Fibonacci Retracement Levels

May 30, 2006

The Smart Profits Report: Issue #313
Tuesday, May 30, 2006

Fibonacci Retracement Levels: Let “Leo” Calculate Your Support and Resistance
By Jim Stanton
Advisory Panelist, Mt. Vernon Research

As an investor, timing your trades is one of the hardest things to do. After all, knowing when to get in and out of a stock is the critical element to successful investing.

Simply put, when a stock with a bullish chart pattern pulls back near its support level, it’s a good opportunity to buy. When a stock with a bearish chart pattern rallies up near its resistance point, it’s a good opportunity to short it.

So, how exactly do you work out where a certain stock’s support and resistance points are, alerting you to the best time to buy and sell? There are a number of ways to do it, including moving averages, trend lines and historical support and resistance levels. But today, let’s focus on buying stocks on pullbacks, using Fibonacci retracement levels.

Profiting From Fibonacci: The “Father Of Mathematics”

In case you’re not familiar with Leonardo Fibonacci, he was a 12th century Italian mathematician, widely considered the “Father of Mathematics.” His theories form the Fibonacci trading technique, using a specific set of numbers known as the “Fibonacci sequence,” which the retracement concept is based on.

Basically, this states that markets do not simply move up and down in a straight line, but fluctuate along the way and establish certain key points. The Fibonacci sequence gives you an idea of how high and low these retracements are going to go, so you know when to buy and sell.

There are three main retracement levels that many traders use: 38.2%, 50%, and 61.8%. After a move up or down, the price will usually “retrace” from its highs and form support, or bounce off its lows and form resistance levels near those Fibonacci points. This can help you figure out the best point to buy and sell.

At times, I will use 23.6% and 76.4% Fibonacci retracement levels if the previous action has been extremely bullish or bearish. Many traders focus on the 50% retracement area, but the extent of the pullback depends on how bullish the stock has been acting.

For example, if the stock has performed strongly and has solid momentum, you may only get a pullback of 38.2% (23.6% if it’s been extremely bullish). But if the stock has experienced an extended downtrend, it could retrace 62.8% or possibly 76.45% in a “retest” of its previous lows.

Let’s see how this works in the real world…

The Fibonacci Retracing of Comcast… And Winning

In the June issue of the Xcelerated Profits Report newsletter, I recommended buying Comcast (Nasdaq: CMCSA) and used the daily and weekly charts to illustrate the use of Fibonacci retracement levels.

The first chart below is the weekly CMCSA chart, dating back from May 10, 2002 through 2004. As you can see, CMCSA bottomed out in October of 2002 and rallied, without much of a pullback, until June of 2003 when it reached $34.85. Since it was a fairly strong rally, you would not expect a sizable pullback and it retraced exactly 38.2% before making new highs in 2004.

CMCSA 38.2% retracement level

Now, take a look at a more recent daily CMCSA chart below. It’s a completely different picture. The stock sank more than 25% between April 2005 and January 2006 when it hit a low of $25.33.

That triggered a buy signal, but since the prior action was very bearish, you can expect a deeper pull back because stocks often have to test lows before a change in trend can be validated. As you can see, CMCSA did test the low (a 76.4% retracement) before reversing and validating the new uptrend.

CMCSA 76.4% retracement level

Charts Courtesy of Trade Navigator Software (http://www.genesisft.com)

Watch Your Fibonacci Retracement Levels!

If you want to try to reduce your risk by buying stocks on pullbacks (or shorting stocks on rallies), you have to watch each Fibonacci retracement level mentioned above for other potential signs of support.

For example, if you think the stock will have a sizable pullback (50% or more), but the 50-day moving average shows the 38.2% retracement level, then you have to watch that level carefully for signs of a reversal.

I rely on Fibonacci retracement levels in my stock analysis and have found that the more support there is surrounding any of these particular retracement levels, the higher the odds are that you’ll see a reversal from that area.

Like I said, though, you need to show some patience, but the upside is that you’ll know fairly quickly if your analysis is correct and can keep your losses relatively low - a critical aspect of any trading strategy.

Good Trading,

Jim Stanton

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Today’s Smart Profits Cribsheet

  • Ever wondered exactly what “resistance” means? Find out here in the Smart Profits Glossary.
  • Timing your purchases using Fibonacci retracements can be a powerful way to invest. For example, I recently used this method to recommend both underlying Comcast shares and January $20 calls (VPKAD) to Xcelerated Profits Report readers in the June issue. And just two weeks ago, they were able to cash out of the Comcast calls for a 32% gain. If you’d like to find out more about becoming a member and put yourself in position to claim profits like this for yourself.

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Ethanol Investments

May 26, 2006

The Smart Profits Report: Issue #312
Friday, May 26, 2006

Ethanol Investments: Two Ways To Profit from the Shift Towards Ethanol
By Karim Rahemtulla
Chairman, Mt. Vernon Research

With Memorial Day upon us, there’s a good chance you’ll be packing up the car and heading off for a few days’ vacation this weekend.

But as Americans whiz down the highway, they’ll be doing so knowing that the national average price for a gallon of gasoline is $2.88 - 75 cents higher than this time a year ago.

But is help on the way? By now, you might have heard about how ethanol could change the future of our energy situation. It’s something the government is promoting heavily, for several reasons:

  • It makes the U.S. a little less dependent on Middle East oil and inches us closer to energy self-reliance.
  • It’s less polluting than gasoline - not by much, but every little but helps.
  • The technology to run cars on ethanol already exists.

Look at Brazil, for example. General Motors and other manufacturers are already making cars for Brazilians that can use any combination of ethanol and gasoline.

So, why aren’t we doing it in America?

The problem is that there are not enough ethanol stations here to pump out pure ethanol. But as gas stations add new ethanol pumps, this will change.

So, I’m going to give you two ethanol investments to think about…

A Pair of Ethanol Investments

The first is Archer-Daniels Midland (NYSE: ADM). My Covered Call members recently took a position in this company when it pulled back - and watched it then set new 52-week highs.

Using a covered call strategy basically allows you to own a company well below current levels. If you want to play ADM, then consider doing the same in order to reduce your cost. At current levels, shares are pretty fairly valued (not expensive, but not cheap either).

Another company for you to look out for is Pacific Ethanol, Inc. (NASDAQ: PEIX).

However, this one is currently trading at mind-boggling levels, thanks largely to Microsoft owner Bill Gates buying a huge chunk of it a couple of months ago (when the price wasn’t so mind-boggling).

Take a look at the recent closing prices for PEIX:

May 11: $42.39 (having hit new 52-week high of $44.50 that day)
May 12: $42.00
May 15: $37.88
May 16: $36.65
May 17: $32.86
May 18: $29.90
May 19: $29.57
May 22: $25.57
May 23: $29.89
May 24: $30.23

That’s some heavy fluctuation! And all in just 10 trading days.

What you’ve got here is the “Gates Factor” at work. He paid about $84 million for just under 25% of Pacific Ethanol. That valued the company at about $10 to $12 per share. But shares now trade around $30.20, down sharply from a 52-week high of $44.50 as recently as May 11.

My advice: Wait for a pullback of around 40% to 50%. This is what it will take for the “Gates Factor” to wear off and for shares to be more reasonably priced in the high teens to low $20s.

Ethanol vs. Oil Investments: Don’t Do It

There are other ethanol-based plays, too. For example, you could buy some of the major oil companies who are thinking of branching out and setting up ethanol service stations.

But that would mean you own oil, too. And if you read the Smart Profits Report Oil Forum last Friday, you’ll know that I’m not fond of oil at its current price. In fact, I have been short on oil using LEAP options for a couple of months now. And while oil hasn’t moved down enough to make me too much yet, with a year and a half to go on my options, I feel pretty comfortable.

But what if ethanol doesn’t take off and you’re stuck with a stock you don’t really want? Well, that’s where ADM in particular is a good bet. It’s a diversified company that could make big bucks from ethanol on the coming months and years - but it relies on more than the ethanol business for its profits.

Bone up on ADM and PEIX. These are two “free” plays that are worth getting excited about at the right price. ADM also has LEAPS available for an options play.

In Additon to Ethanol… Let’s Talk Turkey on Memorial Day

As I write, I’m in Turkey - one of the world’s most vibrant emerging markets. I’m keen to catch up with some old friends and witness the development since my last visit. Nothing excites me more than going back to an emerging market after a few years. It puts it all in perspective.

For instance, when I was in China last year, the growth was noticeable and impressive compared to my visit during the handover of Hong Kong. But my visit to India showed me that China was at least a decade ahead, and India, for all of its growth, has a long way to go - and may prove the better opportunity right now.

When I first started out in this business, I traveled a lot. I wrote about emerging markets before they took off, when there were only about 100 ADRs (American Depository Receipts) trading in the U.S. Back then, the only way to buy foreign stocks then was from an overseas broker; and with no Internet, high corruption, low liquidity, a lack of adequate research, and political tension, emerging market investing was a risky proposition.

For example, I met with the Malaysian Finance Minister a few months before he was jailed on trumped-up charges. And in meetings with a former director of the Bombay Stock Exchange, he mentioned casually that it was prone to manipulation because of its small size and lack of transparency. A few months later, the BSE crashed.

The one place that I returned to over and over again, however, was Turkey. Turkey was the emerging markets investor’s dream. No research, small market, undeniably a capitalist bastion, and beautiful to boot. I made three Turkish picks, and each one was up between 50% and 100% in a matter of months. It was awesome - until we went to sell. Turns out that we were the market! Those gains fizzled to less-impressive double-digit gains.

Emerging market investing has always been dangerous. It is still fraught with a lack of transparency, currency issues, political shenanigans, and outright fraud. The only difference is that there are many more choices for investors than there were before. And thanks to the Internet, you can actually get current information about what’s really going on.

Hopefully, my Turkish trip will yield a couple of investment ideas that are still “emerging.” More later…

Good investing,

Karim Rahemtulla

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Investor Sentiment & Market Behavior

May 23, 2006

The Smart Profits Report: Issue #311
Tuesday, May 23, 2006

Investor Sentiment & Market Behavior: Seven Tips For A Profitable Downside Bias
By Steve McDonald
Advisory Panelist, Mt Vernon Research

It had to happen.

After a strong rally that saw the major indexes set multiyear highs, despite several distinctly negative conditions (geopolitical issues in Iraq, Iran and Nigeria, high gas prices, a falling dollar and a slowing housing market, among others), the run appears to be over for now.

Since the end of October 2005, the Dow alone has enjoyed a steady climb from around 10,200 to 11,125 at Monday’s close. But that’s a huge drop from a high of 11,709.09 as recently as May 10. The correction took longer than expected to occur, and the situation has given me an opportunity to think about investor sentiment and market behavior. One question that springs to mind is this:

“What is it about a drop of a few hundred points that makes investors dump positions as if the world is ending?”

Despite this frequent occurence, we always seem to react rashly, rather than act calmly. It’s because when it comes to the stock market, many of us possess an upside bias. This can cost us a lot of money, and also force us to miss out on big gains. So, here’s what we can do about it…

Making Money On the Ups And Downs

First, what’s an upside bias? It’s when you believe the market has to go up to make money. After all, it seems more natural to believe that something has to increase in value to make money.

But it’s actually harder to make money on the upside than on the downside - especially when you consider that the market is down two-thirds of the time. If you wait to profit during the upward swings, you’d better be very patient.

So, here are seven tips to help you develop an eye for the downside:

  • No upside trend lasts forever, and every new high is an opportunity for a correction.
  • Markets act in cycles, and most of the time they’re down.
  • Good news means a stock will likely run too high and then correct.
  • Let charts guide you. They show when a stock has run too far.
  • Keep a log of when your positions rise and fall (you’ll have more downs than ups).
  • If you find yourself marveling at how high a stock or a sector is, buy a put, or short it. Seven times out of 10, you’ll be right.
  • The investing herd is rarely right.

The market gives you great tools for capitalizing on the downside. Here are two that are just as easy to use as buying a stock or a call…

PUTS: Calls are options that make money when the underlying stock goes up; puts make money when a stock goes down. You buy them the same way, and sell them the same way. They involve no more risk than a call and are priced similarly. They just make money more often.

SHORTS: Shorting is when you sell something you don’t own. You borrow a stock from someone you’ll never meet, sell it, buy it back low and return it when it goes down in price.

Watching Market Behavior & Using Puts

Here’s a great example of how puts can be so profitable. Take a look at the Energy Select SPDR (AMEX: XLE) two-year chart below. It’s made up of most of the big oil companies.

Pay particular attention to the volume on the lower part of the chart. Nobody wanted it at $30 or $35. But as this oil sector play steadily climbed, investors crawled out of the woodwork to buy it. And by the time it got to around $59, the whole world was in it!

Energy Select SPDR (AMEX: XLE) 2-yr chart

While the chart looks impressive, it’s the perfect play for a put or a short, as you can see from the five-day chart below:

Energy Select SPDR (AMEX: XLE) 5-day chart

This is a ride many investors have taken too often. They wait for an investment to go up until they’re convinced it’s good. Then they ride it down.

Ignoring The Herd & Investor Sentiment

I recommended XLE puts about one week before the correction, and the volume tells me there were a lot of rookies out there who totally missed what was coming after the run it experienced.

As I said earlier, learn to ignore what the herd is doing, develop a critical eye, look for charts like the two-year for XLE and use puts and shorts to make money. Let the herd stay stuck in upside bias while you make money on their mistakes.

Good Trading,

Steve

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Today’s Smart Profits Cribsheet

  • Fancy a quick 10% profit in three days? That’s exactly what subscribers to the Xcelerated Profits Report did by playing both the upside and downside of Tektronix (NYSE: TEK) in the most recent issue. Find out how you enjoy a whole year’s worth of profitable investment recommendations for about the same cost as filling your car with gas.
  • As always, check out the Smart Profits Glossary for definitions of words like “put options” or “volume” found in today’s article as well as close to 200 other option terms.
  • Make sure to take a look at Smart Profits #310, The Price of Oil, an article by all of our experts at Mt. Vernon Research and their take on where oil is going and what you can do to profit from it.

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The Price of Oil

May 19, 2006

Special Edition: The Smart Profits Report Oil Forum
The Smart Profits Report: Issue #310
Friday, May 19, 2006

The Price of Oil: “There Is No Oil Shortage”
by Karim Rahemtulla
Chairman, Mt. Vernon Research

With oil prices rising, remember that oil is a self-limiting commodity in the long term. That means it has to compete with demand… and demand is a result of a healthy consumer.

But right now, consumers across the world are enduring the early phases of an upward inflationary spiral. Prices are going up for everything but staples. That means less disposable income.

Consumers do not have an endless supply of money, and when this comes home to roost, demand will begin to fall and we could enter a period of stagflation (high inflation and higher interest rates). That would spell recession for the U.S., and a slowdown for the rest of the world.

Pointing Towards The West

Many people point to the “new growth” of China and India. And while China is a factor, it will only remain that way if the U.S. is healthy enough to buy Chinese goods. However, India is a non-factor when it comes to production or consumption, as it’s still more than a decade behind China.

High oil prices will cause a slowdown in the U.S., hence the China play will be less attractive. Less oil demand from the U.S. and China will lead to a lower price for oil.

The second reason for lower oil prices is actually higher oil prices. As you’ll see in Steve McDonald’s notes below, higher prices will force a speedier search for alternative and more efficient energy sources.

This “substitution” is a basic law of economics: When prices rise above equilibrium, the market searches for substitutes. The worst thing for oil producers is competition from alternative energy, and those fears are hitting home.

The wild card, of course, is the short-term geopolitical climate. This is the main reason that oil is at $70, not $40 or $30 - and it’s the reason oil could reach $100 or more (remember Goldman Sachs’ infamous “super spike” prediction?).

Oil: Shortage Or Surplus?

But, there is no oil shortage. In fact, we’re arguably close to a huge crude oil surplus right now, as the world oil producers are pumping a higher amount of crude today than in the past when oil was half its current price.

As oil goes, so does the exploration and production industry. Aside from taking a short position in oil futures, there is no real way to short oil in the stock market. The oil ETF is not shortable and has no option yet. However, the Energy Select Sector SPDR (AMEX: XLE) does have LEAPS options available for consideration. That way, you can take a nice, limited-risk short position that could bring you huge returns if oil prices return to “normal” levels over the next two years. If not, then your risk is limited and small.

At the end of the day, the number that bears watching the most is U.S. consumer spending. If that slows, no amount of geopolitics will keep the price of oil high. Picture tanker after tanker offloading oil at U.S. ports, with nowhere to go but into storage. It could be a frightening correction.

Good Trading,

Karim

The March To $100 A Barrel
by Steve McDonald
Advisory Panelist, Mt. Vernon Research

Whenever I consider the current mayhem in the oil markets, I can’t help but think back to 1974. Gas lines everywhere, oil prices soaring to what was then thought to be stratospheric levels, the U.S. government doing its best to convince the public that the world was running out of oil, and the feeling that maybe the joy ride of cheap oil was over.

Thirty-plus years later, we seem to have learned nothing - and done nothing - to create a more stable environment where we are not subject to the crazy politics of the Middle East. We are now even more vulnerable to the whims of some of the most unstable governments in the world than we were in the ’70s.

Every aspect of our economy, and the potential of the two largest emerging economies - China and India - is all tied to oil. Just about everything in our lives - essentials and luxury items - require oil. Oil is not optional in our culture. It is as much a necessity as electricity and fresh water.

So, the question isn’t whether oil prices will continue to go up, but how far up they will go, and how much we can stand before we do something about the spiral we are in again.

Reasons For Oil Prices To Jump

I believe oil will soon experience another quantum leap in price - to around $100 a barrel - thanks to three probable reasons:

  • The most obvious reason is the geopolitical situation we find ourselves in. Despite the lessons taught in the ’70s, we have continued to rely almost exclusively on the Middle East for our imported oil.
  • Unfortunately, oil is an absolute necessity. We cannot function without it. We can’t just give up oil the way we could with other products where we can make do without if the price rises too high. Although oil is not completely free of the usual supply and demand market forces, it does seem to be able to run up in price almost at will. Do you really think we should all be paying $3 a gallon for gasoline?
  • Realistically, one has to consider the possibility of another major terrorist strike in America. If that attack were directed at the lifeblood of our economy - oil - it would be devastating. After all, one hurricane shut down a huge percentage of U.S. oil refining capacity for several weeks, so imagine what impact a concerted terrorist effort would have on our ability to refine, transport and deliver oil.

If oil doesn’t break the $100 mark, it will only be because the federal government will have realized the horrible position it has allowed this country to be placed in, and make energy independence a national priority. Not likely.

But you can bet that when oil rumbles close to $100 per barrel, the stakes will be high enough that all the stops will be pulled out, and you’ll see a gigantic effort to push oil alternatives. Even Big Oil’s influence in Washington won’t be able to stop it.

Alternative Fuels vs. Big Oil

Look at a couple of the most popular energy ETFs - the Energy Select Sector SPDR (AMEX: XLE) and PowerShares WilderHill Clean Energy (AMEX: PBW). The alternative fuels in PBW have enjoyed a bigger ride than the big oil companies in the XLE.

XLE & PBW 1 Year Comparison

Above is a one-year comparison of the XLE (containing large oil companies) and the PBW (described as including clean energy companies, or alternatives to petroleum). The alternatives are having quite a ride!

In the short term, I expect crude prices to pull back, but then, as I said earlier, start heading up to the $100 area. So, consider short-term put options on energy-related investments, and LEAPS plays for the long run.

Good Trading,

Steve

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Puts And Calls To Play Volatile Oil

May 19, 2006

Special Edition: The Smart Profits Report Oil Forum
The Smart Profits Report: Issue #310
Friday, May 19, 2006

Puts And Calls To Play Volatile Oil
by Lee Lowell
Advisory Panelist, Mt. Vernon Research

From a trader’s perspective, I certainly can’t see oil heading back down to $40 a barrel. With all the tensions in the Middle East, including the war in Iraq and Iran’s nuclear program, oil will be propped up for the intermediate future.

It’s not so much whether these tensions actually will cause a disruption in oil flow, but more the mere fact that it can cause a disruption that will keep oil prices high. Even though oil is at historically high levels, if it’s justified in the market’s eyes, then it will stay there. And remember, there are a plethora of large institutions and hedge funds invested in this market that will do all they can to protect their long positions.

Obviously, this is an extremely volatile market, with much more risk than usual. The best way to get involved is to take a small position and use limited-risk strategies. I would stay away from playing pure oil futures and use futures options instead. You can buy outright calls or puts, depending on your prediction, and use option spreads to further reduce your risk. Give yourself plenty of time if playing futures options. And remember, you can pick option expirations many months into the future.

If you want to play the energy sector via stocks, you can trade the oil ETFs, or some individual energy stocks. Once again, use option orders to limit your risk. I don’t like playing individual stocks so much, especially if you’re going to use stop loss orders. In such a volatile market, there are many occasions I’ve seen a stock gap open lower or higher than your stop-loss level and fill you with a much worse price.

Good Trading

Lee Lowell

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Charting Crude Oil Prices

May 19, 2006


Special Edition: The Smart Profits Report Oil Forum
The Smart Profits Report: Issue #310
Friday, May 19, 2006

Charting Crude Oil Prices: Oil’s Key "Milestone": $68 A Barrel
by D.R. Barton
Advisory Panelist, Mt. Vernon Research

Crude oil is one of the clearest indications of the limitations of fundamental analysis. Anyone who thinks that the supply or demand of crude oil in world has changed by 10% in the last couple of weeks has a screw loose. Yet, the price of crude oil on the open market has fluctuated by that amount. Why?

Don’t get me wrong. Fundamental factors are certainly influencing the price. Concerns over Iran’s nuclear ambitions, political strife in Nigeria, and fluctuating U.S. reserves have an effect, for sure.

That’s part of the cause. But the effect is how people react to the news, and what they think it means for the future, based on that news. This is where technical analysis comes into play… and I think this current chart of crude oil prices gives a hint about future direction.

Crude Oil Hinting At It's Future Direction

As you can see, oil is showing signs of short- to intermediate-term topping. It has made a series of lower highs, and this weakness has been confirmed by the MACD (an indicator that measures price momentum).

The important milestone going forward is $68.

A drop under $68 could signal a further correction. However, if prices can hold at that level for a few weeks, then we should see higher prices in the months to come.

Long term, it’s hard not to be bullish on oil prices from both a fundamental and technical perspective. But for the near term, indications are for continued weakness or price consolidation.

Good Trading,

D.R. Barton

Expensive Crude Here For Good
by Jim Stanton
Advisory Panelist, Mt. Vernon Research

"It’s different this time." - There are so many times you hear that expression when referring to certain events in the financial markets.

However, 95% of the time, it turns out that it’s not different at all - no matter what the issue.

But I’ve got news for you: The activity in crude oil is different this time around, and higher oil prices are here to stay. Why? Because world demand has grown exponentially, thanks to China, India, and other emerging markets and rapidly-developing countries.

So, until more wells and refineries come online, or new technologies are developed, supply and demand will keep oil prices above $40.

Below is a July weekly chart of crude oil prices in futures. As you can see, the 50-week moving average, the recent uptrend line, and long-term regression line all converge in the $65 area. The July contract is currently selling above $68, and if the current price correction continues, I expect that a test of the $65 area would hold.

July Crude Oil Futures: weekly chart

Looking further out, there is longer-term support around $44 (50-month moving average and 200-week moving average), and if the world economy slows dramatically, that level could be tested. But that’s not likely to happen any time soon.

Good Trading,

Jim Stanton

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Smart Trades For the Computer Age

May 16, 2006

The Smart Profits Report: Issue #309
Tuesday, May 16, 2006

Smart Trades For the Computer Age: Maintaining Profit Targets
by Dean Albrecht
Advisory Panelist, Mt. Vernon Research

I’m one huge fan of the computer age.

As Lee Lowell mentioned in his last message, computers have completely revolutionized the investing age. New technology has allowed ordinary investors to get up-to-the-minute information, real-time quotes, and trade from home just like the professionals.

So, for someone like me, you can bet that I’ve also taken a big advantage of computers. I use them to crunch data, examine price movements and analyze patterns in a number of different ways, so that I can be assured of picking the right investments at the right time. The software I use acts as a radar that looks for buy and sell criteria in real time, and enacts the trades automatically, so you don’t even have to push a button. Basically, it screens, it loads, it tests, and it trades all on its own.

But with the good also comes the bad. You’ve probably heard all about the plethora of nasty viruses out there, as well as computer hackers who try to crack the firewalls of banks, corporations and government agencies and steal people’s identities.

We know that computers have a hard time thinking and putting the past and future together and making decisions. As far as artificial intelligence goes, there are still gaping holes in this process in many fields. But you can still avoid them…

Never Show Your Hand… In Poker Or Your Trades

My online poker-playing experience is a good example of “gaping” holes in technology advancesments. BOTS - as they are known - are computerized programs that play poker ’round the clock in online trading rooms.

They most often work in smaller limit or lower limit tables, taking advantage of inconsistencies of inexperienced players or preying on the fear of new players. More experienced players will actually switch up their game, which makes it more difficult for BOTS to be successful.

Also, programmers may deploy several aggressive BOTS at a table that will scare out or force out smaller players who get spooked easily, making them leave small amounts on the table. Over time, this adds up to significant amounts of money.

Conversely, in trading circles, traders can watch the tape and see where the action is. Some traders will do their best to fake out other traders and post large orders on the buy side to move a price up, or on the sell side to scare traders out of a stock.

In addition, it’s a common occurrence in trading rooms for traders to pile into a stock and move the price significantly. And it’s well known that market makers can see where all the stops are, and they will move the price of an investment down to get rid of them before moving the price right back up. Hence the reasons why many an analyst advises using a mental stop rather than a hard stop that is totally visible to a market maker.

So how does all this relate to making more money in the markets or learning how to do so?

  • Understand that you are not just trading or competing against other humans. Now, you are competing against the decision-making capabilities of computers, as well.
  • It doesn’t make sense to show your hand. You should play your positions and your intentions close to the vest. Understand that computers aren’t emotional and you can even take advantage of situations when prices get too far out of line.

Also, watch where you put your stops and don’t be too predictable if you are posting orders. Protect your profit targets. Don’t get scared out of a trade just because some size comes into the order. Stick to your convictions with a sound strategy, and you should do well.

Good Trading,

Dean Albrecht

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Today’s Smart Profits Cribsheet

  • Want to know how you can get the best price when you sell your options? It’s not as hard as you might think - at least not when you follow our handy guide.
  • As always, don’t forget to check out the Smart Profits Glossary for definitions of words like “market maker” found in today’s article.

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The Anatomy Of A Market Maker

May 11, 2006

The Smart Profits Report: Issue #308
Thursday, May 11, 2006

The Anatomy Of A Market Maker: Pushing, Shoving, Bumping And Making MoneyBy Lee Lowell
Advisory Panelist, Mt. Vernon Research

In my last message to you a few days ago, I gave you a quick run-down on the factors that make up an option price, intrinsic and extrinsic value, and one of the major pitfalls associated with options trading: time decay.

But I got a question the other day that I hadn’t received for some time. And while it was a pretty simple one, it still made me stop and think about the business I’m in, and how sometimes all you need is one key break to make all the difference.

Here’s the question I was asked: “So, Lee… how did you get where you are today? Explain the ‘anatomy’ of a market maker

Told you it was simple!

In Need of Action

The question made me cast my mind all the way back to 1990 when I was diligently doing my desk job at Shearson Lehman Brothers as a stockbroker’s assistant.

I was restless. I knew there was no way I was going to get anywhere by tediously answering someone else’s phones, and it made me think about what I needed to do to get to where the real trading action was. Quite simply, I had to get out - and it was time to make a move.

Fortunately, I had a friend who was working on the floor of the New York Mercantile Exchange (NYMEX) as an oil trader. I didn’t know any more than that and I didn’t really know all the details on what being an oil trader entailed, but I knew that I had to take a look. I contacted him and he arranged to meet me at the NYMEX and show me around the trading floor.

The Roar From the Floor

I was hooked the moment I stepped onto the exchange. The decibel level and energy you could feel as you walked around the pits was captivating. It was loud, chaotic and an entirely different kind of workplace. Just watching the guys in the pit yelling and flashing hand signals back and forth told me that this was an environment that I had to be a part of.

This is where fate stepped in and dealt me a remarkable hand - a true case of being in the right place at the right time.

Small Firm… Big Break

My friend told me about a small firm that had recently opened up on the NYMEX and that they were looking for a floor clerk. I knew immediately that it was a golden opportunity to get my foot in the door to a world that I wanted to be in. Plus, being part of such an important financial business, with many closely-guarded secrets, made it even more enticing.

I’d never thought about being an actual pit trader before - but here I was about to go to an interview for a firm that dealt with lots of money and oil futures and options.

The company that I was going to work for was what they call a Proprietary Option’s Market-Making firm. Its headquarters were in Chicago, but it also had offices in London and Singapore at the time.

The interesting thing was that there were no customers - just its own traders. The owner was willing to put his own dollars in the hands of his traders and let them make money for the firm. And I was being groomed to tap into these millions of dollars that we had at our disposal. That was a pretty heavy concept for a 24-year old to comprehend.

Getting Down and Dirty in the Pits

After less than a year working as a floor clerk - undoubtedly one of the most stressful jobs I ever encountered - I was promoted to “trader.” It was a rapid progression and basically set the stage for a career that has enthralled me from day one - and one that I’m still a part of today.

My job made me one of the few individuals helping set the prices for the energy products used around the world - specifically, crude oil futures and options.

I got to work in the trenches with other traders, pushing millions of dollars around for big institutions such as Merrill Lynch, Goldman Sachs and Citicorp. There were also many other hedge fund traders, large customers and smaller retail participants.

The job was empowering. If someone wanted a price for a crude oil call or put contract, they would have to come to me - a market maker - for that price. I was one of the people setting the levels and calling the shots. As you know, that particular market moves lightning-fast and the pace was frenetic. If you couldn’t adapt or roll with the punches, you wouldn’t last long. Not with so much money at stake. I was there to make money for my boss, who would then split the profits. Plain and simple.

Days were filled giving quotes and making trades on 1-lot orders as well as 500-lot orders. I traded every kind of strategy out there: Straddles, strangles, backspreads, ratio spreads, calendars, Christmas trees, 1 x 2’s, 1 x 3’s, call spreads, put spreads, conversions, reversals… You name it, I traded it. Oil is one of the most volatile commodities out there and anything rumbling in the Middle East would send prices into a frenzy. Flash forward to today: Some things never change…

Pushing, Shoving, Bumping, Hitting… and a Diet of Tums

Life in the pit took a big physical toll. Besides the actual job stress, I was on my feet for six hours a day, sometimes without a break. I was also right in there battling with every other trader - traders who don’t care if you’re a veteran or a newbie. You had to push, shove, bump, spit and hit. Bruises were common and if you didn’t come home with ripped clothes and pen marks on your neck, then it was assumed you didn’t do much work that day. The adage that Tums is the breakfast of champions on the floor is pretty close to the truth.

Being an options market maker is the kind of job where I had to hone my skills “on the job.” Forget theory or book smarts - I was thrown right into the trenches to earn my stripes.

I certainly made my fair share of mistakes at first, but you wise up pretty fast. I knew that if traders made too many mistakes and lost money for their company, they’d be turfed back out on the street. But my company didn’t really want that to happen. It provided me with the education and tools to be one of the best options market makers on the block.

It wasn’t all crazy, though. I got to enjoy the customary dinners and outings in some of the best spots in New York. Steak dinners at Sparks, The Palm and Ye Olde Homestead (one of my favorites) in downtown Manhattan. This is where my colleagues and I planned some of our strategies and formulated our visions of growing the company into a NYMEX powerhouse.

Farewell to the Floor

Toward the beginning of 1998, the Internet was just beginning to start its explosion. That meant I could set up a home computer and receive real-time quotes for any commodity that traded around the world.

But rather than limit myself to just one commodity, I realized that with the power of the web, I could trade anything I wanted at anytime I wanted. And instead of having to pay an $8,000-per-month seat lease on the NYMEX, I could spend just a few hundred dollars per month and have access to any market I wished. This was the wave of the future.

Hello, Hawaii!

Needing only a computer, an ISP and a cable outlet, I decided to pack up my family and move out to Hawaii. I was done slugging it out on the streets of NYC, spending the money on ridiculously high rents. We spent four glorious years living on the island of Kauai, where I woke up at 3 a.m. to start my trading day and was finished by 11a.m. - just in time to catch the best waves for some surfing! It was empowering knowing that my option trading abilities allowed me to make such a move and to still provide for my family.

Make no mistake, trading on the floor is a lot different than trading off it. It was a hard transition at first. As a market maker, I was one of the ones setting the prices, so I profited off the spread between the bid and ask. I didn’t care whether oil was going up or down - all I needed to do was to capture the “edge” on each play that existed between our buy and sell points on those option contracts.

But working from behind a screen, I had to refine my trading methodology to reflect the fact that I actually had to start looking at charts and pick a direction.

A Trading “Combo” For Winning Trades

That’s where my technical analysis angle comes in. I spent the next several years teaching myself the subject and how to decipher which way prices were going.

This actually strengthened my skills as a trader. Not only was I armed with the knowledge and experience of how options work from the floor level, but I also knew how things operated from an “upstairs” environment via chart reading.

Today, I can play on both levels. During my time on the NYMEX, I crafted and molded my best option trading strategies - strategies that haven’t changed over the years; they’ve just got better because of my newfound knowledge of chart analysis. These are the techniques I use to make money for you today.

You get to participate with me using my trading methods that I’ve spent 14 years perfecting. You get to employ innovative option strategies that you’ve probably never thought about using before.

I know what works in this business and my livelihood depends on it. I’ve traded this way for many years. Combine this with my connections to traders who are still on the floor who can keep me up-to-date with what other players are doing, and you’re armed with someone who’s got the experience and know-how to make it in the financial markets.

Good Trading,

Lee Lowell

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Today’s Smart Profits Cribsheet

  • For more on the Market Maker series, check out Smart Profits # 304, Market Maker Insight: Three Reasons They’re Not Enemies.
  • You’ve heard my story. Now create your own! To learn more about the latest research uncovered from the Xcelerated Profits Report team, read this report
  • As always, don’t forget to check out the Smart Profits Glossary for definitions of words like “backspreads,” “market maker” or “straddles” found in today’s article.

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A Lesson On Time Decay And How To Go In the Money For Top Buys

May 9, 2006

The Smart Profits Report: Issue #307
Tuesday, May 9, 2006

A Lesson On Time Decay And How To Go In the Money For Top Buys
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

As an options trader, you’re probably aware of many of the pitfalls out there.

Some apply only in certain situations; others apply all the time. Included in the latter is “time decay.” It’s an obstacle that causes options to lose a little bit of their value day after day, regardless of whether the stock or commodity moves much.

Let’s go over this in a bit more detail.

Anatomy Of An Option Price

There are six determinants to an option’s price:

  • Current price of the underlying security
  • Strike price of the option
  • Volatility
  • Days to option expiration
  • Interest Rates
  • Dividends (stock options only)

The option’s price can then be broken down into two parts: Intrinsic Value and Extrinsic Value.

Intrinsic value: This describes the relationship between the stock or commodity’s current price and the strike price of the option, and encompassesthe first and second items from the list above.

These relationships are described in familiar terms: Out-of-the-money (OTM), at-the-money (ATM) and in-the-money (ITM).

ITM options are the only ones that have true value, or intrinsic value. An example of an ITM option would be buying the $30 call on a $50 stock. The $30 call has $20 of real value - or intrinsic value - built into the option price. That option may cost roughly $20.30, where $20 is associated with intrinsic value.

On the other hand, if you bought the $60 call on that $50 stock, you’d be buying an OTM option which has no real value, or intrinsic value, hence its price would entirely be made up of extrinsic value.

Extrinsic value: This describes the part of the option that encompasses the first through the fourth items in the list above.

In the ITM option price above of $20.30, the $0.30 is associated with extrinsic value. Time decay falls under the extrinsic portion of the option’s price, and that’s what we’ll discuss here.

What Time Decay & Extrinsic Value Mean To You

When you purchase an OTM option, you are essentially buying a security that has no real value to it yet. You’re buying something on “hope.”

For example, if IBM is $80 a share and you’re bullish, you may opt to buy the $90 call. What you’re doing is paying a little bit of money today in the form of the option premium in exchange for the hope that IBM will go above $90 a share before expiration.

Since that option has no real value to it yet (no intrinsic value), the option premium is made up entirely of extrinsic value. A hypothetical price for that $90 call may be $2.65, where all of that premium is extrinsic value, or “hope” value.

So let’s say our option price starts at $2.65, and we have two months before expiration with IBM at $80 a share. IBM then starts trading in a price range between $80 and $85, with a dip down to $78 and a rise up to $87.

So is that option worth anything yet? Well, yes and no. It still has a price, but it’s still OTM with no real value to it.

Another Month Goes By…

IBM is at $82 a share. IBM hasn’t really gone anywhere and there’s less chance now that it will get past $90 a share. So our option is losing value and might be worth $1.65 now. We’ve lost $1 in option value just because of the passage of time.

Even if IBM rises to $89 a share by expiration, our option will still expire worthless because IBM didn’t get above $90. Actually, you’d need IBM to go above $92.65, as that is what our cost basis would be ($90 strike price plus $2.35 option price = $92.35 cost basis).

Is There A Way to Get Around Time Decay?

Absolutely. My advice is to always buy ITM options. These are options that have intrinsic value already built in. ITM options are the ones with the lowest amount of daily time decay, so they will suffer the smallest loss due to the passage of time. ITM options have the highest proportion of intrinsic to extrinsic value.

ITM will always cost more in total dollars, but you’ll still be paying less for it than you would if you bought the stock outright. Our hypothetical $30 call option cost us $20.30, meaning $2,030 in actual cash outlay, but if you bought 100 shares of stock, it would cost you $3,000.

If you’re still intent on buying OTM options, which everyone does now and again, my advice would be to buy even more time. That would entail going out to a longer-dated option.

Yes, the option will cost more in total dollars, and yes, you’re still paying for time, but you’re giving yourself more of a chance to be right.

Good Trading,

Lee Lowell

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Today’s Smart Profits Cribsheet

  • I’m not the only who favors in-the-money options… Just this afternoon, subscribers to the Xcelerated Profits Report locked in a 31.9% gain in just over two weeks going “deep” in the money on a communications growth stock. When Mt. Vernon Research Advisory Panelist Jim Stanton first recommended the option play last month, he pointed out the company’s improving fundamentals, strong management team and the technical indicators that were screaming, “Buy now!” And it paid off… Learn more here about the Xcelerated Profits Report, and find out how to get involved in the next recommendation.
  • You know that I’m a fan of buying in-the-money options because they have real, or intrinsic, value… But there are ways to profit with of out-of-the-money options, too. I’ve put together a simple electronic guide to making money from investors buying these options. How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks is a handbook that can get you started pulling in extra income right away, and it’s e-mailed directly to your inbox… Learn more about this special report here.
  • Also, follow Steve McDonald’s essential guide for options traders and how to avoid the most common mistakes in Smart Profits #273, Common Option Mistakes: Four Options Resolutions to Make Today.
  • Don’t forget to check out the Smart Profits Glossary for definitions of terms like “intrinsic value” or “time decay” found in today’s article.

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Option Strangles

May 5, 2006

The Smart Profits Report: Issue #306
Friday, May 5, 2006

Option Strangles: Reliable Option Strangles For a 70% Win Rate
by Steve McDonald
Advisory Panelist, Mt. Vernon Research

I love strangling…

Not people, of course! Option strangles.

Whenever I have the opportunity to stand in front of a group of investors and talk about making money in options, I take it. After all, the more information I can give you, the better equipped you are to make good decisions.

Look at it this way: Good decisions make money. And people who are making money are generally happy.

So here’s an options trading strategy for you to mull over this weekend - one that I believe will be very helpful to you in your quest to make good decisions and make money.

Grab That Option By the Scruff of its Neck!

I’ve been banging the drum about strangles for the last four months. Basically, with a strangle, you play the long and short side of a stock by buying both calls and puts. Okay, it’s not the simplest options strategy, but it’s certainly one of the safest, and one of the most profitable.

It’s most commonly used when you have a more confused, volatile and unpredictable market. You use a strangle to play the news by tying a stock to an event, such as an earnings report, new product launch, important press release, clinical trials, etc.

The key to this strategy is the unpredictability of the market and the fact that even when you have what appears to be reliable information, the market is still as unpredictable as earthquakes.

Take a look at how Ameritrade (Nasdaq: AMTD) recently made the perfect strangle play.

Here’s a headline from a few weeks ag

“Ameritrade Second-Quarter Net Income Soars to $172.8 Million Because of Takeover”

That was a massive 124% jump from the $77 million in net income recorded a year earlier. With the combined earnings of both Ameritrade and TD Waterhouse, which it acquired recently, that resulted in earnings of $0.30 per share - thrashing estimates calling for $0.21 per share. When income jumps and earnings exceed estimates by that much, it’s always a sign that the stock price will go up.

Overall revenue more than doubled from the previous year’s second quarter, from $232 million to $497 million. That also exceeded analysts’ estimates. More good news.

But It Wasn’t Done There

The company then increased its earnings guidance for 2006 by an additional 3 cents per share - from between $0.85 to $1.03. If you know anything about earnings estimates, this is huge news.

You’d think that traders would jump all over this and send the stock sharply higher.

But despite that excellent news, Ameritrade stock dropped $2.09 per share (9.7%). This came despite the fact that the company also announced it would earn more than it had predicted earlier in the quarter.

Huh? What happened here?

The problem was that Ameritrade also announced that it would change its entire commission structure. Instead of maintaining a variable rate structure, it will now work on a fixed commission schedule. Even so, the company did not say this change would result in making less money. It would make more!

Investors hated the news, though. In addition to profit-taking on the stock, the market decided this was bad news and sent the stock tumbling. A 9% drop in one day is awful. But the sad truth is that this type of reaction happens all too often, leaving investors totally bemused and wondering if the market has lost its mind.

With Option Strangles I Wasn’t Surprised…

Having made my first options trade in 1983, I wasn’t surprised by what happened to AMTD. Great news is announced all the time and stocks go down anyway. Bad news is announced and stocks go up.

Yes, it’s weird. Yes, it can be confusing. But it happens often enough that I use strangles almost exclusively when I am playing an option, based on an announcement from a company.

But here’s how you could have used a strangle on this example:

Since earnings were due at the end of April, I would have played the May options. This would have given me plenty of time before expiration. The $22.50 call (TQAEX), and the $20 put (TQAQD) would have been my choice, as the strike prices were one tick above and below the market price of about $21.50.

The pricing at the time was about $0.75 for the call, and around $0.50 for the put.

When the news was announced, and the stock started its decline from $21.50 to around $19.45, the call dropped almost immediately to $0.20. But the put launched to about $2.05.

With a strangle play, you simply dump the losing side (in this case, the call), and you let your winner ride.

My experience has taught me that there is never a lock on anything in the stock market. It doesn’t matter what the experts say, or what the news is; there is no way to predict with any certainty how the market will react to news.

Play the Odds… And Win With Strangles

Strangles give you better odds of winning in these types of situations. Naturally, you have to stay on top of the trade and dump the losing side as soon as you can, but in my experience, this strategy wins about 70% of the time. If you play both sides and pay attention, you can do very well.

But be warned… This strategy is not for the investor who likes to sit down at night, after dinner, and quietly review what happened in the market that day. If you don’t have the time to track a strangle play, use a full service broker to do it for you. There is no room for the “buy and go to sleep folks” in this type of strategy. It is the options investing fastlane and should be treated as such.

If you are unfamiliar with strangles, I highly recommend you paper trade them for a while. You’ll find that it’s an eye-opening experience discovering how much you can make, and how quickly you can make it. Just use the call and the put, rather than a call or a put.

Best regards,

Steve McDonald

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Today’s Smart Profits Cribsheet

  • Want to become a better trader? Spend some time this weekend to look over our expert trading tips with Smart Profits #178, Become a Better Trader: Small Changes You Can Make for Big Profits.
  • And once you’ve read that, grab some tips on diversification and how to cut the cord when your trades go south with Smart Profits #296, Portfolio Diversification: Falling In Love With Investments Can Cost You Millions.

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