Option Investor
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Daily Newsletter, Wednesday, 05/29/2002

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The Option Investor Newsletter                Wednesday 05-29-2002
Copyright 2001, All rights reserved.                        1 of 2
Redistribution in any form strictly prohibited.

Posted online for subscribers at http://www.OptionInvestor.com
*******************************************************************
MARKET WRAP  (view in courier font for table alignment)
*******************************************************************
        05-29-2002        High      Low     Volume Advance/Decline
DJIA    9923.00  - 58.60  9988.50  9923.00 1070 mln   1397/1770
NASDAQ   1624.39 – 27.78  1644.29  1624.31 1224 mln   1311/2160
S&P 100   530.04 –  4.28   534.38   529.96   totals   2708/3930
S&P 500  1067.66 -  6.89  1074.83  1067.66
RUS 2000  487.60 -  4.81   492.05   485.74
DJ TRANS 2724.92 -  3.21  2731.40  2718.70
VIX        23.10 -  0.04    23.47    22.49
VIXN       45.70 -  0.25    46.77    45.54
Put/Call Ratio      0.89
*******************************************************************

Manhole Covers Outperform Markets

It seems like the only things going up in New York City today 
were manhole covers.  A jittery market responded negatively to an 
accidental underground explosion near the Empire State Building 
that caused several manhole covers to jump into the air.  After 
last week's stream of terrorist warnings one might have thought 
that an eventful Memorial Day weekend would have brought some 
relief to the markets.  Not so.  The crowd of investors who 
pundits had suspected was waiting until after the holiday before 
relocating their money into the stock market must still be on 
vacation.  Volume today was better than Tuesday's but not by 
much.

Wednesday's session marked the third drop in a row for the 
markets and unfortunately the markets appear ready to stretch 
this string to four.  Leading the indices lower were the tech 
stocks again.  Chip bulls were hoping that there might have been 
a positive reaction to the Novellus call last night but failure 
to comment on the third quarter merely handed bears a hammer they 
were more than willing to use.  Shares of NVLS lost 7 percent by 
the end of the day closing at $43.40.  While NVLS might have 
support at its 200-dma near $42.50, the SOX (currently 480.10), 
which has been in a constant slide since mid-May, lost another 
3.3% and may not have support until the 450 area.  The chip 
sector selling hit Dow component Intel and shares slipped 3.8%.  
Truly optimistic bulls might hope for some support on the SOX 
near 475, if a bounce did occur I suspect we'd be witnessing an 
oversold relief rally as shorts did some covering and waited for 
their next entry point.

Another stock weighing heavily on the Dow Jones index is AT&T 
(T).  The stock was already in a bearish pattern of lower highs 
and the stock had fallen through support at the $12.65 level 
yesterday.  To make matters worse, Moody's downgraded T's credit 
rating to two levels above junk status.  Moody's claimed that the 
long-distance giant would have trouble raising revenues in an 
increasingly competitive industry.  Shares of T slipped 3.2% to 
$12.01.

Disaster Du Jour

Of course what is a day in the markets without our daily stock 
horror story.  The runner up for this honorary award was oil 
company Halliburton (NYSE:HAL).  HAL announced late Tuesday that 
they had received notice from the Securities and Exchange 
Commission (SEC) of a preliminary investigation of their 
accounting practices.  News like this can normally run havoc with 
a stock's price but amazingly, shares of HAL rebounded throughout 
the session from the early morning selling.  The stock closed at 
$18.72, down 3.25%.  The lows of the day effectively closed the 
gap from May 23rd when shares jumped higher after a positive 
analyst meeting that left many feeling the company had taken 
appropriate actions to protect themselves from asbestos 
liabilities.  Don't mistake this comment as a bullish 
recommendation on the stock but merely an observation. The 
company did say they would cooperate with the SEC but felt their 
accounting procedures were in full compliance with GAAP rules.

The real disaster du jour is energy-trading firm El Paso Corp. 
(NYSE:EP).  It could have been an attempt to flush its system of 
any Enronitis but the company announced it would slash its 
trading staff in half and increase its investment in its core 
natural gas business.  As a result of these changes the company 
lowered its full 2002 estimates for the second time this year.  
There was no surprise that traders reacted negatively.  Shares 
gapped down $7.52 to open at $27.75.  By the end of the day EP 
closed at $27.01, down 23.4%.  

Some disaster stories sound more like the X-files.  They never 
fully close and a few are harder to believe than others.  Today's 
urban legend was offered by Nortel Networks (NYSE:NT).  The stock 
had a very brief morning rally after the fiber-optic & 
communications company affirmed their Q2 outlook for quarter over 
quarter improvement.  Really?  An improvement in a telecom 
related industry?  I don't believe it.  Basically, NT is telling 
us they'll post a smaller net loss but management also said Q2 
revenues would likely be flat to down five percent.  What really 
got traders' attention and left the stock down 6.75% by the close 
was their next statement.  NT forecasted that the fiber optic 
market would not recover until late 2003 or even early 2004.  Oh, 
and lest we forget, they also cut another 3500 jobs.

Reaction to the news in shares of JDSU was a 5.5% loss.  Yet what 
I find humorous was CS First Boston's downgrade of JDSU from a 
"strong buy" to a "buy".  If no improvement in the sector for the 
next 12 to 18 months earns a "buy" recommendation, what gets a 
"hold" or a "sell"?  The broker also lowered their price target 
from $10 to $7.00.  JDSU closed at $3.77.  

CSCO Gets Cut To Sell

It's not everyday that an analyst slaps a sell rating on Cisco 
Systems (NASDAQ:CSCO), the giant in the networking and Internet 
routing industries.  Over two dozen analysts have a "strong buy" 
or a "buy" rating on CSCO and eight have a "hold" rating.  Only 
one analyst, a Ariane Mahler at Dresdner Kleinwort Wasserstein (I 
know, I know, you're saying "who"), has come out with a "sell" 
rating on the company.  There have been a number of cautious 
comments from the brokerage group on CSCO after the company 
released their 10-K late Tuesday but most are merely voicing 
concerns.  Mahler is telling her clients to sell claiming 
accounting concerns, disclosure issues and the stock's valuation.  
Merrill Lynch did not see any big alarms over CSCO's accounting 
practices but was concerned over the company's allowance for 
doubtful accounts, which had risen to its highest levels ever.  
Solomon Smith Barney also raised flags over details in CSCO's 10-
K.  Jeff Bailey made a note in the Market Monitor today about 
Applied Micro Circuits (AMCC).  Jeff noted that Needham cut AMCC 
from a "hold" to a "sell" and shares closed down 4.28% today.  
How does this relate to CSCO?  AMCC is an OEM for CSCO and Jeff 
offered the theory that if Needham believes business is slow for 
AMCC then it's probably not very strong at CSCO either.

Hello, Did Someone Say Jewelry?

I would be negligent in covering the markets if we didn't touch 
on gold.  While fans of the precious metal are going giddy from 
the huge rise I don't think it will last (at least short-term) 
and Goldman Sachs agrees with me but I but I think their 
reasoning is flawed.  If you have been following the rise of gold 
recently then you may have heard some of the gold bug propaganda 
for a new bull market in gold.  They will be quick to point to 
happier times (if you're bullish on gold) like the 1985 to 1987 
rise in the precious metal.  During that period, a 40 percent 
drop in the dollar had gold run up from $284 to $500 an ounce.  
More fanatical still, some proponents will forecast a return to 
the heyday of gold when it hit $850 an ounce back in 1980.

Dissenters of the gold-inspired fanfare claim that the 
hyperinflation of the 70s doesn't stand a chance of appearing 
anytime soon.  Thus, another long-term bubble in gold is not 
likely to appear.  The XAU.X did pull back today and I would 
credit Goldman's downgrade of AngloGold (AU) and Barrick Gold 
(ABX) on valuation concerns and belief that the rally was near 
its end.  What irks me is Goldman Sachs' reason for calling a top 
in gold.  The Goldman analyst claimed that weakness in physical 
jewelry demand would not sustain the rally.  Hello, did he just 
say jewelry?  People aren't buying gold for a run on jewelry 
stores.  Investors are buying gold as a hedge against the U.S. 
markets, as a hedge against the falling dollar, and as a hedge 
against a land war in Asia (thank you, Vizzini), not to mention 
just plain old momentum buying.

Nothing goes up in a straight line but gold futures have tried to 
do just that.  A chart of the gc02m shows an almost constant 
rally of higher highs from mid-May.  I would not be surprised to 
see a pull back to the $320 to $315; of course I was looking for 
a pull back last week too.  The challenge here is the weakening 
dollar and the new build up of forces on the India-Pakistan 
border.

Chart of Gold Futures (gc02m)


 


Thursday and Friday

My concerns with the broader markets are that now we are under 
recent support levels the major indices will be pulled to the 
early May lows.  Pulled may be too strong a word.  With the 
anemic volume we have been seeing the better word might be drift 
to the May lows.

The Dow Jones is quickly approaching its 200-dma and while this 
might offer support I wouldn't be placing any bullish bets on it.  
The index is down three days in a row and we could get a bounce 
just because we're due for one.

Chart of the Dow Jones


 


The S&P 500 does not look much different.  The break under recent 
support and the imminent bearish crossover in the MACD sound like 
a recipe for a retest of the 1050 level.  Yet again, I wouldn't 
be surprised to see a one or two-day bounce.

Chart of the SPX


 

It was very disappointing to see the Nasdaq break under the 1650 
level but with the SOX.X, the GSO.X, telecom and Internet stocks 
all giving up ground we shouldn't be surprised.  Currently, the 
Nasdaq is down 6.7% from the mid-May closing high but if you look 
at the chart you might see an interesting observation.  It was 
only a few sessions ago that the index had dropped a quick 4%.  
Shorts covered and we got a two-day bounce.  The last three 
sessions have produced a similar decline.  If you were a true 
optimist you could look for another bounce soon but I wouldn't 
put my money on it.  At least not until we retest the 1600 mark.
Something you'll see in the charts of the three major indices is 
the MACD, which has produced a bearish crossover (in the Dow) or 
is about to (in the SPX and Nasdaq).  This is not a good sign but 
that doesn't mean it can't be reversed.

Chart of the Nasdaq


 


Market watchers will also find similar patterns in the Wilshire 
5000 index (TMW.X) and the Russell 2000 (RUT.X).  What is likely 
to concern traders is that the strength in the small caps has 
evaporated and the RUT is hitting new relative lows.  The next 
stop for the Russell could be 480 and then a probable test of the 
200-dma.

If you haven't switched to a defensive posture again I would 
consider it.  The market is already doing so.  Moving to gold is 
the classic defensive posture but the rally there has been 
boosted by the falling dollar and the appearance that a war 
between India and Pakistan is all but imminent.  You should also 
notice that the markets are moving into traditional defensive 
sectors like tobacco (Merrill upgraded the group today) and 
healthcare stocks.  Take a look at the HMO.X.  Go on, do it.  A 
little homework didn't hurt anybody.

James


********************
INDEX TRADER SUMMARY
********************

Leigh Stevens will be back in the office on Thursday, May 30th, 2002.


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***********
OPTIONS 101
***********

Which Option Should I Buy?
By Mark Phillips
mphillips@OptionInvestor.com

As option traders, we know that the path to success involves more
than just picking a bullish stock and buying calls or buying puts
on a weak one.  Technical Analysis, with a dash of fundamentals
and sector analysis thrown in for good measure, do a great job
of helping us to pick the right direction on a stock, but if we
purchase the wrong option, it can turn a potentially winning play
into a loser.  Proper option selection can not only keep our
equity curve on the rise, but it can help us to milk more profit
out of each of our trades.

In my Trader's Corner articles over the past several months, we
have talked about numerous Technical Analysis tools that can be
used to pinpoint strong trade candidates, and those bits of prose
are archived on the site for any and all to peruse at their
convenience.  But that isn't our objective here today.  We want
to talk about how best to utilize the leverage offered by options
to maximize our trading results.

We have talked about various aspects of option selection,
approached from the perspective of analyzing option pricing (and
potential changes to those prices) utilizing the Greeks.  From
Delta and Gamma to Vega and Theta, we pretty much covered all the
fine points from a theoretical standpoint.  For those of you that
may have missed the discussion, you can head on over to the
Options 101 archives and get caught up.   The first article in
the series was Paying Attention to Option Pricing on January 16th.

Based on some of the recent emails I have received, I thought it
would be beneficial to revisit the topic this afternoon, with an
eye towards the real world, rather than theory.  But first, let's
recap what we know intuitively to be true.  Buying options gives
us greater leverage than buying stocks, and if we are correct in
the trade, our percentage returns will be substantially higher.
But not only do we need to be correct about the direction of the
trade, we also have to be correct on the timing of the movement
of the underlying stock.  And depending on what strike we select
(ITM, ATM or OTM), we also need to be correct on estimating the
magnitude of the move.

In simple terms, buying an option nearer to the money will have
the option moving faster with respect to a given move in the
underlying stock than an option that is further out of the money,
due to the effects of Delta and Gamma.  The price we pay for this
outperformance is that the initial cost of the option is higher,
so percentage returns will be lower.  But that may be just what
we need if we aren't sure how far the stock might move in our
favor.  Let's look at some examples of real option trading to
better illustrate the point.

Let's assume that I have a penchant for trading IBM due to
familiarity with the way the stock trades and I've been leaning
to the short side since the big breakdown in early April.  By my
estimation, there have been two high-odds put entries since that
time, each time the stock failed at resistance and rolled over
in conjunction with daily Stochastics dropping back from
overbought territory.  Let's take a look.



 

Ok, so now that we have identified the entry points, let's see
which option we would have tracked.  First, let's look at the
entry signal generated in late April.  Aggressive traders could
have entered the play on the failure at $90 resistance on April
19th, but waiting for the Stochastics to roll over would have
had us entering the play on April 23rd.  With the stock nominally
trading at $87 when that more conservative entry point presented
itself, let's call the $90 Put ITM, the $85 Put ATM and the $80
Put OTM.  At the time, I would have used May strikes, but given
the fact that May expiration has already occurred, let's do our
examples with June contracts, since the data is more accessible.

Taking the high sale of the day for each of the respective
contracts gives us entry prices as follows:

June $90 Put (IBM-RR) - $4.90
June $85 Put (IBM-RQ) - $2.90
June $80 Put (IBM-RP) - $1.50

Let's look at some historical charts of those three option symbols
over the next 2 weeks and see how they would have treated us.  And
let's be really generous and say that our technical analysis
prowess would have enabled us to ride the stock all the way down
to the bottom on May 6th.  We'll assume that our exit for each
option contract was taken based on the closing price on that day.



 

Starting with the ITM option, we can see that our chosen contract
(IBM-RR) would have gone from $4.90 to $13.20 in 2 short weeks,
for a nice little profit of $8.30 or 169%.  That's nothing to
sneeze at, but the results get even better for the ATM Put
(IBM-RQ).



 

Initiating the trade at $2.90 and closing for $8.70 gives us a
profit from the trade of $5.80 or 200%.  That gives our account
a nice little boost over the profit of the ITM contract for a
trade that covers the same move in the same stock.  So let's
carry it to the next level, using our OTM Put (IBM-RP).



 

Well now, would you look at that!  Costing a mere $1.50 at
inception, the trade using the OTM Put could be closed out on
May 6th for $4.30.  The profit in dollars is only $2.80, but
we're going for that high percentage return, right?  Gotcha!
The percentage return on the OTM put is "only" 187%.  That's
right, we've reached the point of diminishing returns, at least
for the magnitude move that IBM offered us in late April and
early May.  Not only does the ATM contract deliver greater
return in terms of dollars, but in terms of percentage on
initial capital invested, when compared to the OTM option.

If IBM had fallen all the way to the $60 level, then there is no
doubt that the OTM option would have provided the highest
percentage returns.  But that isn't the sort of move that we
should become accustomed to, especially in a rangebound market.
Let's take a brief look at the second entry signal that IBM
provided, this time around May 20th.

Using the same contracts, a quick visual scan of the charts above
will show you the trap of using the OTM option.  IBM hasn't
fallen nearly as far (or as fast) this time around and the OTM
option is trading near $1.70 vs. an optimistic entry of $1.20.
That makes the percentage return on the latest move about 42%.
While the percentage move on the ATM contract is only about 40%
(entry at $3.00 and current price of $4.20), you'll find that
with such a small move in the price of the OTM contract, getting
out of the trade with that 40% profit is much trickier.  Should
we have to give up $0.20 to the market maker on each of the 
options, the profit on the OTM contract would fall to 25%, while
the ATM contract return would only fall to 33%.  And if we had to
give up that $0.20 on each end of the trade (both at entry and
exit), we would find our total profit cut to only $0.10 on the
OTM put, which makes the trade hardly worth doing at all.  Lop
the $0.20 off of each end of the trade with the ATM contract, and
we still have a profit of $0.80.  It isn't stellar, but it still
represents a profit of more than 25%.  The OTM contract is far
more sensitive to minute changes in the price, due to the low
cost of entry.

So let's boil it all down to some useful knowledge that we can
all use.  Using OTM contracts is great when you want maximum bang
for the buck, but this strategy only works consistently when we
are rewarded with a large move in the underlying security.
Here's how I gauge which option to buy when I am contemplating a
new trade.  After doing all of my technical analysis on the stock,
I should have a target price for the stock in mind.  If I'm
trading puts, I may find stock XYZ that I reasonably expect will
drop from $47 to $38 over the course of the next 2-3 weeks.  If
my expectations are met, then the best option to trade would
likely be the $40 strike.  The initial cost to enter the trade
will be rather low, but I need the stock to stage that big move.

A far more prudent approach would be to utilize the $45 strike.
Initial cost of entry will be higher, but it will be easier to
harvest my gains when they have accrued, due to the fact that the
option will be deep in the money if my price target is met.  The
real payoff though, is if the stock only drops to $43 before
beginning to recover.  The aggressive $40 option would not yet
have really begun to appreciate, whereas the $45 strike will
already have moved to in the money status.

And we haven't even talked about the possibility of the trade
going against us.  In the event that a trade goes sour, I have
always found it easier to manage my risk in options that are ATM
or even ITM.  The options are more expensive, but they also happen
to also have higher open interest and volume.  Those two qualities
normally translate into tighter bid/ask spreads and that means
that we don't get chewed up giving back a fat spread on an
illiquid option when the trade fails to perform as expected.

There are numerous methods that can be used for estimating price
targets on prospective plays, but in a market that continues to
bounce around in range-bound fashion, I prefer to err on the side
of caution.  While there will certainly be home runs in the weeks
and months ahead, where individual stocks surge or collapse by 20%
or more, the prudent approach is to hit singles and doubles until
strongly trending markets return.  How do we hit singles and
doubles consistently?  First off we have to pick the right
direction on the right stock.  But hopefully I've shown you that
using ATM (or near-the-money) options can help you capture the
lion's share of the profits available from more speculative OTM
options on the large moves, while allowing us to harvest small
gains from the smaller stock moves that seem to be becoming more
common.

I hope this has been helpful!

Mark


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***********************
INDEX TRADER GAME PLANS
***********************

Leigh Stevens will be back in the office on Thursday, May 30th, 2002.


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The Option Investor Newsletter                Wednesday 05-29-2002
Copyright 2001, All rights reserved.                        2 of 2
Redistribution in any form strictly prohibited.


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Anything else is too slow!

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**************************************************************


*****************
STOP-LOSS UPDATES
*****************

CI   - call
Adjust from $101.00 up to $102.00

NOVN - call
Adjust from $20.75 up to $23

TEVA - call
Adjust from $62.50 up to $63.50

THC  - call
Adjust from $69.50 up to $70

COHU - put
Adjust from $26.25 down to $26

PLAB - put
Adjust from $27.50 down to $25

WHR  - put
Adjust from $76 down to $74


*************
DROPPED CALLS
*************

MMM $125.00 –1.78 (-2.95) The continued weakness in the Dow
pressured MMM lower for the third consecutive session today.
The stock closed below our coverage stop by $1, which is
reason enough to cut losses and look elsewhere for favorable
bullish positions.  Look to exit plays if the stop didn’t get
you out today on any relief bounce early tomorrow.


************
DROPPED PUTS
************

None


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guide book:  

“7 Steps to Success – Trading Options Online”.  

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and clicking on the link to the book on its home page.

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**************************************************************


**********************
PLAY OF THE DAY - CALL
**********************

CI - CIGNA Corp. $105.05 +0.05 (+0.24 this week)

CIGNA Corporation and its subsidiaries are an investor-owned
employee benefits organizations in the United States. Its
subsidiaries are major providers of employee benefits offered
through the workplace, including health care products and
services, group life, accident and disability insurance,
retirement products and services and investment management.
CIGNA's operating divisions include Employee Health Care, Life
and Disability Benefits, CIGNA Group Insurance, Employee
Retirement Benefits and Investment Services, and International
Life, Health and Employee Benefits. 

Most Recent Update

CI flirted with a breakout above its short term consolidation
today, but not before pulling back in the early going. The stock
traded down to the $103.52 level in the early part of the
session, just below its 10-dma. From there, it spent the middle
part of the day trading sideways while building an intraday base
from which it rallied into the close of trading. The stock
reached as high as the $105 level near the close of trading,
which could have the bulls on alert for a breakout early
tomorrow. What we're looking for is a rally past the $106 level
on heavy intraday volume, which can be used as a breakout entry
point into new positions. From the $106 level, we will target
the relative highs up around the $110 level for upside
potential. If the stock continues to stall at the $105 level
while tracing relatively higher intraday lows, then look for
entries near support on that weakness. Look for a rebound from
the 10-dma in tomorrow's session on weakness if it comes.

Comments

CI came within 0.02 of breaking out above $106 today.  The
stock and its sector were one of the few bright spots in the
market today.  Look for that breakout early tomorrow and
confirm direction in the sector.  Watch for volume to
increase during intraday action on the way up past the $106
resistance area.

BUY CALL JUN-100 CI-FT OI= 41 at $6.40 SL=4.00
BUY CALL JUN-105*CI-FA OI=156 at $3.00 SL=1.75
BUY CALL JUN-110 CI-FB OI=398 at $1.05 SL=0.75
BUY CALL JUL-105 CI-GA OI=404 at $4.30 SL=2.25

Average Daily Volume = 834 K



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************************************************
BIG-CAP COVERED CALLS, NAKED PUTS & COMBINATIONS
************************************************

The Sell-Off Continues!
By Ray Cummins

Stocks retreated further today with technology issues leading the
slide after a disappointing mid-quarter update from chip-equipment
maker Novellus Systems (NASDAQ:NVLS).

The NASDAQ Composite index lost 27 points to 1,624 amid weakness
in almost every hi-tech sector, however semiconductor, wireless
telecom, and networking issues were among the worst performers.
The Dow Jones Industrial Average dropped 58 points to 9,923 on
selling pressure in Intel (NASDAQ:INTC), Honeywell (NYSE:HON),
Caterpillar (NYSE:CAT) and Eastman Kodak (NYSE:EK).  A downgrade
of AT&T's (NYSE:T) bond rating by Moody's Investors Service also
had a negative impact on the blue-chip segment.  In the broader
market, natural gas and utility issues followed oil stocks lower
while airline, drug and paper shares saw limited buying pressure.
Trading volume came in at 1.07 billion shares on the NYSE and at
1.37 billion shares on the NASDAQ.  Market breadth was poor, with
decliners outpacing advancers 5 to 4 on the Big Board and 2 to 1
on the technology exchange.  Bonds enjoyed limited upside during
today's $27 billion 2-year note auction.  The 10-year note added
15/32 to yield 5.06% while the 30-year long bond gained 17/32 to
yield 5.62%.


***************

MAILBAG - Reader's Comments & Questions

***************

To:	Contact Support
Subject: Credit Spreads Reply


Dear Ray,

    I first wanted to thank you for your time in responding to my
questions concerning credit spreads. If I could, I just wanted to
ask for more information concerning a few items you mentioned in
your response. You stated that successful credit-spread traders
learn to identify periods of extreme volatility.  How exactly is
this accomplished?  Is this something that occurs at certain times
of the month or year, or just when certain volatility levels are
exceeded as compared to historical or current levels?  Also, you
mentioned that the market trades inside the 2nd standard deviation
of a normal distribution.  What exactly does this mean, and how
should I use such information in my trading?

Again, thank you for your assistance in this matter.

KT



Hello KT,

I'm glad to see you have decided to become educated about two of
the most important concepts an option trader must understand to be
successful in the long run: volatility and probability.  Traders
without basic knowledge of the way these mathematical components
affect option pricing have little chance of achieving consistent 
profits in the derivatives market.

Your first question; regarding how to identify periods of extreme
volatility, is relatively simply to answer and the market has
recently given us some great examples of why this idea is so
important.

Corporate earnings announcements, new drug approvals, merger or
takeover speculation, and annual board meetings (splits/spin-offs)
are just a few common examples of situations in which uncertain
information will be released on or near a specific date, thus
creating excess volatility.  Option trading is often very active
in these cases as participants expect the underlying issues to
move significantly after the announcement.  Volatility is also
measured on a larger scale by various technical indicators and
sentiment gauges such as the CBOE's Volatility Index, or VIX.
The VIX is a measure of the level of Implied Volatility and was
developed by the CBOE in 1993.  VIX measures the volatility of
the U.S. stock market, based on S&P 100 Index, and it is updated
throughout the day by the CBOE in real-time using OEX quote data.
The VIX is calculated by taking the weighted average of the Ivs
of eight OEX calls and puts with an average time to maturity of
30 days.  VIX is therefore a measurement of 30-day index options.
It is not a measure of the volatility of one individual stock or
option and it does not measure the Implied Volatility of other
indices.  However, many traders use it as a general indication
of Implied Volatility in equity options.

Using the traditional analysis, there is an inverse relationship
between the price of the S&P 100 Index and the VIX (and between
the VXN and the NASDAQ 100).  When the VIX reaches extremely low
levels, as in the recent past, it means traders are complacent.
Option buyers are timid while sellers are aggressive, and both
for similar reasons -- nobody is anticipating much movement in
the market.  Of course, when the majority of people agree on a
particular outlook, the opposite generally happens and in this
instance, upside surprises are a rare occurrence.  Over the past
few months there have been a number of extremely large swings in
the prices of stocks quoted on the major exchanges and while it's
important to be conscious of the reasons behind this volatility,
most people would do better to simply understand the historical
relationships between proven technical indicators and the market
activity, and use this knowledge to improve their trading skills.
One way that objective can be accomplished is to avoid selling
premium when the underlying issue (or market) has a higher than
normal potential for volatility.


The statement I made about probability; the market trades inside
the 2nd standard deviation of a normal distribution, is slightly
more difficult to understand and will require further study on
your part as I can not explain the fundamentals of statistical
analysis in an E-mail.  Suffice it to say that if you want to
achieve a very high rate of success in your trading (with the
corresponding low return), you should construct positions that
achieve profitability when the underlying issue remains within
the 2nd standard deviation of a normal distribution.

In simple terms, the standard deviation is basically the "mean
of the mean," and it can often help you find the story behind
the data.  To understand this concept, you must learn about what
statisticians call normal distribution.  A normal distribution
of data means that most of the examples in a set of data are
close to the "average," while relatively few examples tend to
one extreme or the other.  If you depict normally distributed
data on a graph, it will look something like this:




 


The x-axis (the horizontal one) is the value in question, and the
the y-axis (the vertical one) is the number of data-points for
each value on the x-axis.  Not all sets of data will have graphs
that look this perfect.  Some will have relatively flat curves,
while others will be steeper.  Sometimes the mean will lean a
bit to one side or the other.  However, all normally distributed
data will have something like this same bell-curve shape.  The
standard deviation is a statistic that tells you how tightly all
the various examples are clustered around the mean in a set of
data.  When the examples are fairly tightly bunched together and
the bell-shaped curve is steep, the standard deviation is small.
When the examples are spread apart and the curve is relatively
flat, that suggests a relatively large standard deviation in the
data.  Computing the value of a standard deviation is complicated
but here what a standard deviation represents graphically:





 


One standard deviation away from the mean in either direction on
the horizontal axis (the red area on the above graph) accounts for
somewhere around 68% of the possible outcomes in this group.  Two
standard deviations away from the mean (the red and green areas)
account for roughly 95% of the outcomes.  Three standard deviations
(the red, green and blue areas) account for about 99% of all the
possible outcomes.  If this curve were flatter and more spread out,
the standard deviation would have to be larger in order to account
for the number of possible outcomes.  That is why the standard
deviation can tell you how spread out the results in a set are
from the mean.

Without going into a complex study of probability analysis, you can
use a simple probability calculator (or preferably, a "Monte-Carlo"
style calculator) to determine when there is a greater than 95%
chance of the issue trading inside the profit range.  Of course,
the fact that it "should" remain in a particular range doesn't mean
it will and that's the reason traders have to learn to manage losing
plays effectively -- so they don't create catastrophic draw-downs
on one's portfolio.

To learn more about this subject, read the bibles of option trading
professionals: Options Volatility and Pricing Strategies, by Sheldon
Natenburg, and Options as a Strategic Investment, by Larry McMillan.
Both books are available in your local library.

Hope That Helps!

Ray



To:	Contact Support
Subject: Spreads on indexes

Ray,
 
After riding the moves of individual stocks with credit spreads,
I see the benefit to initiating credit spreads with broader
holdings instead, like the SMH, XAU, OEX and others. What type of
criteria do you use to screen plays like these?  I'm interested in
doing more spreads of that nature but do not want to blindly rush
in to a bad play just because it's a tracking stock vs. individual
issue.

Thanks for your insight.

ER


Hello ER,

Glad to hear you are refining your skills prior to committing
hard-earned capital to this vicious game we play!

Indeed, you are correct in that it is very favorable to sell
premium in broad-based instruments such as the SMH, XAU, OEX
because they are less prone to large, unexpected moves.  The
problem is, there are fewer opportunities to find deep-OTM
spreads in these issues that provide the returns we target in
this strategy (8-12% monthly).  However, I strongly recommend
this approach whenever you discover a position that meets your
technical (or fundamental) criteria and risk/reward outlook.

My approach to analysis of these broader instruments is much
the same as with any financial issue: Define the primary trend,
the support and resistance areas, the historical volatility
(which leads to a probability assessment) and any potential
news or events that could affect the future price of the
underlying issue.

Good Luck!

***************
Summary of Current Positions
***************
(As of 05-28-02)

Naked Puts

Stock  Strike Strike  Cost Current  Gain  Potential
Symbol  Month  Price Basis  Price  (Loss) Mo. Yield

NVLS     JUN    40   39.05  46.67   $0.95   5.90%
VSEA     JUN    40   38.90  42.50   $1.10   5.86%

Varian Semiconductor (NASDAQ:VSEA) is testing the lower
limits of a recent trading range and any further downside
activity should be considered an "early-exit" signal.


Naked Calls

Stock  Strike Strike Break Current  Gain  Potential
Symbol  Month  Price  Even  Price  (Loss) Mo. Yield

CYMI     JUN    55   55.60  45.93   $0.60   5.98%


Put-Credit Spreads

Stock                                             Gain
Symbol  Pick   Last  Month L/P S/P Credit   C/B  (Loss) Status

RYL    113.00 112.20  JUN   90  95  0.55  94.45  $0.55  Open
SII     73.80  73.44  JUN   55  60  0.65  59.35  $0.65  Open
ADRX    46.06  45.15  JUN   30  35  0.65  34.35  $0.65  Open
BBOX    54.94  51.26  JUN   45  50  0.55  49.45  $0.55  Open
DRS     45.40  39.95  JUN   35  40  0.50  39.50  $0.45 Closed
FDC     82.18  79.36  JUN   70  75  0.50  74.50  $0.50  Open
HON     39.25  37.65  JUN   33  35  0.30  34.70  $0.30  Open
UNH     88.39  88.88  JUN   75  80  0.45  79.55  $0.45  Open
UOPX    34.00  31.45  JUN   26  30  0.35  29.65  $0.35  Open

DRS Technologies (NYSE:DRS), which was previously closed, is
positive now (Murphy's Law!) and should continue to recover
with stocks in the defense sector.  Black Box (NASDAQ:BBOX)
is approaching a "key" moment and should be monitored closely
for any further downside activity.  Positions from the May 22
edition are not being tracked.


Call-Credit Spreads

Stock                                          Gain
Symbol  Pick  Last Month L/C S/C Credit  C/B  (Loss) Status

BHI    35.96 36.41  JUN   43  40  0.35  40.35  $0.35  Open
BGEN   42.44 50.66  JUL   60  55  0.25  55.25  $0.25  Open
ROOM   55.30 51.48  JUN   70  65  0.55  65.55  $0.55  Open

Shares of Biogen (NASDAQ:BGEN) soared last week after a Food
and Drug Administration advisory panel voted to recommend the
firm's experimental treatment for psoriasis.  The unexpected
news and the following recovery rally threatened our bearish
position, so we rolled up and forward to a higher strike in
July (JUL60C/55C) for a small debit.  The new spread, which
is a "recovery" play, has a break-even slightly above $55.
Positions from the May 22 edition are not being tracked.

 
Synthetic Positions:

Stock  Pick     Last    Position   Credit   C/B    G/L   Status

RTN    42.40   43.18   JUN47C/37P   0.00   37.50   0.75   Open
ATVI   33.95   33.57   JUN40C/30P   0.30   29.70   0.30   Open
CTAS   55.02   53.80   AUG60C/50P  (0.10)  50.10   0.60   Open
JPM    36.91   37.20   JUN40C/32P   0.30   32.20   0.80   Open
HSIC   49.75   49.45   JUL55C/45P   0.10   44.90   0.10   Open
ABT    46.90   46.77   JUN42P/50C   0.20   50.20   0.20   Open
LLL    63.95   62.00   JUN70C/57P   0.20   57.30   0.20   Open


Credit Strangles:

Stock  Pick     Last    Position   Credit   G/L   Yield  Status

ERTS   63.21   62.92   JUN70C/55P   1.25    1.25   8.9%    Open


New Candidates:

This following group of plays is simply a list of candidates to
supplement your search for profitable trading positions.  As
with any investment, you must decide if the selections meet your
criteria for potential plays.  Only you can know what strategies
are suitable for your skill level, risk-reward tolerance and
portfolio outlook.  In addition, we recommend that you avoid any
strategy or technique in which you are not completely comfortable
with the potential loss, the necessary adjustments and the common
entry-exit strategies.  (I monitor the positions marked with ***).

***************

BULLISH PLAYS - Covered Calls, Naked Puts, & Combinations

Today's list of candidates will be limited as my family and I have
just returned from a wonderful Memorial Day holiday and I have not
been able to monitor the market this week.  However, that may be a
"good" thing as there is little conviction in the recent activity
and few traders are willing to bet on which direction stocks will
move in the near future.

***************
AVE - Aventis  $71.75  *** Rally On No News? ***

Aventis S.A. (NYSE:AVE) is engaged in the discovery and development
of pharmaceutical products.  Aventis offers a range of patented
prescription drugs to treat patients with serious diseases in a
number of therapeutic areas, including respiratory/allergy,
cardiology/thrombosis, oncology and diabetes.  The company also is
engaged in the areas of human vaccines and therapeutic proteins.
Aventis' major businesses include Aventis Pharma, Aventis Pasteur,
Aventis Behring, Aventis CropScience and Aventis Animal Nutrition.

Shares of Aventis soared this week, but there was little news to
explain the bullish activity.  A report today mentioned that the
company will conduct a study to examine the safety and efficacy
of Lovenox versus unfractionated heparin in heart attack patients
receiving standard reperfusion therapy, however that could hardly
account for the recent, heavy-volume buying pressure.  Regardless
of the reason, the move up and out of a recent trading range in a
bearish market environment suggests further upside potential for
the issue.

AVE - Aventis  $71.75

PLAY (aggressive - bullish/credit spread):

BUY  PUT  JUN-65  AVE-RM  OI=330  A=$0.35
SELL PUT  JUN-70  AVE-RN  OI=100  B=$1.15
INITIAL NET CREDIT TARGET=$0.85-$0.90  PROFIT(max)=20%


***************
INTU - Intuit  $42.92  *** New Trading Range? ***

Intuit (NASDAQ:INTU) is a provider of unique small business, tax
preparation and personal finance software products and Web-based
services that simplify complex financial tasks for consumers,
small businesses and accounting professionals.  The company's
principal products and services include Quicken, QuickBooks,
Quicken TurboTax, ProSeries, Lacerte and Quicken Loans.  Intuit
offers products and services in five principal business divisions
including Small Business, Tax, Personal Finance, Quicken Loans
and Global Business.

Intuit shares have moved higher in recent weeks after Prudential
Securities raised on its target price on the consumer and small
business software maker to $58, saying the company's quarter and
outlook are "rosy".  Prudential said that the company achieved
its own revenue guidance and surpassed its earnings per share
expectations for its fiscal third quarter when it posted revenue
of $545 million and earnings from continuing operations of $0.79
per share.  In addition, TurboTax remains the top-selling tax
preparation software in America, accounting for over 70% of the
retail units sold, and the company recently reported yearly unit
growth of 8.6%, more than triple that of its closest competitor.

The strong fundamental performance of the company is reflected
in its share value activity and traders who believe the bullish
trend will continue can profit from that outcome with this play.

INTU - Intuit  $42.92

PLAY (conservative - bullish/credit spread):

BUY  PUT  JUN-35  IQU-RG  OI=484   A=$0.20
SELL PUT  JUN-40  IQU-RH  OI=1848  B=$0.70
INITIAL NET CREDIT TARGET=$0.55-$0.60  PROFIT(max)=12%


***************
SRCL - Stericycle  $70.09  *** Broad-Market Hedge! ***

Stericycle (NASDAQ:SRCL) is a regulated medical waste management
company in North America, serving almost 300,000 customers in the
United States, Canada, Puerto Rico and Mexico.  The company's many
services and operations include the collection, transportation,
treatment, disposal and recycling of waste, together with related
training and education programs, consulting services and product
sales.  The company has a fully integrated, national medical waste
management network.  Stericycle's network includes 36 treatment and
collection centers and 94 additional transfer and collection sites.
The company uses this network to provide medical waste collection,
transportation and treatment and related consulting, training and
education services and products.  Stericycle's unique treatment
technologies include its proprietary electro-thermal-deactivation
system, as well as traditional methods, such as autoclaving and
incineration.

Stericycle is an old favorite among option traders and it is also
one of the best issues for investors who are interested in hedging
against bearish activity in the broader markets.  Apparently, that
fact is becoming obvious again as the issue has recently completed
a brief consolidation and may be a starting another bullish move.
Our outlook for the stock is slightly better than "neutral" but
the technical support near the sold strike price at $65 (the top
of the trading range in February and March) and the short-term
buying pressure near $68 should provide a reasonable margin of
downside protection for this conservative, combination position.
  
SRCL - Stericycle  $70.09

PLAY (conservative - bullish/credit spread):

BUY  PUT  JUN-60  URL-RL  OI=54   A=$0.40
SELL PUT  JUN-65  URL-RM  OI=106  B=$0.95
INITIAL NET CREDIT TARGET=$0.60-$0.70  PROFIT(max)=14%


***************

Neutral Plays - Straddles & Strangles

One of our traders has been asking for conservative volatility
plays, where the underlying issues have discounted options and
the potential to make extreme movements prior to the straddle's
expiration.  Here are two favorable issues, based on analysis of
the historical option pricing and technical background.  Both
stocks have a history of multiple movements through a sufficient
range in the required amount of time to justify the overall risk
of the positions.  As always, review each play individually and
make your own decision about the future outcome of the position.

***************
DGX - Quest Diagnostics  $85.72  *** Probability Play! ***

Quest Diagnostics (NYSE:DGX) is a provider of diagnostic testing
and related services for the healthcare industry.  The company
offers a broad range of clinical laboratory testing services used
by physicians in the detection, diagnosis, evaluation, monitoring
and treatment of diseases and other medical conditions.  Quest is
engaged in clinical laboratory testing and esoteric testing,
including molecular diagnostics, as well as anatomic pathology
services and testing for drugs of abuse.  The company also has a
network of principal laboratories located in approximately 30
metropolitan areas throughout the United States, several joint
venture laboratories and approximately 150 smaller rapid-response
laboratories and 1,300 patient service centers.  The company also
operates an esoteric testing laboratory and development facility,
known as Nichols Institute, located in California, as well as one
laboratory facility in Mexico City, Mexico and another near London,
England.

DGX - Quest Diagnostics  $85.72

PLAY (conservative - neutral/debit straddle):

BUY  CALL  AUG-85  DGX-HQ  OI=572  A=$6.10
BUY  PUT   AUG-85  DGX-TQ  OI=633  A=$4.90
INITIAL NET DEBIT TARGET=$10.60-$10.75 TARGET PROFIT=40-75%


***************
FLIR - Flir Systems  $44.45  *** Active Issue! ***

FLIR Systems (NASDAQ:FLIR) is engaged in the design, manufacture
and marketing of thermal imaging and stabilized camera systems
for a wide variety of commercial, industrial and government
applications.  The company's products are divided into two major
categories, which include the thermography products and imaging
products.  In the Thermography division, FLIR makes products that
are sold to commercial, industrial, research and machine vision
customers.  For industrial customers, the company has developed
thermography systems featuring accurate temperature measurement,
storage and analysis.  In the Imaging division, FLIR manufactures
products that are marketed to military, law enforcement, news
stations, surveillance and security customers.
 
FLIR - Flir Systems  $44.45

PLAY (moderately conservative - neutral/debit straddle):

BUY  CALL  JUL-45  FFQ-GI  OI=264  A=$3.60
BUY  PUT   JUL-45  FFQ-SI  OI=116  A=$3.90
INITIAL NET DEBIT TARGET=$7.20-$7.30 TARGET PROFIT=35%-60%


***************

BEARISH PLAYS - Naked Calls & Combinations

***************
PHTN - Photon  $42.70  *** Premium Selling! ***

Photon Dynamics (NASDAQ:PHTN) is a provider of yield management
solutions to the flat panel display (FPD) industry.  The company
also offers yield management solutions for the printed circuit
board assembly and advanced semiconductor packaging industries
and the cathode ray tube display and CRT glass and auto glass
industries. The Company's test, repair and inspection systems are
used by manufacturers to collect data, analyze product quality
and identify and repair product defects at critical steps in the
manufacturing.

Here is a good candidate for a bearish, premium-selling position,
based on the underlying issue's technical background.  PHTN has
recently fallen below a near-term trading range from $46 to $52
and the chart indications suggest the trend will remain neutral
to bearish.  However, news and other market sentiment may have
an effect on the position, so review the play thoroughly and
make your own decision about its outcome.

PHTN - Photon  $42.70

PLAY (aggressive - sell naked call):

Action    Month &  Option  Open     Closing  Cost     Target
Req'd     Strike   Symbol  Int.     Price    Basis    Mon. Yield

SELL CALL JUN 50   PDU FJ  124       0.40    50.40      5.2% ***
SELL CALL JUN 47.5 PDU FW  238       0.80    48.30      8.1%
SELL CALL JUN 45   PDU FI  85        1.60    46.60     12.9%


***************
ADBE - Adobe Systems  $35.85  *** Bottom Of The Range! ***

Adobe Systems (NASDAQ:ADBE) builds software solutions for network
publishing, including Web, print, ePaper, video, wireless and
broadband applications.  Its graphic design, imaging, and media
authoring tools enable customers to create, manage, and deliver
visually rich, reliable content.  The company licenses its unique
technology to major hardware manufacturers, software developers,
and service providers, and offers integrated software solutions
to businesses of all sizes.  The company has operations in the
Americas, Europe, the Middle East, Africa and Asia.
    
This play is simply based on the current price and trading range
of the underlying stock and its recent technical history.  ADBE
has drifted to the bottom of a 3-month rectangular pattern near
$36 and the issue is now at a "key" moment with regard to its
future technical outlook.  In addition, there is an area of
substantial overhead supply at the top of the current trading
range (near $40) and it appears the stock has little chance of
reaching our sold strike in three weeks.

ADBE - Adobe Systems  $35.85

PLAY (conservative - bearish/credit spread):

BUY  CALL  JUN-45  AEQ-FI  OI=1468  A=$0.20
SELL CALL  JUN-40  AEQ-FH  OI=4029  B=$0.70
INITIAL NET CREDIT TARGET=$0.55-$0.60  PROFIT(max)=12%


***************

SUPPLEMENTAL CREDIT-SPREAD CANDIDATES

***************
BULLISH PLAYS:

Stock  Last   Short    Bid    Long     Ask   Target  Monthly
Symbol Price  Option   Price  Option   Price Credit   Gain

BWA    66.82  JUN 65P  1.20   JUN 60P  0.40   0.85     20%
TEVA   66.45  JUN 65P  1.10   JUN 60P  0.30   0.85     20%
NBR 	 44.34  JUN 40P  0.55   JUN 37P  0.30   0.30     14%
AET    47.47  JUN 45P  0.75   JUN 40P  0.25   0.55     12%
RNR 	 113.50 JUN 105P 0.95   JUN 100P 0.45   0.55     12%
VAR    46.14  JUN 45P  0.70   JUN 40P  0.20   0.55     12%
LXK 	 60.40  JUN 55P  0.70   JUN 50P  0.25   0.50     11%
UNH    89.89  JUN 85P  0.85   JUN 80P  0.40   0.50     11%


BEARISH PLAYS:

Stock  Last   Short    Bid    Long     Ask   Target  Monthly
Symbol Price  Option   Price  Option   Price Credit   Gain

BBH 	 97.20  JUN 105C 0.95   JUN 110C 0.40   0.60     14%
TDS 	 76.95  JUN 80C  0.85   JUN 85C  0.30   0.60     14%
CUM 	 37.91  JUN 40C  0.50   JUN 42C  0.25   0.30     14%
ROOM 	 50.10  JUN 55C  0.80   JUN 60C  0.30   0.55     12%
UTH 	 87.73  JUN 90C  0.65   JUN 95C  0.15   0.55     12%
LXK 	 60.40  JUN 65C  0.70   JUN 70C  0.20   0.55     12%
MWD 	 46.04  JUN 50C  0.55   JUN 55C  0.10   0.50     11%
XLNX 	 34.83  JUN 40C  0.60   JUN 45C  0.15   0.50     11%

***************


SEE DISCLAIMER
*****************************


************
MARKET WATCH
************

Most watch list candidates remain on hold so far this week.  Here 
are two more ideas worth monitoring.

To Read The Rest of The OptionInvestor.com Market Watch Click Here
http://members.OptionInvestor.com/watchlist/052902.asp


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