Lights On but Nobody Home
Bulls and bears returned to their screens on Monday full of anticipation. The first real decline in several weeks closed on Friday with the indices actually oversold on an intraday basis with prices just beginning to tick up. All were on the alert for an expected bounce. The Fed added $9 billion in overnight repurchase agreements, which yielded a net gain of $6.5 billion available to the market. With no economic reports, many were expecting a sizeable bounce.
Amer. Intl Group - AIG - close: 54.85 chg: -0.24 stop: 52.95
No change from our previous update on 06/05/05. We are still looking for AIG to dip toward the $54.00 level before continuing higher.
Picked on May 26 at $ 55.05
Caterpillar - CAT - close: 94.15 chg: +0.18 stop: 89.99
No change from our update on 06/05/05. We would watch for CAT to pull back toward the $92 level.
Picked on May 18 at $ 92.35
Career Education - CECO - close: 35.45 chg: +0.63 stop: 32.45
No change from our previous update on 06/05/05. CECO remains stuck in its trading range between $34.00 and $35.50.
Picked on May 23 at $ 35.24
Rockwell Collins - COL - close: 48.96 chg: -0.26 stop: 44.95
No change from our previous update on 06/05/05. COL's momentum is starting to stall and its MACD is very close to producing a new sell signal. We are suggesting a trigger to go long the stock on a pull back toward the 100-dma. Currently we're suggesting a bullish entry in the $46.25-45.50 range.
Picked on May xx at $ xx.xx <-- see TRIGGER
Reynolds American - RAI - cls: 82.97 chg: +0.30 stop: 78.75
No change from our previous update on 06/05/05. RAI continues to trade under resistance in the $83.40 region.
Picked on May 16 at $ 81.31
Teekay Shipping - TK - close: 44.40 chg: +0.19 stop: 42.45
Almost open. TK is still trading above its 200-dma but remains under what looks like resistance at the $45.00 mark and its 100-dma. We are suggesting that readers use a trigger at $45.05 to open the play.
Picked on June xx at $ xx.xx <-- see TRIGGER
United Technologies - UTX - cls: 106.95 chg: +0.70 stop: 102.45
No change from our previous update on 06/05/05.
Picked on May 23 at $106.25
Wellpoint Inc - WLP - close: 67.80 chg: -0.60 stop: 64.90
No change from our previous update on 06/05/05.
Picked on June 05 at $ 68.40
MedcoHealth Sol. - MHS - close: 50.69 change: +0.35 stop: 52.21
Uh-oh! MHS did it again. The stock dipped intraday below our suggested entry point to buy puts and then rebounded again back above the $50.00 level. The fist time our suggested entry was a move under $49.90. The second time was a decline under $49.50. We remain bearish on the stock given its broken up trend but this oscillation between $49 and $51 is testing our patience. We would not consider new bearish positions with MHS trading above the $50 level.
Picked on June 01 at $ 49.90
United Thera. - UTHR - close: 47.95 chg: -1.18 stop: 51.26
Target achieved. UTHR lost another 2.4 percent on above average volume to break down below the recent lows and trade into our target range of $48.25-47.50. The move was partially fueled by a press release from Pfizer today. PFE announced that the FDA has approved a new pill for PAH or pulmonary arterial hypertension. This new pill from PFE will compete with several other available therapies on the market and one of them is an injected treatment made by UTHR. We are closing the play at $48.25. We would not hold on to bearish positions as UTHR is nearing what looks like heavy support near $47.50, which is also bolstered by its simple 100-dma.
Picked on May 24 at $ 53.38
The Combination Double Credit Spread
Playing the middle against both ends, with insurance of knowing what you maximum risk will be.
The Theory behind the PracticeSometimes it is better to play the middle against the ends, especially when you have a stock that you feel is really not going anywhere or is stuck in a trading range. The combination double spread works similar to the straight naked combination. However, you can tell by its namesake that this is going to be a lot safer transaction than selling naked calls or puts. Basically, we are establishing risk and rewards with the anticipation that our stock will trade in a range and have both our call and credit spread expire worthless and keep the premiums. The strategy for this trade came about when in 1987 and again in the great Tech Wreck, individual traders would love to sell naked combinations and have a stock trade between a given trading range with both the written call and put expiring worthless and the seller collecting both sides of the premium. However, if one feels that naked call and put combination writing is the way to go, let me remind you of what can happen if you are NAKED the call or the put side. Unlimited losses on the call side and devastating losses on the put side. I only need to mention several high tech issues that fell by the wayside and told many a trader's account values along with them
The combination double spread alleviates the fear of the catastrophic crash or untimely buy out or merger. The strategy is very simple instead of trading anything naked you put on two credit spreads, one on each side of the market using puts and calls. Examine this hypothetical situation for a moment.
Let's say you think company MANX is going to lay flat in a trading range or slightly move up or down very little in the next 30-45 days. Well here is a little strategy that you might want to try with several issues, especially if you have a strong feeling that their performance is going to take them no where fast. Let's say MANX is trading at 65 and has been in a trading range between 60 and 70 for the last 6 months. In fact, the whole market has seemed to be just going nowhere, but you want to profit from this stagnation.
Well here's your opportunity. What we are going to do is to sell a MANX call spread
Sell 10 MANX Jun 70 Calls to Open @ 3 and
This we can do for a net credit of 2 times 10 contracts or a total net credit of $2,000
Sell 10 MANX Jun 60 Calls for 2.75 and
This we should be able to do for a net credit of 1.75 times 10 credits or a net credit of $1,750.
This should give us for the two spreads or 4 transactions a Total net credit of $3,750.
Now our goal here is to have MANX, which was trading at 65 when we made our trade, to close at the end of the June expiration between 60 and 70. If this happens all the options expire worthless and we keep the premiums.
MARGIN ISSUE: Although MANX cannot close at both above 70 and below 60 at the same time. The margin requirement for this trade is the difference between the strike prices and the premium received. Unfortunately, unlike a naked combination, where you are only marked against the mark on one side, you must put up the margin requirement for both the call and the put side. (Just a house requirement, doesn't make much sense, as they can at best only go against you on one side.). Anyway, the house requirement would be $300 per contract times 10 on the call side and $325 per contract times 10 on the Put side for a total margin requirement of $6,250. However, the most you would ever be at risk is $5000, which is the difference between the two strike prices on either side. Remember MANX can't close BOTH above $70 and below $60 on expiration. MANX can only close at one price. So one of the sides has to expire worthless. So your net loss would be $5000 less then $3,750 premium you received on an out of pocket maximum loss of $1,250.
IMPORTANT: It is important to put both sides of the trade on at the same time. This can get a little sticky if you try to be too cute with your entry points. If at all possible enter all 4 trades with a total net credit. This way if all 4 transactions do not get executed you will not be left owning one side of the spread, while failing to execute the other side, which may now have gotten away from you. Secondly, do not try to guess which way the market is going to go and try to leg on these positions one at a time or by buying the long positions and then selling the shorts. You may guess right, but if you don't the whole rationale for the trade is gone and you might end up not getting enough premium as you thought or enough to make it a viable play.
Anyway, if MANX closes between 60 and 70 you keep the premiums. If it closes above 70 or less then 60 your loss is $1275 (plus transaction fees, but no more, even if the stock goes to zero or up to infinity.)
The perfect strategy for the stagnate market.
Now that you understand the theory, lets look at an actual scenario that you can follow
The Real World Example: Actual Date April 20, 2005
CHART 1: YAHOO
Yahoo trading at 34.75
Let's take a look at this strategy using the issue Yahoo. For this transaction, we will be looking at the June series. We will put on the following credit spreads:
Buy (Long) Yahoo Jun 40 call @ 0.30 = $30 Debit
This gives a net credit of $0.60 = $60
Sell (Short) Yahoo Jun 32.50 put @ $0.60 = $60 Credit
This gives us a net credit of $0.40 = $40
Our total credit from both spreads is $2,000
10 Buy (Long) Yahoo Jun 40 call @ 0.30 = $30 Debit
TOTAL NET CREDIT = $2,000
In addition lets see what are maximum gain, maximum loss, breakeven and margin requirements look like after we have successfully put on this trade.
FIGURE 1: Combination Double Credit Spread
As you can see, here is the position laid out when successfully executed. I have included the Margin requirement, the maximum gain, maximum loss and the two (2) breakeven prices. (Remember, you have a range where the trade will be totally profitable and you will keep the $2,000 premiums.
In figure 2 below you will see a complete breakdown as to how this options will act at expiration time the third Friday in June. To get a better idea I have indicated the maximum gain and loss at each possible price that the stock could close on the June expiration.
FIGURE 2: A CLOSER LOOK AT THE DOUBLE COMBINATION IN ACTION
From the chart above we can see that if Yahoo closes on the June expiration anywhere between 32.50 and 37.50 we will keep the entire $2000 premium.
NOTE: The yellow in the chart above clearly shows the profit and loss at each price the stock could close at on the June expiration.
Also note that the maximum losses do not get any larger no matter how high or low the stock should go below or above the breakeven points
Please understand that no matter how high Yahoo may climb or how low Yahoo is able to sink. Your maximum exposure is only $3,000. Even though your margin requirement is $8,000.
The Bottom Line:
In recap, this strategy offers an option individual the opportunity to take advantage of a stagnate market, while carefully avoiding any type of unforeseeable major move or surprise on either the upside or the downside. This is the type of trade that let's you stay in the market and hopefully adds to your gains when the market goes through one of its many lulls.
Until Next Time
Today's Newsletter Notes: Market Wrap by Jonathan Levinson, Options 101 by Steve Gail, and all other plays and content by the Option Investor staff.
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