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Options Insider

Jan. 28, 2008
Volume 3, Issue 4

IN THIS WEEK'S ISSUE:

1. DOC'S THOUGHTS: Rogue Trader Lacked 'Street' Smarts
2. TRADE OF THE WEEK: Short-Side Profits in Martha Stewart Omnimedia a 'Good Thing'
3. WEEKLY TECHNICAL FORECAST: Expect a Test of the Lows
4. TRADING TIP OF THE WEEK: The Technical Side of Options Trading Analysis
5. ON THE LOOKOUT FOR MORE OPTIONS?


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1. DOC'S THOUGHTS: Rogue Trader Lacked 'Street' Smarts

Dear Fellow Options Insider,

When I'm following unusual trading activity on my HeatSeeker system, a lot of the high option-trading volume that takes place in stocks that aren't (yet) making headlines can be attributed to "insiders" sharing investable information with each other.

That doesn't always mean it's "insider trading," which is a serious allegation. But instead, it's fairly commonplace for several parties involved in a merger, for example, to have access to sensitive, confidential data. Unfortunately, it's not unheard-of for someone to use it to their advantage before the rest of the investing public knows that a deal is taking place. On Wall Street, it's just business as usual.

But one thing we've found when big bets are placed before big news hits is that, oftentimes, the culprit isn't someone with seniority or someone who has been around the block a few times. Instead, it's frequently a young, rookie trader who suddenly discovers that he or she has access to some very powerful information -- data that could make them rich if they play their cards right.

And as we all know, even the best-laid plans go awry. But when it's someone inexperienced at the helm, they tend to underestimate how impossible it is to avoid getting caught.

However, in the case of the junior trader who was deemed responsible for fraud to the tune of $8 billion at France's Societe Generale bank, something tells me that he might have had a little help in allegedly orchestrating the biggest bank fraud on record.

The trader in question, Jerome Kerviel, joined the bank in 2000 as an office worker, which supposedly gave him an edge in hiding what the bank referred to as "massive" futures positions taken on the European markets.

Kerviel has been charged with fraud and faces up to seven years in prison and a 750,000-euro fine if found guilty. However, the prosecutor on the case stated that the 31-year-old, who is currently in custody, did not try to make personal profits on the deals he made. So, if he made all those bad bets, why was he going to such great lengths to conceal them? Was he too clever for his own good or is he being framed by someone even smarter?

What's interesting is that, speaking of personal gain, earlier this month 100 shareholders filed a lawsuit after a SocGen board member sold 85.7 million euros worth of shares. But as time goes on, will more events surface that led to the big losses -- not only in the bank's assets but also in its share price? Or are the most-recent events the answer to all the questions that have been raised?

Whether the two were connected or just coincidental remains to be seen, but one thing's certain. All companies want to hire the "best and brightest," and even though that's usually a wise move, sometimes these up-and-comers are a little too smart for their own good.

As we've seen time and again, no matter what or who the culprit ends up being, book smarts simply don't easily translate into a commensurate amount of Street smarts!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader


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2. TRADE OF THE WEEK: Short-Side Profits in Martha Stewart Omnimedia a 'Good Thing' -- By Michael Shulman

There are many reasons to bet on a stock going down, whether you directly short the stock or instead buy put options as a lower-risk way to capitalize on a stock's downside.

If you wouldn't be caught dead owning the shares, that's a pretty good indicator that it belongs in your short-side portfolio. But how do you go about picking the potentially biggest losers?

Like the saying goes, "It's what's inside that counts." And if a company, stock or sector is ugly on the inside, it's only a matter of time before the ugliness -- in the form of broken business models, less-than-spectacular corporate leadership, companies that are losing their competitive edge, and other conditions that signal their crumbling fundamentals -- shows on the outside. And then the stock goes down.

Martha Stewart Omnimedia (MSO) is a great example of a two-pronged recession play -- as it has been impacted by both the housing depression and the pullback in consumer spending.

Several months ago, ChangeWave Alliance surveys started revealing that the bloom was coming off the consumer rose -- even among the well-wheeled folks we survey -- and that spending growth was slowing. When you're looking to get situated on the short side, you want to get into the names that are about to take a serious turn for the worst. And on Sept. 27, Martha Stewart's empire caught my eye as a potential casualty due to a perfect storm of events that was going to kneecap its share prices.

And I'll admit, I love saying it -- I was right!

Given that the consumer drives up to 70% of the economy, and also given that our Alliance survey data told us that consumers across various income brackets were going to tone down their spending going into 2008, we saw Omnimedia as a perfect target, as it was barely profitable when consumer spending was more on-track.

Even better for us, it is also a poorly managed company, which meant that even if the company recognized its flaws, it couldn't execute a turnaround in its business model within a reasonable time frame -- if at all.

Throw in some lackluster holiday sales and a bleak outlook (because, if it doesn't make its money around the holidays, then when will it?), and your feeling of pity for this company is the only thing that will keep you from fully enjoying all of the short-side profits you can make off of it!



Back on Sept. 27, I told my ChangeWave Shorts subscribers to set the table for an elegant serving of short-side profits, via establishing a position in Martha's empire via the MSO Jan 12.50 Puts for $1.70 or cheaper.

This was a bet that shares of MSO would drop below $12.50 and, preferably, continue dropping. That's how you make money with put options -- they are a low-risk way to reap a potentially unlimited reward if the stock falls farther and farther.

Subscribers were able to get in for $1.60 a share ($160 per put option contract), and I picked the January expiration date so that we could see how the holidays panned out -- or, more accurately, did not pan out, for MSO.

We had a few challenging times when the market popped in early October, which rattled our positions in MSO as well as in a few other potential-recession/soft holiday spending plays. But even though I frequently re-evaluate our short-side positions to ensure that we're in the right place at the right time, all my research assured me that the position would turn back into our favor.

And in mid-October, the company announced a revenue increase for the first half of the year, which sent the value investors piling into the stock temporarily, thinking they were going to get a good bargain. In the meantime, I reassured my subscribers that it was worth riding out the volatility in the position because the good news for MSO had just about dried up.

Sure enough, in November, the company announced third-quarter results that included a $5 million loss. Ouch!

All stayed quiet on the short front through early January, when on Jan. 3, our puts had doubled in value, from $1.60 to $3.30, giving us a nice 106.25% gain. Not bad, but the stock was at $9 and dropping quickly, so while it was prudent to preserve some profits, there were many more to be captured.

So, I asked subscribers to roll the position -- that is, take profits in the original Jan 12.50 Puts and use the original investment dollars to buy a new position with a later expiration date and a lower strike price. And the MSO June 10 Puts, which were trading at $1.85, looked like the way to ride the short-side express to even-bigger profits.

Long story "short," the overall market mayhem that came with the dawning of the new year -- plus an abysmal lack of holiday sales for MSO and many other retailers -- made the position work in our favor very quickly.

In fact, on Jan. 16, I informed my subscribers that it was time to take the money -- $4.40, to be exact, which was a 137% gain! -- and run!

Consumers might not have been spending much at their favorite retail establishments this past holiday season, but those of us who did our shopping in the options markets by buying puts on these retailers enjoyed some very merry profits indeed!


Michael Shulman
Editor
ChangeWave Shorts

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3. WEEKLY TECHNICAL FORECAST: Expect a Test of the Lows -- by Sam Collins

The market's focus is currently on the Fed's two-day meeting and its next moves to stimulate the economy. Before the emergency 75-basis-point cut in rates last week, most observers were looking for a 50-basis-point cut this week, then another 50-basis-point cut within several weeks. However, after the emergency cut, many think that no further relief will come, and that sent many traders to the exits on Friday.

For most of last week, interests centered on momentum gained from the big Tuesday reversals in the financial sector, but the week ended on a sour note, as heavy selling erased at least half of the gains from winners in that group.

The Wall Street Journal reported that traders viewed last week's bounce in banks and brokers as temporary and that we should "expect more negative news from the group in the weeks and months to come."

The first bounce following a major breakdown usually takes back about half of the fall from the last peak. So, if last Tuesday's upside reversal has any guts at all, we should expect the rally to top off somewhere around Dow 12,455 to 12,800.

However, despite some very oversold readings from the stochastic indicators, Moving Average Convergence/Divergence (MACD) and momentum, along with high public fear numbers -- all of which should provide some sustenance to a bounce -- Friday's performance was not very encouraging. The Dow's intraday high came within eight points of the resistance zone and within seven points of it on the S&P 500. Instead of just hesitating before mounting a charge into the zone, every index turned from its high and closed lower, executing a reversal down.

Perhaps that is an overreaction from a very nervous market, and it could even be some overeager shorts jumping on the bandwagon. But this sort of failure from an initial rally usually leads to a quick test of the low.

With little support under current prices to sustain any selling, that low could be very fragile especially if the Fed turns away from additional rate cuts. Continue to raise cash and invest defensively.


Sam Collins
Editor
Daily Trader's Alert

P.S. Sam Collins shares a "Trade of the Day" each morning before the bell, complete with why the stock looks like it's ready for a breakout. Plus, he shares his take on how the current market activity is shaping up to impact your trading day.

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4. TRADING TIP OF THE WEEK: The Technical Side of Options Trading Analysis

If you've ever heard someone declare they "trade on technicals," they're really saying they use technical analysis to uncover potential stock and option trades.

Unlike options investors who review a company's fundamental characteristics, such as earnings, sales and other financial factors, technical investors don't look at a firm's intrinsic value to determine their options strategy.

Technical options players look at a company's current and historical prices to determine the value of the stock, and thus will buy either calls or puts to capitalize on the upcoming movement. Still, the evaluation of price movement isn't limited to the actual market value of the stock -- it also includes the underlying stock's volume and open interest.

Some technical analysis tools have more bearing to options investors over others.

Moving Average -- The term simply means the average closing price for a stock over any period -- 200-day, 50-day or even five-day moving averages are some of the more common, and significant, measures.

Bollinger Bands -- Bollinger Bands can be used to measure the height or depth of a security's price relative to previous trades; they help illustrate if a spike in price is significant or not. A Bollinger Band employs three lines (the lower band, the upper band and the centerline) to define the price range.

Relative Strength Index (RSI) -- The RSI is a technical analysis tool that compares the magnitude of a stock's recent gains with the magnitude of its recent losses. The index then turns that information into a number ranging from 0 to 100. The centerline for the RSI is 50; some traders look for a move above 50 to confirm bullish signals or a move below 50 to indicate bearish signals.

There are many other technical analysis indicators that technical analysts use to pick their long stocks (and accompanying call options) or for shorting (and associated puts). Using these tools to determine stock performance can help identify whether the calls or puts will reap profits.


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5. ON THE LOOKOUT FOR MORE OPTIONS?

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