- 2000: Volume 9, No. 3 Puts & Calls: Staying in the Game

I've heard from many traders and investors in the past few weeks about how tough these markets have been. True enough, even the pros have been beaten up. The departure of George Soros' top two fund managers and the demise of Tiger Capital's Julius Robertson have underscored what everyone already knows: The stock market is the world's greatest humbler.

If your results have left you with financial welts and a fear of turning on CNBC in the morning (or evening), perhaps it's time to assess your methodology. Continuing to do the same thing and expecting different results is the definition of insanity. So why keep trying the same old methods for trading stocks in this highly volatile market? What worked once doesn't necessarily mean it will continue to work. Fortunately, there are a variety of trading approaches available that use options to limit and hedge risk. Although determining what's best for you depends on several unique factors, it's safe to say we all want basically the same thing: Healthy profits with the lowest amount of stress possible. What follows are a few of my favorite strategies that work regardless of market conditions.

Cyclical Investing

The term cyclical investing comes from the practice of observing how a stock (and its options) behaves whenever there is an anticipated event, such as an earnings announcement. Yahoo (YHOO) over the past couple of years has become a trader's favorite due to the buildup in both its implied volatility (IV) and stock price prior to earnings announcements.

Figure 1 shows past earnings "runs" Yahoo has made prior to an anticipated event with subsequent sell-offs. The Q1 "Earnings Season," recently completed, offers numerous opportunities for the trader to capitalize on the cycle. When more attention is focused on a company—be it good or bad—the volatility in the options pricing (Implied Volatility, or IV) goes up, causing the options to trade at higher premiums than usual. The strategy, is to enter into your position before this increase occurs.

Figure 1—YHOO Earnings

Optionetics offers a good place to begin your search for IVs near the lower (or upper) ends of their ranges. (www.optionetics.com/start.asp).

Consider the IV price swings illustrated in Table 1 which is associated with YHOO, illustrated in Figure 2.

Table 1

Yahoo Options IV
E.D. IV 10/98	Mid- Point IV	E.D. IV 1/99	Mid- Point IV	E.D. IV 4/99	Mid- Point IV	E.D. IV 7/99	Mid- Point IV	E.D. IV 10/99	Mid- Point IV	E.D. IV 1/00	Mid- Point IV
113	Low 70's	Upper 120's	Low 90's	100	Low 80's	Near 100	Low 60's	Low 70's	Upper 40's	100+	Mid 60's
E.D. = Earnings Date

Figure 2—YHOO Year IV

The gyrations of the IV's along with a stock's price swings make for good trading opportunities. Entry point is the most critical and controllable aspect of trading, so if you follow a company with a history of cyclical IV price swings, you'll have a good idea of when to open a position. Check out the OptionsAnalysis area of the Optionetics.com web site (www.optionsanalysis.com) to begin your search.

Spotting a Channel

A stock sometimes will begin trading in a channel after a big move up or down. When this type of price action is present, traders are looking elsewhere as the stock consolidates. When a formerly volatile stock quiets down with lower than normal volume, a narrow trading band and the IV of its options cool off, this quite often can present a good opportunity to put a trade on.

A few moths ago, Scientific Atlanta (SFA) experienced a sharp point gain, then fell (relatively) quiet. At the time it was difficult to tell just from looking at the chart where the stock would go next. Earnings had been announced in late January, and there were no planned announcements anytime soon.

Figure 3—Scientific Atlanta

The channel that formed for SFA after their post-earnings run lasted from February 9 through 29, in a range from around 49 to 55, settling down to close at 51 on the last day in February. As a hardware manufacturer in the technology sector, they had been "a darling of investors." But after such a big run-up it was difficult to tell where the stock might move next. This represents a good time to put a straddle trade on (the simultaneous purchase of an at-the-money put and call). For a straddle to work, the stock needs to move beyond the net debit of the options in one direction or the other. Plus you need to have the trade in place before the stock grows active again (when the options are cheap from an IV point of view).

Figure 4—SFA 6 Month IV

In the Optionetics,com StraddleFinder newsletter, chief option strategist and author Tom Gentile advises his readers to use the following guidelines when opening a straddle position:

1. Buy ATM contracts at least 45 to 60 days before they expire. In the case of SFA the next earnings announcement wasn't until April, so the May contract was indicated.
2. Look for a (historically) low IV if the potential for increased volatility exists. These can be found at www.optionetics.com/start.asp. This free service lists over 1,500 stock options daily, ranked from high to low.
3. Exit your trade when the profit is 50 percent, and no later than five days after earnings are announced. The maximum time to be in the trade is 30 days. (Note: in this example, earnings weren't anticipated for nearly two months. Part of the strategy of a straddle is to avoid time-value depreciation. There was sufficient price action and IV increase to indicate taking profits long before earnings. However, if you're in the trade to take advantage of the earnings hullabaloo, then the correct month is the contract month after the expected earnings date or longer.)
4. Look for inexpensive contracts.

In this case, the straddle would have been:

I wish to Buy 1 Scientific Atlanta May 50 Call Buy 1 Scientific Atlanta May 50 Put To Open

To place a limit order, indicate a total debit for both sides of the trade.

Scheduled News Events

Being aware of scheduled news, no matter where it comes from, is an easy way to avoid being trounced. Earnings announcements are biggies, as shown earlier. If you're in a straight call or put position (owning a directional call or put, unhedged), holding over an earnings announcement can be harmful to your economic well-being. You should know prior to entering a trade when the earnings are expected. BigCharts.com offers clues as to how the stock trades before and after an announcement. For a list of expected earnings release dates, go to Yahoo's Finance site: http://finance.yahoo.com/?u. You may also want to take advantage of a variety of free services that will notify you via email of critical dates on the horizon for the stocks you are interested in (check out www.cbsmarketwatch.com or www.INO.com.

Since stocks are also influenced by the bond market, it pays to be aware of what bonds are doing or might do when a key economic indicator is released. I have on my desk a calendar that lists anticipated events. A good place to be kept up-to-date on government and economic issues and events is http://www.briefing.com.

The most volatile day of the month is the first Friday of each month or, as it is sometimes referred to, "Un-Enjoyment Friday." That's the day when the Employment Report is issued by the U.S. government. It is the "Mother of All Reports" and can move the markets faster than greased lightning, which can lead to high volatility. The increased volatility sets in as early as the prior Wednesday. This too represents a promising time to put on a straddle trade (once again taking advantage of the subsequent rise in IV). In this case, a near-term contract can be used. For the month of May, the first Friday is the 5th. If you were interested in playing the OEX (which as of this writing is 780), you would open an OEX May 780 put and a May 780 call. With the way these markets are behaving, you might be able to sell your winner for an (overall) large gain, but keep the loser, which could appreciate again in the whipsaw for an even larger gain. (I call the losing side of a straddle a "Toilet Trade" because you've already won, and keeping this losing side alive is almost meaningless, but fun! Kind of like a one dollar bet on a basketball game.)

There are regularly scheduled ones, too-the most important being the Consumer Price Index and the Producer Price Index. These are not regularly scheduled, however, but are posted on Briefing.com's calendar (www.briefing.com/intro/i_markcal.htm).

Avoiding the Belly-flop

I know quite a few traders that are "directional" traders, guessing in the near-term which way a stock or index will go. To some this is their idea of trading, and if it's yours, here are some tips to make sure you can stay in the game without getting your head handed to you.

Jim Brown, president of Option Investor Newsletter (www.optioninvestor.com/), urges his clients "to invest only when it's profitable." You'd be surprised at the number of seemingly bright people who don't do this. If you're bullish, trade when the markets are going up. Let the first hour (amateur hour) pass before determining market direction. Determine if the sector your company is in is positive overall. Has it been a hot sector or is it showing signs of "turning?" And how does it rank overall in it's group? Here's some good ways to tell, at a glance and for free, what the water temperature is before you execute a graceful dive or a painful belly-flop.

www.smartmoney.com has a feature that graphically shows how the market is doing, sector by sector. (www.smartmoney.com/marketmap/marketmap.html). Be sure your play, if it's bullish, is in a sector with a green color. Another is John Bollinger's site: www.equitytrader.com (www.equitytrader.com). John can show you (after a mild learning curve) how a particular sector is performing, as well as the stock you're investigating and other companies within that sector. Again, there is no charge.

The aforementioned Jim Brown's pay site is also worth peering into. In it he lists the near-term direction (from very bearish to very bullish) of each sector. Also, Austin Tanner's "Market Sentiment" section does a good job in highlighting specific stocks that are either experiencing extremely high amounts of optimism or pessimism, as well as the overall market sentiment. A free trial is offered.

Hopefully from these bits and pieces you'll find enough help to make your next trade more profitable. Trading is a balancing act. To be successful, you have to be able to keep walking the tightrope even when it goes slack.

Mike Keller is a senior writer and trading humorist at www.optionetics.com, an educational firm dedicated to empowering investors through knowledge. Questions and comments can be sent to mikekeller@optionetics.com.