• SPR Archives
• Commodities Corner
• Sector Watch
• SPR Reports
• About SPR
• Glossary

Federal Reserve Interest Rates

The Smart Profits Report: Issue #391
Wednesday, January 31, 2007

Federal Reserve Interest Rates: How To Prepare For A Potential Price Shock
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

This Sunday, the Super Bowl will attract more television viewers than any other broadcast this year. But as usual, there’s almost as much hype about the commercials as there is about the game itself. And with so many eyeballs glued to the screen on Sunday evening, the going rate for a 30-second ad spot is $2.6 million.

The media buzz surrounding the Super Bowl commercials reminded me about one of the most well-known financial commercials - and how it relates to another important Federal Reserve interest rates announcement coming at 2:15 P.M. tomorrow…

A Collective Cupping Of Ears

Picture the scene: Two businessmen are sitting in a posh restaurant discussing the markets. The first renders his opinion about market direction, with the second guy chiming in: “Well my broker is EF Hutton, and EF Hutton says…” The camera pans back, and we see everyone in the restaurant - from patrons, to the busboy, to the kitchen staff - stopping what they’re doing, leaning toward the EF Hutton client, and cupping their ears so they can hear the market wisdom from this hallowed firm.

Although EF Hutton folded in the aftermath of the October 1987 stock market crash, the ad was a great success. And tomorrow - just like in that commercial - the financial world will stop and listen intently to what the Fed has to say.

But the big question is: Should you change what you’re doing with your trading and investing when the Fed gets set to make an announcement about interest rates? Let’s see…

When The Fed Moves, Markets Move

Eight times a year, the Federal Open Market Committee (FOMC) meets to determine its monetary policy for the coming weeks. And the group has some serious tools at its disposal. This includes:

• How much money the bank should print

• How many U.S. Treasury securities to sell.

• The reserve requirement for banks.

• What discount rate to charge commercial banks.

It’s this last point that captures the imagination of the public most often - because it’s the most tangible and has the biggest near-term effect on the markets. So what do the bankers have in store for today?

Much Ado About Nothing?

Because we’ve become a “Fed-watching” nation, there’s always much made about whatever the Fed does. But today, there’s very little chance that the Fed will actually do anything, keeping interest rates unchanged at 5.25%.

Some people say this is much ado about nothing. But oftentimes, it’s not so much what the Fed does that’s most important - it’s what the bankers say instead.

Specifically, economists and investors will be watching for comments about inflation to see if they can discern any hints as to future Fed policy direction. And Federal Reserve interest rate announcements do move markets. So we need to have a plan for how to address these scheduled events.

Let’s look at how short, intermediate and long-term traders might approach the Fed monetary policy announcements…

A “Fed-Focused” Investment Plan

• If You’re A Short-Term Trader Or Day Trader: If you have positions that you hold for 48 hours or less, the Fed announcement is very important and could be critical. Even the most benign announcements significantly increase volatility on today. In general, the best strategy for short-term traders is to be out of the markets during times of known price shocks.

• If You’re An Intermediate-Term Or Swing Trader: If you’ve entered a trade and expect to be in it for a couple of weeks to a couple of months, then a Fed announcement alone shouldn’t be the sole reason for jumping out of it. But if you’re close to your exit point, or anticipate a new entry point at the time of a Fed announcement, you might consider getting out a day early, or delaying entry by a day, so that you don’t get caught on the wrong side of a market reaction to the Fed announcement.

• If You’re A Longer-Term Trader: If you’re holding positions for several months or several years, then the price shock that comes from a Fed announcement is more of a nuisance than anything else. For long-term investors, the only consideration might be to not enter a new position on the day of a Fed announcement, since it could send you in the wrong direction quickly.

In general, although Fed monetary policy announcements occasionally have a big impact, they’re usually minor market disruptions. They’re really much more important for the financial media than for traders and investors. But having a prudent plan for handling these periodic price upsets can add to your bottom line.

Great trading,

D. R. Barton, Jr.

Today’s Smart Profits Cribsheet

• As earnings season continues with a vengeance, it’s easy for rookie investors get caught in the crossfire of unpredictable moves. Whether it’s the post-earnings release selloff, or the “overnight gap,” price shocks are one of the most difficult events to handle. But there are three ways you can combat this. Find out what they are in Smart Profits #359, Price Shock: How To Respond To Three Types Of Price Shock During Earnings Season.

• Pundits and investors are salivating… believing that good news on one or both of a couple key looming events will be enough to send the market soaring skyward. But watch out. History tells a different story in Smart Profits #335, The Stock Market’s Reaction to Good News: Why It’s Best to Sell at the Sound of the Trumpets.

• Mt. Vernon Research’s own Technical AnalystJim Stanton will agree that technical indicators can provide some valuable clues in picking the right time to go against the crowd. A contrarian investing strategy can prove quite rewarding, to learn more visit Smart Profits #384, Contrarian Investing Strategy: The Most Profitable Way To Invest In 2007.

Related Articles:

• Trading Lessons: Catching The Market Waves for Stress-Free Trades
• Investor Sentiment & Market Behavior: Seven Tips For A Profitable Downside Bias
• Trade Small… Save Big: The Single Best Piece of Trading Advice Ever

The Chart Of The Week

Qualcomm (Nasdaq: QCOM) is traditionally a very volatile stock. But for the last five months, it’s traded in a well-defined channel, and volatility has been contracting. A breakout or breakdown outside of the channel is usually much more significant after such a severe drop in volatility.

Smart Profits Report Archives

Sphere: Related Content

Crude Oil Prices Per Barrel

The Smart Profits Report: Issue #390
Friday, January 26, 2007

Crude Oil Prices Per Barrel: Former Market Maker Reveals Where Oil Prices May Be HeadedBy Karim Rahemtulla
Investment Director, Mt. Vernon Research

If I had a dollar for every time I’ve been asked the following question from friends, colleagues, and subscribers over the past year or so, I’d be a rich fellow.

“Why don’t you own oil?”

It’s a fair question. As crude oil prices per barrel stampeded their way up to an all-time high of $78.40 on July 13, 2006, virtually everyone was piling into the sector, scrapping for profits. The mainstream financial media couldn’t stop breathlessly talking about how high prices were going to go. Goldman Sachs and others began to tout $100 oil.

About three months ago, our offices were inundated with calls about crude oil. Why weren’t we recommending it? People were seeing write-ups from everyone.

But we held off. Let me tell you why - and where we think crude oil prices per barrel are headed next…

A Direct Link To The NYMEX Trading Floor Market Maker

A few months ago, we launched the Triple-Zone Profits Trader (DEFT) - a commodity trading investment service headed by Smart Profits Report editor Lee Lowell. If you don’t already know, Lee is our resident commodity options and futures expert. Not only that… he’s spent six years as a market maker on the New York Mercantile Exchange (NYMEX) trading floor. Without doubt, Lee is “plugged in.”

I don’t want to spend time talking about how good Lee is at what he does. Rather, I want to show you.

In April 2006, Lee and I met at the Grand Cypress Hotel in Orlando to discuss how we should structure his new service for investors. At the time, oil prices were trading in the $60s and Lee was bullish.

Turns out he was right on the money. Within a couple of months, crude was preparing to break $70, on the way to $78. And today, Lee has an almost perfect track record in this volatile commodities market. So I called Lee and asked him about crude today. Since he has personal trading experience on the NYMEX floor, as well as the key contacts, why not put him on the spot?

A $24 Drop In 5 Months Per Barrel

Even amid all the geopolitical strife and war in the Middle East, and venomous rhetoric from Venezuelan leader Hugo Chavez, crude oil prices are not set in Saudi Arabia, Iraq, or Venezuela. They’re set on the floor of the NYMEX. This is where the buyers meet the sellers in the world of high finance. It’s where rumors are spread and debunked, where you have the best access to information, and where connections matter most.

The luxury for us is that Lee still has all that - and when we need to “plug in,” it’s just a phone call away.

He said he didn’t like the long side of crude any more. His contacts weren’t bullish and the charts didn’t look supportive. That was good enough for me - and that’s why we didn’t chase the market.

And it was the correct decision. Since its high of $78.40 in July, crude oil prices per barrel have slumped $24 to the current price around $54.30 (with a $7 drop occurring in 2007 alone). As Lee states, “That’s a major move. When I was a floor trader in the crude oil options pit, a move of $0.50 was considered a very busy day. Now, moves of $2 or more in crude oil prices per barrel are becoming the norm.”

So where does the market go from here?

Market Set Up For $50 Crude Oil Price Per Barrel

Crude oil prices per barrel have traded in a pretty solid uptrend since early 2002. And with the world still as thirsty as ever for oil, demand isn’t going to lessen too much anytime soon.

That said, however, Lee believes it’s the hedge funds that are the major controlling factor in today’s oil market. And with hundreds of millions of dollars at their disposal, it’s easy to see why. Collectively, they’ve added at least $20 to $30 to oil prices alone.

So when hedge funds and speculators move their money from the market, a big drop follows - as we’ve seen over the past few months. It’s a good way to explain the reason why, with the world beset by geopolitical strife and the Iraq war getting worse, crude oil prices per barrel have still dropped $24.

So how much farther could oil prices drop? I’ll let Lee tell you…

“Volatility has exploded over the last few weeks, and in the short term, I see $50 as a good resting place, based on the Fibonacci sequence of numbers. This is a technical analysis theory that states prices will often revert back to the 50% level of a major move, and since crude oil prices per barrel moved from roughly $20 to $80, a 50% retracement of that $60 move would take it back to the $50 level.”

My thanks to Lee for his insights today. For the record, while I’ve been avoiding oil for months, I am starting to warm up to the idea of energy investments for our portfolios - but not without applying one of our proprietary strategies to be certain that we don’t take needless risks.

Good trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

• While the fall in oil prices has been well documented, other commodities like natural gas and gold have recovered from a widespread sector plunge towards the end of 2006 - just as we predicted in a Smart Profits issue in September. Gold has risen from $600 then to $652 today, while natural gas has hauled itself back from its lowest point since February 2004 ($4.67) to $6.86 today. Click this link to find out which natural gas company and which industry is well-placed for commodity sector gains in Smart Profits #356, Commodities Trading: Looking For Profits Amid the Commodities Collapse.

• Get Rich With Options: Four Strategies Straight From The Exchange Floor: In addition to his oil analysis, Lee Lowell has been busy trading everything from natural gas to silver. In fact, he just bagged gains of 33% in 13 days on a February 2007 natural gas put option spread and 14% in 11 days on a March 2007 silver put option spread for subscribers to his DEFT trading service. His first book, Get Rich With Options: Four Strategies Straight From The Exchange Floor, has also just hit the newsstands. Giving you the in-depth insight and the rare expert advice that very few people are privy to, Lee reveals the four strategies that he personally uses to churn out profits for him in the options arena. And using real-life examples of actual trades and insider tips, Lee shows you how to use these techniques decisively for the fastest route to riches in the options trading game. Follow this link for more information.

• You may also want to check out a great article by Investment U Researcher Don Miller as he reviews the oil-buying strategy called Energy Mercantilism. Through this, producers and consumers bypass the marketplace altogether, and in turn greatly impacting the price of oil.

Related Articles:

• The Future of Crude Oil Prices: How a New Saudi Development is Bearish for Oil Prices
• Natural Gas Prices: The Natural Gas Market is Set to LEAP in the Months Ahead
• Crude Oil Prices: Here’s What An Industry Insider Says Is Next For The Runaway Oil Market

Smart Profits Report Archives

Sphere: Related Content

Improve Your Investing Results

The Smart Profits Report: Issue #389
Wednesday, January 24, 2007

Improve Your Investing Results: Your 8-Step Checklist To More Successful Investing
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

Here’s a question designed to change the way you trade…

Read the following question and then write down your answer immediately. Don’t overthink your answer - the important thing is that you capture the first thought that jumps into your head. And don’t read any further until you write down your answer!

What ONE thing would make a huge change to improve your investing results?

Now re-read your answer. I’m betting that it falls into one of two categories:

• Things I can do something about (items for which I accept responsibility)
• Things I blame on someone else

Want Results? Take Responsibility For Your Trades

One of the core principles that separates the top traders from the mediocre ones is the need to take responsibility for all their trading-related actions.

For example, if you wrote: “I need to upgrade my trading system. Do some research to simplify it and make it more robust,” that would fall into category one.

But if you wrote: “That stinkin’ system I bought isn’t worth the paper it’s written on - the developer is a bonehead. If he had half a brain cell, I’d be making some money,” this clearly falls into category two.

We must take responsibility for our own investment performance. And if you want to enjoy bigger, more consistent profits, this means making some real changes in the areas that matter most. So let’s spend some time today looking at the areas where some seemingly small changes and upgrades can make a big impact on profits.

Ask The Right Question… Get The Right Answer

The question above about improving your investing results is important for several reasons. First, it helps you to think about your current strategy, then challenges you to figure out what’s most important to you in your investment process.

In turn, this leads to other key questions:

• Is there just one thing I can do to make a big difference to improve my investing results… or several things?

• Did I know about it before? If so, what kept me from recognizing it and working on it?

• What are the obstacles to making that thing happen?

• Is the payoff worth the price I have to pay to get there?

Success coach Tony Robbins once said: “Quality questions create a quality life. Successful people ask better questions, and as a result, they get better answers.”

But if you’re stumped for answers, there are actually some simple (yet often forgotten) steps you can take to make your trades a lot smoother… and more profitable…

Your 8-Point Investing Results Improvement Checklist

When I ask investors and traders what one thing they could do to improve their investing success rate, here are some of the most important responses:

• Have a good exit strategy in case things go wrong

• Determine the best point to exit a trade profitably

• Stick to your trading strategy

• Use proper position sizing

• Adhere to your stop-loss points, no matter what

• Pay attention to every signal in their system or newsletter

• Find higher probability entry points

• Understand your personal trading psychology better

This “one thing” exercise is a simple one that can actually be beneficial in many other areas of your life, not just improving your investing results. Thinking about the one thing that could make a huge difference can challenge you to shake off the rust, or outdated ways of thinking.

Think about all of the times that you caught yourself doing low priority, low value tasks. What difference would it make if the next time you caught yourself in a lull or in a low-energy moment, you stopped what your were doing and worked on one key transformation that you could you make for yourself instead?

Great trading,

D. R. Barton, Jr.

Today’s Smart Profits Cribsheet

• The fourth point in the checklist above talks of position sizing. I explain the importance of properly position sizing stocks in your portfolio and debunk the “classic” diversification scenario in Smart Profits #387, Position Sizing Stocks: Are You Losing Money On This Popular Investment Strategy?

• Looking for a new market trading system? I give tips on evaluating any new stock market index trading strategy that you may be considering in Smart Profits #380, Stock Market Index Trading Strategy: A 2-Step Approach To A Successful Trading System.

• Now that I’ve given you an idea of where to start when it comes to identifying that “one thing” that could lead to better investment success, I give you three more actionable tips that you can implement today to improve your trading. Get the details in Smart Profits #374, Stock Market Investing: 3 Things Investors Must Master To Improve Their Trading.

Related Articles:

• Trade Your Way To Financial Freedom: Reviewing The Holy Grail Of Investing
• Price Shock: How To Respond To Three Types Of Price Shock During Earnings Season
• Gasoline Prices: How To Win Big In The “Ethanol Decade”

The Chart Of The Week

Key ethanol distiller Archer-Daniels-Midland (NYSE: ADM) is already bouncing off of key support in anticipation from last night’s State Of The Union address from President Bush should prove to be a very bullish event for ethanol. This could be a good longer-term play with a stop set below January-February lows of last year.

Smart Profits Report Archives

Sphere: Related Content

2007 Market Rally

The Smart Profits Report: Issue #388
Monday, January 22, 2007

2007 Market Rally: Where The Major Indexes Are Heading
By Jim Stanton
Technical Analyst, Mt. Vernon Research

A question that just about everyone in the financial world is asking - but nobody has the answer to is: “How much longer do you think this 2007 market rally will last?” I’m betting you’ve either asked it yourself… had people ask you… or heard the folks in the financial media asking it ad nauseum… To get to the facts, I simply turn to historical data and what my charts show me.

Right now, we’re in the midst of what is traditionally the best six months of the year for stocks. Moreover, my charts tell me that, against all the odds and logic, this rally isn’t over yet. The indexes should go higher still over the intermediate to long-term.

Let’s take a look at the evidence to see what market forces are at work here, and where the indexes are headed next…

Bulls On Parade in 2006

This time last year, the market was painting a similar picture. A New Year market rally lasted through the “best six months” of the year (November-May), culminating in a May 2006 peak. A brutal selloff then ensued as the “worst six months” of the year started.

Since then, however, the bulls have blasted their way through the typical summertime market rally, and then ignored the traditional October-November selloff (particularly during mid-term election years like 2006, and despite a wholesale change in Congressional leadership).

And when the Dow made new all-time highs in October, with all three of the major small-cap indexes (Russell 2000, S&P 400, and S&P 600) following suit in November, that’s when it was apparent that the markets were ignoring the normal cycles and were set for a sustained rally.

But what’s driving this market rally? In a word: Liquidity.

Stock Markets Rally While Commodity Hedge Funds Liquidate

Just as the stock market was enjoying its end-of-year surge, the commodities market slumped. And there was so much money in the hands of hedge-fund managers, because of liquidation in the commodity markets, that money had to filter somewhere.

So in addition to the growing number of private-equity funds and the redeployment of funds by real-estate speculators, the money found a home in the stock market.

Yet all this happened amid pretty poor economic news. The last two quarters have seen U.S. GDP growth slow… the U.S. dollar has suffered a hammering against several major foreign currencies, amid sky-high budget and trade deficits… and geopolitical factors like the war in Iraq continue to worsen and cost ever-increasing amounts of money.

Since July, the biggest correction that the S&P 500 has experienced is a paltry 2%. That can’t last forever, and over the shorter-term, we could see a correction begin at any time. When that occurs, it should provide a great buying opportunity. Here’s why…

What’s In Store For The Major Indexes?

Over the past four years, the strongest-performing market indexes have been all three of the Dow family (Industrials, Transports, and Utilities), along with the three major small-cap indexes. These are the only major indexes that have traded above the highs set in 2000 - and all have reached record highs recently, except for the Dow Transports.

Of the three major equity indexes (Dow, S&P 500, and Nasdaq), only the Dow has reached a new all-time high. But where are they going from here? Let’s take a look…

• Dow: By making new record highs last October, we’re looking at a longer-term price target around the 13,490 level for the Dow Industrials. However, it needs help from the Dow Transports. I doubt the Dow can attain this level over the near-term, unless the Dow Transports take off and make new highs before a correction sets in.

• S&P 500: The SPX is the only index of the three that has not made new recovery highs. It got to within a mere point of doing so on January 12 this year, while the March S&P futures got to within three points of a new recovery high. If the futures trade above 1,444.25, the SPX should get up to its shorter-term projected target around 1,443. If the SPX were to make new all-time highs above 1,553, its long-term target would be in the 1,840 area. However, this isn’t likely before a substantial correction occurs.

• Nasdaq: Although the Nasdaq indexes both made new recovery highs last week (putting them back “in sync” on the upside), they’re a long way from making new all-time highs. The price action on the Nasdaq 100 daily chart projects a minimum target of around 1,860. This level isn’t very far away - and could get there very shortly, as the Nasdaq Composite has already reached its target.

• Small-Caps: These indexes are showing bullish chart patterns. They traded above their 2000 highs in 2004, and reached long-term, minimum targets last spring. But the buy signals triggered on their daily charts back in July projects a minimum upside target of 830 for the Russell 2000… 861 for the mid-cap S&P 400… and around 429 for the small-cap S&P 600.

The Value Of The NDX/SPX Spread Indicator

One valuable indicator to watch for is the NDX/SPX spread (the trading gap between the two indexes). It usually leads the way higher when the markets are bullish and lower when markets are bearish. But in this case, it also helped to identify a good buying opportunity in late December 2006.

Take a look at the daily chart of the NDX/SPX spread below. As I noted earlier, the SPX has only corrected about 2% since July. But the NDX pulled back about 5% going into the end of the year. After a strong six-month market rally, you might have expected a bigger subsequent correction than 5%. But the spread tipped me off by correcting exactly 38% (a key Fibonacci retracement level) before reversing higher.

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

2007 Market Rally Buying Opportunities

So what can we conclude from this technical evidence?

• Short-Term: It’s no secret that the markets are getting overbought again - and could consolidate or correct at any time. It’s long overdue. Since the Nasdaq indexes are close to their shorter-term minimum targets, we can probably expect them to be reached first. Any pullback prior to that is a good, short term, buying opportunity.

• Intermediate To Long-Term: If the markets continue to climb and the Nasdaq indexes reach their upside target, we’ll then be looking at new recovery highs on the SPX. If that occurs, it’s possible for the SPX to reach 1,443 before a serious correction could get underway. Either way, any decent correction prior to the indexes reaching their upside targets is a buying opportunity over the intermediate-term.

Good Trading,

Jim Stanton

Today’s Smart Profits Cribsheet

• Back in November 2006, the stock market entered what is traditionally its strongest six months of the year. So what does it have in store for investors? See why we could be headed for a “cycle inversion,” and why September-October 2007 will be a key period in Smart Profits #368, The Strongest Six Months of The Year for Stocks: Will The Market Spring A Cyclical Surprise.

• The VIX Index is trading near 20-year lows - a fact reflected in the massive stock market rally over the past few months. But for the indexes to continue moving higher, the VIX would have to break below 10, creating a “new paradigm” for the index, and a new range. Mt. Vernon Research’s Small-Caps Specialist Mark Whistler broadens your understanding in Smart Profits #381, The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options.

• It’s difficult to see where any new money will come from that could fund a sustained mutual fund rally. A market decline may not happen imminently, but with mutual fund cash levels nearing all-time lows, it’s worth checking to make sure you have a decent exit strategy. Quantitative Specialist D. R. Barton, Jr., of Mt. Vernon Research, gives more insight into this in Smart Profits #357, Mutual Funds: How To Interpret The Actions of Mutual Fund Managers.

Related Articles:

• Large-Cap Stocks: How Point Spread Shows Large-Caps Re-establishing Dominance
• Index Options: A Billionaire’s Trading Tool Anyone Can Use
• Trade Small… Save Big: The Single Best Piece of Trading Advice Ever

Smart Profits Report Archives

Sphere: Related Content

Position Sizing Stocks

The Smart Profits Report: Issue #387
Wednesday, January 17, 2007

Position Sizing Stocks: Are You Losing Money On This Popular Investment Strategy?
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

“That’s the way we’ve always done it.”

This one phrase has killed more useful projects and progressive ideas than perhaps any other.

The same logic applies to the trading world. But when done properly, diversification can offer good protection and risk management.

However, you need to know that the classic way of diversifying a portfolio by investing equal amounts of cash in different stocks is not always the best. In fact, it can be dangerous, as it unintentionally adds extra risk to your portfolio. Let’s see how that can happen - and show you how position sizing stocks, the right way, helps you to get the most out of your investments.

Position Sizing Two Basic Ways: Equal Dollar vs. Equal Risk

When investing, you have a couple of choices when position sizing: Equal dollar weighting, versus equal risk.

To compare the two, let’s look at how each is done. For simplicity, I’ll talk about stocks, but the same concepts can be applied to futures, options and currencies.

• Equal Dollar Weighting: Splitting your money into equal parts has always been an easy way to allocate money across trades. For example, if you have $100,000 to invest, and want to distribute it in five equal parts, you’d simply buy $20,000 worth of each stock. So if you’re taking a position in a $100 stock, you’d buy 200 shares; for a $50 stock, you’d buy 400 shares, etc.

• Equalizing Risk Across All Your Trades: Instead of buying the same dollar amount in each stock, you use your stop-loss level for each position to determine the risk per share that you’re taking for a given trade (you are using stop losses, aren’t you?) Once you know your risk amount for each trade, you can calculate how many shares to buy, based on how much of your total portfolio you would be willing to risk for each trade.

And it’s this risk-based part of the equation that I’ll talk about today. So let’s do a quick calculation to see how it would work.

Let’s say you’re willing to invest $100,000 and are okay with a 1% downside risk per trade. That’s $1,000.

When the first trade comes along, your strategy dictates that you’ll get out if the stock moves $2.00 against your position. Since you’re only risking $1,000 total on the trade, here’s the math for how many shares to buy:

$1,000 (risk per trade) divided by $2.00 risk per share) = 500 shares to purchase.

And when you compare this risk-based method with just allocating equal dollar amounts across trades, you have an advantage. Let’s take a look at the numbers…

Why Equal Risk Position Sizing Beats Equal Dollar Investing

To do this comparison, we’ll look at two portfolios that contain the same two stocks. To make this even easier, we’ll say both stocks are $50 each.

However, Stock A is a slow-mover with very low volatility, so we set our stop-loss just $1 below the entry price. But Stock B has a very high volatility, so we set the stop-loss $4 below the entry price.

• Equal Dollar Portfolio: This one is easy. We simply buy $50,000 dollars worth of each stock, or 1,000 shares. ($50,000 divided by $50 per share = 1,000 shares). ~ For Stock A (the slow-mover with the $1 stop-loss), we buy 1,000 shares ($1,000 risk per trade divided by $1 risk per share = 1,000 shares).

• Equal Risk Portfolio: We determine how many shares to buy, based on risking 1% - or $1,000 per trade. ~ For Stock B (the volatile stock with the $4 stop loss), we buy 250 shares ($1,000 risk per trade divided by $4 risk per share = 250 shares).

Let’s look at what happens if we encounter a little bit of market weakness and we hit the stops on both stocks:

So it’s easy to see that for stocks with widely varying stops, an equal dollar portfolio can take on too much risk - especially if stocks are lower priced and volatile.

Another scenario is when the more volatile stock hits its stop and the less volatile stock wins an amount equal to its stop amount.

In this scenario, you have one winner and one loser, yet in the equal dollar portfolio, you wind up losing big, while breaking even in the equal risk portfolio.

Without drawing a new table, you can easily see that if the both stocks move in your favor, you do actually make more money with the extra money invested in the equal dollar portfolio. But the increased profit is in equal proportion to the increased risk.

Stock Position Sizing: Equalizes Risk & Makes Sense

And in general, when taking on one unit of extra risk, you don’t want to only get the possibility of one unit of extra return. But since we obviously can’t guarantee which trades will work and which ones won’t, a strategy that equalizes risk makes intuitive sense.

One final note: If your strategy uses a set percentage for a stop-loss or trailing stop (25% of a stock’s price, for example), then the “equal dollar amount” and “equal risk” portfolio position sizing becomes mathematically the same!

So folks that use a 25% trailing stop are, in fact, using an equal risk strategy if they put equal dollar amounts into each trade.

Good Trading,

D. R. Barton, Jr.

Today’s Smart Profits Cribsheet

• Position sizing is the most critical and important lesson that I can share with you about investing. It is a simple concept, yet powerful. It’s the one practice that separates investors who succeed (especially in options) from those who periodically wipe out and either have to save up to start over, or just give up entirely. Mt. Vernon Research Investment Director Karim Rahemtulla explains this concept in Smart Profits #193, Position Sizing: The Most Powerful Investment Concept.

• Learning how to lower your risk exposure, yet still remain aggressive when seeking stock market profits is something every investor wants to know! My fellow colleague and technical analyst Jim Stanton explains how you can achieve this in Smart Profits #286, Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run.

• $4.5 Billion is a lot of cash. Almost unfathomable. But the Amaranth hedge fund lost that amount in just one week. The trader that lost all that dough was up $2 billion for the year, so I guess he got lost in all those zeroes. But he apparently absorbed that huge loss by ignoring the simple rules of proper risk management and position sizing. I give great examples of how you can improve your trades and your market gains through these key techniques in Smart Profits #355, Risk Management and Position Sizing: Three Ways To Give Your Trades A Tune-Up.

Related Articles

• Portfolio Position Sizing: The “10% Rule” for Safe Option Profits
• Volatility Trading: Combat & Survive the Market’s Volatility Swings
• Option Position Sizing - How Much to Invest In Each Option Trade

The Chart Of The WeekQualcomm (Nasdaq: QCOM) has followed up a big drop of 33% with a prolonged five-month sideways channel. Looks like buying at the bottom of the channel and selling at the top will be a very nice strategy until we get two closes over $40 or two closes below $34.

Smart Profits Report Archives

Sphere: Related Content

Apple Options

The Smart Profits Report: Issue #386
Friday, January 12, 2007

Apple Options: Selling Naked AAPL Put Options is the Way to Invest in Apple
By Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research

Boy, Apple (Nasdaq: AAPL) sure knows how to add some excitement to the market. The stock has enjoyed a $20 surge over the past two weeks - with $10 of that coming in just the last two days alone. So what gives? There are two reasons for the move…

The most obvious one is Apple’s major new product announcement - the revolutionary iPhone. This one gadget will “transform” the digital age, combining a phone, music, TV, computer, and movies. Despite Cisco currently suing Apple over a trademark infringement, AAPL shares were sent soaring.

Apple is also recovering from a December selloff when it got embroiled in an options backdating scandal. Backdating is where options are issued retroactively so recipients get the best price, thus increasing profits. It’s not illegal, but cases must be disclosed.

But Apple missed its 10-K report filing deadline amid accounting discrepancies over backdated payments to employees between 1997 and 2002. This followed the resignation of former Apple CFO Fred Anderson in October. In addition, it’s alleged that “… in a few instances, CEO Steve Jobs was aware that favorable grant dates had been selected, but he did not receive or otherwise benefit from these grants and was unaware of the accounting implications” of backdating.

But I believe the news isn’t as bad as many were led to believe - hence the late December rise. But the question is: What is the best way to invest in Apple options? Let’s find out…

The Sophisticated Way To Play Apple’s Rise

If you’re a regular investor, and wanted to buy AAPL between $70 and $75 (which looked likely at the end of December), you’re out of luck - at least for now.

But, if you’re a savvier investor, you could have executed one of my favorite option trading techniques: Selling naked put options.

Take a look at the chart below, and let’s see how it works…

On December 27, AAPL experienced a big move down to $77 per share. At the time, it looked like shares were going to keep tanking. My buy point was down near the yellow 200-day moving average line you see on the chart. That was my limit buy price.

But instead of placing a limit buy order in my trading account, then hanging around like most ordinary stock investors, hoping that AAPL would come down to my level, I got proactive and tried to earn some money while waiting. So I decided to sell an AAPL February 2007 $70 put option for $2.50.

By selling a AAPL put option for $2.50, someone would pay me $250 per option contract today in exchange for the opportunity to have me buy AAPL for $70 per share.

Wait a second… someone will pay me cash today, so I can potentially buy AAPL at my preferred price. How cool is that? Let me break down the deal for you here…

Picking Apple From The Profit Tree: From $2 To $0.10 In 10 Trading Days

Below is a chart that shows the performance of the AAPL February 2007 $70 puts over the past few weeks.

As you can see, it raced to its high of $2 per option on December 27 (at the same time the underlying shares were tanking) and has never traded higher than that.

Today, it’s worth a measly $0.10. So much for me getting filled (for now). Had I tried to sell the AAPL put option at $2 instead of $2.50, I might be sitting on some extra cash. But although I didn’t get filled on the option and the opportunity to buy AAPL at $70, neither did anyone else.

How To Beat Stock Buyers… Even If A Trade Goes Against You

When you sell a put option, you’re giving the option buyer a guarantee that you will buy that stock from him at the stated strike price if it’s beneficial to him.

So in our example, had AAPL shares got crushed and traded down to $60, the put option buyer would require us (the option seller) to buy AAPL at $70 per share, giving us a $10 paper loss on the trade. Sounds ugly… but that would be fine for two reasons:

We wanted to buy AAPL at our limit price of $70 per share and would be happy about it.

If we were starting to re-think the trade, we could always buy back the option and offset the trade. Depending on where AAPL stock is at the time, this could produce a gain or loss.

In order to be able to buy the stock at our preferred level (the strike price), AAPL would not only have to go below $70 per share, but also stay below $70 through expiration for the option buyer to come knocking.

Many times a stock will go below the strike price, giving you a sense of hope that you will get to buy it. But by the time option expiration rolls around, the stock has traded back above the strike price. If this scenario occurs, the option will expire worthless and you won’t get to buy the stock.

But in either case, you’ll always get to keep the option premium that the buyer paid you. That’s your consolation prize for waiting to see what AAPL does. On the other hand, all those regular stock buyers who had limit buy orders placed never received an option premium because they didn’t sell any options. You come out ahead regardless.

Go Naked And Collect A Premium

The reason I like to sell put options is because of the premium you can collect while you wait for your stock to come down in price. Although I wasn’t filled on my option order, it’s much better to give it a shot and try to earn some extra cash.

Selling naked put options is a viable strategy and worth your time to investigate. But remember… only execute this kind of trade on stocks you actually want to own!

Good trading,

Lee Lowell

Today’s Smart Profits Cribsheet

• If you think a stock is headed for a decline, you might want to think twice before you take the risky decision to short it. There’s a much more cost-effective and safer way to play the down move by buying a put option instead. Investment Director Karim Rahemtulla gives you the nuts and bolts of this strategy in Smart Profits #102, Put Options: Why Short a Stock when You Can Buy a Put? 041404

• Lee’s just completed his debut book, Get Rich With Options: Four Winning Strategies Straight From The Exchange Floor - a book that could improve your overall portfolio returns 15-fold over the next year. With a record $378 billion poised to flood the exploding options market in 2007, this is the first time ever that you’ll discover the four simple secrets that institutions and floor traders are really using to earn 100-500% on each trade… while taking less risk than you’d take buying ordinary stocks. Lee’s also devoted an entire chapter on today’s topic - put selling - in the book. More information on how to own this essential guide can be found here.

• There are two ways to play a downside trend in the market. You can either take a bearish position on your long securities to protect yourself or play the downside of the market/company outright. These tactics can protect your portfolio and if you are long a stock in a number of ways. I explain two great investment strategies in Smart Profits #325, Buying Put Options & Covered Calls: Two Ways To Play A Downside Trend.

Related Articles:

• Limit Orders vs. Naked Puts: Getting Paid to Place Them On Your Favorite Stock
• Covered Calls and Puts: How to Grow Your Equity By Going Naked
• How to Use Puts and Calls: For Systematic Short-Term Profits

Smart Profits Report Archives

Sphere: Related Content

Trade Your Way To Financial Freedom

The Smart Profits Report: Issue #385
Thursday, January 11, 2007

Trade Your Way To Financial Freedom: Reviewing The Holy Grail Of Investing
By D. R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

From Arthurian legend, to Monty Python, to Indiana Jones, the mystical concept of the “Holy Grail” has fascinated people and enlivened their imaginations for centuries. Today, the quest for the Holy Grail has become a metaphor for reaching an almost unobtainable solution - the best that we hope to attain.

And it’s something that every trader and investor wants. But the good news (no… the great news) is this: You can reach the Holy Grail of trading and investing. And today, I’m going to show you how through a book that every trader and investor should have on the shelf: Trade Your Way To Financial Freedom by Van K. Tharp.

Is Trade Your Way To Financial Freedom On Your Bookshelf?

The central theme of Trade Your Way To Financial Freedom is about finding the Holy Grail in trading. It covers every key area that distinguishes top traders and investors from the crowd. Very simply, it’s a “must read.” Every serious investor or reporter includes the first edition of the book in their list of best trading and investment books.

Written by my good friend Van K. Tharp, the second edition of this classic investor’s companion was recently released. You’ll hear from me in there, too, as Van asked me to write a section on band trading. (By way of full disclosure… although I’m a contributing author, I won’t receive a penny in royalties).

So let me share with you what I consider to be the three best ideas from the book…

Van K. Tharp’s Holy Grail Investing Trifecta

“You cannot trade the markets. Instead you trade your beliefs about the market.” ~ Van K. Tharp, Ph.D.

• The Holy Grail

Take a look at the quote above from Dr. Van K Tharp. I believe this is a key concept that will be around generations after we’re all gone. Trading your beliefs about the market, rather than the market itself is your holy grail. This is not simply an idea that always makes money, no matter what - but instead, finding a system or strategy that fits you.

Time and again, I’ve seen people buy trading systems, diligently learn strategies, or be given great, workable trading methods - yet not be able to make them work, even if the strategies are successful. Why? Simply because the strategy or system was not aligned with one of more of the person’s beliefs about the market. When you find the trading style that fits your personality and beliefs, you’ll have found your Holy Grail of trading.

• The Missing Link: Position Sizing

Position sizing is a critical concept. The most common path for traders and investors is to have too much money invested when things are going poorly and not have enough invested when things are going well. Trade Your Way To Financial Freedom does a great job of describing how top traders use position sizing as the most significant weapon in their arsenal. Understanding the principals of position sizing (the part of your system that tells you “how many”) is worth the price of the book itself - but getting specifics on how to do it for any trading style is priceless.

• Understanding (And Controlling) Yourself

This is another key component that focuses on understanding the biases that keep traders from successfully building and implementing strategies. If you’re having a problem pulling the trigger when you receive a buy or sell signal, or you’re constantly tweaking your strategy, you’ll know that your strategy doesn’t yet fit you.

The Three Core Pillars of Investing Success

Bottom line: There are three core pillars of successful investing:

• Have a strategy that fits you.

• Know how much to trade at any signal.

• Understand and control your personal psychology.

Van K. Tharp covers these topics extremely well in Trade Your Way To Financial Freedom - and once you understand them and implement them, you’ll be on the right track.

Good Trading,

D. R. Barton, Jr.

Today’s Smart Profits Cribsheet

• Smart Profits Report Investment Director Karim Rahemtulla calls it “the most powerful investment concept in the world.” But as simple as this concept is, it’s one that continues to trip up many investors. Don’t be one of them. Find out how to “position size” your investments properly in Smart Profits #193, Position Sizing: The Most Powerful Investment Concept and in Smart Profits #229, Option Position Sizing: How Much to Invest In Each Option Trade.
• Looking for tips on evaluating that new market strategy you might be considering? There are steps you can take to prepare and objectively evaluate any new stock market index trading strategy or trading system and I explain them in Smart Profits #380, Stock Market Index Trading Strategy: A 2-Step Approach To A Successful Trading System.

• Did you know that stocks can stay overbought or oversold for much longer than you might think? Technical indicators can provide some valuable clues in picking the right time to invest “against the crowd” & adding a contrarian investing strategy can prove quite rewarding to your portfolio. Learn more about this strategy from our resident technical analyst, Jim Stanton, in Smart Profits #384, Contrarian Investing Strategy: The Most Profitable Way To Invest In 2007.

Related Articles:

• Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio
• Basic Trading Rules: The Four Rules of All “Smart Money”
• Trading With Confidence: How You Can Develop More Confidence In Your Trades

The Chart Of The Week

As you can see above, Hudson City Bankcorp (Nasdaq: HCBK) has been hanging below the key $14.00 - $14.10 resistance area for the better part of a month. I really like a dual strategy here: Shorting, or buying puts just below $14.00, then reversing to a long position if the stock closes above 14.10.

Smart Profits Report Archives

Sphere: Related Content

Contrarian Investing Strategy

The Smart Profits Report: Issue #384
Friday, January 5, 2007

Contrarian Investing Strategy: The Most Profitable Way To Invest In 2007
By Jim Stanton
Technical Analyst, Mt. Vernon Research

As a technical analyst, I’m not an advocate of simply trying to pick tops or bottoms. That’s because stocks can stay overbought or oversold for much longer than you think (the current impressive rally and the dot-com boom in 1999 are good examples).

But technical indicators can provide some valuable clues in picking the right time to go against the crowd. And a contrarian investing strategy can prove quite rewarding.

Signs Of A Short-Term Market Reversal

One of the first signs you should look for is higher-than-average volume. When the majority of players are bearish on a beaten-down stock (or index), the stock is probably setting up for at least a short-term reversal. Here’s how it works:

• Phase I: Aggressive traders are the first to step in, which causes the stock to stabilize and possibly start moving higher.

• Phase II: If the rally continues, the increased buying will catch the eye of other professional and momentum traders, and they start buying. This increases the demand for the stock.

• Phase III: The final people to jump on the bandwagon are the regular retail investors. But this means that most people who are bullish already own it - and it’s the first warning sign that the rally is probably near at least a short-term top. And once the talking heads on CNBC begin waffling about it, the caution flag comes out.

You see, once a stock rally is in the news and the retail buyers are in control, this is when the professional, short-term traders begin selling into an extremely high volume rally - just as the public is sure they’re riding a winner.

Shortly thereafter, the stock usually begins to struggle as the volume tapers off. Shares will back off or move sideways as the battle begins to determine the next trend. If the stock begins to violate any technical parameters, the technical traders begin selling. This is where fear kicks in…

Is Fear A Factor In Your Trading?

Once a stock begins dropping, the public starts to get nervous. As a correction unfolds, fear sets in and the retail investor selling intensifies. You can feel the angst of investors, with the amateurs usually the last to sell - often at, or close to, a low.

Once a stock has undergone a substantial decline, it’s very tough to overcome the “fear factor” - even by the professionals. Most of the players are bearish, and the media hates the stock. It’s mentally very tough to buy into this kind of weakness, but if the sentiment and technicals are set up right, adopting a contrarian strategy, and buying a stock near its low point, is quite a thrill. And it can set you up to maximize your profits.

Here’s how…

Develop A Contrarian Investing Strategy And Win

Developing a contrarian investing strategy isn’t as easy as it sounds. It’s an art, as well as a science. The “art” part of the equation is usually exhibited by the professional traders who have seen how tops and bottoms have evolved through their years of experience.

For the less experienced contrarian investor, however, I suggest waiting for some type of short-term technical breakdown before entering a trade. I suggest using an hourly chart and look for a short-term violation of a stock trendline… a break of previous support or resistance… a close below a 2% regression channel… or any other technical indicator that you find to be reliable.

As a guide, if you pay attention to the points below, you can overcome the overriding fear in a market, and begin to pick up the profitable art of contrarian investing:

• Watch for extremely heavy volume, or a sharp volume spike after a sustained move.

• Bullish or bearish sentiment on a stock appears to be heavily one-sided.

• The mainstream media chimes in and agrees with the popular sentiment.

• Investor complacency is widespread.

• The stock is close to its long-term support or resistance level.

Being an optimist when everyone is selling or a pessimist when everyone is buying requires independent thinking and is one of the hardest things a trader can do, although history shows that opposing the crowd can be very profitable.

Good Trading,

Jim Stanton

Today’s Smart Profits Cribsheet

• One of the best ways to gauge investor sentiment is by looking at the CBOE Volatility Index (VIX). This measure has proven to be a reliable indication of whether the overall investment mood is fearful or complacent - and can be critical in determining your next move. Just before Christmas 2006, my colleague Mark Whistler wrote extensively about how to use the VIX - so if you missed it over the holidays, check it out in Smart Profits #381, The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options.

• When everyone is on board with a certain point of view, the smart money is already leaning the other way and that’s one of the key tenets of sentiment analysis. Mt. Vernon Research’s own Quantitative Analyst, D.R. Barton, Jr., talks more about this type of indicator in Smart Profits #378, Sentiment Analysis: Incorporating Contrarian Investing in Your Trading & Financial Endeavors.

Related Articles:

• Contrarian Investing: The Best Investment Strategy You Should Use Today
• Sentiment Analysis: Incorporating Contrarian Investing in Your Trading & Financial Endeavors
• Leverage Investments: How To Use Options Delta To Vanquish Volatility

Smart Profits Report Archives

Sphere: Related Content

First Five Days Indicator

The Smart Profits Report: Issue #383
Wednesday, January 3, 2007

First Five Days Indicator: 3 Reasons To Forget This Useless Myth & Follow The Average True Range Instead
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

With this being the second issue of 2007, we’re going to do a little myth-busting today - alerting you to one dangerous indicator that just doesn’t indicate what it’s supposed to.

It’s human nature to reduce complex systems to simple terms. We’re often willing to believe cause-and-effect explanations that really don’t make logical sense. One good example is Groundhog Day. If Punxsutawney Phil sees his shadow on February 2, there will be six more weeks of winter weather. We all know how accurate Phil is…

As 2007 gets underway, the stock gauge getting the most press this week is the “First Five Days” indicator. But be warned… it’s a lot of hype, and it just doesn’t work.

January’s “First Five Days” Indicator - It’s Popular… But It Ain’t Useful

The “First Five Days” indicator was popularized by Yale Hirsch’s Stock Trader’s Almanac. It holds that the “First Five Days” of January predicts the direction of the market for the remainder of the year.

As proof of the indicator’s effectiveness, its proponents trace the indicator’s performance back over 55 years, and state that of 35 “First Five Days” periods that finished up, the stock market subsequently finished up in 30 of those years - an impressive 85% win rate for the predictor.

Consequently, venerable sources such as The New York Times, U.S. News & World Report, CNN and Money Magazine have quoted the indicator.

The problem is: It’s a useless indicator, based on shaky logic and even shakier statistics. And even worse, it’s potentially dangerous to your wealth.

Why You Shouldn’t Waste Your Time On The “First Five Days” Indicator

Let me be blunt: The “First Five Days” indicator is the lowest form of analysis. It’s the opposite of cause-and-effect. As you’re about to see, it’s the kind of analysis that looks for any cause to tie to an end effect, regardless of logic, and statistical support. It’s really no more valid or useful than predicting the stock market based on Super Bowl winners or groundhog shadows.

The Logic Is Arbitrary

The raw numbers for this indicator show that the market has gone down during the first five days of January 20 times over the past 55 years. In those 20 occurrences, the market finished the year up 10 times and down 10 times.

Looking at the data, the authors conclude that the indicator has “been right” 30 out of 35 times if the market begins the year on the up. But wait… this means that the indicator has no predictive value if it starts out to the downside.

This “working in one direction, but not the other” is too arbitrary for me - and is a classic example of where if the numbers don’t fit the hypothesis, then you change the hypothesis to fit the data. This is “curve-fitting” mentality. Do you want to risk your money based on that logic?

The Triggering Event Is Not Statistically Significant

This “First Five Days” indicator states that all you need to trigger a yearlong market prediction is any move for five days. This means that trivial moves in the market could shape your outlook for the coming year.

But suppose that after the first five trading days, the market was up only one-quarter of a point. This would still trigger the indicator’s prediction for an up year. And the problem with having a move of any magnitude trigger an indicator is that a tiny move like this doesn’t tell us anything about what the market is doing. A small move either up or down is just random - part of the background “noise” of the market.

So how do we decide what is meaningful and what is just background noise?

Using The Average True Range To Measure Volatility

One measure that many analysts use is the average volatility of a price movement. Long-time readers know that I use the Average True Range (ATR) of price as a measure of volatility. In simple terms, the ATR measures the average size of the daily range (the high minus the low), while accounting for gaps between bars.

If we look at the ATR for a five-day move, we’d want our trigger to move up or down by at least half of the average. Anything less would almost have to be considered random.

With that in mind, your industrious editor dug deep into the details of the “First Five Days” indicator’s raw data. I calculated the S&P 500 index’s ATR for the last 20 years and checked to see how many of the “First Five Days” trigger signals could be considered more than random. The answer: Only 4!

The Sample Population Is Too Small

When we eliminate the trigger signals that are mere noise, we now only have 12 to 15 triggers of the “First Five Days” indicator over the last 55 years. This is not a statistically significant sample to base any predictions on, and this indicator is uncovered as just some simplistic curve-fitting that doesn’t mean a thing for traders and investors.

There is plenty of other good analysis for you to use to help guide your trading and investing decisions. So it makes a lot of sense to throw out overly simplistic, statistically meaningless ones like the “First Five Days” indicator.

And even though the “First Five Days” indicator worked last year, don’t fall into the trap of assigning an excessive amount of meaning to the most recent data points. By all means use it for cocktail party discussions, but don’t waste any money trying to use it to help you make sense of the markets.

Great trading,

D. R. Barton, Jr.

Today’s Smart Profits Cribsheet

• So which way will the stock market trend in 2007? Analysts and pundits continue to chatter about whether 2007 will herald a continuation of the impressive rally over the past few months, or a major correction. While it’s impossible to predict with any certainty, there are ways that you can be prepared either way - and actions you can take for both an upside or downside scenario. Read all about it in Smart Profits #376, 2006 Stock Index Comparison: Here’s How To Play Both Correction or Breakout Scenarios. 120706

• Study stock chart patterns for a long time and you’ll come to one inescapable conclusion: They are a picture of fear and greed. My colleague Jim Stanton has developed a proprietary trading model based on advanced pattern recognition. The one pattern he goes back to time and again has been around for many years. To learn more check out Smart Profits #291, Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline.”

Related Articles:

• Technical Analysis Indicators: Harness The Power Of Leading Indicators And Bollinger Bands
• The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options
• Investing In Options: 3 Powerful Option Strategies That Make More Sense Than Stocks

The Chart of the Week

Skyworks Solutions (Nasdaq: SWKS) showed a beautiful double-top in December. I usually like to show actionable items for “The Chart of the Week,” but good teaching opportunities are too good to pass up. This double-top showed a classic approach to a whole number ($8.00 - which the stock hit in April 2006 and promptly rejected) and a weak close on the day the stock made new 8-month highs. This is a very reliable signal, as “The Chart of the Week” readers have seen time and again.

Smart Profits Report Archives

Sphere: Related Content

Leverage Investments

The Smart Profits Report: Issue #382
Tuesday, January 2, 2007

Leverage Investments: How To Use Options Delta To Vanquish Volatility
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

There’s more than one way to skin a cat on Wall Street. But it’s remarkable just how many investors choose to tread down a very narrow path, faithfully sticking to just one, standard mode of investing: Buying stocks.

That’s why at investment conferences and seminars, I often talk at length about the power of leverage investments. But based on the number of questions from audience members that follow, it’s clear that many are either unaware of this concept completely, or don’t understand how to incorporate it into their investment strategy.

Slowly but surely, however, this is changing, as investors figure out that options don’t have to be confusing, but instead are a really easy and powerful way to control shares of your favorite investments - and more importantly, something that can produce excellent returns.

Simply put, options offer this leverage investment. After all, if you can control 1,000 shares of a stock for a stock for a dollar a share, why pay $50 a share? The problem is trying to figure out which strategy is right for you.

You Use Leverage In Life… So Why Not Leverage Investments?

Here’s the thing: You probably use leverage every day of your life. Whether it’s a mortgage payment, car payment, or simply buying goods with credit, you’re controlling or owning an expensive item for a relatively small amount of money.

The same applies to the investment world - and with options in particular. This is actually unfortunate in a way, because many investors use options in the same way as they use their credit cards: Recklessly. They choose the cheap route of trying to play short-term options. After all, the “lottery effect” is quite a strong lure outside the market, so why not in the market, as well?

But I’ve often said that investors who trade short-term options without a clear system or strategy are heading for trouble. I mean, if you can accurately, and consistently predict the short term movement of a stock, then what the heck are you doing reading this column?

I’d estimate that more than 90% - maybe even 99% - of investors cannot predict the closing price of a stock at its options expiration when that expiration is less than two or three months away.

But as the investment time horizon increases, the probability of being right increases, as well. There is more time for a company to post better earnings, acquire a new partner, develop a new drug, make a blockbuster announcement, etc. So you have to choose: Are you a short-term better, or a longer-term investor?

Well, whether you’re bullish or bearish, your goal is to make money. That’s why, instead of buying the shares outright, you want to increase your leverage investments by using an option. Let’s see how this works…

Vanquish Volatility And Accelerate Your Profits With The High-Delta Trade

In the October, I recommended a play on a healthcare giant to subscribers of our Xcelerated Profits Report service (for more information on this, check out our Cribsheet below). And while it would be unfair to subscribers for me to reveal the pick here, I can break down the mechanics of the play for you here - just like we do with each pick in every issue - so that you can see the best way to invest and “accelerate your profits.”

The company I found had super earnings, a great growth profile, and was in the midst of a ton of insider buying. Even better… the company’s shares had sold off because earnings had missed by a mere penny in the previous quarter.

But what many investors failed to notice was that the CEO had explained the reason for the miss and said that the problem had been resolved and earnings growth was back on track. He put his money where his mouth was, too, ponying up over a million dollars to buy shares on the open market.

So we had two choices:

• Buy the underlying shares at the market price - about $39 each.

• Look for leverage investments. This is where our real moneymaking opportunity comes into play - and it does so in the form of the high-delta options trade.

Simply put, delta is a measure of change. In options speak, delta refers to the rate of change of the option, based on the rate of change of the underlying stock. In other words, if a stock moves $1, delta figures out how much the underlying option will move.

There are several different factors that affect the delta:

• Time
• Strike price
• Underlying volatility

The most important factors are time and strike price. Volatility is what we can conquer with the high-delta trade. Here’s how it’s done…

How To Invest 70% Less And Earn A 72% “High-Delta Profit” Potential

Take a look at our two choices again from above:

• Option #1 sees us spending $39,000 to buy 1,000 shares of the company. My target on the shares was $51. So on the share trade, we stand to make $12 - or about 30%.

• Option #2 - the high-delta trade - is to buy an out-of-the-money (OTM) call option. In this case, a $40 one-year LEAPS option would cost about $5. That $5 is pure premium with no intrinsic value. On this option, we stand to make a net of $6 on the $5 we have invested - or 120%. But we can only make money if the stock closes above $45 at expiration. Any close below that number and we would lose money.

I chose neither option. Instead, I decided to take the high-delta route.

As I scanned the various delta figures on the options, I saw that the January $30 option was sporting a Delta of 87. This means that the option should move up 87 cents for every $1 move in share price. The down move would be the same ($0.87 down for each $1 down).

The cost of the option was $11.60. This means our actual risk was $2.60 in premium. We calculate this by taking the strike price ($30), adding the premium ($11.60), and subtracting the stock price at the time of the recommendation.

With a $50 price target, my profit potential is 72%:

• $50 minus $30 minus $11.60 = $8.40.

• $8.40 divided by $11.60 = 72%.

The amount of money I have to invest is $11.60 as opposed to $39, or about 70% less capital at risk. Also, as long as the shares are above $41.60, I am making money.

Ring In The New Year With Some High Delta Options

So as we enter 2007, resolve to add high-delta options trades to your investing repertoire - for both calls and puts. It allows you to make the most of any move in the underlying shares, with much lower capital at risk than owning the shares outright. After all, with an almost dollar-for-dollar move, what’s the point of buying the shares and taking unlimited risk?

In the example above, we accomplished our goal of finding a way to participate in an accelerated profit play without having to put in a lot of money up front - an enticing scenario for any investor.

Good Investing,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

• Having spent six years as a market maker on the trading floor of the New York Mercantile Exchange, my good friend and colleague Lee Lowell is a master of the high-delta options play. He’s expanded on the concept here, as well as deep-in-the-money options. So for more details on how to accelerate your profits through this powerful, cost-effective technique, visit Smart Profits #262, Options Leverage: How to Use Delta to Maximize Leverage.

• On December 21, we released the January 2007 Xcelerated Profits Report issue. Besides the regular 8-page issue, where we recommended a flourishing company in the lucrative water sector, and a 2007 chart-based outlook that showed readers how to profit from the key stock indexes, most influential commodities markets, and the U.S. dollar, we extended the issue to include an additional 7 pages of online content, with a comprehensive review of our portfolio. In addition to the winners we already banked in 2006 (including 84%, 66%, 63% and 55%), we’ve got plenty more to come in 2007, as all our open positions are currently in the money. If you’d like more details on how to use powerful investment techniques to “accelerate your profits” in 2007, simply go to Mt. Vernon Research.

Related Articles:

• Derivatives: Take the Big Guys’ Money With Their Own Weapons
• Option Volatility: A Free Tool for Finding the Best Option Bargains
• In the Money Options: Make Mondays Your Discount Stock-Buying Day

Smart Profits Report Archives

Sphere: Related Content