The Option Investor Newsletter Wednesday 5-24-2000 Copyright 2000, All rights reserved. Redistribution in any form strictly prohibited. Posted online for subscribers at http://www.OptionInvestor.com ****************************************************************** MARKET WRAP (view in courier font for table alignment) ****************************************************************** 5-24-2000 High Low Volume Advance Decline DOW 10535.30 + 113.00 10554.90 10364.00 1,142,336k 1,405 1,483 Nasdaq 3270.61 + 106.06 3276.19 3042.66 2,086,635k 1,612 2,488 S&P-100 747.10 + 14.55 749.14 724.75 Totals 3,017 3,971 S&P-500 1399.05 + 25.19 1401.75 1361.09 43.2% 56.8% $RUT 461.74 + 2.73 461.74 443.99 $TRAN 2829.07 + 74.80 2867.06 2746.49 VIX 27.87 - 1.43 31.20 27.59 Put/Call Ratio .50 ****************************************************************** Airline Deal Helps Markets Soar Past Costco Fiasco Costco had investors scared early when there was a mysterious delay to their earnings, but cooler heads prevailed. It was a strange story this morning when investors were waiting for news of COST's earnings report before the bell, but to no avail. In some sort of strange mix up, the press release didn't hit the wire in a timely fashion. This caused some degree of panic and the stock was halted before the opening. The word was that Costco had provided some sort of earnings warning, but facts were hard to come by. This set the stage for more fear on Wall Street during the morning hours. But the Bears eventually had to give up and go home because this market was ready for a relief rally. Quite frankly, if it wasn't for relief rallies, we wouldn't have any rallies at all. The Nasdaq sunk to 3042.66 to the year's low before bouncing back, and this bounce had legs behind it. The rally that ensued took the Composite up 200 points off that low to settle out at 3270.58, just a touch off the day high. How was volume you ask? Great question, as we all know that is the one missing ingredient that everyone is waiting for. It did come in much better than expected at over 2 billion shares. It had been a long time since we've seen this kind of volume. Some may say that the incredible volume in COST at 144 mln shares traded inflated the total volume, but even without the extra 100 mln, the Nasdaq would have still been pushing 2 bln. Advancers still beat the decliners 24 to 16 though. Take a look at the technical picture on the Nasdaq chart for the week and it's easy to see why we need a relief rally. At today's low, we were off 15% in less than a week. It is my feeling that the NASDAQ will have a tough time going below the 2900 level, but I won't be surprised to see it try once this relief rally subsides. Note the downtrend is still in tact. The DJIA also had a strong day, thanks to the strength in the Transports. This typically forgotten sector of late decided to shine on news that UAL, parent of United Airlines, would be acquiring US Airways (U). The full story is listed below, but it was definitely welcome news to the ailing markets. The DJIA closed up 113 to 10535, up just over one percent. The volume was good here too at over 1 billion shares. The Transports gained 74.80, or 2.71%. Advancers and Decliners were even at 14-14. The technical picture on the DJIA isn't stellar, but you can make a case for support at 10,400. The problem is, what is the real upside? A move over 10,600 could be clear sailing back to 10,800. The moves on some individual stocks were amazing. Let's run through a couple to give you an idea. RMBS opened at $150, fell to $144, before rattling off 24 points to the upside to close at $168.38. SDLI opened at $168, dropped to $147.50, and rallied to close at $175.31. A $28 intraday swing. It was a similar story in AETH, ISSX, SEBL, INKT and EBAY. Money was rushing in at a rapid clip in the final two hours. The VIX was all over the map too. As high as 31.20, before tanking to the low at 27.64. So the disappoint of the day was Costco (COST) earnings. They missed analysts' estimates of $0.27 by a penny and warned that fourth quarter earnings will be sub-par. Yet, what was really disappointing and confusing for investors was the early release. At 5AM EDT, the earnings report was faxed to about 300 investors and analysts, resulting in pre-market selling. It wasn't until 9:30AM EDT that the report came across BusinessWire. Needless to say, COST may find itself in a heap of legal trouble with the SEC if these reports of selective disclosure prove to be true. This controversy certainly will be heated as disgruntled investors seek recourse. COST was down 21%, or $8.63, in regular trading to close at $32. The merger market continues to heat up as United Airlines (UAL) made a surprise $11.6 bln bid for rival U.S. Airways (U). This move raises the question of whether there will be a realignment in the airline industry. Government scrutiny is certain as the merger raises anti-trust questions as well. Analyst speculate that this announcement is just the beginning of airline wheeling and dealing. American Airlines (AMR) is expected to made a competing bid for U. Under the terms of the merger, UAL would pay $60 per share of U.S. Airways, which is a 128% premium to yesterday's closing price. DLJ analyst James Higgins cut his rating on UAL from a Buy to Underperform as he believes this move could put pressure on UAL's future earnings. He also downgraded AMR to a Market Perform from a Buy in expectation of their competing bid. AMR fell $2.56 to $30.06. UAL slid $7.19, or 12%, to $53.19. U shares benefited from the news soaring 85%, or $22.44, to close at $48.75. Once again, MSFT has its hands full with the government as a federal judge rejected MSFT's request for more time to examine the breakup proposal. Questioning the effectiveness of a two-way breakup of MSFT, U.S. District Court Judge Jackson entertained the suggestion to divide MSFT into three companies rather than two. He also put the remedy phase of this case on a fast track by ordering the government to submit a revised plan by Friday. Jackson only granted MSFT 48 hours to examine that plan before it becomes court record. This is a severe blow to the MSFT legal effort which was requesting an additional six months to depose witnesses and prepare for more extensive hearings. It is expected that Judge Jackson may issue a final judgment within two months. MSFT shares rallied today with the NASDAQ, closing up $2.38 to $65.56. This market has been a tough one to play if you learned to trade options in the past year. You are probably used to the bulls returning at each dip, right? I have found way to the sidelines and have been staying there for the most part. I love to trade, but hate trying to fight the trend. One bullish note though, typically when we have as many puts as calls in the plays section, we are nearing a bottom. This morning I looked at all of our puts plays to see most of the stocks down another 10-12%, taking them to absurdly low levels. They have been great plays, but when the puts start looking that attractive, I use it as the contrarion. When it looks too good to be true, well...you know. Besides, I have been waiting for the return of volume to the 2 billion level and we got that today. I will really be excited if we can do that tomorrow in front of a three-day weekend. Not likely, but that would have my online broker back up in my browser in a heartbeat. There is one economic report due out Thursday. It is the revision to first quarter GDP. Analysts expect a 5.4% number and anything less should lift the markets. A good number, with good market volume will bode well for the up coming week. To reiterate Jim's thought yesterday, it is always darkest before the dawn. Ryan Nelson Asst. Editor *********** IN THE NEWS *********** Costco Misses Estimates By Matt Paolucci Costco Wholesale Corp. (COST), the nation's top warehouse club retailer, said its third-quarter profits rose 14 percent to $120.3 million, but missed Wall Street expectations. Costco operates membership warehouses, which offer its members very low prices on a limited selection of nationally branded and selected private label products in a wide range of merchandise categories. The 305-warehouse chain also cut earnings expectations for the fourth quarter by one or two cents below the consensus estimate of 45 cents a share and said it expects earnings-per- share growth in the range of 11 to 13 percent for fiscal 2001. Shares of Costco, after being delayed for several minutes, finally began trading, with a first trade at $28.50, down $12.125 from Tuesday's close of $40.625. Costco earned 26 cents per share in the third quarter, versus the 27 cents expected by analysts at First Call/Thomson Financial. In last year's third quarter, Costco earned 23 cents per diluted share. Net sales for the third quarter increased 14 per cent to $6.77 billion from $5.94 billion a year ago. Costco said it plans to open 10 to 12 new warehouses including two or three relocations of existing warehouses before the end of its fiscal year 2000 on Sept. 3. Several brokerage firms chimed in with downgrades. Lazard Freres lowered its rating on Costco shares to Hold from Outperform, Morgan Stanley lowered COST to Neutral from Strong Buy, and Legg Mason reduced its rating from an Outperform rating to Market Perform. Yesterday, PaineWebber analyst Jeffrey Edelman said he was expecting 15 percent plus earnings growth. Robert Toomey of Dain Rauscher added, "We remain very confident in the company's business model and the company's aggressive new store expansion." Toomey rated the stock a "strong buy" with a 12-month price target of $59 a share. Earnings estimates, before today's announcement, for fiscal 2000 and 2001 were $1.38 and $1.60 per share, respectively. Costco said it is budgeting for 8-9 percent growth in fourth quarter same store sales. Shares of Costco (COST) closed at $31.875, down $8.75 per share. *************** ASK THE ANALYST *************** State of the Market By Eric Utley My fellow investors and traders, we are in a bear market. While the pundits on CNBC debate whether or not we are in a bear market let me present to you a few interesting items. First, there is the obvious, the NASDAQ is down roughly 36% from its peak in early March. And have you noticed the action in the stale sectors such as Food, Gold, and Tobacco? If not, pull up a chart on ABS, KBL, NEM, and MO. The preceding stocks are clearly defensive plays, and their respective rises signal a bear market. The advance/decline line looks terrible, and new lows are far outpacing new highs. And we all know what has happened to the once beloved market leaders such as AMAT, CSCO, SUNW, and YHOO. Additionally, and a little more concerning, we are starting to see a few isolated cases of companies falling short of earnings estimates, today it was COST. I've also heard a few traders on CNBC mumble something about layoffs on Wall Street. You know the bear has arrived when Wall Street starts talking job cuts. While each bear market is unique, they all have one thing in common. Eventually, every bear morphs into a bull. So how do we know when the new bull has emerged? I'll turn to William O'Neil for the answers. In a recent interview O'Neil explained that the market will find real support once almost every stock has broken down, all the bad news is digested, and enough time passes. Eventually, the market will rally, and one of the major indices will have what O'Neil calls a "follow-through" day, when either the DOW, S&P, or the NASDAQ will rally over 1% combined with an increase in volume from the initial rally day. The "follow- through" day will usually occur four to seven days after the initial attempted rally. Clearly, two of O'Neil's criteria have been met; broken down stocks and a lot of bad news. I think the only variable is if enough time has passed. This bear market is approaching its third month of existence, in our times of instant information maybe the worst is over. If you would like a more complete explanation of O'Neil's hypothesis, read Chapter 7 in his book titled, HOW TO MAKE MONEY IN STOCKS. By the way, you can purchase that title in the OIN bookstore under the resource tab. I've received requests from several astute readers that have found stocks that have bucked the bear. If you have a winning stock that you would like discussed, please send your request to asktheanalyst@OptionInvestor.com. Please put the symbol in the subject line of the e-mail. ---------------------------- NASDAQ Composite Index - COMPX While we're on the topic of bear markets, I thought it appropriate to examine the long-term trend of the NASDAQ and the current conditions of the US economy. Unlike the famous markets of 1929 and 1973-74, this bear is much different. In 1929, capitalism was feared to fail, and the US economy was facing many uncertainties, most notably the collapse of American banks. The 1973-74 bear market foreshadowed super-inflation and high unemployment. Unlike those famous crashes of the past, our New Millennium Bear is not faced with a collapsing financial system, nor hyper-inflation, nor high unemployment. And, although Alan Greenspan hasn't helped the cause for bulls recently, he is on our side. The bottom line here is that the economy is in great shape, inflation is still low, and employment is high. I think the New Millennium Bear was caused simply by excesses in the market. I know that is not a profound statement filled with insight and vision. But, if you think back seven months ago when the NASDAQ really took off, not a lot has fundamentally changed with the US economy since then. Okay, the Fed is in tightening mode, but from a historical perspective, interest rates remain relatively low. And prosperity reigns supreme! Biotech concerns are increasing our life expectancy and curing diseases. Tech companies are making life easier, and the Internet is connecting the world. Don't let the bear get you down, we are living in the greatest time mankind has ever known. Eventually a new bull will emerge, but until it does, we must practice patience. I've provided a weekly chart for the NASDAQ below. As you can see, the long-term upward trend-line remains intact. I think the critical support level going forward is 2950. If that level holds in the coming weeks, I think we'll be just fine. You can also see on the chart, the bullish hammer formed during Wednesday's trading. Is this the bottom? Maybe. As O'Neil might suggest, wait for a "follow-through" day to confirm the rally. ---------------------------- Echelon Corp. - ELON Thanks for your articles. I read them every week and continue to learn from them. Would you please evaluate Echelon (ELON)? Thank you. - Michael Well thank you Michael, your comments are much appreciated, I try hard to write articles that are useful for our readers. I'd love to take a look at ELON, as you well know, it's a very interesting company. ELON makes hardware and software that connects everyday devices such as light switches, washing machines, and gas pumps to the Internet. ELON helps original equipment manufacturers cut costs by linking electrical devices to a control network, thus cutting costs through centralized control and increasing service efficiency. ELON is expected to report its first quarter of profitability in its next earnings report. And the story gets better. ELON is estimated to grow earnings 30% annually over the next five years. And get this, ELON is expected to earn 19 cents per share during fiscal 2001, an 1800% increase over fiscal 2000! If the analysts are correct, ELON looks attractive for the long-term. And more good news, Thomas Weisel Partners initiated coverage on ELON Tuesday with a Strong Buy rating and set a 12-month price target of $80 per share. The analyst action helped ELON to buck the decline Tuesday, and edge higher. What's even more interesting is the chart pattern formed over the past two months. ELON has developed a classic cup-and-handle formation, which by the way, O'Neil believes is the most telling trading pattern in the technical analysis universe. Although the stock retraced much of its gains from earlier in the year, the chart formation looks strong. The stock consolidated its gains in the cup portion of the chart through much of April, it has since rallied on heavy volume to form the handle. A breakout around $72 would provide a good entry to go long. Notice the resemblance of a cup-and-handle formed earlier in the year. Look at what happened when ELON broke away from the handle. ---------------------------- Silicone Storage Technology - SSTI Wassup with these stocks in this bearish market? AMD, NVDA, SSTI, ELON. - Surya & Sheela Most of the stocks you mentioned above had held up relatively well until recently. SSTI had been holding steadily above $100, but the bear mauled it down over the past five trading sessions. As you well know, the semiconductor sector is extremely cyclical. And the memory chip market, in which SSTI operates, is even more volatile. Going back to 1998, SSTI was trading below $2. The stock has since rocketed higher in the past two years along with the boom in the semi business. If you take a look at SSTI's financials, you'll see why the stock has risen over 1700% in two years. The company reported sales of $62.3 mln for in its first quarter of fiscal 2000, and blew away analysts' estimates by 48%. And analysts estimate that SSTI will grow earnings by nearly 100% next year. So what has led to the recent decline in SSTI? Most notably, concerns over a slowdown in the chip sector. The chip equipment companies recently reported a slowdown in orders for their semi manufacturing products. The book-to-bill ratio for April was lower than the record number of orders in March. Also, there is the uncertainty over the long-running litigation against ATML. SSTI is challenging ATML over a patent infringement. If the analysts are right and SSTI grows earnings 37% over the next five years, this might be a good buying opportunity. But, further signs of slowdown in the chip sector will send the stock tumbling. Turning to the chart, despite the sharp sell-off recently, SSTI's upward trend is intact. However, like many other leading tech stocks, it is hovering above key support levels. On a bullish note, the stock did form a hammer pattern Wednesday. You can see the spike in volume which may signal a capitulation by sellers. If the sellers lost their power Wednesday, the stock could rebound quickly as there is very little resistance above $80. Also of note, you'll notice a similar hammer pattern in early April, where after SSTI enjoyed a quick, but brief rally. The big difference is that Wednesday's hammer came on much higher volume. ---------------------------- DISCLAIMER: This column is an information service only. The information provided herein is not to be construed as an offer to buy or sell securities of any kind. The Ask the Analyst picks are not to be considered a recommendation of any stock or option but an information resource to aid the investor in making an informed decision regarding trading in options. It is possible at this or some subsequent date, the editor and staff of The Option Investor Newsletter may own, buy or sell securities presented. All investors should consult a qualified professional before trading in any security. The information provided has been obtained from sources deemed reliable, but is not guaranteed as to its accuracy. *********** OPTIONS 101 *********** Discipline By David Popper Is it not amazing that in America today there are more books on how to lose weight, and yet, we have more overweight people than ever. It is not the lack of knowledge that causes people to be overweight, rather it may be a medical problem or more commonly, a lack of discipline. So to, in the markets, many people have very workable trading systems but simply lack the discipline to make that system work. Howard Abell, in his book "The Day Trader's Advantage," stated "technical analysis is very important. It is not, however, in my opinion, as important as working through the psychological and attitudinal issues of trading in general and day trading in particular." In other words, a discipline to execute your plan is of paramount importance. The operative question is, how do I develop a plan and how do I develop a mind set for successful trading. How can I develop a winning edge? Below I would like to explore some aspects of these questions: Understand your motive for trading: Most traders are in a constant state of conflict. They turn on CNBC in the morning and are depressed when a stock they were considering but had not yet purchased, has gapped up. They wish they were in total cash when the market goes down and somehow feel guilty that they were not clairvoyant enough to take preventative action. They feel equally as foolish when the market goes up and they are not fully invested. These type of concerns are unrealistic and detrimental. Instead of worrying about all of the could haves, should haves and would haves, a disciplined trader must be able to take the trades that are consistent with his methodology. His goal is not to maximize every trade, rather his goal is to achieve consistent positive results. Remember singles are more consistent than home runs and can easily help you achieve your overall goal. Develop a personal strategy that works for you and fits your personality. If the system does not feel right, then you are going to lose before you even start. You must trade a system that feels comfortable even if it is less profitable than other systems. Confidence and consistency are key. Experiment with different systems and pick the one that's most comfortable. If it works, stick to it. The system should be enjoyable. The whole purpose of trading is to either provide a living or extras for you and your family. If your trading creates needless anxiety and actually causes you to lose money on a consistent basis, then that system simply is not for you. Hard work is essential. You simply must put in the time. Despite the myriad of self-help trading books, there is no substitute for the hard work of reading charts, knowing your stocks, fine tuning your system and implementing your buy and sell rules. Confidence. You must believe in your analysis, your trading system and your execution of trades, whether you win or lose. During a bull market, very little discipline is required to make money. People could almost throw a dart at the Wall Street Journal and find a winner. Times are changing. Bear markets will expose weaknesses in your discipline, weaknesses in your system and weaknesses in your execution. If you find that you are having too much difficulty at this point, sit it out. A good market will return. If you must trade at this point, it is critical that you ratchet up your focus and discipline. It is simply hard to win today. Nevertheless, most experts will tell you to find one system that you are comfortable with. Find several stocks that you know well. Trade only those stocks and trade them only in your one system. Do not use margin in sideways markets, but instead maintain a comfortable amount of cash. This cash reserve may lead to explosive gains later when a bottom is finally reached and a rally ensues. Contact Support ********************** PLAY OF THE DAY - CALL ********************** SDLI - SDL Incorporated $175.56 +5.06 (-20.69 this week) SDL's products power the transmission of data, voice and Internet information over fiber optic networks to meet the needs of telecommunications, DWDM, cable television and satellite communications applications. They enable customers to meet the bandwidth needs of increasing Internet, data, video and voice traffic by expanding their fiber optic communications networks more quickly and efficiently than would be possible using conventional electronic and optical technologies. SDL's optical products also serve a variety of non- communications applications, including materials processing and printing. Most Recent Write-Up SDLI was added this past weekend, and we would hope you have let patience be your guide. Remember our place is not to try and convince anyone that they should jump into a play, just because it showed up on our list. Entry points are the key to success. The fact is this one is down 13% so far this week and a bottom may or may not be in place yet. The volume on the decline the first two days of the week has exceeded 13 million which is fairly substantial indicating their may be more room to move to go. Long and short term fundamentals have not changed. Unfortunately at this point SDLI is just like many of the tech issue that have suffered from Fed fears, and a lack of buying interest. There is economic data and a speech by Alan Greenspan in the next few days, which could help bring a few buyers back to the market. No company news so far this week to help prop up the stock, although in these markets it would have to be darn good news to make a difference. SDLI closed on support at $170. The next levels show up between $155 and $160. If we do get a move up, be ready to take profits at a moments notice. If we see further weakness, continue to be patient. Comments Impressive volume on the NASDAQ and an impressive rally today. Finally. On an intraday chart, you can see how this increased volume pushed SDLI higher in the latter half of the session. Quite a beautiful climb. This upward surge brought SDLI above 100-dma of $169.63, which represents a short-term support. As you can see from today's tail on the candlestick, SDLI can really sell-off before finding support. Today's low was $147.50. Yet, the strong volume today is very positive. Resistance will be found at $180 and $183, its 50-dma. Targetshoot on the intraday dips and confirm any upside moves with volume. BUY CALL JUN-170 YAL-FN OI= 46 at $22.75 SL=17.75 BUY CALL JUN-180*QZL-FP OI=317 at $18.25 SL=14.25 BUY CALL JUN-190 QZL-FR OI=415 at $14.38 SL=11.25 BUY CALL JUL-190 QZL-GR OI=421 at $25.50 SL=20.00 Picked on May 21st at $196.00 P/E = 390 Change since picked -20.69 52 week high=$244.75 Analysts Ratings 14-9-0-0-0 52 week low =$ 21.63 Last earnings 04/00 est= 0.16 actual= 0.22 Next earnings 07-19 est= 0.22 versus= 0.09 Average daily volume = 2.39 mln /charts/charts.asp?symbol=SDLI ***************************************** BIG CAP COVERED CALLS & NAKED PUT SECTION ***************************************** Conservative strategies are looking more attractive every day! ****************************************************************** Today the assistant editor for this section is attending a very important family event, a graduation ceremony. Without this key member of the research team, it is difficult to produce a viable group of candidates. With that in mind, I have decided to review some of the techniques and guidelines that we use to profit from this strategy. ****************************************************************** Success with Covered-Calls... Investors usually write covered-calls to generate monthly income, collecting the premium for the sale of an option against a stock position in his or her portfolio. This conservative strategy can be used effectively on all type of stocks as long as the outlook (fundamental or technical) for the issue is favorable. One of the advantages to this approach is that it allows new investors to learn successful trend-trading techniques with a small margin of safety while managing the combined position for upside profit and downside risk. This underlying basis for this strategy is a high probability of limited profit. The major advantage to a novice trader is the technique is easy to use and the resultant position is more conservative than outright stock ownership. In writing an option on the stock, the investor has insured the issue against a future drop in value. Regrettably, the downside risk in ownership is not eliminated, only reduced. In addition, the actual cost of opportunity loss or potential upside movement can be substantial. There are other, more subtle benefits and disadvantages but these are the most common reasons that investors choose (or avoid) this strategy. Each week we receive a number of questions regarding the various approaches to the investment strategy of selling covered-calls. In our personal portfolios, we utilize the "in-the-money" covered write as a primary technique for consistent profits. This method is easy to master and works in harmony with a low maintenance, low risk investing style. The underlying theory behind our success is to be "aggressively conservative." This tactic is in contrast to the more popular "conservatively aggressive" outlook used by many traders, where the underlying position is bullish, (based on OTM calls) and requires an upward movement from the stock for profit. In general we are conservative, long-term investors with contempt for excessive risk and the potential for large losses. Studies suggest (and our results confirm) that the average investor will make substantially greater returns through the consistent profits from "in-the-money" covered writing than he would using the high risk, high reward approach of more aggressive positions. You may think that this technique is far too conservative to yield favorable returns however, the "magic" ingredient of the strategy is the power of compound interest. Covered call writing allows investors to potentially compound their returns on stock ownership each month of the year. Unfortunately, while most investors begin writing covered calls with the goal of compounding their money on a monthly basis, many lose focus of the fundamental outlook of the technique (consistent, low risk profits) and start to concentrate on higher, single transaction returns. This is a common mistake and it can substantially increase risk and the probability of loss. The market historically offers a 2-4% monthly (annualized) return for this conservative strategy but with diligent research and analysis, and proper money management, the margin of profit can be increased. In our personal portfolios, we attempt to establish positions that offer on average, a 4-6% (8-12% on margin) monthly return on investment. Even with this meager profit, the long-term portfolio growth is excellent, based on the simple mathematics of compounding. Earning just 3% per month in a personal portfolio, without compounding or margin trading, equates to a 36% yearly return. We haven't found a bank or CD that matches that rate (but Mr. Greenspan is working on the issue). Obviously, most retail option traders regard a 3% monthly return as far too low. In fact, why would anyone want such a paltry reward when the market offers such great potential for wealth. There is answer is quite simple: RISK. Any strategy that yields 10% will be riskier (on a purely theoretical basis) than one offering a 3% return. You know the old adage, "The greater the risk, the greater the reward." Some of you will learn the hard way, as we did. After getting hammered on the majority of aggressive positions, we made the transition to ITM covered writes with lower returns. Now our portfolios grow on a consistent monthly basis. The goal of the covered-call writer is to have a good selection of favorable positions with adequate downside protection. With this approach, an investor reduces risk by entering several stock and option plays with a predetermined conservative profit target for each one. We strive for a 5%-8% monthly return in the newsletter but again with a lower profit target, the higher the probability of a favorable outcome and the lower the risk. To further reduce the potential for catastrophic loss, a trader should diversify his market exposure through a wide variety of covered-call positions. The stocks you purchase should generally represent companies of different types in a variety of industries. Most novice investors ignore this principle and consequently, their portfolio losses are substantial when a heavily weighted sector falls "out of favor." Many experts suggest you should limit each investment to no more than 10% of your overall portfolio. This is very important to the success of the covered call strategy as you do not want one issue to have a significant impact on your overall gains or losses. The fact is, no one really knows what a particular stock is going to do in the future. History suggests that the most prolific traders are correct in only slightly more than 50% of their directional forecasts and that statistic reinforces our basis for choosing to hedge poor selections with "in-the-money" covered writes. Before you open any position, it is important to understand the strategy that you are using and identify the specific goals for that particular trade. You can't make good decisions without knowing the mechanics of a specific technique. Don't use complex or advanced methods simply because they are intriguing. The best strategy is usually the simplest one that accomplishes your goals. Prior to executing a transaction, you should know exactly what the break-even (cost basis) point is, and be prepared to take action if the underlying issue reaches that price range. Once you have a candidate in mind, do your homework! Know the company and the calendar; upcoming events, earnings dates and scheduled reports. When you have a superior knowledge of a stock and its industry, you are way ahead of the investor that trades simply on intuition or outside advice. Portfolio management is critical to the success of any trading system. After you take a position in a particular issue, stay informed by monitoring all the news and announcements affecting that play. Observe the daily progress of the your stocks and realize that you have the ability and control to adjust or close the position at any time. Obviously you do not need to check the prices on an hourly basis, but we do recommend that you review each day's closing quotes. News and public opinion can have a significant impact on a stock's price and unfortunately, it is impossible to research "future" events before you buy an issue. The most painful lesson comes when you close a losing trade. It is very difficult to learn to exit unsuccessful plays in a timely manner but the simple fact is, there is no reason to hang on to a losing position when there are so many other profitable plays that deserve your time and money. Accept your losses, learn from your mistakes (evaluate each one critically), and move on! With any strategy losses are inevitable. Instead of being surprised, we anticipate them. We know that a percentage of the covered write positions we select will be unprofitable therefore, when the situation arises, it is not regarded as a failure but rather an integral part of the trading system. Our portfolio is evaluated based on the sum of its positions, rather than each transaction. In this manner, success is gauged by growth in portfolio value and the losses become less significant. That is the fundamental reason for entering several positions. It becomes much easier to identify and act on a potentially negative play when it doesn't have a substantial effect on your overall success. The concepts of most exit and adjustment strategies are relatively simple but there is no way to develop a specific guide for proper position management. With stock and option combinations, the key is to evaluate the risk-reward outlook of each possible scenario and construct a position that fits your trading plan and technical outlook for the underlying issue. Remember, success with this strategy lies in one objective; a consistent flow of monthly income with limited portfolio risk. The focus of play selection and management should be to continually generate an acceptable level of option premium while protecting against the potential for downside losses. Positions that become unfavorable due to changes in the fundamental or technical characteristics of the underlying issue must be removed from the portfolio before they can generate significant deficits. Catastrophic failures are not unavoidable but they can be sufficiently managed to reduce the effects of the shortfall. Obviously, each situation will require a different solution but in general, we try to limit individual position losses to 20%. Unfortunately, there are occasions when issues fail without warning, leaving no opportunity for exit or adjustment. Unexpected events simply occur; earnings warnings, shareholder lawsuits, negative news in the industry or sector and changes in public sentiment. All of these activities can affect the success of an individual position but with a diversified portfolio, the long-term effects are minimal. Our approach to "in-the-money" covered calls is designed to lock in profits whenever possible and reduce the inevitable losses to a minimum. A rise in share value is the ultimate goal of stock ownership and with this strategy, a significant short-term move can provide additional opportunities for profit. When the share value rises substantially after the initial position has been established, you have several choices. You can do nothing, get "called-out" and accept the original return that was established when the play was opened. If the option is priced near parity, you can close the play early or, you may also choose to adjust the position to match the new outlook for the underlying issue, "rolling" the call up and forward to a higher strike price. When you roll up (buy-back the current sold call and sell a higher strike call), the profit potential of the position is increased. Unfortunately, the downside break-even point is also increased by the amount of debit required to complete the transaction. That is the main reason most traders transition to a future expiration date; it reduces the debit required for the new position. While it is not our preferred investment approach, there are a number of benefits and advantages to long-term stock ownership. If that is your intention, additional measures are necessary when utilizing "in the money" covered-writes. As expiration nears and the "time value" premium disappears from the written option, you should consider rolling forward to reduce the likelihood of early assignment. The overall profit potential of the position will be increased and the outlook for the stock/option combination can be adjusted, consistent with your forecast for the movement of the underlying issue. With "deep-in-the-money calls," most of the time value premium vanishes long before expiration. However, as long as (time) premium remains in the call option, there is little risk of early assignment. As the option price (bid) falls to parity or a discount, there is a considerable probability of exercise by arbitrageurs; floor traders who do not pay commissions for trading. When this situation occurs, you should endeavor to roll-forward or adjust the position in some manner that prevents a monetary loss through unexpected assignment of the short option. One last opinion, Larry McMillan's book, "Options: As a Strategic Investment," is an excellent resource that completely explains the various aspects of the covered write strategy. It is available in the OIN bookstore Good Luck! Summary of Previous Picks: (May Strikes based on Friday's close) Covered Calls: (Margin would double the listed Monthly Return) Stock Strike Strike Cost Current Profit Monthly Symbol Month Price Basis Price (Loss) Return TIN MAY 50 48.88 54.06 $1.12 7.7% CY MAY 45 42.06 46.25 $2.94 7.1% PLXS MAY 70 68.75 80.50 $1.25 6.1% SEPR MAY 75 70.75 99.75 $4.25 6.1% AMD MAY 60 55.25 83.81 $4.75 5.9% TQNT MAY 80 76.65 83.75 $3.35 5.8% PDLI MAY 85 82.71 132.63 $2.29 5.3% TER MAY 85 81.56 84.75 $3.19 5.2% PLXS MAY 65 62.56 80.50 $2.44 5.2% PVN MAY 85 80.38 89.50 $4.63 4.7% AHP MAY 55 52.75 59.50 $2.25 4.3% BBRC MAY 60 57.56 58.63 $1.07 3.5% INSUA MAY 35 32.19 33.06 $0.87 2.2% NVLS MAY 50 48.06 46.94 -$1.12 0.0% CGNX MAY 55 51.34 49.56 -$1.78 0.0% BRKS MAY 70 66.88 61.50 -$5.38 0.0% NEWP JUN 110 104.44 130.38 $5.56 5.4% NVDA JUN 90 85.50 106.50 $4.50 5.3% RFMD JUN 95 90.50 96.38 $4.50 5.0% Key moment ARBA JUN 55 51.63 53.19 $1.56 2.5% Nearing support IMNX (MAY) - Closed CSCO (MAY) - Closed: Broke 150 dma on Thursday 5/18 Naked Puts: Stock Strike Strike Cost Current Profit Monthly Symbol Month Price Basis Price (Loss) Return PLXS MAY 70 68.50 80.50 $1.50 20.8% TIN MAY 50 48.94 54.06 $1.06 18.4% YHOO MAY 100 98.75 120.31 $1.25 14.1% CIEN MAY 100 99.00 116.50 $1.00 12.6% CY MAY 40 38.56 46.25 $1.44 12.6% SEBL MAY 105 103.88 123.25 $1.13 12.4% BBRC MAY 55 54.06 58.63 $0.94 10.8% PLXS MAY 60 58.75 80.50 $1.25 10.1% NVLS MAY 45 44.06 46.94 $0.94 9.7% TER MAY 75 73.50 84.75 $1.50 9.0% SEPR MAY 65 63.25 99.75 $1.75 8.8% INSUA MAY 30 29.06 33.06 $0.94 8.7% TQNT MAY 70 68.87 83.75 $1.13 7.5% PDLI MAY 70 69.19 132.63 $0.81 6.9% STT MAY 85 84.31 113.13 $0.69 6.0% BRKS MAY 60 58.94 61.50 $1.06 5.9% AHP MAY 50 49.12 59.50 $0.88 5.8% PVN MAY 70 68.75 89.50 $1.25 5.2% CGNX MAY 45 44.25 49.56 $0.75 4.8% ARBA JUN 50 48.00 53.19 $2.00 10.6% NEWP JUN 95 92.00 130.38 $3.00 9.5% NVDA JUN 80 77.87 106.50 $2.13 8.9% RFMD JUN 85 82.94 96.38 $2.06 8.3% SDLI JUN 140 136.75 175.31 $3.25 7.3% YHOO JUN 115 112.75 122.75 $2.25 6.6% AFFX JUN 105 102.94 128.81 $2.06 6.1% Naked Calls: Stock Strike Strike Cost Current Profit Monthly Symbol Month Price Basis Price (Loss) Return PWAV MAY 80 81.46 64.06 $1.46 21.0% Adj for 3-1 split CMTN MAY 115 117.19 76.00 $2.19 12.4% JNPR MAY 260 262.25 163.00 $2.25 10.4% BRCM MAY 220 222.00 139.63 $2.00 10.2% TDS MAY 120 121.13 102.63 $1.13 10.1% ITWO MAY 185 187.25 98.06 $2.25 9.5% CHKP MAY 270 273.25 161.38 $3.25 9.3% AAPL MAY 145 146.56 94.00 $1.56 7.8% AMAT MAY 125 126.13 80.19 $1.13 7.8% NEWP MAY 160 161.25 128.63 $1.25 7.3% JNPR JUN 270 272.13 157.00 $2.13 6.1% ************************Advertisement************************* Tired of waiting on trades to execute? 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