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Another Volatile Week!

The major equity averages traded in mixed fashion Friday as Dell Computer (NASDAQ:DELL) led a rally in technology shares while the broader market sectors retreated in the wake of disappointing economic news. Dell posted a 28% percent jump in profits and forecast higher revenue growth for the current quarter, bolstering investor optimism about future corporate earnings. However, the buying activity was moderated by the University of Michigan's consumer sentiment index data, which showed a larger-than-expected drop in confidence. The May index came in at 85.3, substantially lower than the consensus expectations. At the closing bell, the Dow was 49 points lower at 10,140, while the S&P 500 index ended down 5 points at 1,154. In contrast, the tech-laden NASDAQ gained 12 points to 1,976.

Stocks in the finance group were among the underperformers during the session and that trend did not help the new position in Legg Mason (NYSE:LM). Shares of LM dipped below the suggested exit price late in the afternoon and the short JUN-$75 puts were repurchased to prevent additional losses. The remaining (long) JUN-$70 puts are currently quoted at $0.35 X $0.60, thus conservative traders should target a credit $0.50 - $0.55 to close the spread entirely. With any luck, readers who used a more aggressive loss-limiting strategy will benefit from the "Murphy's Law" activity (in the stock price) that generally follows our early-exit recommendations.

In the commodities segment, oil prices rebounded slightly after two consecutive days of selling pressure that took the June crude contract down nearly 7% and initiated a broad retreat in the Oil Service sector. One of the less fortunate issues in the sell-off was Baker Hughes (NYSE:BHI) and Thursday's decline in the issue breeched our closing stop in the short portion (MAY-$42.50 put) of the bullish spread. Depending on your method of exit (individual orders or net-debit), the overall loss in the position ranged from $0.25-$0.50 per contract. Those who used a "contingent" order to buy back the MAY-$42.50 puts still have 5 contracts of the (long) MAY-$40 puts, thus they may be able to further reduce the capital drawdown from the spread. Based on the range-bound character of the underlying issue, we recommend that conservative traders sell those options now while there is still some premium available.

The recent volatility in the market demonstrates the need for effective executions, especially when a trade is necessary to limit potential losses and considering the numbers of readers that have asked about this subject in the past, it may be a good time to discuss the features of a superior broker.


Finding a Broker

There are a number of features a brokerage must offer in order to be an asset to a successful options trader. These qualities should include: extensive knowledge of the derivatives market, online access with an easy-to-use trading platform, adequate resources and tools (quotes, charting, research, market reports, paper-trading), low commission costs, prompt and knowledgeable customer service and most importantly, efficient trade execution. Obviously, there is more than one firm that may qualify in this regard however we have found that OptionsXpress meets or exceeds our stringent criteria in all of these categories. In fact, OptionsXpress was top-ranked by Smart Money and Forbes in 2004 and Barron's recently named OptionsXpress the best browser-based brokerage for the third consecutive year, citing its technology platform and product innovation as being particularly noteworthy. Barron's evaluated 18 online brokers, gauging their capabilities in a number of areas and OX was the winner in trade execution, usability, research amenities, customer access and help, portfolio analysis and reports, and overall costs. Traders who are interested in learning more about OptionsXpress can tour the site here:

http://www.optionsxpress.com/welcome/tour/


Using the OptionsXpress Trade Screens

One thing we really like about OX is the ease with which a spread position can be managed using their online trading platform. The trades can be entered individually or through the use of net-credit (to open) and net debit (to close) orders. Here is an example of the process using the recent (5/1/05) position in WellPoint (NYSE:WLP):



First, we need to enter the opening trade, which involves buying a put (MAY-115) and selling a higher strike put (MAY-120). This transaction, when completed, will create a credit spread with a potential profit of $45 per contract, or $225 for a 5-contract position ($45 X 5). But, before we go any further, it may be best to explain the data published for each new play. The individual option positions that produce the spread are listed in two lines:



The next piece of information in the play description is the "net-credit" target.

INITIAL "NET-CREDIT" TARGET = $0.45-$0.50

This is the (per contract) price we hope to achieve through the purchase of the MAY-$115 puts and the sale of the MAY-$120 puts. Since the lower strike option is more distant from the share value of the underlying issue, it will be worth less than the higher strike option and this difference yields a credit when the trade is initiated (hence the name "credit" spread). You will notice the target credit is less than the mathematical difference between the current (last) quotes for each option. The reason is simple: you can generally expect to shave $0.10-$0.20 off the composite BID/ASK price of the spread when opening or closing even the smallest position. The margin can be more or less, depending on the price of the options, whether they are ITM or OTM, the time value remaining, the volatility of the stock, etc. In short, the published "target" is intended to give traders an idea of the value of the spread because the option prices are always different the next day. At the same time, you may need to adjust this target based on the activity of the underlying issue, the trading volume of its options or the implied volatility of the series being traded.

This net-credit target is also the maximum profit (per contract) available from the spread and the following line:

POTENTIAL PROFIT (X 5 contracts @ $0.45) = $225

reflects the expected cash gain (less commission costs) when a 5-contract position is initiated and expires successfully. Below the potential profit is the:

MARGIN REQUIREMENT (X 5 contracts) = $2275

Margin is the amount of cash or collateral that must be available in your brokerage account to initiate the trade. Then comes the:

RETURN ON INVESTMENT (max) = 9.89%

ROI is calculated by dividing the potential profit ($225) into the margin requirement ($2275), however it is not adjusted for any specific time period. Finally, there is the:

COST BASIS = $119.55

which identifies the "break-even" point, based on the stock price, for the position (at expiration). If the share value is below this price, the spread will lose money. If the share value is above this price, the spread will achieve a profit.


Now, back to the example...

In order to initiate the suggested spread, we log into the OptionsXpress site, select the "trade" tab and then select Xspreads. This will take us to the following screen:



As you can see, all of the required elements of the trade have a logical place on the order form. The next step is to make these entries. First, we insert the individual symbols for each option (using a slightly different format specific to the OX site):



Then we insert the quantity or number of contracts for each trade:



Then we select "limit/credit" and type in the target credit amount ($0.45) as listed in the play description:



Finally, we identify the duration of the requested order which, in the case of opening trades, is generally a "day order." Since this is the default selection on the screen, no changes are required.



After entering/editing the data on the order screen, select the preview button to complete the final step in the order entry process, where the trade request will be confirmed. The last screen in the sequence should look like this:


And there you have it...nothing else to do but sit back and wait for the "fill" report. When this occurs, it will be necessary to initiate some type of stop-loss order to protect against unexpected moves in the underlying issue. But, what if you aren't filled at the requested price? How long should you continue to place the order before changing the net-credit or abandoning the position altogether? A reasonable period might be one day to one week, possibly longer, depending on the volatility of the underlying issue, the time remaining until expiration, etc. Occasionally, you will have to evaluate the position on an individual basis to determine a suitable balance between the potential for achieving a larger profit and the possibility of not entering the spread. Remember, the "net-credit" target is simply a suggested entry point; a reasonable price at which to initiate the spread, given the current option quotes and the price (and technical character) of the underlying issue. At times, a smaller amount may be acceptable - based on your personal risk/reward outlook - if the order can not be filled at the suggested price within a reasonable period.


Protecting Against Losses

Learning to correctly manage portfolio positions; maximizing gains while limiting losses, is one of the most important aspects of successful trading. The first thing a trader must realize is they should never enter a position without a pre-planned exit strategy. The motive for this approach is simple: the most common reason for losing money in the options market is failing to close a position in a timely manner, regardless of whether the action is to limit losses or lock-in gains. A surprising number of traders achieve excellent profits, but end up giving most (or all) of it back simply because they don't develop a sensible plan to manage each position.

In the MCM Portfolio, we provide "loss-limit/exit point" prices to give subscribers who are less experienced with options a reasonable starting point at which they can plan for a potential closing (or adjustment) trade in the recommended spread. This information is published at the bottom of the narrative for each new position. Again, here is the content from the WellPoint (NYSE:WLP) play:

Once the position is open, traders should place a (contingent) order to close the short ($120.00) put options if the stock moves below $121.25. A "net-debit" order of $0.95-$1.00 to close the spread may also be appropriate for some portfolios.

As you can see, there are two different strategies available; one includes a stop-loss point, based on technical analysis, while the other uses a suggested spread-closing debit, based on percentage loss. The first technique involves a contingent order to close the sold options in the spread when the underlying stock trades at or beyond a particular price.

Below is a screen shot of the (initial) closing order using the OptionsXpress platform. The specifics of this "contingent" trade are:

Buy to Close - 5 contracts - WLPQD - at MARKET - When the bid price of WLP moves below $121.25 - Good Until Cancelled



Obviously, there are some inputs that can be modified, based on your personal preferences, as well as a few alternatives with regard to advanced orders. However, this is the basic data and format necessary for a (protective) closing order on the short option in a spread.

Traders who utilize the "stop-loss" method with the short option in a spread can often limit the effects of a large, unexpected move in the underlying issue. A good example of this technique was demonstrated in the recent (4/24/05) bullish spread in InfoSpace (NASDAQ:INSP). Readers that used this tactic when the stock price plunged "after hours" were out of the short puts a few minutes after the opening bell, leaving the long options available to be sold (for a higher price) at a later time, and substantially reducing the loss in the spread. As you can see, it's a good method for issues that reverse course unexpectedly because you can often use the new trend to your advantage when closing the long options in the position.

In contrast, traders who want to limit draw-downs based on a percentage change in the value of the spread often utilize a net-debit (limit) order to close both option positions simultaneously. With this approach, the target (exit) price is generally a multiple of the initial credit in the spread and we recommend a limit of roughly twice the per-contract profit for a conservative position. For readers who use the OptionsXpress platform, the Stop on Spread order is available as an advanced trade. Here is a screen shot for the Stop on Spread (market) order with the WLP position:



Since this is a complex order, the screen shot reflects only one of the possible variations and it is not yet available (for a more in-depth example) in the OX Virtual portfolio - only with "real" positions. However, a detailed (textual) description follows:

To place the Stop on Spread order (from the positions page), click on "Sprd" under the Action column. Then on the order form, choose "Stop Order" from the advanced drop-down box. Then click preview, and on the next page you will be able to enter the stop price you want the (exit) trade triggered at, and if you want it to close at "market" when that occurs, simply leave the default settings on the order form. If you want a specific "limit" debit price to be triggered by the order, you can do that as well. Keep in mind, there is a possibility the stop could be hit, even thought the limit has not been met, so you wouldn't be out of the position until the limit is reached after the stop has triggered. The unique facet of this order is that it is processed "in house" by OptionsXpress' complex software-based technology, so the trade is initiated only when the difference in the individual option prices reaches the target threshold.

Obviously, some of the MCM positions are going to be "losers" regardless of the exit strategy used by traders who follow the portfolio. However, it is important to be aware of the various techniques for closing/adjusting spreads because there are definite advantages to specific strategies, based on the projected trend or character of the underlying issue.

Next week, we"ll discuss some common adjustment strategies for credit spreads that don't perform as expected.

MCM Staff

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