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TheStreet Open House

All About Options

Options aficionados have punched in -- thankfully! -- responding to last week's Ask Marilyn question. I print the responses here unabridged because, frankly, this options stuff goes way beyond my scope of knowledge. Which is not saying much, of course.

On other topics, I continue to struggle with this idiotic, whipsaw market. Here are my latest strategy options:

A) Wait it out, and take up needlepoint to pass the time.

B) Gnash my teeth, and look for a quality dental plan.

C) Become completely unglued.

D) Do nothing.

Well, you know me: C is the obvious, and only, course of action!

Want help with your strategy from someone who always maintains an even keel? Just send your questions to technicalforum@thestreet.com . As soon as I get the noose off my neck, I'll be happy to weigh in.

Gary,

The last writer in your Saturday column has some good ideas about using options but appears to be somewhat in the dark as to the magnitude of price changes in the options as they adjust to the underlying common price. I suggest that he do paper trades for a while to see how things actually work. It's not as simple and cheap as he seems to think.

-- Tom Ficor

Gary,

I have not written to you in the past, but I very much enjoy reading your articles. I trade options quite a bit (in fact, almost exclusively) and have done quite well. I used to teach seminars and now just trade my own account on a full-time basis. You have identified the most obvious problem with Patrick's question. But I see a few others.

First, the extra commissions are a real issue (buy/sell options + buy/sell puts). Fine if you have a large bankroll, but these commissions add up.

Second, the slippage is much worse in options than in equities. Spreads are wider. I really think that while this strategy may work theoretically, it's just too tough to implement consistently and would probably only work if the stock made a large move (bad earnings, downgrade, etc.). But if you are watching your positions and your trading size is appropriate, then you will probably just be closing out your position anyway.

Frankly, I think that a better strategy would be to write a covered call on this type of stock. That way, time works in your favor, not against you. You are limiting your upside if the stock makes a fast move, but you can always buy the call back at a small loss and continue to let your profits run. There are so many options (pardon the pun) with options. It's impossible to just "cookbook" the strategy like Patrick suggested.

-- Dan Fitzpatrick

Hi Gary,

Enjoyed your columns this weekend. There's some great TA reading on the Web for us TSC subscribers! I read everything that you and Cramer write.

I've been trading stocks and options intensively for close to five years now. I've come to specialize in stocks only, but I have extensive experience with stock options and OEX options, along with S&P futures. Here's some feedback for Marilyn, about where the "catch" is in using options to hedge a stock position. Let's say she buys 1,000 shares of XYZ at 40 ($40,000), and hedges it with 10 at-the-money put options for $4 each ($4,000 outlay). Each put option is designed to hedge 100 shares of stocks, so this would be an appropriate weighting for the hedge.

First of all, she is down the "spread" of the options, right off the bat. Let's say the puts were trading 3 1/2 (bid) by 4 (ask). She bought them at the offer ($4). If she turns right back around to sell them, she gets $3,500 and so is already down $0.5 x 10 = $500. And that's without anything "bad" happening! Just the price of doing business with the folks in the options pits.

If the stock goes up, her puts will rapidly decline in value. Let's say the stock runs 5 points; now the stock is worth $45,000. But she's lost most of the $4,000 she spent on the puts. So, the net gain is almost a wash, after a 5-point run-up! The puts dilute the gain on the stock.

If the stock declines, she is (in theory) "hedged" by the puts as they go up in value. But she'll need to be a nimble market timer to get out of the puts at the right time -- when the stock bottoms. What's more likely to happen: She'll see the puts shoot up but hold them since they're protecting her from the stock's selloff. Then, the stock will recover and she'll watch the options revert to where she bought them or lower. Why not just use a trailing stop on the stock or ride out the volatility?

Not to mention, the options won't go up like she'd want them to -- point for point. She has to contend with "the Greeks" -- delta, etc. -- which mean the options don't move in lockstep with the stock. Very disappointing to many options beginners.

All the while, the time decay factor is whittling away at the options value. The longer she holds the puts, the less they are worth. On top of that, the options are subject to change in value to changes in "implied volatility" (VIX), as defined by movements in the OEX (broad market).

When you combine these factors, sometimes it can seem like the option buyer is confronted with very difficult odds. In short, unless you are a very sophisticated options player, thoroughly understand how they are priced and have an excellent market-timing and stop-loss methodology, you are better off avoiding them in favor of trading stocks! However, for some sophisticated market players, it can be a potent tool, used properly. I'd advise her, if she wants to learn options, to get good at selling covered calls. This is the lowest-risk way to learn how options work, and there is less downside risk.

-- Steve Bell

Gary,

Let's rule out sell stops, my experience has proven them to be a bad choice in a volatile market. You are long the stock, which means you think the price will go up. Let's eliminate puts. Why not buy the calls? This removes the risk inherent in holding the stock.

To buy calls, you should have a reasonable idea of how far you want the stock to go, and how long you think it will take to get there. I look for value by measuring my target price and dividing the gain by the premium attached to the option. I look for 3-1 or better. When your calls double, sell half and hold the rest until expiration. You can also place sell stops on options, but once they get in the money, you are once again vulnerable to market volatility.

If the call doesn't look right and you must buy the stock, I would recommend out-of-the-money puts because they cost less, and I think the delta can move faster than their near-the-money cousins in a downdraft.

-- Dave Reutter

Hi, Gary,

I might be able to offer some insight into this situation.

While Patrick speaks to an unnamed momentum stock, one might substitute biochem several years back or Internet now in the same example. Let's say you go long 400 shares of said optionable momentum stock at 38, and get a quick 2- or 3-point pop to 40 or 41. You're bullish on this guy, so you want to hold on, but there is a potential for news, or some other source of (added) volatility.

My suggestion is to buy a 6 or 8 lot of put options at 35 or 40, with an expiration one to three months later than the anticipated news, against the long stock. If the stock runs on the news, you only give up a few points of profit because of the premium paid, but if the news kills the stock, you end up effectively backspread 3:2 or 2:1 on the stock. This means that a big downside move will make you money even if you hold the stock for the duration, as long as you intelligently cover the options. You need to weigh the option premium against your existing profits and evaluate risk tolerance, but this is a tried and true strategy for dealing with momentum stocks near earnings and other news.

-- Brian F. Bartlett

Gary,

LOVE your column! (I'm buttering you up in the hopes that you will answer this request.) I'm new to investing and TA and I'm learning a lot from your column. Fascinating stuff!

Could you please analyze the chart and give me your opinion on Check Point Software (CHKP)? I got in at 38 in mid-February after it pulled back from its high of 56 in January.

I thought at the time that it was a normal correction after being oversold and that it would go back up again. Now I'm not so sure. What do you think? Will the downtrend continue? I put in a stop loss at 36 just in case.

Thanks and keep up the GREAT work (more buttering up)!

-- Richard Ng

Gary,

I think you're my favorite, just because you avoid losing us money (kidding). Please share your views on the Nasdaq. I'm looking at a two-year graph, and I can't help but feel that creeping feeling.

-- Antonio Piano

Hi Gary,

I am a new member to TheStreet.com . I am quite impressed by your analytical capability. I have a question. Do you think it is the right time to short eBay (EBAY)?

-- Sandip Ghosh

Sandip,

Are you related to Nilasha Ghosh, one of the top 10-year-old swimmers in the country?

Just a random thought ...

Gary,

Love the articles, Gary. Keep up the good work!

I have a question about CMG Information Services (CMGI). I am thinking of starting a position in CMGI and started looking at the chart. I'm fairly new to TA, but I have noticed a formation mentioned as a pennant in your articles twice before. It looks like this may be happening now.

I was thinking of waiting to see when it breaks the two trend lines and either going long if it breaks out of the trend line from the high on early January to the high on early February on the upside. Or possibly going short if the trend line from the lows of late January and mid-February is broken on the downside.

-- James Henton

Gary,

Love your charts. I notice most are relatively short term. How long term can you make a chart and have it hold ? One stock I am charting has a nine-year uptrend and has not broken down. It is AMD (AMD). What do you think?

-- Charlie Holloway

Charlie,

If you're asking about TA's "predictive ability" (or at least mine, anyway), I'd say I'm OK for maybe a few months at max. Anything longer and I'm just guessing.

Hello Gary,

Cirrus Logic (CRUS) has easily been the most frustrating and unprofitable stock I have ever owned. I've averaged down to about the 10-per-share level but am still a little underwater.

What do you see when you look at this stock? Any long-term prospects, or should I dump this thing and move on? I've been in it for three years now.

Thank you.

-- John Caley

John,

Let me answer your question without using a chart, because it gets to one of the key ingredients of good trading: knowing your exit before you enter your position. Let me be blunt: When you went long Cirrus Logic, you should have had a stop and a limit price in mind. From then on, if the stock acted according to Hoyle, then you keep it in your portfolio. But if it slipped, then you abandon it without remorse. Unprofitable stocks? My trading is littered with them. Frustrating? None. They either acted well or they didn't, and if they didn't, I just cut my losses and moved on.

Now, so you don't think I'm a total jerk, my advice to anyone who is in a position and is frustrated by it is: Dump it and move on. You've already lost enough sleep and spent too many hours agonizing over it. If it perks up, you can always get back in. But if it doesn't, you saved yourself some money and have a clear head to make more profitable trades.

Gary,

Could you analyze Sprint (FON)? It looks good to me ... would you go long here? Where would you put a stop?

-- Don Sweat

Dear Gary,

I love the columns with straightforward analysis and honest personal vignettes. That story of your Saturday CNN appearance and the spilled coffee still stays with me.

I would like your opinion of ADIC (ADIC). I combine fundamental and technical analysis and confess to being pleased with their recent 50% upside earnings surprise. But I also note that it is now above both its 50-day and 200-day line, and wonder what you think about going long here and if you have any upside target you could specify. Thanks.

-- Dr. Kendall S. Harmon

Gary,

I am impressed with AutoZone (AZO). This stock is so close to breaking out to an all-time high. I played this scenario with Genzyme from approximately 37 to 53 per share. What is your opinion on this chart?

-- Todd Maushund

Hello, sir,

I have bought shares of UIHIA (UIHIA) at 60 a share. The company just spun off UPCOY (UPCOY). UIHIA owns 62% of UPCOY. UIHIA has a $740 million-dollar loss in revenue right now. The value of assets for UIHIA is $510 million dollars. Before UPCOY went public, UIHIA was trading at around 20 a share.

Presently the market cap for UIHIA is $1.4 billion, and the market cap for UPCOY is $4.6 billion (also trading on the Amsterdam stock exchange under UPC).

Shouldn't the market cap of UIHIA be at least 62% the market cap of UPCOY? I looked at the DBCC (DBCC) and MarketWatch (MKTW) case, and the numbers match up very well. But in this case, the numbers are way off. I hope I didn't miss anything. I would appreciate it if you could analyze the abovementioned stocks.

-- Monish Chadha

Monish,

You've given me a cornucopia of stocks here, and I believe you have hit every letter of the alphabet. However, who really cares about the other stocks? The only one you have a position in is UIHIA, and as one of my key tenants is KISS, I'll concentrate solely on that chart.

When you start throwing in items like market cap, relative value, spinoffs, etc., you'll only make a simple decision more complex. Live by the charts, die by the charts!

Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Smith also writes Technician's Take each Monday and Charted Territory, which appears every Wednesday.

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