2. Allocating Option Trades
3. Putting a Collar Option on Your Investments
5. Current Trades
6. Closing Thoughts
The bulls had their four-week winning streak snapped as the bears took last week’s battle. Much of the beginning of the week was focused on the Fed meeting which turned out to be a non-event and most of the economic news came in a little light of forecasts.
Big Ben and the Federal Reserve left the fed funds rate unchanged at 0.00%-0.25%, as most on Wall Street expected. The Fed also expects inflation to remain subdued and economic activity is likely to remain weak over the foreseeable future. This means we can expect interest rates to stay at these exceptionally low levels over the near term.
We have a slew of retailers reporting earning this week and it will be interesting to see if these stocks hold or trend lower. Some retailers will do well but others will disappoint. Especially after we learned July retail sales slipped 0.1%. The Street was looking for an increase of 0.8%. We also got weaker-than-expected wholesale and business inventories, and the consumer sentiment numbers really zapped the energy the bulls had going into Friday.
As a result, the Dow fell 76 points on Friday and 48 for the week to settle at 9321, or -0.5%. The Nasdaq was clinging to the 2000 level but ended up at 1985, down 14 for the week, or -0.7%. The S&P 500 fell 6 but stayed above 1000 and closed at 1004, down 0.6%. As you can see, the market suffered less than a 1% drop on a batch of crummy news.
This week will be important for the bulls if they expect to grab any momentum back and if the retailers start to come in light then the bears could begin to stir. Then again, we could be setting up in a trading range as both sides look for the next catalyst to take us higher or lower.
Be patient, the next trend will soon develop.
2. Allocating Option Trades
One of the most frequently asked questions I get from the Blog is option position sizing 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 my options trading account, I do not risk more than $5000 in any one position. For someone that is new to trading options, then your starting point should be a little lower, like $250-$500 due to your lack of market experience. And that would be based on a $10,000 trading account.
If I buy 10 contracts at $2, it’s $2,000. If I do a 20 contract trade at $2 then it’s $4000. I don’t usually buy options that are priced over $2.50 but once in a while I may. These are my comfort levels, based on several years of trading options but 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 consider a discount broker and not a full-commission or “service” broker. The fees from the full service broker will be substantially higher and they will usually frown on you (this also comes from my own personal experiences). 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.
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.
3. Putting a Collar Option on Your Investments
There are many different option strategies that investors can use when it comes to protecting their portfolios. In times of high volatility, which seems to be the current market theme, collars can be used to limit the downside risk to a portfolio. There are numerous ways to use collars by buying and selling a combination of puts and calls but the end result will always keep losses and gains on a stock within a specific range.
One of the best features of using collars is that the cost of implementing this strategy is “free” or close to it. It is considered “free” because you use the price you receive for selling a call to buy a put. In some cases, it is even possible to receive a credit into your account. Here’s how they work.
Let’s say you own 100 shares of Microsoft (MSFT) which is currently trading around $23.70. Regardless if you have owned the stock for years or a matter of weeks, when you use a collar strategy, you will know that your expected return can be no higher than the return defined by what strike price you use on the call, if exercised. You will also know that your expected loss can be no higher than the loss that results from the strike price of the put, if exercised.
The Microsoft January 25 call (MSQAE) is currently trading at $1.25. The January 20 put (MSFMD) is currently trading at 75 cents.
If you sell the call, you would receive $125 in your account. You would then buy the put for $75, leaving you with a net credit. Of course, one must consider commission costs, so there may or may not be a net credit depending on who you use as a broker. Either way, by employing this strategy your gain on Microsoft will be no higher than $1.30. Your loss will be no worse than $1.25 by selling the call and buying the put. Here’s how it would play out:
1) If Microsoft is above $25 come January 15th, the call you sold will be exercised and you will have to sell your shares at $25. The most you can make is the $1.30 profit or $130 for every 100 shares. If you add in the $50 from the difference you got from selling the call and buying the put options you made $180, or 7%-8% on you money.
2) If Microsoft is below $20, you could exercise your put and sell your shares at $20. The most you would lose is the $3.70 or $370 for every 100 shares no matter how low the price of the stock goes. If you add in the $50 it reduces your loss to $320. Or you could hold onto the stock and sell the put option if it continues to gain in value.
3) If Microsoft is between $20 and $25 by the January expiration date, both options expire unexercised, and you are left with your shares of Microsoft.
There are certainly other benefits of using collars to where you can get an even much better reward-to-risk ratio than the example I just used but you will have to do your homework. Obviously, this would be a better trade if you owned 1000 shares of Microsoft instead of 100. Again, this strategy is used for protection more than anything else.
Just remember, your returns are likely to be somewhat limited because when you sell a call option you give up the right for further appreciation beyond the strike price of the call you sold. However, your losses will also be limited because of the protection you have by buying the put.
Monday: Lowe’s (LOW, $22.83, down $0.48), Simcere Pharmaceutical Group (SCR, $8.35, down $0.29), Trina Solar Limited (TSL, $28.31, up $1.05) and Valspar (VAL, $26.41, down $0.25).
Tuesday: Analog Devices (ADI, $27.39, down $0.42), Cardinal Health (CAH, $32.90, down $0.30), Hewlett-Packard (HPQ, $44.09, down $0.26), Home Depot (HD, $27.14, down $0.54), Perrigo (PRGO, $26.50, down $0.27) and Target (TGT, $42.03, down $0.21) and TJX Companies (TJX, $35.09, down $0.27).
Wednesday: BJ’s Wholesale Club (BJ, $31.05, down $0.55), Cyberonics (CYBX, $18.22, up $0.07), Deere (DE, $44.53, down $1.10), Eaton Vance (EV, $30.00, down $0.59), Gymboree (GYMB, $40.94, down $1.02), Hot Topic (HOTT, $7.49, down $0.20), NetApp (NTAP, $23.59, down $0.48), PetSmart (PETM, $21.49, down $0.19) and Synopsys (SNPS, $20.10, down $0.28).
Thursday: Aeropostale (ARO, $35.91, down $0.86), Barnes & Noble (BKS, $20.87, down $2.11), Buckle (BKE, $26.54, down $0.26), Children’s Place Retail Stores (PLCE, $32.03, down $1.06), Dick’s Sporting Goods (DKS, $20.10, down $0.65), Foot Locker (FL, $11.35, down $0.32), Gamestop (GME, $26.44, up $0.11), Gap (GPS, $18.78, up $0.11), H.J. Heinz (HNZ, $37.79, up $0.07), Hormel Foods (HRL, $37.39, up $0.09), Ross Stores (ROST, $44.40, down $0.81) and Sears Holdings (SHLD, $77.10, down $1.27).
Friday: AnnTaylor Stores (ANN, $12.40, down $0.30), J. M. Smucker (SJM, $51.94, down $0.14) and Met-Pro (MPR, $10.43, down $0.25).
5. Current Trades & Closed Trades
Abercrombie & Fitch (ANF, $34.25, up $1.29).
September 32 puts (ANFUJ, $1.20, down $0.65)
Entry Price: $1.25 (8/14/09)
Exit Target: $2.50
Stop: 60 cents
Action: Abercrombie reported a lousy quarter and posted a 30 cent loss versus a year-ago profit due to weak sales, higher costs and continued markdowns. The loss was more than what Wall Street had been expecting. The stock popped 3.5% Friday as weaker revenue did top estimates and there is a chance shares could test $40 as the break above $32 was big. However, I think any continued rally will be short lived and I like the put options as a way to play a trip back to $30.
Bank of America (BAC, $17.39, up $0.39)
January 20 calls (BYOAT, $1.45, up $0.16)
Entry Price: $1.18 (8/12/09)
Exit Target: $2.20
Stop: 55 cents
Action: Shares of BofA jumped 2% in the afternoon on Friday and it would be nice to see the stock break its December high of $17.84. That would clear the way for $20 so watch this number. Trading was brisk in the August options as 75,000 contracts of the August 17 calls (BYOHQ, $0.70, up $0.20) traded hands. The high was 82 and the low came in at 30 cents. The August options expire Friday so stay away from them. There are quite a few option traders playing the August call and put options daily and they are going to have some wild price swings.
Citigroup (C, $4.04, down $0.02)
January 7.50 calls (CAQ, $0.15, up $0.02)
Entry Price: $0.14 (8/12/09)
Exit Target: 50 cents
January (2011) 10 calls (VRNAB, $0.40, up $0.01)
Entry Price: $0.40 (8/12/09)
Exit Target: 80 cents
Action: Citigroup traded over a billion shares on Friday, folks. A billion. Wow. Average daily volume has been about 4.25 million. The August 4 calls (CHW, $0.17, down $0.02) traded 112,000 contracts and hit a high of 34 cents before fading. We took a lot of the volatility out by going further out with the January 2010 and 2011 call options.
Imax (IMAX, $9.20, up $0.10)
September 7.50 calls (IMQIU, $1.70, up $0.10)
Entry Price: $1.90 (8/4/09)
Exit Target: $3.00
March 2010 12.50 calls (IMQCV, $0.47, up $0.07)
Entry Price: $0.45 (8/10/09)
Exit Target: $1.00+
Action: Imax got a nice pop in after-hours trading on Friday and I have a quote of $9.98. If that price holds going into Monday and the shares pop to over $10 then the September 7.50’s should get a lift to $2.50 and the March calls could trade to 60-65 cents.
Wells Fargo (WFC, $27.73, down $0.15)
September 26 puts (FHUUZ, $0.90, unchanged)
Entry Price: $1.30 (8/11/09)
Exit Target: $2.60
Action: If the bank rally stalls Wells should be one of the first to fall. Shares hit a low of $27.30 and the puts traded up to $1.05. I’d like to see a drop back to $25 this week.
6. Closing Thoughts
Earnings should play a larger role this week as a number of key companies will be reporting. Of course, the big question is just how much gas do the bulls have left in the tank. We have seen a huge rally and most of the talking heads continue to call for a pullback.
I mentioned last week we were climbing a “wall of worry” but that doesn’t mean I’m not looking down the road. I have been bullish and I have talked about us getting to Dow 9000, Nasdaq 2000 and 1000 for the S&P 500. I called that back in July. However, I also know in the back of my mind that September is historically the worst month of the year for stocks. After a 50% pop in the S&P 500 off it March lows and the fact that consumers are still saving, I’m starting to get “cautious” on the rally. That doesn’t mean the market can’t go higher but we will need unemployment to come back down and more “shovel-ready” projects need to be rolled out.
Asian markets are weaker as I go to press which are weighing on the futures. Dow futures are down 59, Nasdaq futures are lower by 10 while the S&P 500 futures are lower by 7.