TSC Options Forum: Spotting the Trend

More on how to employ options to bust the 'waiting for the correction' paralysis.
By Steven Smith ,

Hi Steve:I really enjoy your columns. This last one, though, I am wondering why you wouldn't sell puts on the first group that has already corrected ... isn't that less risky than on the second group that has run up so much recently? Is this more of a buy-on-strength strategy for the second stronger group?Thank you, --K

The reader raises a great point, one I grappled with while writing that

column. It was premised on acknowledging that the overall market is in an uptrend, and I wanted to offer some ideas on how options can be used to break the "waiting for the correction" paralysis.

One of the great things about options as an investment and trading tool is their flexibility and dynamic nature. Unlike the binary choice of buying or selling the underlying shares (though analysts have tried to create gradations through ratings such as "strong hold" or "market outperform"), options allow for establishing a customized position. There is no one right way to trade or invest using options; the challenge is finding the strategy that offers the best risk/reward scenario based on your particular outlook and objectives.

My suggestion -- to buy calls on stocks that have already dipped and sell puts on those that are rising -- was based on two things, both of which are underpinned by a belief that the market continues to trend higher over the next six months. Quality stocks that have already corrected may be poised for a nice rebound; buying calls provides for more upside potential compared with selling puts.

In addition, many people, when faced with a falling stock, tend to wait for a lower and safer entry point, but inevitably miss it and wind up owning nothing as the shares move higher from the bottom.

In the same vein, selling puts on stocks that are trending up lets you get a bullish toe in the water without feeling like you've just jumped in at the high.

But certainly the case can be made for buying calls on rising stocks (as it does provide a limited-risk way to ride a stock that might be due for a substantial correction) and selling puts on stocks that have already broken down.

For example, I'd rather buy calls on

Research in Motion

(RIMM)

than sell puts. It is the type of highflying momentum stock that can get knee-capped by 25% in a day on a piece of bad news.

On the other hand, selling puts on broken stocks or those that seem to be in turnaround mode might be the best way to target a value entry point. For example, an unglamorous company like

Newell Rubbermaid

(NWL) - Get Report

, which has suffered several gaps down over the last six months, might have been a prime put-selling candidate. If you thought the stock represented good value and would be a willing buyer in the $20-$22 range, selling puts over the past two months would have proved quite profitable and possibly given you a long position in the stock through assignment at a cost basis near its $20.27 low.

Newell is currently trading around $25.50, and as an added bonus it recently announced it will begin paying a quarterly dividend. This highlights that variables such as dividends, expected return and time frames all must be factored in when deciding on the most appropriate strategy.

More on Stop-Loss

When I mentioned in the earlier column about the use of stops and taking profits, one reader rightfully reprimanded me for not fully explaining the risks of selling puts short or expanding on how stop-loss orders might be applied.

The risks of selling puts short are essentially no different than buying the shares of the underlying stock. As I wrote, "Only sell puts on the stocks you are willing to own." Here's an earlier article for a fuller discussion on the application of

stop-loss orders.

You Are the Market

Steve:I agree with your options opinions. However, the bid/ask on options tends to be wide. Do know any online brokers that have a small bid/ask difference? --T.W.

The bid/ask spread is set by the market, not the brokerage firm. While professional market makers and specialists have a responsibility to provide and abide by firm bid/ask quotes, those spreads can indeed be quite wide. In fact, it is you and all the other customers and traders that truly set the market. A brokerage firm can and should provide timely execution and intelligent order routing, but they can't provide tighter bid/ask spreads.

Don't Ignore Me

I want to thank all of the readers who've asked questions and offered great commentary. As many of you know, I typically respond in a timely fashion. But with the various computer viruses traveling around, I'm sure some emails sent to me are not being received or don't get opened. I apologize for the former and hope you understand it's out of my hands.

As for those comments that do get through, here's a small request that might help: When writing, please put some signifying words in the subject line referencing a topic or column. This will give me the confidence to open the message and file it appropriately. Thanks and have a great weekend.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.

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