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The early bird gets the worm…

Last week I had moved American International Group (AIG, $37.69, up $3.72) to the top of the food chain (our Watch List) as the stock stood at $33.  Now, remember, AIG was at $13 at the beginning of the month.  On August 20th, here were our notes (quotes from 8/20):

“American International Group (AIG, $33.49, up $6.85) is up 25% today and it’s hard to believe the stock has rebounded from a low of $13 since the beginning of August.  Incredible.  The September 35 calls (IKGII, $4.10, up $3.05) have soared nearly 300% after opening at $1.22.  There is a combination of a lot of things going on with AIG right now and although I don’t trust this dog to go long, there may be a chance for a STRANGLE option trade.  The September 25 puts (AIGUY, $1.65, down $1.05) have dropped 40%.

The stock is up on some CEO fluff who believes he can “maintain shareholder value”.  Good grief.  Give me break.  He failed to mention that his company did a 20-to1 reverse stock split and right now the shorts are getting hammered.  I’m going to do some more research on this one but a strangle trade is when you play both sides of the ball hoping for a big move.  AIG is so volatile that it fits the bill.  You can do 2-to-1 with puts to calls but it is expensive.  I almost want to suggest the put options straight-up but short squeezes can be tough to predict.  I do know that AIG is not worth $33 right this second but it’s  a tough call.  Don’t take any action just yet because I’m thinking out loud.” (END)

Here is how the “strangle” option trade is playing out.  A strangle trade is like a “chicken trade” because if you don’t know the direction of the stock but you know it is going to make a big move, you buy an out-the-money call and put option about the same strike prices away.  Sometimes you can go way out with the strike prices and I leaned heavier on the puts as I listed the 25’s.

The September 35 calls (IKJII, $5.45) were going for $4.10 and the September 25 puts (AIGUY, 56 cents) were at $1.65.  That was $5.75 to do one contract of each option or $575 last week.  Now, AIG was up 10% yesterday when news hit that its old CEO, Hank Greenberg, is being courted by the current CEO for tips on how to run the company.  The stock zoomed in the last half hour of trading when word hit Wall Street and in after-hours trading shares stood at $39.29.

If things hold the call options will continue to go up and the put options will take another hit.  However, here is the beauty of the trade.  It may sound sexy and it may sound hard to do but I’m showing your first hand how strangle option trades work and how easy they are to do.

At current prices, before the opening bell rings, the call and put option are worth $6 total.  $5.45 for the calls and 55 cents for the put options.  Your entry price for both had you done the trade last week was $5.75 so now you are at $6.  A small gain but you are not losing money.

Let’s say AIG opens to over $40..then the call options could be trading at $7.  The puts will fall but don’t worry about that.  Let’s say you can exit the call options at $8.  That gives you a 33% return on the trade even if the put options expire worthless.  If you sell the calls into a strong open or another rally then you have made your money AND you have a risk-free trade on the puts that you can leave open.

Now, let’s say the market tanks in September and everything starts to melt like candle wax.  In the downturn, let’s say AIG falls back to $20.  That would mean that the September 25 puts that were left for dead will be worth $5.  That brings our total return to $12-$13.  You sold the call for $7-$8 and you would sell the put for $5.

If your entry price is under $6 then you have just doubled your money folks!

If AIG continues to shoot to the moon then the calls will continue to go higher and they could triple again if AIG goes to $50.  They would be worth $15.

As you can see, there are a lot of factors left that will determine how much you make on the trade but by knowing what your profit targets are AND what the outcome could be if this or that happened then you take out all of the emotion.

I wanted to update this trade because the market is acting weird.  I don’t often say that but something is up.  We get GREAT economic news yesterday and the day before and we get no big push to Dow 10,000.  Before, we were getting crappy news and the market was banging out new highs.  The indexes are still higher but it feels like we are reaching a ceiling.  Once again, we either break through or we fall back down.  It’s that simple.

The point is that RIGHT NOW this is a trader’s market which is why we are taking quick profits and going out 6 and 8 months on bullish option trades.  Look, we haven’t dropped or had a 10% correction and we may or may not get one.  The key is we have to be smart while others are worried on direction.

Market direction is easy to “feel” and you will get the same feeling once you know how this beautiful game is played.  If we can make 33% in a week in this environment then we aren’t going to look a gift horse in th mouth.

Honestly, I wanted to get some of our other trades closed and lighten up before the holiday weekend before I came back to this trade.  Many of our positions are now closed and I was going to take another look at AIG on Thursday with these same options.  Well, the market threw us a curveball and we got caught looking in the bottom of the 9th.  Congrats to anyone who took this trade while I was thinking out loud and there may be another way to play this puppy.  However, we will have to see how the stock opens and where it trades afterwards.

If I see another setup, I’ll let you know in the 1pm update.

Futures are lower as I go to press.  I may miss the opening bell this morning which is rare but I wanted to get this out in case I’m not back in time for the fireworks.  I may do an update at 11am if needed but I will be back by 1pm (EST).