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A 'Super' Hedge

January 17, 2007

Hedging: an investment that is taken out specifically to reduce or cancel out the risk in another investment.

Dear Fellow Options Trader,

Did you ever wonder why active gamblers are served free drinks in Las Vegas? Me either. It's pretty obvious that it's not just to keep us happy. Instead, it's to keep us at the tables and, perhaps, to dull or maybe even deaden our sense of loss. The more we drink, the tougher it is to keep our discipline and the easier it is to get us to part with our money!

I didn't learn that lesson in Vegas; actually, I learned it in Fort Lauderdale, Fla. You see, my folks liked to go to auctions at the antique stores partly for sport and partly because my father came from a long line of Oriental-rug salesmen. He could tell in the blink of an eye whether a bargain was a bona fide Isfahan or Tabriz or something we should pass up. Sure enough, we'd make a purchase and, within moments, we'd be whisked to a private, closed-circuit viewing area and plied with champagne, or other adult beverage.

As I said earlier, the purpose of the drink was not just to enhance the fun of the evening; it was to loosen our grip on our wallets. Such was the case this past spring, when I attended a fundraiser for my daughter's school in Chicago. All the folks who attended the scholarship dinner were offered plenty of premium adult beverages prior to the live auction, and given the prices that various items garnered, I'd say the money they lavished on liquor was well-spent!

So here's how I usually go about these fundraisers and charity auctions. First I check out the wines, because like our friend Toby Smith, I've got a cellar I've gotta fill! Next, I'll value the travel packages, meaning I don't take the charity's valuation. Instead, I price it myself. Since I pride myself on where to get a deal (by paying well below retail) I am using a valuation model that is geared much more toward the wholesale than the retail model suggested by those running these types of events.

So, since my model is more of a deal-finder, I rarely get past the first round of bidding. Someone else who has been more suitably marinated in fine wine or spirits (i.e., inebriated), will usually outbid me for the trip through France, or that week in Tahiti. At least, that's what usually happens.

This past spring, a combination of premium adult beverages, an undervalued trip and maybe even fate conspired to change my usual model. The folks at Gatorade had donated four Super Bowl XLI tickets to Miami on Feb. 4, 2007. They also donated use of their corporate jet and tickets to a host of Super Bowl parties. And just for good measure, the package included limos to and from the airports, and two rooms for two nights apiece at a very nice hotel in Miami.

I applied my proprietary algorithm to the package and told my lovely bride she could do the honors of bidding up to a particular dollar amount that I'm not willing to share just now! Brigid enthusiastically agreed to do the bidding, which should have tipped me off that something strange was afoot, but it didn't.

We were both surprised that the package was trading well shy of my projections. Just like an undervalued stock or option that looks cheap, the first thought running through your head isn't, "Oh great, I'm getting a deal!" Instead, the first thought is, "What did I miscalculate?"

As the bidding continued, but still well below my "wholesale" estimate, the father who donated the package for Gatorade, noted that the price was "too cheap" and threw in tickets to the Sports Illustrated Swimsuit party and a couple others that I can't mention without blushing.

The bidding went higher by another $5,000 but Brigid, knowing her limit, kept bidding right along with them. In a flurry that defined the entire bidding process, she even ended up bidding against herself, raising her winning bid by another $1,000 before she realized what she'd done!

When the gavel came down we were the proud owners of "the ultimate Super Bowl package" -- and now all we had to do was to figure out what to do with it!

As I said, that auction was done in the spring of 2006, long before the Chicago Bears clinched home-field advantage throughout the playoffs and became 9.5-point favorites to beat the Seattle Seahawks in the second round of the NFL playoffs. But this brings me to the reason I brought up the auction in the first place, which is hedging!

So here's what I did. I called a friend who is a very active bettor and asked for both the betting line and the odds bet for the Bears vs. Seahawks game. My friend "Skinny" said he could get me 9.5 points and the Seahawks, or I could take the odds bet and get 3.3-to-1.

Since I couldn't bring myself to bet against "da Bears," I could put money on the Seahawks as a hedge against the Super Bowl package, and if the Bears were to win by fewer than the 9.5 points, I'd be a winner both ways -- making money on the bet and the value of a Bears Super Bowl package that should increase rather dramatically as well.

I'm happy to say that the hedge paid off as the Bears won their last game in overtime by three points (27-to-24) and the Super Bowl package is obviously in greater demand as a result. The tough part now is deciding whether I should hedge again this weekend against the New Orleans Saints, or let it ride. But that's a question for another day!

BUY LIST UPDATE

COVENTRY HEALTH CARE

It's expiration week, and our Coventry Health Care (CVH) Jan 50 Calls (CVHAJ) are about to come off the board. The stock closed at $51.55 today, and our calls are currently trading just a nickel above where we recommended them at $1.45 back on Dec. 1.

The company isn't expected to release its earnings until Feb. 9, and it announced this week that it expects revenues to be in line with analysts' expectations. I plan to watch this position and update you in the coming days how to handle it, but for now, let's sit tight.

CREE

Our CREE March 20 Calls (CQRCD) hit their sell stop last week and I was hoping to see them rebound, but they aren't budging. If you got in at the recommended 85 cents and set a 50% sell stop of 40 cents, the stop was triggered and you don't have to do anything. But if you haven't yet gotten out of the trade yet, it closed at 40 cents today, and you can get out at this level tomorrow.

NEKTAR

Our recent recommendation to initiate a position in the Nektar (NKTR) Feb 15 Calls (QNXBC) up to 85 cents presents a great opportunity to remind you about the nature of options trading. Because we're following big-money buyers into our call option trades, the prices may be running a bit because of the number of buyers jumping in as well as the large amount of contracts these institutions are scooping up.

So, when we give you a buy-in price, such as 85 cents, that means we believe the trade is a good deal at that price but don't recommend that you "chase" it higher. Our simple rule of thumb is to watch a recommendation for five trading days, and if you aren't able to catch the recommended price within that time frame, to sit out that trade because we'll always have another one (or two!) for you each week.

That said, these calls have traded up as high as $1.25 in the past few days but pulled back today and closed at 90 cents. Oftentimes, subscribers will ask whether I would recommend buying in at a higher price, and while I wouldn't formally make that recommendation, I recognize that many of you may get into a trade a nickel or a dime above the recommended price.

If you do this, note that any extra money placed in a trade could reduce the overall profitability of it, or could increase your loss should the trade turn against us. I'm still very bullish on this trade and, as such, have decided to put it on the Open Positions list at 90 cents. But if you can get in on a pullback, I recommend that you do that instead.


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader