Dollar Index falling to support at 75 again, futures out of sight and lots of good information in the reader survey.

This commentary will be a little longer tonight because I want to share what everyone said in the reader survey and try to answer some questions. First I want to thank everyone from taking the time to answer the various surveys. It always helps to know how our efforts are being received by the readers. If we are doing something wrong we very seldom hear from a reader that takes the time to write an email. Very few people want to put a name on a complaint and I completely understand. These surveys allow everyone to complain anonymously and fortunately compliment as well.

I also discovered through some of the responses to the Option Writer questions that I was not doing a good job of explaining the strategy. Specifically the reason I like to go deep in the money as opposed to positions out of the money. Several readers asked for the out of the money plays to reduce volatility and I will do my best to include some of those in the future. Normally unless you go farther out in time there is not enough premium to make it worthwhile to me personally. I hate to sell a put for 50-cents and have to sit on it for several weeks BUT that is a viable strategy.

I also had several readers request put writes as a way of buying stocks cheaper. That is definitely a valuable strategy but not one that fits the Option Writer playbook. Normally you want to write puts on stocks you want to own. If the stock dips and you get exercised then the premium received lowers your cost in the stock. Hypothetically if you wanted to own Apple you could pick a strike $10-$15 under the present price and write the December put. Apple closed at roughly $200 on Friday. If you wrote the $185 December put today you would collect $2.06. If Apple closes under $185 on Dec expiration you will get the stock with a cost of roughly $183. That does not sound particularly exciting but the plan would be to write a put every month just far enough out of the money that you don't get exercised. If you can stretch the string of unexercised puts for 5-6 months before an untimely dip finally hits you then you can collect $10-$15 in premiums and that significantly lowers your cost in the stock. Remember, the idea was to eventually own the stock when you were finally exercised.

The risk is that Apple keeps rising to $250 over the next six months and you never get it put to you. You did make $10-$15 in premiums and that is not bad but Apple rose $50 in price. It just depends on your investment plan. This strategy does not work for OW because I don't know which stocks you want to own. I might like RIMM but readers might want Apple or IBM. Since I am not in the business of telling you what stocks to own long term that strategy does not work for OW.

I also go requests for longer term put write including put LEAPS. I have no trouble with that idea except that it creates a very boring newsletter. If I suggest writing the $50 Jan-2011 LEAP put on RIMM ($59.72) then we are going to take in $7.55 in premium. That sounds great for this week. Money in the account and surely RIMM will be over $60 in a year. It is a sound plan. However, for the next 60 weeks I have to report on it. Obviously not every day but it is always a paragraph here and there and a line on the portfolio. People who missed that week in the newsletter or come in later in the year see the line on the report and endure the reporting but they are not in the play. That play only worked for the people reading that week. I could recommend 10 LEAP puts today and put a lot of premium in the account but that only works for everyone reading today's newsletter. If you subscribed a month from now how bored would you get from seeing those same ten LEAP puts in the portfolio? Don't get me wrong, it is a good strategy and a relatively safe one if you sell puts on the dip. It is just a very low level activity play. Actually after getting stopped out on everything we played so far in November a "low activity level" play sounds good today.

I had readers ask for wider stops and to take assignment of the stock rather than exit with a stop. They wanted to then write covered calls on the stocks that were put to us. That is a valid strategy ONLY IF you don't mind owning the stock. Normally people who don't exit for small losses are forced to become long term investors rather than traders. If you took assignment of Broadcom tomorrow at $30 from the put we sold last week then your cost on Monday would have been $1.20 less than $30 because we took in $1.20 in premium. So let's say you write the Dec $30 call for .72 cents on Monday and Broadcom continues to slide to $25 over the next couple weeks. Your call expires worthless and your cost is now $28.08. You write another call for 75-cents and unless Broadcom rallies it would take several more months before you broke even.

For those months you would have $3,000 in cash tied up in stock. Not only is your cash tied up but your MENTAL capital is tied up. You will focus more time, effort and mental anguish over that position as the weeks pass than it is worth. After all what is your game plan three months into the trade? It is to break even. You will no longer be trying to make a profit but to simply exit the trade for a breakeven and go trade something else. Even worse, let's say Broadcom rallies after a couple months and your $25 call is exercised when your cost in the stock is higher at say $27.50. Now you have no stock and a large loss. Are you going to buy more Broadcom to continue the plan until you trade yourself back to breakeven? I doubt it. You wound up investing $3,000 for 3 months making 4 trades and losing $2.50 per share plus the mental anguish. I believe it is much simpler to take a 30-40 cent loss on a trade that does not work and go make a different trade. Trying to work your way out of a losing position through assignment and covered calls is like betting on the same losing horse over and over again. If the horse loses, throw the ticket away and try to find a winner for the next race.

Another request was to make more recommendations. I would love to do this but not in this market. If we could get a trending market I would write every put I could find. Unfortunately we are playing with fire right now with the dollar dictating our markets. Gap up +100, gap down -100, repeat. The S&P is three points away from where it closed on Nov-9th. That is ten days with no gain. There was actually only one day with a decent gain and that was the 16th when the S&P gapped open +16 points and managed to hold onto +12 points at the close. The rest of the last ten days was a coin toss with intraday reversals routine. This is not a market to be backing up the truck and loading up on positions. That could change this week but until it does I will continue with small entries and small losses.

The topic of writing deep in the money always comes up. I am a proponent of deep in the money because the return is so much better and the risk the same. If Broadcom is $26 and I write a $30 put for $4 or a $50 put for $24 my risk is exactly the same. If Broadcom falls to $23 I lose exactly $3 on both positions. If I had written the $25 put for 50-cents I would lose $1.50. Granted I would lose less on an out of the money put but I am looking to make money not save money. If Broadcom rallied to $30 I would make $4 on either of the in the money positions but I would only make 50-cents on the $25 put. There is slightly more risk on the ITM puts but significantly more reward. If we catch the right stock we can easily make several dollars per position on ITM. I will include some of both types in the future.

I had some comments about energy plays. Some readers thought I picked too many energy plays and others not enough. Because of the dollar impact on oil I think they are risky until the dollar settles down and demand is still much less than capacity. There is no fundamental reason for oil to go higher other than as a dollar hedge. I plan on avoiding oil unless we get a really good dip. It is up strong tonight on the dollar decline.

Almost everyone wanted more ETF plays. I think that is a valid request and I will work on that. Unfortunately we still need a trending market to make any put write successful.

Several readers wanted to write naked calls because they expected the bear market to return. Guarantee me that it will start on Monday and I will write a boatload. I agree that a market stalling at new highs is a target for naked calls but assuming we had written some last week the gap open we are expecting for Monday (Futures are up +11.50 at 5:AM) would be a really ugly surprise if you were short calls. The risk in calls is so much greater and the margin so much higher that I tend to avoid it whenever possible. Did you ever wonder why there was not a opposite to the term "short squeeze?" Why is there no "long squeeze?"

Almost everyone said "only send a newsletter when there is something to say." Thank you, thank you, thank you. I agree. If there is something to say or a position change I will send an email. Otherwise it is just something to clutter up your inbox.

Several readers wanted a track record. I do keep a complete track record on the website in the Option Writer Portfolio section.

Again, I want to thank everyone for responding to the survey and even though there were a lot of questions and comments I did not answer here you can rest assured I will try to work them into future newsletters.

Unfortunately we are faced again on Monday with a monster gap open and the absolutely worst kind of market to enter. The potential for a gap and crap is always huge. However, with two down days behind us the shorts should have loaded up and they will be squeezed hard at the open. I am going to add a couple positions just in case the market finds some traction.

Jim Brown



Current Portfolio



NO OPEN POSITIONS


New Recommendations


MSFT - Microsoft $29.62

Microsoft Corporation is engaged in developing, manufacturing, licensing, and supporting a range of software products and services for different types of computing devices. The Company operates in five business segments: Client, Server and Tools, Online Services Business, Microsoft Business Division, and Entertainment and Devices Division.

Microsoft is riding the wave of acceptance for Windows 7. I know several people who have installed it and everyone seems to love it. The Windows Vista experience is rapidly going to be just a bad memory. I believe MSFT will break over $30 soon and every dip is bought because they are a highly liquid large cap tech with little or no risk. Fund managers seem to love them now.

I am going to recommend the ITM put because the OTM options have no value. The $29 Dec put is only 48-cents and after Monday's gap open it will probably only be 25-cents.

SELL DEC $32 PUT MSQ-XT currently $2.46, stop loss $29.25

Chart of MSFT

PALM - Palm Inc $11.73

Palm, Inc. (Palm) is a provider of mobile products for individual users and business customers worldwide. Palm’s products for consumers, mobile professionals and businesses include Palm Pre, Treo and Centro smartphones, as well as software, services and accessories. The Company sells its products in two product lines: smartphones and handheld computers.

Palm has a new line of smart phone and there are constant rumors about somebody buying them out. Palm has fallen from its highs and appears to have found support in the $11 range. This should be one of those low volatility OTM plays for conservative readers.

SELL DEC $10 PUT UPY-XB currently $.42, stop loss $10.50

Chart of PALM

EXP - Eagle Materials $27.13

Eagle Materials Inc. (EXP) is a manufacturer of basic building materials, including gypsum wallboard, cement, gypsum and non-gypsum paperboard and concrete and aggregates. The Company’s primary businesses are the manufacture and distribution of gypsum wallboard and the manufacture and sale of cement..

Eagle reported earnings that declined -23% on a drop in revenue due to lower concrete sales. The stock was knocked back from $30 to support at $25 where it has begun a rebound. There was nothing wrong with Eagle's earnings other than the continued recession/construction hit. If the bottom is behind us then Eagle's sales should increase. I am looking for a return to $30 if the market cooperates. I am using an ITM put because the OTM is worthless.

SELL DEC $30 PUT EXP-XF currently $3.40, stop loss $26.50

Chart of Eagle


Methodology

We do not sell out of the money puts for a few cents and then hope the market does not correct and cost us a fortune to exit. I don't like to risk a dollar to make a quarter.

The concept for Option Writer is to find solid momentum plays with enough volatility to inflate the option premiums. We will sell in the money naked puts ahead of the stock price and let the stock rally to our strike.

Selling in the money puts allows us to capture nearly dollar for dollar the movement in the stock price.

Because we are selling in the money that same dollar for dollar move can go against us as well. For this reason we establish tight stops to take us out of the play for a loss of a few cents rather than let the losers grow and "hope" they rally again. In a typical month we could get stopped out of twice as many plays as we close for a profit but those stops will be minimal and the winners worth the trouble.

If you do not have the ability to sell options you can turn the plays into spreads by buying a lower strike put. This will decrease your margin requirements but it will also decrease your profits.


Margin Requirements:

There are several different formulas for determining margin requirements for naked put writing. These are normally broker specific and some can require larger margin requirements than others.

Here is the most common margin calculation for naked puts.

100% of the option premium + ((20% of the Underlying Market Value) - (OTM Value))

For simplicity of calculation simply use 20% of the underlying stock price and you will always be safe. ($25 stock * 20% = $5 margin)