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Preserve Capital Gains with Puts

August 02, 2006

Dear Fellow Options Trader,

When the economy is in an uptrend and we find ourselves in a bull market, a number of investors like to trade call options, as they indicate bullishness about a company, index or industry. But then in May, when geopolitical tensions coupled with fears about inflation and the Fed's next moves in relation to interest-rate hikes, underlying securities took tremendous hits. No one saw the meltdown coming, but most people who have ever traded or invested certainly felt the aftermath.

When I spoke at the Washington, D.C., Money Show recently, there were two concerns at the forefront of many people's minds: how to protect one's portfolio during uncertain market times, and how to make money in a down market. My answer to both questions, of course, is to take advantage of the options markets. One good way to do this is to buy protective puts on stocks you own or even on your whole portfolio.

'PUT' SOME PROTECTION IN PLACE

When you buy a put, you're securing an insurance policy wherein you prevent (further) loss in your holdings and/or lock in a gain.

To do this, look at where shares of your stock are trading and choose a put at a nearby strike price that's below it (i.e., with the stock at $37.50, you might buy an option at the $35 strike). As the owner of this option, you have the right to "put" that stock to the seller at that strike price anytime during the life of the contract. So if shares drop to $30, you can exercise your right to sell your stock at $35. But if the market price spikes and your shares go to $40, the most you can lose is the amount you spent to buy the puts.

What you've done, then, is bought is peace of mind knowing that no matter what happened, your profits would be preserved!

As this was such a hot topic in D.C., today I want to talk more about why investors might avail themselves of these derivative products. Did you know that using a protective put to decrease your risk doesn't have to destroy your holding period to qualify for the lowest capital-gains tax rate?

Read on, and I'll give you a quick primer on how to preserve ALL of your gains!

DON'T LET SHORT-TERM TRADES JEOPARDIZE LONG-TERM GAINS

Securities (which, for this example, will include stocks and options), that are held for one year or less are considered to be short-term and, thus, are taxed at ordinary income tax rates. However, the federal government designed the new tax law to encourage long-term investment in companies, and as a result, the gain realized from selling a long-term holding is taxed at a lower rate than short-term gains.

To qualify as a long-term holding, a security must be held at least a year and a day after you bought the investment, which is 366 days in a normal year and 367 days in a leap year. Several possible rates could apply to long-term capital gains, but for most investors, the rate is 15%. Those in the 10% or 15% income tax brackets would pay 5%.

Now, here is where that protective put can limit your downside without destroying the holding period.

PROTECTIVE PUTS AND HOLDING PERIODS

A protective put, when used improperly, might restart a security's holding period, so it's important to understand what the IRS says is an appropriate put option to invest in -- i.e., one that won't restart that period.

As long as the put you purchase is out-of-the-money (that is, a put whose strike price is less than where the stock is priced), then it will not destroy your holding period. But if you were to purchase an in-the-money put (i.e., a put with a strike price above the level where the stock is trading), then that WOULD restart the holding period for your stock.

It's important to keep in mind that securities you've already held for 366 days are not subject to a restart in their holding period, because once you've qualified for long-term capital gains treatment, the die has already been cast and you will not destroy or restart the clock with additional strategies you choose to employ.

It's also worth noting that if you are holding the securities in a tax-deferred or tax-free account, such as an IRA, Roth IRA or 401(k), then protective puts and long-term capital gains treatment are not something you need to be concerned with.

WHAT DOES THAT MEAN FOR US?

Since the inception of ChangeWave Options Trader in 2004, we've been in a bull market and have taken advantage of it with a number of bullish (call-buying) strategies. But now, here we are in this inconsistent market that changes direction at a moment's notice -- a market that doesn't flinch on some headlines, yet flies into overdrive because of others.

To help us profit no matter what the markets are doing, we're looking to eventually incorporate more put recommendation strategies (where appropriate). Our HeatSeeker and Distant Thunder technology is phenomenal for detecting unusual trading activity in the options markets, and while they uncover extraordinary trading in the puts, these programs have been more successful on the call side.

That said, on the development front, we've been tweaking our computer models to find better bearish indicators that would serve to complement our existing programs, and we're excited about the progress we've made so far. To gain additional confidence in the readings, we're presently back-testing to see how accurate our new technology would have been in a variety of past market conditions.

Because we've named our bullish indicators HeatSeeker and Distant Thunder, we need some bearish names. We've come up with Depth Charge and Red October as code names for our unusual put activity scanners, but then thought about creating a naming contest for this new technology.

So, if you'd like to "name that bearish program," please drop me a line and I'll send the winner a T-shirt with my logo on it.

WHAT THE OPTIONS MARKETS ARE TELLING ME

It seems that Wall Street is overreacting to every headline, and this news event-based trading environment has produced as volatile a market as we have witnessed in some time.

At mid-session, the S&P 500 (SPX) moved higher by 11.03 to 1,281.91 and volatility (as measured by the Volatility Index, which is based on options trading in the S&P) eased by more than 6%, falling to a midday reading of 14.11. We showed 71,527 calls trading versus 136,718 puts, giving it a 1.91-to-1 put/call ratio. This ratio has lost just a bit of strength since yesterday.

The iShares Russell 2000 (IWM) index showed a volatility level of 28.62 at midday, and HeatSeeker has revealed 84,869 calls trading against 154,909 puts, giving us a 1.82-to-1 put/call ratio.

The Nasdaq 100 Trust (QQQQ) had a volatility level of 20.15 at mid-session, down 5.7% from yesterday's close. The Qs traded 131,788 calls to 230,452 puts by mid-session, for a 1.74-to-1 put/call ratio, gaining some strength since yesterday.

TRADE OF THE WEEK UPDATE

To take advantage of prime market conditions when they arise, we've been sending the weekly trade recommendation independent of the newsletter. Moving forward, even if both happen to come on the same day, we'll send any trade information as an alert so that you can give it priority attention.

That said, we saw some nice movement in our Genesis (GNSS) and Coach (COH) calls this week and took profits accordingly. I'm looking forward to us chalking up some more great wins, and I'll alert you when I find the next one on the horizon!

Good luck trading and remember -- pigs get fat, but hogs get slaughtered, so don't be a hog!


Jon "Dr. J." Najarian
Editor
ChangeWave Options Trader