Options Strategy


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Options Plays We Use
-------------------------------------------------------As we described in Digital Economy the investment strategy of buy and hold has not worked for some time. Stock prices move in cycles with predictable up and down moves for short periods of time. Spikes occur each quarter when companies announce their earnings. The option plays outlined here are specifically designed to take advantages of these short-term moves.

Stocks identified in the weekly research for option plays may not be the same as stocks identified in the weekly research for stock plays. First, option plays require additional analysis since not all stocks have options available. Second, the option price must be low enough to generate a high rate of return. Finally, in addition to the stock average trading volume the underlying option must have a large open interest.

Research for stocks identifying a pattern of cycling through lows and highs follows a process of elimination. The criteria used for stock and option research are the same, however, the parameters used for each criteria may be different. For example, the parameter used in the stock selection criteria eliminates all stocks over $60 while the option criteria does not. For example, a 100-share purchase of a $60 stock in a portfolio with $25,000 of available cash to invest would represent 24% of the cash. Cash management would indicate that a 100-share purchase of $20 stock represents 8% of the available cash.

Options offer the ability to control more shares of a $60 stock at a much smaller cash outlay. As of 11-22-2002 Cardinal Health Inc. (CAH) closed at $62.29. CAH is 15 days into a 25-day down cycle with $-3.38 left in its historical downward move. Purchasing 100 shares of stock places $6,229 at risk to potentially earn $338 on a short sale. Purchasing a Jan in the money Put at $65 would cost $5.80 per contract or $580. A $1.00 move in the stock produces $100 or a 1.6% return on the $6,229 placed at risk. A $1.00 move in the option price produces $100 or 17.2 % return on the $580 placed at risk.

A synopsis of the process used to identify stocks and their underlying options are as follows:

A general screen looking for stocks in a range bound cycle usually within a 10
to 60 day cycle.

Eliminate all stocks under $5.00.
Eliminate all stocks that have less than $1.50 left in their price cycle move for
options (up or down).

Confirm price direction with technical oscillators, specifically stochastic, MACD
and on balance volume.

Eliminate all stocks with a Beta rating of less than .75.

Determine if the option for the underlying stock is under or over priced, using the
Black Scholes pricing model.

Rank stocks by price.

Eliminate smallest daily difference from open to close.

Select the top three stock/options.

Option plays require additional analysis since not all stocks have options available. Second, the option price must be low enough to generate a high rate of return. Finally, no more than three stocks are selected for each week’s research. For these reasons stocks in the option play may not be in the stock basket. The option play selected for each stock represents the lowest risk with the highest return.

This should give you an idea about the amount of work that goes into our research every week!

Vertical Spreads

The credit vertical spread and the debit vertical spreads are the plays we research. The credit spread takes cash into your account at the time of the trade and debit spread establishes a charge (cost) against the cash in your account. Generally, credit spreads offer a better risk reward ratio.

Credit Spread

The following example illustrates a Bear Call Credit Vertical Spread option trade for QUALCOMM Incorporated:

Description

Strike

Price

Option
Symbol

Buy Higher Call Dec 45.00

$45.00

$0.35

.AAOLI

Sell Lower Call Dec 42.50

$42.50

$0.55

.AAOLV

Total premium – Net Credit

$(0.20)

This Bear strategy takes in cash by establishing a credit (deposit) created by the difference between a sold call price (short sale) and a purchases call price. You keep the cash as long as the stock prices moves down.

The credit spread can be played as a Bull or Bear play.

Debit Spread

The following example illustrates a Bull Call Debit Vertical Spread option trade for Cardinal Health, Inc:

Description	Strike	Price	Option Symbol
Buy Lower Call Dec 70.00	$70.00	$2.95	.CAHLN
Sell Higher Call Dec 80.50	$80.50	$0.70	.CAHLP
Total premium – Net Debit		$2.25

This Bull strategy does not take in cash. It establishes a cost in our trading account by buying a higher priced call. Selling a lower call price option lowers the cost of the by taking in cash creating a lower cost for the transaction. The value of the debit will increase as the stock price moves up.

The debit spread can be played as a Bull or Bear play.

The whentobuy.com research finds the most cost effective option combination.

Straddles

Straddles are non-directional price spread plays. When an earning announcement falls in the middle of price cycle a breakout in price could be expected. Meeting earnings expectation could cause the price to exceed the historical upward price move. Conversely, should the company miss its earnings target the price cycle of a stock could fall much lower than the historical downward price move.

A straddle is formed when a call and put are purchased for the same strike price in the same expiration month. Should the stock price increase the call value increases while the put value decreases. Conversely, if the stock price falls the put value increases while the call value decreases.

The following example illustrates a Straddle option trade for Eastman Kodak:

Description	Strike	Price	Option Symbol
Buy Call Jan 25.00	$25.00	$4.40	.CAHLN
Sell Put Jan 25.50	$25.00	$1.75	.CAHLP
Total premium – Net Debit		$6.15

During the price cycle the value of the straddle will change. The following chart illustrated how the Eastman Kodak straddle changed in price to eventually realize a $2,108.25 gain!

While others shy away from stocks in a range bound pattern, we find steady and dependable profits week after week. Whether your preferences are stock or option plays we have the research you need for consistent profits? Join now!

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Total premium – Net Credit

Total premium – Net Debit

Total premium – Net Debit