1. Commentary
2. Month-end Review
3. Opening and Managing a Trading Account
4. Using Option Straddles
5. Current Trades
6. Earnings
7. Closing Thoughts

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1. Commentary

The market suffered its fourth straight losing week but the losses were kept to less than 1%. The Dow got off to a good start and by Wednesday, the index had hit a high of 8,446. That momentum quickly faded with the indecision in Congress on how to deal with the “good bank, bad bank” financial crisis. Financial stocks got a good pop on Wednesday, but reversed course on reports suggesting there was “great confusion” on what is a fair price is for all of these toxic assets that the banks are holding. As such, there were rumblings late Friday that the “bad bank” plan has been put on hold indefinitely.

There was an opportunity to make some money with Goldman Sachs (GS, $80.73, down $1.99) and JPMorgan Chase (JPM, $25.51, up $0.08) but you had to be in-and-out quickly. Goldman started the week off at $74 and made a run to $90 before falling back.

There were a slew of earnings announcements, some good, some bad. There we over a 100 companies that reported last week and most of them could not give clear guidance for 2009. It is pretty made clear Wall Street’s earnings estimates need to come down further as many companies issued warnings and gave pink slips in the process.

General Motors (GM, $3.01, down $0.17) Home Depot (HD, $21.53, down $0.47), Pfizer (PFE, $14.58, down $0.54), Sprint Nextel (S, $2.43, down $0.14) and Target (TGT, $31.20, down $1.50) all announced layoffs. The job market is lousy and getting worse.

For the week, the Dow lost 77 points and finished right at 8,000. The Nasdaq lost less than a point and closed at 1,476 while the S&P 500 fell 6 points and settled at 825. For the month and YTD, the Dow lost 8.8%, the S&P 500 skidded 8.6%, and the Nasdaq dropped 6.4%.

Not a good start to the New Year if you’re a bull.

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2. Month-end Review

The market may have had a bad month but there were plenty of opportunities for trading. The volatility has carried over into 2009 which is a good thing. We were able to play Apple (AAPL, $90.13, down $2.87) twice for quick trades to the upside by buying call options. We were able to play the banks stocks both ways as we bought put options on HSBC (HBC, $38.84, down $0.14) and call options on Goldman and JPMorgan.

There are quite a few sectors that are allowing us to take advantage of the market’s volatility and that trend should continue into the forseeable future. The market is still in a tight trading range which can be tough on beginning option traders. Fortunately, in this trading range we have been able to buy calls at the bottom and puts at the top. But you have to get a feel for the trading ranges.

My philosophy is simple and I try to create a market feel in the blog when I am tossing out option ideas. This may sound simple but it is a bit more complex to determine whether or not an option has a really good chance in making money. Some of the gains from these trades are pretty amazing but please realize my style of option trading is a little more riskier than others.

The market is full of juicy information that is available at your fingertips. The key is to find that information and turn it into you advantage. Just like we did last week on the “bad bank” plan. I mentioned how the market would “sell the news” and those trades were good for only a day or two.

January is normally a good indicator of how the market will do for the rest of the year so the outlook doesn’t look good for the bulls. If you are scared of down markets, don’t be. We can show you how to trade in all types of markets.

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3. Opening and Managing a Trading Account

One of the most frequently asked questions I get asked is how much does it cost to start a trading account and how much to allocate for each trade. This is always a difficult question to answer and one that affects each investor differently.

What makes it complex is that every investor has a different level of money they can afford to invest along with different levels of income and age. Obviously someone in their 20’s can be a bit more aggressive than someone who is nearing retirement.

When it comes to trading options, the following advice may not be the right choice for you but it should give you a better idea from which to base your decisions. For a new options trading account, do not risk more than 10% of your assets in any one position. For someone that is new to trading options in general, your should start on paper at first until you get the feel for trading. Then when you actually do your first trade, do not risk more than 5% due to your lack of market experience.

Once you have built-up your trading account your overall trade allocation my end up being less than 1%. I try to buy options in blocks of 10 and never risk more than $3,000 or $4,000 in any one position. A $1,000 or $2,000 could be average. If you only have a trading account of $2,000, then buy one contract but make sure you do so with free trades. Most brokerage houses give you a number of free trades when you open an account and if not, ask. This will help you with commisions when you start with a smaller amount.

I have known investors who have opened option trading accounts with $2,000 and risked half of it on their first trade. Needless to say, if the trade went south, they were either done with options or reloading their trading account. To me, that is gambling, and it’s important to think of trading options as a business and not a “get rich quick” scheme.

You should always consider a discount broker and not a full-commission or “service” broker. The fees from the full service broker will be substantially higher. The discount brokers are pretty reasonable charging anywhere from 75 cents to $1.50 per contract with a $15-$25 minimum. A “broker-assisted” trade could cost in the range of a $45-$60 (or higher) minimum and as much as $2.25 per contract. Try ThinkorSwim.com and mention us.

Also have an open mind that every option trade is not going to be a winner. With that, you must consider the percentage amount you are prepared to lose if you happen to be in a trade that is not going your way. My set amount is usually 50% depending on market conditions due to the nature of a leveraged position. What I mean by that is – think in lots of 10 contracts – it means you are controlling a 1,000 shares of stock.

In the end, it all comes back to you and what you are comfortable with. These are some of the guidelines that I use but they are important, especially if you are just getting started in option trading. It’s a far cry (and greater thrill) from trading options on paper to when you actually make your first trade. Going in blind will only increase your chances of frustration.

Also, if you haven’t given our free DVD a try, click on the link below. It’s free and it’s packed with a ton of good information:

http://www.optionsmentoring.com/freedvd.cfm

or give Mike Albright a call at 1-877-709-8716.

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4. Using Option Straddles

A long straddle is an option strategy that can be used when you are anticipating a rather large move in a stock. If you are unsure which way the stock will move based on current events or a longer term outlook, a long straddle could provide a decent return on your money with limited risk with a stock that moves.

Here is how a long straddle works. You would buy both a call and a put with the same strike price and the same expiration date. Buying a straddle can be pricey because you are buying both sides of a trade but your risk is limited by the amount paid for the contracts of both the call and put.

Finding stocks that make attractive candidates for long straddles can be challenging especially when this strategy requires the stock to make a sharp move in either direction beyond your “breakeven” points. Breakeven points are calculated from where the stock price is currently at and adding the premiums you paid to establish the position.

If a stock is at $85 and the 85 call is selling for $1.60, and the 85 put is selling for $1.15, you would need the stock to be at $87.75 or $82.25 for you to break even. We get $87.75 by adding the price of the straddle and $82.25 by subtracting from the stock’s current price. These prices are based on a straddle with options that expire in a month.

Keep in mind though the amount paid for the options could be higher if your straddle position is a few months out. The further out you go when establishing a long straddle, your breakeven points will also change. For instance, if the aforementioned premiums of the straddle were six months out, the 85 call may sell for $5, and the 85 put could be selling for $4. Your breakeven points would now be $94 ($85+$5+4) and $76 ($85-$5-$4).

So which straddle do you choose? Although there are numerous variables that could affect the trade, you could use the month out straddle based on an earnings announcement, or other expected or unexpected news that you think will move the stock.

This concept alone makes straddles sexy, but they also provide you with a downside breakeven point as well as an upside breakeven point. Of course, where the stock actually ends up at the time your options expire, the returns could be greater or worse.

As you can see, straddles can offer the best of both worlds when it comes to predicting the direction of a stock. Finding the right stock is the fun and challenging part. Here’s one from last week.

Amazon (AMZN, $58.82, up $8.82) was right at $50 on Thursday when the market closed. After the bell, the company reported earnings that blew Wall Street’s numbers away and the stock was up 13% in early after-hours trading to $56. You have to remember, options don’t trade in extended hours so the gains or losses do not matter until the opening bell the next day. The stock held its gains and opened Friday at $57.43 and traded as high as $59.74.

The February 50 calls (ZQNBJ, $9.65, up $5.50) were at $4.15 and the February 50 puts (ZQNNJ, $0.75, down $3.35) were at $4.10 on Thursday. That day, volume was 13,000 for the calls and 10,000 for the puts. If you were unsure of the direction of Amazon you could have put this straddle on if you were pretty confident that the stock was going to move 10%-15%. The total cost of the trade would have been around $825.

The shares gained 18% on Friday, the call options jumped 130% while the put options sank over 80%. If you closed just the call options on Friday, your total return is already $965 for each call option you bought, or 15%. More importantly, you still have the put options open which do not expire for another three weeks. If Amazon falls from here and reverses course, the puts could actually go up in value. If you closed both the calls and puts, your return is nearly 20% as you would get another $75 for the puts.

The risk would have been if Amazon’s stock didn’t move that much. If the stock would have moved just 5%, there would have probably been a small loss of 10%-15% as the premiums would have taken a hit. This was basically a risk free trade but I wanted to show you how you can use straddles and the pros and cons of doing this type of trade.

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5. Current Trades

Neflix(NFLX, $36.14, down $0.74)

On Tuesday, I profiled the March 35 calls (QNQCG, $3.80, down $0.20) and said they had a good chance of making it in-the-money when the stock was at $34.40. The options were going for $2.60 at the time and hit a high of $4.50 on Thursday. The calls did not fall below $3.50 which was right at our stop but bounced off that level which was good to see. I still like the calls and we can bring the stop down to $3.20 which gives us a little more wiggle room.

The March 40 calls (QNQCH, $1.75, down $0.05) were trading for 90 cents and doubled by Thursday. Some of you may have sold them at $2.00 and stops were set at $1.50. You can lower them to $1.20. These calls still have two months before they expire and Netflix is finally getting it. The stock could make a run at its 52-week high of $40.90 if the market relaxes but the stops will protect our profits.

The March 50 calls (QNQCJ, $0.30, unchanged) are still going really cheap and is a speculative buy for those of you who missed the action. Realize however, if you buy them, that it could lose your entire investment if the stock can’t muster a run to $50 or languishes.

Genentech (DNA, $81.24, down $2.85)

The February 95 calls (DWNBS, $0.10, down $0.10) and the March 95 calls (DWNCS, $0.30, down $0.30) got 50% haircuts and are down more than that from entry prices of 85 cents, and $1.50, respectively.

On Friday I provided this update in the blog:

“Roche threw us a curveball this morning and took its bid for Genentech (DNA, $80.95, down $3.14) directly to the shareholders. The company is now offering about $42 billion, or $86.50 a share for Genentech which is $2.50 less than the offer it made last July. Hogwash.

Roche’s attempt to get Genentech at a lower bid is another slap in the face to its shareholders and although Genentech has not made any comments, this camp says Genentech again holds out for more. One top 10 Genentech shareholder is already rebuffing Roche’s new bid and I don’t believe other shareholders will tender the offer either.

From the head brass at Roche: “We are disappointed that the discussions over the last six months between Roche and the special committee of Genentech have not produced a negotiated agreement. We feel it is now time to give the Genentech minority shareholders the opportunity to decide on our offer. Especially in the current market environment the offer provides an opportunity for all public shareholders to achieve liquidity and to receive a fair price for all their shares.”

Fair price? Geez. If Roche offered $89 back in July, why then, the lower offer? Genentech expects to report results in mid-April for its Avastin colon cancer trial, in addition to pending FDA decisions to expand the drug’s use. Roche is trying to get the rest of the company it does not own before that data is released.” —

Roche feels “very confident” that it will be successful in getting the rest of Genentech it does not own and Genentech has formed another “special committee” that will make a formal response within 10 business days. That’s puts us on track to hear something by February 13. A Friday before the weekend. And I’m sure Genentech will reject the offer again.

These are the first two losing trades that I have profiled out of 20-something trades in January. I have losing trades, sure, but this one burns me up. The 95 calls are way out-of-the-money and will probably expire worthless. The March calls have a chance but the stock will need to get to $96.50 for us to breakeven. I’ll keep you posted…

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6. Earnings

Monday: Aflac (AFL, $23.21, down $0.13), Mattel (MAT, $14.19, down $0.59), Piper Jaffray (PJC, $28.71, down $0.55), Rent-A-Center (RCII, $14.85, down $0.52) and SanDisk (SNDK, $11.43, down $0.76).

Tuesday: Archer Daniels Midland (ADM, $27.38, down $0.05), BP plc (BP, $42.47, up $0.03), Corinthian Colleges (COCO, $18.68, up $0.08), Electronic Arts (ERTS, $15.44, down $0.75), Merck (MRK, $28.55, down $0.39), Motorola (MOT, $4.43, down $0.23), Northrop Grumman (NOC, $48.12, down $0.33), United Parcel Service (UPS, $42.49, down $2.35) and Yum! Brands (YUM, $28.62, down $0.93).

Wednesday: Akamai Technologies (AKAM, $13.48, unchanged), BHP Billiton (BHP, $37.54, down $2.00), Cisco Systems (CSCO, $14.97, down $0.96), Clorox (CLX, $50.15, down $0.30), Harris (HRS, $43.29, down $0.19), Kraft Foods (KFT, $28.05, down $1.23), Philip Morris International (PM, $37.15, down $1.60), Pulte Homes (PHM, $10.15, down $0.48), Time Warner (TWX, $9.33, down $0.57) and Visa (V, $49.35, up $3.08).

Thursday: Burger King (BKC, $22.25, down $0.25), Diamond Offshore Drilling (DO, $62.76, down $1.22), GlaxoSmithKline (GSK, $35.26, up $0.51), Kellogg (K, $43.69, down $1.43), MasterCard (MA, $135.78, up $6.69), Pitney Bowes (PBI, $22.26, down $0.84) and Western Union (WU, $13.66, down $1.08).

Friday: Biogen Idec (BIIB, $48.65, down $0.63) and Toyota Motor (TM, $63.51, down $1.59) are the biggies.

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7. Closing Thoughts

The market is stuck in neutral and the Dow is either going to keep gliding, put it in first, or we could be waiting for it to throw it in reverse and back into a tree. The 8,000 level remains the teetering point and this is the third time we have tested this level. Triple bottom anyone? This is a reversal pattern made up of three equal lows followed by a breakout above resistance. While this pattern has formed over just a few weeks, it is usually a long-term pattern that covers many months. Time will tell.

As a triple bottom develops, trading volume usually drops off and we saw that in January. Nobody wants to believe in a market rally, jobs are being lost at a rapid pace and the housing market hasn’t improved that much. Mortgage rates are around 5% but they need to go to 4%.

Gold is rallying again. The yellow metal rose over 3% last week to $928 an ounce and was up 5% in January. The Spider Gold Shares (GLD, $91.31, up $1.81) is the largest gold ETF and has been, could be making a run towards its 52-week high of $100. The March 99 calls (GLDCU, $2.90, up $0.85) traded over 5,000 contracts and the March 100 calls (GLDCV, $2.65, up $0.60) traded over 2,500 contracts.

Keep an eye on the Electronic Arts February 15 puts (EZQNC, $0.90, up $0.25) and the February 17.50 calls (EZQBW, $0.40, down $0.25). There were over 4,000 contracts that traded on the calls but I’m not so sure if the action is bullish. EA has been a mess since its botched bid for Take-Two Interactive Software (TTWO, $7.02, down $0.17) and Nintendo (NTDOY.PK, $36.40, down $2.90) just slashed earnings estimates by 15%.

It should be another interesting week so check the blog daily to see what’s happening.

Rick Rouse
Rick@OptionsMentoring.com

***Please feel free to send me your thoughts on the newsletter this week. If you want to get the Weekly Wrap a little earlier, use the email box there on the right, at the top of this page, to get it sent right to your email inbox. I will not be posting the Weekly Wrap much longer in the blog and you will need to be added to the list to receive it.