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The Continued Erosion Of The Housing Market

The Smart Profits Report: Issue #366
Friday, October 27, 2006

The Continued Erosion Of The Housing Market: Three Reasons Why Real Estate Will Crumble In 2007
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

September turned out to be a particularly ugly month for the continued erosion of the housing market.

This morning, the Commerce Department reported that the median price of a new home sold last month slumped by 9.7% from a year ago to $217,100. This came on the back of a 2.5% price decline in existing home sales last month, and was the biggest single-month drop since December 1970.

While overall sales did rise 5.3% from August (the biggest one-month gain since March), it came after three straight months of falling sales. And news that prices are falling is the latest piece of evidence that suggests the market is getting tapped out. The $217,100 figure is the lowest median price for a new home since September 2004.

Three Reasons For A Real Estate Wreck In 2007

But I’ve got news for you: The speed with which housing prices will fall in 2007 will dwarf that of this year. Here’s why…

• First of all, there is an oversupply of homes on the market.

• Second, builders have not yet finished projects that were begun six months ago when all was rosy.

• Third, sellers are still wishing and hoping they can sell their houses to the “right” buyer for the “right” price next week. Just like the Nasdaq collapse earlier this decade, homeowners are prone to overly optimistic projected outcomes in their personal situation.

By this time next year, home prices in places like Nevada, California, Florida and Arizona may not decline 5% as the experts are saying… they could fall twice or three times that number.

Overall, we may not see a full-blown crash in housing prices, but a fall of 20% to 40% from the highs in many areas will be the norm, not the exception.

That’s because right now, sellers aren’t selling. They’re in denial - still waiting for Santa to deliver their asking price… or close to it. But when homeowners finally adjust to the prices that reflect the marketplace reality, bolt the door - because prices will fall like dominos.

My advice: Take the first reasonable offer and count yourself lucky.

For example, my contractor is selling his house. He told me six months ago that it was on the market. Since then, he’s only had one offer - $5,000 less than his asking price. He said he’d wait it out. Given the market, I mentioned that he should sell at the lower price. He declined. The house remains on the market - and probably will be for some time yet. In the meantime, he’ll have spent a ton in mortgage interest, maintenance, insurance and taxes. Multiply that guy by several million - and the future of U.S. real estate looks ominous.

The Market’s Falling, So Why Is Greenspan Upbeat?

So imagine my surprise when I heard Alan Greenspan recently declare that the housing market has seen its darkest days.

I wonder if the former Fed maestro has fallen prey to the same ill-conceived thinking that is so pervasive on Wall Street? After all, it was only recently that a number of major investment firms breathlessly upgraded home building stocks… only to report the very next week that they saw disaster ahead in the housing market.

Take D.R. Horton, for example. This is one of America’s healthiest homebuilders - a very well managed company, with a stellar balance sheet. Yet recently, it said: “The company’s cancellation rate (homes cancelled divided by gross homes sold) for the fourth quarter of 2006 was 40%.” That means almost half of all potential buyers backed out.

But I don’t need to see D.R. Horton’s numbers. I can just look down the street and see a “For Sale” sign on every other house.

The “For Sale” Signs Are Everywhere… So Why Are Homebuilders Still Building?

I’ve always wondered who owns all these houses on sale. Nobody I know has more than one house, unless they buy and sell homes as investments. But that hasn’t stopped homebuilders constructing an inexplicable number of new homes, on top of apartments being converted into condos. Earlier this month, the Census Bureau reported that housing starts unexpectedly increased.

I fear this situation is eerily similar to the Nasdaq slump in 2000. Back then, the regular guy got sucked into a market of low-float Nasdaq small caps, hyped up by irresponsible investment banks who wanted quick hits from IPOs.

Result? The regular guys ended up getting killed. And now, the lure of quick profits is sucking some people in again. And they’re quick to fall for irresponsible comments from people like Greenspan, the Commerce Department, the Housing Lobby, and realty companies.

“Irrational Exuberance” Revisited

Remember “irrational exuberance?” This was arguably Alan Greenspan’s most famous speech. If you’d listened to him back then, you’d have missed out on huge gains in the market. Why? Because Greenspan has an impeccable history of being correct - but even more impressive is his ability to be right too early. He got it right - but at the wrong time. It was two years later that the market crashed.

When interest rates hovered around 3%, Greenspan never suggested locking in a fixed-rate mortgage and not speculating. Nope. Instead, he said adjustable rate mortgages make sense.

Result? With mortgage rates having risen throughout the summer, research group First American Real Estate Solutions predicts that interest rates will rise on about $300 billion in adjustable-rate mortgages this year alone. That figure is projected to jump to more than $1 trillion in each of the next two years.

That means an increasing number of homeowners could see their monthly payments more than double, fail to meet them, and file for bankruptcy.

So ignore those trying to make it seem that the worst is over for housing. While homebuilders’ stocks might be bottoming at the moment and represent dead investment money for a while, house prices aren’t bottoming just yet.

Bottom line: The housing bust is not today’s news. It’s going to be tomorrow’s. I think we’re about two years away from the seeing the bottom in the real estate market.

Good trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

• If you’re thinking about playing the downside in the real estate market, then one of the best ways to do that is through index options. This is a powerful tool that allows you to spread your risk by investing in just one asset that represents an entire market. Read more about it in Smart Profits #215: Index Options: A Billionaire’s Trading Tool Anyone Can Use.

• There’s something I really think you should check out. My good friend and colleague Michael Masterson has just published what I consider to be his best book to-date. It’s called “Seven Years To Seven Figures.” I’ve known Michael for more than 10 years and watched him build dozens of successful businesses from the ground up, creating millionaires in the process. He’s doubtless the best I know at generating real wealth. The book contains Michael’s personal wealth-building secrets and goes beyond the usual repetitive fluff. Amazon is featuring it at a pretty heavy discount right now. It’s a good deal.

Related Articles:

• Stock Options: How to Buy $2,446 Worth of MSFT for $1,270
• Volume: Reading Volume to Find 20% Gains… In 45 Minutes
• Volatility Trading: Combat & Survive the Market’s Volatility Swings

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Dow Jones Industrial Average

The Smart Profits Report: Issue #365
Wednesday, October 25, 2006

Dow Jones Industrial Average: Don’t Be Fooled By The Dow’s New Highs & Beware The Pullback Signs
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

The Dow Jones Industrial Average just keeps making new highs. In fact, it’s made a new all-time high on 11 of the last 16 trading days.

The Dow is the most watched stock index in the world. It’s so popular it acts as the benchmark for the overall market (as in, “What’s the Dow doing today?”) And the fact that it’s making a string of new record highs is significant.

But right now might not be the time to get caught up in the bullish fever.

That’s because while the Dow Jones and the other broader market indexes push higher, there are ominous signs that point to a pullback in the markets - and sooner rather than later.

How Are The Pros Playing The Markets?

One set of data that I like to use is sentiment analysis. I’ve written about it many times before. But as a brief refresher, sentiment analysis seeks to quantify and qualify investor sentiment to gain an understanding of what the market is likely to do next. There are many tools used for sentiment analysis - including:

• Put/call ratios
• Volatility measures
• Asset flows
• Sentiment surveys

One sentiment tool I like is the Commitments of Traders Report. This comes from the Commodities Futures Trading Commission (CFTC), which collects data from all traders who trade in “reportable size” (a size above a threshold set by the CFTC).

This data can prove quite useful, especially since the CFTC separates the data into three categories: Large Speculators, Commercial Traders (those who use futures contracts in their day-to-day activity, and may have the best read of current market conditions) and Small Speculators (mainly retail traders).

So what’s the big story here?

Commercial traders are holding their largest short position in the S&P of the past 22 months! Check it out on the chart below:

This research by Bennet Sedacca of Atlantic Advisors, LLC (and reported by analyst Tom Peterson) also shows an interesting correlation of up and down moves during times when the commercial traders held extreme positions.

But that’s just one early warning flag for us. Here’s another…

Charles Dow Himself Warned About This Market Condition

Charles Dow is widely regarded as the father of technical analysis. One of the tenets of his “Dow Theory” is that when the Dow Industrial Average and the Transportation Average are at odds, the market is unstable (for more information on Dow Theory, and how it works, check out today’s “Cribsheet” below).

And that’s exactly what’s happening today. Take a look at the chart below, and you’ll see that the Transports haven’t been as excited as their Industrial brethren about these new highs. This type of divergence usually leads to a correction (kudos to my good friend Christopher Castroviejo for pointing out the divergence in this venerable relationship).

Your Next Move?

I don’t think it’s time to jump ship just yet on this recent bullish run. There’s a good chance we could get a “blow-off top” before this is over.

But I do think we’re getting clear indications that a pullback is due in the near future. But if you don’t want to look at the short side and you’re not fully invested, don’t jump in when the market is at its most frothy unless you have a strategy. To short this market, I think you need a clear sign that we’ve started to pull back (basically a couple of weak sessions on the Dow Jones Industrial Average). So wait for the expected pullback to give you better entry prices.

Good Trading,

D.R. Barton, Jr.

Today’s Smart Profits Cribsheet

• My colleague and top technical analyst, Jim Stanton, has written in detail about Dow Theory, and the relationship between the Dow Jones Industrials and Dow Transportation Index in this column before. So for more information on this interesting and pretty reliable relationship, check out Smart Profits #362: Dow Theory: The Most Important And Powerful Concept In Technical Analysis.

• In the above article D.R. Barton Jr, uses sentiment analysis to watch sizable commodities futures trades that set the moods for the markets. Check out the Smart Profits Glossary for definitions of other types of analysis used by technical traders or you can also check out the Smart Profits Site Map for other articles dealing with all things technical analysis.

Related Articles:

• The Stock Market’s Reaction to Good News: Why It’s Best to Sell at the Sound of the Trumpets
• The Dow Jones: Technical Charting Shows Trouble On the Horizon
• Defensive Covered Call Strategy: What’s Better Than Making Money? Keeping It

The Chart of the Week - Pat On The Back Edition

This chart shows the relationship between 100 shares of Archer-Daniels-Midland (NYSE: ADM) and a contract of corn futures. Back in August, I recommended shorting this ratio, because of the fervor over ethanol and how it was only being reflected in the distillers’ price, while the corn farmers were getting the short end of the stick. This ratio has dropped as predicted, bringing the relationship back into a more reasonable range.

Smart Profits Report Archives

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Credit Spread Trading

The Smart Profits Report: Issue #364
Friday, October 20, 2006

Credit Spread Trading: How To Be Wrong… And Still Win On Your Trades
By Lee Lowell
Futures Options Specialist, Mt. Vernon Research

Two weeks ago, I jetted off to Las Vegas with the rest of the Mt. Vernon Research team for our first-ever Commodities and Trader Seminar.

While there, I gave a detailed presentation on my favorite investment strategy - option credit spread trading. Simply put, this is a fabulous way to invest - one of the most profitable techniques I know to squeeze gains from just about any market. I execute this type of trade for myself more than any other, and it’s also one that my Triple-Zone Profits Trader subscribers will see time and again.

Before I go over the finer points of option credit spread trading for you so you can see just how profitable it can be, let me start by telling you the biggest benefit of the strategy…

How You Can Be Wrong… And Still Profit

Picking the correct direction of the market is not the driving force behind being profitable.

That’s right.

When was the last time someone told you that? Probably never. I’m sure we’ve all learned over the years that the only way to win on a trade is to get the direction right.

If You Want To Be “In The Money,” You Have To Go Out-Of-The-Money

Well, that’s all going to change when I show how to profit with the option credit spread.

The trick to succeeding with option credit spreads is to use it with out-of-the-money (OTM) options. The option credit spread is an “option-selling” technique that involves selling a more expensive OTM option and offsetting it by buying a cheaper, farther OTM option.

Since we are selling the more expensive option, the buyer will be putting a cash credit into our account. Remember: We’re not paying for this spread, someone is paying us.

There’s just one thing you need to know before you initiate an option credit spread: You must have at least some idea where you think the market may be headed. The market can be anything you want - the Dow… S&P… commodities… bonds… currencies… or an individual stock. You won’t have to be totally correct on the direction, but you must have an idea about it. Once you’ve got that covered, then you can move on to the next step.

How To Grab Gold Profits By Shifting Your Attitude

Take a look at the chart below, which shows Gold futures that expire in February 2007. Even though the price of gold has trended lower over the last few months, you might think that gold will start to head higher in the near future, or at least not go down much farther. This is a bullish attitude and we want to play that directional call with an option spread. So what do we do?

Listen to my next sentence…

We’re not going to try and predict how high or how far gold might go to by option expiration. We’re going to predict where it likely won’t go to by option expiration.

There’s a huge difference in those two approaches. We know gold is going higher, but we’re not sure how high. However, following our technical and fundamental analysis (don’t forget to do that!), we’re more sure that it won’t be going lower than the $530 level.

Since we’ve predicted that gold won’t be going lower than $530, we want to sell an OTM put option credit spread. This is a limited risk/limited reward, bullish type of trade. We want to choose options that correspond to our support levels, so we will sell a February 2007 $530 put option and simultaneously buy a February $520 put option in one single transaction and collect a premium of $1.30 ($130 in real dollars with the $100 Gold multiplier). Someone will be paying us $130 to sell that spread to them. Since we’re selling this option spread, the most we can make on the trade is that $130. There is no chance to make unlimited profits with this trade.

The option credit spread is a type of strategy used to hit singles and doubles and to collect premiums over and over again in as many markets as you want to trade in and as many times during the year as you can.

It’s a slow, steady gainer type of trade with an extremely high probability of profit. That’s why I execute it so much - because the probability of winning is very high. How do we know that…?

Know Your Chance Of Success Before You Trade

Take a look at the probability calculator below - specifically the box in the bottom right-hand corner. It shows us that our probability of being successful on this trade is 88.1%. I like those odds.

What we don’t want is for gold to trade lower than our breakeven price of $528.70 (calculated by subtracting the spread price of $1.30 from the short strike of $530 - $530 - $1.30 = $528.70).

If gold retraces back down to the $528.50 level, that’s where we’ll start to lose money. However, we’re starting with a huge cushion. Gold is $70 above our danger zone. As long as gold doesn’t go back down there by option expiration, we get to keep the whole $130 per spread. And the probability calculator is telling us that there’s an 88.1% chance that gold will not go below our breakeven price of $528.70. That’s sweet!

Make Your Life Easier With Option Credit Spread Trading

Why would you want to make life difficult for yourself by trying to predict where a market/stock might go? That’s a very hard thing to do. Save yourself the frustration by simply figuring out where it likely won’t go. Do that… and you’ll give yourself three chances to win. In our trade above, it works like this…

• As long as gold stays above $528.70, we win.
• Gold could flatline and we’ll win.
• Gold can even move lower, against our prediction, and we can still win.

So get out of the mindset of trying to predict where the market is headed. Give yourself a better chance of being correct by figuring out where the market is not headed. Once you’ve done that, you can sell OTM option spreads and reap many small winners over time.

Good Trading,

Lee Lowell

Today’s Smart Profits Cribsheet

• I gave a detailed introduction to the option credit spread technique, and explained exactly how you can implement it into your investment strategy today. Check it out in Smart Profits #348, Credit Spreads With Options: How Option Credit Spreads Give You a Better Chance to Win.

Related Articles:

• Out-Of-The-Money Options: Buyer Beware… Seller, Take The Money
• Strike Prices: Increase Your Odds by 99%
• Understanding Options Leverage: The Power of Leverage Is Bigger than You Think

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Trade Small… Save Big

The Smart Profits Report: Issue #363
Wednesday, October 18, 2006

Trade Small… Save Big: The Single Best Piece of Trading Advice Ever
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research

In today’s fast-moving and volatile market, there are now more traders than ever before. Volume on the NYSE has soared 495% over the past decade - from a daily average of 403 million shares traded in September 1996 to 2.4 billion today. That means two things:

• Investors now face fiercely increased competition for profits.
• With so many new investors (who often lack the proper investing education), you need to be even more aware of what you’re doing, since they can add to volatility… and erode your profits.

So today, I’m going to offer you a truism - a remarkably simple, yet powerful message that is perhaps more important today than at any other time. Trade small and save big while you’re learning.

The last thing you want is to plunk down a large amount of money when you’re starting on a new system or strategy, only to see it evaporate as you learn to trade it.

One Case Where A Few Singles Are Better Than A Homerun

I’ve given that advice to literally thousands of people in person, and to hundreds of thousands in print. And one of the benefits of being a trading coach, and speaking frequently at seminars and conferences is that I’m able to get instant feedback on what I teach from attendees.

And in all my years, I’ve never once had someone come up to me and say, “You know, D.R. - I started trading with that system/strategy/newsletter, but because I was trading in small amounts, your advice has ruined my life.”

On the other hand, I’ve had many people tell me that trading small has “saved their bacon” and prevented them from absorbing a big loss. I wrote the same advice in an e-mail last night to a new investor who was struggling with exactly that issue.

It’s not rocket science… but from a psychological standpoint, you’d be surprised just how difficult this strategy is to implement. Here are a few reasons why - and what you can do to overcome it…

Trade Small… Save Big

Ever wondered why it’s sometimes difficult to do something that seems logical and rational and that’s best for you? Because it can be boring! It’s often more exhilarating to go with your emotions, and feel the rush. But when investing, it’s dead wrong.

Here are the issues with trading small - and how to beat them:

High Excitement Trading

It doesn’t matter whether it’s a new trading system, new hobby, or new relationship. When you start out something new, your excitement is at its highest. Same goes for investing. It’s our natural response. And much of that excitement stems from the profit potential of our new strategy. So when the rational parts of our thought process chime in with “trade small while you’re learning,” it dampens the excitement and enthusiasm.

The thing is: Many people choose to cling to the excitement and toss away thousands of dollars in losses when they could have easily limited those losses to hundreds of dollars and gotten the same experience and education just by trading smaller sizes. Use restraint and common sense.

Paying Too Much Attention To Trading Expenses (eg. Commissions)

The most frequent comment I hear about trading small is, “I’ll never be able to cover my commissions if I only trade a few shares. There are two ways to overcome this problem:

• Start out trading with a broker who charges “per share” commissions (or low per contract commissions for options traders). There are plenty of reputable brokers like Interactive Brokers, TradeStation and CyberTrader who charge very low “per share” commissions.

• But if you like your broker who is charging “per transaction” fees, then re-frame your commission costs. Set up an account that you will use to pay for commissions until you can prove to yourself that you can trade a new strategy profitably over time. Then you can evaluate the system and your ability to execute it properly based on trading results, exclusive of commission costs. Once you can trade effectively and profitably, you can then gradually ramp up your size per trade.

Missing The “Big Trade”

This is another of the more frequent reasons given for not trading small when starting. “Man, I nailed that trade… but could have made even more if I’d invested more. I’ve lost all of that potential profit.” While that could happen, most of the time, the opposite happens, and you could find yourself in a big losing trade - or a string of them.

And if you do that while trading big sizes, you’ll get crushed - both financially and psychologically. It’s much better to make a modest profit on one or two nice trades than it is to lose a huge amount while you figure out your trading psychology and whether a system fits you or not.

Whether you’re new to investing, are trying out a new system or options strategy, or just aren’t sure which way a trade will go, it’s critical that you exercise common sense when deciding how much to invest. Trade small at first, and you’ll save yourself a lot of financial headaches.

Good Trading,

D.R. Barton, Jr.

Today’s Smart Profits Cribsheet

• One of the most important keys to being a successful investor is being able to trade with confidence. If you don’t have it, you’ll always be second-guessing yourself. I examined this often overlooked concept, and gave some crucial tips for developing your trading confidence in Smart Profits #323, Trading With Confidence: How You Can Develop More Confidence In Your Trades.

Related Articles:

• Position Sizing: The Most Powerful Investment Concept
• Price Shock: How To Respond To Three Types Of Price Shock During Earnings Season
• Trailing Stops: How to Give Your Options Room to Grow

The Chart of the Week

Once again, Intel (Nasdaq: INTC) makes it into “The Chart of the Week.” As the company releases its quarterly earnings, Goldman Sachs’ downgrade of the stock sent it down almost 3% today. If it breaks below $20, beware. This will be a clear signal that semiconductors in particular, and the tech and broader markets in general, will be under severe downside pressure.

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Dow Theory

The Smart Profits Report: Issue #362
Friday, October 13, 2006

Dow Theory: The Most Important And Powerful Concept In Technical Analysis
By Jim Stanton
Advisory Panelist, Mt. Vernon Research

Over 100 years ago, Charles Dow came up with the foundation for what would become the most powerful and commonly-used investment theories. But it was actually his understudy, Wall Street Journal editor William Hamilton, who refined and expanded the concept.

I’m talking about Dow Theory. And being a professional technical analyst for about 25 years, it’s something that has always fascinated me, since it’s one of the oldest and most reliable intermediate- to long-term chart patterns.

Simply put, Dow Theory states that both the Dow Jones Industrial Average and Dow Jones Transportation Index have to make higher highs together in order for a bull market to stay intact. The same goes for a bear market - both indexes have to make lower lows around the same time in order for a bear market to continue. When one index does not confirm the other, within a reasonable amount of time, there is a good chance for a reversal in both indexes.

Since my technical specialty is “pattern recognition,” Dow Theory obviously forms a critical part of my overall analysis. And what that analysis is telling me right now is that some interesting changes could be around the corner…

Dow Theory: Accept No Imitations… Always Follow The Leader

Recently, numerous traders have tried to dilute the Dow Theory down to a “system,” whereby a series of confirmations in both indexes is taken to be “buy” or “sell” signals. But this neglects other important factors such as valuation, economic conditions, and investor sentiment.

Steer clear of this rather simplistic analysis. The key to Dow Theory is that you have to give the “lagging index” time to catch up with the leading index. If the Transports make new highs and the Industrials do not, you have to give it some time to “catch up” and/or wait for some kind of sell signal on the Industrials before declaring that a Dow Theory sell signal has been triggered. Let me give you an example…

Back in January 2000, the Dow Industrials hit a top. But the Transports didn’t follow suit, and the move wasn’t confirmed. Result? We got a 3-year bear market that eventually ended in March 2003 when the Transports made new lows. Again, we knew the bear market had ended, because Dow Industrials didn’t copy the Transports’ low.

If a market is showing signs of a potential reversal, I use Dow Theory as a “confirmation” tool that proves to be very valuable in my analysis. And what I’m looking at now shows that there is a potential Dow Theory signal setting up, as the Industrials have hit new all-time highs, while the Transports and many of the other indexes are lagging behind.

So what’s the deal here?

Transports Edging Back Towards Crucial Fibonacci Level

Back on May 10, the Transports hit a high of 5,038.58 - but right now, the index needs to rally almost 10% to reach new highs and confirm the bull market. And while a 10% jump would be a tall order, I’ve seen stranger things happen over my many years analyzing the markets.

My analysis indicates that the next major upward resistance level for the Industrials is around 12,050, which is only 102 points above current levels (the Dow rose 96 points yesterday and carved out another new record high of 11,959.63 in the process).

The chart below shows a daily chart of the Dow Transports, which, as you can see, is approaching the crucial 62% Fibonacci retracement level (4,860) set during the May-August correction. From current levels, that would be about a 2% move.

Chart Courtesy of Trade Navigator Software: http://www.genesisft.com

Setting Up For A Sell Signal?

What I conclude from this analysis is that, while the bulls shouldn’t be too concerned, some caution is warranted.

If the Industrials reach the 12,030 to 12,050 level, and the Transports continue to lag, a Dow Theory sell signal could occur. BUT… we would need to allow time for the Transports to play catch up, or trigger a sell signal.

Keep a close eye on the various Nasdaq indexes, too. They are only about 3% to 4.5% below this year’s highs, and if they make new highs for the year, the Transports may have more time to confirm the Industrials. Of course, if a Dow Theory signal looks imminent, I’ll keep you posted right here.

Good Trading,

Jim Stanton

Today’s Smart Profits Cribsheet

• In today’s message, I focused mainly on the key Dow Theory relationship between the Dow Industrials and Dow Transports. But I also referred to another key technical trading concept - Fibonacci retracements. This specific sequence of numbers are the work of 12th century Italian mathematician Leonardo Fibonacci - and can greatly help you in identifying the points at which you should buy or sell assets when investing. I explained the concept in full detail in Smart Profits #313: Fibonacci Retracement Levels: Let “Leo” Calculate Your Support and Resistance.

Related Articles:

• Continuation Patterns: Cashing In On Technical Analysis
• Breakout Trading: The “Stanton Gap Rule” For Next-Day Profits
• Technical Indicators: How to Overcome the “Evil Twins of Trading”

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The US Dollar’s Next Move

The Smart Profits Report: Issue #361
Wednesday, October 11, 2006

The US Dollar’s Next Move: Ignore The Dollar Doom Merchants - The Greenback’s Got Room To Run
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research

Dollar bashing has certainly been a particularly popular pastime over the past couple of years.

Even the world’s best-known investor, Warren Buffet, has taken on the greenback in recent years - and lost.

So ignore the naysayers: The dollar isn’t dead yet. And it won’t be for a long time as we watch for the US dollar’s next move.

Backing Up The Bullish US Dollar

To back up my bullish theory, I put out a U.S. dollar-based recommendation in the recent October Xcelerated Profits Report issue. This was because as the issue was being broadcast around September 22, the dollar had just broken and held an important trend line - as you can see from the last arrow in the chart below.

At the same time, the important “Commitment of Traders” Report highlighted some key buying trends among Commercial Traders. It was clear that sentiment was at a turning point - and so far, the dollar has performed true to form.

The all-important questions now are: What’s next for the greenback? Will the rally continue? Let’s turn to the charts for some clues…

Will the Dollar Stay Strong?

The first thing to notice in the chart below is that since early August, the dollar has consistently made a string of “higher lows.” This is a very bullish sign, especially since it’s also made “higher highs” over that period. This is the very definition of an uptrend (higher highs + higher lows = definitive uptrend).

However, while that certainly bodes well for a continued rally, there is one note of caution: The key high that formed in July could provide some short-term resistance, especially since the currency has moved up fairly fast in the last few days.

But if the U.S. dollar can close above that summer high of 87.33, it could propel the greenback forward to possibly test its highs set earlier this year.

How To Play The Dollar From Here

So if you want to capitalize on the dollar’s rise from here, what should your next move be?

In my technical opinion, the most prudent play at this point is to wait for it to take a “breather” and consolidate, or see a small price pullback. I almost always favor buying on short-term weakness rather than trying to jump in after the price has just made a strong move in our favor, and end up chasing the asset and paying too much.

Good Trading,

D.R. Barton, Jr.

Today’s Smart Profits Cribsheet

• Using technical analysis to predict price movements is one of the most powerful forms of studying the markets. We identify something any investor can use in Smart Profits #214, Technical Analysis: Two Simple Tools for Spotting a Technical Trend.

Related Articles:

• Index Options: A Billionaire’s Trading Tool Anyone Can Use
• Timing Your Trades: Two Ways to Expand Your Thinking And Your Profits
• Option Pitfalls: Avoid These Five Options “Red Flags”

The Chart of the Week

Back in February, Intel (Nasdaq: INTC) formed a small gap that has yet to be filled. This gap has now formed a key resistance area for INTC’s advance. If we clear this area (which is not what I’m betting), then the next two resistance levels are the boundaries of the big January gap: $23.06 and $25.32.

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Trading LEAPS Options

The Smart Profits Report: Issue #360
Monday, October 9, 2006

Trading LEAPS Options: The Most Profitable Five-Letter Word In Options
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

I think trading LEAPS options is one of the smartest, most cost-effective ways to buy stock - and anyone who tells you otherwise probably doesn’t know exactly how powerful this method of trading can be.

It forms an integral part of my investment strategy because it provides me with low-cost diversification that I might not ordinarily be able to afford. After all, how many stocks can you own if you have limited investment funds?

Three Key Benefits of Buying LEAPS

LEAPS (Long-Term AnticiPation Securities) are options that have longer-term expiration dates - up to one, two, or three years in advance. There are three key benefits of buying LEAPS:

• They allow you to control underlying shares at a greatly reduced cost. For example, the cost of a LEAPS option bought at a strike price close to where the shares are trading usually costs no more than 15% of what it would cost to buy shares outright - and often less than 10% of the underlying share price. In addition, LEAPS can actually return you more than the underlying shares in real and dollar returns if the underlying shares move in your specified direction.

• Because they’re long-term options, you have more time on your side for the underlying asset to increase/decrease in value (depending on what you want it to do). You don’t have to be right in days or weeks like short-term traders - you just need to get the direction right, and you’ll be in the money.

• You spread your risk over a longer period of time and limit your potential loss. The most you can lose is what you have at risk in the option - that is, the price you paid. This is always less than the 20% or 25% stop loss typically used by traders on a stock.

Beat The Shareholders And Pocket Bigger Gains In Less Time

LEAPS are basically proxies for stocks that I want to own. My anticipation is that these companies will make strong moves either up or down in the coming months. But using LEAPS allows me to control the shares for less, and give me the benefit of time for the asset to rise.

For example, let’s say one of those talking heads on television boldly proclaims that a stock is headed for a 30% rise. No matter what the broader market is doing, that’s a pretty ambitious move. Not to mention the fact that you could be laying out a lot of money to buy shares outright, and be waiting a long time for the move to happen.

But here’s the thing: If you trade LEAPS options on the underlying shares instead of buying stock, the company doesn’t have to move up by very much (and certainly not by 30%) before you’re making money. Far from it. In fact, you can make considerably more than shareholders - you just need the share price to move in the right direction for a few days or weeks to clean up.

Let me give you a real-life example from my LEAPS Trader service…

How To Turn 3% Into 30%

A while back, I advised my readers to buy LEAPS on General Electric. At the time, shares were trading for $30, and we bought the $32.50 LEAPS.

Within three days, the shares moved to $30.90 - a whopping 3% gain for shareholders.

However, we cashed out of our LEAPS for a 30% gain in three days.

So how did the LEAPS rise that much higher, despite such a small move in the share price? The answer lies in the time-value component of the options-pricing model.

It goes something like this: If the stock can move up 3% in three days, it can keep climbing at that pace for a couple of weeks. And if it does, it could rise to, say, $33 or $34, and the LEAPS option would then be worth more.

That’s because the market, if it senses such a surge in the stock price, re-prices the option accordingly. Thus, the more time left until the option expires, the more it will cost… and the more you will get for it when you sell.

A few weeks later, we did the same thing with a defense stock. The underlying shares moved up about 4%, and we made 36% in less than a week.

In both cases, the shares did not even approach the strike price on our LEAPS - yet the options made us a ton of money.

Your 4-Step LEAPS Checklist

There are several rules you should keep in mind when considering LEAPS options:

• Use LEAPS as a proxy for expensive stocks that could lose you a lot of money if something goes wrong (even huge companies like Merck aren’t immune from quick and ugly price slumps. Shares dived some 40% in the aftermath of the Vioxx debacle).

• Only use LEAPS when you outlook is less than 2 to 3 years since LEAPS options are only valid for that period of time.

• Use LEAPS for riskier strategies, such as betting that shares will fall. Shorting stocks has unlimited downside potential, and LEAPS give you a better, more cost-effective way of doing the same thing.

For example, in my LEAPS trading service, we recently shorted Hilton Hotels using LEAPS, and walked away with 15% to 20% profits within a couple of weeks. The benefit of doing this versus shorting the stock is obvious. Using two-and-a-half year in-the-money LEAPS, our risk was about $2.40. But shorting the shares directly would have put us on the hook for $26 per share.

• Use LEAPS to diversify your portfolio at lower cost. You can control a million dollar stock portfolio for two years for about $100,000 using a LEAPS-based portfolio.

For example, I once advised traders to go long on Sun Microsystems (Nasdaq: SUNW). But instead of paying $4 a shares, we chose to pay $0.75 for a two-year LEAPS contract - nearly 85% less. It also gave us time and limited our losses to the amount we had at risk. If we’d bought the stock and used a 25% trailing stop or stop loss, we would have risked more. I chose the $5 strike price, and I was looking for the shares to move just 10% to 20% within a few months to make some good money - and with a tech stock like SUNW, which had traded within a 40% range annually over the past few years, it was a sound bet. It paid off. We just closed out our SUNW position for a 60% gain, in a staid market. Unless you’re planning on buying shares and holding them for more than a year or two, I believe you’re putting too much money at risk up front by buying large blocks of shares.

Using LEAPS = Comfortable Investing

One of the most comforting aspects of investing using a LEAPS strategy is the ability to withstand all manner of negative events and still live to fight another day.

Most recently, two of our LEAPS positions were hit hard. Back in late July, we got knocked on our Advanced Micro Devices (NYSE: AMD) spread, watching the shares fall from the mid $20s down to about $17. At that point, most regular stock investors would have been stopped out.

For us, however, while we did endure some pain, the LEAPS we owned didn’t lose all of their value. That was because with so much tine left on the options, anything could have happened. And it did. AMD has since recovered to the mid $20s again, and is gaining momentum on the heels of several analyst upgrades and the company’s announcements that it would attain close to 30% of the market within two-and-a-half years. If it continue on its current track and affirms guidance in coming quarters, this position will deliver.

The second situation occurred with Israel-based Teva Pharmaceuticals. We got into this position just before the Lebanese-Israeli war. What timing! And even through Teva shares fell by 20%, our LEAPS survived nicely. Now that the hostilities have ended, Teva is on an upswing as well with better than expected earnings and improved guidance. Barring a full-fledged Israeli crisis, our Teva spread will make us money as well.

Time Is On Your Side With LEAPS Strategies

A LEAPS strategy works because time is on your side and offers you much more protection than shareholders. In most cases, we can withstand many short-term crises that would knock ordinary stock investors out of the game. And why risk 100% of your money buying shares outright when a LEAPS position allows you the luxury of paying 10% to 15% of the capital required for a position?

My point is: When you use the right type of option and the right system, you can dwarf the returns from the stock market well before the stock reaches your target.

Good Trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

• How many times has an otherwise good stock trade gone against you simply because of one weaker-than-expected earnings report, or negative Wall Street gossip? That doesn’t have to be the case if you trade LEAPS options instead. Read Smart Profits #223: LEAP Option Investing: The Best Options Play on eBay - and learn how you can beef up your trades’ ability to withstand shocks, and still emerge with upside potential.

• Speaking of shocks, check out Smart Profits #359, Price Shock: How To Respond To Three Types Of Price Shock During Earnings Season by D.R. Barton Jr., as he examines one of the toughest and least understood parts of trading, an unpredictable move that is too fast to trade called a price shock, and how to combat these through position sizing.

Related Articles:

• LEAP Options: The Pro Strategy That Provides Protection And 177% Profits
• LEAPS vs. Stocks: How to ‘Own’ Almost Any Stock for Pennies on the Dollar
• LEAPS Option Strategies: A Gold Strategy That Beats Stocks, Bullion or Coins
• LEAP Spread Trading: Gold’s Hot And It’s Time To “Spread” Out Your Fortune

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Price Shock

The Smart Profits Report: Issue #359
Wednesday, October 4, 2006

Price Shock: How To Respond To Three Types Of Price Shock During Earnings Season
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research

In the stock market, price shocks - unpredictable moves that are too fast to trade - are one of the toughest and least understood parts of trading. They’re the market’s equivalent of a low blow - and the market loves to take cheap shots.

The problem is that nobody is immune. A series of price shocks (along with poor risk management) even crippled the most infamous hedge fund of all time, Long Term Capital Management.

Watching For Several Forms of Price Shocks

Price shocks show up in several forms, the most prevalent of which is the overnight gap. All investors are familiar with this ugly scenario, where a company reports bad news, and the stock promptly gets hammered.

One of the cases I remember most was biotech stock Human Genome Sciences (Nasdaq: HGSI). I was following the stock closely and it was a year ago exactly that the company happened to report disappointing clinical trial results for one of its products after the market closed. The next morning, the stock opened down nearly 30%.

Price shocks occur much more often than we imagine. And while it’s not always easy to see them coming, there are steps you can take to mitigate the effect and even take advantage when they occur in our favor - particularly now that another earnings season is about to kick off. That means the market is sure to be more active and under some pressure, as companies report third quarter results. It also means that there are going to be many more price shocks, as investors respond to the news.

Your #1 Protection Plan: Position Sizing

Understand that whenever a negative price shock occurs, the horse has already left the barn, so to speak. So it’s imperative that you’re prepared for this in advance.

Therefore, the most important thing you can do today is make sure your position size for each trade protects you. That’s why we recommend you put no more than 1 to 2% of your account equity at risk on any single trade or investment. If you follow this prudent risk-management strategy, you’ll be prepared for the worst-case price shock scenario, and protected from a catastrophic loss.

How To Respond To Three Types Of Price Shock

What we need is a systematic approach for dealing with price shocks in managing our portfolios, whether they have had a negative or positive effect on our account. So here’s how to combat three common types of price shock.

• Major Structural Or Fundamental Change:

Price shocks that have concrete reasons are the easiest to understand. These are the announcements that will clearly have lasting effects on an asset. After the price shock, the price typically continues to move in the same direction. For example, if a company comes under SEC investigation, it will get a negative price shock that is not likely to retrace any time soon. If this happens to one of your holdings, exit the position.

On the other hand, a takeover target or a company that is already receiving bids from multiple companies - or is in the process of being bought - usually sees a positive price shock that is not likely to be reversed.

There are two ways to play this. If you’re aggressive, you can hold the position in hopes of the expected continuing move. But a more conservative approach would be to take profits on half of your position, especially if you are not certain about your analysis.

• Overreaction To A Move That Had A Sound Basis:

Price shocks often cause overreactions. People tend to punish bad news more than is warranted or reward good news above and beyond what is reasonable. This is especially true if the news only affects a limited time frame. Events like quarterly earnings and new contracts typically move the price, but do not have a structural, long-term effect.

The same can be said for weather-related news and its effect on commodity prices. After this price shock, the price usually retraces. A great example was the effect that Hurricane Katrina had on oil prices. In the chart below, note the price spike from $65 to $71 as the hurricane approached, followed by a quick retreat the day after the hurricane hit.

If the price moves in your direction: Take profits on at least half, if not all, your position. Many times, the price shock is most extreme move you’ll see and prices will retreat.

If the price moves against you: If you’re not already stopped out, you may be able to hold on for a retracement. This type of news may warrant tightening your stop, and don’t expect to recapture all of what you lost from the shock price move.

• Overreaction To Rumors And Other “False” Moves:

Price shocks can happen because of rumors such as takeovers, or strategic alliances. This is the most difficult type of move to identify. After this type of price shock, the price usually retraces all the way to the original price level.

What To Do When Prices Move

• If the price moves in your direction: Take the money and run! Many times, you may leave part of the position in place if you can’t make a firm decision on whether you are dealing with rumor or fact.

• If the price moves against you: If you’re not already stopped out, hold on for a retracement. Again, this type of news may warrant tightening your stop, but you have a good chance of recapturing your losses.

Good Trading,

D.R. Barton, Jr.

Today’s Smart Profits Cribsheet

• When price shocks occur, they hit hard and fast, often wiping out solid gains in just a few minutes. That’s why employing a stop loss policy is imperative to your trading success, so you choose the risk that’s right for you, and are always protected against heavy, unexpected losses. Mt. Vernon Research Chairman Karim Rahemtulla explains how to do this in Smart Profits #133: Trailing Stops: How to Give Your Options Room to Grow.

• Do you have any idea what an asian tail option is? No? Then don’t hesitate to immerse yourself in the Smart Profits Glossary, chock full of over 175 options terms and definitions!

Related Articles:

• Principal Protection: How to Defend Your Principal From a 50% Bomb
• Position Sizing: The Most Powerful Investment Concept
• Exit Strategies: Prenuptial Agreements for Options

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Options Trading Online

The Smart Profits Report: Issue #358
Monday, October 2, 2006

Options Trading Online: Power Up Your Options Trading With A Trio Of Top Options Web Resources
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

If you want to get the most from your trades and maximize your gains, you need to start from the ground up.

That means getting your hands on as much research as possible and doing your due diligence before you trade. These days, the power of the Internet has made investing a lot easier for everyone - including options traders. And there’s a wealth of information at your fingertips. Best of all… it’s free. You just need to know where and how to get it.

That’s where I come in. Although I spend the majority of my time examining which options trades to execute, I also devote a big chunk of time to scouring the web looking for the best options trading online tools. And you’d be surprised how much is out there. So let’s take a look at the resources I’ve found most useful to my own trading, and show you how they can enhance your trading abilities.

A Trio Of Top Web Resources To Get You Started

Although I’ve used many other data sources in the past, I always come back to Futuresource because it boasts the quality of the data is first-class and the cleanest you’ll find. The site has charts available, along with many technical indicators to choose from. And, if you need to read market commentary, it has a news feed, too.

• www.futuresource.com: Without a doubt, this is my favorite free site for commodities data. It has real-time (mostly e-mini markets) and delayed data for every futures and futures option market.

• www.ivolatility.com: I use this site almost daily, because the options calculators and volatility charts are top-notch. If you’re serious about trading options, make it your priority today to spend some time surfing this site. It has several scanner services that scan the universe of stocks and options to find the best strategies based on your criteria.

• www.888options.com: This is the website for the Options Industry Council (OIC), whose main goal is to spread the word to the general public about the benefits of options trading.

The firm offers free options help over the phone, and also has a free interactive CD called “The Options Investigator,” which I highly recommend. The CD allows you to input different option positions to see how they will perform over time. Check out the site - you’ll find plenty of good information there.

The Grand-Daddy Of Options Websites

No proper discussion of the options market should go very far without mentioning the biggest of all the options websites: www.cboe.com. This is the official site for the Chicago Board of Options Exchange, where millions of contracts are traded every day.

There is far too much information on the site to mention, but my suggestion is to take a look at the archived section of their free webcasts. These are online “webinars” approximately 45 minutes in length and cover a multitude of options trading topics, which you can get by going here:

• http://www.cboe.com/LearnCenter/webcast/archive.aspx. The CBOE also has a free CD similar to the one offered by the OIC. It’s called the “Options Toolbox.”

• Also, go to the Chicago Board Of Trade’s website: www.cbot.com. This is the home of many pit-traded commodity futures and options, and it has its own section of new and archived free webinars as well (http://www.cbot.com/cbot/pub/page/0,3181,1058,00.html)

How To Calculate Your Chances Of Success Before You Trade

Wouldn’t it be great if you knew what your chances of success were before you made a trade? Well, now you can.

OptionVue Research has a great probability calculator that allows you how to calculate this exactly. It’s something I use frequently in my brand new Triple-Zone Profits Trader service. Go here for all the details: http://www.optionvueresearch.com/marketvue.aspx#

Lastly, I have two volatility-based alternatives for you. The first is courtesy of the king of options trading, Larry McMillan. Hs website provides both historical and implied volatility data of every index, stock & commodity. It’s a huge page, but well worth a look. Best of all, it’s free: http://www.optionstrategist.com/free/analysis/data/index.html

In addition, here’s the website I use for free volatility data for the futures markets:

http://platinum.optionetics.com/cgi-bin/oamergef/www/tablesf/rank2yr

Not only does it rank the most actively traded futures markets from high to low according to their volatility numbers, but it also gives you a six-month and two-year implied volatility chart.

Getting Something For Nothing

With investing now more popular than ever, there are a plethora of companies fighting for your business. The bonus is that the Internet has leveled the playing field for investors and made the process much more cost-effective. So make sure you use the free tools available to you and give yourself a better chance of trading more successfully.

Great Trading,

Lee Lowell

Today’s Smart Profits Cribsheet

• Now that you know where to go to get the best free options research, you need to make sure you get the best deals on your actual trades. I explained exactly how you can do this in Smart Profits #331: Online Broker Commissions: How to Get the Best Deal on Your Options Commissions.

• For more information on all of Larry McMillan’s books, check out our Recommended Options Books area on the site as well as our Recommended Options Websites area.

Related Articles:

• The Best Commodities Website on the Internet
• The Chicago Board of Options Exchange: The Website Every Options Trader Should Know
• Two Simple Ways To Increase Your Options Win Rate

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