Options Strategies

The Smart Profits Report: Issue #333
Friday, July 21, 2006

Options Strategies: The Perfect Options Strategies For A Seesaw Market
By Steve McDonald
Advisory Panelist, Mt. Vernon Research

So much for the traditional “summer doldrums.” In all of my 22 years of stock market experience, I’ve rarely seen a wilder, more volatile time than the past 10 weeks. With major swings in and around all of the major index support levels, it’s enough to make even the coolest investors flinch.

You can pin the volatility squarely on a quartet of concerns:

Several ongoing wars
A rash of second-quarter earnings reports
A deadlocked Congress
Bloated debt levels

But fortunately, it’s not all doom and gloom… While many people worry and panic about their crimson-colored portfolios, smart investors know that there are always opportunities to make money - whether the market’s up, down or flat.

And one of the best ways to deal with the market fluctuations is to use options to insure your portfolio. This is exactly why options were created. And if you use the right options strategies, not only can you protect yourself against risk, you can also churn out some healthy gains…

An Options Strategy for Downside Portfolio Insurance

Let’s assume you own a solid portfolio of stocks, well diversified, and you have no intentions of selling off the first time the market hiccups. In other words, this is your investment portfolio, not a trading portfolio. When the market starts swinging 200 points in both directions, even the most seasoned investor gets sweaty palms.

Insuring your stocks means buying options on the down side. Here’s an example…

Apple Computer (Nasdaq: AAPL) is currently at $60.71. Its high for the year is $86, its low is $42. Let’s say you own it at $60. With the market so unpredictable, where the stock will be tomorrow is anyone’s guess. So, you buy the following option:

The August 2006 $55 put, trading for $2.35.

Then, Iraq announces it’s suspending oil shipments, or Syria decides to openly support Hezbollah, or North Korea announces it’s launching more missiles - just to name a few possibilities. The market then has another week where we shed several hundred points, the more actively traded stocks lose 10% or 20%, and your portfolio drops.

The put you bought should increase in value and increase exponentially as you approach your strike price of $55. In other words, it should have a higher percentage increase than AAPL’s drop.

Options Strategies That Help Keep You In The Market

You may not recover your losses dollar for dollar, but you get an unseen benefit that is much more important: The trade will help keep you in the market.

Letting the market’s wild swings be the guiding force for your buy and sell decisions is the shortest route to the poor house. Using this options trading strategy as insurance to soften the blow of another down day will give most people the confidence to stay the course - and in an investment portfolio, that’s how you make money.

The down side is that if the stock doesn’t move down, you stand to lose some (or all) of what you paid for the put. The past few months have taught me that this is good tool to keep in your back pocket. I don’t think we’re moving out of this type of market anytime soon.

An Options Strategy For Playing Uncertainty For Profits

In addition to using options as an insurance vehicle, you can also take advantage of the market’s volatility to make some significant gains using options straddles.

Employing a straddle is when you buy a call and a put at the same time, literally “straddling” your position. As the underlying shares move up, you benefit from the increased value of the call. If the shares sink, your put makes some money for you. Just be sure to sell the losing side of the straddle when the trend surfaces. And let your winning options ride. This is a more expensive strategy, but one that could make a ton of money if our “bipolar market” continues.

As with all options, I always recommend you buy at- or near-the-money contracts - don’t be too much of a bargain shopper. Remember, you have to get close to the strike price for an option to start to pay off significant money. And don’t go too far out in time, either. Paying for extra time for your play to work may seem prudent, but it will end up costing you too much money.

Stay the course, use the strategies options trading affords you, and keep your eyes on the horizon.

Good Trading,

Steve McDonald

Today’s Smart Profits Cribsheet

High levels of anticipation during earnings season presents spectacular profit opportunities… no matter what the broad market is doing. Take a look at the anatomy of a perfect strangle in Smart Profits #282, Option Trading Strategies: Option Plays That “Earn” Their Keep… To the Tune of 633%.