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Commodities

May 27, 2004

The Smart Profits Report: Issue #114
Thursday, May 27, 2004

Commodities: How to Create Your Own ‘Mini Hedge Fund’
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

The stock market still gets most of the press, but the financial media is finally waking up to the roaring bull market in commodities.

It’s about time…

Since the beginning of 2002, stocks have returned negative 0.9% - even with the 2003 rally. On the other hand, the CRB Index of commodity prices is up 46% and individual commodities have done even better.

  • Gold is up 51%
  • Silver is up 81%
  • Copper is up 101%
  • Soybeans are up 146%

Many investors have tried to profit from the commodity bull by buying commodity-based stocks. The problem is, owning a commodity stock does not necessarily mean full (or even partial) participation in a rally of the underlying commodity. Crude oil has rallied 66% since the beginning of 2002, but Exxon Mobil has only rallied 6% in the same time frame. For other commodities there is simply no stock alternative.

Direct Commodity Plays: Major Profits at a Serious Discount

Both futures and futures options enable the individual investor to make direct plays on commodities, currencies, interest rates and stock indexes for a fraction of the cost of more traditional investments.

That’s why professional traders use them.

For example, if you own an index fund, the odds are good you are probably already trading futures in your fund. Why? Because it is perhaps the cheapest way for a fund manager to mimic index performance.

Similarly, you can use long-dated futures options to create your own “pennies on the dollar” mini hedge funds in crude oil, metals, grains, currencies and virtually every major asset class, for a fraction of what it would cost you to do so with stocks or actual hedge funds. However, before you get to futures options, you need an understanding of futures contracts themselves.

Anatomy of a Futures Contract

A commodity or “futures” contract is an agreement between two people. The “seller” of a futures contract agrees to deliver a specific item to the “buyer” of the contract for a certain price on a fixed date in the future. The buyer of a futures contract agrees to take delivery of the same item under the same terms. The buyer of a futures contract is said to be “long” the market. The “seller” of a futures contract is said to be “short” the market.

Futures contracts are essentially “paper transactions” in that they do not involve the purchase and sale of the actual investment instruments themselves. They are contracts for delivery at a specified future date. Because no delivery takes place prior to a specified period, no money actually changes hands. Consequently, the buyer of a futures contract does not have to pay money for goods received, and the seller of a contract does not receive any money for them.

As long as the buyer of a futures contract offsets his contract before the delivery date by selling it, he will not receive delivery of the commodities (or currency, or basket of stocks) he has contracted to take delivery of, and will not have to pay for them. His profit or loss is the difference between the price he paid for his futures contract and the price at which he sold it, multiplied by the contract size.

Ditto for the seller… As long as the seller of a futures contract offsets her sale by buying it back before the delivery date, she will not have to make delivery of the underlying commodity, currency or basket of stocks. Her profit will be the difference between the price she sold the contract for and the price at which she buys it back.

How to Go Short or Long with Equal Ease

The treatment of long and short futures positions is identical. Unlike a short seller in stocks, the seller of a futures contract does not need to “borrow” his contract from another party. This makes it just as easy to sell as to buy.

Contract sizes are set by the different exchanges and are fixed. Barron’s, The Wall Street Journal and The New York Times list the contract sizes of major U.S. futures contracts. Most futures contracts trade thousands of contracts per day, with many trading well in excess of 10,000 contracts per day, making futures liquid and just as easy to buy and sell as most stocks.

Consider one of the more popular futures contracts: oil.

Let’s say Joe buys a 1,000-barrel crude oil futures contract traded on the New York Mercantile Exchange (NYMEX) for a price of $30 per barrel… and Sue sells a 1,000-barrel NYMEX crude oil contract at the same price of $30 per barrel. If prices rise 10%, to $33 per barrel, Joe’s profit would be $3,000, or $3 times the contract size of 1,000 barrels. Conversely, Sue would lose $3 per barrel, or $3,000 per contract.

Similarly, a drop of 10%, or $3 per barrel, would make buyer Joe $3,000 poorer and seller Sue $3,000 richer.

And keep in mind: Because their positions were entered before the delivery period, buyer Joe never had to pay for the crude oil and seller Sue never received any money for it. So how did they “pay” for their transactions?

They didn’t.

What they did was post performance bonds with their respective commodity brokers in the form of “margin.” We’ll cover margin in our next installment. Until then…

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Crib Sheet

  • Check out our Smart Profits Glossary to find definitions of words commonly used in The Smart Profits Report like “commodity” or “hedge fund.”

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Day Trading Stocks

May 24, 2004

The Smart Profits Report: Issue #113
Monday, May 24, 2004

Day Trading Stocks: Lessons From An After-The-Market-Closes Plumber
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

While speaking in Vegas last week at The Money Show, I remembered to call Bob the plumber. I met Bob when I refurbished my house in Florida about three years ago. Since that time, I have referred him to a lot of friends and family. Why not? Bob is a talented plumber and with a 10% friends-and-family discount, his hourly rate is only $65.

The only problem with Bob is that he likes to talk. So, whatever discount I get is negated by the 10% longer Bob spends working and talking. But a good plumber is hard to find, and much harder to let go of. Bob is very smart, mathematically inclined and frustrated in his profession as a plumber. Instead of plumbing, he would rather gamble at a casino (he is a card counter) or immerse himself in day trading stocks.

Since trading (not day trading) is something I have grown fond of myself, these are the conversations I have with Bob.

Day Trading vs. Plumbing

You might be thinking, “When does Bob trade stocks or practice counting cards? After all, plumbers like him are busy all the time.” Well, Bob is an after-the-market-closes plumber. He starts his plumbing day at 4 p.m. and continues until 2 a.m. Some nights, he finishes by midnight.

I asked Bob why he bothers with cards and stocks when plumbing is a respectable, moneymaking profession? And, Bob being about 5 feet tall with small hands and fingers, has the ideal plumber’s build.

Bob confessed that after 30 years of plumbing he has very little to show for it. A house that is almost paid off, little in the way of savings (for 30 years of sweat) and a yearning to use his mind for solving complex issues like stock trading and winning against the house.

Plus, Bob says, he is so good at counting cards (illegal in most casinos and worth a swift kick out of the establishment if caught) that he can make more in a couple of hours of gambling than he can in a week of work… on a good night.

Bob: A Barometer For The Norm

You see, after paying taxes, workman’s comp and keeping his truck tuned, Bob really does not make very much. He is looking for the easy way out. Bob is a great barometer for the norm.

When I first met Bob, he had just finished losing his ass as a day-trader in the Internet bubble. So the next step was to recoup his losses by working more hours at his day/night job. But Bob has ambition. So just after he finished my project, he drove to Vegas for a three-month stint in a dealer’s school.

He lived overnight in Vegas at a campground patrolled by a retired cop from Michigan. I asked him how he could stand the heat at the campground. He replied that he was doing double shifts at the dealer’s school, which was nicely air-conditioned. So he got home at 10 p.m. when it was cool and left at 7 a.m. when it was even cooler.

Bob returned from Vegas a new man. He had been offered a job upon his return as a resident. He even made a down payment on a house. While in Vegas he scouted out a couple of places that were suitable for his family. He found that the housing market was booming and homes outside Vegas proper were selling for just over $120,000 for a decent three-bedroom, two-bath, newly constructed home with a view of the desert and mountains. It was now early 2003. Bob had sworn off day trading after the 50% swoon in techs.

Just before Bob left for Vegas, he came by to do a little work on a new project. He told me that his house in Vegas, which he had yet to live in, was up more than 20% in just a few months, and it was increasing in value daily. So much so, that he bought another house as a speculation in the same neighborhood. Why not? Everybody was doing it. Also, he asked me to call if I thought rates were going to move higher so he could catch the bottom and lock-in.

Viva Las Vegas!

Last week in Vegas, I called Bob and asked him to join me for breakfast, lunch or dinner. He said he could not make it because of his busy schedule, but he would try. In the mornings from 6 a.m. to 2 p.m. he is day trading stocks at a local brokerage house that also teaches day trading. After that, he’s at casino school until 10 p.m., learning how to be a craps dealer.

“I thought you were doing blackjack, Bob?”

“I was, but you are more employable when you can deal two types of games,” he said. He promised he would try to skip out of class early to meet me for lunch and give me a ride to the airport.

Bob came through and we met for lunch. He was very excited about the stock market. He was making a lot of money using this new system that worked solely by using standard deviations and trading in the first 10 minutes of the day. I pretended to care. I was actually upset.

“Bob, I thought you gave up day trading after getting killed in the tech bubble?”

“This time it’s different.” I asked him how he was making ends meet, considering he was going to school fulltime and not really working, other than day trading. He answered that both his houses had appreciated more than 40% each, so he decided to take out a home equity loan to make ends meet while he was in school. After all, home prices in Vegas have never crashed and the number of California plates were increasing daily.

What If The Housing Market Crashes?

That will never happen according to Bob. Is the second house empty? No, apparently it is being rented to a fellow member of his day trading group (month-to-month, of course). As I was paying the check, Bob left to get his car.

He swung around the front of the hotel in a spanking new Mercedes convertible and sped me to McCarran Airport for my flight back to reality… and sanity.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • While today we focused mostly on Bob and his foibles, you may want to brush up on your options terminology for next time by visiting our free Smart Profits Glossary.

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Battle With Your Broker

May 20, 2004

Battle With Your BrokerThe Smart Profits Report: Issue #112
Thursday, May 20, 2004

Battle With Your Broker: Make Your First Option Trade in Three Easy Steps
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

As I pointed out in the last letter, being mature, sensible and experienced is not the magic key to the options kingdom. Many brokers make it hard for you to get in. And when the salesman - I mean broker - that you deal with isn’t comfortable with options himself, expect a battle with your broker.

There are times when Smith, Smith and Smith will tell clients in the Roanoke office they can’t trade options, yet the same firm’s Boston office is approving people just like them. I’ve heard from investors with million-dollar portfolios who were turned down. They could easily afford to put some of their money to work at higher risk for higher potential returns.

Most of the time, it’s the broker who is wrong. Occasionally, the broker is right. The customer who is on the phone with panicked questions every time one of his stocks drops 50 cents is not going to be a good options candidate. If you’ve been over-nervous and showing it, better cure that habit before trying to get an options account.

But if you are ready to go and the broker is the only thing standing in the way, then fight back. There are other ways to get in the door - including the three listed below. Read more

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Open an Options Account

May 17, 2004

The Smart Profits Report: Issue #111
Monday, May 17, 2004

Open an Options Account: Not Always a Simple Task When Dealing With Brokers
By Karim Rahemtulla
Chairman, Mt. Vernon Research

You’ve never seen this written anywhere, but you’ve heard it, even if phrased with devious politeness when trying to open an options account…

“You don’t have a clue about options. For that matter, you don’t have a clue about investing. I do. I am a broker. To get to where I am, I had to pass an exam, on my third attempt. And, now I can tell you if you are qualified to trade options. What? Don’t you get it? You don’t understand money unless you are a broker. Oh, by the way, if I screw up, then you MUST use arbitration (run by a committee of insiders who love my company) to try and recover any funds from me…”

If nobody ever said those exact words to you, be sure it’s exactly what 99% of brokers think. That, in my opinion, is what the disclosure SHOULD say at the bottom of every stock and options agreement that you must sign before you can trade. And you might even throw in this:

“Good luck and thanks for leaving your hard-earned money with me to control and of course collect a piece of it every time you decide that you know better.”

You’re Bright, Rational and Have the Money… Not Enough!

You would think that a 50-year-old person of sound mind and body with 30 years of investing experience would know more than an 18-year-old just out of high school.

But, no, brokers are often in a position to say that YOU just may not be “suitable” to trade options. And while there are good brokers out there, the majority of brokers are just not qualified to determine your suitability to trade options.

Yet they do, and on a regular basis…

The suspicion that every customer is incompetent is a rampant myth in the brokerage world.

It’s rather like getting that first job. To get one, you have to prove you’ve done well at your last job, so you have to get a job to get a job! If you have never traded options before, you may not get the chance to participate in this emerging market until you can prove you’ve participated before.

The Process Begins with You on the Defensive

Here’s how it works: In order to trade options, you must fill out an application. The application asks you pointed questions. And, unless you answer that:

  • Yes you are willing to lose everything.
  • You won’t get upset if you do.
  • You won’t sue the brokerage firms regardless of how negligent they are, you’re in trouble.

Chances are you will not be allowed to trade any options except covered call plays.

Okay, so I am exaggerating a bit. A little bit. In reality the options agreement is reviewed by each firm’s options department to see whether you should be allowed to trade different options strategies. You may be able to buy puts and calls, but not engage in straddles (I’ll explain a straddle in a later issue, or check the Cribsheet below.)

But more likely, as a beginning options trader, you may not be allowed to do anything except trading covered calls. Why? Because there is absolutely no risk to the broker if you are trading against a stock you already own.

At the start, your chances are best if you have had a regular account for a while, have plenty in it and are willing to sign the form saying that you are willing to lose money and understand the risk.

Some brokerages make it hard. Others make it easy.

In later columns, I’ll tell you how to manage your money to offset this risk. But for today, think hard about how much risk you can stand. If you can take a little bit of a hit, then the broker is probably right. Covered calls are probably your best strategy.

But what if you’re all set to go mentally and the broker still stands in your way. Then you have to take charge. I’ll tell you how to get around this hurdle in the next letter.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Crib Sheet

  • When the Market Volatility Index is low, premiums should be low, too. And in the options world, low premiums are great for straddle and strangle positions. These techniques are best used when you’re unsure of which direction the market will take. Straddles and strangles can relieve you from having to choose the direction, find out more in Smart Profits #381, The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options.
  • Today we talked a good deal about covered call options strategies. For more on what covered calls are, visit our handy Smart Profits Glossary full of useful options-trading terms.

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Time Value

May 14, 2004

The Smart Profits Report: Issue #110
Friday, May 14, 2004

Time Value: With Options You Need to Be Right on Time
By Karim Rahemtulla
Chairman, Mt. Vernon Research

We’ve all heard the cliché a thousand times, but in options, “time is money” - literally. In fact, when you buy an option, what you’re paying for is time or time value.

Some months ago I made a quick trade with puts on Martha Stewart Omnimedia. Once I knew the jury in the Martha trial was likely to announce its verdict on her guilt or innocence within hours, I bought the puts that were set to expire in two weeks.

That may sound as if I gave myself plenty of time. In theory, my puts were good for two weeks… but had the jury been hung or the verdict delayed for any reason, my two-week options would have lost their value as fast as a Popsicle in July.

The puts I bought for 25 cents could have dropped to 10 cents in a day, being that close to expiration. Worse, if the jury had dawdled, other investors would probably have taken it as a good sign and the stock might have nudged up a bit before it fell. And my puts would have been worth zero.

Options Pay Off: Moving Before Time Value Evaporates

When you are betting on the direction of a stock/commodity/futures price, and using an option, then that underlying vehicle has to move within that time frame. That is what options are all about - not just being right, but being right in time. For an option to pay off, the stock has to make a significant move faster than time value evaporates. That is the hook, the bait, the lure. And to add to the challenge, the closer an option gets to expiration, the more quickly its time value declines.

It makes perfect sense. If the market lets you bet a penny instead of a dollar and offers big rewards with leverage, too, there has to be a downside somewhere. The downside is time. It’s the great leveler in options.

Give Yourself Enough Time, Or Else…

Here’s my take on short-term options - by that I mean ones that expire in a month or two. If you trade short-term options and you don’t have a system, then you are betting that Nostradamus was one of your ancestors - and his genes are dominant in your gene pool.

When you bet on a short-term option, you are saying to the world, “Look, I can predict the future!” If you really can predict the future, please contact me ASAP and I will put you on our payroll with a six-figure-no make that seven figure-salary. If you are normal and cannot predict the future, then read on.

The good news is that there are many types of options. Some expire in a month, some three months, some in a year and some in three years. The more time value you have on an option, the more expensive it will be. (For example, GE is currently trading at $30 levels, and its January 2006 $15 calls are trading at more than $15.)

Again, this is just logical. If you have more time value, then that’s just more time for things to go your way. You will be less affected by the underlying stock’s normal up and down moves when they go against you.

I prefer to use a strategy that gives me more time for something to go my way. I can’t predict what will happen next week or next month, but I can make an educated guess about what may happen in a year or two. And, with a long-dated option, like a LEAP option, I can withstand a lot of temporary shocks in the market or a stock.

Almost As Good as a Crystal Ball: Long-Term Options

For instance, back before the war in Iraq, we had a few two-year options in Duke Energy (NYSE: DUK). We bought the January 2005 $15 calls on February 20, 2003.

When the war began, the options went down, along with the underlying stocks. Short-term traders with calls got brutalized. But my long-term options were safe. More than safe, in fact. Because as soon as we recognized victory, about three months into the war, the reaction in the United States was ebullient. The stock market took off… and so did our options.

We wound up selling on August 4, 2003, pocketing a nice 83% return. Compare that to the fate of the short-term trader. If he bought a call, even on a great stock, just a month or two prior to the war, he took a huge risk. The longer the market waited for war to start, the worse stocks did.

Gloom & Doom Spreads To All Stocks

The gloom spreads to weak and strong stocks alike. No one knew just when the war would begin, so those short-term traders were really spitting in the wind. They had no idea when the market might stop going against them, and whether to hold on or bail out. They watched their calls became worthless in a hurry. Even if they were right in the long run, they failed to give themselves long enough to run, time value was working against them.

A thousand things and events affect stocks and the market as a whole every day-it could be waiting for war, it could be news of fraud at a competitor, an employment report, a better-than-expected GDP report.

Give your options enough time value for the effect of these ancillary events to work out and your chances of being right about where your stock (and ultimately your option) is headed improves dramatically.

Here’s to good times - and profits - ahead.

Good Trading,

Karim Rahemtulla

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Traders vs. Investors

May 11, 2004

The Smart Profits Report: Issue #109
Tuesday, May 11, 2004

Traders vs. Investors: Seven Questions to Reveal If You’re an Options Junkie
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I hate Vegas. I only go there to speak at conferences. Then I leave… unless I am off to the Hoover Dam or the Grand Canyon for a day trip.

I know, part of going to Vegas is to “have fun” losing money. God knows how often I have heard that one. But the odds of winning at a casino are slightly higher than the odds that a politician is telling the truth. In other words, it’s not for me. I don’t like losing money.

Most people would say they don’t like losing money either, especially with their investments. But I have to wonder. I talk to more investors than the average guy, thousands upon thousands over the years. I run into at least 3,000 people a year at the seminars that I speak at or host. It comes down to traders vs. investors, they all believe they want to make money, and they do… but some seem destined to live in Las Vegas, wherever they are.

Traders vs. Investors… And Where You Fit In

Within a minute I can usually tell if a person is a trader or an investor. There is a huge difference. Traders make a LOT of money… they also lose a LOT of money. They are into investing for the thrill, the adrenaline rush. The few who succeed are different than the pack. For them the adrenalin rush is controlled with a very strong system.

In contrast to the average speculator, the investor makes a lot of money as well. But he takes the time to understand the strategy. He gives it plenty of time to work. Indeed, he doesn’t get involved in trades that have to pay off immediately, or else. The investor is patient and a stringent rule follower. He’s balanced. He does not have all his eggs in one basket, and he knows when to fold his hand.

What’s better? Being early or right? The answer is obvious to me, but many people want that quick fix. If options were crack, there would be a lot of junkies out there.

Here’s a quick test to determine whether YOU are fit for options investing. Each “yes” answer is worth 2 points. If you score more than 2 points, better read to the end! You may be an options junkie - or well on your way.

Seven Questions to Determine If You’ve “Got a Problem”

  • Does the lure of short-term profits (less than 30 days) turn you on?
  • Do you go to Vegas, Atlantic City, or Biloxi to gamble more than once a year? (You get four points for Vegas, because you actually pay more to lose there.)
  • Do you read AND file direct-mail solicitations?
  • Do you pay the minimum on your credit cards?
  • Do you get turned on by the prospect of making money from alternative-fuel technologies …12 years before the first product hits the market?
  • Is your portfolio studded with oil/gas/real estate limited partnerships from the 70s?
  • Do you like disco, wear large gold chains and leave your top four buttons undone on your shirt? (Okay, this one is a trick question!)

If you answered yes to any of the questions on this short quiz - you get 2 points. And if you scored 4 points, uh-oh. You’re ripe to become an options junkie.

But of course, I rigged the quiz a bit…

You’d have to answer “yes” to at least one question - unless you’re a monk or a nun. If you like the idea of making money fast (Question #1) and are willing to take the level of risk it calls for, you may be speculator material.

Investors vs. Traders: Have A System

If so, you better have a system. Most short-termers lose their shirt quickly. Those that thrive all have systems and rules… in other words, they are as disciplined as investors. It is only their time frame and handling of risk that differs.

Both of which I’ll show you how to control in future columns.

Good Trading,

Karim Rahemtulla

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Option Exchanges

May 6, 2004

The Smart Profits Report: Issue #108
Thursday, May 6, 2004

Option Exchanges: The New ‘Boston Market’ And How to Profit from It
By Karim Rahemtulla
Chairman, Mt. Vernon Research

When one option exchange offers a better price than another, a good broker gets the best. So it’s good news to us that a new Boston Options Exchange is quickly gearing up for action. That brings the total to six exchanges handling options. Ultimately it means six choices for us on most options. I say most because an exchange is not required to trade all options. The more liquid the option and underlying stock, the more participation by exchanges.

The new Boston Exchange opened in late February and is quickly adding contracts. As of mid-April it was up to 232 option classes including heavily traded names like Agilent, Microsoft, Pepsi, General Electric and such. It will be adding more companies steadily.

A Word To The Wise About Exchanges…

When a new exchange enters the fray, it often gives you better fills because it wants business and it’s willing to forgo some profits by actually filling orders at a fair price to get them. Can you believe that? There actually is a point in time when an options exchange actually operates like a legitimate and respectable business…

Before you start dancing, hold up a minute. There’s a catch here. Don’t expect the big benefits to last more than a couple more months. After that it’s back to fleecing the public along with the rest of the gang.

But until BOX, as the new exchange calls itself, has as much business to reassure itself that it’s one of the players now, the added competition should drive the level of fleecing down somewhat. Then, look out again…

Same Old Option Exchange Story, Same Option Cautions

I recall when the ISEX (Independent Exchange) opened last year. All of a sudden I was getting great fills on my trades. The ISEX narrowed the spread and the other exchanges either followed or lost business. Today, however, ISEX is just like its brethren, quick to show a good price and even quicker to back away from filling you at that price.

The exchanges that control the options markets are about as honest as the top-level executives at Enron were. They are there to make money, and that means you are going to get hurt unless you know what you are doing.

How do you know what to do to protect yourself? Three simple steps will lead you to the best prices you can get:

  • Do not chase an option based on a recommendation.

The option price will move and you can bet your bottom dollar the market maker at the exchange is well aware that you and several others are simultaneously in the hunt for that particular option. Wait a day or two, and once the dust has settled, that option will come back down, unless the shares skyrocket simultaneously.

I have seen this simultaneous explosion of a stock moving fast even as my recommendation went out three or four times in the past decade. So, chances are you will get filled if you are patient. I am long-term focused. Some services that rely on technical analysis to zero in on momentum and short-term trades may see it slightly more often, but that’s when you need rule 2…

  • Use limit orders only.

You will be surprised at how often you WILL get filled with a limit order below the offer. Most likely you will get filled at the end of the trading day. If you don’t get filled, be glad. You will not make money - or you will make much less money, not worth the risk - if you insist on getting filled at too-high prices.

  • Be sure to direct your order to the exchange that is doing the most volume.

Having your order sitting at an exchange that has yet to trade any volume or one that is in cahoots with your broker will not serve your purpose.

Last But Not Least…

By the way, if you are using a broker, check his policy on fills. A very few firms are set up for options traders so that our orders are routed to the best prices. If your broker tells you he is one of them, then I suggest you follow the market and look at contracts trading after your order is in to see if you really are getting the best prices (see today’s Smart Profits Cribsheet below for details on where to get the price updates).

Finally, BE GREEDY. That means being patient. There is always another day and another play. If your advisor is not giving you picks that are liquid enough that you get filled, consider finding someone who will.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Crib Sheet

  • You can get option price updates with any good real-time quote service, including the one offered by the Chicago Board of Options Exchange (www.cboe.com). It’s work and you may not want to do this all the time - after all, that is why you pay a broker. But it’s in your best interest to check the hired help even if it’s only for a month.
  • To learn more about options trading terms like “limit order” or “volume,” just visit our handy Smart Profits Glossary.

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Market Volatility

May 3, 2004

The Smart Profits Report: Issue #107
Monday, May 3, 2004

Market Volatility: How to Pay $27 for a $50 Stock
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Repeat after me: Market Volatility is my friend.

Time is an important factor in options trading, as we’ve already seen. After all, what good is being right if you run out of time? But almost as important as time is volatility.

Volatility is the measure of how much the underlying stock or commodity moves in a given time. The more volatile the underlying instrument, the more volatile the option will be as well. And the more expensive…

Let me explain why that’s not such a bad thing…

You Pay More for a Race Horse than a Plow Horse

In researching my covered call strategy, one company I looked at was General Electric. This old stalwart of the Dow was growing its profits about 12% a year. Its share price moved in a $10 range in any given 12-month period. When GE was trading at $30, the $35 call option with a 1-year expiration was trading for $3 per share - about 10% of the stock’s current price.

That meant it would cost you $3 for the option and another $35 (the strike price on the call) to buy GE if you decided to exercise your option - or a real cost of $38 a share. And remember, GE at $30 was only likely to go to $40 within an average year.

Now, compare this to Amazon.com. Amazon was trading at a split-adjusted $13 per share. In a 12-month period, the shares moved from $13 to $110. The $20 option (which was far out of the money and should have been “cheap”) on Amazon with a 1-year expiration would have cost about $7 - over 50% of the stock price, versus 10% in the GE example. That’s a ratio of 5 to 1.

The huge difference was solely due to volatility. You weren’t especially likely to make big money trading GE options, but with Amazon’s volatility, lightening could strike.

With Amazon, you might easily have paid the $7 option premium, then exercised at $20 for a total cost of $27. Of course that $27 would have bought a stock that was going for $40, $50 or more on the market. Makes the high premium on Amazon look a lot different, doesn’t it?

Market Volatility Makes Them Expensive for a Reason…

Volatility is an important indicator to add to your analysis arsenal. Many investors get turned off by high-priced options. They want the low 50-cent options, thinking a little investment will make them big returns.

But when an option is cheap, the options market is actually telling you that it doesn’t think much of your chances. You are less likely to make money on a 50-cent option than you are on a $5 option.

How can you know this? You can check for yourself. This effect wasn’t limited to the high days of the Internet bubble. These disparities are in the market every day. Compare at-the-money options on some stocks selling for the same prices today. For instance, Exxon, Computer Sciences and Amazon are all selling around $40 now. But if you wanted a January 2005 call at $40 on them, you’d find the prices much different. You’d pay 4.20 for Exxon calls, about 5.10 for Computer Sciences, and 8.70 for Amazon.

Which one do you think is going to make a big move? Even now, Amazon is still able to move up or down more than $30 in a year. Computer Sciences may move up or down $10… and Exxon is lucky if it makes a $4 move.

The most expensive option (and they are all at-the-money options for stocks at the same price with the same time to run) is Amazon’s because it reflects the ABILITY of Amazon’s shares to make a big move. The better this ability, the more you will pay to play this game.

Price = Volatility = Potential… All Else Being Equal

Expensive options usually have high potential. That’s why I give them serious consideration when I find them on a company that interests me.

A good example is Research in Motion (Nasdaq: RIMM), the maker of the handheld Blackberry communications device. Recently, I told my readers that this company was a good short, meaning I thought it was likely to fall in price. Over the past year, speculators gone wild had pushed the share price from $13 to $100 before it seemed ready to turn down. When RIMM was back down to $95, I recommended a put option with a $90 strike price that would expire in June. It was trading at 6.70.

Two days later RIMM was down to $87 - and that put option went to 11, a 64% gain in two days on an 8% move in the share price. You aren’t likely to see that with a cheap Exxon option.

So, while the RIMM option was expensive, it was also one that produced significant profits on a relatively small move in share price. RIMM has a history of moving up or down 10% in any given week. That volatility is transferred into the options price.

Don’t turn away automatically when you find an option is expensive. Instead, explore why it is “expensive.” More often than not, you will find that the higher price is worth the investment.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Crib Sheet

  • Visit our Smart Profits Glossary to learn more about options trading terms like “volatility” or “strike price.”
  • For more on the two types of volatility within options, mainly historical and implied volatility, check out Smart Profits #186, Option Volatility: A Free Tool For Finding The Best Option Bargains.

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