Deep-In-The-Money Covered Calls
January 31, 2005
The Smart Profits Report: Issue #180
Monday, January 31, 2005
Deep-In-The-Money Covered Calls: How to Beat Stocks with Less Risk
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
I am often asked which strategy I like best. My answer is always the same. I like buying stocks and selling deep-in-the-money covered calls against them.
Is this a “boring” strategy, as some investors seem to think? Well, only if you find annualized returns that consistently beat the markets boring.
That’s what we keep doing in my covered-call trading service. And today, I’ll reveal the secret behind those terrific returns - returns that should beat stocks again this year by averaging about 12%.
By using covered calls in your own options trading, you can take the most dynamic, profitable investing tool out there (options) and make it safe as a blue chip stock. Here’s how to beat stocks and lower risk at the same time using options…
The Income Trader Secret
Now in its seventh year, the Income Trader has been able to maintain a win rate of more than 70%.
That’s right - more than seven out of every 10 recommendations is a winner. The other three are either break-even or losers. Still, some people say that’s too boring.
These days, people want the big numbers… even ridiculous ones, like 10,000% overnight!
Me, I’d rather get rich off boring ideas…
The goal with covered calls is to safely make between 1% and 2% on our investment every month and roll the money over to do it again. That way we create annualized returns of between 12% and 24%.
This month, for example, we closed out five winners - the best returning about 12% and the worst about 2%. All of the open positions on our books right now, about six of them, are profitable and should make us an average of 12% this year alone.
Now, I don’t have a problem understanding these numbers or getting excited about them… Remember, this is a safe money strategy, and it’s only fair to compare apples to apples. Last year we not only beat safe-money investments like CDs - by miles - we also beat all of the stock indexes when our returns were annualized.
So you might say: “Why do you annualize? That is not fair.”
If You Do It All Year Long…
I agree. In most cases annualizing your returns is at best an iffy marketing technique. It is definitely questionable to make 10% in one month and then claim that it’s an annualized return of 120%.
But, hear me out on this one. There are times when annualized returns do make sense, and that’s when the money is continually reinvested to create a steady stream of returns all year long.
When we do a trade in the Income Trader, we have a finite amount of time and are looking for a specific and predictable return. We are not shooting for the moon or hoping “it goes up” and then wondering when to sell.
So when a trade expires, it is over, and if we made 5% in two months, we then roll that money over. That 5% is a real return on capital invested. Period.
Here is how the system works. We buy a stock that we like (this can cost you money) and then we sell an option against the stock (we get money back).
But instead of betting that the shares are going higher, as most people do, we sell deep-in-the-money covered calls. That’s actually a bet that the shares are going down.
By doing this, we do several things. We dramatically reduce our cost, we win if the stock goes up, we win if the stock goes nowhere, and we usually win even if the stock goes down… but not as much as our cushion.
Buying and Selling Covered Calls
Let me give you an example from real life… We made this trade in October of 2002 but the lesson is just as valid today.
We like Cisco Systems and, using deep-in-the-money covered calls, we had a choice: Either we would own Cisco at $6.30 or we would make 19%.
Both choices sound boring, but let me explain the beauty here…
Cisco was trading at $10 per share. Down from $77, you would have thought Cisco was a good buy on fundamentals. But since the NASDAQ was crashing and burning around you, you really didn’t want to pull the trigger…
So here is what we did…
We bought Cisco at $10 and sold the January 2004 $7.50 call options against our position. At the time, these options were trading for $3.70. So when we sold the option, we got $3.70 back for each share of Cisco. Our cost was now $6.30 (10 minus 3.70).
Our upside, however, was limited to $7.50 - the strike price on the call.
Our return on this trade was 19%. (Our adjusted share price was $6.30, so our profit when our shares were called away at $7.50 was $1.20. Divide the profit by the cost - $1.20 / $6.30 - and you get 19%).
Because we bought deep-in-the-money covered calls, we were able to profit as long as Cisco didn’t drop more than 37% (that is, below $6.30, our cost).
Why Isn’t a Win-Win-Win Deal Sexy, Anyway?
What a deal! If Cisco went up, you would have made 19%. If it stayed where it was, you would have made 19%. If it went down, but stayed above $7.50, you would have made 19%.
As long as it didn’t go below $6.30, you would have made money.
I liked those odds. And in fact, it was an exciting trade. And a profitable one…
Consider too that covered calls are one of the few options strategies approved for your IRA, so you can even defer your taxes. What’s not to like?
The investors who have taken the Income Trader service are profitable, loyal and very happy. And now you know why: they understand the beauty of “boring” covered calls.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Options strategies come in all shapes and sizes. Some are complex, and some are simple. But you have to take the time to understand the goal behind each system before committing to it. If you do that you will be a very satisfied investor. And winning over 70% of the time will enhance that feeling of satisfaction from trading smart, safe covered calls. Learn more about this so-called “complex” Income Trader strategy by clicking here.
- Check out the Smart Profits Glossary if you need to update yourself with any unfamiliar option terms like, “deep-in-the-money” or “bull spread.”
Related Articles:
- Writing Covered Calls - How to Double Your Stock Profits with Options
- IBM and Google Covered Calls - Tracking These 2 Giants For An Income Jolt
- Strike Prices - Increase Your Odds by 99%
Breakout & Resistance
January 27, 2005
The Smart Profits Report: Issue #179
Thursday, January 27, 2005
Breakout & Resistance: How to Anticipate and Profit From These Twin Concepts
By Mt. Vernon Research Team
Mt. Vernon Research
On Monday, I mentioned that one of the keys to a successful option trade was predicting how high an underlying stock should rise and when.
And that means you MUST understand the twin concepts of breakout and resistance.
- Resistance is the level at which a stock will hesitate before rising higher, or stall completely and fall back, time and again.
- A breakout occurs when a stock blasts through the resistance level. When a stock breaks through resistance, momentum often carries the stock well above the old resistance level.
You can be sitting on a nice profit if you time your option play right… Here’s an example of what I’m talking about… plus some basics for identifying resistance and breakout points using basic stock charts.
Why We Might Take Our 84% and Walk Away
Right now I’m watching my Comcast (CMCSK) April 2005 $30 calls. I recommended these calls to my Optionist readers back in mid-December, and we’re still in the position, up 84% so far.
Once they rose 60%, we sold off half so that those gains would be in the bank. But I’m not worried about this stock. The news is good. Fundamentals are attractive. Buyers are outnumbering sellers.
Comcast is on quite a bullish trend… it could easily go to $35 before the week’s out, above $40 before the calls expire. (My technical analysis points to Comcast rising to $45 before it’s all said and done.)
In fact, the stock has attacked the $33 price nine times in the last two days alone. But it keeps falling back.
So why is a stock headed to $45 unable to jump the fence at a mere $33?
That’s resistance. It’s something to watch out for when you make a bullish play. And it’s also why I’m going to take my 84% gains and walk if Comcast doesn’t crack $33 pretty soon.
Resistance Can Indeed Be Futile
Resistance is an area overhead where you can anticipate the stock might stall. On most charts, it’s the price where there was an old high in the past.
You can run your finger across the chart and see where the price line has stopped at the same price level many times.
When we got into Comcast, there wasn’t any resistance nearby. It was a “clean chart.” The trend was bullish, the stock was at its high at the time (just over $30) and rolling upward. But the first time it hit $33 it stopped and pulled back. Heck, it took a pretty sharp drop back to $31.50 before turning around and trying again.
Resistance Levels Explained
Resistance usually happens because buyers are sated for the time being. Everybody who wanted in at the going price got in. If you look at the volume right before it happens, you will usually see that the stock kept moving up for a few days but the volume was dropping. This is a pattern to watch for. It happens frequently before a stock peaks or stalls. (And this phenomenon is why resistance is also called “congestion.”)
Then comes a day when the sellers begin to outnumber the buyers. Many of these people are cashing in on their profits. The price will stall. That’s resistance, and the stock will need a good drive to push through it.
Charting Resistance Is Easy… Here’s How
When you are looking at charts and considering trades, it is easiest to find bullish plays for most new options traders. I suggest you look at the Comcast chart for a good example.
Use the CMCSK symbol. (The CMCSA is similar but at slightly different numbers.) I also suggest you use the www.stockcharts.com website to do this so that you will see exactly what I’m talking about.
You can see that in December when the price passed $30, there were no old highs above $30 in the past several months. That meant it was clear of all resistance and could move right up until the supply overcame demand again.
If you had made this trade in early November when the stock was at $29, you wouldn’t have had such a clean shot to the upside. The previous peak around $29.50 in October created resistance every time the stock got to that price again in November. Prices stuck around that resistance area for eight days.
Altogether it took Comcast from early October (when it first hit $29.50) to the middle of December to get past that resistance and continue higher without looking back.
Now, some people will say that the person who waited until December to make this trade missed a bit of action. It’s true, from $29 to $33 is a 13.7% gain on the stock. From $30 to $33 is only a 10% gain.
How Far Back Should Your Charts Go?
But options also involve a time premium and it is the most costly facet of any option that is not deep-in-the-money. If you’d made this trade in November, the six weeks you waited for the stock to get past $29.50 once and for all would have reduced your gains by at least 20% on an April option. And you had no way of knowing it would only be take six weeks. Stocks can hit resistance and go sideways for months.
Could I have spotted this resistance now at $33 in Comcast? Well, maybe. With a longer-term chart, using weekly prices, you can see that the price stopped climbing briefly around $33 five times going back to June 2003.
Which brings up the question: How long a chart do you look at? A good rule of thumb is, always use at least a one-year chart if you want to see all the pertinent resistance areas.
Breakouts: Huge Momentum Equals Huge Returns
So the next time you have a stock that can’t seem to make a break higher, pull up the chart and give it a shot.
See if you can spot some past congestion or an old high that creates resistance. This is worth doing not just to become adept at reading where your stocks might stall. There’s a bonus in it… When a stock breaks through resistance, that can be a strong buy signal.
When my Comcast shares go through $33, they will probably shoot up sharply again. And then it’ll be time to cash out the rest of that position for even higher profits.
Good investing,
Mt. Vernon Research
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “breakout” or “resistance” found in today’s article.
- For more information on chart analysis swing over to Smart Profits #291, Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline”
Related Articles:
- Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options
- Options Straddle: Using a Straddle to Harness “Uncertainty”
- Technical Indicators: How to Overcome the “Evil Twins of Trading”
Become A Better Trader
January 24, 2005
The Smart Profits Report: Issue #178
Monday, January 24, 2005
Become a Better Trader: Small Changes You Can Make for Big Profits
By Mt. Vernon Research Team
Mt. Vernon Research
One thing about trading options… I’ll never fear stocks again. Stocks are easy in comparison. All you have to do is pick a direction. Either you think it’s going up, and you buy, or you think it’s going down, and short.
Trading short-term options is like playing one of those three-dimensional checkers games where you have to calculate your moves on multiple planes. Suddenly, an easy game is a gut wrencher.
First, you have to decide whether the stock’s going UP OR DOWN… then HOW SOON it will happen, because time runs out on your option. Worse, you also have to know HOW FAR it will go so that it will move enough to overcome the effect of diminishing time value.
That’s a lot to get right… But just by making a couple of changes to your trading approach, you can go from being a so-so trader to becoming a better trader. It starts with taking just a bit of time to evaluate your own trading.
Hey, 50% Ain’t Bad… But You Can Be A Better Trader
With most things in life, if you had a 50/50 track record, it would prove that you might as well throw darts. You’re doing no better than chance.
For short-term options, though, a 50/50 track record probably means you are doing quite a bit right. You are probably getting the direction correct and maybe even how far a stock will go. It’s not enough to quit your day job. But it is close enough to know that with one or two adjustments you could be a better trader…
If you could just figure out what those one or two things are!
Actually, many professional options traders have fine careers, despite being wrong up to 60% of the time, because they take small losses and get enough big winners to pull them out of the fire. You probably don’t want to lose that often or live that dangerously, and neither do I.
In fact, I thought last year was horrible for trading from May through October. The worst. It seemed as though I had to work three times as hard as usual. I ended up with a win ratio of 69% for the year, not quite making my 70% goal. For short-term options, that’s actually very good. But it still means that a lot of trades went wrong.
What do you do when your trades stab you in the back? You could console yourself by remembering that baseball’s power hitters only get three out of 10. Even Barry Bonds never made it to .400 for a full season. So cool down. Missing some is normal for hitters and options traders.
And after you resolve not to beat yourself up… with a clear mind, get to work on your swing.
Making the Jump from 50/50 Trader to “Elite” Trader
What’s critical to becoming a more effective trader is separating the losing trades that weren’t mistakes - the ones that you made for good reason - from the ones where your own habits did you in.
Every trader has weaknesses, even the best. The best just know what theirs are and how to work around them.
I found mine by reviewing the trades that missed. Going into every trade, I write down why I took it, what fundamentals, news or technical signals I used.
How to Profit from the “Trades That Missed”
When one fails, I look back at those notes, review the chart again and see if there was something I misinterpreted… or what changed that I should have paid more attention to. If you do the same, you’ll find certain things turn up as often as a begging dog.
For instance, I always did extremely well in trending markets, hitting 80-85% win rates. But not so well in ranging or flat markets. So I worked on ways to improve that.
- First, I tried some added technical indicators until I found ones that worked with my system. I still don’t hit 85% in ranging markets, but I did 64% this year in the flat period from May to October.
- Second, I’ve learned to take profits sooner in these markets.
Other traders may do well in the ranging markets that bug me, then fall apart in a trending market. Usually, they don’t know their system is based on signals that are inappropriate. Some people don’t do as well in bear markets, and believe it or not, some don’t handle bull markets well.
You should know this much about yourself. Soon, you will be profiting from your winning trades - and your losing ones, too.
Good investing,
Mt. Vernon Research
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “fundamentals” or “bear market” found in today’s article.
- To learn more about options, swing over to Smart Profits #188, Understanding Options Risk: How to Beat the “Volatility Premium” on Options.
Related Articles:
- Technical Analysis: Two Simple Tools for Spotting a Technical Trend
- Volume: Reading Volume to Find 20% Gains… In 45 Minutes
- Trading Short Term Options - A System for Reading the “Market Weather”
LEAP Options
January 20, 2005
The Smart Profits Report: Issue #177
Thursday, January 20, 2005
LEAP Options: The Intel Bargain & A Potential 566% Return
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Some people feel nothing but pain when the market falls. But I have often made the most money in down markets - more money than in ones that are moving higher or sideways.
Down markets are a dream for LEAP options or long-term options. Here’s the simple reason: Would your rather want to own a two- or three-year call option on a company like Intel when the market is valuing it at 10 times sales or at 3 times sales? When a lousy market has pulled a popular (and good) company down that far, you have a good long-term opportunity, and sometimes a genuine bargain on your hands.
A few years back Intel was trading at $70 per share. The Nasdaq 100 index was trading at 5,000. Intel LEAPS calls were around, and some people were even trading them then. The thinking was that momentum has no bounds and the company would continue to grow year after year at double-digit rates… you know the story.
Today Intel is at $23, about 3.5 times sales, a low for the company. It just announced a record quarter and forecast an excellent year ahead. Yet, now people are treating the company as a pariah. Instead of buying on a bullish forecast for better times ahead, investors are willing to sit on their hands or put their faith in less proven companies. Meanwhile, Intel is poised to produce a very nice return for us that could easily reach high triple-digits.
Let me explain…
An Intel LEAP Play That Could Return 566%
It is precisely at times like this that you should look over your holdings for the real companies with real earnings… and put aside the fads.
Fads usually end badly - see TASR and Krispy Kreme if you want to watch how fad stocks work.
Real companies cycle from good earnings to great earnings. Intel is now on track for great earnings.
Of course, it would have been a good time to invest in Intel a few weeks ago, before it announced its projections and its earnings. And in fact, I had bought Intel LEAPS options a couple of months back.
Not only did we take profits, we also entered into a bull spread, controlling shares of Intel for pennies.
We bought Intel options that had a $22.50 strike price when Intel was around $21. Within a couple of weeks, Intel announced that it would have a better-than-expected quarter.
The shares surged to $23 and it was clear we had made a good choice.
Now we could either take some super-sized profits or engage a bull-spread.
We Chose Both: Bull Spreads & LEAP Options
We took profits (for those who don’t like spreads) and we sold the $25 calls as the second part of our spread. By selling the $25 calls, we took a good chunk of our original investment off the table to re-deploy elsewhere.
We also set ourselves up for a huge return on our money at risk. If Intel closes at $25 or higher by January 2006, we stand to make something like $2,000 on a $300 investment - or approximately 566%.
Not bad for a down market.
I strongly believe that buying good companies cheap is a good strategy. What makes it even better is to buy the same company for 10% of what its shares are selling for and have years on my side to find out if I was right.
Great trading,
Karim
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Today’s Smart Profits Cribsheet
- Can’t fool you! Last week’s Smart Profits #175, Limit Prices: Tip the Odds on Options Trades In Your Favor contained an error… I made mention of each nickel in an option trade being worth $50. In actuality, that should have been $5. The reason I said $50 is because I am always under the assumption of using 10 contracts for purposes of example since it is easier to work with round numbers. Please forgive the oversight.
- Check out the Smart Profits Glossary for defintions of words like “LEAP” or “bull spread” found in today’s article.
Related Articles:
- Using LEAPS: These Options Are Set to Run Full Tilt
- LEAPS As Proxies: Making 30% While Others Make 3% - On the SAME Stock
- Timing Your Trades: Two Ways to Expand Your Thinking And Your Profits
Options Flyer
January 18, 2005
The Smart Profits Report: Issue #176
Tuesday, January 18, 2005
Options Flyer: Three Rules for Profiting from an Options “Flyer”
By Karim Rahemtulla
Chairman, Mt. Vernon Research
When you trade options you should ALWAYS have a definite goal - something you are trying to accomplish. It should govern what you buy and sell and how much risk you are willing to take. Most of the time, I’ll settle for small, steady gains. I think that’s a smart way to build wealth for the long haul.
But sometimes I don’t feel “conservative.” Sometimes I’m willing to accept more risk (as in, total risk) for tremendous returns. And that would be my definition of “taking an options flyer“…
Contrary to what some experts will tell you, flyers can be both risky and sensible. If you understand your objectives, and accept the risk in taking these positions, why not trade boldly? Taking the occasional flyer is worth it, as I’ll explain in today’s e-letter - but only if you know what you’re getting into to…
The Three Rules of Successful Option Flyer Trading
With my LEAPS Option Trader portfolio, it is sometimes open season on option flyers. We’re certainly not averse to taking on the occasional high-risk/high-reward position.
However, for an option play to represent a good flyer opportunity, it must adhere to these three rules:
- First, the initial cash outlay has to be low. Our two flyers in the LEAPS portfolio cost us $0.35 and $0.55 respectively - not a big investment.
- Second, flyers must be able to have the potential to double or triple in value within a year or so. Both of the LEAPS could double with less than a 20% move in the underlying shares.
- Third, the flyer has to be an all-or-none deal. In other words, when we do a flyer we will usually either win or lose.
One of the reasons for this all-or-none position is that the flyer shares are so hot they require only one good week to make us a ton of money. And that gain of between 20 cents and 30 cents in a week can come at any time. (In the case of our two flyers, they moved enough during one day to yield those results, let alone a week.)
So How Do You Account for the Option Flyer Losers?
Now, the trouble with “option flying…”
When they go south, flyers can have a devastating impact on your psyche - and I assure you, they can have can have a terrible effect on published returns.
So it’s important to keep it in perspective when evaluating how flyers really affect your portfolio, for good or bad.
With an all-or-nothing posture, it is possible to lose 100% of the investment. While that may “only” be $0.35 per share - it is still a 100% loss. This can distort a portfolio’s returns substantially. Let me give you an example.
Option Flyers: Distorting Your Returns?
A few weeks ago we “made” 63% on a position. That 63% was equal to $2.40 profit per share.
For the sake of argument, let’s say we had a flyer that expired worthless at the same time - a flyer for which we originally paid $0.35. That’s a 100% loss. On a percentage basis, the average for both trades would be a negative 37%. Even worse, between these two trades we had a meager 50% success rate.
But in real terms, on the basis of what you saw in your account, you would have netted $2.05.
So in reality, the portfolio would still be making you very good money. Yet someone not looking at all the facts might become convinced that he should never take a flyer again.
And that just leaves more profits for us… because we can accept the risk ahead of time, and are willing to strike when the time is right.
Good trading,
Karim
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “underlying” or “LEAPS” found in today’s article.
Related Articles:
- Reducing Option Risk: Don’t Take Insane Risks When You Have Options
- Options Straddle: Using a Straddle to Harness “Uncertainty”
- Maximum Fear: How to Turn “Maximum Fear” Into Maximum Profits
Limit Prices
January 13, 2005
The Smart Profits Report: Issue #175
Thursday, January 13, 2005
Limit Prices: Tip the Odds on Options Trades In Your Favor
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
When I research and write a recommendation for one of my options-trading services, I get pretty excited. And I want my readers to be excited, too.
But I also want my trading-service subscribers - and you - to understand the difference between excitement and foolhardiness.
Investing is all about buying at the right price and selling at the right price… Excitement means you should want to buy or sell the options within the limit prices prescribed in the recommendation. Foolhardiness means buying at any price and selling at any price, thinking that the price will “get away” and the opportunity will be missed.
Here’s how to get the price you want, so you can see the profits you want from your next option play…
Using Limit Prices Is KEY
One of the observations I can make after trading for more than a decade is that 99% of my recommendations were and could have been filled at or below the limit price.
Sometimes it may have taken a day or two for this to happen, but it happened.
However, I can also say that 99% of the time, someone paid more than the limit price instead of waiting.
If you wait, the odds of you getting in below the limit price are 99 to 1 - IN YOUR FAVOR. So wait, if you have to, instead of buying at any cost.
Each Nickel in Price Equals $50 In Profits - Or Losses
For options this is especially serious, since every nickel that you overpay is HUGE in percentage terms. Because options trade in 100-share contracts, each nickel is equal to an additional $50 per trade.
So trust me, if you want to pay more, the market maker is more than happy to fill your order at a higher price.
How to Be Sure You Pay the Price YOU Want
How can you know that you will be filled at the limit price or lower? Here are a couple ways… Options pricing is based on a model that takes into account several factors.
One of the most important factors is the underlying share price. If you watch the underlying share price and you see it falling, then the option must also fall at some point - down to your limit price.
The other way you can be sure an option will tend to fall toward your limit price is the diminishing time value present in all options…
Benjamin Franklin once remarked that the only sure things in life are death and taxes. There is one more sure thing: Options are a decaying asset. Because they have an expiration date, the value of an option declines a fraction each day.
And, unless the underlying share price moves in your direction, you can bet that the price of the option will not acquire legs and start moving on its own away from your limit price…
If you can have a little patience, you’ll be able to get into your next option play at YOUR price - not the market maker’s. And buying at the right price is 50% of the battle when it comes to profiting from options.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- limit prices“, “decaying asset” or “liquidity.”
Related Articles:
- Liquidity and Limit Orders: An Options Balancing Act
- Limit Orders vs. Naked Puts: Getting Paid to Place Them On Your Favorite Stock
- Writing Covered Calls: How to Double Your Stock Profits with Options
Profiting from Crude Oil
January 11, 2005
The Smart Profits Report: Issue #174
Tuesday, January 11, 2005
Profiting from Crude Oil: In the Age of "Perpetual Shock"
By Steve Belmont
Research Specialist, Mt. Vernon Research
Profiting from crude oil is big news. But crude oil hasn’t always been the center of attention. A few years ago, it barely rated a mention on CNBC, never mind a spot on the ticker. Americans used to take cheap oil for granted.
Those days are over…
Crude has always been vulnerable to political price shocks, but the rules have changed. Consider these factors that have changed the dynamics of the crude oil market…
- War in the Mideast
- Depletion of cheap, easily recoverable supplies worldwide
- The phenomenal growth of Asia
Asia’s 3.6 billion people consume 20 million BPD. Now consider that America’s 293 million people already consume 22 million barrels of oil per day.
Asia has over twelve times the U.S. population but consumes 9% less oil than the U.S. Imagine the increase in demand if Asian per capita usage grows by just a few percentage points.
Welcome to the age of perpetual shock…
Existing global supplies are being depleted at a rate of 4-5% per year. New demand is increasing by 2% per year. That means new supplies must increase at least 6% per year in order to keep the market on an even keel.
Plenty of Crude Oil Remains… But It’ll Be Expensive
The trouble is, all the inexpensive oil has already been found. What remains is hard-to-get, expensive oil - most of it in unstable nations. In order to make it worthwhile for oil companies to invest the capital necessary to get at the remaining oil, prices need to rise. This is how capitalism works.
In this sense, the world isn’t necessarily running out of oil; however, it may be running out of cheap oil.
Not surprisingly, crude oil has been in a rip-snorting bull market for the past two years. However, like most bull markets, it got crowded near a top.
Fears of a pre-election terrorist attack in the U.S. sent prices skyrocketing as high as $55 per barrel in October. Since then, crude futures have corrected, getting as low as low as $40.25 per barrel - a drop of 27% - before bouncing back above $45.
How High Might Crude Oil Really Go?
Despite the drop, crude oil remains in a powerful uptrend. The fact that crude was able to test its intermediate-term uptrend and bounce significantly is positive.
How high could crude go? Barring a global slowdown, supply/demand fundamentals could have crude re-testing $55 per barrel by the end of the year. Throw in a successful terrorist attack and $70 per barrel is not out of the question. This is still well short of the inflation-adjusted $83-per-barrel highs made back in 1977.
The question is: Is it time to jump back in? Our answer would be a qualified yes - "qualified" because crude may continue to test the staying power of the late-to-the-party bulls until their spirit is finally broken.
This would probably happen below $40 per barrel.
Crude could dip as low as $35 without negating its long-term uptrend. Should this happen, we believe it would be a huge buying opportunity. Yes, because in an uptrend you want to be long the market. Crude may not get back to $35 per barrel. It may not dip below $40. In the event it doesn’t, we want to jump back in, but not necessarily with both feet.
Crude oil futures are extremely volatile, so we would not recommend trading them directly for most investors. However, most energy stocks don’t keep pace with gains in crude oil. Crude rose 157% from 2002 to 2004 while Chevron Texaco rose just 16% in the same time frame. There are loads of other examples just like this.
An Options Play on the Crude Boom
Consequently, we are looking at the NYMEX crude oil call options instead - more specifically NYMEX bull call spreads.
NYMEX crude calls enable investors to make limited risk bets on crude oil directly. Big volatility means the calls are currently expensive. Bull spreads are a way to remove the bulk of this volatility premium in exchange for a cap on potential gains.
Here’s a quick example of how bull spreads work….
On Friday, Jan. 7, December 2005 $50 NYMEX crude oil calls closed at a price of $2.74 each. Each option covers 1,000 barrels of crude oil, so buying one option would require a total cash outlay of $2,740. (1,000 barrels times $2.74) Each call gives the holder the right but not the obligation to be long a crude oil futures contract at a price of $50 per barrel. This right is good until option expiration on Nov. 15, 2005.
The key phrase here is, "not the obligation." Since the call buyer has no obligation to buy - all he or she has at risk is the $2,740 paid for the option.
Still, $2,740 is a lot to pay for an option that is currently 16% out-of-the-money…
Lowering Cost and Risk Simultaneously
In order to lower our cost and our risk we want to simultaneously SELL a December 2005 $60 crude oil call. The $60 calls closed at $1.19 on Friday or $1,190 per option. We receive $1,190 into our account in exchange for our obligation to sell a crude futures contract at $60 per barrel.
We can now use the $1,190 we receive for our obligation to sell crude at $60 to offset part of the $2,740 we paid for our right to buy crude at $50. What we get is a trade that costs us $2,740 minus $1,190 or $1,550. (Note: we place the trade as a "spread" order making sure we get both sides of the transaction.)
We have now paired the right to buy 1,000 barrels of crude at $50 per barrel with a corresponding obligation to sell 1,000 barrels of crude at $60 per barrel. That means we can make the $10 per barrel difference but no more. Since each spread covers 1,000 barrels, this makes our net potential return the $10,000 difference between strike prices minus the $1,550 net cost of our spread or $8,450. The downside is we will not participate in gains over $60 per barrel.
Right now we’ll take the cap and the lower risk that goes along with it.
Good trading,
Steve Belmont
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Today’s Smart Profits Cribsheet
- Visit our Smart Profits Glossary for more on the option terms used in today’s report, like "strike prices" or "exercise price."
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You should be aware that options are not for everyone and, in general, should only be traded with "risk capital" or money you can afford to lose. Prices may have changed by the time you read this but the basic technique described above remains the same.
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For more information about commodities you can contact Sue Rutsen at Rutsen Meier Belmont Group LLC, A Division of Man Financial Inc: toll-free 800.345.7026 and 312.528.3494 direct.
Related Articles:
- Crude Oil Prices: Here’s What An Industry Insider Says Is Next For The Runaway Oil Market
- Bear Spreads - Totally Risk-Free Profits Shorting Crude Oil
- Crude Oil Prices Per Barrel: Former Market Maker Reveals Where Oil Prices May Be Headed
Reading Option Chains
January 4, 2005
The Smart Profits Report: Issue #172
Tuesday, January 04, 2005
Reading Option Chains: The "Fail Safe" Trading Signals Revealed
By Mt. Vernon Research Team
This morning I got an e-mail from a guy telling me not to make a great trade he’d just spotted. Huh?
I have to wonder why the writer wasted his time. It wasn’t an educational column; it was a "trade alert." Supposedly. This is rather like the newspaper reporting that it didn’t rain and the fireworks weren’t cancelled last night. Journalists dub that "negative news," and any good one would call in sick before writing such claptrap.
The stock in question supposedly had great technicals. (I think the writer got that wrong, as it was still below bear resistance and trading in a range. It’s on my bullish watch list, but is still a dollar short of breakout.) But, he warned, much as he loved it, it was thinly traded and the spreads were too big when reading option chains.
As Charlie Brown would say, "Arrrgh."
Option Chains: Thinly Traded Might Be a Good Buy Signal
The goofiness I hear over volume and "thin trading" makes me want to pull out my hair sometimes. Yes, it is a concern, but it seems 90% of traders get it wrong. That includes at least half the "professionals," too.
Out of curiosity, I went to an options chain for the stock to see what the story was today. Let’s just say for our example - this is a pretend price in the spirit of using aliases to protect the innocent -that this was a stock that was just over $36. You could take an in-the-money call at $35 or an out-of-the-money call at $40.
Was it thinly traded? Well, sort of. The market was closed, and… whaddyaknow! Nobody was trading it! Now there’s a revelation.
In fact, the market had been closed for three days for the Christmas holiday. This was a "Christmas stock." It was one that analysts would be watching to see whether its holiday sales did well. Moreover, that means that not many people were trading it right before Christmas because its seasonal news was due to come out days from now. Everybody who wanted to be in place based on the available information had already done that a week and a half earlier when it last had news.
The market opened, and sure enough, not many people were biting. So right now, you could say it’s thinly traded. But contrary to our friend’s analysis, this is precisely when I’d consider buying in… If I liked the stock’s chances, I’d be on it. When it begins to be heavily traded again, it’s going to get expensive.
Why? Options prices go up when surges of demand come in - Capitalism 101. In options, the idea is to get there when the crowd is pessimistic, with the right idea, and profit when the late-wakers catch on.
Looking at daily volume on only one or two option contracts is an excellent idea - for people who like to lose their money quickly instead of taking the longer route via buying hopeless tech stocks. I applaud the people who do it, though, because they make my job easy.
Okay. You suspect there’s a better way, right? You bet. First of all, you have to answer the question "what is adequate trading?"
Watching The Underlying Stock on Option Chains
Not long ago, I listened to another trader (a very good one) say he no longer recommends options on stocks that trade less than 3-4 million shares per day. His readers buy options in volume and he has a big list. Plus, they veer toward the day-trading end of the spectrum and profit from relatively small but fast changes in price. So he doesn’t want his recommendations to push the option price even a half percent.
There are two very valuable clues in his statement.
- First, it is the activity of the underlying stock that matters most.
- Second, he defined volume in terms of his situation, not abstractions.
When I recommend trades, I don’t need that much volume. My trades last a week to three months, and I’m looking for strong gains over that longer period, not dozens of small day-trading gains. And my list is relatively small compared to the fellow who needed 4 million shares a day to get into a trade without moving it. I usually look for stocks trading about a million or more shares a day, but can go down to 500,000 shares without stress as long as there are plenty of options and they’re well followed. If I were writing an advisory service for only 12 people, I could trade just about anything. Of course, the subscription fee would be outrageous.
If you are generating your own trades, you don’t have to worry about fellow subscribers acting the same time you do. Any stock that trades 300,000 shares or more a day and has sufficient open interest - which we’ll come to - will do.
Because after looking at the stock, there’s another step to take… looking at the option chain, the whole darned thing.
Buying In Volume? Save It for Wal-Mart… Here’s Why
There are many good and non-lethal reasons why volume might be low on any given day in a particular month and strike price. Perhaps while you are looking at February options, most people are queuing up for April or July ones. Maybe you like the in-the-money option, but a farther-out one is getting all the attention. Maybe today’s the day the market is fixated on chip stocks and all the retail stocks or insurance stocks are temporarily out of the limelight. Maybe you are even bullish for good reason while everyone else is still bearish, or vice versa.
But if you look at, say, a March call, and see little activity there while there are lots of takers for February and April options, you need not fear March. If you want the $25 call and see lots of activity at the 22.5 and 30 strikes, even if the 25s aren’t getting much attention, you need not fear the 25 strikes. If you are the only one buying a March 30 call but traders are piling into the March 30 puts, you don’t have to worry about liquidity.
It’s a CHAIN: when the 22.5 strike goes up and the 30 strike goes up, the 25 is going to move in the same direction, generally speaking. When the February put moves up and the June put moves up, the March put will, too. You don’t have to be in the same contract everyone else is buying. Their nearby interest is in your interest.
And most of all, if open interest is strong, who cares what today’s volume is?
- Volume could mean lots of people are getting out instead of getting in, anyway.
- Volume is how many people are taking trades on an option today - in or out. It’s a one-day snapshot stat.
Open interest is how many contracts are out there altogether. It’s by far the more important number, because when your option shoots up 100%, all those other players are going to have the same instinct you have. Even if some of them did buy on days when the volume was 200 and some when the volume was 5.
Spreads: If You Can’t Make 20% Without Even Trying… Don’t Try!
As for spreads, well the writer of the hapless bulletin was partly right. The spread between the bid and ask was about 11-12%. Most of the time, they range from 5% to 10% on reasonably active stocks. Fifteen percent is not uncommon.
I only worry when it’s more than that. And remember, a mere 2% move in a stock can easily translate to a 10-30% move in the option. Frankly, if I didn’t think I could cover a 10% spread, or even a 12% spread, I wouldn’t be trading options at all. Spreads and commissions are a fact of life.
Besides, even if the spread is narrow, a mere 5% on the day you buy your option, it can, and often does, widen later to your detriment. You can almost count on the spread changing even when things are going right. Especially then. If you’re bullish and have a call while the stock starts rising rapidly, you will see the option’s ask price go up somewhat faster and earlier than the bid price. The spread widens when the market maker sees he’s going to have to start paying off. It happens all the time. That’s something you have to live with. Your system had better allow for it.
For instance, I never take a trade without calculating my potential risk and reward first. And unless I think I have an easy 20% gain to cover the spread - even if it widens later - PLUS another 50% or more on top, I wouldn’t even consider the trade. Often, I see that spread covered the same day. That’s options.
That’s what you should expect from short-term options trading. Don’t worry so much because there are obstacles. That’s like saying you could be a great hurdler if it weren’t for the fences you had to jump. Instead, understand what the challenges are and make sure your system is built to cover them.
Economists like to say there is no free lunch. There are none in the options market. There aren’t even any cheap sandwiches. Then again, there are lots of double- and triple-decker wins with caviar on top, which makes the risk worth the rewards.
Good trading,
Mt. Vernon Research
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Today’s Smart Profits Crib Sheet
- For more about liquidity in options, check out Smart Profits #116, Liquidity & Limit Orders: An Options Balancing Act.
- Also, for any definitions to terminology used in today’s issue, like "limit price" or "spread trade", check out our Smart Profits Glossary.
Related Articles:
- Spread Trades & The Market Maker: Two Valuable Options Lessons From Boston
- Quote, Trade and Hedge… In Less Than 30 Seconds
- Selling Naked Puts: Get Paid Now To Bargain Buy Your Favorite Stocks Later
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