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Make Money During Market Mania

July 20, 2007

Dear Fellow Options Trader,

This year, we've experienced some of the best trading conditions for as long as I can remember, and we've only just passed the halfway mark for 2007. I can't wait to see what the rest of the year will bring!

The surges in volatility and subsequent violent movements in the market have provided opportunities a trader can only dream of. And when they're coupled with the private-equity feeding frenzy, I'd say we've got the most target-rich environment I've every seen.

That's not to say that it's been effortless to initiate, hold and/or decide to close trades. It also doesn't mean that we aren't also sometimes forced to sweat it out through somewhat-more-predictable market conditions.

To the contrary, the current market has been quite challenging, but this has served to keep us on our toes because it seems like things literally do change every day!

Lack of concentration can kill a great trade almost as fast as purposely going against the odds (i.e., forcing trades when the conditions aren't overly conducive to initiating them or by taking long shots instead of having solid reasons for entering new positions).

The wild moves have kept me focused on picking the ones that have the best risk/reward pictures, and this is what I take into consideration when making recommendations that are poised to pay off. The unpredictable action can be our friend or our foe, and we try to use it to our advantage wherever possible, because it doesn't look to be going away anytime soon.

VOLATILITY

As you may know very well by now, my mantra has been (and continues to be) that we should get used to a significantly higher level of volatility than we've seen in the past 18 months.

In layman's terms, that means I expect even more 100-, 150- and, yes, even 200-point moves to occur several times per month in the broader markets. These moves will be bigger and more violent than some of you are accustomed to, but they have served to create great opportunities -- and will generate plenty more -- and we'll attack and cash in when they occur.

LOOKING AHEAD AT INTEREST RATES

Fed Chairman Ben Bernanke has done a masterful job working with the other members of the Federal Open Market Committee to not be as reactionary as some would like, and this has served our markets well. His steady hand meant that the pop in the 10-year Treasury bond yield to 5.31% was short-lived, and that lack of panic has kept us in the sweet spot despite all the hand-wringing over the infamous subprime slime.

I'm looking for rates in the 10-year note to moderate between 4.9% and 5.2% for the third quarter, and this is a prescription for continued upside bias for the market.

HOW TO BEST USE OUR INFORMATION

Unlike many on Wall Street, I have no problem putting my derrière on the line and making a bullish or bearish call. Some of you may take this as bravado, but I prefer to view it as confidence in my trading methodology and my discipline.

My methodology is a process that goes back more than a decade now, but it has been refined in the past two years to produce the best early-warning system for the stock market that I've ever seen. And, in 26 years of trading, I can safely say that I've seen just about everything!

This proprietary technology helped me to see the unusual options trading activity just prior to Sept. 11, 2001, when someone was busy buying puts in American Airlines and United Airlines, as well as the insurance companies and brokerages that were located in the twin towers of the World Trade Center. More recently, this early warning system has scored home runs in Pride (PDE), Seagate (STX) and Archer Daniels Midland (ADM).

My system is based on identifying unusual trading patterns that occur in stocks, options and futures, and it breaks out the best opportunities in real time through our trademarked HeatSeeker and Depth Charge systems, which track unusual trading activity in calls and puts, respectively.

However, as good as our data and systems are, you always need to exercise discipline when trading, and I'll outline the process I go through below. It can help you to manage your own trades more effectively.

DISCIPLINE

Whenever I invest in an option, I always set an exit strategy. If it runs in the direction I'm predicting, then I will sell 50% of my position when the option doubles and hold the balance to see if there is more gas in the tank. This ensures that I protect my investment from the get-go and that I'm only using my profits in my quest for even-bigger returns!

If there happens to be more fuel, then I'll let the options run and take profits once the buying subsides and/or selling takes over. If, after selling 50%, the options come back to their entry point, that's the best time to close the remaining position.

If you analyze this style of trading, you see why once we get a winner, we can keep the winnings

As an example:

Suppose we buy 10 Juniper Aug 30 Calls for $1.50. Juniper rallies on a great earnings report and we sell 50% (or, five contracts) at $3, thus collecting $1,500. If the stock keeps running, we will sell more at higher prices, perhaps doubling or even tripling our invested capital.

But if Juniper shares fall and our systems pick up significant call selling, then the ideal situation would be to close the remaining five calls for $1.50, thus collecting $750 and recouping our investment on that half of the trade.

If that same trade had not worked out, meaning the option value declined, then we would cut our losses when the calls dropped to 75 cents, a loss of 50% of their initial value. Thus that $1,500 investment (10 contracts x $1.50 x 100 shares) would have dropped to $750.

UPDATE ON JULY EXPIRATIONS

It's oftentimes tempting to overstay our welcome in a trade as we await the potential catalysts that could take it higher. Especially when a trade shows amazing promise, we know it would hurt to miss the upside we'd been waiting for all along. Sometimes hanging in there pays off, and other times it doesn't.

Such was the case with our QLogic July 20 Calls (QLCGD), Sun Micro July 5 Calls (SUQGA), Electronic Arts July 50 Calls (EZQGJ) and MannKind July 12.50 Calls (MWUGV), which came off the board today as it's expiration Friday.

It's challenging for any type of investor -- myself included -- when a trade displays incredible momentum, especially during its early days of being open. Our discipline worked very well with the Electronic Arts trade, as we saw it pop significantly and decided to cash in half the position for 71.43%, so the other half expired today. The stock ended the day at just shy of $52 per share, and the last option trade today took place at $1.80, at 40 cents above our $1.40 buy price, for a 28.57% increase.

Shares of SUNW closed the day at $5.33, just a few cents over the $5 strike price of our calls. We got in at 53 cents and the last trade took place at 33 cents, a 37.76% decrease. With earnings coming out July 25 -- yes, less than a week away -- I was looking for an early rally to bring these back to our entry level. Whether that means its numbers will be impressive or not is still up for grabs, but our time is limited with any options trade, and even though we can always wish we could extend our contracts by just a few days to accommodate any potential catalysts, it's time to say goodbye.

Our QLGC calls dropped awhile back, and did so very quickly. When an option loses most of its value, it's sometimes better to save the commission costs of closing it and to let it ride just in case something can come along to help it regain some of its original value. But even the anticipation of its July 26 earnings announcement didn't breathe any life into them.

We got into these calls at the $20 strike when the stock was trading at $18.50 and the big-money guys were piling in, in anticipation of a spike. But the stock never went any higher than $18.50 and finished today at $17.72, so our calls finished out-of-the-money.

It was a similar story for the MNKD calls, as the stock closed a mere 63 cents below our $12.50 strike price. Shares briefly went above $13 last week, but the closer an option gets to its expiration date, the less time value it has, and this move didn't do anything to help matters.

So, it's adios to MNKD as well as the others, but this just clears up our board for the next wave of opportunities. So, stay tuned to your e-mail because there are always potential winners waiting in the wings that can turn these guys into a faded memory in no time at all!

Remember, we're always looking for the next home run, and sometimes we strike out. But when we see big-percentage returns (and we've certainly seen more than a few in our day here!), we can take the occasional losers in stride much better.


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader


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