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The Market Volatility Index

December 22, 2006

The Smart Profits Report: Issue #381
Friday, December 22, 2006

The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options
By Mark Whistler
Small-Cap Specialist, Mt. Vernon Research

Some of the savviest Wall Street investors turn to this gauge for market guidance. They use it to find out whether the overall trading mood is fearful or complacent.

But while many see this gauge as a very useful tool in determining whether to adopt a bullish or bearish stance, few actually understand what it means in relation to options.

I’m talking about the Market Volatility Index (VIX) - a measurement of two of the most important market sentiments: Fear and complacency in the market, as judged by S&P 500 stock index options.

And today, I’m going to “demystify” the VIX, so that it’ll become a useful tool in your trading repertoire, too.

Interpreting The Market Volatility Index Movement

First, it’s important to know that the VIX is traded as both futures and options on the Chicago Board Options Exchange (CBOE), and trades inversely to the markets. So when the market is going up, the VIX should be falling and vice-versa.

Simply put, here’s the basic equation:

  • When The VIX Is Falling: This implies that investors are complacent, and not worried about a market correction.
  • When The VIX Is Rising: This means investors are worried about a selloff, usually during times of economic concern.

Let me give you an example: In 1998, just before the infamous dotcom bomb, the Market Volatility Index was trading near 50 - an abnormally high level. As the VIX cooled off in the following years, the major indexes recovered from their lows. And right now, the VIX is trading near 20-year lows (just over 10), while the major stock indexes are trading close to 52-week highs.

When analyzing the Market Volatility Index, it’s important to look for “capitulation” points that indicate a looming trend reversal for the major indexes.

What you basically need to remember is this:

  • When the VIX gets too low, it means investors are almost overly-complacent, and the major indexes could be on the verge of a surprising and large selloff.
  • Conversely, when the VIX travels too high (in the 40-50 range), the index is telling us that investors are very fearful of market conditions, that stocks have declined substantially - and a short squeeze could be in the cards.

But there’s more to the story…

Paying Too Much For Stock Options? Check The VIX For Clues

The Market Volatility Index also lets us see whether options premiums will be cheap, or expensive. As a definition, volatility is a measurement of how rapidly stocks can fluctuate over a given period. And high volatility means more expensive options.

Again, here’s a quick guide to what you need to know:

  • When Volatility Is Low: This means investors do not believe stocks will fluctuate dramatically (i.e. they are complacent). Thus, options premiums should also be low.
  • When Volatility Is Elevated: Wall Street perceives a significant risk of large price swings, causing options premiums to become pricier.

Traders who sell options are pretty darn savvy bunch. If there is a greater risk that a stock will move through a strike price, they will demand more premium for the additional risk of writing the options.

What’s Happening In The Market Volatility Index Now?

The VIX is currently trading at $10.93 - a historically low reading by any measure. This is important for two reasons:

The VIX 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. While this certainly isn’t impossible, it’s fairly unlikely. Thus, those who patiently follow volatility closely, are more than likely waiting for the VIX to jump up before initiating fresh long positions in stocks.

After all, “When the VIX is in the sky, the bulls are looking to buy.” Why? Because in theory, when the Market Volatility Index is elevated, stocks should be cheaper. But right now, stocks are not discounted relative to the large run over the past few months. And again, for the major indexes to continue traveling higher (without taking a breather first), the VIX would have fall below 10 - something that’s probably not going to happen.

Many who covet volatility attentively are contending that at current “overly-complacent” levels, a sharp pullback is looming. And while this may be true, it’s almost impossible to predict the exact time when the selloff will commence. However, should the Market Volatility Index make a dramatic spike upwards, it’s probably a good idea to make sure all long stock positions are protected with trailing stop orders.

Using The VIX To Straddle And Strangle

When the Market Volatility Index is low, premiums should be low, too. And in the options world, low premiums are great for straddle and strangle positions. These techniques are best used when you’re unsure of which direction the market will take. Straddles and strangles can relieve you from having to choose the direction.

Here’s a refresher on straddles and strangles:

  • A straddle is buying calls and puts that have the same expiration month.
  • A strangle is buying calls and puts that have different expiration months.

However, straddles and strangles are not without risk. Low volatility also implies that the stock might not move at all, causing both puts and calls to expire worthless. In low volatility, sideways markets, time decay can be a killer.

In addition, even if the stock does move “in-the-money” on one side of the trade, if it only moves a small amount, the losing side of the trade can outweigh any gains from the winner. One way around this issue, however, is to find high-beta stocks, thus indicating greater volatility to the broader market.

Fear, Complacency, And The Dreaded Sideways Slide

Let’s wrap this up…

Essentially, the Market Volatility Index is a measurement of fear and complacency, but the index can also give us guidance as to whether option premiums will be higher or lower. What’s more, when the VIX is at extreme levels, it’s important to keep a close eye out for a reversal in the major indexes.

And finally, during periods of low volatility (like now), straddles and strangles can be an effective strategy - so long as the stock or market does not travel sideways.

In all, we see that the Market Volatility Index is not just a “guide to fear,” but it can also help clue us in to what type of option strategy might work well at that time.

Good investing,

Mark Whistler

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Today’s Smart Profits Cribsheet

  • If you think market volatility always has to work against you… think again! Mt. Vernon Research Investment Director Karim Rahemtulla explains how and why market volatility is actually your friend when it comes to successful, profitable investing in Smart Profits #107, Market Volatility: How to Pay $27 for a $50 Stock.
  • In the issue above I mention the possible creation of a “new paradigm” within the Market Volatility Index. Investment Director Karim Rahemtulla offers a detailed options strategy for protecting your portfolio against a new investment paradigm that could pose a threat to your wealth in Smart Profits #375, Option Strategies: The Solution To The Most Dangerous Investment Paradigm Today.

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Stock Market Index Trading Strategy

December 21, 2006

The Smart Profits Report: Issue #380
Thursday, December 21, 2006

Stock Market Index Trading Strategy: A 2-Step Approach To A Successful Trading System
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

Everyone loves getting gifts. Sure, we all know some old curmudgeon who has become jaded by the season. After all, Charles Dickens didn’t invent Scrooge out of thin air! But I’m talking about the part of us that’s still like a little kid and gets excited about receiving a gift. When we get one, the moment is “pregnant with possibility.” It could be anything. It puts us in a hopeful state. The hope that it’s what we want and will thrill us.

Then we open the package. And the moment that was just filled with the unknown turns into a finite reality. It becomes something. Hope becomes certainty. Expecting becomes knowing. And what was once our heart’s desire can’t help but degrade into a slight disappointment in that transition. I’ve seen this in my children and in adults, as well.

And it happens in the investment world, too - and is one of the biggest trading problems that I believe we all face, whether it’s within a stock market index trading strategy or a trading system. So what do we do when tough reality sets in and our exciting “anythings” get turned into mundane “somethings?”

How Investors Get Burned by “Christmas Present Syndrome”

Hundreds of people have shared with me their feelings of moving from excitement and anticipation to disappointment once they started looking at both the promise and the flaws of any given stock market index trading strategy or investment system.

I call this the “Christmas Present Syndrome” because whether we’re unwrapping a gift or digging into a new trading system or idea, we’re confronted with a difficult emotional and intellectual transition: We move from a world filled with hope and unlimited expectation into a world of definitive knowledge, filled with the reality that flaws exist and that it may not work as well as it did on TV.

During the holidays, having our gifts turn from eager possibility into harsh reality can cause a bit of post-celebration disappointment. With a trading system, it can cause us to toss out good, useful ideas.

But wait! There are steps you can take to prepare and objectively evaluate that new stock market index trading strategy or trading system! Here’s how the top traders that I know and work with approach new investment ideas and strategies:

Set Expectations For Your Stock Market Index Trading Strategy

Setting expectations for your stock market index trading strategy or trading system is one of the most overlooked aspects of the process of developing a trading plan. And managing your expectations is really a very concrete exercise.

It all begins with setting goals for your trading. Developing your trading goals and objectives is a critical first step - but also the part of trading that most people want to skip. While goal-setting can follow a prescribed format, it is inherently personal (no one else can tell you what’s right for you). And it requires thought. In my good friend Dr. Van Tharp’s first book Trade Your Way to Financial Freedom, Tom Basso (a successful money manager and a market wizard himself) said that when developing a system, one should spend 50% of the time on determining objectives.

Let that sink in for a moment. If you’re serious about managing your expectations for your next trading system, spend some serious quality time on developing your trading objectives - before you take the proverbial wrapper off of that new trading idea.

Determine The Objective Of Your Trading System

The best tool I know of for setting goals or objectives for trading is also one of the cheapest! The third chapter of Trade Your Way to Financial Freedom (mentioned above) has a great objective-setting section for traders and investors.

If you don’t have this book on your shelf, check out the Smart Options Cribsheet below to see how to get a copy of the new revised edition. Go through Chapter 3 in intimate detail. I obviously can’t go into the depth that the book provides in this short space - but here are some areas to consider (while the book is in the mail!)

  • How much equity do you have to invest?
  • What percentage returns do you hope to achieve?
  • How much of your equity are you willing to risk (in the form of drawdowns) in order to achieve your rate of return?
  • How much time do you have available to spend on developing your stock market index trading strategy or system?
  • How many hours a week will you apply to execute the trading strategy?
  • How are you at working and strategizing by yourself? Do you need others to help in strategy development or for accountability and feedback?

Many traders and investors throw out great trading ideas when they discover the first imperfection within any trading system or strategy. Understanding that no stock market index trading trading strategy is perfect and knowing how to use a system within the framework of your overall objectives will be a great help as you evaluate any new investment strategy.

Great trading,

D. R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • Are you looking for an options strategy for protecting your portfolio against a new investment paradigm that could pose a threat to your wealth? Our Mt. Vernon Research Investment Director, Karim Rahemtulla, offers detailed strategies in Smart Profits #375, Option Strategies: The Solution To The Most Dangerous Investment Paradigm Today.
  • My good friend Dr. Van Tharp wrote what many people consider to be one of the best trading books of all time in his classic Trade Your Way To Financial Freedom. But he has now revised and updated this classic - and the second addition is now available. You’ll also see a section from yours truly on swing trading in the new edition. Every serious trader and investor should read this book! To get it - and six great bonuses, this link has more information.
  • Our resident expert in futures commodities, Lee Lowell, of Mt. Vernon Research gives a quick and easy breakdown of 3 different options strategies while seeking to answer the ultimate investment question in Smart Profits #377, Investing In Options: 3 Powerful Option Strategies That Make More Sense Than Stocks.

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The Chart of the Week


Google hit hard on 12/18/06's market pullback

Google (Nasdaq: GOOG) was hit hard during Monday’s market pullback. Any close below $453 (the gap support level) would be a severe warning sign.

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The Dogs of the Dow

December 18, 2006

The Smart Profits Report: Issue #379
Monday, December 18, 2006

The Dogs Of The Dow: Forget the January Effect & Kick Off 2007 With Some Rebound Profits
By Jim Stanton
Technical Analyst, Mt. Vernon Research

December brings many things to mind: Christmas, New Year, shopping and parties are the obvious ones. But as far as the financial markets are concerned, visions of sugar plums are replaced by end-of-year tax selling and stock market window dressing. And while some people often consider the period to be quite uneventful, all you need do is take a look at what going on right now.

The net result of the remarkable July-December rally is that all three major stock market indexes are currently trading at highs. The Dow hit a new record high of 12,486.30 on Friday, with the S&P 500 following suit and setting a six-year high of 1,431.63. The Nasdaq Composite also bounced to a multiyear high of 2,470.02. Many of the smaller-cap indexes are also at new all-time highs. And all this despite a lack of truly explosive economic news.

What this does is present some pretty attractive possibilities for you - particularly with the Dow Industrials - because it puts additional pressure on stocks that have underperformed for the year and, in the process, creates some good buying opportunities in high quality stocks. There are many different ways that you can search for these artificially depressed stocks… but one tried-and-tested method is by buying the “Dogs of the Dow.” So let’s take a look at how this strategy works, and see how you can kick off 2007 in style by bagging some “rebound profits.”

Ring In The New Year With Some Dow Dogs

While many investors have heard about the Dogs of the Dow theory before… some don’t actually know how well this buying strategy has performed over the past 30 years. And this is the perfect time of year to familiarize yourself with the mechanics of this strategy and how it works.

It’s really a very straightforward method. After the stock market closes on the last trading day of the year, you simply select the 10 stocks within the 30 that make up the Dow Jones Industrial Average that have the highest dividend yield (Dividend yield is the annual dividend payout of a stock divided by its share price). Then just call your broker, or go to your online account, and invest an equal dollar amount in each of these 10 high-yielding stocks. You should hold these 10 Dogs of the Dow for one year and repeat the process at the end of each year.

The Dogs Of The Dow Track Record: 17% A Year

So how has this Dogs of the Dow strategy performed over recent years?

According to an article in the July 1996 issue of U.S. News and World Report, employing this technique at the end of each year would have given you a 17.7% average annual return since 1973.

That’s not bad considering the overall return of the Dow Jones Industrial Average during that same period was 11.9%.

Profits And Safety Wrapped Up In 10 Stocks A Year

Moreover, not only has investing in the Dogs of the Dow been historically more profitable than buying all 30 Dow stocks, it’s also been safer. I’ll give you a few examples…

  • During 1973-1974, the Dow Industrials lost 33%, while the Dogs of the Dow actually gained 2.6%.
  • 1977 and 1981 were two more years in which the Dow Industrials lost ground, while the Dogs gained.
  • During the difficult bear market years of 2000-2002, the overall Dow Industrials shed more than 23% of its value. But had you followed the Dogs of the Dow strategy instead, your loss would have totaled less than 8%.

There have been some years when the Dogs have underperformed. But remember… this is a long-term strategy that should be implemented every year. And recent history has proved this:

  • During the tech bubble of the late 1990s, the high-dividend Dogs of the Dow stocks were up 28.6% in 1996… up 22.2% in 1997… up 10.7% in 1998… and up 4.0% in 1999.
  • During the brutal bear market at the turn of the century, the Dogs of the Dow were up 6.4% in 2000… down 4.9% in 2001… and down 8.9% in 2002. Losses, yes. But they were still much less than the overall Dow, S&P 500, and Nasdaq.
  • In 2003, the Dogs of the Dow gained 28.7% and made new, all-time highs - despite the fallout from the massive bear market of 2000-2002.
  • In 2004, the Dogs of the Dow notched up a 4.4% gain.

The Dogs of the Dow Outperforming the Dow Industrials

The fact is… the Dogs of the Dow have outperformed the Dow Industrials over the long-term. And although we don’t yet know what the new Congress will do concerning current tax law, the favorable 15% tax on dividends enacted by the Bush administration is another powerful incentive to seek out stocks that pay generous dividends - and have the capacity to maintain their dividend payouts over time.

And to get the most from the strategy, it’s important to employ it properly by holding all, or most, of the relevant stocks, because you never know which ones could be the big winners.

For example, 2005 was one of the few times that the broader Dow outperformed the Dogs - but that was mostly due to a 51% collapse in GM. But if you stayed patient and implemented the strategy again for 2006, you’d see that GM corrected and is the biggest winner this year.

Don’t Want Dogs? Try Puppies Instead

If you don’t have the capital to invest in the 10 Dogs of the Dow, fear not. There is a similar strategy called “Puppies of the Dow.”

The only difference between the two is that you take the ten highest-yielding Dogs of the Dow stocks - but instead of investing in them all, the Puppies of the Dow theory requires that you invest equal dollar amounts in just the five lowest priced stocks within the group.

According to the same U.S. News and World Report I referenced above, this strategy even outperformed the Dogs of the Dow, with an annual return of almost 21% between 1973 and 1996.

Forget The “January Effect”… Follow The Pack Of Dogs Instead

Around this time of year, you’ll begin to hear more and more mentions of the “January Effect.” Simply put, this phrase refers to an increase in share prices throughout January, as investors go on the hunt for bargains in the stocks that sold off at the end of December, due to investors creating a tax loss in order to offset any capital gains.

But, since most of Wall Street has become aware of this anomaly (and because many investors now trade with tax-protected retirement accounts), it seems to occur more so now in December than January. That’s why implementing the Dogs of the Dow strategy 2-4 weeks before the end of the year may enhance your return even more.

The Dogs of the Dow or Puppies of the Dow?

Right now, I’m in the process of researching whether the Dogs or Puppies of the Dow would work even better during the best six months of the year (November-April) and avoiding the worst 6 months (May-October). If the results are noteworthy, I’ll update you in a future Smart Profits issue.

So this holiday season, you might want to think about adding the Dogs of the Dow or Puppies of the Dow to your investment strategy. The track record over the past 25 years or so speaks for itself, but do bear in mind that there have also been periods in which buying the Dogs of the Dow has under-performed the Dow as a whole. You should be aware that this is a long-term investment strategy and not expect the Dogs to outperform the broader Dow every year.

Good Trading,

Jim Stanton

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Today’s Smart Profits Cribsheet

  • Now that you know about the Dogs of the Dow, enhance your education further by learning about one of the oldest, most important, and most reliable concepts in technical analysis - Dow Theory. I covered it extensively in Smart Profits #362, Dow Theory: The Most Important And Powerful Concept In Technical Analysis.
  • In the best of all possible worlds, as traders and investors, we’d now like to know two things: “Which direction will the stock indexes head from here?” & “Where would be the best place to invest?” One great way to get some insight into those questions is to check out Smart Profits #376, 2006 Stock Index Comparison: Here’s How To Play Both Correction or Breakout Scenarios.

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Sentiment Analysis

December 13, 2006

The Smart Profits Report: Issue #378
Wednesday, December 13, 2006

Sentiment Analysis: Incorporating Contrarian Investing in Your Trading & Financial Endeavors
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

The editorial staff of one of the country’s most prestigious newsletters has just taken me out back to the proverbial woodshed. And for a sound beating at that.

“D.R., are you sure about this analysis that the dollar is going up? Every other analyst that we’ve talked to says the dollar is going to crash. This is really going against the crowd.” “But I thought this was a contrarian newsletter,” I protested. “A crashing dollar is contrarian,” shot back the reply. “Apparently not today,” I thought to myself.

The above discussion is largely fictionalized to help bring home a point. You see, 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.

Let’s take a look at one of the most basic tools of sentiment analysis - consensus opinion - and how you can use it today to protect or build your own portfolio.

The Dollar and Sentiment Analysis

On December 5, the dollar made an 18-month low.

Dollar sentiment was (and still is) at ridiculously low levels. Every talking head and analyst in the land has been kicking the good old greenback square in the ribs.

In fact, The Economist, that venerable British weekly, had a picture on its cover showing George Washington from the U.S. dollar bill looking down with his mouth agape, accompanied by the headline: “The falling dollar.”

So when I did my analysis of where the dollar is likely headed, two things stuck out:

  • Everybody and his brother thinks the dollar is going down.
  • We are less than 5% away from the all-time lows established in the trade-weighted dollar index.

Anytime we get sensational gloom-and-doom news magazine covers, together with overwhelming consensus opinion, I get excited about market turns. Because history shows us that when everyone thinks a market can only go one way, it usually heads the other way - and in a hurry.

The Power of Contrarian Investing

Since the aforementioned discussion on the dollar, it has risen almost 2%. This has prompted headlines like: “Euro Collapses In Corrective Selloff.” The power of contrarian investing and trading shows off again.

Sentiment analysis is a fairly blunt tool when it comes to timing market turns (though it may have nailed a turn in the dollar pretty closely). However, it is one of the most powerful predictive tools available. If you’d like to learn more about contrarian investing and the basic precepts of this facet of sentiment analysis, please see the Smart Profits Cribsheet below.

So how can you incorporate contrarian investing in your trading and investing activities? Here are some guidelines:

  • Don’t start selling out of your positions just because consensus opinions start to move to extremes and news weeklies start to run cover stories. BUT… these useful indicators should prompt you to make sure your stops are in the right place and that you take extra care in opening new positions.
  • Remember that consensus opinion is generally a poor timing tool. Consensus can gel for quite some time before the smart money takes over. Use good technical and price analysis tools to sharpen your timing of market tops and bottoms. It’s best to wait for the price to start moving in your favor, instead of trying (or hoping) to pick a top or bottom.

Good Trading,

D.R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • I also talked about the use of sentiment analysis along with technical charting of the developments of crude oil prices in Smart Profits #329, The Future of Crude Oil Prices: How a New Saudi Development is Bearish for Oil Prices.
  • Two classic “must-read” books for all traders and investors (not just contrarians) are: “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay and “Devil Take the Hindmost: A History of Financial Speculation” by Edward Chancellor. You’ve got just enough time to stick them on your Christmas gift list!
  • Good technical and sentiment analysis will always be trumped by big news in the short term. If you’d like to take a look at some reasons why you might want to consider adding an “early exit” contingency to your trading or investing plan, check out Smart Profits #332, Stop Loss: Three Reasons to Get Out of a Trade Before it Hits Your Trailing Stop.

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The Chart of the Week

Level 3 Communications vs. 3 technical indicators

Level 3 Communications (Nasdaq: LVLT) has three tough technical indicators working against it going into today’s trading session:

  • It tested a major resistance level at $6 on Monday and was rejected.
  • The stock finished Monday’s session weakly.
  • Momentum is down sin the last test of the $6 area. Look for a pullback from here.

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Investing In Options

December 8, 2006

The Smart Profits Report: Issue #377
Friday, December 8, 2006

Investing In Options: 3 Powerful Option Strategies That Make More Sense Than Stocks
By Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research

As a professional investor and someone who spent six years as a market maker on the floor of the New York Mercantile Exchange, there’s one question that my friends and associates seeking the ultimate investment ask me all the time:

“What’s the best strategy you recommend for investing in options?”

Alas, I wish there was an easy answer… but there isn’t. The truth is… no single options strategy can be perfect for every situation because each person’s outlook and financial situation is different.

But right off the bat, there are three great reasons why it makes sense to invest in options instead of stocks:

  • Lower upfront cost
  • Less downside risk
  • Greater leverage

After all, why pay full price for a stock when you can spend half as much money and get all the same rewards? The question is… how do we do that?

Here’s a quick and easy breakdown of three different option strategies, which will cover most of the bases.

Investing Deep In The Money

I’m talking about deep-in-the-money options. And your first job is to buy and invest in options that have a high delta. Delta is simply a figure that tells you how much the option price will change in relation to a corresponding move in the underlying stock. Delta values range from 0 - 100, so you want to buy an option with at least a 90 or greater delta.

Let’s take a look at an options chain, showing Walt Disney Co (NYSE: DIS) calls that expire in April 2007:

Option chain DIS calls that expire in April 2007

As you can see, the “Delta” column shows the delta for each option strike in the chain. And although there are quite a few that have a 100 delta (the highest you can get), we like to choose the one whose breakeven is closest to the current price of the stock.

Since DIS closed at $34.10, it would cost $3,410 to buy 100 shares of stock. But we can buy one April 2007 $20 call for $14.10 (splitting the bid/ask prices) and only pay $1,410 for the same play. This is a deep-in-the-money option, because the strike price is well below the underlying share price.

With a 100 delta, the $20 call will move point for point with the stock. The breakeven for the call is the same as the stock ($20 strike + $14.10 premium = $34.10). The bottom line here is that you spend $1,410 instead of $3,410 ($2,000 less!) and reap the same rewards.

Far Out Options, Man

Far out-of-the-money options, that is. This option investment strategy is the opposite of in-the-money - and is one for gamblers and high speculators. Buying deep-out-of-the-money options gives you the ultimate leverage. You pay pennies on the dollar for the options, and if your market prediction is right, you can hit a grand-slam-mac-daddy of a winner.

Let me give you an example, using the same Disney options chain above:

You can buy the April 2007 $45 call for $0.15 (splitting the bid/ask prices) and spend $15 per option while retaining the right to buy 100 shares of DIS at $40 per share if it ever gets profitable to do so.

Since one option contract represents 100 shares of stock, you could buy 227 call options for the same price that it would cost you to buy 100 underlying shares of DIS outright. (227 x $15 = $3,405). Your 227 option contracts are the equivalent of owning 22,700 shares.

If your prediction is right and DIS moves up to $40 by April 2007, you’ve got a whopper of a winner.

While the owner of the 100 shares would make $1,090 and see a tidy return on investment of 32% (1090/3410 = 32%), the owner of the 227 call option contracts would see a dollar gain of $110,095 and a ROI of an astounding 3,233%! ($110,095/3405 = 3,233%). That’s sweet!

Spread ‘Em With Credit Spreads

Credit spreads is one of my favorite strategies when investing in options - one where you become the option seller and receive the money from the buyer.

Specifically, you sell one option at a certain strike and buy another option at a different strike, forming an option spread. You just want to make sure the options are out-of-the-money, as that gives you extra cushion if your directional assessment is incorrect.

Let’s say you’re bearish on DIS and you think there’s no way that its share price will get above $35 and stay there by April 2007 option expiration.

You could sell the $35 call option for $1.25 (splitting the bid/ask prices) and simultaneously buy the $37.50 call for $0.50 (splitting bid/ask). This would give you a credit of $0.75 on the trade ($1.25 - $.50 = $0.75).

When you sell the more expensive option and buy the less expensive option, you get to receive that money from the spread buyer. So you get to receive $75 per option spread.

As long as DIS stays below $35 between now and April 2007 expiration, you’ll get to keep the $75. And the great thing is that DIS doesn’t even need to go lower to reap the reward. DIS only needs to stay below $35 the whole time, and you win.

If DIS ends up going above $35 by expiration, you can rest easy knowing that when you do a call spread, your risk is always capped and known ahead of time. In this case, the maximum risk will be $1.75 per spread. You calculate the maximum risk by subtracting the money you received by the width of the strikes. Since the spread is $2.50 wide ($37.50 - $35 = $2.50), you subtract $0.75 from it to give you your $1.75 risk. That means the most you can make on the spread is $0.75 and the most you can lose is $1.75.

The reason why I like this type of spread is because it gives us three ways to win:

  • If DIS goes lower, the strikes can expire worthless, allowing us to keep the whole $0.75.
  • If DIS stays at $34, the strikes will still expire worthless, allowing us to keep the money.
  • And even if DIS goes up slightly - let’s say to $34.85 - the strikes will expire worthless, allowing us to keep the money.

So there you have it: Three great ways to invest in options and play the options market - ways that truly allow you to use your money in a different fashion and put it to work for you.

Good trading,

Lee Lowell

P.S. There are two ways for you to grab much more information on these options strategies. First, I’ve talked about all of them in my upcoming debut book, “Get Rich With Options: Four Winning Strategies Straight from the Exchange Floor,” which will be available on January 8. We’ll send you more information about the book as its release date gets closer… so stay tuned.

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Today’s Smart Profits Cribsheet

  • Want to beat stocks and lower your risk at the same time? Simply dig deep to maximize your profits by harnessing the power of deep-in-the-money options - one of the most dynamic investing tools you’ll find anywhere. Let Investment Director Karim Rahemtulla fill you in on all the details in Smart Profits #180, Deep-In-The-Money Covered Calls: How to Beat Stocks with Less Risk.
  • I use the trading strategies I talked about in this issue regularly in my VIP commodity option advisory - The Triple-Zone Profits Trader. If you’d like to find out more about this service - one that recently chalked up gains of 32% and 30% on wheat put options and 26% on a natural gas credit spread find that information here.

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2006 Stock Index Comparison

December 7, 2006

The Smart Profits Report: Issue #376
Thursday, December 7, 2006

2006 Stock Index Comparison: Here’s How To Play Both Correction or Breakout Scenarios
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

As 2006 winds down, the year has given us three distinctive market moves:

  • A modest move up in the broader indexes from January to late May.
  • A very hard move down from May into mid-July.
  • A strong move up from July until now.

In the best of all possible worlds, as traders and investors, we’d now like to know two things: “Which direction will the stock indexes head from here?” & “Where would be the best place to invest?”

One great way to get some insight into those questions is to look at a 2006 stock index comparison and see if their relationships to each other is telling us anything. And right now, these indexes are sending some pretty clear signals.

A Dangerous Stock Index Game of “Follow the Leader”

Remember the playground game of “follow the leader?” It’s great fun - and is even more fun, depending on the how interesting and exciting the leader decides to act.

But have you ever been playing the game when the leader stopped leading? Chaos ensues, and everyone goes off to do their own thing. We’re on the verge of having the same thing happen in the equities markets.

Since the market bottomed in October of 2002, small-cap stocks (represented by the Russell 2000 Index) and the Nasdaq have led the upward charge. Here’s a chart showing the performance of each of the four major stock indexes, with their percentage returns since the October 2002 lows:

The 4 Major Indexes Performance since 2002

As you can see, small-caps and tech stocks have led an impressive multi-year rally. But the problem now is that their leadership is fading. And the chart below, showing this year’s activity in the four indexes, illustrates this well:

The 4 Major Indexes Perfomance in 2006

In the first upswing of the year, the Russell 2000 clearly outperformed all the other stock indexes, while the Nasdaq lagged slightly. During the midyear pullback, the Russell 2000, S&P 500 and Dow all gave back their earlier gains, while the Nasdaq endured a significantly bigger drop.

In the current rally, the small-caps have performed well, but have not outpaced the Dow or S&P by a significant amount. And the Nasdaq is still a significant laggard, because the hole it dug at midyear was so deep.

Playing Correction or Breakout Scenarios: Where To Place Your Bets

What insights can we gain from the recent movement of the major stock indexes?

  • Market Correction Scenario: If the market heads toward a correction, the best shorting opportunities will be in the tech sector and the small-caps. Easy shorts will be in the broad index ETFs: The QQQQ’s for the Nasdaq and the IWM for the Russell 2000.
  • Market Breakout Scenario: If the market breaks out to new highs, look for the Dow to continue to lead the way. However, the flight to quality stocks (meaning money moving away from the tech and small-cap sectors and into blue chips) seems to me to be more of a precursor to topping activity than an indication of an extended bull run.

Good Trading,

D.R. Barton Jr.

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Today’s Smart Profits Cribsheet

  • Just because the stock market is in the midst of an outstanding bullish upward run doesn’t mean you should join in this dangerous game of “follow the leader.” With little economic news driving such a strong run, it’s important to not get complacent. For my tips on how to spot the pullback signs - and what to do when the market inevitably corrects check out Smart Profits #365, Dow Jones Industrial Average: Don’t Be Fooled By The Dow’s New Highs & Beware The Pullback Signs.
  • Over 100 years ago, Charles Dow came up with the foundation for what would become the most powerful and commonly-used investment theories, the Dow Theory. But it was actually his understudy, Wall Street Journal editor William Hamilton, who refined and expanded the concept. For more information on this theory check out Smart Profits #362, Dow Theory: The Most Important And Powerful Concept in Technical Analysis.

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The Chart of the Week

Microsoft (MSFT) running into resistance at $30

Tech bellwether Microsoft (Nasdaq: MSFT) has run into whole number resistance at $30. The stock has enjoyed a great run and could be one of the forces of that pulls the indexes down if it doesn’t gain some traction here. You certainly wouldn’t want to put any new money to work here without a close above $30.

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Option Strategies

December 1, 2006

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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Stock Market Investing

November 29, 2006

The Smart Profits Report: Issue #374
Wednesday, November 29, 2006

Stock Market Investing: 3 Things Investors Must Master To Improve Their Trading
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

Poker champion Puggy Pearson once said: “Ain’t only three things to gamblin’: Knowing the 60/40 end of a proposition… money management… and knowing yourself.” Truer words were never spoken. And in fact, if you substitute the word “tradin’” for “gamblin’,” the same logic is true within stock market investing.

Back in 2004, I gave a keynote address at a conference, entitled, “The Three Pillars of Investment Success,” which were the same three areas listed in Puggy’s quote above. But Puggy puts it much more eloquently and succinctly than I did!

Pearson was a world champion poker player and the father of the modern poker tournament format. (So you have him to blame for the fact that you can’t turn on the TV today without seeing a No Limit game!)

He obviously understood the critical aspects of the game well - aspects that can also be applied to the investment world. There are three things investors must master - so let’s look at them today and see what specific things you can do in each area to improve your trading and investing profits now.

Master These 3 Core Concepts to Maximize Your Profits

In school, learning the “three R’s” has always formed the basis of a solid education. Until you learn readin’, writin’ and ‘rithmetic, there’s no use working on much else. The same is true in trading. These are the three most important core concepts. And it’s vital that you nail them in order to maximize your profits:

  • Know The 60/40 End Of The Proposition: You have to have an edge - but what exactly is your edge in each trade? So many people enter a trade or investment without knowing and understanding exactly why the odds are tilted in their favor. But if you know your edge, you can have the confidence to stick with an individual trade or with the trades within a system - even when things aren’t going well.

What To Do Today: Revisit your trading system or trading plan. Identify the market conditions where the system should be very strong, and the conditions where it might not perform so well. With this key information, you can approach every trade with more understanding and confidence.

  • Understand Your Money Management Strategy: You have to be able to protect your money long enough to realize your edge and take advantage of the times when you’re doing well. But many traders don’t have a money management strategy. They trade the same number of shares or contracts, regardless of the trade’s risk profile.

What To Do Today: Define a strategy that allows you to allocate your risk equally for each trade. This means that you trade more contracts or shares when the risk of loss per share is lower (meaning that your stop-loss point is closer) and trade fewer shares or contracts when the risk of loss per share or contract is higher.

  • Commit To Working On Your Personal Trading Psychology: Every great poker player, golfer and trader knows the link between knowing their personal psychology and performance. And great traders have always stated that 60% to 90% of trading is knowing and understanding your own psychology. But there are a huge number of people who believe that if they just find the right system or newsletter, then they won’t have to worry about anything else. Unfortunately, nothing could be further from the truth. Trading is such a counter-intuitive game that almost everyone who studies it concludes that success is 60% to 90% related to mastering your personal psychology.

What To Do Today: Find a good set of resources to help you develop your trading. My personal favorite is Dr. Van Tharp’s “Peak Performance Home Study Course,” find more information about this here.

Like every savvy speculator, we need to pay attention to each of the three key areas of trading in order to get the most from our investments.

Great trading,

D. R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • Once you’ve read over the three core concepts of investing, you might want to check out another issue I wrote about how to avoid three common investment mistakes in Smart Profits #371, Asset Protection Plan: How To Avoid 3 Mistakes That Could Cripple Your Investment Account.

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The Chart of the Week

Archer-Daniels-Midland (NYSE:ADM) vs. Corn Futures

This chart shows the relationship between 100 shares of Archer-Daniels-Midland (NYSE: ADM) and contract of corn futures. In August, I recommended shorting this ratio, because of the fervor over ethanol and how it was only being reflected in the distillers’ price, while the corn farmers were getting the short end of the stick.

As predicted, this ratio continues to drop - and is now reaching a stretch point on the other side. With the continued demand (artificially induced or not) for ethanol, I think this ratio is set for a bounce to the upside. My good friend and fellow Smart Profits Report analyst and commodities expert Lee Lowell agrees (at least on the corn side of the equation) and is bearish on corn for the short- to intermediate-term.

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Merger Mania

November 22, 2006

The Smart Profits Report: Issue #373
Wednesday, November 22, 2006

Merger Mania: 4 Ways To Profit From $60 Billion In 48 Hours
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

It took only a 48-hour period recently to rack up more than $60 billion dollars through buyouts from merger mania.

That’s a lot of scratch.

In fact, that’s more money than the total Gross Domestic Product (GDP) of 70% of the 181 countries that are members of the International Monetary Fund. Indeed, Borat’s “own” resource-rich Kazakhstan had a GDP of only $56 billion in 2005.

With so many companies getting bought and sold in a very short time, what does that mean for us as traders and investors? Plenty - including the fact that stock prices are racing higher, and investors are doing almost anything to chase higher yields.

Let’s look at the drivers for this recent spending spree and what we can do not only to protect ourselves, but profit, too.

M&A Feeding Frenzy: Partying Like It’s 1999…

In the leveraged buyout boom of the late 1980s, the driver was massive amounts of debt (in the form of high-yield or “junk” bonds). In 1999 and 2000, the bulk of merger and acquisition (M&A) activity was largely driven using tech companies own money - in the form of over-inflated stock shares.

But the 2006 M&A feeding frenzy features the best of both worlds. Stock prices are currently soaring, with the Dow at all-time highs and the broader indexes at multi-year highs. This gives companies high book values and financial leverage.

But the even bigger driver for this current round of buyouts is a chase for yields that would make former junk bond king Michael Milken proud.

There are really only two ways to buy something:

  • Using money you’ve made.
  • Or money you’ve borrowed.

And companies are borrowing money like never before.

The Wall Street Journal reports that at least two companies have made their buyouts with so-called “toggle” bonds - a type of bond that is every bit as risky as it sounds. They allow companies to borrow money on the premise that they can repay the debt either with company cash flow (the old fashioned way) or by issuing more bonds (the new fangled leverage-to-the-hilt way).

And the Wall Street Journal reported today that the value of leveraged buyouts in 2006 has already eclipsed total M&A value of 2000. All of the sudden, the current round of M&A activity starts to sound like a merger mania.

What to Do When Things Start To Look Too Rosy

When companies start buying others at a clip that outpaces the most torrid in history, we should take notice. And when they do it using leveraged borrowing strategies that would make even the most jaded home lender blush, I want to make sure I have a tight grip on my wallet - and my portfolio.

Here are a few things you can do to protect yourself - and even profit - from the current frenzy:

  • Be Very Careful Looking For a Top:

If you think things are getting a bit too heated up and that the market has to correct down, I’m with you. BUT… don’t get too excited about selling positions or jumping on the short side just yet. The lessons of past tops show us that the market can remain overheated (and even overbought) for a long time. There are some good cycle analysis reasons to look for a reversal in the next few days. However, you need some significant price moves off of these tops to trigger any portfolio rebalancing.

  • Remember: Price Moves Are Over-Exaggerated At Stretch Points:

I wouldn’t be at all surprised to see a blow-off top during this current move. The market has enjoyed consistent strength for six weeks… M&A activated is reaching a fever pitch… and retail investors may still get to frenzied participation. When things heat up like this, we can reasonably expect to see some wild moves - both up and down - before the market decides whether it will continue its march upward or take a plunge.

  • Don’t Over-Indulge In High-Yield Instruments:

Having some exposure to high-yield instruments (a.k.a. junk bonds) is a good practice - especially when there is so much capacity in the market at present. HOWEVER… remember that things ended badly, and suddenly, when the bottom dropped out of the junk bond market at the end of boom in the 1980s. Moderation is the key word here - don’t stay overexposed in this area.

  • Keep An Eye On Investment Banks:

Who consistently has the most to gain when M&A activity is hot? The answer is the investment banks that broker deals, handle due diligence, etc. So keep an eye on Goldman Sachs, Lehman, JP Morgan Chase and the other top players - because trouble in the M&A world will be quickly reflected in their share prices. Until then, look for their prices to continue strengthening.

Frothy merger & acquisition activity is a both a result of strong markets - and an early indicator of over-extension. But make sure you look for confirmation from technical analysis indicators and other market activity before deciding that the market has topped out.

Good Trading,

D.R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • While a soaring stock indexes and frenetic M&A activity certainly shows that the market is vibrant and strong, this is the time to stay alert - because corrective shocks can, and often do, occur quickly. In an earlier issue I wrote about how when the market is awash with good news, it’s often better to “sell at the sound of trumpets.” Check out Smart Profits #335, The Stock Market’s Reaction to Good News: Why It’s Best to Sell at the Sound of the Trumpets.

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The Chart of the Week

Palm One (PALM) signals between up & downside

Palm One (NASDAQ:PALM) is being sued by NTP - the same folks that took on RIMM (and the Blackberry device fueled by their technology). But RIMM came out smelling like roses, and has notched up new highs for weeks now. With a gadget-hungry society heading into the Christmas gift-giving season, it’s prudent to buy Palm on any pullbacks to its strong support level at the $14 area. A break to gap resistance just above $17 should signal upside for Palm.

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Gasoline Prices

November 17, 2006

The Smart Profits Report: Issue #372
Friday, November 17, 2006

Gasoline Prices: How To Win Big In The “Ethanol Decade”
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

This time next week, the majority of Americans will be waist-deep in Thanksgiving celebrations and likely in the midst of digesting a fat turkey and generous dollop of pumpkin pie. But that might not be all you’ll be digesting…

If, like millions of others, you’ll be traveling to your relatives’ Thanksgiving bash this year, you’ll again have to contend with gasoline prices that are distinctly unappetizing. Call me a cynic… but wouldn’t you know it? No sooner are the mid-term elections over… gasoline prices in eight of the nine U.S. regions (as measured by the Energy Information Administration, a branch of the U.S. Department of Energy) have mysteriously crept up a few cents per gallon - despite oil prices continuing to fall to under $57 a barrel. Hmm…

The national average price per gallon of gasoline is now $2.23 - meaning consumers are still feeling the pinch in a bad way. And while I’d hate for you to endure any acid indigestion thinking about that this Thanksgiving, the fact is… it could get worse.

But as much as the gasoline companies want to empty out your wallet every time you fill up the tank, there is fortunately a way you can combat this…

Demand for Gasoline vs. Demand for Oil

Demand for gasoline is actually more prone to wild swings than demand for crude oil. Why? Because few countries have the ability to refine crude for use as gasoline. That adds an extra layer of time and cost to gasoline inventories and production.

Consider that countries like Iran, which pumps out more crude than 80% of the rest of the world’s producers, must re-import their own crude as gasoline because of limited refining capability.

Here in the U.S., the situation, while not as dire, is pathetic. And it could mean “barrels” of profits for the companies solving this problem…

OPEC’s Market Manipulation of Gasoline Prices

For all the talk about America freeing itself from the shackles of the Middle East oilmen and gaining greater oil independence, the country hasn’t built any new oil refineries in more than two decades.

But building a refinery is no easy thing - it takes years and lots of environmental studies and approvals before a refinery can start producing gasoline. There are a couple of refineries on the board right now, but the first drop of gasoline from these proposed facilities is years away from your gas pump.

Naturally, politics is also a major factor in gasoline production. Since it’s derived from crude oil, much of the world is at the mercy of the OPEC oil cartel that can play havoc with supply and demand.

And because crude prices are determined at the margins, it’s not the first 30 million barrels a day that determines the price; it’s the last million barrels. And if those last million barrels are taken off the market, you’ve got a simple supply-demand equation at work: The price of crude can spike because there are no substitute sources available.

But OPEC doesn’t have to control all the oil - in fact, the U.S. gets most of its oil from Canada, Mexico and Venezuela. But when OPEC opens or closes the oil spigots, the price reacts because the cartel controls the oil that can be pulled off the market during peak demand or supply. Right now, we’re in peak demand… thanks largely to China and India’s mega-consumption.

China in particular needs gasoline to power its tremendous growth. This is an additional demand that simply wasn’t around a decade ago. But today, demand from China - a country growing at more than 10% a year - is tugging at the margins.

Ethanol: Gasoline’s Alternative Energy Solution

There is no room for error or natural disaster in the crude oil market. Sure, you may see some short-term fluctuation, but that does nothing to address the long-term demand for crude oil and gasoline. And that demand is not projected to slow - rather it is expected to outstrip the ability to produce more oil.

Therein lies the long-term problem… and the long-term solution: Alternative energy. So far, only one form of alternative energy has proved economically efficient - ethanol.

Ethanol, which is energy derived from non-carbon sources, can be produced in mass quantities around the world. It can be used with current engine technology with few modifications - there is no need for battery technology, hydrogen fuel cells, etc.

Ethanol is here now - and it represents one of the best long-term alternative energy solutions. Countries like Brazil are already ethanol dependent, and almost fossil fuel independent. And the resource has the firm backing of some of the biggest governments and private investors in the world (Bill Gates and Sir Richard Branson, to name just two).

Is There an Ethanol Downside?

Yes, ethanol has it downsides. For a start, it has to be transported by wheel technology, because there are no ethanol pipelines yet. The fuel must then be dispensed through special hoses and pumps developed to withstand ethanol’s unique chemical features. Cars and trucks must be modified or built to use ethanol.

Fortunately, those issues are being addressed in real time. And within the next decade, ethanol could end up replacing 12% of the gasoline market. And if enough money is poured into ethanol development, it’s feasible that ethanol could completely replace gasoline within 20 years. If you think that seems unrealistic, Brazil has shown that it can work. For the U.S., even a 25% replacement rate would achieve significant environmental and economic savings.

There are several companies that are top players in the field. Some are pure producers - but as such, and considering they’re in the developmental stage, they’re consequently prone to huge swings in volatility.

You could also buy a company that is a major agricultural and ethanol player. But the bottom line is that to invest in ethanol, you must have a three- to five-year time horizon. And as we’ll see in the “ethanol decade,” the potential returns are incredible.

Good trading,

Karim Rahemtulla

P.S. This past summer, I recommended a “stealth” ethanol play that not only makes money from a huge ethanol interest it owns, but also has other investments to soften ethanol-related volatility. Third-quarter earnings ballooned 41% year-over-year, allowing it to offer a $3.52 annual dividend (8.1% annual yield). What’s more… it boasts $7.8 billion in assets… a market cap of $6.3 billion… and a P/E ratio of just 8.

In a special report from myself and the investment professionals at the Xcelerated Profits Report, we’ve outlined this and other several ethanol-based companies and show you how to play the “ethanol decade.” Each company has its own set of characteristics that will appeal to all types of investors - conservative, speculative and those in the middle. Get all the details here!

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Today’s Smart Profits Cribsheet

  • Back in August, the Smart Profits Report team participated in an enlightening “Ethanol Forum,” where each editor gave his own particular take on the industry… it’s history… its upside and downside… and its prospects going forward. Educate yourself on this burgeoning industry today in our two-part series: Ethanol Investing, Part 1 & Part 2
  • D.R. Barton, Jr. gives further details about ethanol, the hottest topic since solar energy in Smart Profits #344, Ethanol’s Government Intervention: Why the “High-Growth” Ethanol Business Matters to Investors.

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