Option Investor

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A Positive Attitude Prevails!

Stocks ended the week on a bullish note amid renewed optimism about the economy and encouraging inflation news. First quarter real GDP growth was revised significantly higher on Thursday, suggesting steady expansion into the second quarter, and the April core deflator for personal consumption expenditures was up just 0.1%, despite a previous monthly increase of 0.2% and a 0.3% rise in February. The major equity averages reacted favorably to the data with most of the broader market sectors closing higher ahead of the long Memorial Day week-end. The Dow industrials were up 4 points to 10,542, while the NASDAQ climbed 4 points to 2,075 and the S&P 500 index finished a point higher at 1,198.

Most investors were pleased with Friday's upside activity however the bullish bias did little for our new position in Research in Motion (NASDAQ:RIMM). The stock dipped only once during the morning session (near 10:30 AM) and the best price observed on a simultaneous order basis was $0.05 below the target credit. Although $0.35 per contract was certainly an acceptable profit for the conservative spread, it's hard to determine how many readers actually participated in the play at that price. Since this situation has occurred in a number of recent bullish candidates, it seems appropriate to review the basic objective of the "target" credit listed with each new position.

Trading Basics - Opening a New Position

Many of our subscribers are less experienced traders that need simple, easy-to-understand strategies and one of the first skills new market participants must learn is to execute a favorable opening trade. A good technique for opening a combination position is to place the order at a "net" credit (or debit), which is determined by the difference in prices of the individual options in the spread. Thus, when a new spread candidate is published in the MCM Portfolio, we include a target credit to help readers open the play. This is simply a recommended entry point - just an opinion of what a trader might use as an initial price for the combined (spread) order. It should be a reasonable price to initiate the play even with small changes in the option quotes. The target price is always less than the composite BID/ASK numbers (we do not use "market" orders to enter a combination position!) and usually, a trader can expect to add $0.05-$0.15 per contract to the existing credit when opening even the smallest spread. This amount can vary, depending on the price of the options, the relative distance to the option strikes, the time value remaining, the volatility of the stock, etc. Since the option prices are always different after a new play is published, a target credit is essential to give beginning traders an idea of how much money they should receive when they open the position.

Obviously, readers may need to adjust the target based on the activity of the underlying issue, the trading volume of its options, or the implied volatility of the series being traded. In addition, a smaller credit may be acceptable - based on a trader's risk versus reward outlook - if the order can not be filled at the suggested price within a reasonable period. Nearly all of the positions listed in the MCM Portfolio are viable with a slightly lower profit potential, so it is up to the individual to determine when the initial credit should be reduced to ensure a "fill" in the opening trade. Readers often ask how long they should wait before reducing the limit price in the order and based on our experience, a reasonable period might be a few days to a week or longer, depending on the expected volatility of the underlying issue and the time remaining until the options expire. While this time-frame may sound vague, there is simply no easy solution for this dilemma. Each individual trader will have to evaluate the position and determine a suitable balance between the potential for achieving a higher credit and the possibility of not entering the spread.

There are a number of disadvantages to using net-credit versus individual orders and most apparent is the fact that you are telling the market-makers exactly what your terms are, and how you expect the underlying to react in the future. The situation gets worse when the liquidity (open interest) in a particular option series is relatively low as you will become "the market" and if there was previously a favorable disparity in the option spread, the market-makers will correct it immediately - without filling your order. Remember, they are required to provide a market in which to trade, but they don't have to make it favorable for you. Considering these limitations, there are many occasions when you will need to use individual orders to enter a spread because you don't want to "show your cards" with regard to the desired outcome of your trades. In these instances, most experienced players would suggest that filling the short side of a credit spread first is essential as it defines the profit potential in the position. This task is generally accomplished through the use of a "limit" order with a price slightly above the current bid for the option. Once the short position is established, it is important to open the long position before a move in the underlying issue changes the risk versus reward outlook for the spread. Occasionally, you may have to use a "market" order to get the remaining second side filled, especially if there is a need to (immediately) establish the spread to limit the consequences of unexpected volatility. If you simply can't tolerate the uncertainty involved with "legging" into a position, consider using a "one triggers other" order to buy the long options (at market) after the order for the short options has been executed.

Oil Stocks Continue to Blaze!

As if there weren't already enough fires to fight, the rebound in oil-related issues caused another MCM Portfolio position to go "up in smoke" as the Oil Service HOLDRs (AMEX:OIH) torched our stop-loss price during Friday's session. The OIH reached a high near $93.50 late in the day, initiating a buy-to-close order for the short (JUN-$95 call) options in our bearish spread. The cost to exit the short position was roughly $1.50 per contract, which produced a debit of $1.05 per contract, or approximately $525, for the position. Now the question is how long to hold the long portion (JUN-$100 calls) of the spread in expectation of recouping some of the losses generated by the unexpected rebound in the Oil Service sector. A brief review of the recent price activity suggests plenty of upside potential for OIH, however the eroding time value in the options will reduce their value on a daily basis. In addition, the recent technical pattern reflects a number of resistance levels near the current price, so it is unlikely the OIH will breach $100 (thus placing the options "in-the-money) before the June contracts expire. With these facts in mind, we recommend waiting no more than a few days to sell the remaining options in the spread and based on Friday's closing quotes, a target exit credit of $0.30 to $0.35 per contract seems appropriate for all but the most aggressive traders.

Another issue that warrants attention is Conocophillips (NYSE:COP) as the stock ended the week near $107.55 amid a strong rally in integrated energy companies. With the issue trading less than $2 below our suggested exit/adjustment price, it appears we will soon be making the transition to a bullish position. As noted in the original play narrative, we intend to roll into a horizontal (calendar/time) spread if COP moves back into the intermediate-term lateral pattern near $108. Readers who want to join us in this conservative adjustment should enter a contingent "stop-market" order to purchase five (5) contracts of the AUG-$110 call options (COP-HB) if the stock trades above $109.25 on an intraday basis. Those who do not believe the bullish momentum will propel COP's share value beyond the top of the recent lateral pattern (near $111) should consider adjusting their exit stops to allow for additional upside activity before the trend consolidates.

Another Buying Binge in Biotech HOLDRs (AMEX:BBH)

The Biotech HOLDRs (AMEX:BBH) continued its winning ways last week, up another 10% on the heels of Genentech's (NYSE:DNA) sharp rally. Shares of DNA, which accounts for nearly half of the BBH's net value, rallied after the company announced favorable results from a clinical trial of its macular degeneration drug, Lucentis. The upside move pushed BBH well above the sold strike price in our (call) credit spread and provided ample motive to make another adjustment in the bearish position. Although we hesitate to add a large amount of money to a losing play, this is one of those few instances where it may be necessary to recover some of the losses in the current spread. At the same time, we do not relish the idea of making an official recommendation as there are many different ways to offset additional draw-downs in the position and some of them may not be appropriate for everyone. As with all trading strategies, we suggest that readers carefully consider the potential risk versus reward in type of "recovery" technique and implement a specific alternative only when it meets their personal criteria with regard to account capital, experience level, trading style, etc.

The current (unrealized) debit in the MCM Portfolio's BBH spread is roughly $3.25 per contract, thus we need to offset that amount while also hedging against additional gains in the underlying issue. The first step in this process is to roll up to a higher strike spread and possibly, to a more distant expiration date. With five months of time value remaining in the existing position, there is little incentive to move further into the future. However, a trader who wants to use the same time frame (October) will have to increase the number of contracts accordingly. Based on Friday's closing prices, one possible adjustment scenario for the MCM Portfolio position would look like this:




at a net-debit of $3.25 per contract or better.

Total cost = $1625 plus commissions
Overall debit = $1750 plus commissions

Then we could...

BUY (10) OCT-180.00 CALLS GBZ-JP



at a net-credit of $2.00 per contract or better.

Total credit = $2000 less commissions
Realized gain = $250

The new position will have a "break-even" basis near $175.25, well above the current value of BBH, however there is still the matter of offsetting any upside activity in the issue. Obviously, this task might be accomplished through a variety of strategies but the required portfolio collateral and additional risk will limit the choices available to the average trader. Depending on person's individual situation, the alternatives range from the purchase of options (including LEAPS) and low cost debit or ratio spreads, to the sale of uncovered puts and conservative credit spreads on the underlying instrument. These methods could also be used with Genentech (NYSE:DNA) as a proxy, since it accounts for a large percentage of the daily movement in the BBH.

A brief review of the technical outlook for both issues suggests that a consolidation is forthcoming, so we plan to wait for a pull-back before recommending a specific "hedge" technique for the MCM Portfolio position. Keep in mind, our approach may not necessarily be suitable for all traders, especially those who can't tolerate further draw-downs in the position.

Now let's go find some new plays for the coming week...

MCM Staff

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