Option Investor
Educational Article

Are Options A Safe Choice\?

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On Friday mornings, I have breakfast with two dear friends who also share my passion for the market. Last Friday, one of my friends was beating himself up for missing the upward move. He played Monday morning quarterback over and over, particularly because some of the stocks that he held just last week shot up over 50% in just three trading days and he was not a part of the move. My friend was looking at the chart and finding all of the "reasons" that he should have known that the market was going up.

He discounted the fact that there were many false rallies over the past several months. In most of the rallies, there was very little buying, rather there was more short covering than buying. By the time most of the moves were discerned, the move was over and the short positions reestablished. Most people who bought the move bought in too late and were burned once again. Yes, we were due for a relief rally, but these often come too late. The only factor that made this move different was that the Fed surprised the market. No one could have predicted this event with any certainty. None of this made my friend feel any better.

Such emotional turmoil is not uncommon these days. The simple fact though is that no one can predict the unpredictable. This is why buy and sell rules are so important. Today there are mixed signals in the market. On the one hand, many stocks have blasted through their 50 day moving average. Some stock charts even indicate the 50 day moving average crossing over an upwardly moving 200 day moving average. This is very positive. On the other hand, many stocks have invaded the upper bollinger band and most oscillators indicate that the market is overbought. Additionally, many stocks have run into severe resistance. One could guess that we are due for a short-term pullback before the new uptrend continues. It would be only a guess. We could also reestablish the downtrend. Damned if you do and damned if you don't. Of course, if you play it safe on the sidelines, you get to beat yourself up if the market goes higher. What can an individual trader do in these times of uncertainty besides staying on the sidelines? One thing a trader can consider using LEAPS.

I have learned to appreciate the value of LEAPS in uncertain times. Too often in the recent past, I have purchased 1000 shares of QQQ (AMEX:QQQ) at a technically appropriate time, only to be stopped out of the trade. Even though the losses are "minimal," a two or three thousand dollar loss does not feel minimal to me. Too many failures like these can get costly and can make you gun shy. When you finally let an opportunity pass and it is a real rally, it can inflict damage to your confidence. On the other hand, if after being stopped out, you see the stock soar thereafter, you could be tempted to stay long in violation of your sell rules. Sometimes the stock continues its downward spiral. Suddenly you can be sitting on a huge loss.

LEAPS allow you to purchase control of a stock for up to three years at a fraction of the cost. Recently, I purchased ten QQQ 40 calls for January 2003 at a cost of $8.80 each. The LEAPS give me the potential for significant gain over the next 19 months and my downside risk is only $8.80. This sure beats the risk of holding the stock while it melts. It also beats being stopped out several times. When I bought these LEAPS, I no longer felt the self-induced pressure of trying to catch the next move because I already placed my bet. I can wait for a real trend to develop without risking more capital and without being afraid of missing a move. In a sense, the LEAPS give me a new sense of freedom in uncertain times. Holding these 10 LEAPS allows me to trade less emotionally. The pressure of attempting to discern mixed signals is over. Further, in downturns, you can write calls against these LEAPS thereby reducing the cost of the LEAP and reducing the exposure. Damned if you do, damned if you don't is an awful way to live. It can lead to desperate and potentially dangerous decisions. Let LEAPS help you avoid this trap.


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