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Options Insider

Feb. 11, 2008
Volume 3, Issue 6

IN THIS WEEK'S ISSUE:

1. OPTIONS THOUGHTS: A Macro Approach to Mega Profits
2. TRADE OF THE WEEK: Merck (MRK)
3. WEEKLY TECHNICAL FORECAST: More Selling on the Horizon
4. TRADING TIP OF THE WEEK: Margin Accounts Give You More Investing Options
5. ON THE LOOKOUT FOR MORE OPTIONS?


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1. OPTIONS THOUGHTS: A Macro Approach to Mega Profits -- by Michael Shulman

Dear Fellow Options Insider,

When Wall Street looks back on the latter half of January 2008, they will remember it as the era in which the future of Ben Bernanke's job was decided.

The decision will revolve around whether he kept the country out of a deeper recession than we are currently in, whether he shocked the markets enough to prevent a real crash rather than a bear-market correction, and whether the Fed headed off the continuing effects of a worldwide credit squeeze with its interest-rate cuts.

It is, of course, too soon to tell.

But Bernanke did signal something he is not supposed to -- his emergency interest-rate cuts told all of us that the stock market's behavior counts, something that Fed chairmen are not supposed to say even though we all know it to be true.

These rate cuts are dramatically improving the profitability of banks, if not necessarily lessening the credit squeeze.

That being said, the economy is still going to struggle for the near term and we will continue to play it accordingly, in addition to the companies we identify as stellar short-side prospects through ChangeWave Alliance survey research and other data.

SO HOW DOES THIS IMPACT OPTIONS TRADERS?

In my ChangeWave Shorts service, we use put options to ride stocks to the downside. We made some very nice profits on the banks before Dr. Ben's big intervention, closing out positions in Citigroup (C) and the Financial Select Sector SPDR (XLF) -- an Exchange-Traded Fund that represents the banking industry -- for gains of 179% and 143% while the market was struggling to stay afloat. And those are only two of many success stories under our belts, and many more to come, by investing on what I call the "short side."

Where do we find short-side investing opportunities? I'm glad you asked.

'PUTTING' OUR MONEY BEHIND ALLIANCE FINDINGS

Two core sets of data drive my picks -- macro data from ChangeWave Alliance surveys and other sources, and then segment and micro data. Some of this micro information also comes from the surveys, as well as information found in financial and other reports, like proprietary databases and analyst reports.

Macro Data -- The ChangeWave Alliance completes three surveys each quarter that look at the general economy and specific market segments: Consumer Spending, Corporate Sales (which includes capital spending, pricing, hiring and so on) and Corporate IT (Information Technology) Spending. These keep me ahead of other analysts because we're talking to the men and women who are responsible for budgeting and/or making (or choosing not to make) the purchases.

I supplement this with select research and the opinion of analysts I respect -- which is not many, admittedly.

For example, we made a fortune because I had lunch last February with a homebuilding expert at a major investment bank -- it was the best fifty bucks I ever spent, not to mention the best Caesar salad, according to Washingtonian Magazine.

On a serious note, though, the profits we made on the lack of new homes being built was enough for many of my subscribers to purchase vacation homes of their own!

Segment and Micro Data -- The ChangeWave survey staff does more than 40 surveys each year of narrower market segments and/or individual companies. Segments range from semiconductors to hospitals, with equally diverse topics ranging from Linux servers to staph infections. I work closely with the staff to ferret out the truth weeks and months before Wall Street becomes aware of emerging trends -- and these surveys are dead-on.

From this data, stock picks are made. Once we've identified the biggest losers, I pick the put options with the right combination of reasonable cost (anywhere from a few cents to a few dollars per share), ones that give us enough time for the position to work in our favor, and ones that stand to become money-doublers or even -triplers.

Stocks fall faster than they rise, so it's important to be positioned before the fall takes place in earnest -- and that's why we play the game with put options. Not only is it profitable to allocate a portion of your portfolio to the short side, but watching stocks fall has never been more fun!


Michael Shulman
Editor
ChangeWave Shorts

P.S. When the banks -- or other sectors -- are losing money, who profits? When you're investing on the short side, YOU do! Click here to check out ChangeWave Shorts and learn how to love losing stocks!


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2. TRADE OF THE WEEK: Merck (MRK) -- By Jon Najarian

Why pay more to enter an options trade than you have to?

The answer is, of course, "Don't!"

Using option spread strategies is an effective way to reduce both your capital and your risk, and one of my favorites right now is a bear-put spread.

The tactics behind a bear-put spread are both easy to understand and to execute. It's an options trading strategy for when you are moderately bearish on a particular company, index or sector. You simply buy one put option and sell another put option against it with the same underlying stock at a lower exercise price.

With the markets suffering an abysmal start to the new year, we successfully used this strategy in my ChangeWave Options Trader service.

While few names are flourishing in this screwball market, few sectors have been hit harder than big pharma.

On Jan. 17, things were going pretty badly in the drug stocks, as Merck (MRK) and Schering-Plough (SGP) were hit hard with the ugly stick, falling 6% and 7%, respectively.

Merck was removed from the "Focus 1" list at Merrill Lynch (MER) that morning, which contains the firm's top stocks. And to add insult to injury, a Seattle law firm claimed to have filed a class-action lawsuit against both MRK and SGP, saying they violated state consumer-protection laws for the marketing of cholesterol drugs Zetia and Vytorin.

Our Depth Charge system showed some 10,500 MRK Feb 55 Puts trading almost exclusively on the offer price, which is to say they were bought aggressively from the opening price of $1 up to the day's high at $2.05.

A total of 45,000 puts changed hands in MRK versus a 30-day average daily put trade of 5,500 contracts. The open interest at the $55 strike was 7,200 contracts.

In plain English, the trading activity was bearish, to say the least. The stock was trading in the $58 area, so if investors were buying puts at $55, it means they were making a bet that the stock was going to drop three points before February options expiration came around.

Now, if I had recommended that my Options Trader subscribers go out and buy the MRK Feb 55 Puts, they would have shelled out $2.15 (or $215 per contract).

There was no need for them to pay full price, so instead I recommended they institute a bear-put spread by purchasing the MRK Feb 55 Puts at $2.15 and selling an equal number of the MRK Feb 50 Puts against them for a 60-cent credit, which lowered their net expenditure to $1.55 per share.

The very next day, MRK was down another 4.5%, and it spelled more ugliness for the drugmaker. Just a few short days later, on Jan. 22, I recommended that my readers close out half of their positions in the MRK Feb 55-50 bear-put spread to preserve our 64% profit in the batty market, but I wanted to keep some on the table just in case of a pop.

We didn't have to wait too long for the next spike to come around. In fact, it came the next day (Jan. 23). We closed our position for an additional 106% win. Cha-ching!

The spread was up to $3.30 from our $1.55 investment, but even though the drug giant was on its backside, I was worried about an emergency European Central Bank rate cut and what it might do to impact the global market and, specifically, this declining drug stock. So, we bid farewell to the MRK Feb 55-50 bear-put spread, pocketed our overall 85% winnings, and went hunting for fresh meat.

My systems that track unusual options trading activity are always on the prowl, and I'm constantly in search of the next big winner. I'm already hard at work, looking for this week's biggest opportunities -- click here to join my Options Trader service and get positioned for our next trade!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader

3. WEEKLY TECHNICAL FORECAST: More Selling on the Horizon -- by Sam Collins

Not only did last week end on a sour note, but the group that some were crediting with perhaps making a bottom -- the financial stocks -- took it hard on the chin throughout the week.

In fact, the Financial Sector SPDR (XLF) fell almost 9% in six days and it, along with the broader market, is heading for a test of the Jan. 22 low.

As for the major indices, they have retraced about half the distance down from the Jan. 31 high to the low of Jan. 22, but the internal indicators are still just a bit overbought at only one-quarter to one-third down. This could indicate that the current round of selling has at least several more weeks to go.

A rough calculation shows that they could become oversold at a point just under the lows of Jan. 22. But if the market lows are broken, I'd expect to see a sell-off that would decrease the indicators to extremely oversold numbers.

As for the sentiment numbers, just following the upside reversal from the Jan. 22 lows, the advisers' sentiment, as reported by Investors Intelligence, turned slightly more bullish. That coincides with the American Association of Individual Investors' bullish/bearish numbers.

The public bearish numbers, as measured by the AAII numbers, have dropped for three successive weeks from a high of over 58% to just over 47%. These numbers can change rapidly, and it is the direction of change that is important -- in other words, their move toward a more bullish attitude is not favorable.

Essentially, the primary downtrend, which was triggered in late January and started with the failed breakout high on Oct. 11, is intact. Here are the ultimate but tentative targets for the selling: Dow Industrials 10,840 - 10,900, S&P 500 1,185 - 1,250, and Nasdaq 2,000.


Sam Collins
Editor
Daily Trader's Alert

4. TRADING TIP OF THE WEEK: Margin Accounts Give You More Investing Options

As you build confidence and experience buying options, it's only natural to start thinking of the potential profits to be had by selling options.

Options traders can make money purchasing options and selling after their value has increased, as well as selling options that you don't even own, which is also called "naked writing."

The sale of options through naked writing deposits funds in your account up front. It's literally that simple -- instead of "buying to open," as you'd traditionally do when purchasing a call or a put, you "sell to open" to initiate a short option trade. However, to write options, you must set up a margin account.

When you're opening a brokerage account, you might want to establish a margin account at the same time, even if you don't plan to use it right away. A margin account allows you to borrow money to buy securities. You might be required to put down as much as 50% of the value of the options contract and then borrow the rest from your broker.

In essence, this account can enable you to effectively double your buying power. Suppose you buy a stock for $20 per share, and you want to purchase 500 shares. The margin account lets you buy another 500 shares, using the money your broker has loaned to you. So, if that stock goes up to $30, you pocket the $10-per-share gain not on 500 shares, but 1,000, and you pay your broker back for the loan.

Trading options on margin is a similar process, but what if you want to short stock or options instead of buying them?

When traders use margin, the broker incurs risk for the money it lends, so it takes steps to cover itself. Your broker will charge you interest for the right to borrow money and will use your securities as collateral. Further, most brokerages will require proof of some trading history and options knowledge before granting a margin account.

How much margin you'll need is dependent on the risk of an individual position. If you sell an option that is trading fairly far out-of-the-money, then the margin will be small. The best way to find out is to ask your broker to give you an idea of what the margin will be before you take a position in the market.

As the expiration date approaches for your option, the loss potential increases so the margin is increased. However, if you cover a short call with a stock you already hold long then you do take some of the risk out of your position, which also reduces margin.

It's important to be aware that margin accounts have consequences. Margin offers traders tremendous leverage, which means that both your gains and losses are intensified. So, while you can enhance your wins, you may also be putting your money -- and your broker's -- in jeopardy on a trade that doesn't go in your favor.

Your broker is keeping track of your trade's performance, and if it goes against you by a certain amount, you may receive what's known as a "margin call," in which you are required to deposit additional money into your margin account to cover your losses. Or, you may have to sell some of your assets in order to raise this cash to maintain a minimum balance.

Margin is great when your investment's value is increasing, but the double-edged sword of leverage can really draw blood if your portfolio nosedives. Because margin exposes you to extra risks, be sure to start small and work your way up to using it to help you win big.


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5. ON THE LOOKOUT FOR MORE OPTIONS?

ChangeWave Shorts editor Michael Shulman will appear on the Fox Business Channel from 10 a.m. to 11 a.m. Eastern on Wednesday, Feb. 13.