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High Risk Doesn't Always Bring Big Rewards

March 07, 2007

"The moment somebody says 'this is very risky' is the moment it becomes attractive to me." -- Kate Capshaw

Dear Fellow Options Trader,

Surely this comment from Ms. Capshaw (or, as many of us know her, Mrs. Spielberg) will ring true, as there are those among us who are indeed drawn to risk like a moth to a flame.

Perhaps it's the excitement of living on the edge. Moreover, it's usually where the big rewards can be found. The disconnect comes when the risk is greater than the reward, yet some people just keep taking the risk.

We all witnessed the explosion in risk premiums charged by market participants, as the Dow Jones Industrial Average just experienced its worst week in four years. Triple-digit losses should have caused the hairs to stand up on the back of most investors' necks, yet clearly there were some who ignored those warning signs and continued banking on the same reward scenario -- even though the market was screaming that risk was increasing!

RISK AND REWARD, WHAT A CONCEPT!

My longtime friend Bill Griffith, host of CNBC's "Power Lunch," posed a question to me on-air last week that I was dying to answer, but time didn't permit. It was perhaps the best question about what transpired last week in the market meltdown that took upward of 400 points off the Dow in a single session.

The question was whether the market is riskier now than before the 400-point drop.

The easy answer is yes, it is indeed riskier now. Were we seeing 200-point swings within a mere 10-minute period prior to China's implosion? No, we weren't, but there's more to it than that. Responding yes or no to the increased level of risk is only part of the answer.

The other part of the answer is that, post-meltdown, the sellers of insurance for global markets were being better-rewarded for taking on risk. So, while the markets are more dangerous today than they were a week ago, the risk premiums have increased dramatically. And this may be hard to believe, but those higher premiums mean the risk-takers are actually taking less risk!

Just think about that for a moment. If you were playing backgammon and the die were turned against you, then you'd understand that the potential reward had increased and it would be up to you whether the reward actually justified the risk. This doesn't just happen at gaming tables; it also happens in real estate, the futures markets and, of course, the stock market.

Right now, what we should concentrate on is milking the opportunities where the rewards have shot up, as the foolhardy have panicked and created significant rewards -- in many cases, rewards that are two or three times as great as the same amount of risk would have yielded just 10 days ago.

As a recent example, we saw our existing put-option positions in Honeywell, Home Depot and H&R Block explode higher during this recent downturn. And in general, I'd say we've seen roughly three to four times the normal amount of stocks lighting up our Depth Charge (our bearish option-tracking indicator) versus our HeatSeeker (which tracks unusually bullish trading patterns in call options).

When you're lucky enough to be in a poker game with someone who doesn't understand the game, or is just taking unnecessary risks, it's incumbent upon you to gratefully accept the money they seemingly insist on throwing into your pocket.

The same is true with the stock market, and I must say I take perverse delight in watching those overconfident souls come back to pay the piper. As an option trader, you know that reducing your risk as much as possible is the safest and smartest way to play. So, when those less-savvy folks are ready to throw their money away, we should be gladly standing by, ready to catch it!

BUY LIST UPDATE

In the face of the erratic market activity, our current call option positions have taken a bit of a beating. I'd like for us to continue exercising patience with our STMicroelectronics (STM) April 20 Calls (STMDD). The company is presenting at the Morgan Stanley Technology conference tomorrow, and while that may or may not be a markedly positive catalyst, the trade still has some upside left in it, and we'll take it any way we can get it!

Likewise, our QLogic (QLGC) July 20 Calls (QLCGD) took a hit in the correction, but we may get a bit of a bump on March 14, when the company is slated to present at Citigroup's Small and Mid-Cap Conference.

I oftentimes remind you to set a 50% sell stop beneath our open positions, but with the markets being so volatile lately, we might have been taken out of all of our positions just because of the market's behavior and not because we were ready to exit the trades. Still, you should keep a mental stop in place, and once things cool down in the market, we'll revisit our thoughts on these positions. For now, we still have a few months with both of these guys, so let's give them a shot to become profitable.

Our other bullish position, the Elan (ELN) March 15 Calls (ELNCC), however, rolled over and isn't just playing dead -- the calls are just unfortunately out-of-commission. The company has some presentations coming up in the next few days that may provide a boost, but not enough of one to convince me to stay in the trade. If you want to hang in there to see if it rallies up, you can, but with this option trading at 5 cents and its expiration date just a little over a week away, I'm going to close the position here.

Remember, if an option you're holding is in-the-money by 5 cents or more (or by 1 cent if it's an index option), then it will be automatically exercised. If there's still some value left on expiration Friday and you don't want your calls to be turned into stock on your behalf, be sure to let your broker know!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader


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