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Good Cheap vs. Bad Cheap

November 22, 2006

"That man is richest whose pleasures are cheapest." -- Henry David Thoreau

Dear Fellow Options Trader,

There's good cheap and bad cheap. And as I have just come back from Las Vegas, I have complete confidence that I am qualified to speak about the difference!

Good cheap is picking up a pair of $200 shoes for $59. Bad cheap is standing in a buffet line for 45 minutes for some grizzled piece of something they say is bacon and powdered eggs for $3! Trust me, don't go there under the guise of being economical -- not with Emeril Lagasse or Wolfgang Puck's or any of the hundreds of great dining experiences available in Sin City instead!

Because we're kicking off the merriest season of the year with a shortened week, you've no doubt seen volatility, or risk premium, trade lower in the markets. In fact, traders looking to get into positions must take into account the fact that we really just had two full trading days this week, Monday and Tuesday, before the world headed off to grandma's house for turkey, cranberries and pumpkin pie tomorrow evening!

A number of people choose not to trade on the Wednesday before Thanksgiving, as volumes are typically anemic at best. And then, whatever seemed like a snack today would, by comparison, seem like a four-course dinner on the half-day of trade this Friday!

(Of course, we must take exception with that rule, thanks to today's run in BJ's Wholesale, in which we took profits earlier thanks to its pre-holiday activity! Our BJ Dec 30 Calls (BJLF) that we'd recommended closing for $2.30 or better ended the day at $2.80 on a nearly 10% spike in the underlying shares.)

True enough, it's no surprise that you could shoot a cannonball across the trading floor and typically not hit anyone on either Wednesday or Friday during Thanksgiving week. But what's really odd is that even with volatility at multiyear lows, we are still seeing quite a collapse of risk premiums as the hedge funds go back to dancing with the one that brung 'em: selling (i.e., writing or shorting) calls and puts.

Hedge funds have made small and, in some cases, large fortunes by selling index calls and puts. Sure, there have been times when the sellers had to sweat, as the markets rocked down in May and then ran up through the fall months. But overall, the traders who have assumed the role of "being the house" have profited mightily as they sat back and the premiums rolled in.

But before you mortgage your house to get in on the premium-selling game, consider this: As we've climbed the wall of worry, the metric for risk in the S&P 500 -- known as the Chicago Board Options Exchange's Volatility Index (VIX) -- is now trading at its lowest level in 12 years. It's one thing to go with the momentum, but it's quite another to play musical chairs with the S&P at record levels with the VIX nearing all-time lows!



I'm not saying that North Korea, Iraq, Iran, Nigeria, or some other geopolitical hotspot has to overheat, but I do think that the longer things stay calm, the greater the risk of something happening in one of those areas and, thus, affecting volatility in the options markets. That's not to say that I believe the S&P is overvalued and due for some correction -- just simply that we should be cognizant of the fact that this index has more risk -- not less! -- when it's at record levels.

As I began this article, I said there's good cheap and bad cheap. Right now, I think good cheap is our ability to buy protection (i.e., through the purchase of put options) against a correction for the cheapest prices in more than a decade.

Remember, buying put options is a tool you can use to play a stock or index to the downside, whereas when you're shorting puts, you're hoping that the price won't move too much. There are profits to be made using both strategies, but for my money, I'd rather take less risk whenever I can!

Of course, bad cheap does occasionally win, but it rarely holds that victory for long. Just look at Britney Spears and you probably know exactly what I'm talking about!

CATCH ME ON 'CAVUTO'

I'm scheduled to make an appearance on "Cavuto on Business" Saturday morning on the Fox News Channel. Tune in at 10:30 a.m. Eastern to catch the show.

I hope that you and your loved ones have a wonderful Thanksgiving holiday!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader