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Daily Newsletter, Monday, 07/25/2005

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Options 101

Market Wrap

The Session That Almost Wasn't

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The Session That Almost Wasn't

If volume was any indication, market participants just stayed in bed today, putting in one of the lightest days of the year. Combined exchange volume was less than 2.8 billion shares, and QQQQ barely edged past the 50 million share mark. Breadth was mixed during the session but finished negative, with 2.07 declining shares for each advancing on the NYSE and 1.83 in the red on the Nasdaq for each advancing.

Light volume and thin markets can facilitate sudden moves, as any penny stock trader can attest, but the index ranges remained narrow as the markets drifted through another day of summer doldrums. Crude oil rose strongly, building on Friday's gains, while treasury bonds declined following an abysmal Treasury bill auction announced at 1PM.


Index volatility remained in the cellar, despite minor bounces as the indices plumbed the session lows. Characteristic of this July's rally, new highs were reached by some indices while others languished. The SPX was today's beneficiary, touching levels not seen since July 2001 before reversing this morning. The CBOE total put to call ratio opened at very low levels, as it has done several times in recent weeks, with today's first half-hour's reading a mere .55. The daily cycle indicators for the Dow, Nasdaq and SPX are trembling on the brink of a new downphase from overbought. Oil has been relentlessly bullish, as have treasury bond yields, and today's Treasury auction was poorly received (see below). Overall, these factors mandate caution for bulls and suggest impending bearish opportunity. But the price refuses to break down, as it has all month.

Daily Dow Chart


The Dow ran to a session high at 10686 in the morning before reversing in a decline that filled the remainder of the session, touching a low of 10591 and closing -55 at 10596. While price has been sliding sideways between 10570 and 10680 for the past week, the daily cycle indicators have begun to roll over from the top of their July range. As discussed in the Market Monitor, longer cycles tend to take longer to turn, and in this case it appears that the week-long sideways range would be the daily cycle making its turn. As well, the weekly cycle (not shown) is also in a top zone. If this interpretation is correct, then last week's highs should not be exceeded by much, if at all, and not on a daily closing basis. A break of 10560-70 support on a closing basis would confirm a new daily cycle downphase.

I have highlighted bear wedges on the daily chart, but am not very confident in the July wedge. A bounce from 10560 could turn the pattern into a bear flag. Unlike in June, when the wedge break was followed by an immediate, sharp drop, the current support break has been followed by more light-volumed, sideways chop.

Daily S&P 500 Chart


The SPX tagged a 4 year high today at 1238.36 before reversing to an afternoon low of 1228.15. The SPX was the strongest of its peers today, finishing lower by a mere 4.65 points at 1229.03. Like the Dow, the SPX is on a preliminary daily cycle sell signal, awaiting a support line break to generate the Macd confirmation. What was for the Dow last week a sideways range was a pattern of higher lows for the SPX. Today's break to new highs was quickly sold in a gravestone doji, not a bullish print. But the light volume and higher low are not the stuff of which daily cycle sell signals are made, and as with the Dow, SPX bears will need to see some downside price action below 1225 to confirm a new rollover.

Daily Nasdaq Chart


The Nasdaq peeked its head above 2180 but didn't like what it saw, reversing from a high of 2186.46 to hit a low of 2165.93, closing -13 at 2166.74. The daily cycle is in the first stages of a possible rollover, also awaiting Macd confirmation on a close below the recent range- in this case, 2160 is key support. Again, if this bearish interpretation is valid, then last week's high should not be exceeded.

Daily TNX Chart


The Treasury auctioned $19 billion of 13-week bills and $17 billion of 26-week bills. The 13-week auction generated a high-rate of 3.345% and a bid-to-cover ratio of 1.94. This was the highest high-rate and the weakest demand in several years, below the averages going back to 2000. The 26-week auction generated a high-rate of 3.54% and a bid-to-cover of 1.93, again the highest yield and weakest demand in years. Foreign central banks took a respectable $9.1 billion of the $36 billion total.

The weak demand at the 13- and 26-week auctions was matched by higher yields for ten year notes as well, with the TNX rising 2.4 bps to close at 4.247%. On the daily chart, the TNX retraced Friday's decline but fell short of the Thursday high. With the daily cycle indicators looking for an imminent top, bond bears/yield bulls will want to see the TNX hold above 4.2%, targeting last week's highs in the 4.3% area.

Daily Chart of Crude oil


Crude oil gapped higher from Friday's close and declined as China reported weaker than expected demand growth for the month of June. Tropical depression Gert made landfall, with no major disruptions, but this remains the most aggressive start to the annual Atlantic hurricane season on record, having shut in over 6 million barrels of Gulf of Mexico output so far.

September crude oil futures pulled back quickly, filling the opening gap to a low of 57.70, following which they ran higher to close above Friday's high and one tick below the day high of 59.025, +.35 from its gap up open at 59. So far, the daily cycle downphase has been getting very poor price traction, with Friday-Monday's one-two punch stalling the 10-day stochastic well above overbought territory. A clean break above the 22 day EMA targets confluence to 60.75, and would abort the daily cycle downphase early in its run.

Today's lone economic report was Existing Home Sales, released at 10AM. The National Association of Realtors reported that sales of previously-owned homes rose 2.7% to a record annual rate of 7.33 million units. Last month's 7.13 million units were adjusted 7.14 million. Expectations for this month's figure were for 7.15 million. However, inventories rose as well, with the number of unsold homes on the market increasing 3.8% to 2.653 million units, or a 4.3 month supply at current rates. The middle sales price is up 14.7% from June 2004 to a record $219,000.

Tomorrow, we'll get July Consumer Confidence, following which the schedule heats up with Durable Orders, New Home Sales and Fed Beige Book on Wednesday. On Thursday, it's Initial Claims and the Help Wanted Index, and on Friday, the GDP, Chain Deflator, ECI, Michigan Sentiment and Chicago PMI.

Xerox (XRX) reported a rise in earnings and revenue for Q2, reporting earnings of $408 million or 40 cents per share on revenue of $3.92 billion. The company had earned 21 cents or $187 million on revenue of $3.85 billion in Q2 2004. Consensus estimates for the current quarter were 23 cents on revenue of $3.86 billion. Net of a 33 cent per share one-time tax gain and a 13 cent per share restructuring charge, the company earned 20 cents, 3 cents below estimates. Following what has been a recurring theme this earnings season, the company stated that it sees Q3 earnings of only 16-18 cents, well below the previously forecast 22 cents. XRX got smoked on the news despite the mainstream press' emphasis on the 2% increase in revenue, losing over 7% in premarket trading. For the day, XRX closed -6.05% at 13.20.

Wal-Mart (WMT) grabbed early morning headlines, announcing its intention to double its presence in China by the end of 2006 and its expectation of double-digit sales growth in that market. WMT has been building new stores in China at an increasing pace following Beijing's abolition of a requirement that foreign companies have a local partner. While WMT did not offer figures for its sales growth in 2004, Reuters reported that Chinese government data shows a 31% increase in sales to 7.6 billion yuan or $940 million. As of December 2004, WMT had 43 stores in China, and intends to reach 55 stores by the end of 2005 and 90 by December 2006. Worldwide, WMT has approximately 5,000 stores. WMT closed lower by 13 cents at 49.41, off a low of 49.31.

In merger news, Teva Pharmaceuticals (TEVA) announced its agreement to acquire Ivax (IVX) for $7.4 billion, pursuant to which IVX holders will receive $26 per share in cash, a 13/6% premium to IVX's close on Friday, or .8471 American Depositary receipts in TEVA. TEVA expects no more than 50% of IVX shareholders to select the cash option, and the deal is subject to proration. TEVA and IVX are two of the largest generic drug companies, and the deal awaits antitrust clearance in Europe and the US. The deal is expected to generate synergies of $150 million within 2 years, with anticipated combined sales exceeding $7 billion. Following the announcement, S&P placed TEVA and its associated entities on credit watch "negative," stating that it sees challenging conditions ahead for generic drugmakers as well what it perceives as excessive debt levels that would be used to fund the acquisition. TEVA closed +.04 at 31.20, while IVX gained 10.1% to close at 25.19.

BellSouth (BLS) reported Q2 earnings from continuing operations that declined from Q2 2004's $996 million or 54 cents to $795 million or 43 cents. Including its participation in the Cingular/SBC venture, BLS earned $849 million or 46 cents on revenue which rose 27% to $8.52 billion, topping estimates of 43 cents and $8.49 billion. The company added 124,000 high-speed internet accounts in Q2, which Reuters reported was "well-below" forecasts. BLS gained 8 cents to close at 26.80.

American Express (AXP) reported in the early afternoon, announcing Q2 earnings of which rose 14% from last year's Q2 $876 million or 68 cents to $1 billion or 81 cents. Revenue rose from $7.2 billion to $8 billion in the current quarter. These results beat estimates of 78 cents and $7.78 billion on revenue, and the stock closed down a penny at 54.56.

After the bell, Altera reported lower Q2 earnings, declining from 20 cents or $75.3 million to $67.6 million or 18 cents in the current quarter, on revenue that rose from $269 million or $285.5 million. Estimates were for 18 cents on $277 million revenue. The stock was up 2 cents at 22.55 as of this writing, building on its 33 cent gain to 22.53 during the regular session.

Netflix (NFLX) reported a 53% jump in subscribers, with earnings nearly doubling to $5.7 million or 9 cents from last year's Q2's $2.9 million or 4 cents. EPS beat estimates by 8 cents. Revenue jumped 37% to $164.5 million, beating estimates of $163.5 million. NFLX was up 7.37% or 1.25 in afterhours trading at 18.21 as of this writing.

Texas Instruments (TNX) was the much-anticipated report afterhours, beating EPS expectations by 3 cents and coming in at 32 cents (net of tax-related items), with revenue rising 9% to $3.24 billion. Operating profit was $669 million, a record high. The company announced its intention to raise its dividend 20% to 12 cents per share annually, along with q $2 billion stock repurchase. The stock, which had closed -.16 at 30.60, was still halted as of this writing after trading +.20 afterhours at 30.80.

For tomorrow, bulls will continue to watch their stops and bears will continue to angle for those lower lows and lower highs which have so far eluded them. Forgetting the secondary indicators noted above, the cycle picture is becoming less bullish as the price holds its current ranges. The one component eluding bears continues to be the price, which steadfastly refuses to break. With earnings flying fast and furious, and mostly positive, the impetus may be a bunker-buster from one of the biggies this week. If last week's Dow/Nasdaq or today's SPX highs are broken with authority, then the bulls fondest wishes will be on track to come true. But barring that, the benefit of the doubt should begin shifting toward the bears' favor.
 

 
 




New Plays

New Option Plays

Call Options Plays
Put Options Plays
None AZO
  BBY
  FNM
  KBH

New Calls

None today.
 

New Puts

AutoZone - AZO - close: 98.13 chg: -1.01 stop: 100.01

Company Description:
As of May 7, 2005, AutoZone sells auto and light truck parts, chemicals and accessories through 3,505 AutoZone stores in 48 states plus the District of Columbia in the U.S. and 73 AutoZone stores in Mexico and also sells the ALLDATA brand diagnostic and repair software. (source: company press release or website)

Why We Like It:
Now that the broader stock market averages are showing a little weakness it is easier to see that we could be on the verge of a more pronounced consolidation lower. Thus if the markets are poised to move lower we like the odds of buying puts on AZO here. The stock has rallied toward resistance in the $100 region and a failure here could produce a double-top pattern. Technical oscillators like the RSI and stochastics are already turning lower and its MACD is hinting at a new sell signal soon. We will suggest new bearish positions here with a stop loss at $100.01. More conservative traders may want to wait for a decline under $97.50 before opening positions. Our target is the 50-dma near $92.50.

Suggested Options:
We like the September puts.

BUY PUT SEP 100.00 AZO-UT OI= 531 current ask $4.10
BUY PUT SEP 95.00 AZO-US OI= 461 current ask $1.95
BUY PUT SEP 90.00 AZO-UR OI=2048 current ask $0.90

Picked on July 25 at $ 98.13
Change since picked: - 0.00
Earnings Date 09/20/05 (unconfirmed)
Average Daily Volume = 748 thousand

---

Best Buy Co - BBY - close: 73.61 chg: -1.30 stop: 76.61

Company Description:
Best Buy Co., Inc. is an innovative Fortune 100 growth company that continually strives to create superior customer experiences. Through more than 840 retail stores across the United States and in Canada, our employees connect customers with technology and entertainment products and services that make life easier and more fun. We sell consumer electronics, home-office products, entertainment software, appliances and related services. A Minneapolis-based company, our operations include: Best Buy (BestBuy.com and BestBuyCanada.ca), Future Shop (FutureShop.ca), Geek Squad (GeekSquad.com) and Magnolia Audio Video (Magnoliaav.com). (source: company press release or website)

Why We Like It:
This play here in BBY is very similar to the one in LEH. Both have been very strong stocks over the past several weeks and both look extremely overbought and extended and way overdue for some profit taking. Both plays are also very speculative and should only be played with high-risk money. The challenge is whether or not investor's urge to lock in profits will overpower those bulls still on the sidelines looking to buy the next dip. We believe that with the broader market averages poised to turn lower after last month's rally that BBY will turn lower as well. Yet just to be sure we're going to use a trigger at $73.25 to open the play. Until BBY trades at our trigger or lower we'll sit out. There could be some support near the $70 level but we're going to target the 40-dma currently at $67.00 (and we'll adjust the target higher as the 40-dma climbs). It is worth noting that BBY is due to split its stock 3-for-2 on August 4th and that will probably impact the change in option values (and the symbols).

Suggested Options:
We are going to suggest the September puts.

BUY PUT SEP 75.00 BBY-UO OI=2658 current ask $3.90
BUY PUT SEP 70.00 BBY-UN OI=3630 current ask $1.80
BUY PUT SEP 65.00 BBY-UM OI=9455 current ask $0.80

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 06/14/05 (confirmed)
Average Daily Volume = 3.3 million

---

Fannie Mae - FNM - close: 57.51 chg: -0.89 stop: 59.51

Company Description:
Fannie Mae is a New York Stock Exchange Company. It operates pursuant to a federal charter. Fannie Mae has pledged through its American Dream Commitment to expand access to homeownership for millions of first-time home buyers; help raise the minority homeownership rate to 55 percent; make homeownership and rental housing a success for millions of families at risk of losing their homes; and expand the supply of affordable housing where it is needed most. (source: company press release or website)

Why We Like It:
It has been a rough year for FNM shareholders and it looks like the stock is poised to turn lower yet again. The rally from its April lows is starting to look more and more like an oversold bounce. If you look at the chart you can see that the rally stalled under its exponential 200-dma and near its 50% retracement level. Today's breakdown under the simple 50-dma looks like a new bearish entry point but we want to be sure. We're going to suggest a trigger at $56.49 to open the play. This is under potential technical support at the 100-dma near $56.75. Our target will be the $51.50-50.00 range.

Suggested Options:
The only options we could find were January strikes. These are for January 2006.

BUY PUT JAN 60.00 WFN-ML OI=11178 current ask $4.80
BUY PUT JAN 55.00 WFN-MK OI=17631 current ask $2.50
BUY PUT JAN 50.00 WFN-MJ OI=32419 current ask $1.25

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 00/00/05 (unconfirmed)
Average Daily Volume = 3.3 million

---

KB Home - KBH - close: 80.00 chg: -3.45 stop: 82.51

Company Description:
Building homes for nearly half a century, KB Home is one of America's premier homebuilders with domestic operating divisions in some of the fastest-growing regions and states: West Coast-California; Southwest-Arizona, Nevada and New Mexico; Central-Colorado, Illinois, Indiana and Texas; and Southeast-Florida, Georgia, North Carolina and South Carolina. Kaufman & Broad S.A., the Company's publicly-traded French subsidiary, is one of the largest homebuilders in France. In fiscal 2004, the Company delivered homes to 31,646 families in the United States and France. (source: company press release or website)

Why We Like It:
We are actually bullish on the homebuilders but it looks like the rally is running out of steam. The DJUSHB home construction index has failed to rally past the 1100 mark for the last two days and its technical indicators have turned bearish. Meanwhile KBH has also shown similar indicators that it's about to turn lower with a new MACD sell signal and weakness in its RSI and stochastic indicators. We want to remind readers that bearish positions on the homebuilders have been very risky over the past couple of years. The group has been incredibly strong and leaving a wake of injured bears in its path. This is a speculative play based on how the major stock indices look and the technicals on KBH. The trend is still very much up for the stock. Our concern is that when it drops it will probably drop quickly. More conservative traders may want to wait for the DJUSHB index to close under the 1050 level first or wait for KBH to trade under its 21-dma before initiating bearish positions. Our suggested entry point will be at $79.85. Our short-term target is the $75.00 level. FYI: one of the biggest risks in this play are upcoming earnings from fellow homebuilders. One to watch for is PHM who reports on July 27th.

Suggested Options:
We are going to suggest the September puts although August puts will probably work and have more open interest.

BUY PUT SEP 80.00 KBH-UP OI=692 current ask $4.20
BUY PUT SEP 75.00 KBH-UO OI=443 current ask $2.25

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 09/15/05 (unconfirmed)
Average Daily Volume = million
 


Play Updates

In Play Updates and Reviews

Call Updates

Las Vegas Sands - LVS - close: 39.00 chg: -1.30 stop: 36.99

Ouch! The market weakness today sparked a round of profit taking in LVS and the stock lost 3.2 percent. The drop back under the $40.00 level and its 100-dma and exponential 200-dma is technically bad news. We would watch for a rebound from the $38.00 or $38.50 levels as a potential bullish entry point. However, readers should keep in mind that the broader market indices look poised for further losses and this could exaggerate any downward consolidation in LVS.

Picked on July 21 at $ 40.31
Change since picked: - 1.31
Earnings Date 08/03/05 (confirmed)
Average Daily Volume = 934 thousand

---

Pediatrix Med Group - PDX - cls: 77.73 chg: -0.18 stop: 74.25

PDX continues to inch higher with its slow and steady pace. The stock hit another all-time high today at $78.54. Shares did lose their early gains and we would be prepared for a dip back toward the simple 10-dma near $76.85. Our target is the $80-82 range.

Picked on July 11 at $ 76.10
Change since picked: + 1.63
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 158 thousand
 

Put Updates

Infosys Tech. - INFY - cls: 71.54 chg: -0.66 stop: 75.01

Good news! The rally in INFY stalled at $72.60 and today's decline back under its simple 50-dma might be used as a new bearish entry point. More conservative traders may want to wait for a little more confirmation before buying puts. We do notice that after a day of churning sideways between $72.00 and $72.50 shares of INFY finally broke down in the last 30 minutes of trading. Our target is the $62-60 range.

Picked on July 20 at $ 69.92
Change since picked: + 1.62
Earnings Date 07/12/05 (confirmed)
Average Daily Volume = 922 thousand

---

Lehman Brothers - LEH - cls: 106.03 chg: -0.97 stop: 108.01

The market weakness managed to stall the rally in LEH today so our very speculative put play remains alive for now. We see no changes from our weekend update.

Picked on July 21 at $105.13
Change since picked: + 0.90
Earnings Date 06/14/05 (confirmed)
Average Daily Volume = 2.7 million

---

3M Co. - MMM - close: 74.17 change: -0.54 stop: 77.51

No change from our previous update. MMM continues to look weak. News that MMM has purchased Mercury Online Solutions did not appear to affect the stock price of MMM. Our target is the $70.00-68.00 range.

Annotated Chart:
Picked on July 19 at $ 74.29
Change since picked: - 0.12
Earnings Date 07/18/05 (confirmed)
Average Daily Volume = 3.4 million

---

Children's Place - PLCE - cls: 46.61 chg: -0.03 stop: 47.51

PLCE is trying really hard to rally but the bulls are struggling with the stock's six-week trend of lower highs. The rally today stalled under the $48.00 level near its simple 50-dma. We are currently still on the sidelines waiting for PLCE to breakdown under the $45.00 level and produce a new P&F chart sell signal. Our suggested entry point is $44.90.

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 08/11/05 (unconfirmed)
Average Daily Volume = 775 thousand
 

Dropped Calls

Reynolds American - RAI - close: 84.12 chg: +0.20 stop: 79.99

Target achieved. RAI spent most of the day trading sideways in a 45-cent range but this was after its spike to $84.42. Our target is the $84.00-85.00 range so we are closing the play. Don't forget that RAI is due to report earnings on July 27th. We would not hold over the report.

Picked on July 10 at $ 78.83
Change since picked: + 5.29
Earnings Date 07/27/05 (confirmed)
Average Daily Volume = 664 thousand
 

Dropped Puts

None
 


Options 101

Think Twice Before Going Naked

If you ever had the urge of selling "naked" puts or calls for the premium, take a good hard second look before you leap.

The Theory behind the Practice

The concept of the options market was originally created around the concept that the owners of stock could generate added income for their stock if they could entice individuals who did not or could not own significant shares of stock that they could participate in the stock market by giving these individuals an opportunity to control stock issues just like themselves. The inducement was to give these individuals a contractual right, but not an obligation to purchase a contract that would allow them control shares of stock at given price, for a given period of time and in return these individuals would play a price (called a premium ) to the owners of original owners of the stock for that right. The theory was if the owners could get individuals to pay these premiums in return for their ability to leverage shares of a security, the individuals who really could not afford the shares would be interested in that enticement. Hence the concept of "covered" call writing was conceived. An option is the right to buy a stock, but not the obligation, at a specified price, for a specified period of time. The buyer controls the option and the rights that come with that option, until the specified time associated with that option ends or expires. In return the seller of that option is obligated to sell his stock at the given price, within the time specified by the option contract. Now with all this being said, and time evolving to the sophistication of options as we know them today, someone got a bright idea (so they thought) of selling these option contracts WITHOUT owning the underlying stock. The idea being, if I don't have to buy the stock and all I have to do is put up the margin requirement to sell these options with owning the stock, I can make a windfall of money every month just like the covered option writers do. Think about it. If the margin requirements are 50% to buy stock and do covered rights and the margin requirement is only 30% of the underlying value of the stock less the premium you received for the option, wouldn't it make sense to do? Take a look below at two accounts. Covered call with options in a margin account at 50% and a "Naked" option account. (See FIGURE 1-1 & 1-2 & 1-3 below)

Scenarios:

FIGURE 1-1: A HYPOTHETICAL EXAMPLE OF A "COVERED" WRITING
PORTFOLIO

In Figure 1-1 above we can see that it his brokerage account that this covered call writer
Has 3 long positions and has sold "covered calls" on all three of the positions.

Let's assume for calculation purposes that he purchased these stocks today and decided to sell these options today as well.

In order for him to put on this position and received the $1,290 in option premiums he must have purchased $50,150.00 in stock.

So his outlay to receive the $1,290 in option premiums was the purchase three securities above for $50,150.00.

Now he could cut his net capital outlay by at least 1/2 to around $25,075, if he does the same transaction in a margin account. ( In addition the $1,290 he receives for the option premium would reduce his margin to $23,786.00. However, he would still have a debit balance to pay interest on that ultimately would go against any profit he makes on the "covered" premiums.

Finally, the Option writer that decides he wants to sell the "Naked" calls would have an account that look like the following in FIGURE 1-2

FIGURE 1-2 NAKED POSITIONS WITH INITIAL MARGIN REQUIREMENT

As you can see in Figure 1-2 above the "Naked" option writer has only a $9,195 initial margin to sell the same 3 call positions. However, everyday that any of the stocks move up his margin requirement goes up for that particular naked option position and any day any of the stocks move down his margin requirement will go down for that particular option position. So on the surface if you look at it in terms of net outlay including margin requirements the three positions compare as follows for net capital outlay

1. Long the 3 stocks and writing covered calls you need $50,150.
2. Long the 3 stocks and writing covered calls in a Margin account - $23,786 Debit Balance (which includes the option premiums you received helping to reduce your debit balance)
3. Short the 3 covered call position for an initial margin requirement of $7,905
(which is marked to the market and will go up if the stocks rise and go down if the
stocks fall.)

In addition, some "naked" call writers also write "naked" puts on the other side of the market in anticipation of the market just trading in a narrow trading range and the "naked" writers picking up both the expired calls and puts premiums from both sides.

POINT OF NOTE: It is interesting that when a "naked" option writer sells bth out of the money puts and out of the money calls he is only marked to the market on one of the sides. So he only has on margin requirement and that is which side is going against him. However, when you want to do credit spread combinations on both sides of the market. You must satisfy the margin requirement for both of your positions. Even with the spread being the much safer of the two positions.
So on the surface the "naked" call writing concept has some merit. But look at what happens when you get a raging bullmarket rally or momentum run to the upside. Does anyone remember the exuberance of the technology and internet rally? How quick we forget.

The Real World Example:

Figure 1: CHART OF NASDAQ 100 - NDX

The is no doubt had you decided been on any of the stocks in the NASDAQ 100 or particularly any stock in any of the major Indexes, you would have a major problem

For example if we told the hypothetical stocks above and assumed they were NASDAQ 100 stocks we easily could have seen a scenario like the following.

FIGURE 2-1: A HYPOTHETICAL EXAMPLE OF A "COVERED" WRITING
PORTFOLIO

In Figure 2-1 let's assume that this was our covered account and now our Technology/internet stocks went crazy. ZZZ goes to 105, TTT to 70, and AAA only to 65. In our hypothetical "covered" write account the worse that happens is they take our stocks at the strike prices and we receive

1. $65 a share for ZZZ = $19,500
2. $35 a share for TTT = $14,000
3. $45 a share for AAA = $22,500
4. Plus the $1,290 we received for the July call premiums

All this leaving our portfolio with a net value of $57,290 and $5,890 profit or a 11.45% return for the month of July all sitting in CASH of the money market fund. We may have missed some fantastic upside profits, but we made a PROFIT. The same would have been true with our margin account except the return would have been closer to 22% plus, since we only put up 50%. However if we look at our "Naked" positions.
You will see, why under no uncertain terms, you NEVER WANT TO SELL NAKED CONTRACTS PUTS OR CALLS.! I REPEAT. NEVER!! (See FIGURE 2-2 below)

FIGURE 2-2 NAKED POSITIONS AFTER MARKET RALLY

The "naked" Trade losses over $34,710! That is only if he is able to get out at the prices that the covered writer was exercised at. Remember the "naked" seller has to replace all the stocks that were called away at the then current market price and will only receive the strike price that he sold the shares for. He could be faced with unlimited losses.

The Bottom Line

Remember the days Amazon, Cisco, Sun Microsystems, Rambus, Microstrategy. These companies would climb 3-20 points a day just on momentum. If you think that was bad, imagine being short "naked" puts when we had the great technology and internet bubble crash.

Imagine for one second being just shorting short 10 Cisco 75 puts and have received a premium of $3.00, sixty days later seeing Cisco at 30 and each put now valued at $45 - $47 each or you having to come up with $45,000; and if you had time left and held those puts even longer; than seeing Cisco drop to $20 than $10 and knowing your owe as much as $65,000. Not to mention that is just for one short put position. Imagine the individuals who had multiple positions and totally got hung up in the euphoria. It is not worth the risk and it is not worth the anxiety. Even if could put together a streak of 1 or 2 years of "naked" writing successfully (Good Luck!); it could all be gone, and then some ,with one major market move one way or the other and with you sitting on the wrong side of that move. It is in no way worth the risk. Options offer so many other advantageous ways to market money. There is no reason to play Russian roulette by selling any type of Naked options, especially calls. At least with puts you get something of value put to you. Take heed and remember to look at the risk/reward ratio. "Naked" writing just doesn't offer it to you in the long run.
 

Today's Newsletter Notes: Market Wrap by Jonathan Levinson, Options 101 by Steven Gail, and all other plays and content by the Option Investor staff.

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