Option Investor

Record Prices, No Gains

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The August crude contract hit a record for a front month contract of $75.78 in trading on Friday. A late day sell off on profit taking produced a close at $74.08 or -$1.74 off the highs. Despite the record prices most energy stocks were already well off the Thursday morning highs. Why? I believe investors were selling resistance and taking profits after a strong two-week gain.

The play for traders had been to buy energy ahead of the high demand July 4th weekend and ahead of the initial Iran deadline on the 5th. When it appeared the US was not going to launch cruise missiles on Thursday and the Iran problem was going to drag on another week or maybe even a month there was a dash for the exits. Profits are not profits until they are turned into cash. An implosion in natural gas prices also produced a drag on oil and coal prices.

Natural gas prices fell more than 50 cents for the week to close on fictional support at $5.50. I say fictional because we have not seen this $5.50 level since July 2004. The +73BCF injection into storage over the last week pushed inventories to 29% above the five-year average. Cooler than normal weather across much of the south should continue to prevent drains on those inventories. Eventually this situation will change but not until we see some seasonal weather appear. The damage to gas supplies in the Gulf will slow future replenishment and the appearance of any hurricane should produce a premium in prices. Lots of shoulda and coulda in the outlook but reality for gas stocks is still ugly. Most have held up well but eventually that reality has got to come home to roost.

Saudi Arabia announced the activation of its 100th drilling rig and a milestone in development. Never before in the history of the kingdom has there been 100 rigs actively looking for energy. This shows they are going to follow through on their promise to raise capacity to 12 mbpd. Only 43 of the 100 active rigs are searching for oil. In comparison there are 1666 active rigs in the US with 302 drilling for oil. Natural gas has become a big business in Saudi Arabia for multiple reasons. It takes gas to refine their heavy crude and for electricity generation. The extreme heat in the kingdom and the rapid modernization and increased air conditioning requirements are draining existing electric power. Saudi also injects natural gas back into oil fields to maintain pressure necessary for oil flow. Once the oil is depleted the gas will be extracted and put to other uses.

Oil prices hit the $75.78 level on Friday despite news from Iraq that production was increasing from their northern fields. This production is typically lighter crude of the type that is in short supply. After nearly four weeks of production out of the Kirkuk area no significant interruptions have been seen from terrorist activity. Iran also announced they were going to award exploration contracts soon but finding bidders could be tough until security is strengthened.

I am still expecting a top in oil prices soon but soon is a vague term. To date we have not seen any hurricanes although the season is still young. The Iran issue is dragging and will likely not be resolved or brought to a head until late August. Traders will tire of holding contracts while waiting for that event if inventories begin rising and prices begin falling. If Iran can maintain its northern production and no hurricanes appear we could see prices begin to slip quickly. However, ANY external event could quickly push those prices even higher once shorts load up for the rise down to September. This promises to be a volatile time for oil prices.

I wanted to sell some calls to offset some of our premium decay once the decline begins but I believe we are still early. The Iran event could boil by the G8 meeting on July 15-17 but I doubt it will explode. We should see increased gasoline demand in next week's report but that is past tense and declines should follow. Speculation is the only thing that will keep prices high after July 15th unless a hurricane appears. Once a decline begins it could be very sharp. If we do see a spike to $80 I will definitely sell some calls. Until then patience is still the key. With energy earnings over the next two weeks there is no future in adding any new positions. Once past earnings we can begin setting up for the potential August decline and September buying opportunity.

I am going to answer some emails in this newsletter so everyone can benefit from the answers. Have a great week!

1. Should all plays on the watch lists be entered by us with a limit order for a trade if the trigger is hit?

No. I do not recommend that anyone enter all positions listed in the newsletter. Each investor should only enter the positions that appeal to their risk/reward profile. Some options are $4-$6 while others are over $10 each. Some are shorter term 4-6 months while others are up to two years away. Chose those that fit your profile. I would not recommend using limit orders. Many times our triggers are hit with a gap move and a limit order would prevent you from being filled.

2. Are insurance puts protective puts?

Yes, insurance puts are protective puts. Different people refer to them by different names but they are long puts purchased to protect against a loss if a drop in the underlying appears. Investors should buy these puts only if it fits their risk profile. Sometimes buying puts increases exposure and reduces profits. Other times the put is a money saving investment that lowers the cost of the LEAP. Some readers would rather "stop out" of the LEAP rather than incur the cost of the put.

3. Under the NewPlays you have some with the word "Buy" and others there is no such word or the word position.

If the recommendation is new the word "buy" is used. Once the position has been entered the action word is removed or replaced with "position".

4. What is the difference between a breakout target, a breakdown target, and a split target?

A breakout target is normally a price above the current stock price. A breakdown target is normally a price below the current stock price. Typically we want to enter a position on a dip (breakdown target) but we can't always guarantee a future dip. When we don't want to miss the trade on a move higher without a dip we place a entry point above the current price. (breakout target) The split target has no meaning of its own and was mentioned in several play descriptions when discussing even money strike prices such as $60 or $80 when picking strikes. You want to avoid odd number strikes such as $55 or $65 when facing a 2:1 split. Those strikes result in an odd increment strike post split like $27.50 or $32.50. Those will always have decreasing volume as time passes. Stick with strikes that result in even numbers.

5. You give prices of the options. Should we assume that this number is say $10.00 or better? Should we use a limit order?

No! The price listed in the play description is the price at the time the play was written. It is not a suggested limit order price. Do not use limit orders or you may not be filled in a fast market.

6. Some of the positions say "Calls" and other do not?

Some of the companies listed do not have LEAPS. In place of LEAPS we use the farthest "Call" option available at the time. In the play description the recommended strike is listed as "LEAP Call" when it is a LEAP and simply "Call" when it is a call. A reader should enter the short-term calls positions only if it matches their risk profile.

7. You don't say in the portfolio if past recommendations are still buys. Should we assume so unless you say otherwise?

Normally yes. However reader discretion should be practiced. If a position has moved substantially above the initial entry level it would not normally be advisable to take the entry. Sometimes a stock can move $20 to $30 from our entry making the original strike and play description obsolete. Recently we have had some move substantially below our entry levels during the May massacre. These would represent better entries but I would not use the original LEAP strike if the move has been significant. PetroChina would be an example. We entered the position at $116 before the May massacre and it dropped to $90 before the rebound began. It hit $111 again this week. Anyone entering that position on the dip would have been well ahead of the game. We have a 2008 $120 LEAP so there was never any real danger with 18 months of time on our hands. You could have entered that $120 LEAP or a lower strike based on your risk/reward profile. If a position is not acceptable for future entries I will note that in future play descriptions. See question 10.

8. What is the best way to get started? Should one just invest in new positions? Which current positions are OK to invest in?

The best way to get started to enter cautiously. Read a couple back editions of the newsletter. Get familiar with the mindset for the current energy market. For instance, with oil at record highs I would not enter any new energy plays this week. We are expecting a decline in August so waiting for this dip would be preferable. Review current positions and see which ones are near support. Once you have decided to make an entry those would represent the best options. Above all be patient. In most cases we are buying LEAPS 12-18 months into the future. Waiting a week or two will not kill you and sometimes will result in a better entry.

9. Do you ever take LEAP positions in Puts or Indexes.

Yes, we do take positions on indexes and we do sometimes enter put positions on indexes. Since the focus of this newsletter is mostly energy as it relates to Peak Oil we are primarily focused on long positions in the energy sector or a related sector like transportation or mining. Our put positions are normally hedge positions or protective puts on individual positions.

10. Would you consider putting an action indicator on each play description to let us know if you still think the position is still good for a new entry? Maybe a "Buy" or "Hold" descriptor.

I think that is a good idea and I will implement it with the coming format change in two weeks.

11. In the case of an all cash buyout such as KMG, if the acquisition closes before an in-the-money call option expires, how is the option settled?

If you have an in-the-money call option on KMG you gain nothing by waiting for the deal to close. Because it is a cash deal for a substantial premium there is not likely to be a higher bidder. Time premium has already evaporated due to the minimal likelihood of the price rising over the acquisition price. KMG is currently $69.55 and the Jan-2007 $60 call is $9.90. Take the money and run. You are not likely to see any further rise in premium. You are losing money by not participating in the gains in some other position.

12. I find the Leaps Trader interesting, well-written and generally profitable! However, I object to your practice of ceasing to make recommendations whenever you make adjustments that "lower your cost" to a minimal level. I don't make all the same trades you do and view any profits on protective puts as separate transactions - my tax basis in the original call option is certainly unchanged. While I think it is fair to report your cumulative status on a position where you have been successful with such adjustments, I think you should continue to advise on making further adjustments wherever it seems advisable to do so. That's the advice I feel I am buying when I subscribe. Please understand that I make this suggestion from the perspective of a pleased subscriber who is seeking your continued advice about how best to handle all current recommendations.

In many instances it is not advisable to assume more risk by entering a new cost reduction position. In our Valero position for instance we actually increased our cost to $4.50 from $1.60 when the extra position moved against us. As a newsletter catering to various levels of investor experience it does not make sense to incur additional risk when there is no material reward. I agree your "separate accounting" does not apply to this situation since each trade stands on its own. As an experienced investor you probably know when it makes sense and when it doesn't and can make those decisions on your own. Some of our readers are inexperienced with those types of decisions and depend on us for guidance. I will try to suggest plays in the future but I may not take them in the newsletter. Call it reader discretion.

August Crude Futures - Daily

December Crude Oil Futures Chart - Daily

December Natural Gas Futures Chart - Daily


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