Archive for November, 2009

A Cheap Strategy to Play Microsoft

Posted by admin on November 16th, 2009

Bill Gates is super rich but his once high-flying software company has been in the doldrums since mid-2002 after falling from the $35 level. The problem with Microsoft (MSFT) has been its failure to grow both its revenues and earnings at the superlative rates the company once enjoyed.

Any company the size of Microsoft, with a market-cap of $242 billion, will find growth an issue because of its size. But this is not to say the stock is dead. Far from it, Microsoft remains a viable long-term software company and is cash rich with $34 billion or $3.28 per share in cash. This gives the stock plenty of financial flexibility to develop or buy growth technologies. Microsoft just announced it would spend $1.1 billion in R&D at its MSN Internet unit in the FY07. And according to the Wall Street Journal, Microsoft is exploring the possibility of taking a stake in Internet media company Yahoo (YHOO) to take on Internet advertising behemoth Google (GOOG).

But with an estimated five-year earnings growth rate of a pitiful 12%, the company has its work cut out for it. Trading at 16.30x its estimated FY07 EPS of $1.44, the stock is not expensive but appears to be priced not as a growth stock.

Its PEG on the surface of 1.51 is not cheap, but if you discount in the cash of $3.28 per share, the estimated PEG falls to around 1,0, a decent valuation. Also, if Microsoft can improve on its estimated 12% growth rate, the PEG would decline further.

The fact is Microsoft at the current price deserves a look. If you want to play the stock but don’t want to shell out the $2,347 for a 100-share block, you may want to take a look at the long-term options, also known as LEAPS. For instance, the in-the-money January 2008 $22.50 Microsoft Call LEAPS not set to expire until January 18, 2008 currently costs $380 a contract (100 shares).  

This means you risk a total of $380 for the chance to participate in the potential upside of 100 shares of Microsoft over the next 20 months. The breakeven price is $26.30. If Microsoft breaks $26.30, you would begin to make money on your LEAPS. Conversely, if Microsoft fails to do anything, your maximum risk is $380 on the initial option play.

Warning: The aforementioned example is for illustrative purposes only and not to be construed as an actual option strategy. Due to the higher risk inherent in options, I recommend you speak with an investment professional before deciding to employ any strategy involving options.

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Managing Option Directional Trades

Posted by admin on November 12th, 2009

Options provide great position management and risk control potential when using them to trade the market directionally. This goes beyond the simple fact that a long position in a call or put option has an absolute maximum risk equal to the cost of the option (plus commissions, of course). That, in and of itself, is a very useful thing. What this article discusses, however, are a couple of handy little things one can do while holding an option position to maximize the return and keep the risk well constrained.

Roll Up/Down

Most traders are familiar with the concept of a trailing stop whereby one moves their protective exit as the market moves in favor of the trade. This is used to lock in profits. The same thing can be accomplished when one is trading options rather than the underlying. This is done by rolling one’s position up or down strike prices depending on whether the trade is a long using calls or short employing put options.

Here’s a recent example from the author’s own trading.

A long position in Seagate Technology (STX) was initiated when the stock was trading at around 21.50 using the March 22.50 call options. They were purchased for $0.80. The market rallied over the next few weeks, eventually moving up above $24. At that point, a roll-up was executed by selling the March 22.50 calls at $2.60 and purchasing the March 25 calls at $1.40. This action served two purposes. The first is that it took $1.20 off the table, reducing the portfolio exposure and freeing up cash for use elsewhere. It also locked in a profit of $0.40 ($2.60 sales price minus the $0.80 purchase price for the 22.50 calls minus the $1.40 purchase price for the new 25 calls). At the same time, it had no effect on the remaining upside potential for the trade. The two strikes would probably profit about the same from any further appreciation in the price of STX shares.

If the portfolio exposure was deemed acceptable at $2.60, an alternate course of action would have been to sell the March 22.50 calls and not take any money out, but rather roll it all in to the March 25 calls. For example, if the position was 10 options, selling the 22.50s would net $2600. That cash could have been used to purchase 18 of the 25 calls ($2600/$140 = 18.57). By doing so, one actually increases the upside potential for the trade substantially. Of course, the full position is at risk, meaning one could theoretically lose the whole $2600 invested, which is more than could have been lost when the trade was first initiated.

Roll Forward

One of the issues with options is the limited duration they provide for holding trades. If one is an intermediate to longer-term trader, this can be an important hurdle. That said, however, in a manner similar to the roll up/down, if one wants to extend the holding period of a position it can be done by rolling forward the expiration month.

Continuing with the STX example, we can look at rolling forward. That would be accomplished by going from the March contract to the June one. As of this writing, the March 25s are trading at $2.40 and the June 25s are at $3.60. There’s the rub, though. Because of the longer time to expiration, the June contract is priced significantly higher. That is why a roll forward is often best accomplished with a roll up/down.

Consider the earlier roll-up in STX from the 22.50 call to the 25 call. If we were still in the former, and wanted to both roll forward and up, we could jump to the June 25 call. The current price on the 22.50 option is $4.10. With the June 25 at $3.60, we could accomplish both the roll up and roll forward and take $0.50 off the table. That is not quite as much as we accomplished with the roll up, but it does extend the time we could hold the position by three months. Whether that is worth the trade-off depends on the anticipated holding period for the trade.

The rolling of strike prices and expiration is something easily accomplished. The transaction costs for options trades have come down substantially for the individual trader in recent years. That opens up a great many possibilities for playing the market directionally and managing positions efficiently.

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Option Trading Strategy matching Your Trading Style

Posted by admin on November 1st, 2009

The thrill of options trading is that allows for a diversity of tactics to be corresponding with distinctive stock trading plans. Each strategy has a different success and risk tolerance level, and by means of a variety of strategies can add zest to a portfolio very nicely! In this article, four different stock trading strategies, will be demonstrated and how they can be coordinated with corresponding options trading strategies which you can apply to your portfolio. The main idea is to first concentrate on an underlying stock trading strategy, and then add significant leverage and power to the trade by using options.

The most significant issue when taking into account each of these strategies is the theory of TIME DECAY. The value of any option dwindles over time, until the day the option expires. This concept can be the major rival of any option trade, reducing its profits, or it can be the key to successful and profitable option trading.

Firstly, which Strategy?

There are generally four different strategies employed by stock traders, each of which has implications when applied to options:

(i) Position Trading

Traders buy a stock and hold it for long periods of time, based on good fundamentals of the company. They will often wait for a stock to reach really good value, and then watch for institutional or insider buying before making a move. As the stock price increases, they look out for other buyers to step in and move the price even further.

APPROPRIATE OPTION STRATEGY

Buying calls and puts is NOT appropriate, because you pay large premiums for time value, most of which could be wiped out over time even as the stock gains in price. TIME DECAY is your enemy.

Selling covered calls each month in the option cycle on the stock you already own can significantly reduce the cost you paid for the stock in the first trade. Even if the stock goes down, you can still come out a winner!

(ii) Momentum or Trend trading

Once a stock has made clear move or breakout, the Momentum traders step in, and ride the stock up along a trend to its first major reversal. They hope to make shorter term profits from a rapid move in the price. Holding periods range from six weeks to six months.

APPROPRIATE OPTION STRATEGY

Buying calls and puts is NOT appropriate, because you pay large premiums for time value, most of which will be wiped out over time even as the stock gains in price. TIME DECAY is your enemy with Momentum Trading, unless you have a particularly strong and fast moving trend.

Selling Credit Spreads is a good strategy, and in fact can be very profitable, because as you sell spreads on the opposite leg from the stock’s direction of momentum (e.g. selling put credit spreads in stock with a strongly bullish trend), you can repeatedly buy back the spreads for minimum cost and sell another spread closer in. This strategy can easily yield 10-15% profit per month. Time Decay is your secret weapon for trading this strategy.

Selling Naked Puts is a good strategy, and can be even more profitable than selling credit spreads. However, it leaves you a position of possibly having to buy a lot of stock if the trade goes against you, and so your broker requires you to have a lot of margin.

(iii) Swing Trading

Swing Traders buy and sell swings or oscillations within a trend. Holding times are from between 2 and ten days. This is a shorter term trading technique that is more dependent on the trend direction than it is on fundamentals or technical indicators.

APPROPRIATE OPTION STRATEGY

If you have mastered the skill of identifying reversals or swings within a trend, and know how to plan an exit strategy, you will be able to start buying calls and puts, or DITM options, which will take you to real profits! With Swing Trading, holding times are short (2-10 days) and so you minimise the effect of your arch enemy, TIME DECAY.

(iv) Day Trading

Day traders focus on the many small moves that happen during the trading day, mainly shown up by candlestick patterns. This strategy has a broker’s requirement of a minimum of $25,000 to qualify, which knocks out many beginners.

APPROPRIATE OPTION STRATEGY

Option trading is not appropriate with this strategy. Broker fees for options trading are quite high, and Day Traders end up paying vast sums to their brokers.

In Summary:

If you own at least 100 units of a stock that is not particularly trending in any particular direction, sell Covered Calls each month in the option cycle. You can reduce the net price that you originally paid for the stock by between 5-12% each month.

If you have at least $1,000 in your account, and can identify a trend, you can easily sell Credit Spreads or Sell Naked Puts each month in the option cycle.

If you have mastered Swing Trading principles, especially the idea of planning entries and exits, you can start to buy Calls and Puts, or DITM options and make phenomenal profits.

 

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