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Stocks set for flat open

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Stocks look set to open relatively flat this morning as the S&P 500 futures (sp01z) are unchanged at 1,072. NASDAQ futures (nd01z) are also unchanged at 1,353 and Dow futures (dj01z) are indicating lower by 13 points at 9,179. Fair value for the S&P 500 for today is $2.35. HL Camp and Company has their computers set for program buying at $3.61 and their computers set for program selling at $0.57. Fair value for the NASDAQ-100 today is $5.10.

Crisis!

The word "crisis" in Chinese is composed of two characters: the first, the symbol of danger; the second, opportunity.

Many traders and investors for that matter may be feeling like "a deer in the headlights." Which way are things going to go? Up or down? If I don't know, I'm going to squirrel my money away in the money market account that's yielding 2.5% interest, pay taxes on that money and settle for a guaranteed loss of purchasing power when factoring for inflation.

On September 28th, in the 09:00 EST update, I tried planting the seed for subscribers with two options strategies that perhaps fit well in times of "crisis" for the shares of WebEx Communications (NASDAQ:WEBX). A strategy that allowed traders and investors to actually take advantage of perceived "danger" and provide the "opportunity" to make money due to uncertainty in the markets.

Did we need to know direction? No! All we needed to "know" was that the stock had to have a history of volatility, be trading near a pivot point and move! Up or down made little difference, but the greater the move, then the greater the reward!

I didn't stop there. On October 4th, in the 10:30 EST Update on OptionInvestor.com, we used the straddle option strategy (buying both call and put, same strike price and expiration day) for shares of Qualcomm (NASDAQ:QCOM).

With October option expiration having been completed on Friday, it's now time to assess things and try and learn what worked, but also what didn't.

Hypothetical outcome on 1 contract in each option

Please note: That my q-charts portfolio tracker is not calculating some "value" and "profit loss" amounts correctly due to options having now expired. During normal trading hours the amounts have been correct. I've printed the more accurate amounts on the above chart.

As you can see from the above three trades profiled in past intra-day commentaries, a few bets sprinkled around may have had a trader/investor putting $1,485 to work (excluding commissions) and ending up with $975 in gains (excluding commissions). That's about a 65% gain on capital invested and not bad for a trader or investor that had no clue which way the stocks were going to move. All a trader had to "know" was that the stocks were near a pivot point (a point where they expect a sharp move either side of, up or down) and that the stock would move away from that pivot point as determined by the MARKET.

There are those investors that don't trade options because there is the perception that you have to watch them like a hawk. Not true. In fact, some option experts feel it is best to let a trade run its course until option expiration and play your hand to the end.

Sometimes I take issue with that thought, but more times than not, I find that discipline works quite well. For those subscribers that may not "trade for a living" the straddle or strangle strategies allow you to go about your daily work relatively "worry free" and perhaps not dreading an uncertain market environment.

Personally, I like to set a goal or target for a trade/strategy and once that goal/target is reached, then close the trade. If my goal is to sell the strategy when the position is up 100%, then that's when I either raise stops, or sell the position base on reassessment of the market conditions.

Had we placed all our bets on one stock, QCOM or WEBX, but not both, the results would have been vastly different.

Qualcomm (NASDAQ:QCOM) by itself would have resulted in a loss of approximately $300 (based on 1 contract of each call and put option) or 50% on that trade. We'll review these numbers below.

Never Argue with Mr. Utley!

My esteemed colleague Eric Utley argues that the straddle/ strangle trader should sell both the call and put option the moment the strategy reaches the trader's desired goal or feels the strategy has played itself out related to market conditions. I argued with this, but I'm quickly beginning to see his point.

On October 5th in the OptionInvestor.com 12:00 EST Update, I profiled "trading" the Qualcomm straddle and suggested selling the call and holding onto the put, then placing a stop on the put option should the stock break back above the $42.58 level (based on rolled down retracement). You see, I'm a firm believer in that the "trend is your friend." While the stock fell further from $39.72 to a low of $38.31 on October 5th, the stock never hit my bearish target of $35.86. In fact, October 5th was the low and the stock rallied from there, right back up to our 38.2% level on retracement bracket near $50.

I learn something new every day. Never argue with Mr. Utley! I argue (make that discuss) strategies with Mr. Utley every day. It's interesting to go back and look at the 12:00 EST Update, review my thoughts as it related to how things were trading at that time. Then make a comparison to how things would have worked out in the above portfolio and test for yourself how you feel a straddle or strangle should be managed.

What the Strategies looked like on 10/5/01 near 12:00 EST

Here are some things I will note at this time after reviewing these positions and past strategies discussed. I mentioned before that we should sit down at the end of each month and review our trades to see what took place and try to learn from what we did, or didn't do. I think you'll find that these observations will make you a more educated, confident and competent options trader. I certainly learned something!

In the WEBX trade, I should have forgotten about trying to "trade" that straddle and just held on until option expiration. Had we "traded" those positions by selling the calls and holding onto the puts, they would have ended up with a profit from the trade, but not the profit found on option expiration (Friday, October 19th).

Mr. Utley would have been proved correct in his belief that if you're going to close out one side of the straddle/strangle then you might as well close out both calls and puts at the same time. Why was he right? In the WEBX Oct. $17.50 straddle, had we just sold the call portion we would have walked away with a $410 gain ($920 sale of call - $510 for cost of straddle). Had we closed out the put side of the straddle at the same time we could have walked away from the straddle with an additional $30 (excluding commissions). Mr. Utley would argue.... "A penny saved is a penny earned." Again... never argue with Mr. Utley.

Same thing for the WEBX strangle, but different dollar amounts and percentages.

"Trading" the QCOM straddle would have actually proved to have been "better" than holding to expiration. By trading out of the call and selling it, a trader would have lost about $155 on the call portion. If a stop had been placed at the 42.60 level, the rally back higher and breaking above our 19.1% "rolled down" retracement level at $42.58 may have had the "trader" stopping out of his/her put option at $3.70 and taking a fractional gain of $10.00 (not including commission). By "trading" we may have lost $145.

But, like I said, "Never argue with Mr. Utley." Mr. Utley's belief (and now mine) of closing out both sides at the same time would have resulted in a gain of $105 (not including commissions).

What did I learn?

There is really nothing "conclusive" from what we've discussed above in reviewing these trades. However, I will note that in the three trade reviews (not a broad sample), I would have saved myself some extra work and money if I had simply closed out both sides of the straddle or strangle strategies instead of trying to trade them. Perhaps the "uncertainty" I was trying to take advantage of found me to be the "victim of uncertainty" when I then tried to be making a prediction on further direction of the stock's price (if a straddle trader sells a call for a profit, then the bet becomes on a decline in the stock) Again, when a trader establishes a straddle/strangle, the DIRECTION of the stock's price movement isn't important. Only the AMOUNT of movement away from the pivot point (pivot defined here is time and price of trade establishment) is important.

Note to Jeff Bailey: When you establish a straddle or strangle, you're original intent was to establish the position to take advantage of uncertainty and a potential movement away from the pivot point. Jeff should not be trying to predict the direction of the stock. Therefore, don't try and predict the direction of the stock a couple of days later in the directional break away from your pivot point. If you do this, you are deviating from your original reasons for the trade and this may come back to haunt you!

When I outlined these trades, I had a "bullish bias" toward each stock, but felt the market environment was very uncertain due to the recent terrorist attacks. I felt each stock was at a trading point where we could expect some good volatility. In the end, my "biases" proved to be correct, but the STRATEGIES combined would have also resulted in a relatively pleasant experience for the trader/investor.

Note to Jeff: Good job with your original analysis on direction of these two stocks by end of option expiration. The work you did with the bullish percent data along with identification of levels with retracement and volume along with other historical data would have served you well on a bullish bias from date of observation until today.

I would not say that "holding until expiration" is always a strategy for success. Capital exposed is capital at risk. The longer you're in a trade, the more risk you are willing to assume. In stocks, but even more so in options, the amount of time you're capital is exposed, the greater the risk! But what do we know about risk? We know that the more risk we take (in a straddle/strangle, RISK can be defined as TIME and MOVEMENT away from pivot point) the larger amount of gain then becomes expected. Yes, risk is also defined as capital, but we know going into the straddle/strangle how much money we are willing to risk. You should NEVER expose more capital to an option than you're willing to lose.

I've lost count of the number of people I've talked to in the past 6-months that asked me "which way do you think the markets are going to trade?" Without a firm answer, many "traders" or "investors" have packed up their toys and gone home.

The straddle or strangle trader could care less about market direction and often times thrives in times of "crisis" or uncertainty. The key for the straddle/strangle trader is not market direction, but identifying volatile stocks that are near a point where a break from a perceived pivot point brings a volatile move in direction from that pivot.

Have you reviewed your trades this month?

Hopefully you've found the above commentary education and useful going forward. Reviewing your trades and learning from them will make you a much better and more confident trader in the future. I made a few notes to myself as an example of how you might review some of your own trading observations. Sigmund Freud once said, "The less a man knows about the past and the present the more insecure must be his judgment of the future."

I'm not anywhere as smart as Mr. Freud was, but if we have no clue as to the success or failure of our past investments, the more uncertain we will be in our trading going forward and more likely to duplicate mistakes.

I've known traders that have traded much more than $1,500 in a months' time and have far less than a $900 gain to show for their efforts. Take some time to review past results. Try and uncover what worked and what didn't work and then try to come up with an answer as to the "why's" a stock may have done what it did.

The answers we're looking for are NOT ... "He told me to buy it and it went down." "He told me to sell it and it went up." No, the answers should be more like "Darn, I bought this stock/option right at a level of what now looks to have been resistance and I should have had a stop under that trade" or "What was I thinking when I shorted that technology stocks when the NASDAQ-100 bullish % was at 0%?"

Focus on the bad trades first, get those out of the way. Then review what worked! Observations like "Hey, I bought that one right at the 19.1% retracement level when the bullish percent for the NASDAQ-100 first reversed up from 0% bullish and the stock ran up to 50% retracement in 7 days when I sold it for a profit!"

What you uncover by months-end, may well determine November's results!

Jeff Bailey
Senior Market Technician
Option Investor

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