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How to trade the next two months

By Chris Rowe November 9, 2006 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Believe it or not, I’m going to try to make this Tycoon Report short and sweet.  That’s right, this is Chris Rowe, and I’m going to keep this short and to the point!

Okay, here it is …

You may have read my article on August 17th titled, “The worst time to invest all year” or the article titled, “The shocking impact of mid-term elections on DOW since 1914”.

In these articles I try to remind you that we are entering what is typically the worst time of the year (for bulls) and that we are in what is typically the worst year out of the 4-year cycle.

I stress the word typically because high probability obviously doesn’t guarantee the outcome.  As a matter of fact, while the odds are that we will get a sell-off some time in the next few months, the indicators that I am seeing these days are saying that this year is showing a picture of the market that isn't as bad as it usually is in this time of the year, on average. 

The reality is that these are extremely critical times for the stock market.  We could hear the wrong news from the Fed, the market can get bushwhacked BIG TIME!  Or the market could rip much higher from here. 

When you use options strategies, you don’t need to accurately predict the market’s direction.  But with the super simple option strategy that I’m about to show you, you can position yourself so that if the market takes off, you will realize about 90% of the profit that you would have realized by owning stock. 

But at the same time, if the market tanks, you will have minimal risk, and you will be prepared with plenty of cash on the side.  This way, if we see a sharp sell-off in the stock market, then you will be the person with cash, deciding which stocks you want to buy at basement prices!  

Now this can get pretty detailed, and I will be going over all of the details in depth in a report that will be published in the near future.  But I’ll skip through most of the details today and stick to bare bone basics, using approximate numbers.  You’ll have enough knowledge to implement the strategy successfully. 

First you have to understand that an option contract on a stock represents 100 shares of the stock.  In other words, one call option gives you the right to buy 100 shares.  Sounds simple enough, right?

Obviously, when you buy 100 shares of a stock, you will make $100.00 for every point that the stock trades higher, and you will lose $100.00 for every point that the stock trades lower.

But did you know that if you replace the stock with the right option, you will make close to $100.00 for every point that the stock trades higher (similar to the stock) but you should lose much less than $100.00 for each point that the stock trades lower?

That’s right.  You have less risk dollar wise, than you would by owning the stock.

Here’s an example: 

If you buy 100 shares of XYZ stock at $50.00, you will have invested $5,000.00.

If the stock trades down to $45.00 then you are down $500.00.  But if the stock trades up to $60.00, you will profit $1,000.00 right?  Right!

If you use the correct call option contract, you can invest about $550.00 (which would allow you to control 100 shares,) and for every point that the stock trades higher, you will make almost the same dollar amount. 

So if XYZ stock trades from $50.00 to $70.00 (where you would have made $2,000.00 on the stock itself,) you will make about $1,950.00 on the call option.

If we get a huge bull market and the stock trades from $50.00 to $100.00, you would have made $5,000.00 profit on the stock, and you would have made about $4,950.00 by owning the correct option.  (I’ll get to the “correct option” part in a minute.)

Now why should you give up that extremely small part of your profit that you would have made on the stock? (In this example, you’d only give up $50.00, or 50 cents/share of profit.)

Because you have significantly reduced your risk!  Let me show you why …

If your 100 shares of XYZ stock traded lower next month, from $50.00 down to $45.00, then you would have lost $500.00 on the stock position.  But the same call option in the example above would have probably only lost about $250.00 - 300.00 in value.

So in this hypothetical example so far: 

 

100 shares XYZ stock

1 call option

XYZ trades up to $70.00 

$2,000.00 profit 

$1,950.00 profit 

XYZ trades down to $45.00 

$500.00 loss 

$300.00 loss 

 Here’s where we fall in love with the strategy … 

You can only lose the dollar amount that you have invested – Obviously.

So what happens if the market takes the typical path of tanking right around this time of the year and election cycle, and decides to really take a sharp move lower sending your XYZ stock all the way down to $25.00/share?

That would mean that your loss on the stock would have been $2,500.00!  I mean technically you could lose all $5,000.00 that you have invested in the 100 shares of XYZ if it traded to zero like Enron, but let’s keep this example a little more conceivable.

If you decided to own this particular call option contract (which had just about the same upside) instead of the 100 shares of stock, then your maximum downside risk is $550.00 (the amount that you had invested in the option.)

So XYZ stock can trade to $30, $20, $10 or zero, and your maximum loss you could incur by owning the call option is only $550.00.

By owning the call option, you are only committing about 11% of the cost of what 100 shares of stock would be.  ($550.00 as opposed to $5,000.00)

If you were to use this type of strategy on your entire portfolio, assuming that your portfolio is worth $100,000.00, you would be able to put $89,000.00 in cash, or in something that you can collect interest on such as Treasuries.

You would only have about $11,000.00 at risk.  (Here comes my favorite part.)

IF the market really takes a sharp nosedive later this month, or in October, and you lose anywhere from $9,000.00 to $11,000.00 which is really only 9% - 11% (while everyone else is looking at 30 – 50 – 80% losses, praying to their maker that their spouse doesn’t turn on CNBC or read the Wall Street Journal and find out what their new net worth is,) then you will be sitting pretty with your $89,000.00 in cash or treasuries.

Hmm …  What could we do with $89,000.00 in a market that just took a 10% - 15% haircut?  Well, you could go to the bank and ask for 89,000 one dollar bills to take home and roll around in like Woody Harrelson and Demi Moore in the movie “Indecent Proposal.”

Of course, if you don’t like rolling around in cash, you can use some of that cash to buy $1.00 bills for 50 cents.  In other words, you can buy stock on the cheap. 

What if you are shaking in your boots and you believe that the sky is falling (like everyone else will believe at the time, which is why the market would be tanking in the first place?)  What if you don’t want to risk putting that $89,000.00 into a seemingly disastrous stock market?  You can simply repeat the process all over again risking a minimal amount by purchasing the correct call option.

And Now – The moment you’ve all been waiting for …

BUYING THE “CORRECT” CALL OPTION 

I’ll keep this part simple, too.  What you want to do is:

  1. Buy a call option that is deep in-the-money. 
  2. Buy a call option that has a small amount of time value.
  3. Buy a call option that expires in 6 months (which is March.)

What does that mean? 

Buying a call option that is deep in-the-money.   

If ABC is trading at $50.00/share, then you should focus on the March 45 call option.  The March 45 call option is 5 points in the money.  This is because the option contract gives you the right to buy ABC at $45.00/share which is 5 points lower than the actual price of the stock (which we said was $50.00.) 

If you were to use the March 45 call option to actually purchase ABC stock at $45.00, then you would automatically be up by $5.00/share (since ABC stock is trading at $50.00.)

The dollar amount that the stock is trading above the call option's strike price is the dollar amount that the stock is “in-the-money.”

Always keep in mind that the dollar amount that you invest in an option is the dollar amount that you are willing to lose.  Do NOT commit the same dollar amount worth of options that you would commit to the stock.  Instead, you should match the share amount, with the number of call options (with the understanding that one option represents 100 shares.)   So if you would normally buy 200 shares of stock, then only buy two option contracts. 

Buy a call option that has a small amount of time value. 

Do not confuse this with a call option that has a small amount of time before expiration.

What’s time value?

Let’s assume that the March 45 call option is trading at $6.00.

To calculate the time value of an option, you would take the difference between the stock’s price and the option’s strike price, which is $5.00 (Stock price of $50.00 – option’s strike price of $45.00 = $5.00) and subtract that number from the asking price of the option which is $6.00.  The remainder ($1.00) is your time value.

So here’s how to calculate “time value”:

Asking price of call option – (Stock price – Strike price) = Time Value

$6.00 – ($5.00) = $1.00

You should decide how much profit you are willing to sacrifice in the event that the stock trades higher.  The time value is going to be the dollar amount that you are willing to sacrifice if the underlying stock trades higher. 

For instance, here your time value is $1.00.  So if ABC trades from $50.00 to $70.00, while the 100 shares of ABC would realize a $2,000.00 profit, your March 45 call would realize a $1,900.00 profit.  You would have sacrificed $100.00 of your profit, but you have significantly reduced your risk.

If you are satisfied with that, then you have found a good option to buy as long as you also do the following.

Buy a call option that expires in 6 months (which is March.) 

Why do you do this?  Because although you already said that you are willing to sacrifice that $1.00 of upside return, you have to remember two things:

  1. Time value starts to deteriorate significantly, 90 days before expiration, quickly 60 days before expiration, and very rapidly about 30 days before expiration.  So your goal would be to get out of the call option some time before you hit that 90 day before expiration mark (which in this example is December 13th.)
  2. If ABC stock trades slightly lower — for instance, if it trades from $50.00 down to $45.00 — then the entire value of the call option will consist of time value

    For Example:  

    If you have a decent amount of time left before expiration (90 days ,) then  if ABC stock trades from $50.00 down to $45.00 (losing $5.00 in value,) then the call option should trade from $6.00 down to approximately $2.50 (losing only $3.50 in value.)  If ABC was at $45.00, then the ABC March 45 call option would no longer be “in-the-money” (which is okay, since you have over 90 days left before expiration which is why the call option still has some value.)

    But if you don’t have much time before expiration, then the call option would lose its value quickly.  For example, if we were in January of 2007, and ABC were trading at $45.00, then the ABC March 45 call option would more likely be trading closer to $1.00 or $1.70.

    If the last few (more detailed) paragraphs confused you at al l … 
    … don’t sweat it.  Because no matter which way you slice it, by owning the call option, you would be in a much better position than if you had owned 100 shares of ABC stock!

Don’t be afraid to give it a try.  If you are afraid of this, then try simply buying only one deep in-the-money call option, and watch the price of the option contract change in relation to the stock’s price change.  If you pay $500.00 for one call option which is trading at $5.00, you will be investing in an education (and you just might make money doing so.)

Okay folks, I’m sorry that I didn’t succeed in making this article “short and sweet.”  But I want you to understand this before it’s too late.

Until next time,  

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