The Option Investor Newsletter Monday 11-27-2000 Copyright 2000, All rights reserved. 1 of 1 Redistribution in any form strictly prohibited. To view this email newsletter in HTML format with embedded charts and graphs, click here: http://www.OptionInvestor.com/htmlemail/112700_1.asp Posted online for subscribers at http://www.OptionInvestor.com ****************************************************************** MARKET WRAP (view in courier font for table alignment) ****************************************************************** 11-27-2000 High Low Volume Advance/Decline DJIA 10546.10 + 75.90 10626.80 10479.30 929 mln 1555/1288 NASDAQ 2880.49 - 23.89 2998.75 2874.71 1.71 bln 1790/2260 S&P 100 714.78 + 3.62 724.84 711.16 totals 3345/3548 S&P 500 1348.97 + 7.20 1362.50 1341.77 48.5%/51.5% RUS 2000 471.70 - 0.17 478.72 471.65 DJ TRANS 2824.76 - 25.13 2852.81 2820.27 VIX 29.02 - 0.56 29.09 27.97 Put/Call Ratio 0.48 ****************************************************************** After A Big Friday, The Markets Are Split Kinda like the Election, right? Not anymore. Bush was certified the winner of Florida's electoral votes last night, but it is not etched in stone just yet. As promised, Gore and Lieberman are contesting the results in three Florida counties by filing legal documents in state court. So the battle continues. Did the markets pay much attention? Not really, the word "valuation" seems to be the driver on the Street. The INDU rallied quite nicely while the NASDAQ shied away from 3000 and sold off. It feels like the Election snafu has been front and center for so long that market watchers have become numb to it. In fact, it seems like a non-event these days. The selling on the NASDAQ after Friday's impressive gains was a product of the technical health of the tech index and valuations. Just as 3000 represented a critical support level, it now represents a critical resistance level which will be formidable. But the NASDAQ only gave up 23.89 points today, hanging onto a large portion of Friday's advance. Not bad. The problem with today's trading was that traders sold into strength once again after this morning's gap up. As a result, on the chart, 3000 represents another failed rally attempt and a lower high in the downtrend. Quite honestly, I do not put much merit in gaps. There is no real volume to support the move besides negligible pre-market activity. Real volume is not buying the index to that level, or selling it down to that level. It is merely a perception of where the market should be valued at the open based on information priced into the futures contracts. NASDAQ futures were up 71 points this morning. S&P futures were up about 13.50. Today's gap up can be attributed to the Florida certification, topped off with the Abbey Factor. CNBC reported before the market open this morning that Abbey Joseph Cohen of Goldman Sachs forecasted a 234 point rally for the S&P 500 year-end. That's a target of 1575, and the S&P 500 closed today at 1349. Essentially, this was a reiteration of her previous predictions last month and her list of tech favorites. It includes CSCO, SUNW, VRTS, GLW, ITWO, EMC, SLR, and DOX. Obviously, when she speaks, the markets get excited. But that was the pre-market, hence, the futures. The gap up brought the market near 3000 where traders took advantage of the artificial strength and sold. It has been the trend that the NASDAQ has been giving us, and another great opportunity to trade it. Put entries abound. Adding to the negative sentiment was selling in the Semiconductor sector. ALTR and XLNX got whacked after Lehman Bros. lowered its earnings projections on them, citing slower demand in November. Both companies manufacture programmable logic device(PDL) chips. Of course, there's always someone on Wall Street that begs to differ. Bear Stearns analyst Charles Boucher, while agreeing that there is a slowdown, doesn't think it is very dramatic, calling the Lehman call "overstated." ALTR lost $3.88 to $27.31, and XLNX closed at $46.50, down $10.31. BRCM felt the selling heat today after Salomon Smith Barney reduced its price target from $300 to $200, citing signs of flattening orders. BRCM lost 16.7%, almost $20 to $97.56. Some positive news for the Semis came from Ashok Kumar of US Bancorp Piper Jaffray on INTC. He sees modest upside to Intel's quarter-to-quarter revenue growth guidance and noted that the stock looks attractive at current valuations. WOW! Someone actually said it! Let's not forget that Ashok is the one who called the Semi slowdown in the summer and was almost chased off Wall Street. Not a bad call in retrospect, huh? Splitting the market was the INDU which managed to muster up a 75 point gain on the day, following through from Friday's move. Investors piled into issues like WMT(+4.13), MMM(+3.44), MRK(+2.19), JNJ(+2.31), HD(+1.25), JPM(+1.94), and AXP(+1.63). That's what I call a well-rounded rally. Retails, Drugs, and Financials all attracted buyers. The holiday shopping season began with a bang on Friday. Drugs stocks held strong as usual, anticipating a Bush victory. And beaten down Financials had buyers step in at what appears to be attractive levels. Put it all together and the INDU looks really good. Friday's gains broke through the most recent downtrend since running into 11000, and today's trading showed some consolidation. Contrary to the NASDAQ, the INDU has been making higher highs and higher lows since bottoming at 9654. It would follow that the retested support at 10369 must hold for the INDU continue rolling higher. 10600 is the next level of resistance in the near term. Then, 11000 must be broken in order to establish a higher high. If this occurs, the INDU will be looking very strong. Market bellwether and INDU component GE didn't add to the index's gains today but they did unveil the much-anticipated successor to CEO Jack Welch. Jeffrey Immelt, the head of GE Medical Systems, will succeed Jack Welch, who retires next year after two decades of leading a pillar of Corporate America. Analysts are pleased and confident with the choice. If GE gets the kick start in its stock price as predicted, the INDU could be off to the races. Watch this bellwether into year-end. Looking ahead, pessimism on tech stocks continues to grow, which may indicate that we are nearing the end. The NASDAQ continues to be oversold. In fact, the NASDAQ generals are holding up relatively well: MSFT, INTC, and SUNW. The INDU is looking good. There is a ton of cash sitting on the sidelines. Money managers must be salivating at some of these current valuations. When the buying begins, it should be explosive. Once the Election results can be put behind us for good, the one catalyst that could set this market free is the Fed. They meet on December 19th and change to a neutral stance could be just what the doctor ordered. Until then, we must trade what the market gives us. Matt Russ Editor ***************** STOP-LOSS UPDATES ***************** NEWP - put play Adjust from $75 down to $71 VRSN - put play Adjust from $103 down to $101 ************ DROPPED PUTS ************ RATL $38.50 +2.88 (+2.88) It appears that the buying that began last Wednesday when the stock dipped below $32 was real. Friday's light volume buying never cleared $36, and we held the play to see if the buying was legitimate. Today's gap up over our stop at $38 should have discouraged any further entries into this put play. The close over our stop, not to mention the newfound buying, has led to dropping RATL. ARTG $39.75 +3.00 (+3.00) We got one good down day on Wednesday with this put play, but ARTG reversed course after bouncing from the $30 level. When we added this play, we put a tight stop of $38 in case ARTG did indeed reverse. The stock gapped up over $38 this morning never trade below it. While ARTG may roll over at its 10-dma at $42, we are dropping the play tonight with a close over our stop. ************** TRADERS CORNER ************** Methodical Account Management II By Austin Passamonte Last week we portrayed examples of managing our trading account by percentage of gains and drawdown versus merely buying options at whim. Let's finish up that thought with some specific rules to this approach. Can you see from last week's examples how managing your trade size to fit profit/loss percentage can make all the difference between good and poor results? Both account sizes were identical and so was trade execution. We managed our risk/reward strictly by percentages and our trading model design favors us over Trader #2's whimsical approach. Trader #2 never bothered to figure this stuff out and blindly bought ten contracts each time because that's what most option traders buy out of habit or false reasoning. One of the main reasons for this being the limit for instant electronic execution of ten-contract "market order" trades. This appears to be an advantage versus filling bigger lots or "buy-limit" orders on the floor. Believe it or not, traders feel that instant execution at prevailing market prices equates to overall profit or loss percentage of their account. I believe this stems from a lack of discussion on this topic. I can't find widespread coverage on different money management approaches in the option world, although it is a common feature in trading commodities. Trader #2 in last week's examples bought too few contracts on the winning plays and too many in the losing plays while disregarding dollar-cost risk/return management. A desire to delve deeper into account management optimization can return big rewards. My trading approach is to target percentages of profit from option trades rather than buy & wait to see where they end up. That approach works during long-term trends without major correction but those days are far behind and likely just as far ahead. Meanwhile, volatile markets with big swings up and down are a trader's euphoria if handled right. Index options work better for this than most equity options do for numerous reasons. I focus on the QQQ, OEX and SPX for 90% of my trades. If I had to pick only one it would be the SPX due to a blend of old and new economy, volatility and liquidity. This is NOT a market for new traders! It takes precise entry, careful stop placement and a good familiarity of its normal behavior for continual trading success. The QQQ (NASDAQ 100 HOLDR) would be my choice for new traders. Premium prices are very low compared to others, volume is high and the bid/ask spread is tight. Heck, these parameters make it a favorite of big players too! All three indexes have good movement more sessions than not. This gives us plenty of chances to play both market sides frequently. Lastly, OEX and SPX options (and all true index options) are taxed on a 60% long-term/40% short-term capital gains basis. This allows you to keep more of your after-tax profits than equity options yield on an equal dollar basis. I try to set up trades on a 2/1 - risk/return ratio. That allows me to reach sell targets only half the time (or slightly less) and still profit over the long term if I manage them well. Whether my stop loss is set at -25% of cost and sell target is +50% or -50%/+100% the end result is still the same. Win half the trades, make big money OVER TIME. The way you manage profit & loss means everything. Let's explore a generic example to explain: We have an account balance of $100,000 and are willing to risk 5% of that to loss. We buy twenty options on the ABC underlying instrument for $10 each and set stops at $2.5 each. Our sell target if $15 for each. This trade fits our risk/reward parameters. We win that trade as option prices reach our sell target and close at $15 each. $100,000 balance (Trade #1) 20,000 option cost - 5,000 risked on stop-loss + 10,000 trade profit (+5 x 20 contracts hit sell target) $110,000 new balance We take the exact same setup once more with similar results: $110,000 balance (Trade #2) 20,000 option cost - 5,000 risked on stop-loss + 10,000 trade profit (+5 x 20 contracts hit sell target) $120,000 new balance We take the exact same setup once again and lose: $120,000 balance (Trade #3) 20,000 option cost - 5,000 risked on stop-loss - 5,000 trade loss (-2.5 x 20 contracts stopped out) $115,000 new balance We take the exact same setup once again and lose: $115,000 balance (Trade #4) 20,000 option cost - 5,000 risked on stop-loss - 5,000 trade loss (-2.5 x 20 contracts stopped out) $110,000 new balance In this simple equation we show how cutting losses at 25% while taking profits at 50% of contract cost builds methodical gains in a trading model that wins/loses a 1/1 ratio or thereabouts. The only difference we make when option prices change is to adjust how many we buy in order to fit the $5,000 loss/$10,000 win basis. Of course we actually risk a bit less than 5% total after each win and a bit more than 5% after some drawdowns. That's why we strive to keep our excess capital in reserve to pad losses and continue maintaining our business model. We must always adjust our option purchases by specific dollar amounts and let the option's current price dictate how many we buy in order to make this work. An easy way to internalize this is not to think about how many option contracts you want. Think about how much of your capital you are willing to risk versus what you expect in return. Then choose your trade vehicle and how many from contracts from there. The trade vehicle happens to be options on the market of your choice. The amount you buy rests solely on how much money you allot to work with. How many you allot to work with rests solely on how many contracts your risk balance allows you to afford! As long as you trade the number of contracts your maximum loss amount can handle dictated by the stop-loss order, you'll make more money than you lose with the following in mind: Your system should avoid long strings of losing trades. It should have strings of wins and losses mixed among average results. Five or six wins or losses in a row can happen to most any system from the natural law of probability. That should be the exception instead of norm when it comes to losses. The system must have a higher average percentage of gain to loss. This makes sense, but most traders think you have to win most trades in order to profit. While that is certainly desired, too many times new traders will take strings of small winners and get wiped out by one or two big losses. By the same token you can win only 40% of the time is winning trades are much bigger than losing trades in dollar percentage. If more than half of trades win this is great and adds to overall success. Utilizing moving stops also reduces the number and/or size of overall losses as well. If you carefully manage advanced stop strategies to lock in unrealized gains it will prevent small temporary wins from becoming significant loss. Any plays that fail to reach maximum profit targets will offset maximum loss trades to lower the overall losing trade percent average. A dramatic gap-move against you can cause greater loss than the 5% range of your stop protection. This is why we must maintain a separate account balance for high-risk methods versus other less volatile option investment strategies. If we use 20% of our total high-risk balance on option purchases, much or most of this is vulnerable to actual loss, especially with equity options. I'm willing to risk 20% of my total high-risk account balance on index option purchases because large gap moves are the exception. I would likely think twice about that trading equity options as we've recently seen what can happen to MSFT, INTC and a host of other "blue chip" stalwarts. Can you see how designing your account management approach to fit the win/loss ratio and average percent of wins to loss heightens the odds of probability in your favor? This is by far the most critical part of successful trading, as demonstrated by the scenario of us versus Trader #2 in the exact same situations. We profited, he lost and the only difference was proper account management. Think it's easy? I'm here to tell you it's not. We must ALWAYS honor our stops even when we know for sure "the market will come back to us" if we just pull them this one time. One time leads to many and the markets will cunningly wait for our biggest play to be left unguarded before racing right through us never to look back. Trust me on that one! This is how we manage an account based on profit/loss percentage as our trading models are designed. Simply buying a static number of contracts won't work; you will more likely lose money than profit with that approach. Next week will complete this exploration as we compare several management scenarios with the same account balance and trades. I bet we'll all be surprised at the results one can achieve over time just by tweaking what we risk and settle for as returns! Contact Support ********************* PLAY OF THE DAY - PUT ********************* VRSN - VeriSign, Inc. $87.19 -6.06 (-6.06 this week) VeriSign is the leading provider of Internet trust services and digital certificate solutions needed by Web sites, enterprises and individuals in order to conduct secure electronic commerce and communications over IP networks. VRSN has used its secure online infrastructure to issue over 100,000 of its Website digital certificates and over 3.5 million of its digital certificates for individuals. The company also offers the VeriSign Onsite service, which allows an organization to leverage the company's trusted service infrastructure to develop and deploy customized digital certificate services for use by an organization's employees, customers and business partners. Most Recent Write-Up The bears had a field day with VRSN last week as the NASDAQ dropped to post 3 new consecutive 52-week lows. With bearish comments hitting the Internet sector in the form of earnings concerns leveled at YHOO and EBAY, selling volume in the Internet security stock increased, dropping our play to $78.31 on Wednesday, another lower low in the 8-week downtrend. The severity of the selloff this past week steepened the descending trendline, and even Friday's relief rally couldn't put much of a dent in the stock's losses. After gapping above $90 at the open on Friday, VRSN ran out of momentum before reaching $95, despite the fact that the NASDAQ continued to move up into the early close. This looks like a classic sucker's rally, and barring a continuation of the NASDAQ recovery on Monday, VRSN should head lower again as the bears reassert their control. Above current levels, VRSN has resistance between $100-102, so we moved our stop down to $103 to insure that we keep the lion's share of our profits. Nothing has really changed, with election and economic concerns sure to add further downside pressure in the week ahead. Use any failed rally as an opportunity to initiate new positions with a better entry point. Target shoot to your level of risk tolerance as the stock rolls over and heads back towards the lows seen last week. More conservative players will want to stand on the sidelines until the bears can poke a hole in Friday's weak intraday support at $90 before adding new positions. Once the selling begins in earnest again, VRSN should have little trouble challenging its lows from last Wednesday. Comments VRSN opened today near $100 and simply cratered. What an entry! The selling momentum is there and VRSN could very well go back for a retest of the $78 level. To play this put, look for failed rallies near resistance at $95 or $92. A challenge of these levels along with a rollover would provide entry. Further breaking down below $85 would warrant entry as well. Watch for the direction of the NASDAQ and the sector when placing a trade. Also note that we have lowered the stop to $101, today's high. BUY PUT DEC-95 XVR-XS OI=239 at $15.63 SL=12.25 BUY PUT DEC-90*XVR-XR OI=493 at $12.75 SL=10.50 BUY PUT DEC-85 XVR-XQ OI=499 at $10.13 SL= 7.50 http://www.premierinvestor.com/oi/profile.asp?ticker=VRSN ******************* FREE TRIAL READERS ******************* If you like the results you have been receiving we would welcome you as a permanent subscriber. The monthly subscription price is 39.95. The quarterly price is 99.95 which is $20 off the monthly rate. We would like to have you as a subscriber. You may subscribe at any time but your subscription will not start until your free trial is over. 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