Option Investor

Daily Newsletter, Wednesday, 08/21/2002

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The Option Investor Newsletter                Wednesday 08-21-2002
Copyright 2002, All rights reserved.                        1 of 2
Redistribution in any form strictly prohibited.

In Section One:

Wrap: Back to the Future
Weekly Fund Family Profile: Evergreen Investments
Options 101: Preventing Whiplash

Updated on the site tonight:
Swing Trader Game Plan: Calm Day in the Markets

Posted online for subscribers at http://www.OptionInvestor.com
MARKET WRAP  (view in courier font for table alignment)
08-21-2002                High    Low     Volume Advance/Decl
DJIA     8957.23 + 85.16 8974.36  8798.89 1600 mln  1969/774
NASDAQ   1409.25 + 32.66 1410.88  1378.09 1609 mln  2241/1032
S&P 100   480.04 +  6.01  481.33  470.68   totals   4210/1806
S&P 500   949.36 + 11.93  951.59  931.32
RUS 2000  406.79 +  8.95  406.79  397.84
DJ TRANS 2432.21 + 84.49 2432.21  2347.43
VIX        31.63 -  0.93   34.02  30.62
VIXN       46.11  - 1.60   49.72  45.99
Put/Call Ratio 0.67

Back to the Future
by Steven Price

The Dow, S&P 500, Nasdaq Composite and NDX all broke through 
their 50 day moving averages on Monday.  I addressed this point 
then, so I will not simply repeat the same information.  For 
investors looking at whether we have now achieved a new level of 
support, let's examine what the indices have done since then.  

On Tuesday, the broader markets took a step backward, which can 
be expected after a run of over 1400 Dow points since July 24.  
However, all of the averages finished the day above the 50-dmas, 
lending credence to the belief that we have established a new 
base from which to work higher.  On Tuesday, the Dow traded below 
the 50-dma by 13 points, however rebounded to finish above it by 
36.42.  The S&P 500 came within 1.27 of the 50-dma, before 
finishing 6.84 above it.  The NDX fell to just 5.11 above the 50-
dma, eventually finishing the day 11.29 above this level. The 
Nasdaq Composite traded 2.04 points below the 50-dma, but closed 
3.57 points above it. These amounts are not very large, and that 
is exactly the point.  All of these indices found enough buyers 
to keep them just above the 50-dmas on a market pullback.

This morning, the market pulled back once again, with the Dow 
touching just below the 50-dma, the S&P 500 just above it, and 
the NDX just above it. Once again the buyers came in and pushed 
these averages back up and over the hump.  The more supported 
pullbacks we see, the more impressive is this level.  

Historically speaking, we may be seeing something even more 
significant.  This past July, when the Dow traded as low as 
7532.66, we saw the lowest levels in this index since the end of 
August 1998 and beginning of September 1998. When looking back at 
that time period, we see a double dip, with the first low in 
October of 1997, followed by an extended second dip in August-
October of 1998, 10 months later. This is similar to the double 
dip we've seen with the market bottom in September of 2001, and 
again 10 months later in July 2002.  While the impetus for the 
drops is different, the similarities are striking. 

Chart of the Dow Double-Dip 


The next similarity is the 50-dma crossover.  In 1998, the 50-dma 
crossover appeared shortly (about a week and a half) after the 
October 1998 low.  In 2002, we see the 50-dma crossover about 
three weeks after the July 24 low.  In 1998 this crossover 
signaled the start of an extended rise, in which the Dow rode the 
50-dma as support all the way up to 10,500.  It crossed below, on 
occasion, during a consolidation period a few months later, 
however stuck very close to it during this 2-month period.  It 
was not until June 1999 that the 50-dma was decisively broken to 
the downside, and even then the Dow saw a wide consolidation 
trading band, before moving higher.

Chart of The Dow 2002 50-dma Crossover


Chart of The Dow 1998 50-dma Crossover


The market does seem to be in consolidation at the moment, with 
the Dow first getting a little beat up this morning, showing a 
major turnaround and trading up over a hundred points at one time 
this afternoon, and then giving back to close at 8957.02, up 
84.95 on the day.  

The Nasdaq Composite, which also broke its 50-dma on Monday, and 
has held above it, crossed a significant barrier today as it 
passed the 1400 mark, to close at 1409.08, up 32.49 on the day.  
This is partially due to the strength of the semiconductor group. 
The Semiconductor Sector Index (SOX.X), which was unable to hold 
its 50-dma on Monday, and was turned back on Tuesday, has now 
broken the barrier, hanging on by a hair.  Today's 16.12 point 
gain put the index at 361.80, just above the 50-dma of 360.48.  
If this group is able to hold the rally, in spite of a lack of IT 
spending, and lowered estimates for sales and revenue in 2003, it 
may be evidence that the valuations are now more reasonable.  If 
the Semis, which have been a major drag on the Nasdaq indices, 
can find legs for even a mild run, that may be the catalyst for a 
continued rise in all of the major indices.  The past several 
years the NDX has led the market, as was evidenced by its bullish 
percentage turning up ahead of the rest of the group prior to the 
most recent rally.  If the semiconductors can spark a continued 
rally in the NDX, this may be the last piece to the recovery 
puzzle.  I am skeptical, however, as we are still not seeing 
evidence of a turnaround in the PC market.  In fact, Dell's 
recent prediction of single digit sales growth next year was 
considered a disappointment.

Today's market swings may be the result of investors digesting 
the comments of three Federal Reserve Presidents, who gave 
comments regarding the economy today.  The first to speak was 
Philadelphia Fed President Anthony Santomero, who is a voting 
member of the FOMC committee, which sets interest rates.  There 
is a rotation that determines which bank presidents vote each 
year.  Santomero admitted to reduced forecasts for economic 
growth, but stated that he thought consumer spending would help 
bring the economy out of its rut.  He is relying on the equity 
people have built up in their homes, and the continued rise in 
real income, to fuel this growth.  In a statement indicating 
there may not be an interest rate cut at the September 24th FOMC 
meeting, he said, "The Fed's current monetary policy stance is 
appropriately supportive of the recovery process... At some 
point, prudence will dictate that we begin moving monetary policy 
back toward a more neutral stance."   This statement can be 
viewed as confirmation of revelations contained in the minutes of 
the June FOMC meeting.  Those minutes revealed that there was 
more talk of when the Fed would need to raise rates, rather than 
when to lower them further. 

Comments from Chicago Fed president Michael Moskow echoed the 
same sentiment, when he said he also was convinced the economy is 
strengthening.  The October Fed funds futures are now showing 
less than a 30% chance for a rate cut on September 24th.  The 
current rate stands at 1.75%, which has not changed since 
December 2001

Oil prices remained over $29 a barrel today, in spite of a 
surprise increase in last week's inventories.   After the 
inventory announcement last night, it looked as though crude oil 
would be giving back some of its recent gains.  However, as 
tensions continue with Iraq, oil prices are likely to remain 

The first domino in the Enron prosecution seems to have fallen.  
Michael Kopper, former managing director of Enron's global 
finance department, plead guilty to criminal conspiracy charges 
to commit wire fraud and money laundering.  He also agreed to pay 
a $12 million fine, which the SEC intends to eventually 
distribute to Enron shareholders. Kooper worked with former CFO 
Andrew Fastow, in illegally managing off-balance-sheet 
partnerships used to artificially inflate Enron's financial 
results.  More importantly, Kopper has now turned stool pigeon, 
agreeing to co-operate with prosecutors.  Ever since prosecutors 
took down Arthur Andersen, investors have been wondering when the 
Enron executives would follow.  Most federal prosecutions rely on 
a series of witnesses rolling over on one another.  Once the 
first defendant agrees to testify against others, the sense of 
"all for one and one for all" is gone. The dominos usually fall 
quickly, as no one wants to be the last one standing without a 
chair when the music stops.  With each successive co-operating 
witness, information flows geometrically and the picture of what 
really happened grows much brighter.  Expect the pace of 
prosecutions in this case to speed up now, and keep an eye on the 
companies that had close ties to Enron, such as J.P. Morgan and 
Citigroup. I'm not predicting anything specific about these 
companies, just the possibility that if there is information out 
there that hasn't yet been discovered, it will probably be coming 
out in the near future.

On a similar note, Congress may be looking deeper into the 
relationship between Citigroup and Global Crossing.  J.P. Morgan 
may be looking at a debt downgrade from Moody's, which placed the 
long-term ratings of J.P. Morgan and its subsidiaries on review 
for possible downgrade.  Moody's cited current and prospective 
profitability, earnings volatility, weak operating margins and 
rising credit losses.

The U.S. posted a budget deficit of $29.2 billion for July, 
according to a treasury report today.  This contrasted with last 
year's surplus in the same period.  The deficit was less than the 
$32 billion predicted by the Congressional Budget Office, but 
year-to-date the U.S. is running a deficit of $147.2 billion, 
compared to a surplus of $172 billion at the same point last 
year.  This deficit has been blamed on defense spending and lack 
of capital gains taxes, since the stock market has not produced 
many.  The lack of income tax, due to unemployment, has also 
figured into the equation.

The mortgage market is still going strong, with the MBA mortgage 
index hitting a new high last week.  However, the Dow Jones Home 
Construction Index experienced a decline of 5.34 points today, as 
it ran into converging 200 and 50-dmas.  While the record number 
of mortgages, combined with low interest rates, would seem to 
have led to a gain in the sector, a closer look at the index 
shows that re-financing is near a record high, however purchase 
activity, while strong, is slightly off from the second quarter.  
This may be the reason for today's sell-off of the home builders.

As we head into the end of summer, we shouldn't expect Earth 
shattering activity in the stock market. Summer is traditionally 
the slow time of the year, when investment bankers head to the 
Hamptons and traders leave the trading floors by noon.  Of 
course, this summer has been anything but boring.  Volumes have 
fallen off in both the NYSE and Nasdaq recently, and investors 
may grow squeemish as we head toward the September 11 
anniversary.  Keep an eye on the 50-dmas for signs of overall 
weakness.  I seem to become more bullish with each market wrap, 
however we still haven't seen a change in basic fundamentals.  
The technicals are, however, looking much stronger than they have 
recently.  The fact that the market was up on a day when the Fed 
Presidents seemed to hint at no rate cut in September, is also 
encouraging.  As the market continues its upward pace, the 
chances of another cut grow slimmer.  The Fed successfully held 
onto its bullets, and now has more ammunition in case a cut is 
needed. Of course if we are trading much higher a month from now, 
there won't be many calls for another cut anyway.  


Leigh Stephens will be back in the office on Thursday, August 22, 2002

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Evergreen Investments

"Investments that stand the test of time" is the tag line for 
this Boston-headquartered asset management firm with 70 years 
history managing assets.  Today, the firm ranks as one of the 
industry leaders, with about 350 investment professionals and 
$215 billion in assets under management through June 30, 2002.  
Accordingly, Evergreen Investments is ranked among the top 30 
largest asset management firms and top 20 largest mutual fund 
families in the United States.

Like others, Evergreen Investments has evolved over the years 
into a broadly diversified asset management organization that 
distributes its products and services across several lines of 
business.  The company manages investments from institutional 
portfolios, private client accounts, retirement plans, mutual 
funds, and variable annuities.  Investment decisions are made 
using a team management approach that is designed to benefit 
shareholders by drawing upon portfolio managers and research 
analysts who have specialized expertise in their asset class.

Evergreen Investments offers a complete range of mutual funds 
investing across all asset classes, designed to help personal 
investors meet their financial goals.  Investment styles also 
vary from fund to fund, providing investors different sets of 
risk and return characteristics to fine-tune their portfolios.

Per the fund website www.evergreeninvestments.com, Evergreen's 
goal is to provide consistent, enduring excellence in investment 
management and service to its institutional investors, personal 
investors, and financial intermediaries.  Their website proudly 
displays a 2001 Dalbar Mutual Fund Service Award in recognition 
of outstanding service.  It is an industry recognition the firm 
has repeatedly achieved.      

Evergreen's mutual funds are marketed and sold through financial 
advisors, who help individuals learn more about their needs and 
discuss how Evergreen's strategies can bring enduring success to 
their investment program.  We'll see later how well Evergreen's 
mutual funds have performed compared to similar funds on a risk-
adjusted basis and using other measures of performance.  Mutual 
funds are available in Class A, B, C and I shares, which differ 
both in fee structure and availability.  A, B and C shares cost 
$1,000 to invest initially ($1,000,000 for I shares).  There's 
also a Y share class that is available only to shareholders of 
record in any Evergreen fund prior to December 30, 1994, and to 
institutional investors.    

Additional Background

The website states that for 70 years, Evergreen Investments has 
provided its clients (and mutual funds) with sound, time-tested 
investment strategies.  Evergreen's first mutual funds date all 
the way back to the 1930s, when open-end funds were first being 
introduced to personal investors.  Six Evergreen funds (now all 
Class B shares) were launched in 1936, as follows:

 Evergreen Large Company Growth Fund (EKYBX)
 Evergreen Blue Chip Fund (EKNBX)
 Evergreen Small Company Growth Fund (EKABX)
 Evergreen Diversified Bond Fund (EKDMX)
 Evergreen Balanced Fund (EKBBX)
 Evergreen High Yield Bond Fund (EKHBX)

In 1954, Evergreen International Growth Fund (EKZBX) was added, 
one of the first funds to invest primarily in stocks of foreign 
companies.  Only American Heritage Fund (1952) came before this 
pioneering international stock fund offering.

The firm's largest long-term mutual fund, Evergreen Foundation 
Fund (EFOBX) with $1.7 billion in net assets, got its start in 
1990, and was made available to retail investors in 1995.  The 
symbol for the popular Class B shares is reflected.

Evergreen's executive officers are William M. Ennis, president 
and chief executive officer of Evergreen Investments, and Dennis 
H. Ferro, president and chief investment officer of Evergreen 
Investment Management Company, LLC, the firm's investment arm.  
Evergreen Investments is headquartered in Boston, MA, and has 
offices in Charlotte, NC; New York City, NY; Philadelphia, PA; 
Richmond, VA; and overseas (London).

Over 1300 employees serve the needs of 4.2 million mutual fund 
shareholders at Evergreen Investments.  

Investment Style/Strategy

If you go to the Evergreen Funds website, you will find further 
information on the firm's management philosophy, which is based 
on the premise that investors of all types, regardless of their 
objectives, share a common goal: superior and sustained results 
without undue risk to principal.    
In addition to shared disciplines, Evergreen uses a specialized 
team approach to manage fund assets.   Their portfolio managers 
and analysts work together in specialty teams which focus on 
delivering superior results within defined investment styles 
within their areas of expertise.  Each team conducts its own 
research and analysis, the website states, but operates in a 
shared environment that permits one team to leverage another 
team's research and staff.

While team structure is decentralized, Evergreen maintains a 
centralized, risk-controlled management process.  Trades are 
monitored daily and performance attribution analysis is done 
regularly to monitor style, valuation, dispersion, and other 
portfolio qualities.  Attribution analysis helps managers by 
explaining the sources of under- or over-performance.

Evergreen Investments seeks to deliver superior performance 
relative to the competition, without the valuation and style 
drift that can result in unacceptable volatility and disrupt 
individual asset allocation strategies.  In the next section, 
we'll see how well the Evergreen funds have performed versus 
their respective category peers, using data from Morningstar.

Fund Performance and Ratings

Currently, no retail class shares of Evergreen Funds hold a 
Morningstar 5-star rating.  Six funds, however, have "above 
average" 4-star overall ratings from Morningstar as follows:

 Evergreen Omega Fund (EKOBX and EKOCX)
 Evergreen Special Values Fund (ESPAX)
 Evergreen International Growth Fund (EKZAX, EKZBX, EKZCX)
 Evergreen Emerging Market Fund (EMGAX, EMGBX, EMGCX)
 Evergreen High Yield Bond Fund (EKHAX, EKHBX, EKHCX)
 Evergreen Strategic Income Fund (EKSAX)

The Omega Fund is a large-cap growth fund that has an annual 
equivalent return of 1.4% for the past five years (August 20, 
2002).  That matched the return of the S&P 500 index and was 
solid enough on a relative basis to rank the fund in the top 
quartile of the Morningstar large-cap growth category.  Fund 
downside volatility (risk) has been "average" in relation to 
other large-cap growth funds, while returns have been "above 

The Special Values Fund is a small-cap value fund that has a 
trailing 5-year return of 7.2% as of yesterday's close, 5.6% 
better than the S&P 500 large-cap index and strong enough to 
place in the 26th percentile of the small-cap value category 
(near top quartile) per Morningstar.  It would make a decent 
compliment to the Omega Fund, considering its value bias and 
small-cap sector orientation.  Compared to other small-value 
funds, Special Values Fund has "low" risk and average return 

Evergreen International Growth Fund (EKZBX) is classified by 
Morningstar as a foreign stock fund.  Although the fund lost 
approximately 0.2% a year on average over the trailing 5-year 
period through August 20, 2002, it outperformed the MSCI EAFE 
index benchmark by 2.1% a year, ranking in the top quartile of 
Morningstar foreign stock category.  The fund's longer period 
performance (10 years) places in the category's top one third.  


In relation to other foreign stock funds, the International 
Growth Fund has produced "above average" returns with "low" 
relative risk.  Note that the fund's 3-year risk rating was 
"below average" but overall the fund is rated as having low 
relative risk versus similar funds for a Morningstar 4-star 
overall rating.  The fund is a Lipper Leader for consistent 
strong returns as well as preservation of capital.  

Evergreen High Yield Bond Fund (EKHBX) may appeal to income 
investors seeking high current yields and some appreciation 
potential.  Compared to other high-yield bond funds, it has 
produced "above average" returns, with "below average" risk, 
according to Morningstar.  The fund's 1.0% annualized total 
return over the past five years through August 20, 2002, is 
minimal in absolute terms, but it was strong enough to rank 
within the top quintile of the current high-yield bond fund 

The other 4-star rated bond fund, Evergreen Strategic Income 
(EKSAX), is a multi-sector bond fund that has posted average 
risk-adjusted returns for the last three to five years, with 
"above average" relative returns over the past decade versus 
category peers.  Considering the fund's greater than average 
relative volatility in recent years, its current return-risk 
profile warrants further analysis.


Because Morningstar provides a snapshot of a fund's historical 
risk/reward profile, and takes sales charges into account, not 
many of Evergreen's funds are rated 4 stars or above.  Class A 
shares carry a 5.75% front-end sales load.  Of the 52 Evergreen 
Class A shares in Morningstar's system, counting all fund share 
classes, only five funds are currently rated 4 stars or better.  

While annual expense ratios on the Evergreen Class A shares are 
reasonable versus the competition, but some Class B and Class C 
expense ratios are relatively high.  For example, the Evergreen 
Emerging Markets Fund, Class B and C shares have a 3.10% annual 
expense ratio.  One of every four Evergreen funds (A,B,C shares) 
in Morningstar's database has an expense ratio that is equal to 
or greater than 2.00% of assets annually.

In our opinion, more Evergreen mutual funds would garner "above 
average" ratings if their costs and expenses were simply lower.  
This is another classic case of "like the funds, don't like the 
costs and expenses of some funds."  For complete information on 
the Evergreen Funds, go to the EvergreenInvestments.com website.

Steve Wagner
Editor, Mutual Investor


Preventing Whiplash
by Mark Phillips

Anyone who has been watching the intraday market action over the
past 2 weeks can tell you that these are some whip-saw markets!
Many technical tools are giving false signals, as the markets
crash at the open, rally back by noon, sell off in the afternoon
and then rally back to close positive.  When I signed up for this
gig, nobody told me that I needed to keep some Dramamine on the
desk.  This type of action is great for the hyperactive
day-trader types (a club I frequently visit), but for those that
like to enter into a position and ride a major move to its
eventual destination without getting spooked out by all the
volatility, it's safe to say you've been eating Tums like they
were candy.

Every day presents a new dilemma of "Is this the top?".  Let's
assume you took advantage of the huge July selloff to enter some
longer term positions and you were smart and brave enough to pick
the very bottom.  Being the conservative type you are, you opted
to buy shares of your favorite large-cap stock, avoiding paying
through the nose for the sky-high volatility then priced into
the options.  Since that time, you're looking at a solid rally
off the lows, but you don't want to sell out just yet.  "What if
that was The Bottom?  I don't want to settle for a paltry 15-20%
gain, when there might be another 30-40% in store."  Those of you
that have been reading my ramblings for awhile know that I don't
happen to share that view, but let's run with it just the same.

Wouldn't it be nice if there were a strategy that could protect
our current gains, while still giving us the ability to
participate if the rally continues up the charts?  Well, today's
your lucky day!  Such a strategy does exist and it is known as a
collar.  I didn't invent it (I'm not that clever!), but I sure
can learn and apply the lessons of those that have gone before me.

Here's the basic strategy.  You have a long position (let's
assume for the sake of discussion that you bought shares of MSFT
near the low on July 24th at $42), and while it looks like the
stock is breaking out, you want to insure against a drop in price,
which could wipe out a big chunk of your gains in a hurry.  So,
figure out how much of a loss you are willing to accept, and buy
a protective put at that level.  Let's assume that we don't want
to absorb any further loss below the $50 level.  In that case, we
would want to buy a $50 put to protect against potential downside
risk.  If MSFT falls below that level, we will make money on the
protective put at the same rate that we are losing it on the long
shares, meaning that our loss on the long position stops as soon
as the price drops below $50.  MSFT can go all the way to zero,
but we only lose $2.28 on the position (Current price = $52.28 -
$50 strike).  But that costs money, cutting into your paper
profits.  So let's sell a higher call, to finance the purchase
of the put.

Effectively what we are doing is turning the long position into
a covered call and using the proceeds from the covered call to
finance the purchase of a protective put.  Sounds great, huh?
The best part is that due to differing timeframes and our
associated expectations, we can create all sorts of different
scenarios, tailored to meet our needs.  Think of it like the
collar that the doctor gives you after you've suffered whiplash
from being rear-ended in your car.  It restricts your movements
(puts a cap on potential profits), but protects you from further
injury (reduces the risk of giving your profits back).

I think the best way to demonstrate the concept is through
example, so let's go.  Start with 1000 shares of MSFT with a
cost basis of $42.  The stock is now trading at $52.28, giving us
a paper profit of $10,280.  We are concerned about near-term
weakness causing the price to drop below $50.  We don't want to
incur a loss below the $50 level, so we will buy protective puts
at the $50 strike price.  Since we're just getting ready to enter
that nemesis of bullish traders, the Ides of September and
October, let's buy puts with enough time to get us through the
bulk of that timeframe, selecting the OCT contracts.  That is
enough time to protect our position for the next 8 weeks, getting
us through the upcoming earnings warning season and through the
worst of the foreseeable near-term risks.  The OCT $50 Put
(Symbol: MSQ-VJ) is currently selling for $2.45, making our net
insurance cost $2450 (10x$245).

Now we need to pick a call to sell that will allow us some
upside in our underlying MSFT shares, but one that has enough
premium to offset the cost of the puts we want to buy.  There
seems to be significant resistance waiting overhead in the
$57-58 area (with the additional obstacle of the 200-dma just
over $58), so let's sell strikes just above that area to minimize our
chances of getting called out of our shares.  The October $60 calls
are a little too cheap to get my attention (currently priced at
$0.60), so now I need to make a decision.  I can either sell a
lower strike, limiting the upside of my long position in the
event that my fears are ungrounded, or I can sell the call with
a longer timeframe.  

Selling a longer term call is the approach that appeals to me,
because it gives me more potential upside on the play.  So I
decide to sell the January $60 calls (Symbol: MSQ-AL for $2.40
each, bringing in a total of $2400.  We could have chosen a
closer strike in a nearer expiration month, so long as the calls
we sell bring in enough premium to cover the puts we bought.
We're looking to put on the collar for no out of pocket expense.
Granted, we didn't quite accomplish that with our example, as
the collar on MSFT cost us $50.  For the benefits available from
this strategy, that's a cost I'm more than willing to accept.

It is a matter of personal preference, whether to take in more
premium now by selling a closer strike, or give the position
more potential room to run to the upside.  Since I'm primarily
concerned with protection without sacrificing upside potential
here, I want to select the higher strike.  If I'm called out of
my MSFT position in January, then so be it.  I will have
protected my gains and ended up with a solid gain for the
overall trade.

So let's review.  I own 1000 MSFT shares with a cost basis of
$42,000, and a current profit of $10280.  Selling the JAN-60
calls brings in $2400, and buying the OCT-50 puts costs $2450.
Adding it all up, gives me a hedged, profitable position with
$2330 (2280+50) of downside risk and $7720 of upside potential.
That's a reward-to-risk ratio of 3.3 to 1; a situation that will
definitely allow me to sleep at night!

Just in case the math isn't clear, let's run through some
possible outcomes, so you can check my math.

Case #1: The bottom falls out of the Software sector, and MSFT
craters, falling back to $40 at October expiration.  The long
position has lost all of its profits,...and then some!  What
originally cost me $42,000, is now only worth $40,000.  I gave
up over $10000 of profits and then lost another $2000 from
there.  So from the time of initiating the trade, my long
position lost $2,000...OUCH!  Aahhh, but don't forget about
that little insurance policy.  Those 10 $50 strike puts (that
cost us only $50 because of the covered calls we sold) are now
$10 in the money, meaning each of them are worth a cool grand.
Total profit on the puts is $10,000.  The calls are so far out
of the money now that they are next to worthless, and we could
likely buy the whole lot back for about $100.  So the worst
thing we could imagine came to pass and our loss is limited to
$2330, or 4.5% of the position value when we initiated the
collar.  Here's the math:

Cost Basis = $42,000(MSFT shares)+$2450(Puts)-$2400(Calls)
           = $42,050

Expiration Value = $40,000(MSFT shares)+$10,000(Puts)-$100(Calls)
                 = $49,900

That leaves us with a total profit of $49,900-42,050 or $7850.
The best part is that we still own the MSFT shares, and unless
the NASDAQ looks like it is headed much lower, we are set to
enjoy another nice and profitable rally.

Case #2: The economy roars back to life and MSFT announces
blowout earnings (the day before option expiration in October)
and the stock soars to $75.  Needless to say, our puts will expire
worthless, and we are in a position to pocket a portion of the
gains from our long position.  The MSFT shares are worth $75,000
now, but it will cost us $15 to buy back each of those covered
calls.  They are so deep in the money that all the value is
now intrinsic...no time value.  So if we buy back the calls, it
will cost us $15,000, leaving us with a profit on the long
position of $17,950 (75,000-15,000-42,050).  That's a profit
increase of more than $10,000 for an additional 8 weeks in the
trade.  Seems to me like the collar was a good idea.

Case #3: Finally, the most likely scenario.  The NASDAQ
continues to waffle in its current range, and MSFT is only able
to claw its way to $56 by October expiration.  Our puts expire
worthless and we are left with a nice little covered call
position.  We could then evaluate the current market condition
and decide what to do next.  By now we are through MSFT's
earnings, and if things are starting to look healthier, I might
just hold the position.  Ideally MSFT would end at $59.99 and I
wouldn't be called out of my shares.  If they closed above that
level, I would likely be called out, ending the play and locking
in my profits.  If the current cycle of earnings was looking
weak and Greenspan was starting to make noises about raising
interest rates, I might decide to just close out the play early,
buying back the calls and selling the shares, also locking in my
profits.  Either way, the collar served its purpose, allowing me
to stay in the position a little longer without putting all my
profits at risk.

There are innumerable variations to this strategy.  While we
didn't cover half the possibilities, hopefully this little
discussion gives you a glimpse of how combining options can
allow you to obtain a free insurance policy, giving yourself a
little more staying power in an uncertain market.

Until next time, protect your profits.


If you trade options online, then you need an online broker that:
offers true direct access to each option exchange offers stop and 
stop loss online option orders offers contingent option orders 
based on the price of the option or stock offers online spread 
order entry for net debit or credit offers fast option executions

PreferredTrade offers these online option trading features and 
more; call 1-888-889-9178 or click for more information.



Leigh Stephens will be back in the office on Thursday, August 22, 2002

”If you haven’t traded options online – you haven’t really traded 
options,” claims author Larry Spears in his new compact guide 

“7 Steps to Success – Trading Options Online”.

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



Calm Day in the Markets

Another boring summer day if you spent it reading six-month-old 
People magazines in the doctors office for about four hours. That 
is how I spent my day but traders were treated to three triple 
digit moves before seeing the indexes close near the highs of the 
day. Volume was very light and any serious buyers and sellers were 
able to push indexes quickly in the direction of the trade.

To read the rest of the Swing Trader Game Plan Click here:


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Contact Support
The Option Investor Newsletter                Wednesday 08-21-2002
Copyright 2002, All rights reserved.                        2 of 2
Redistribution in any form strictly prohibited.

In Section Two:
Stop Loss Updates: EDS
Dropped Calls: None
Dropped Puts: ESRX
Play of the Day: Put - GS
Big Cap Covered Calls & Naked Puts: A Necessary Respite!

Updated on the site tonight:
Market Watch
Market Posture

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Does your broker offer Stop Losses on Options?

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Stop Losses based on the option price or the stock price.
Move your trading into the next millennium with PreferredTrade.

Anything else is too slow!



EDS - Adj up from $36.50 to $38.00




ESRX $46.72 +1.83 (+4.02 for the week) ESRX has rebounded from 
its technical breakdown last week, and rallied to just below its 
50-dma.  The current level is also just below a downward sloping 
trendline beginning at the end of April.  The sudden move, 
however, has traded through our stop loss of $45.00, despite the 
stock's inability to hold over this level at yesterday's close.  
We are closing this play and will look for better opportunities. 

”If you haven’t traded options online – you haven’t really 
traded options,” claims author Larry Spears in his new compact 
guide book:  

“7 Steps to Success – Trading Options Online”.  

Order today and save 25% (only $15) by clicking on PreferredTrade 
and clicking on the link to the book on its home page.



GS – Goldman Sachs Group $79.88 -0.63 (+0.35 this week)

Company Summary:
The Goldman Sachs Group is a global investment banking and
securities firm that provides a wide range of services worldwide
to a substantial and diversified client base that includes
corporations, financial institutions, governments and high
net-worth individuals. The company provides investment banking,
which includes financial advisory and underwriting, and trading
and principal investments, which includes fixed income, currency
and commodities, equities and principal investments.  GS
recently completed the acquisition of Spear, Leeds & Kellog,
which is engaged in securities clearing, execution and market
making, both floor-based and off-floor.

Most Recent Write Up:
Highlighting our skepticism about the recent rally in the Brokerage 
sector (XBD.X), we decided to put our money where our mouth is, with a 
bearish play on shares of GS last weekend, following their meteoric 
rise off their lows of just a few short weeks ago.  Needless to say, we 
were quite pleased to see the stock continue to rise with the broad 
market yesterday, as it seemed to be setting us up for a better entry 
point.  Monday's advance came to a halt just below $82, as the bulls 
deferred to the looming 200-dma at $82.43.  Profit taking arrived on 
Tuesday, with GS promptly falling back to the $80 level, but recovering
late in the day to close above that important level.  That
presents a picture of Tuesday's decline being no more than profit
taking.  Clearly we'll need more weakness than that if our bearish
thesis about GS and the broader Brokerage sector is to prove
fruitful.  Resistance at $82 is now defined by yesterday's highs
and another failed rally below that level can be used for
initiating new positions.  But those with a more cautious stance
will want to wait for a close back under the $80 level, preferably
Friday's consolidation zone near $79.50 before jumping into new
positions.  If trading the breakdown, make sure to confirm sector
weakness, looking for the XBD to decline back under the $408
level.  We're keeping our stop in place at $82.50 tonight.

Why This is Our Play of the Day:

GS finally experienced the breakdown we were looking for, as the 
investment banks were downgraded by Salomon Smith Barney this morning.  
The reason for the downgrade was in line with what OI has been saying 
all along. The stocks have passed logical valuations, and are 
overextended.  GS broke below support at $80, and a look at today's 
short-term chart (10 minute) shows $80 now acting as resistance to the 
upside.  The stock traded as low as $78.40, before riding a broad 
market rally back up over $79.  This break in support, however, is all 
the stock should need to re-test prior resistance at $77.00, and then 
head toward previous support at $75.

BUY PUT SEP-80*GS-UP OI=3553 at $3.50 SL=1.75
BUY PUT SEP-75 GS-UO OI=6550 at $1.90 SL=1.00

Average Daily Volume = 5.64 mln

If you trade options online, then you need an online broker 
offers true direct access to each option exchange
offers stop and stop loss online option orders
offers contingent option orders based on the price of the 
option or stock
offers online spread order entry for net debit or credit
offers fast option executions

PreferredTrade offers these online option trading features and 
more; call 1-888-889-9178 or click for more information.



A Necessary Respite!
By Ray Cummins

The editor of the "Big-Caps" section is on hiatus from the market
this week, but he has generously provided an educational narrative
on one of the most popular strategies among conservative traders.

Understanding LEAPS and Covered-Calls

One of the most popular techniques among conservative investors
that participate in the options market is the strategy of writing
covered-calls on LEAPS.  For those of you who are not familiar
with LEAPS, or Long-term Equity AnticiPation Securities, they are
simply options with expiration dates far in the future.  LEAPS
are available for the year 2004 and, as with other standard equity
and index derivatives, these unique instruments allow investors to
establish bullish, bearish and neutral-outlook positions using the
most popular trading techniques and combinations.  In most cases,
strategies involving LEAPS do not differ much from those utilizing
shorter-term options and LEAPS can also be an ideal investment
tool for the option trader who expects future growth in an
underlying stock but does not want to make the substantial capital
outlay required for entering an outright position in the issue.
Since the expiration dates for LEAPS are months or even years in
the future, time decay occurs very slowly with these options and
they are much less affected by premium erosion; the fundamental
drawback in the use of derivatives to stock positions.  This
unique quality allows these instruments to offer an effective
way to benefit from a stock's appreciation without incurring the
higher costs associated with the actual purchase of shares.
Indeed, buying LEAPS is considered an excellent strategy for
conservative investors because it finds the happy medium between
aggressive, short-term option trading and simply owning the
underlying issue.

Covered-call writing is a stock-option trading strategy that many
traders use when they are trying to establish a conservative risk
versus return profile, while maintaining a meaningful profit
potential, in neutral to bullish market environments.  An investor
will usually write a covered call to generate income, collecting
a premium for the sale of an option against a particular stock in
his portfolio.  This strategy can also be used with LEAPS, but it
differs because it does not involve direct ownership of shares of
the underlying stock; LEAPS are substituted for the long position.
The technique is similar to a calendar spread (or time spread); a
position that involves the sale of one call and the simultaneous
purchase of another call, both on the identical underlying stock,
with the same strike price, but with one option near-term and the
other option further out.  The theory behind a calendar-spread is
based on a neutral-outlook philosophy in which time erodes the
value of the near-term option at a faster rate than the far-term
option.  Using LEAPS in a calendar spread can make the strategy
even more productive because the premium in extremely long-term
options is less affected by time-value erosion and any near-term
volatility in the underlying issue can increase the price of the
sold (short) options.

Selling Time for Profit

One of the most conservative combination positions is the calendar,
or time spread.  This type of spread benefits from the rate of
decay in the time value of the short-term option.  Also commonly
known as a horizontal spread, the position involves the purchase
of an option with one expiration date and the sale of another
option with the same strike price but a different expiration date.
A spread that is established when the stock is at (or near) the
strike price of the target options is a neutral spread and if the
stock price remains relatively unchanged until the near-term option
expires, the position will earn a profit.

It is important to understand how a calendar spread profits from
the passage of time.  When opening a horizontal spread, a long-term
option is purchased and a short-term option is sold.  Both options
have the same exercise price, thus they have the same intrinsic
value.  Regardless of the movement of the stock, time value will
always be less in the near term option.  As long as the underlying
stock price remains relatively close to the exercise price, the
value of the spread will be determined by the time premium of each
option.  When the position is closed at expiration, the remaining
time value in the short-term option will be very low relative to
that of the long-term option.

Calendar Spread (Time Erosion) Example:
XYZ Stock Price = $10.00

1  month  $10 call option = $1.00
4  month  $10 call option = $2.00
9  month  $10 call option = $3.00
16 month  $10 call option = $4.00


Buy 16-month call option for $4.00
Sell 1-month call option for $1.00
Cost basis = $3.00

Outcome After 1 Month (with XYZ Stock Price Unchanged at $10)

One month call option     = $0.00
Three month call option   = $1.73
Eight month call option   = $2.82
Fifteen month call option = $3.87

Position Profit = $0.87 on $3.00 invested (with no movement in
the underlying stock).

To the average trader, it would appear this technique couldn't
lose.  One would simply buy the longer-term option and sell
the shorter-term option.  As both time values decayed, the
position would gain value.  In reality, it's rarely that easy
because the underlying stock does not remain constant and since
the profitability of this strategy is determined by the relative
behavior of time-value decay in each of the option positions, it
is important for the underlying issue to remain near the strike
price; where time premium is theoretically the highest.  If the
stock price is at a high or low extreme, the time values of both
options will be relatively small and the position will likely
incur a loss; the remaining credit will be less than the opening
debit.  One way to reduce the negative effects of a volatile
stock is to establish the play at least 2 to 3 months before the
near-term option expires, capitalizing on the ability to sell a
second position against the longer-term option.  Another method
that can increase the probability of profit in this strategy
requires an understanding of implied volatility (premium) in
option pricing, whereby a trader can take advantage of pricing
disparities to create the best possible position.  Using this
approach, traders try to initiate new plays when there is excess
value in the sold option, or a discount in the purchased option,
thus ensuring a position with a theoretical edge.

Using the Calendar Spread with LEAPS

Covered-calls with LEAPS positions can be constructed for any
market outlook or bias on both volatile and less active issues.
The strategy is best initiated when the front-month options are
trading at a premium with respect to longer-term volatility.
Most investors prefer to establish these positions at least 6-9
months before the LEAPS expire, capitalizing on the ability to
sell a number of short-term options against the longer-term
option.  Writing calls against the LEAPS on a regular basis helps
reduce the overall cost basis of the position as each short-term
option expires.  Ideally, the trader would like to have the stock
finish just below the sold strike price when the near-term option
expires but if the short-term position is "in-the-money" on the
last day of the strike period, you must buy it back so that you
don't have to exercise the LEAPS to cover your obligation; that
would defeat the purpose of the strategy.  Of course, there is
always a risk of early exercise in a calendar spread, especially
when the sold option is "in-the-money."  The degree of risk
depends on which options are bought and sold and the distance to
the underlying stock price.  The greater the time value in the
sold option, the lower the probability of it being exercised.  If
an early assignment occurs, a trader can fulfill the obligation
by simply purchasing the underlying stock or an offsetting option.
The more important issue is to be notified by the broker in a
timely manner, so that the appropriate action can be taken before
the stock price changes significantly.

There are a number of advantages to buying LEAPS in directional
plays and selling monthly premium against the long-term options
can significantly improve the overall performance of the position.
In addition, the profit potential in this conservative strategy is
very favorable and the investor who is unfamiliar with combination
trading can use the strategy to learn the some of the basics of
option pricing, such as delta and premium decay in a low risk
environment.  The concept of the calendar spread is very easy to
understand and once established, the position can be managed with
little difficulty.  The occasional adjustments also provide the
necessary background for more advanced techniques and those who
enjoy directional trading can construct positions to fit their
personal style.  Although the potential for large gains is less
than some of the more popular trading strategies, the limited
capital exposure and relatively consistent returns in time-selling
positions offers a more attractive approach to the options market
for the majority of investors.

Until Next Week...


Putting On Our Horns

To Read The Rest of The OptionInvestor.com Market Watch Click Here


Eyes Peeled on 50-dmas

To Read The Rest of The OptionInvestor.com Market Watch Click Here


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