And it’s this time component that is a critical factor when it comes to valuing the price of a LEAP option and the amount of risk involved.

An option’s price is determined by a computer program – either the Options Pricing Model or the Black-Scholes Model. Black, Scholes and Merton developed the latter model in the 1970s, winning a Nobel Prize for it.

Essentially, though, both models take the same main factors into account…

* The amount of time until expiration.
* The price of the underlying shares.
* The volatility of the share price.
* The risk-free rate of return.

Let’s take a look at these factors, so you know how to pick the right options with the best chance of yielding handsome profits…

Put Time On Your Side With LEAPS

~ Time To Expiration: When most people think about options, they think about getting the biggest bang for their buck and profiting in the shortest amount of time.

But be careful, because it isn’t that simple. With short-term options, time is against you. If the outcome you desire isn’t achieved within a short period of time, your option expires worthless.

However, LEAP options give you plenty of time for you to be correct and profit from the trade. Time is a critical component of a LEAPS trade.

For example, I’ve seen a LEAP option on a gold stock recommendation move from the $3 price we paid, to $0.50, then right back up to $16… all during a 12-month period.

Contrast that with a short-term option, which would have flamed out a long time before the share price recovered. With LEAPS, you have time to withstand a bad earnings report, a market correction, a terrorist attack, or a plethora of other shocks that would otherwise mean a world of hurt for your position.

Stock-Watching: How The Share Price Affects The Option Price

~ Price Of The Underlying Shares: It stands to reason that the price of the underlying shares is another key factor in determining how much you pay for the LEAPS options.

Basically, the closer the strike price (the price at which you have the right to buy or sell the stock) is to the current share price, the more expensive the option will be.

For example, if IBM (NYSE: IBM) trades for $100, a $95 call option would be considered in-the-money since the strike price is less than the current option price. In this case, the option premium will have intrinsic value. For example, if the option cost $9, $5 of that would be intrinsic value and $4 would be the amount paid for time and risk.

If your option is out-of-the-money, you pay for time and risk. So if IBM was at $100 and you bought a $105 call option for $5, the entire $5 would be for time and risk. But while the option premium is less than an in-the-money option, the probability of winning is also lower.

How Much Will Your Option Move? This Volatility Number Will Tell You

~ Volatility: When we talk about volatility here, we’re referring to how the share price performs in relation to the broader market. This is known as a stock’s beta.

Simply put, a stock with a beta of 1 will move in line with the market. A number under 1 means it’s less volatile, while a number higher than 1 means it’s more prone to volatility. So if the S&P 500 moves down 1% and your stock moves down 2%, your stock has a very high beta – double that of the market.

The higher the beta, the more expensive the options are, since options have the ability to move with greater speed in either direction.

For example, the beta on shares of tech giant Apple (Nasdaq: AAPL) will be much higher than the beta on a stodgy pharma company like Procter & Gamble (NYSE: PG).

~ Risk Free Rate Of Return: Measuring the cost of money at the cheapest possible price and the best possible return with no risk, this final factor is usually associated with government Treasury securities, especially 10-year Treasury Bonds.

Together, these four features – time to expiration, underlying share price, volatility, and risk free rate of return – represent the critical components in determining the price of LEAP options (or any options, for that matter).

Next time, we’ll explore the economics of the LEAP strategy along with how you can invest in the market with 15% of your cash while the rest of the world is foolishly using 100% of theirs.

Karim Rahemtulla
Smart Profits Report

But with one or more institutional traders making bets that suggest a bearish end to 2009, the question becomes: How do you read this information and what do you do about it?

I’m struck by a sense of déjà vu.

In September 2007, there was a $900 million options wager that became known as the “Bin Laden Mystery Trade.” Widely believed to be a massive downside bet on the S&P 500, it was a combination of options totaling 120,000 S&P call options contracts (NYSE: SPY).

Because of its size and the way it was placed, the trade appeared to nervous investors as if somebody, somewhere “knew” something about the S&P 500 being in for a big tumble. Not surprisingly – in this always-anxious, post-9/11 era – speculation about the trade took on a life of its own. In addition to lighting up the chat rooms and conspiracy hotlines, it quickly went mainstream. I recall being asked about it several times on various radio shows and at investing conferences around the world.

I wasn’t a popular guy because, instead of playing to the conspiracy theories, I saw another explanation based on 20-plus years of professional investing. As it turns out, I was correct and the trade was some derivation of a “box-spread” options trade.

In case you missed the original article, here’s a quick explanation. A box trade is a highly specialized transaction that professional traders or sophisticated institutional investors use on occasion to “box” in the market and guarantee a pre-set level of profits, an acceptable level of risk, or – as may have been the case for that particular trade – it may have been designed to enable an investor (institutional or otherwise) to obtain below-market-rate financing.

This time around, there’s a slight wrinkle in that the options seem to be a so-called “put-ratio spread” that expires in December. This transaction calls for an investor to buy a number of “put options,” and then to sell more “put options” of the same underlying stock and expiration date, but at a different, lower strike price.

It’s a limited-profit, unlimited-risk options strategy that is used when traders think the underlying issue – in this case the SPY – will experience a little volatility in the near future.

According Andrew Wilkinson of Interactive Brokers Group Inc. (Nasdaq: IBKR), an investor last month purchased a “ratio put spread” that expires in August. Wilkinson told Forbes.com that the investor established the bearish trade by using 120,000 “92″ strike puts against 240,000 “80″ strike puts, a 2:1 ratio established at the equivalent of 920 and 800 on the S&P 500. But as the markets rallied, this investor appears to have closed this trade in favor of a similar strategy involving December contracts.

According to Wilkinson, the trader then moved the long strike up to 95 (the equivalent of 950 on the S&P 500) and sold an additional 240,000 “82″ strike puts that would have provided a defense against a market downturn of 14.5% at the time.

Clearly, there is a wide margin for error and a big zone for potential profits if the S&P 500 loses steam. (For reference, the S&P 500 closed yesterday (Tuesday) at 994.35).

In its current form, the options trade appears to have spread out to the point where the ratio spread is no longer clearly visible, or has morphed into an entirely different strategy. But the disproportionately large open interest of 182,157 contracts at 95 and 153,387 contracts at 80 in December seems to suggest that there is still a somewhat sizeable number of traders positioned for a potentially bearish end to 2009.

In addition, based on similarly large and disproportionate open interest in contracts that expire next month, traders seem to have spread their bets out over the third and fourth quarters, which means they’re apparently less concerned about the actual timing of any bearish move than they are the actual direction. While they don’t mention this in the options textbooks, institutions tend to concentrate their positions in the months coinciding with quarterly earnings reports, since there is more liquidity and depth than in the calendar months.

As of press time, there were concentrations exceeding 100,000 put contracts at the following September strikes: 80, 88, 91 and 95. Any or all of these could be used in conjunction with December contracts to profit if the S&P 500 does drop.

So what does this mean and what can individual investors do about it?

Never one to let the old “X-Files” theme song fade away in my head (okay, I’m a bit of a conspiracy-theorist at heart…), I find it interesting that the initial trade as reported by Wilkinson was 120,000 options contracts. In an era of multi-legged contracts – accounting for hundreds of millions of shares – it’s ironic that two disparate trades made nearly two years apart (the “Bin Laden Trade” of 2007 and this latest transaction reported on by Interactive Brokers’ Wilkinson) both involve that same number of contracts. Folks tempted to read deeper into the tea leaves than I am may conclude that something sinister is in the works, but at the end of the day I think it’s probably nothing more than a coincidence.

As for what this latest trade could mean – well, as was the case with the “Bin Laden Trade,” I suspect that there’s nothing untoward at play here, either. Therefore, I chalk up the increasingly large positions to savvy traders who understand – as we do – that with the S&P’s massive surge since early March, a pullback from current levels is not only likely, but probable.

My view is that it’s only logical that traders – the shrewd lot that they are – will want to prepare for that contingency.

If you’re of the same opinion and want to play along, there are a number of ways to do so. However, the actual moves you make will depend a lot on your preferences as an investor – as well as your risk tolerance.

For instance, if you’re options savvy, you could assemble a put-ratio spread of your own using similar strikes. That way, depending on how far and how fast the S&P 500 falls, you could be sitting on some potentially large windfall gains – while those who didn’t prepare for this contingency are forced to conduct financial triage on their investment portfolio.

Of course, if options spreads are not your cup of tea,  you could simply buy a handful of cheap SPY put options, and hope the “lottery” pays off: After all, depending on how deep out of the money you go, your chances of winning would be about the same.

Or, you could buy a specialized “inverse fund,” such as the Rydex Inverse S&P 500 Strategy Fund  (RYURX), which actually appreciates as the S&P 500 drops. If you prefer “high-test” investments, you could also opt for a double- or triple-leverage investments – such as the  ProShares Ultra S&P 500 Exchange-Traded Fund (NYSE: SSO), or the ProShares UltraPro Short S&P 500 ETF (NYSE: SPXU).

But tread lightly. In an era where central bankers around the world continue to play “risk taker of last resort,” there are no guarantees that we’ll see the “normal” market behavior – the market behavior we would normally expect to see after such a torrid advance in a major bellwether index. Things could just as easily power up in a hurry if the markets – and the investors who comprise those markets – become more confident … regardless of the reasons why. In cases like that, these bets would turn into losers in a big way and in a big hurry.

By Keith Fitz-Gerald
Money Morning

For example, one reader wanted to know how options can work with short positions – and referenced doing so on Yamana Gold (NYSE: AUY). We talked about protecting against downside risk with long positions the other day, so let’s look at the other side.

In this case, I’m assuming that you’re short on Yamana and trying to manage the position in order to not take a big loss in case it moves against you.

The way to do this would be to buy out-of-the money call options to protect you against any sharp moves up. This is like insurance. You’ll lose a little bit of money, but your downside will be capped once the option goes in-the-money.

The problem here is that if Yamana trades sideways, you’ll lose on the call option and would have to buy more as each one expires. The way around this would be to buy a LEAP call option, but it will be more expensive and eat away at your potential profits.

Here’s a couple more questions on options that many investors have been asking.

Explaining The Benefits Of Buying Deep-in-the-Money Options

“Please explain the benefits of buying deep-in-the-money options.”

• The buyer stands a lesser chance of benefiting from deep-in-the-money options than the seller, since the underlying shares must rise in order for the buyer to make money.
• On the other hand, the seller can either have Yamana stay at the same price, move up, or move down to make money. Just as long as it’s not by more than his cost. The seller clearly has the better end of this deal.

So what prompts buyers to buy these options? Simple… they’re speculating and only want to risk a little bit of money, as opposed to buying the shares. They’re betting on a strong move up, but will unfortunately lose out 70% to 80% of the time.

That’s why we don’t buy short-term options. Because doing so is basically saying that we can predict where Yamana will be by expiration in a few weeks or months.

Options Investing: What to Do When Your Options Expire

There’s been a number of options investing questions that deal with “what happens next,” after the transaction closes.

“Whenever I read about covered calls strategies, there never seem to be much information of what to do after expiration. For example, if the shares get called away or increase in share price, do we buy the same shares again? And do we still sell deep-in-the-money calls then?”

It depends on your goals.

• For us, when we’re using the deep-in-the-money strategy, the objective IS to get called away every time since we are looking to own the shares at lower levels.
• However, if you’re looking to own the shares and continuously sell calls, then you would buy back the calls the day before expiration, taking advantage of all the premium you have captured from the expiration of time value and volatility.
• Then you would sell another option with either a higher strike and further out. This is called “rolling” your trade.

“If the shares don’t get called away, due to a drop in the share price, do we sell covered calls again, except at a lower strike price in order to get a good premium? Or do we sell out-the-money calls now (but the premium is lower).”

• With the strategy we use, we always try to sell options at the same strike price.
• So if the shares are lower than the strike price and we hold onto them, we’d then sell options at the same strike price and lower our cost even more.
• Our goal is to own the shares for zero or negative cost.

If you want to go out-of-the-money, you’re now engaging in a pure long strategy, which is not the goal of deep-in-the-money investing. The worst case is that the shares fall well below the strike and your cost.

In this case you can either book the loss, or if you’re investing in a very good company, you just hold the shares until they recover. This happens about 20% to 25% of the time.

This is also the reason why you should only invest in companies that you truly do want to own… because sometimes you’ll end up owning them.

Good investing,

Karim Rahemtulla
Investment U

For example, one reader wanted to know how options can work with short positions – and referenced doing so on Yamana Gold (NYSE: AUY).

Here’s how…

In this case, I’m assuming that you’re short on Yamana and are trying to manage the position in order to not take a big loss in case it moves against you.

The way to do this would be to buy out-of-the money call options to protect you against any sharp moves up. This is like insurance. You’ll lose a little bit of money, but your downside will be capped once the option goes in-the-money.

The problem here is that if Yamana trades sideways, you’ll lose on the call option and would have to buy more as each one expires. The way around this would be to buy a LEAP call option, but it will be more expensive and eat away at your potential profits.

But what if you want to “go deep?”

Buying Short-Term Options Is A Sucker’s Bet

Here’s another question:

“Please explain the benefits of buying deep-in-the-money options.”

The buyer stands a lesser chance of benefiting than the seller, since the underlying shares must rise in order for the buyer to make money.

On the other hand, the seller can either have Yamana stay at the same price, move up, or move down to make money. Just as long as it’s not by more than his cost.

So what prompts buyers to buy options? Simple… they’re gambling and wish to spend a little bit of money, as opposed to buying the shares. They’re betting on a strong move up, but will unfortunately lose out 70% to 80% of the time. That’s why we don’t buy short-term options. Because doing so is basically saying that we can predict where Yamana will be by expiration in a few weeks or months.

What To Do When Your Options Expire

Finally, here’s another question – a two-parter:

Part 1: Whenever I read about covered calls strategies, there never seem to be much information of what to do after expiration. For example, if the shares get called away or increase in share price, do we buy the same shares again? And do we still sell deep-in-the-money calls then?

It depends on your goals. For us, when we’re using the deep in the money strategy, the objective IS to get called away every time since we are looking to own the shares at lower levels. However, if you’re looking to own the shares and continuously sell calls, then you would buy back the calls the day before expiration, taking advantage of all the premium you have captured from the expiration of time value and volatility. Then you would sell another option with either a higher strike and further out. This is called “rolling” your trade.

Part 2: If the shares don’t get called away, due to a drop in the share price, do we sell covered calls again, except at a lower strike price in order to get a good premium? Or do we sell out-the-money calls now (but the premium is lower).

With the strategy we use, we always try to sell options at the same strike price. So if the shares are lower than the strike price and we hold on to them, we’d then sell options at the same strike price and lower our cost even more. Our goal is to own the shares for zero or negative cost.

If you want to go out-of-the-money, you’re now engaging in a pure long strategy, which is not the goal of deep-in-the-money investing. The worst case is that the shares fall well below the strike and your cost. In this case you can either book the loss, or if you’re investing in a very good company, you just hold the shares until they recover. This happens about 20% to 25% of the time.

This is also the reason why you should only invest in companies that you truly do want to own… because sometimes you’ll end up owning them.

Good investing,

Karim Rahemtulla
Smart Profits Report

In my column, I used the example of Yamana Gold (NYSE: AUY), showing you how to reduce your cost when buying stocks – and thereby increasing your upside potential if the shares move higher.

Today, we’re going to kick things up a notch and explain how you can cleverly take the same covered call strategy and add a twist, by using deep-in-the-money covered calls. When you do so, you can achieve more consistent returns over time, while also protecting your capital.

Simply put, I’m going to focus on mitigating risk…

Getting Deep-In-The-Money… Even When Your Stocks Fall

With a conventional covered call strategy, you buy regular shares of a stock and then sell a call option against them, whose strike price is higher than the current share price. Your aim is that the shares will move higher and will get called away at expiration for a profit.

While this does happen, it doesn’t occur as often as you might think. Plus, it usually only happens during an upward moving market.

However, with the deep-in-the-money (DITM) covered call strategy I’m focusing on today, we’re not expecting the shares to move higher. In fact, we don’t even need the stock to trade higher in order for us to make money. It can actually go lower (sometimes much lower) and we’ll still make money.

Pretty compelling, right?

In short, what we’re seeking is safety. And to get it, we need to employ a strategy that protects us much more often than not.

Deep-In-The-Money Calls: A 75% Win Rate Over 13 Years

So how about a win/loss ratio of 75%? That’s the performance the deep-in-the-money strategy recorded over the past 13 years that I’ve used it. That means we’ve only lost money or broken even 2.5 times out of 10. At all other times, we’ve made money, usually notching up market-beating returns.

Just yesterday, in fact, in my Strategic Income service, we closed out two winning positions – 13% on Wells Fargo (NYSE: WFC) and 33% on Goldcorp (NYSE: GG) – positions we initiated before the market’s collapse.

Here’s how it works, using the Yamana Gold example again. Recall that in last week’s example, we bought Yamana under $9 and sold the $10 (out-of-the-money) calls against our position.

Using Deep-In-The-Money Covered Calls On Yamana

This time, we’re going to buy the same Yamana shares. But instead of selling the $10 calls, we go deep-in-the-money instead.

• Buy 1,000 shares of Yamana at $9.50 – a total outlay of $9,500.

• Sell 10 contracts of the January 2010 $9 calls (AUY-AL). Trading at $1.75 per contract, you receive proceeds of $1,750 (remember that each contract contains 100 shares, so it’s $1.75 multiplied by 100 = $175. Then $175 multiplied by 10 = $1,750).

• Your cost for Yamana shares is now $7.75 ($9.50 minus $1.75) – a full 18% below the current price. This is the crucial number. If Yamana closes above $7.75, you’ll be profitable.

• If Yamana closes above $9 at expiration, you’ll make 16%. You arrive at this number in this way…$9 (strike price) minus $7.75 (cost) = $1.25 (profit).
  $1.25 divided by $7.75 = 16%.

  If the stock moves higher, your returns are capped at 16%, regardless of where it goes.

• Even if Yamana shares stay at today’s level, you’ll still make 16%. So you have an additional chance of profiting from the trade, versus just one with a straight long strategy, which requires the shares to move higher.

Additionally, you reduce your cost of ownership in Yamana to $7.75.

Basically, you’re saying that you’re willing to own Yamana at $7.75 – 18% below current prices. But if you don’t get the shares at that price, then you want to be paid for trying – something that happens nearly 80% of the time.

Key Points to Remember When Using DITM Covered Calls

Here are a few things to remember whenever using deep-in-the-money covered calls:

• You can execute a deep-in-the-money covered call strategy in any trading account.
• If you do end up with the shares, you can sell additional calls against your position to reduce your cost even further. The goal is to own the shares for zero dollars or even a negative cost over time.
• Always make sure you employ position sizing – i.e. never put too much in a single investment.
• At expiration, if the shares are trading above your strike price, they’ll be automatically taken from your account.

That’s all for this issue.

Karim Rahemtulla
Smart Profits Report

At the risk of sounding like a conspiracy theorist, I firmly believe that most investors are intentionally kept in the dark about anything that breaks away from the “buy stocks and mutual funds” mantra that makes Wall Street money.

Most mutual fund managers can’t see much further beyond Investing 101, and too many people in general are skeptical of options altogether. The problem is that they have no idea what they’re missing.

The options market was created for professionals, institutional money managers, and those who report to their wealthy, sophisticated constituents instead of the general public. But that doesn’t mean that the average Joe and Jane can’t use it too. They just need to get a few pieces of inside information first.

When George Soros took down the Bank of England to the tune of billions of pounds, he did it by using the leverage that options provided him. Basically, he saw a trend and figured out how to exploit it legally and with a surprisingly small amount of risk.

Sure, if it went against him, he would have lost out big time, but not nearly as much as someone who played the game the usual way. You see, the key to trading options is knowing how to use them to maximize the efficiency of your money. And the first and easiest strategy for doing that is the covered call trade…

Get “Free” Money

In order to execute a covered call trade you need to use both a stock and an option, hence the term “covered.” It means that your trade is covered by the underlying shares that you own.

There is no risk to the broker when you execute it since there is protection of equity by the shares you already own even if it goes against you. And that’s the reason why covered calls can be used by anyone in any type of account, including your retirement account.

When you enter into a conventional covered call trade, you’re essentially pledging to sell your shares at a certain price – known as the strike price – on a certain date, commonly referred to as expiration.

For pledging your shares, a buyer pays you an amount of money called a premium. And it doesn’t matter what the final outcome is; you still get to keep that premium regardless of who ends up with the shares in the end.

Since it’s yours to keep, spend or reinvest, you reduce the basis of your stock. Remember: Anytime you reduce your basis or capital risk, you also reduce your risk.

The One, Two, Threes Of A Covered Call

A typical covered call trade would go something like this:

Step 1: You buy 1,000 shares of Yamana Gold (NYSE: AUY) for $8.40 per share, totaling $8,400, and since you believe that the stock can go to $10 by year’s end, you look at an options chain (a listing of options available) to find out what the market is buying and selling the Yamana $10 options for.

(Note: This market is open to anyone who wishes to buy or sell options)

Step 2: The option is trading for $0.90 on the bid and $0.95 on the offer, so you sell 10 contracts of the Yamana January $10 call options, receiving proceeds of $900.

Now a few things to keep in mind before we go on…

• Just as with stock, you buy at the offer and sell at the bid.

• Options are always priced in increments of $0.01, $0.05 and $0.10 depending on volume traded and selling price. The Yamana options are priced in $0.05 increments and the price reflected is per share x 100 shares.

• Options trade as contracts, and each contract is equivalent to 100 shares of stock. So while the Yamana options are priced at $0.90 by $0.95, the minimum dollar amount that you need to be aware of is for 1 contract or $90 by $95. And it also means for the purpose of covered call trading, that you need to own at least 100 shares of Yamana to execute the trade.

• The strike price of $10 means that the buyer or seller of the option has the right to either buy or sell Yamana at $10 depending on the strategy used. If the option is sold – as in the case of a covered call trade – the seller of the option is obligated to deliver shares of Yamana to the buyer of the option if the shares close at $10 or higher.

The buyer of the option then has the option of taking delivery of the shares or selling the option back into the market.

As Close To A Win-Win Conclusion As You Can Possibly Get

Step 3: With your cost now reduced by 90 cents per share to $7.50 ($8.40 – $0.90), you wait for one of three possible outcomes.

Yamana closes at $10 or higher at expiration in January, in which case your shares will automatically be sold to the buyer of the option at $10 per share.

(In order for the buyer in this case to have made any money, Yamana would have to close at $10.90 ($10 strike price + cost of $0.90 per option) or higher. Anything less, and it wasn’t worth it.)

If it closes at $10 or higher you make 33% on your money ($10 strike minus $7.50 cost = $2.50 profit. $2.50 profit divided by $7.50 cost equals 33%). Or…

Yamana stays at $8.40 come expiration. In that case, as the seller, you still make money because you took in $0.90 per option you sold. Therefore, your return on the trade would be 12% ($8.40 minus $0.90 = $7.50. $0.90 divided by $7.50 = 12%) and you would still retain ownership of the shares since they didn’t close above $10. Or…

Yamana closes below $8.40, in which case you still make money, since your cost was $7.50. The only way you lose money if Yamana closes below $7.50, your adjusted cost and your breakeven point.

Covered Calls: As Simple As That

Basically, just as long as Yamana closes below $10, you retain ownership of those shares. And from there, you can either sell your stock at a time you see fit or keep it to sell even more call options against your position, reducing your cost even more in the process.

And as the owner of the shares, you’re entitled to any dividends paid out to shareholders during your stint as owner.

So let’s summarize:

• A covered call trade requires you to own the shares that you then sell options against.
• The money received from selling the options is yours to keep immediately.
• If the shares close above your strike price, they will be taken away (called away) from your account automatically and the money will be deposited in your account.
• Covered calls can be done in any type of account, including retirement accounts.
• Covered call trading can generate additional income while reducing your risk.

Next week, we’ll explore a variation on covered call trading that can reduce your risk substantially while still providing double-digit returns.

Karim Rahemtulla
Smart Profits Report

At that time, a 1% swing in the market was an anomaly. Today, it’s the norm. And even though we’ve seen volatility calm down somewhat in recent weeks, don’t be fooled. As we enter another earnings season, we’ll see volatility pick up again.

So what are you going to do?

Paralysis is not an option. Neither is making 1% or less on your cash every year when there is a high probability of out-of-control inflation in the years ahead.

You need to have a plan that can take advantage of what the market offers. And simply put, that means employing strategies that work both the long and short sides…

Expand Your Investment Horizons

Until recently, most investors have feared executing anything but the most basic investment strategies: Buying stocks, trading stocks, and in many cases, just buying and holding stocks.

While there’s nothing wrong with any of those moneymaking methods, they only scratch the surface of what the market really has to offer.

And in an increasingly complex and volatile market, there’s no better time to expand your horizons and learn how to execute the strategies that can enhance your returns, protect your portfolio and get you excited you about investing, rather than fearful.

Are Options Dangerous?

My specialty is options.

When I mention that to people, I’ll often get a rolling of eyes, or some kind of, “Wow, that’s kind of risky, isn’t it?” reaction.

Are options “dangerous” investments?

Well, any investment is dangerous if you don’t understand it. Even having money in a CD can be a painful experience when interest rates are rising and you’re locked into 2% for five years. Just ask those who locked up their money at 8% in U.S. Treasuries in the mid 1970s, only to watch rates eclipse 18%.

So options can be dangerous… if you don’t know what you’re doing. Then again, investing in Worldcom, Enron, WAMU, Fannie Mae and General Motors was dangerous, too.

And if you don’t take the time to learn how options work and what’s happening with your money when you use them, options most likely will prove dangerous for you.

The people who lose money in the options markets are the ones who view it like Vegas on Wall Street. They use options to gamble. But options aren’t weapons of financial destruction. They are, in fact, the opposite…

A Barrage Of Options Benefits

I’ve spent years telling people that far from being scary, options are very efficient instruments that allow you to control your money like no other tool on the market today.

Many investors have realized that once you do your homework, options make you a smarter investor, less dependent on the market’s vagaries and whims.

Among their benefits, options allow you to…

• Buy stocks for less than their current prices… or get paid for the effort.

• Protect your downside by offering insurance against downward movement in price.

• Generate greater income than dividends from your current holdings.

• Control stocks and benefit from their movement, while using significantly less capital to do so and giving you the luxury of more time for the situation to work in your favor.

• Play both sides of the market or a stock simultaneously for potentially unlimited gains.

So why do people think options are dangerous?

To answer this question we must take a look at the other side of the trade…

Winning Without Gambling

For every option seller, there is a buyer.

For every covered call, put-sell, straddle, strangle, etc, there has to be a counter-party. Most of the time, you don’t want to be in this position.

These are the gambling types I mentioned a moment ago. In their eyes, options represent a lotto ticket to fortune. The chance of winning the lotto in a state like Florida is one in 18 million. But that doesn’t stop people from buying tickets. The losers in the options market adopt the “you can’t win if you don’t buy a ticket” mentality, giving the entire subject a bad name.

But you don’t have to join them. Instead you can execute proven strategies that work – and work well in any type of market, especially volatile ones. Over the next few weeks, I’ll explore several strategies in-depth (a mini-workshop if you will), so stay tuned, Meantime, feel free to browse our archives to get a head-start.

Karim Rahemtulla
Smart Profits Report

Sound crazy? Well it isn’t.

There’s an incredibly profitable, but little-known trading and investment strategy that you will come to love as much as I do because of all the “instant cash” it can generate for you.

In the lucrative world of options trading, this strategy is called “selling a naked put option.”

Sounds sexy, and to some it is, but really it’s an incredibly simple way to buy stock you want to purchase at a specific price – while having someone pay you to do it. It’s easy to do but there are a few things you need to know first…

Here’s how you can use this powerful options strategy to get paid for buying stocks.

Understanding Put Option Contracts

If someone has a bearish outlook for a particular stock, they can either sell the stock short or purchase a put option contract. My colleague, Karim Rahemtulla, discussed put options at length in “Short Selling Strategies” last week, but there are some terms to be aware of.

• When you purchase a put option contract, you gain the right to sell that particular stock at a particular price within a specified period of time. To do this, you must pay a fixed amount of money upfront, which is called the “option premium” to the option seller.
• The option seller gets to keep this upfront cash regardless of any future outcome of the transaction.

• The amount at which you can sell the stock is determined ahead of time by the “strike price” – the only price you’ll sell the stock at.
• The time period that the option is active for is also determined ahead of time – and it’s referred to as the “expiration date.”

So as a put option buyer, if the stock you choose ends up falling in price below the strike price you have chosen within the time frame, you will have a winning trade.

It sounds simple enough for most investors to make money hand over fist, but it’s not.

• In about 80% to 90% of option buyer’s transactions, the option will expire worthless and the option buyer ends up forfeiting the option premium he paid upfront to the option seller.
• Most option buyers (both calls and puts) do not end up picking the correct strike price and expiration period to give them a profitable trade.

So who really comes out ahead? The option seller of course – he gets to walk away free and clear with the money. So let’s put ourselves on that side of the trade.

The Secret to Selling Options

Sounds like being an option seller is no-brainer? Well, it is – if you do it correctly.

For getting paid upfront, the option seller also has an obligation to fill if certain conditions arise. His obligation is to buy the stock from the option buyer (remember, the option buyer wants the stock to fall in price) if the stock falls to a certain price within the expiration time period.

Here’s where it gets good.

As a put option seller, you also can determine ahead of time where you would feel comfortable buying a stock if it dropped in price, and then collect the cash from the option buyer.

This is how to be a smart put-option seller – only sell put option contracts at strike prices at which you would like to own the stock if called upon to do so.

That’s it.

The secret to selling naked put options is to pick a stock that you would potentially like to own at a cheaper price than where it currently trades, sell the corresponding strike price, collect the money from the option buyer, and then sit back and wait until option expiration to occur.

These are the profitable types of trades we do all the time.

In fact, since launching The Instant Money Trader service in November 2008, we’ve had a 100% win streak, meaning all the options have expired worthless, allowing us to bank all the money paid to us upfront from the option buyers.

And it couldn’t have been easier.

Good investing,

Lee Lowell
Investment U

Thanks for the heads-up, guys. You’re about two months too late. Not only did we call the bear market rally before it began, we’ve also spent the past couple of months warning you not to get swept away by the sudden surge of optimism and over-confidence as stocks have pushed higher.

Bear market rallies are fun while they last. But they’re only temporary. And the last week of sharp sell offs reminds us that the market has an uncanny knack of sucking the wind out of your sails when you least expect it.

But far from being gloomy, it also reminds us that there’s just as much opportunity to make money from the downside as the upside. But you need to do it the right. When you’re bullish on the market or a stock, you go long. When you’re bearish, you go short. Here’s how you can profit from market pullbacks with some short selling strategies and protect yourself in the process.

Short Selling Strategies – Dangerous For Pro & Rookie Investors

Short selling strategies can spell great risk and danger for rookies – and many professionals.

Many investors believe that the best way (and sometimes the only way) to make money from a falling market or stock is to “short” it. So let’s quickly go over the mechanics of how short selling works…

• You sell shares of an asset into the market before buying them. Because you’re anticipating a drop in price, you’re hoping to buy the shares back at a lower price once this happens. Short sellers sometimes aren’t popular because they’re hoping the market and/or stock goes down.
• You go short by “borrowing” the shares from someone who is long on the asset (you don’t own the shares when you go short) and hope that it tanks. So when you buy the shares, you’re essentially replacing the shares that you borrowed.
• If you’re right and the asset falls, you profit because the shares you buy back are cheaper than when you borrowed them.

But what if you’re wrong and the asset rises? The real danger is that a stock – theoretically – could go to any price and you’d be stuck with the difference. It’s the nightmare scenario…

The Short Squeeze: On the Wrong Side of Short Selling

Let’s say, you short an asset that you are convinced is about to decline, but it turns the tables on you and rises instead. You’re now on the hook to buy the shares at a higher price than you borrowed them – you’re on the wrong side of a short squeeze.

• A short squeeze puts short sellers in a losing position, faced with the prospect of unlimited losses as the asset rises. 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 is known as short covering. The buying demand, coupled with the lack of sellers drives the price up even more, thus adding to your unlimited losses.

For example, let’s say you shorted 1,000 shares of Boeing (NYSE: BA) at $35 where it was three months ago. That would have given you $35,000. But you’d still have to replace those shares eventually because you only borrowed them.

But Boeing has performed very well over the past three months and is trading around $50 today, so if you hadn’t covered your shares till now, you’re forced to buy them back for $50,000 – at a loss of $15,000. And the more the stock rises, the more you lose on your original investment.

You never want to be in this situation, period.

Short Selling Strategies: Lower Your Risk With Put Options

Here’s an easy short selling strategy to make sure that you’re not on the wrong side of unlimited short losses again:

• If you think an index or stock is set for a fall, buy put options on it. This allows you to play the downside, but with far less risk than if you shorted the stock.
• When you buy a put, you have the right, but not the obligation, to sell the shares. That means your loss is only limited to the amount you pay to buy the option contract if the asset rises. No more. And if it falls, your put makes money.

For example, let’s say that instead of shorting Boeing shares at $35, you’d bought put options instead, trading at $1 per contract. Ten contracts (the equivalent of 1,000 shares, since one contract is made up of 100 shares) would have cost you $10, putting your total risk at $1,000.

That’s much better than the $15,000 you’d have lost by shorting the stock.

Short selling strategies can be extremely profitable if you’re right… but very risky if you’re wrong because your losses are unlimited.

So keep an eye out for stocks that are overpriced and ripe for a decline, or economic/company news that could drag them down. And if you want to play the downside, do it with put options.

Good investing,

Karim Rahemtulla
Investment U

This week, we hop over the fence to the straddle’s sister strategy – the strangle options play.

To refresh your memory, a straddle is when you essentially bet on both sides of a trade by using options that have the same strike price and same expiration date.

For example, if you like Bank of America (NYSE: BAC), currently trading around $12, you could buy a $12 call option and a $12 put option. In doing so, the goal is that once the stock moves in a particular direction, one option will move high enough that it offsets the loss from the other one – and more.

With a strangle option, the basic goal is exactly the same, but the trading strategy is slightly different. Here’s how it works…

Reasons to Use A Strangle Option vs. Straddles

The main reason to use a strangle option over a straddle is to lower your cost on the trade.

Like straddles, strangle options also involve buying a put and a call option. But the difference is that instead of buying a call and a put with the same strike prices at or near the current share price (at-the-money option), strangles involves buying a call and put with different, out-of-the-money strike prices.

Let’s take our Bank of America example and assign some prices to various strikes.

STRADDLE PLAY (In or At-The-Money Options)

• BAC January 2011 $12.50 calls                 $3.75
• BAC January 2011 $12.50 puts                 $4.00

• Total Cost                                                     $7.75

STRANGLE PLAY (Out-Of-The-Money Options)

• BAC January 2011 $10 puts                             $2.65
• BAC January 2011 $15 calls                             $3.00

• Total Cost                                                     $5.65

As you can see, the strangle option play costs more than $2 less. And like the straddle, your goal is for the stock to move very strongly in one direction – either up or down.

So let’s say BAC rises to $25 by January 2011. In this case, you’d make $10 in gross profit ($25 minus $15 strike). Subtract your total cost of $5.65 and your net profit would be at least $3.35 – or more than 60%.

On the downside, you’d need BAC to fall far enough to cover the loss of the premium from your call option ($3) and your investment in the call option. Since there is more room on the upside in this case, the bias of this strangle is bullish.

Strangle Options: The Best Times To Use Them

So what are the best times to use a strangle options play – and the best stocks on which to use it?

Because the underlying stock has to work a lot harder to make you money in strangle, you need to use the strategy wisely. Simply put, that means it’s best to employ it on stocks that have lots of volatility, both up and down.

In the current market, strangle options work well on financial shares like Bank of America, as well as:

• SunTrust Banks (NYSE: STI),
• JP Morgan (NYSE: JPM),
• And Morgan Stanley (NYSE: MS).

Strangle option plays would also work well on technology sector shares like:

• Apple (NYSE: AAPL),
• And Research in Motion (NYSE: RIMM).

But don’t try using strangle options on stodgy healthcare stocks like Merck (NYSE: MRK) or on traditionally stable utility companies like Consolidated Edison (NYSE: ED).

You can also execute straddle options and strangle option plays on the broader stock market through index options on the Dow, Nasdaq 100, or S&P 500.

So next time you’re looking at a situation where it’s hard to predict the market/stock’s direction – but you’re confident that there will be a big move eventually – don’t feel like you can’t do anything, strangle the trade and walk away a winner.

Karim Rahemtulla
Smart Profits Report

“Right now, the market looks VERY promising, jumping around like a banshee. Interest rates are low, home prices have not collapsed, China is still growing and the geo-political situation around the globe stinks. Why is this promising? For options traders, nothing is better than uncertainty and instability.”

And apart from the statement about housing collapse, his commentary rings true today and the market’s trading patterns are looking similar. It’s why we thought it’d be a good time to take a look at some options trading basics…

Many years ago, when I first started trading options in earnest, I remember pausing to think: Why would anyone buy a call option – as in, ever?

I look back now and wonder how I could trade without them.

Many investors hear the words “trading options” and dismiss anything that has to do with them flat out. Concerned about their risk and, in many instances, truly unsure how to use them, options get a mixed reputation from many investors.

They have difficulty looking past the “scapegoat coat” that the options wear.

In reality, using options can be a way to reduce the risk in your portfolio while opening up explosive, life-altering profits. But you need to understand what you’re doing and why…

Trading Options: Call Option Basics

When trading options in the options market, a call option gives you the right to buy a certain stock at a certain price by a certain time. Think of a call option like a real estate transaction…

• Say you know of a piece of land that you’d like to buy because you are fairly certain it is going to become more valuable. Maybe you even know of some development headed that way…
• It’s too good to miss, but you don’t have all the money you need to take advantage of the opportunity – right now, at least. Or you don’t want to tie up that much capital in one investment. It’s a fairly common investing situation.
• So you decide to take an option on the land instead. You approach the owner and offer him a deposit to “hold” the land for you for six months at an agreed upon price.

Let’s add some numbers to this example…

• The price of the land is $100,000. You put up a deposit of $5,000 to have him hold the land for you at $100,000.
• At the end of six months, the land is worth $115,000. Since you still have the right to buy the land for $100,000 and can now sell it for $115,000, you have just made $15,000 on your $5,000 investment.
• When you put up the $5,000, you entered into an option contract with the seller. It gave you the right to buy the land – or not. In options terminology you bought a call.

Your deal satisfied the three criteria that make up an option contract: It had a price, expiration date and premium (the amount you paid for the right to buy the land.)

Trading Options: Harnessing the Power of Leverage

Putting up $5,000 to control a $115,000 investment is an example of smartly using the power of leverage. That kind of leveraging power is what prompted me to buy my first call option. At the time, I didn’t have enough money to buy the underlying stock that had caught my eye.

In this case the stock was IBM, which I had been following for some time…

• It was trading at $82 per share and based on my analysis, I believed strongly that it was ready to move higher. The problem was that I didn’t have $82,000 on hand to buy a thousand shares.
• I decided to buy a call option rather than pass up this trade altogether. But it wasn’t without risks. If the stock moved lower, or didn’t move at all before the contract ran out, I could lose all of my money.
• In this case I had to spend about $2 per option, or about $2,000 total, to control 1,000 shares of IBM. If I was right, I would make a bunch of money. If I was wrong, I would lose my $2,000. Still, that was a better alternative than having $82,000 at risk.
• As fate would have it, IBM did report a blowout quarter, and the stock took off – to the tune of $15 per share.I pulled the trigger when the shares hit $90 and sold my option for an $8,000 net profit, or 300%, days later.

I pulled out early, but you never can lose when you sell at a profit.

Now, if I’d bought the shares instead of using the call options, I would have profited as well. But I would only have made 9.7% and tied up $82,000 instead of $2,000. That’s why investors love trading options, it gives them the ability to use leverage to their advantage.

In addition, most options move much faster than the underlying stock price. It’s how we hit the triple-digit gainers.

Trading Options With Short Expiration Dates? Try LEAPS

One of the biggest complaints I hear about trading options are their short expiration dates. But there’s a simple answer to this problem though, called LEAPS – also known as Long-Term Equity Anticipation Securities.

LEAPS are one-, two- and three-year options that give you control of the underlying shares through the purchase of PUTS (short) and CALLS (long). In short, they give you much longer timelines to invest in the long-term movement of individual securities.

Two to three years is a long time to take advantage of market movements. And more importantly – they reduce your risk. Why risk 100% when you can take 90% of your money off the table and risk only 10%?

Call options and their older brethren LEAPS help you put time on your side when you use options leverage.

Now, options are volatile. Their prices can change rapidly – both up and down. You have to be right about which direction prices are headed and how fast, or you can get nuked in the short term.

Plus, call options can expire worthless if you are wrong about the move of the underlying stock. Despite the big returns options can deliver, they still carry big risk.

I urge you to do your research and find out if using call options and LEAPS are right for your investment strategies and risk levels. Because if they are, you could find yourself looking at a 300% gain at the end of this year instead of only a market return of 14%.

Good investing,

Karim Rahemtulla
Investment Director, Smart Profits Report

Source: Investment U

Question is: How do you go about getting it – especially in a tough climate like this one? After all, cash is only king if you have it. 

In today’s column, I’m going to show you how to squeeze cash from the stock market – without really having any to begin with. 

Yes, you read that right – money from next-to-nothing. 

But before you embark on this “free money” strategy, you have to have an implicit understanding of what you are doing, because there are no free lunches on Wall Street for those who don’t do their homework. 

But for those who do, this is the freest lunch you’ll find…
 

A Moneymaking Strategy For All Markets

Let’s say you have an ordinary stock portfolio. Even if it’s full of stocks that aren’t doing much, it still has value. You might not think so as you watch it stagnate, but it does. 

You just have to harness the right strategy that will allow you to take advantage of the current market conditions. But in fact, this strategy actually works well in all market conditions.

It’s called put-selling. 

• Basically, you sell a put option on a stock to a buyer at a level well below the current price.  
• And when you do, that buyer pays you money into your account immediately – yours to keep, no matter what, and spend however you wish. 
• Be careful, however. In return for accepting that money, you’re obligated to buy the stock at the designated put option strike price if shares hit that level at options expiration.
   

An 8-Step Put-Sell Trade Example On General Electric

Let me give you a put-selling trade example, so I can walk you through the 8-step process and terminology… Let’s assume you like General Electric (NYSE: GE). 

1. With the stock currently trading around $13, you’re interested in selling puts on the shares at a level that you think GE would be an attractive buy. Let’s say that level is $7.50.
2. Your next step is to check out the company’s options chain (a listing of all the available put and call options on the stock, with symbols and prices). 
3. For the sake of this example, you see put options with a $7.50 strike price, which expire in July. They’re trading for $0.40 on the bid price (the price at which a buyer is willing to buy) and $0.50 on the ask price (the price at which a seller is willing to sell). 
4. Your entry price – be it $0.40 or $0.50 – must be multiplied by 100 to give you the actual price or cost because each options contract consists of 100 shares of the underlying stock. 
5. So you decide to sell 10 GE July $7.50 put option contracts (that’s equivalent to 1,000 shares). By doing this, you’re saying that if GE closes at $7.50 or below by expiration in July, you’ll buy the shares at $7.50. 
6. And for taking this risk, you’ll be paid $400. That’s because when you sell 10 contracts at $0.40, you’re getting 40 cents per share, multiplied by 10 contracts. That’s $400. This money is yours to keep, regardless of what the shares do. 
7. If GE hasn’t fallen to $7.50 or below by expiration in July, your obligation ceases. 
8. And at any time before that you can reverse the trade by buying back your puts. You’ll be able to do this for less in two cases.

• The first case is if the shares trade at the current levels and expiration is approaching, as the time value of the premium decreases as expiration approaches (this is commonly known as time decay).  
• The second case is if GE moves higher, which means the options price will also decrease, as the risk is diminishing. That means the probability of GE shares moving to $7.50 is also decreasing. 

The Free Money Strategy – 3 Keys To Selling Puts

At the end of the day, when you sell puts you follow a set of rules that will ultimately allow you to get money for nothing. And there are three keys to doing it right… 

• Choose companies that are not in danger of going bust. The higher the risk, the higher the premium – and the higher the chance that you’ll be forced to buy the shares.
• Only choose companies and strike prices that would give you the best bargain in the world if the shares get put to you. There are a lot of companies out there that are extremely attractive at the right price.
• If a position moves in your favor, close it out early. This is all about making money and reducing risk. 

Karim Rahemtulla
Smart Profits Report

Now, several parts of the world are in the grips of another nasty disease – this time, born in Mexico: Swine flu. 

Unsurprisingly, Mexican stocks are taking a hit as the death toll from the disease increases – just as Asian shares got hammered as the SARS and bird flu outbreaks ran wild in the various countries. 

For example, stock shares of Mexican telecom giant Telefonos de Mexico (NYSE: TMX) got slammed, as investors worried about the impact that the flu may have on companies. 

This is a perfect example of mass selling with no basis in logic. In fact, Telmex reported today that its customers have actually used the company’s services more over the past few days, as people decided to use the phone instead of going outdoors and risking infection. 

Looking back, the long-term effects of SARS and bird flu were muted. From an investment standpoint, the plays offered – vaccine companies, mask manufacturers, etc. – proved to be short-term bets that didn’t work. 

So what lessons can we apply from SARS and bird flu to the current swine flu news?
 

Mexican Stocks – Attractive Valuations & Opportunities 

I’m not outright advocating a “buy” on Mexican stocks today… or even tomorrow. After all, the global economic contraction is a much bigger story. 

However, if an investment opportunity presents itself, then we should be ready to act. And with swine flu, the news may get much worse in the short-term. That means we could have a chance to pick up shares or buy long-term options at very attractive valuations. 

It’s essentially the potential “double whammy trade:” An already weak Mexican market is further weakened by an unexpected event, whose duration and final impact will likely not be as serious as many think. 

Suffering Sectors Can Provide The Best Profits 

In the aftermath of the SARS and bird flu events, the sectors that suffered the most – airlines and hotels, for example – turned out to be excellent short-term trades that made many people a lot of money. 

So if the Mexican market – and even U.S. airline shares – continues to get hammered, you should seriously consider putting on a low risk trade. 

Note: By “low risk,” I’m suggesting that you execute a trade that allows you to benefit from both an eventual recovery in share price, and do so while risking very little capital, compared to what you’d invest if you bought the shares outright. 

The answer lies in LEAPS options…
 

Take Advantage Of Mexican Stocks With LEAPS 

LEAPS are longer-term options, with a duration of one year or more. They’re available on Mexican stocks like Telmex (which only date to January 2010 at the moment, but new options should be issued shortly) and U.S. airline shares. 

You can usually purchase LEAP options with an at-the-money strike price (close to the current share price) for 10% to 20% of the underlying share price. 

For example, with Telmex shares currently trading around $16, you can buy the $17.5o call options expiring in January 2010 for $1.50 per contract. This means you have less money at risk than if you buy the shares outright. 

• Let’s say the swine flu outbreak gets worse and TMX drops to $12 or $13.  
• At that point, the $12.50 strike LEAPS would be trading for $1.30 or thereabouts. 
• A move back up to pre-swine flu levels would take the shares up to the $17 level – a $5 move in the share price and a return of about 40%. Pretty good. 

But the LEAP options would move to $6 or so – the same $5 move, but a return measured in triple-digits. And you achieve this while risking less than 15% of the capital you had at risk if you bought the shares. 

Remember… this is a trade, not a long-term investment. But sometimes, especially when there are events that warrant it, it makes more sense to engage in low-risk; high return trades like this. 

Karim Rahemtulla
Smart Profits Report

In the past, investing in the banking sector was a no-brainer. Just buy a strong bank like JP Morgan (NYSE: JPM) or US Bancorp (NYSE: USB), sit back, and collect the healthy dividends they dished out.

There used to be an incentive to buy bank stocks because you got paid to hold them. Not any more. Few banks on the Top 50 list currently pay dividends worth noting. Worse still, most are actually cutting their dividends to pennies per year or eliminating them altogether.

So, why buy a bank stock?
The Banking Sector’s Recent Carnage

Cast your eye across the banking sector carnage and the list of the dead is impressive: Washington Mutual, Wachovia and IndyMac are among the biggest.

The list of walking dead is equally remarkable: Citigroup (NYSE: C) and Bank of America (NYSE: BAC) – two banks that once graced the Top 50. Not any more.

The main reason to consider buying bank stocks is in anticipation of a significant turnaround.

Many banks will recover from current levels and having been oversold, will provide stupendous returns in the months ahead, as the bounces will be as sharp to the upside.

But there is risk.

Last month, for example, shares of Wells Fargo (NYSE: WFC) – one of the top banks on Global Finance’s list crashed by more than 50%. The company then slashed its dividend by more than 80%. Not exactly a compelling reason to dip your toes into this sector, right?

Well, not so fast. Here’s how you can play bank stocks with low risk and very high return potential…

Using LEAP Options to Buy Banking Stocks

One of the best ways to invest in a volatile sector like banking is by using a strategy that allows you to risk just 10% to 20% of the capital that you’d use to buy the shares.

That way, if the shares move lower, the amount of money you have at risk is less than you would have risked had you placed a 20% stop-loss. But if they move higher, you’re looking at substantial returns. So what is this strategy and how does it work?

LEAP options.

The beauty of these options is that they expire in one to two years, thus allowing you to participate in the upside of a stock (or the downside if you’re buying puts) without risking the capital you’d need if you bought the shares outright. It also works well for sectors that are struggling, as it gives you more time to be correct with your call as the stocks recover.

Let’s take JP Morgan as an example…

How To Buy Banking Stocks For 5 Times Less Risk

If you wanted to buy 1,000 shares of JPM today, with a target price of $40 in two years, it would set you back a hefty $18,000. The company has the earnings power to make $4 per share in 2010 if the economy normalizes and a ten times multiple is not out of the question.

• Instead of spending $18,000 to make $22,000 – a heck of a return if you can make it – you could buy the JPM $30 LEAPS for $3.50 per contract (expensive because of the volatility). So it would cost about $3,500 to control 1,000 shares.

• If JPM hits $40, you stand to make about $6,500 for each $3,500 you invested. Sure, $6,500 isn’t as much as $22,000, but it’s still a heck of a return. And throughout the process, you gain one crucial peace of mind benefit: A lot less risk.

• To have $18,000 at risk through simply buying the shares is five times more than the money at risk if you bought the LEAP options. And if you set a 20% stop-loss, you’re committed to losing $3,600 on the JPM stock trade- more dollars than you’d risk by buying the LEAP option.

In the past, this trade would have made less sense because while in it, you’d also be receiving a couple of dollars per share each year in the form of dividends. But with no dividend to speak of any more, why put so much capital at risk?

Next time, I’ll show you how to make dollar-for-dollar gains on stocks with only half the dollars at risk!

Until then…

Karim Rahemtulla
Smart Profits Report

If you believe, as I do, the rally that began on Tuesday will continue for at least a few more days, then there’s a ton of money to be made. But you won’t make it by betting on the upside. You need to bet against the downside.

Let me explain…

Option premiums are huge right now. Anyone buying calls and betting on the upside needs to see their stocks rally by 5%-10% over the next week in order to profit on their trades. While that’s possible, it’s a low-odds bet.

Betting against the downside makes more sense. In other words, I’m more inclined to sell put options than to buy call options.

Selling put options obligates you to buy the underlying stock at the agreed-upon price. And it pays you upfront for that obligation. For example, if you want to bet Yahoo (YHOO) will rally with the stock market over the next week, you can sell the YHOO March 13 put options (YHQOM).

These puts are selling for about $0.45. So you’ll receive $45 per contract and you’ll be obligated to buy 100 shares of YHOO at $13 per share if it closes below that level next Friday. This is the equivalent of buying YHOO at $12.55 per share ($13 minus the $0.45 premium from selling the put option).

This trade is profitable as long as YHOO closes above $12.55 per share next Friday. It closed yesterday at $13.39.

In other words, you’ll make money on this trade if YHOO goes up… if it stays the same… and even if it falls a bit. In fact, the only way you’ll lose money on this position is if YHOO drops below $12.55 – a decline of 6% – by next Friday.

Of course, you only want to sell puts on stocks you’d like to buy anyway. After all, if the market drops significantly, you’ll end up buying the shares. But, you’ll get paid handsomely upfront by agreeing to do so.

Check with your broker before you try to do this the first time. Brokerage firms have varying requirements for selling put options.

This is one of my favorite strategies. And with put premiums as high as they are right now, the next week may be the most profitable week of your trading career.

Best regards and good trading,

Jeff Clark
Growth Stock Wire

Leuthold is one of the most respected fund managers in the world. He is a cofounder of Leuthold Weeden Capital Management which oversees $3.2 billion assets. Leuthold is also the manager of the Grizzly Short Fund, which, as the name implies, bets on falling stocks (the practice of “shorting” stocks). The fund returned 74% in 2008. So, in an inverse way, the fund beat the S&P 500 by about 30%.

In a rare bit of honesty and forthrightness for money managers, Leuthold went as far as saying investors shouldn’t buy into his Grizzly Short fund. I don’t think I’ve ever heard any fund manager, who gets paid on fees based on total assets under management, tell prospective clients not to buy.

The only time a manager would do this is if they couldn’t find anything they wanted to buy. In this case, with a short fund, it means Leuthold can’t find much he wants to sell short.

That’s a good sign. It might not signal a bottom for the overall markets – and I wouldn’t take it as such – but it shows there are much fewer significantly overly valued stocks out there.

So, if the short-sellers are having trouble finding stocks worthy of shorting, is the market due for a rebound? Is Leuthold right? What if this is the “last great buying opportunity in stocks?”

If you’re looking to wade back into the stock market, there are ways to do it safely. There is one way to safely get your toes wet in the market. This way has historically outpaced rising markets. It doesn’t do nearly as bad when markets fall. And it actually gets better as the market gets more volatile.

It’s the best of all worlds. And it doesn’t require dealing with complicated stock options or having to sit by your computer watching the markets all day. That’s why I consider it one of the safest ways to start moving back into the markets. But first, you’ve got to understand how this potential opportunity as created.

Bull Market in Volatility

You see, we predicted higher levels of market volatility are here to stay back in October. The markets were on edge. They’re still on edge and will continue to be until some details about the future start to clear up.

For now, unprecedented government intervention overriding the markets, significantly higher earnings volatility, increasing international tensions (we’re all friends when everyone’s getting rich), and surging job destruction (and not knowing where the new jobs will be created) will only continue to add to the uncertainty.

There’s nothing the markets hate more than uncertainty.

Just look at what happened yesterday. The feds finally revealed the details of the housing rescue plan. Whether it’s a good program or not, didn’t matter. The fact that the details are now known and can the market can try to estimate the impact and then make investment decisions accordingly was a welcome relief.

But that’s just one uncertainty the market no longer has to worry about. There are still a lot of unknowns to expect a big rally (i.e. 30% to 40%) in the short term.

The Bear Case

For instance, the markets are due for another big helping of reality on Friday. It’s that time of the month and the latest U.S. jobs report will be unveiled. This time around, a loss of 500,000 would be good news. Most economists are forecasting 648,000 jobs to have been lost in February though. It’s a situation where the best we can expect is “not as bad as expected” types of numbers.

Then we have the bailouts. On the one hand, we can finally see the bottom of the AIG money hole.

The New York Times says, “At its peak, the A.I.G. credit-default business had a ‘notional value’ of $450 billion, and as recently as September, it was still over $300 billion.”

The notional value is how much AIG had at risk if it had to pay on all of its credit default swaps (CDS). In other words, if all of the bonds AIG had guaranteed all defaulted and went to zero (yes, very unlikely), AIG would be on the hook for another $300 billion. The good news is there is a bottom to the black hole. The bad news is it could be a few hundred billion dollars away.

On the other side of the bailout issue, we still have to go through all the “stress testing.” And we can’t forget about GM, Chrysler, Citigroup, and Bank of America. Then just around the corner, you’ve got to look at the underfunded pensions, and on and on.

There’s a lot to work though here in the U.S. For time being, overseas markets aren’t looking too enticing either. Just look at China.

We’ve been tracking the hidden problems there for a while, so we’re not too surprised. The top U.S. trading partner is finally starting to publicly face reality there. Today, China’s government announced it will be expanding its $586 billion stimulus plan. The market loved the news (kind of ironic how stimulus packages from the Chinese government have so much more credibility than ones from the U.S. government).

On the good side, China’s got a pile of money saved up for a rainy day. On the bad side, it’s raining very hard.

All of this just proves how uncertainty will remain strong for a while. As most investors have stressfully learned, uncertainty inevitably leads to volatility.

Cashing in on Volatility

The good news is you can turn all that volatility to your advantage. It’s ugly out there, and the markets are still whipsawing 2% or 3% every day. It’s volatile, really volatile.

But you can turn all the volatility into a buffer against losses. And you’ll also be padding your gains if the market does recover from here. And right now could be the best time to start doing it.

It’s called covered call writing. (There’s a way you don’t have to even deal with this strategy, I’ll explain how in a second)

Covered call writing normally requires you to buy at least 100 shares of stock. Then sell (or “write” in options-speak) the right to someone else to buy that stock from you at a predetermined price. You get a cash payment upfront (the premium) and the buyer of the call option gets the right to buy the shares from you.

If the stock goes up, they’ll buy it from you and pocket the difference as a profit. As a result, your upside is limited. If the stock goes down though, you have the cash payment to offset your losses. If it stays flat, you just collect the cash and keep the shares.

Covered call writing works well in a rising market. It doesn’t work in a rapidly falling market. It works great in a flat, highly volatile market.

During an average market with low to medium volatility, you’ll only get a 5% or 6% premium. During a bull market, you’ll get a 2% or 3% premium because volatility is so low. But during a highly volatile market, you’d get cash payments as high as 10% or 15% every month or two.

A One-Stop Covered Call Writing Shop

Now, if all this sounds a bit confusing, don’t worry. Covered call writing is a more advanced strategy that takes a bit of time and practice to do well. For those who don’t have the time or desire to learn how to do it, there’s a way to take advantage of this strategy.

In a way, you get all the benefits without having to buy shares and write a bunch of options. There are exchange traded funds (ETF) which do all the work for you.

One we’ve been waiting for the markets to level out on is the iPath CBOE S&P 500 BuyWrite Index (NYSE:BWV). This is a covered call writing ETF which does all the work for you. It owns the S&P 500 and writes call options against it. It collects the payments and buys the shares and pools all the funds. (Technically, it’s an Exchange Traded Note which essentially outsources all the trading activity – but you get the point)

In the chart below, you can see how the covered call strategy played out over the past 18 months (S&P 500 Index is red and BuyWrite Index Fund is blue):

The chart starts when the market peaked in October of 2007.

The S&P 500 has steadily declined since then. It’s down a bit over 50%.

Meanwhile, the covered call strategy has proved its worth. It’s down about 35%. And if you look back in time, right before the markets really started to drop last September, you’ll see the covered call ETF was flat while the S&P 500 was down by more than 10%.

Outlook is Great

It’s easy to see the value of covered call writing. Like I said, covered call writing works well in a rising market. It doesn’t work in a rapidly falling market. It works great in a flat, highly volatile market.

That’s why I’m starting to look at the strategy again now. Just take a look at what’s happening around us.

Steven Leuthold is advising clients to steer clear of his Grizzly Short Fund. A few months ago, Bill Fleckenstein, announced he would be closing down his short-selling fund.  Fleckenstein said, “The recent carnage in the stock market, real estate market, and the financial system (as well as the job losses) has washed away [the market] excesses to a large degree.”

This signals to me the short sellers are starting to run out of opportunities. In other words, stocks in general are reaching much more reasonable valuations.

On top of that, we’ve got to look at the trillions of dollars governments around the world are pumping into the system. As we discussed before with Harry Dent a few months back, this will likely spark a soft recovery – at least a temporary one.

This means we could be dealing with a relatively flat market for a while or a market which is starting to slowly turn around – at best. Volatility isn’t going away either.

These are the ideal conditions for covered call writing.

The markets are going to be a tough place for a while. Don’t let one up day fool you – especially one led by the “theory” China will be able to lead the world out of this recession.

There will be plenty of opportunity along the way. But, I warn you, it will only be those of us with the knowledge, focus, ideas, and the tools to take advantage of it all like the ones we routinely delve into here in the Prosperity Dispatch. Covered call writing, whether directly on individual stocks or through an ETF, will definitely be one of the tools you’ll want to have in your tool box.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Say what you want about the validity of China’s “official” numbers, but it’s bad and it’s probably going to get worse. As you can see in the table below, the downtrend is still accelerating.

The U.S. is Sneezing

At this rate, China is on its way to a full-blown crisis. As we looked at a few months ago when the first wave of manufacturer shutdowns in China swept through the country, there would be a lot more to come. After all, about 1/3rd of China’s economy comes from production, manufacturing, and exports and about 1/3rd comes from expanding export and production capacity.

That’s why China’s economy takes a double hit during tough times. When toy factories are shutting down, the economy loses the jobs. Of course, there’s no need for new toy factories either, so the production expansion sector of its economy gets hit too.

The old saying, “when the U.S. sneezes, the rest of the world catches a cold,” certainly seems to be proven in China. China Daily estimates, “A drop of 1 percentage point in the economic growth of the US and Europe would send the Chinese exports falling by 4.75 percent, and the exports of electronics and textiles down by 0.5 percent respectively.”

Now, we’re starting to see the impact on GDP growth. Of course, the quickest way to get China back on track is to get exports rolling again. As we saw a few weeks ago, that’s not going to happen anytime soon. That’s when China announced its exports fell the fastest in over a decade.

This is the first time China has had to deal with all three of its top customers, U.S., Europe, and Japan – being in recessions.

What does this mean for China stocks?

Well, since November, there’s still a lot of interest in China stocks. It’s pretty tough to make a case against the long-term opportunities in China. The country’s economy is showing signs of change. For instance, last month retail sales increased more than 17%. So internal demand is growing, but it’s got a long way to go. The short-term outlook, however, isn’t very strong at all.

One indicator I look at is the volatility component of long-term options on the iShares FTSE/Xinhua China 25 Index ETF (NYSE:FXI) which tracks 25 of the largest publicly traded Chinese companies. The volatility on the FXI is the equivalent of the VIX (CBOE Volatility Index, or “Fear Index,” for the S&P 500). Although it has a bigger exposure to mining and energy stocks than the S&P 500, it’s the closest thing to a “China VIX” as you’re going to find.

The VIX is basically a way to value the cost of downside protection. It’s the cost of insurance. When the market is falling, the VIX goes up and vice versa. Today, the China VIX ticked up to 80 (for the January 2010 FXI 25 Put option). Compare that to the S&P 500 VIX of 50 and it shows there’s still some strong demand for “insurance” against Chinese stocks, but it’s not near crisis or panic levels.

Combine a steadily declining economy, and growing fear, and it’d be a pretty safe bet there will be an opportunity to “buy China” down the line at a noticeably better price. We’ll keep you posted in our 100% Free e-Letter, the Prosperity Dispatch. Remember, China’s economy is built for booms and no one knows how well it’s going to fare during a downturn. So far, it hasn’t fared well at all.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Siegel’s work has both adherents and detractors, but it’s hard to argue with his data.  His most famous work may be the following bit of pictorial pulchritude:

Plotted on log scale so that percentage gains are apparent (rather than nominal gains), Siegel has traced the value of a single dollar invested in a number of asset classes from 1800 until the present.  His findings are shown on the chart above.

In short, a dollar invested in stocks has produced gains that dwarf all other asset classes.  On average, equities have returned 7% per year for the last two centuries.  Cash has become worthless, while gold, interestingly, has proven itself a near perfect store of value.  One dollar of gold purchased in 1800 has returned nearly exactly that – one dollar nineteen cents.  (This may be the most compelling argument for those who maintain that gold is the ultimate hedge against inflation.)

Whether or not any of these trends will continue into the future is a point of debate for another time.  What is most interesting for us at this juncture is the absolutely straight regression line that marks the return in equities over the period in question.  It is to this straight line that we now turn our attention.

A Truer Regression to the Mean?

Many of the arguments of the investment world’s perma-bears center around the phenomenon of “regression to the mean,” a perfectly legitimate line of reasoning that states:
 

1. that there is a verifiable, historical statistical norm, and
2. that deviations from that norm are eventually corrected such that
3. the long term historical trend remains in force.

The bears employ this argument with respect to dividend yields, P/E ratios and a host of other metrics to prove that the market is out of whack and has to fall before we can be sure that it’s safe to own equities again.

Nothing wrong with that.

Until Professor Siegel comes along with his charts and explains otherwise.  According to him (via the chart above), the regression line that is most significant to equity ownership has, in fact, been adhered to remarkably well for hundreds of years, and we needn’t worry about doing anything but buying equities and holding them for the long term.

Here is another look at his equity return line for the last 40 years.

What can be seen here are the dips and jabs above and below the regression line that mark the overbought and oversold moments in market history since 1970.  Deeply oversold markets in 1974 (40.7% below trend) and 1981 (40% below trend) were only worsted by the grand-daddy bear market of 1932, which brought equities 42% below trend (not shown).

Until now.

Siegel’s research shows that the 2008 bear market has brought stocks 43.1% below trend, pointing to a bear market relatively worse than anything we have seen for the last 200 years!

Does that mean stocks will not fall further?  Absolutely not.  Things can fall apart (as nearly everything eventually must).  And we have certainly entered a new era where the results of unprecedented central bank meddling will reap consequences unknown, unintended and likely dire.  But, at the same time, investors must also be aware that two hundred years of history has a momentum of its own – and must also be reckoned with.

Therefore, should we regress to the mean that Professor Siegel’s work points us toward, we could be witnessing the S&P 500 back between 1200 and 1400 in no time.

Conversely, Siegel’s work indicates that there’s no historical precedent for indexes to fall significantly from these levels.  Figure out what history means to you, and take that for what it’s worth.

Option strategies for the Siegel-wise

If Siegel’s data and the conclusions drawn from them make sense to you, there are some fairly straightforward options strategies that could net you (limited) profits while at the same time minimizing your risks.

We would recommend bull put spreads on the SPY with a nice cushion on them – earliest expiration April.  That should give the market time enough to find its feet.  And be sure both strikes chosen are below the November lows of 75. 

For those who’ve never traded them, there’s lots of liquidity in the SPYs.  Pick the credit spread of your choice (and the amount you’re willing to risk) and set up shop.

If the Siegel pop comes as we expect it should, you’ll walk away with your chosen credit easily.

“Our ignorance of history causes us to slander our own times.”
– Flaubert

Matt McAbby
Analyst, Oxbury Research

Let me begin by saying that options are tools, nothing more. Tools can be used to build something. Or they can be used to tear something down.

The key is to understand and master your tools and, more importantly, not destroy wealth when your intention is to create it.

Let’s start by defining our terms…

The Difference Between Put & Call Options?

Here are the differences between put and call options:

• A put option gives the owner the option of selling a stock at a specific price, again known as the strike price, over a given period of time.

   

• A call option gives its owner the option to buy a stock at a specific price, known as the strike price, over a given period of time.

The key advantage of buying options is that it allows you to control a large amount of stock for less money than it would cost you to buy the underlying shares.

• If the stock moves up rapidly in a short period of time, your percentage gain in the call options will be much larger than if you had bought the shares.

   

• By the same token, if the underlying stock suddenly falls off a cliff, your percentage gain in the put options will be much larger than if you had shorted the shares.

Under normal circumstances, however, few stocks move sharply in the near term. They tread water. They bounce around in a narrow range. Or they trend gently higher or lower.

When you have rare periods of extreme volatility – like the one we’ve experienced over the last three months – options become pricier, making it more difficult to score easy gains.

But the bottom line is this: The overwhelming majority of options expire worthless. Most people trading call and put options lose money.

Why Options Are Riskier Than Stocks

Why are options so much riskier than stocks?

• With stocks, time is your ally.
• With options, time is your enemy.

Built into the price of every option is a time premium. As time passes, that premium diminishes.

To make big money in puts or calls, the stock doesn’t just need to move in the right direction. It needs to make a sharp move in the right direction in a short period of time.

This is no easy trick.

And it’s exactly why selling options – collecting those premiums – is a conservative strategy, while buying options – paying premiums – is an aggressive one.

In the world of options, buyers are gamblers. Sellers are the casino.

Why Investors Continue To Use Option Trading Strategies

If the odds are long against long-term success with buying options, some might ask, why do so many investors continue to use option trading strategies?

Here’s an analogy …

If you’re a decent golfer playing a short par five, you may be tempted to go for the green on your second shot and give yourself a putt for an eagle.

The golf course architect knows this, of course. So what does he do? He puts a pond in front of the green and sand traps on both sides.

The smart thing – the percentage shot – is to just lay-up in front of the water and then chip on for a shot at a birdie.

Yet, often as not, the weekend golfer pulls out his three-wood or long iron and goes for the green. He realizes that his ball will probably end up in the cat box or the drink, but he goes for it anyway.

Why? Because if he pulls it off and makes an eagle, it will be the best thing he did all week. In short, he’s willing to risk it.

If it doesn’t pan out, well, what the heck, he knew the odds when he stepped up to the ball.

I guess what I’m saying is we’re all big boys and girls. Options are a “no-tears” investment. If you don’t understand this, you shouldn’t be trading them.

Puts and calls are neither good nor bad. They are simply tools.

Give a man a chainsaw and he’s likely to do some good work with it. Give it to a six-year-old and someone is likely to lose an arm.

Govern yourself accordingly.

Good investing,

Alexander Green
Investment U