opportunity. What if someone were to short one of these names? After all, you’re pretty confident they’ll be headed south, right?

CASH: Indeed. I was going to let folks read between the lines… but you’re connecting the dots instead. Verso also represents the type of opportunity I’ll be covering in the new trading service.

JL: Oh man. I bet you just made thousands of ears perk up. What about AGNC, though, the other stock you mentioned?

CASH: AGNC is toast. There’s no opportunity there because the stock will open at a discount and likely go dormant almost immediately. But VRS has the potential to drift lower over the course of several weeks. You have to be nimble and quick, but there’s a great chance to make some profits shorting Verso Paper.

JL: Nice. I wasn’t expecting you to give out that kind of name to a broad audience.

CASH: Believe me, I won’t be making a routine habit of it. These kinds of opportunities — the real inside baseball-type stuff — are best suited for a smaller and more exclusive audience. If word gets out on the street that a connected player is spilling the beans, it would make my own trading that much harder… and might make it harder for me to dig up this kind of information, too.

JL: Don’t worry. We’ll get the kinks worked out behind the scenes so you can share your secrets with a more tightly knit circle of readers. Nobody wants to kill the goose that lays the golden trades.

CASH: Good deal. Next week we’ll talk about some more mainstream ideas — but for this week, you guys got a sneak peek into the deeper realms of Cash’s world.

JL: Yeah, thanks for that. And don’t lose too many of those black poker chips.

CASH: Oh, I won’t. And for every chip I give up, you know I’ll make even more back…

JL: I surely do. Have a great rest of the week.

by Justice Litle, Editorial Director, Taipan Publishing Group

JL: So, here we are after another few days of unpredictable action. Big rallies on strong volume followed by weakness in the face of $120 oil and more bad banking news. How’s it look to you? Think we’re out of the woods yet?

CASH: Yes and no…

JL: There’s a nice definitive answer. Should we shake the Magic 8-ball again?

CASH: Ha ha. Not messing around this week, eh? You’re right, though — it’s tough to have definitive answers in this kind of market. There are so many different time frames and elements to consider. In all fairness, though, I’ve been pretty dang definitive in the trading calls I’ve made these past few months.

JL: True that. You’ve had a pretty hot hand, no doubt. Tell me a little bit more about what you’re seeing overall right now. There seems to be a lot of curveballs flying around.

CASH: Definitely. That big rally on Friday was yet another one. It looks like a strong accumulation day to go along with strong momentum on good volume. But remember what Friday was…

JL: You mean because Friday was the day before Passover weekend? But that would lead to lower volume because of at least a few traders taking the day off, wouldn’t it?

CASH: True, but I’m talking about something else. Friday was also an options expiration day.

JL: Ah, right. Forgot about that. So what does that say about the rally?

CASH: Options expiration days can bring in extra share volume, as traders close out, hedge and re-hedge positions that are affected by contracts expiring. In the last few months, we’ve seen big volatility around expiration days. We’ve also seen traders who are short “out of the money” contracts suddenly caught napping by a sharp move, forcing them to trade out of a tight position. This is the kind of thing where volatility leads to more volatility. The movement can feed on itself and really pump up the market (or knock it down, depending on what’s happening). At the end of the day, I think Friday’s rally was more of a technical move than an actual fundamental shift in the economy.

JL: For our readers who may not trade options or know the mechanics of options, can you give a quick summary of how this works?

CASH: Sure. To start, imagine you were shorting call options on the Dow at a strike price of 12,800. This means you’d be collecting a premium for selling Dow 12,800 calls to the bullish traders who want to buy them. You would receive cash for selling the contracts, and as long as the Dow closes below the strike price at expiration, you get to pocket the cash you sold the contract for.

JL: So the example you just gave is called selling “naked options,” or naked short selling, because the options seller wants the options to expire worthless so he or she can pocket the premium. It’s also extremely dangerous and NOT recommended, because the risk is so open-ended.

CASH: Exactly. Naked options selling may be dangerous, and even foolhardy, but some brave souls do it anyway. It’s different when professionals do it, especially when there are day-to-day strategies for managing the position, but I don’t blame you for sounding an extreme note of caution — especially given the famous trader “blowups” attributed to naked options selling.

JL: Let’s keep going with your example.

CASH: Okay. So let’s say you (or some confident soul) has sold short a bunch of calls on the Dow. You expect the Dow to be flat to down, or at least not to rise above your strike price, so you can keep the premium you collected. But once the index starts trading up and flirting with your strike price, you’ve got a reason to sweat. Here’s where you hedge your risk by purchasing stock.

JL: So a trader is short Dow calls in a neutral-to-bearish bet. He expects the Dow to be flat to down. The Dow starts trading up and threatening to wreck his position and cost him a lot of money. So he starts purchasing stocks — probably shares in the Dow Jones components — in order to offset his risk. If the Dow keeps going up, that means the value of the shares are going up, and so the money he makes on his hedge is meant to offset losses that could be building up on his short options position.

CASH: Yep. And now imagine that a lot of traders were short those Dow calls, or otherwise bearishly inclined after the GE news of the week before. If enough traders were set up in the same manner — which is more likely at a key resistance area — then once the market moves through a certain price point, it can set off a chain reaction of short covering and long-side buying to hedge positions.

JL: So you think Friday’s rally wasn’t quite the “all clear” sign that some might have believed. Instead of signaling fresh optimism, it was a bunch of traders scrambling to hedge their shorts and bailing out of losing positions.

CASH: Exactly. But there’s another side to that coin — and what I’m about to bring up shouldn’t be a surprise to you. After all, we’ve been talking about this week since this time last month.

JL: We have? Refresh my memory. What was last month?

CASH: It’s been almost a month since the Visa deal! And as I’ve said, it takes several weeks to get the road shows underway and bring everybody onboard, but now it’s happening. We’re about to see a big ramp in the IPO markets.

JL: Yes, it’s coming back to me now. And I think you mentioned we have three deals up for this week, too. So you’ve got to be busy with last-minute details right?

CASH: Three? Try five, big boy!

JL: So did you just miss a couple of them last week?

CASH: I’m hurt! Do you really think I was just not paying attention?

JL: I could never think that about you, amigo. That trader’s mind of yours is just too sharp. But where did the other two come from?

CASH: Well, companies and underwriters alike see that the sun is shining for now, and that this could be their only chance to make hay for a while. So now Hatteras Financial Corp (symbol HTS) and Whiting Petroleum Corp (symbol WHX) are on the roster, along with four secondary offerings. Another solar company has placed a stake in the May calendar, too… so we’re starting to see these guys come out of the woodwork.

JL: That’s a lot of new action. The natural question, then, is whether this flurry of deals will dilute the market. How many new issues can this market handle? Will we see less strength than we might have with so many companies competing for the limelight?

CASH: That’s actually a pretty good point. Underwriters do try to spread inventory out over time, as many hedge fund guys (like me) don’t want to be spread too thin. Most traders like to have a few concentrated positions in their favorite names, and are less likely to buy a dozen brand-new companies in the same week. So it’s definitely a balancing act. The underwriters want to take full advantage of a strong market, and yet if they get too greedy and push the deals too fast, many of those deals could flop.