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Option Strategies

The Smart Profits Report: Issue #375
Friday, December 1, 2006

Option Strategies: The Solution To The Most Dangerous Investment Paradigm Today
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

If you cast your mind back to 2000, you might remember hearing stuff about how we’re in a new investment paradigm - specifically, how the Internet spelled the end for anything made of bricks and mortar. This new paradigm suggested that it was the norm to pay $1,000 per share for any Internet-related company - even if it had no revenues or earnings! It was the time that the market value of Cisco topped out at $550 billion.

But there is a newer, more disturbing trend developing - talk of another paradigm shift that could pose a greater threat to your wealth. And it’s something you need to be very aware of, so let’s take a look at this new shift and how you can combat it with a few simple option strategies…

In a similar way as the Internet boom did back at the turn of the century, the new paradigm today claims economics, volatility and plain-old sound thinking as its victims - basically, that logic and empirical evidence are passé and that the past has no bearing on the future.

And there are three main areas in which this “climate change” manifests itself - metals and money… volatility (specifically, the CBOE Volatility Index)… and the housing market.

A Trio Of Lost Paradigms… Don’t Fall For The Fluff

1) Metals & Money

Today, one of your hard-earned American dollars will still buy you a dollar’s worth of gold. But the problem is that while that dollar would have bought you 1/30th of an ounce of gold 30 years ago, that same greenback will buy you just 1/600th of an ounce of gold today.

Now, you don’t have to be a mathematician to figure out that your dollars are worth 20 times less today then they were in the early 1970s. That’s one heck of a decline in 30 years. That’s inflation. And today, dollar inflation is out of control.

Each day, the dollar is worth less than the day before - regardless of what the currency market is saying. Why? Because each day, more money is being printed to support all manner of causes that are out of the control of everyday Americans.

This is the first paradigm that is lost on many investors today: You hear talk now of how deficits don’t matter, as long as the economy is humming… Wrong. Deficits do matter.

And the solution is to make sure you own gold or silver in your portfolio.

2) Volatility

I recently read a column about how one of the best measures of volatility, the CBOE Volatility Index (^VIX) isn’t really a good guide of the market climate anymore. The reasoning is that the VIX has been wrong before.

In layman’s terms, the VIX signals the complacency of investors, based on the volatility of options. A low VIX number (in the low teens or high single-digits) used to mean that the market was topping out. A high VIX number usually meant that the market was bottoming and investor fear was in full swing.

The talk today is that the VIX is useless because it is at or near all-time lows, and the market continues to soar. And, because so many people use the VIX today, it is no longer a reliable indicator.

But here’s the thing: It was reliable in 1987 and it was reliable in 1999 - and people knew about it then as well!

Here’s a rule of thumb: When the VIX is high… buy. When the VIX is low… start to unload.

3) The Housing Market

The final shift in the paradigm is talk about how the housing market will recover next year. Again, this is a misunderstanding of supply and demand. There is an oversupply of housing in the market today. Unsold inventory in some areas has moved from a month’s supply to over a year’s supply.

Housing company shares are one thing, but the housing sector is something else. One is financial creation; the other is real bricks and mortar. The housing-company executive is not responsible for your monthly mortgage payment - you are.

The old paradigm says that when there are more houses than buyers, the price of that house will come down until there is a buyer. The old paradigm also says that if you own one house more than the market can bear, you will have a hard time selling that house.

But the new paradigm says that low interest rates will reignite the housing market. That’s what supply and demand is - a struggle towards equilibrium - and once it rears its ugly head, it tests the truth of the new paradigm. We’re not there yet, and if you have one more house than you can afford, take the best offer out there.

So how do we combat these new paradigm shifts - and take advantage? My job is to look for an investment approach that allows me to benefit at a discount to everyone else. And as you may know, one of my favorite strategies revolves around options trading.

Two Ways To Use Option Strategies In The New Paradigm

With access increasing and commissions falling, the options market is getting bigger everyday. Within a couple of years, it’s my opinion that options prices will be quoted in penny increments, not nickels and dimes - further evidence of strong demand.

There are several option strategies that can allow you and your portfolio to weather any storm. I will talk about two. But remember… if you want more information on options and options strategies, check in the related articles below or search through our archives.

“LEAP” Into Increased Safety

I’m a strong advocate of using LEAPS options - a category that acts as a proxy for the underlying shares of an asset, and can have a life of up to three years.

Here’ s the deal: If you want a investment holding period of less than a year or two and only want to risk 10% to 15% of your capital, rather than 100%, consider LEAPS.

For example (not an actual recommendation), let’s say you like the prospects for gold over the next two years. You’ve basically got several choices: You could buy gold… gold shares… the gold ETF… or LEAP options on a gold stock.

Assuming you want to buy 100 ounces of gold, here are your options:

  • You could spend $63,000 to own 100 ounces of gold or 1,000 shares of the gold ETF. Return: If gold moved to $800 by 2009, your gold bullion or ETF would be worth $80,000 - a return of $17,000, or 26%.
  • You could own 1,400 shares of Newmont Mining Corp. (current price $45). Return: Newmont would likely be trading at about $75 per share - a return of 66% or $42,000.
  • You could buy 14, two-year LEAPS options on Newmont, with a $40 strike price for $14,000. Return: Your return here would be $35,000 ($75 minus $10 (price of the option) minus $40 (strike price) x 14 contracts) - more than 200% on your initial outlay of $14,000.

The difference with the LEAPS options is that you risk almost 80% less capital than with any of the other strategies. And with a 25% stop-loss, the maximum you’d lose on your Newmont stock trade or the ETF trade would be about $15,700 - more than the outlay for the options.

Plus, the 80% that you did not invest in the trade could be earning 4.5% in a money market account, helping to offset about $5,000 of the cost of the options resulting in a net outlay of less than $10,000.

Cushion The Unexpected With Covered Call Options

The second option strategy is more of a slow, steady approach to any market condition. The aim here is to protect and grow your capital with the assumption that stocks don’t always go up. It’s a modified covered call strategy that allows you to own the stock of a company that you like at your price… or get paid for trying. This is my favorite investment strategy if executed properly - because it allows you to build in a cushion for the unexpected.

If the unexpected doesn’t happen, you make money. If it does happen, you’ll still most likely make money, or at least end up owning a good company at a 20% to 40% discount to the price at which it was trading when you first bought the shares. The strategy requires more capital than an options trade, but less than a stock trade - and is also a strategy aimed at the “safe” portion of your portfolio.

How The Covered Call Options Strategy Works

Let’s say you like shares of Newmont at current levels, but are unsure about the prospects for gold. You’d be more attracted to the shares for the longer-term if you could buy shares of Newmont after a correction in gold price.

But get this: You can create your own correction - or get paid for trying. At $45, Newmont may seem a tad pricey to you. But, it’s down from $62 and you’re not that greedy, so you settle on $35 as your preferred entry price.

You can buy Newmont today at $45 and sell a $40 one-year option against your Newmont shares for about $10. This means that you receive $10 for each option that you sell - but you are obligated to sell Newmont at $40 at expiration, if the shares are trading at that level or higher.

Your cost in Newmont is $35 and your profit potential is $5 or 14% in a year (5 divided by 35).

Here it is by the numbers:

  • $45 minus $10 (proceeds you received from selling the options) = $35 (your cost).
  • $40 (the price at which you are obligated to sell Newmont) minus $35 (your cost) = $5.
  • $5 divided by $35 (your cost) = 14%.

So, you’ll now either own Newmont at $35 - a full 22% lower than the current $45 price - or get paid 14% for trying.

Options strategies can appear complicated on the surface. But I promise you that they become much simpler once you execute a successful trade and see the results. An option is just another tool that is available in an evolving market to better manage your portfolio. And in this time of new paradigms, it makes sense to learn about new tools to master the changes.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet It’s a sad fact… but many investors don’t maximize their profits with options because they shy away from them, citing their confusing and volatile nature. But when you learn the core fundamentals, you can put yourself ahead of the masses and win at the game of making money. For the lowdown on call options and how they work check out Smart Profits #101, Call Options: Why Would Anyone Buy a Call?

Don’t get left trailing in the market’s wake, wondering how you’re going to grab your next piece of the pie. Simply plug yourself into the fastest-growing segment of the investment market: derivatives. Learn more in Smart Profits #352, How Derivatives Work: Use the Options Boom to Beef Up Your Leverage. Related Articles:

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