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Game Theory

December 31, 2004

The Smart Profits Report: Issue #171
Friday, December 31, 2004

Game Theory: Making Profits With Mathematical Precision
By Dean Albrecht
Advisory Panelist, Mt. Vernon Research

Last night there was a terrific documentary on PBS about mathematician John Nash. So what does that have to do with options? Well, quite a bit, as it turns out.

This particular mathematician - along with going completely mad at one point in his life - won the Nobel Prize in 1994 for his work on “game theory.”

Game theory is one of the most powerful mathematical models used by modern economists to explain and predict the behavior of the markets (and many other hard-to-grasp phenomena).

Predicting the behavior of the markets has obvious advantages if you’re trading options. In fact, by using a mathematical technique I’m about to show you - one Nash might appreciate for its simplicity - you can determine both stop losses and expectations of gains on any trade you enter.

You can also time your put and call trades with greater precision. In fact, the predictability built into this approach lets you know how large a gain to expect - or how far to let the price of a stock or option drop before bailing out of the position - with mathematical precision.

Let me explain…

Finding Meaning In Repeated Patterns

The strategy of game theory uses a mathematical system where we look at historical numbers that constantly repeat themselves. (People, as Nash’s theory proved, also behave in predictable patterns.)

We test for price patterns in stocks, options and ETFs. We look at percentage moves rather than penny or dollar moves, which makes it easier for us. We then look to identify repetitive instances of price action.

For example, in our research we found that stocks on the NYSE move just a little differently than stocks traded on the Nasdaq. We also found that AMEX stocks move differently than their NYSE and Nasdaq cousins. (By moves we mean distance and by distance we mean percentages.)

Game Theory & The QQQQ

Let’s take a look at the Nasdaq index (Nasdaq: QQQQ - formerly QQQ). The “Qs”, as they’re often called, move an average of 3.5% when they change direction, up or down.

This piece of information is valuable because it allows us to set profit targets and stop losses whenever we enter a position, by giving us the precise numbers of what to expect.

The interesting thing is that the percentage didn’t change when QQQQ was trading at $50, $60 or $30.

That gives us an expectation of gain. Let’s say you buy an ETF at $40, and you know from observation that the upside potential of a move is 3.5%. From that, you also know to expect a move of about $1.50 to the upside. So once that move is completed, you can take your profits - rather than buying and holding while the trend reverses against you.

Speaking of the downside… We do studies to get statistical averages of downside expectation of price, given certain market conditions. For instance, QQQQ is currently in an uptrend (see chart below), and pullbacks are smaller than when the QQQQ is in a downtrend.

That means the downside expectation is less than the upside, so we know how far to let a stock’s price go against us in all market conditions.

How To Take Advantage of Game Theory

So how to take advantage of game theory for yourself? If you have a favorite stock that you trade, such as QQQQ, then simply do the following:

Overlay a 50-day moving average line on a daily chart going back about one year. You can easily do this online at www.bigcharts.com (see chart below):

Then plot the move of the price in percentage terms when the price goes above and below the 50-day moving average.

You’ll find that the price drifts about 8% or so above or below the 50-day moving average.

Which means your expectation of profit on this simple crossover system is about 8%.

You can also count the number of times the price moves above and below the 50-day MA line, going back several years. Now you will have a gauge on how many positions (or potential option trades) to expect per year.

This is a simple example, but it should give you an idea of how easy it is to start incorporating quantitative research, like game theory, into your own trading.

Good Trading,

Dean Albrecht

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Today’s Smart Profits Cribsheet

  • At Quantitative Equity Research, where I work, instead of doing our research by hand we use automated computers screening the data based on our inputs throughout the day. But again, you can do your own “quant” research using simple techniques like the one I showed you today.

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Smart Money Investing

December 30, 2004

The Smart Profits Report: Issue #164
Friday, December 03, 2004

Smart Money Investing: The Four Rules of All “Smart Money”
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

As I was escorted to my daughter’s classroom for a fifth-grade “Career Day” presentation, one of my little handlers asked me if I “got nervous” before a speech. I said yes. He asked if it was the same kind of “nervous” as the competitors on the reality show Fear Factor experience. Within seconds I was standing in front of the class, beginning my presentation, a little more nervous than I otherwise would have been…

So what does all this have to do with options trading, exactly? Nothing. Except for the fact that four of the most important rules about money are so simple, even fifth-graders can understand them.

Yet, they’re so powerful - and so basic to smart money investing - that every trader should memorize and follow these four rules before trading a single option.

Let me explain…

The Four Rules of All Smart Money Investing

My goal for the class was to try and teach them four rules regarding money that I would encourage anyone to memorize before trading options. Now, I know from experience that even adults have a hard time learning just one thing in 30 minutes. And, when it comes to managing money - it might never make any sense.

I chose four things that I believe are the most important rules of dealing with money… rules that you may want to share with your kids or other loved ones, regardless of their age.

Smart Money Rule #1 - Go With Moderation Over Excess

I started with moderation versus excess - something a kid can understand and adults often forget.

The first example I gave the kids was the “need” for everyone to buy the biggest car with the worst mileage just to get from point A to point B. To an environmentalist, that’s excessive consumption, end of story.

I don’t go that far, but to a “money person” it’s excessive spending, especially for those who have trouble making car payments. (I also used the Halloween tummy-ache example - go overboard with the candy, and you pay…)

Moderation versus excess affects our future ability to achieve financial independence… To a fifth grader this means being able to buy another video for his Game Boy. To the options trader, it is spending a lot of money chasing hot short-term trades without a system, most of which go bust, instead of focusing on high-probability trades like the LEAPS options.

Smart Money Rule #2 - Stay on the Right Side of Compounding…

Second, I talked about compounding. The example I used here was a kid who got a dollar a day and spent it on candy and the kid who put the money (some of it, at least) in the bank. At the end of the year, I explained that Child A would not only have no money, but also lots of cavities. Child B would have all the money he saved, plus something extra for “lending” the money to the bank. I was quite impressed by how many kids actually knew that banks loaned out people’s savings at higher rates - I know I did not know that at age 10.

Smart Money Rule #3 - Use Credit; Don’t Let It Use You

Third, I talked about credit. I explained good credit (buying a house) and bad credit (spending money at a restaurant and paying for it six months later). I tried to impress upon them that spending more than you can afford would likely result in a sad retirement.

I told them that they would be getting offers for credit cards in the mail once they were in their senior year of high-school. My advice: Tear up the envelope before you open it. I also explained that if they did not know how to manage credit, they could spend 30 years paying for video games that may only be played for a year. The video game themes resonated well with this crowd.

Smart Money Rule #4 - Always Own Some Tangible Assets

Finally, I brought in 450 one-dollar bills and an ounce of gold. I asked the group which they though was worth more. They all pointed to the currency. I tried to explain fiat money and what tangible assets were.

I think I lost them on this one. But, there were a lot of oohs and aahs when they saw the stack of bills. (My favorite response from one girl who picked the gold coin was, “It’s worth more because it is so shiny.” Almost right…)

The day was quite a success and I enjoyed the Q&A. I encourage you to talk to your kids and grandkids often about smart money and investing. It could be one of the best early childhood lessons that you could impart to them.

And if they want to follow you into the options market someday - and win - they’ll need to know these basics first.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • By the way, I would also like to thank YOU for all of your comments and topic recommendations, especially the following readers: Sledd S., John A., John G., Sandeep C., Steve S., Claude S., Iaron S.

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Long-Term Covered Calls

December 21, 2004

The Smart Profits Report: Issue #169
Tuesday, December 21, 2004

Long-Term Covered Calls: The Best Way to Play Sirius Satellite Radio
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

A month ago I recommended buying shares of Sirius Satellite (Nasdaq: SIRI). At the time, Sirius shares were trading far below the current prices.

I gave subscribers to the my trading service very specific reasons to buy the company now. And I included a long-term covered call play that I think is the smartest way to play Sirius.

If you don’t know what a covered call is, here’s a quick take that will help you understand the Sirius play I’m about to describe… A covered call combines two instruments: an option and a stock.

Long-Term Covered Calls Just Make Sense

It works like this: You buy shares of a company like Coca Cola at, let’s say, $50. You think Coke will go no higher than $55 in the next 12 months. If it goes higher, you will sell since that is your target price.

So far, that’s just normal investing. Well, if you can handle that, then why not make MORE money than just the $5 that you projected to make?

To do this you would SELL (or write) a $55 call option against your Coke position. You can sell one option for every 100 shares of stock you own. When you sell your call, you will be obligated to deliver the shares if requested. That may or may not happen. Nonetheless, you will be sure to receive something for the option you sold. It’s called a premium. And it can amount to a good deal of money.

One way to view this premium is as rental income on your stock. You get the “rent” the minute you sell the option.

The transaction you entered - when you sold your call and collected your premium - has one consequence you have to find acceptable. It limits your upside gain on the stock (in the Coke example, to $55), since that is the strike price at which you’re obligated to sell your shares.

Looking for Reasons NOT to Buy

What we do with the Income Trader is trade covered calls using a system and a set of criteria…

We’ll take a company that we like, such as Sirius. And the first question I ask is whether Sirius is a company I want to add to my portfolio regardless of the circumstances. (Well, almost… To me the most extreme circumstance is when the management of the company lies, or another competitor is going to put my company out of business. And these are deal breakers.)

Then I look at the fundamentals…

  • Can the company survive through thick or thin?
  • Does it have enough cash?
  • Are the insiders unloading or loading?
  • Is the business competitive?

Basically I am looking for reasons NOT to buy a company. When I am satisfied with the fundamentals, I look to the options market.

I am looking for a specific return. I want to make at least 1% to 2% per month from my picks. AND, I want to buy the shares at a whopping discount to the current price, if possible.

Simply put, I want to buy the shares at my price, or I want to be paid at least 1-2% per month for trying.

And I got Sirius at my price… in fact, we’re holding it right now…

Our trade worked out like this. We have the following possible outcome:

Either we will make close to 20% on the position in a year, or we will own Sirius for $2.10 per share. At the time our downside cushion on Sirius was about 35%. This meant that Sirius would have to fall more than 35% from the price that we paid, in order for us to lose any money.

A Downside Cushion of More Than 70%

As it stands today - only a month later - Sirius is at $7.50. This means that Sirius must fall more than $5.40 per share for us not to win on this trade. That is a downside cushion of more than 70%! Here’s the great part: Many of my readers have already made close to 20% on this trade in one month. That’s right: They did not have to wait another 12 months.

Why? That’s today’s lesson.

When you sell the right to someone to buy your shares, as you do when you are writing a covered call, the person who buys the call can exercise the option to buy your shares AT ANY time as long as they pay your strike price.

In this case, the option buyer exercised his option - for whatever reason - 12 months early. That resulted in a gain of almost 20% in one month as opposed to 12 months. That is a good trade in my book. And it is not the first time this has happened.

A couple of years ago we covered our positions on Intel, Cisco, Motorola and Oracle for average returns of 15% to 20%, more than six months prior to expiration. If we held the positions to term, we would have made 1% to 3% more. In this case, the extra six months of risk was not worth the extra gain.

So we booked our profits and got out… always a great option to have.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Crib Sheet

  • Check out our Smart Profits Glossary if you are having trouble defining option terms like “covered calls” or “strike price”, it’s chock full of over 150 option terms!

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LEAPS Option Strategies

December 6, 2004

The Smart Profits Report: Issue #165
Monday, December 6, 2004

LEAPS Option Strategies: A Gold Strategy That Beats Stocks, Bullion or Coins…
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

Like gold? Then read this… Back in January of this year I made a recommendation to the readers of the Daily Reckoning.

Knowing that the readership was quite fond of precious metals investing, I showed them an alternative way to profit from gold while taking 90% of monetary risk off the table.

It was partly based on a recommendation I made to my readers. I can tell you about this now, because it worked like a charm, proving that the LEAPS option strategies we used was considerably more effective than buying a gold stock… or physical gold bullion… or rare coins.

Let me explain…

Securing 291% Returns With LEAPS Options Strategies

The participants in my LEAPS service closed out a position in Placer Dome a few days ago for a return of 291% in less than 12 months.

We did this using LEAPS options and a bull spread. We basically bet that the price of Placer was going higher, and instead of buying the shares for $17 we bought the LEAPS option with almost two years of time value for about $2 or so.

Let me ask you a question… If you wanted to buy gold because you thought it was going much higher, what would you rather do: invest $17,000 to make $5,000 or invest $1,800 (about 10%) to make $5,100?

Well, if your answer is $17,000 to make $5,000 then you can stop reading right now!

The beauty of options is that if you know what to do, when to do it and why to do it, you can walk away a very wealthy person in a very short period of time. Right now you have a choice: If you are interested in investing in gold because you are convinced that it is going to $500 or $600 in the next couple of years, then you need to look at the LEAPS available on gold stocks.

Four Major Gold Producers With LEAPS Options

There are four major gold producers that have LEAPS options:

  • Newmont (NYSE: NEM)
  • Barrick (NYSE: ABX)
  • AngloGold Ashanti (NYSE: AU)
  • Placer Dome (NYSE: PDG)

If the price of gold were to hit $500 per ounce, all of the above companies - except for ABX - would move between 50% and 100% in price.

Any in-the-money LEAPS purchased would increase between 300% and 700% - if this were to happen over the next two years.

If gold were to hit $600, you would be talking about 1,000% to 1,500% returns across the board with LEAPS… and with only 10% to 20% invested versus buying the shares outright. In fact, at $500 per ounce the actual dollar profits from the LEAPS would even exceed the dollar profits from the stock investment.

So LEAPS are not just one of the smartest ways I know of buying any stock - this might be the best way to play the ongoing bull market in gold, too.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • In our Placer Dome play mentioned in today’s article, we used a “bull spread” strategy. I talk more about this powerful options-trading tool in Smart Profits #151, Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth
  • If you’re new to the world of options trading, all the terminology can get a bit confusing for example, do you know what a call option is? To help clarify the lingo for you, feel free to vist the Smart Profits Glossary to find definitions of terms like “LEAPS” or “bull spread” found in today’s article.

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Opening An Options Account

November 22, 2004

The Smart Profits Report: Issue #162
Monday, November 22, 2004

Opening An Options Account: Smart Profits Basics Part 1
By Karim Rahemtulla
Chairman, Mt. Vernon Research

If you’ve been reading this e-letter for while, you’ve seen the kinds of enormous gains you can make trading options. Maybe you even did a little paper trading just to see in more detail how it works. And now you’re ready to start making some money with options. Now what?

Well, the first step is opening an options account for trading, which means getting clearance from the brokerage. This is not always easy.

In fact, the process can be a little frustrating, but by knowing what to expect and preparing for it in advance, you’ll get up and running with less hassle and less time. Which means you can start profiting sooner.

And it starts with getting clearance from the brokerage…

Clearing the “Clearance” Hurdle In a Single Bound

You’ve never seen this written anywhere, but you’ve heard it, even if phrased with devious politeness…

  • “You don’t have a clue about options. For that matter, you don’t have a clue about investing.
  • “I do. I am a broker. To get to where I am, I had to pass an exam, on my third attempt. And, now I can tell you if you are qualified to trade options.
  • “What? Don’t you get it? You don’t understand money unless you are a broker. Oh, by the way, if I screw up, then you MUST use arbitration (run by a committee of insiders who love my company) to try and recover any funds from me…”

If nobody ever said those exact words to you, be sure it’s exactly what 99% of brokers think.

That, in my opinion, is what the disclosure SHOULD say at the bottom of every stock and options agreement that you must sign before you can trade. And you might even throw in this:

  • “Good luck and thanks for leaving your hard-earned money with me to control - and of course collect a piece of - every time you decide that you know better.”

You’re Bright, Rational and Have the Money… Not Enough!

You would think that a 50-year-old person of sound mind and body, with 30 years of investing experience, would know more than an 18-year-old just out of high school.

But, no. Brokers are often in a position to say that YOU just may not be “suitable” to trade options. And while there are good brokers out there, the majority of brokers are just not qualified to determine your suitability to trade options.

Yet they do, and on a regular basis…

The suspicion that every customer is incompetent is a rampant myth in the brokerage world.

It’s rather like getting that first job. To get one, you have to prove you’ve done well at your last job, so you have to get a job to get a job! If you have never traded options before, you may not get the chance to participate in this high-profit market until you can prove you’ve participated before.

Start With Covered Calls and Go From There

Here’s how it works: In order to trade options, you must fill out an application. The application asks you pointed questions. And, unless you answer that:

  • (1) yes you are willing to lose everything and
  • (2) you won’t get upset if you do and
  • (3) you won’t sue the brokerage firms regardless of how negligent they are

You’re in trouble. Chances are you will not be allowed to trade any options except covered call plays.

Okay, so I am exaggerating a bit. A little bit. In reality the options agreement is reviewed by each firm’s options department to see whether you should be allowed to trade different options strategies. You may be able to buy puts and calls, but not engage in straddles, for example.

But more likely, as a beginning options trader, you may not be allowed to do anything except trading covered calls. Why? Because there is absolutely no risk to the broker if you are trading against a stock you already own.

At the start, your chances are best if you have had a regular account for a while, have plenty in it, and are willing to sign the form saying that you are willing to lose money and understand the risk.

Some Brokerages Make It Hard - Others Make It Easy

In later columns, I’ll tell you how to manage your money to offset this risk. But for today, think hard about how much risk you can stand. If you can take a little bit of a hit, then the broker is probably right. Covered calls are probably your best strategy.

But what if you’re all set to go mentally and the broker still stands in your way. Then you have to take charge. I’ll tell you how to get around this hurdle in the next letter.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • Today we talked a good deal about covered call options strategies. For more on what covered calls are, visit our handy online Smart Options glossary full of useful options-trading terms.

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Quantitative Research

November 19, 2004

The Smart Profits Report: Issue #161
Friday, November 19, 2004

Quantitative Research - An Interview with Dean Albrecht
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

What’s in a word? When the word is Quant, the answer is profits! Lots of them and consistently.

In the coming weeks, months and years you will be seeing a new name in your e-mail and regular mailbox. The name is Dean Albrecht. Dean is the newest addition to the fold, and I look forward to introducing him to you.

Dean is a Quant. No, not some exotic animal, but a rare find nonetheless.

Quants don’t believe in fundamentals, technicals or “good” stories. They focus on numbers and quantitative research. They take numbers and they input them into a computer loaded up with proprietary algorithms, which then spit out buys and sells for stocks and options.

A True Rain Man of the Markets

They are the “Rain Men” of the market. Dean has developed a very successful set of formulas that he uses to do short-term trading.

Among his current clients, he counts major institutional investors, hedge funds and some brokerage firms - a pretty nice roster of clients willing to pay well for his recommendations. Currently, Dean is managing director of Quantitative Equity Research.

As a result of my relationship with Dean, I have finally convinced him to join me in the writing business and make his talents available to our readers. I can’t wait for the results.

One of my goals is to have a monthly newsletter that covers alternative investments like options, ETFs, futures and more - from every angle. I want fundamental analysis, technical analysis and quantitative analysis in the same boat.

Come next year, we will be launching such a letter, with myself, Mt. Vernon Research Team and Dean Albrecht as co-editors. I can’t wait!

Quantitatitve Research Q&A With Dean Albrecht

For now, I want you to get to know Dean (Mt. Vernon Research has already been contributing regularly to this report). He will be writing some Smart Option reports for us over the next few weeks. But first, here is an introduction to Dean… I sat down and asked him some questions that will help you get acquainted with both the man and his very profitable methods…

Karim: Can you give us more insights into your background?

Dean: My experience in the financial industry goes back to 1992, when I started my investment management career under famed investor and now multi-billionaire and Global Forbes 400 member, Michael Lee Chin. I worked under Lee Chin’s tutelage for more than two years, and I then moved on to working with and consulting to financial and investment professionals in the stock, option, futures and commodity arenas throughout North America.

Karim: I know of Lee Chin, a real legend, as you say. What did you do next?

Dean: After hanging up my consulting cleats, I then took over the helm and ran one of the most successful high technology financial research firms in North America. While president and CEO of that firm we were named one of the top 100 fastest growing privately held companies in America in Inc Magazine, as well as one of the fastest growing public or privately held high technology firms in North America.

Karim: Then you branched out and launched your own venture, correct?

Dean: Exactly. I founded Quantitative Equity Research in 2002. I created the firm to serve institutional clients in the Quant Research and Algorithm development area. In fact, for the last two years our clients have been exclusively hedge funds, broker dealers, independent financial professionals and sell side trade desks of boutique high-end broker dealers. We now offer institutional-quality Quantitative Equity Research, which we’ll be bringing to Smart Profits readers.

Karim: Give us some examples…

Dean: First, my background, along with finance, has been in professional sports. Pro football, to be exact. No, I didn’t play pro but I was brought up inside the game from day one, and when I say day one, I mean day one. My first word was not Mama, or Dada. It was “WIN,” and I take this same attitude into the trading room and investing arena. No joke. This drove my mother nuts but put a huge smile on my father’s face - at the time of my birth he was with the Dallas Cowboys.

Karim: So did you work in the NFL in some capacity?

Dean: I did. In the ensuing years I became one of the youngest scouts in the game, traveling around the country with my father to scout both pro and college football games, searching for the next superstar or diamond in the rough at the age of 10. One could say that my research, albeit sports-based research, started at a very young age. As I grew older I continued my pursuits in the pro sports arena. And as a freshman in college I started a pro sports representation agency and signed more than 17 clients in my first year.

Karim: Tell us a little more about your quant background…

Dean: Although we are quant researchers and developers of proprietary indicators, expect sports-based and winning-based analogies in our writing. We have been told by many that it gets our point across. Don’t be intimidated by the word quant, either. Our methodologies and strategies are complex, yet we break them down to be quite simple, easy to understand, actionable and most importantly, profitable. We don’t talk about the thousands of lines of code that make up our filter and search and identification algorithms. But from it, we provide specific entry and exit points on options, stocks and a variety of other equity instruments.

Karim: One secret I’ve told me readers is: Have a system. You share that belief… What do you think makes your system work?

Dean: The true test of a robust system or strategy is to see if it works well on multiple instruments, on multiple markets, on multiple time frames. Our indicator does just that. Our research associates have backgrounds in equity research, systems and software development, control systems engineering and trading. We have research associates who are long on experience in testing, trading-system development and quantitative analysis. Our methods provide significant analytical advantages in today’s equity markets to the financial professional and are based on a simple yet proven methodology.

Karim: Thanks, Dean… This was a good introduction… We’ll look forward to your coming insights.

Good Trading,

Karim Rahemtulla

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LEAPS Call Option

November 11, 2004

The Smart Profits Report: Issue #159
Thursday, November 11, 2004

LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns
By Karim Rahemtulla
Chairman, Mt. Vernon Research

The trading patterns in the market following the elections point to quite a finish for 2004. That’s not good news for options investors… IT’S GREAT NEWS. Whenever we get volatility up or down in the market, there’s money to be made. What’s different this time is that the rally is broad, touching almost all sectors. Energy is hot… gold is shining… tech is rebounding sharply, along with many industrial sectors.

If you haven’t explored or used options, there is no better time to get started. That goes for options in general, including: LEAP Call Options, LEAP Put Options and Long or Short Covered Calls. Pay special attention to the first item on that list: LEAP call options…

If you’ve never executed a portfolio swap using LEAP call options (the colloquial term for LEAPS - Long-Term Equity Anticipation Securities - call options), you definitely want to consider it now…

With this one simple LEAP call option trading technique, you can take 90% of your money off the table and still reap 300% returns if your position continues in an up-trend.

Tripling Your Money With 90% LESS RISK

For example, let’s say you bought Exxon last year in the $30s. Now that Exxon is at $50, you may want to consider swapping your shares for LEAP call options. You can cash out and take your profits on the shares, but continue playing any remaining up-trend in the company with your LEAP call options - reducing your risk significantly in the process.

Here’s what I mean…

Say you own 2,000 shares of Exxon. Right now that 2,000 shares is worth $100,000 - so you are up more than $30,000 from last year.

You could ride it out and hope that the energy sector and Exxon keep powering ahead, or you could take most of your money off the table, pocket the $30,000 and reinvest a small percentage into some LEAP call options on Exxon.

First you need to set a target price and a stop loss.

Let’s start with a target price….

  • Again, Exxon is at $50 right now. Let’s say your target for Exxon over the next two years is $65, about 15% a year (remember, it has moved up almost 50% in just one year, so we are not way out of line with our assumption).
  • Your upside if Exxon hits $65 is $30,000.

Now let’s take a look at the possible downside to holding Exxon stock…

If the stock begins heading south, how much are you willing to lose before you liquidate your position? What is your point of maximum pain? How much of that $100,000 stock holding are you willing to put at risk?

Some people recommend a 25% stop loss, others 10%. For the sake of this example, let’s use 15%. If that’s the case, you are willing to risk $15,000 on this play…

LEAP Call Options, a Proven Technique… And a Good Night’s Sleep

Now let’s look at how LEAPS can put you in a position of profits - and easy sleeping.

If you sold your stock position and bought the Exxon $50 LEAPS that expire in just over two years, you would spend about $10,000. You just took $90,000 off the table.

That $90,000 is in a money market account earning 2% a year, bringing in about $3,600 over two years. That $3,600 reduces your cost in your Exxon LEAP options position to around $6,400.

If Exxon goes to $65, then you would make $10 on each contract of Exxon, or about $20,000 (300%) profit on your $6,400 investment.

So, let’s review…

  • Hold the stock and make $30,000 on $100,000 invested…
  • OR hold the LEAP call options and make $20,000 on $6,400 invested…

If this type of investing appeals to you, then it is time to scour your portfolio for possible swap trades. This kind of technique will become increasingly profitable should the market continue to recover into the new year…

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • For a definition of “LEAPS” or “call options“, visit our Smart Profits Glossary.
  • If you want ultra-timely recommendations and ideas, check out my fast-paced trading service that will steer you toward the best LEAP call options trades available today. For more information about how volatility affects us as option traders, check out Smart Profits #107 - Market Volatility: How to Pay $27 for a $50 Stock.

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Covered Calls Strategy

November 8, 2004

The Smart Profits Report: Issue #158
Monday, November 8, 2004

Covered Calls Strategy: The “Big Daddy” of Options
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

I have been invited to speak to my daughter’s fifth-grade class in a couple of weeks. As a professional options trader and speaker, you would think this would be a piece of cake. But I must admit: I am petrified.

What do I tell a group of 10-year-olds about options strategies and investing? Should I go ahead and get them up to speed on the latest covered calls strategy or tech straddle play I’m researching?

Should I make it a good-versus-evil speech about the evil options market makers trying to scalp every last penny from the good, unsuspecting investors? Or to go more in the Marvel direction, I could make it seem like a superhero adventure with Elliot Spitzer donning a cape and mask, swinging through the options pits zapping traders who cross the line…

In any event, I am sure I will be in a room with a doctor, a police office and a fireman. Hmm… Who do you think will be the most popular: the geek with a Wall Street Journal or the guy with a holstered Glock and a shiny star?

I think I will keep it simple and talk about money and why they should take money seriously.

Money Is Simple… Making Money Can Be More Complex

Most kids I have met are clueless when it comes to handling or understanding money. I think if you took away the “change” function on cash registers, most of the operators would not be able to calculate the change for you. Heck, some have a tough time even with the answer blinking in front of them.

I have vowed that my kids will learn about the power of investing and by the time they graduate from high school, they will have learned about compounding, saving, spending, credit, record keeping and the like.

(Then I think back to what I knew when I graduated from high school… Maybe I will be happy if they just understand that they can’t ask Daddy for money whenever they want to buy something!)

Money is not a complex issue. What’s complex is understanding how money works.

When I discuss options, for example - especially long-term options, or LEAPS - people’s eyes light up when they see how they can minimize their “money” risk by learning about a new way to invest. How is it possible that there is an instrument in the market that is actually ON YOUR SIDE?

Well, options ARE THAT instrument, and learning how to USE options, especially covered calls can be extremely rewarding to your portfolio.

How You Can Bat .700 With Your Stock Investments

I remember having dinner in Colorado with an experienced options trader from a big-name firm. He spent the whole evening ridiculing and trying to shoot holes in the system because he just did not get it. Finally, in a huff, he left the table.

The issue he had problems with was commissions. As a commissioned salesperson he could not see that online trading reduces transaction costs enough to provide my readers with a relatively safe and easy way to make 1% to 2% per month. What really bothered him, and what many people still don’t understand, is that making 1% to 2% a month on a regular basis IS a big deal… to me, anyway.

When I first employed my deep-in-the-money covered call strategy, I was nervous. Would it work as planned? Theory is always good, but practice is the real test.

Covered Calls Strategy - A Win Rate of 70%

Well, it worked, and six years later we are batting better than .700. (A good friend of mine who I trust, Dr. Steve Sjuggerud, recently wrote that most great traders have a win rate of about 33% - so 70% is truly remarkable.)

My personal portfolio is invested using this system to the tune of 60% to 70%. That is how much I believe in the system. I can remember the early days when most professionals, even other editors at my company, could not embrace the system because they could not believe how easily it worked. What was the trick? There is no trick. You just have to take some time to understand what an option is.

But back to more important matters… That speech to a room full of fifth-graders.

I would love to have some input from YOU about a topic that would be interesting for fifth-graders… One that involves money and investing.

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • To learn more about my high-end trading service, The Income Trader: A Covered Call Strategy, click here.

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The Short Squeeze

November 5, 2004

The Smart Profits Report: Issue #157
Friday, November 5, 2004

The Short Squeeze: Don’t Get Squeezed When Investors Rush to Sell!
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

The squeeze… it’s what shareholders and officers of many publicly traded companies dream about, sometimes in nightmares.

After I mentioned the short squeeze in the TravelZoo article recently, several readers e-mailed me to ask for more details. The questions weren’t about TravelZoo; they were about the squeeze thing.

What exactly, they wanted to know, is a short squeeze? How does it work? How do you use it?

Here goes: Companies that trade publicly have two components to their trading action, buying and selling. When you buy a share you are long. When you sell a share - that you don’t own - then you are short.

Usually, selling short is a bearish trade. And short sells can make you a lot of money quickly when a company’s stock tanks… But you’re also putting yourself at great risk, because you can lose MUCH more than your original investment.

Let me explain…

When Bad Stocks Soar, You Get Squeezed

You go short by selling shares into the market before you buy them, with the anticipation that you will be able to buy back the shares at a lower price to “cover” your position. The shares that you sold short were borrowed from another shareholder who was long. This is an internal transaction that the brokerage firm you use will handle for you. So, when you buy the stock to cover the shares, you are actually replacing the shares that you borrowed.

If the shares fall in price, you will make a profit because the shares that you bought back to replace the ones that you borrowed are cheaper. The difference in price is your profits. Just like buying stocks - or “going long” - you buy low and sell high, only you do it in reverse order. That’s if all goes according to plan and the share price drops.

If it doesn’t, and the price jumps up on you, the market may be setting up for a short squeeze.

Anatomy of a Short Squeeze

A short squeeze occurs when the price of the stock moves up sharply, which puts all the short sellers in a losing position, faced with the prospect of mounting losses. The more people who went short, the more severe the reaction will be.

In a panic, they all pile into the stock at the same time, trying to buy back the shares to cover their trades and get out of them. This buying demand and the lack of sellers drive up the price exponentially.

Is running into a short squeeze a great danger? Not really, and it’s one you never have to face even if you do want to go short.

First, a short squeeze will ONLY happen if you are dealing with stocks that have very small floats. The float refers to the number of shares that are trading in the public markets. While a company may have a lot of shares outstanding, a lot of those shares may be held by insiders or investors who are not interested in selling, thereby drying up the supply. And second, there’s a way around the whole problem - with options.

Short Squeezing Without the Unlimited Risk

The short squeeze is one of the most exciting “plays” in the market. But it can cause unlimited losses for short-sellers. In theory, a short squeeze could lose you many times what you have invested.

For example, let’s say you shorted 1,000 shares of TravelZoo at $5 - a price it has seen within the last year. When you shorted the shares you got $5,000, but you are still on the hook to replace those shares eventually. Today TravelZoo is at $86. If you had not covered until today, you would lose $81,000 on your $5,000 “investment.” OUCH!

The solution is simple: Buy put options, which give you the right BUT NOT THE OBLIGATION to sell shares of a stock. If the stock falls, you will make money on your put. If it doesn’t, your loss is limited to the cost of the put and not a penny more. I’ll show you with a hypothetical case… what would have been possible if TravelZoo had had options available.

Another Look at the TravelZoo Example

Let’s say a put on TravelZoo was outrageously expensive, 15% of the share price, or 75 cents a share when TravelZoo was at $5. A put contract for 1,000 shares would still cost you only $750 - and if you were wrong, as you would have been, that was the most you could have lost. Losing $750 is a lot smarter than losing $81,000!

Not many stocks go up as much as TravelZoo. It’s up more than 1,500% in the last year. And it keeps rising because of a massive short squeeze. TravelZoo certainly isn’t worth the $90 a share it commands now. It was questionable at $15 a share. No wonder everyone was so eager to short the stock. But they made a mistake you don’t have to. The solution is simple…

If there are no put options available, as was the case with TravelZoo until recently -STAY AWAY!

Good Trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • Travelzoo was poised on the brink of disaster. It plunged $14 per share the other day, though it had soared to well over $70 before the big crash… I knew it would likely nosedive, I was powerless to act. Why? Because there were no bleeping options available. I could not buy a put if my life depended on it, find out more in Smart Profits #148, Travelzoo Stock: My Kingdom for an Option.
  • The Travelzoo conundrum does offer something: two ideas that are critical to profiting from options: Going with the market instead of emotions when timing your trades and applying good theoretical ideas like shorting TZOO with puts to another trade that could generate even more money, check out Smart Profits #146, Timing Your Trades: Two Ways to Expand Your Thinking And Your Profits.

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Options Trading Books

November 3, 2004

The Smart Profits Report: Issue #156
Wednesday, November 03, 2004

Options Trading Books: The Only Realistic Options Book at Barnes & Noble
By Mt. Vernon Research Team

They joke in my family, “Please don’t give her a book on brain surgery!” I’m a reader and a firm believer that if anyone is skillful at something they can pass it on… and if they can write, they can pass it on in a book… I learned to knit, to do some light auto body work, cook, assemble a wedding cake, cut a perfect miter and build a Parson’s table, fix a leaky faucet, replace a floor, hypnotize myself, meditate, read Spanish, arrange flowers… you name it… from books.

I even learned a lot about investing from books too. But I didn’t learn much of anything about options from any of the options trading books I’ve ever read. Of all the endeavors humans assay, options must be unique in having so many worthless books and so few passable ones. Even when you find a few good pages here and there, bad pages usually surround them.

When anyone asks me what book to read to learn about options I say, “Please don’t.”

The One Options Book I Recommend Without Caveat

But there is one book I would recommend to every options trader, whether you are a beginner or an old hand. It is High Probability Trading by Marcel Link (see the Cribsheet for more info).

Get it. Read it.

Link is an experienced trader and he’s had a lot of contact with beginning option traders - including people who have decided to quit their day jobs to become instant millionaires “the easy way, with options.” He answers the strategic questions that new traders either ask or should ask.

This options trading book is solid from start to finish, but you don’t have to use the whole book - the meat in the first half of the book will put you light years ahead of most traders.

A Dose of Reality Improves Your Odds

What’s the most valuable reason to own this options trading book? Link’s realism.

The one thing a new trader does not know until he experiences it and learns the hard way is what to expect when trading options. Because he doesn’t know what to expect, the typical new trader doesn’t have the right goals and - more important - he doesn’t have a strategy for getting out of trouble, let alone knowing when to cash in.

Link will help you know what to do when you start trading options for real.

For example: What do you do when…

  • Your option is up 40%… Do you hang on for more or take the money and run?
  • You lost on three trades in a row… Do you change your whole system or is that normal?
  • The stock made a big move in the wrong direction… Was that a warning to bail out or was it just a normal blip?

This Book Will Give You Something Essential: A System

Even after years of trading I can tell you that the options market presents many such dilemmas every single day.

Along with questions like those above, I often hear ones like: Can you really make $10,000 a month? How much should you put on one trade?

Yes, Link’s book will help you answer some of these “newbie” questions - and it’s only natural that people should want these questions answered.

But in the end, it gives you something more than that: It gives you the tools to build your own options system. As Karim has said many times: To win at options, you must create a high probability for success. And the only way to do that is with a system.

Good Investing,

Mt. Vernon Research Team

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Today’s Smart Profits Cribsheet

  • If you can’t find High Probability Trading by Marcel Link in your bookstore, you can order it online at Amazon. Quality books on options (which you don’t want to read anyway, since they are mostly formulas and jargon) cost $70 and up.
  • Today we talked a little about the importance of having a system when you trade options. If you’d rather use a proven system developed by a master options trader with a success rate of 70%-plus, check out Karim Rahemtulla’s Income Trader: A Covered Call System, or his LEAPS Option Trader.

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