Greetings, fellow Pro-fundity team members -
6-18-99 Page

This week's Editorial Guidepost:

1. Having completed our series on Technical Analysis, we feel it's the right time to review issues that play an important part in short-term trading success. First, to cover actual trading scenarios with stock picks posted on the Pro-fundity Page using technical analysis tools. Secondly, to bring back to the table important money-making strategies studied in the far past with some new twists for today's market.
2. The Big Finger: I recall taking a written drivers exam in an Asian country many years ago. As I sat pondering the exam in front of me, puzzled by the not-so-familiar choices in a different driving culture, suddenly a hand came over my shoulder and a finger pointed to a choice on the puzzling question. An exam proctor, in military dress, had compassion on me and was helping me make the correct choices. I passed the exam and entered that segment of my life an official auto-jockey. I have often mused how great it would be to have a big finger point the right way through life. Particularly, in making stock picks and getting in and out of a position at the best time.
3. Such is not the case. However, I understand the desire we all have for this type help and the tendency to pounce on what seems to be a pat-answer, relieving us of the necessity to think. Unfortunately, we've used the computer this way with frequent disastrous results. The computer is a great aid in helping us make more intelligent decisions. It does not, and cannot, take the place of common-sense or the need to continually study and learn more of the tremendous body of knowledge available.
4. Case in point: A subscriber this week asked; "Can I use only the Stochastics to set my buy and sell points, waiting for a break to the upside of 20% to buy and a break to the downside of 80% to sell? Is this sufficient information to place a trade? Isn't the upswing above 20% an important indicator and a necessity to identify a buy point?"
5. This is a recurring question, a good question. My answer in part was, "Stochastics are a good predictor for overbought and oversold conditions in regularly rolling sideways-moving stocks. The 20% and 80% upswings/downswings have worked well for many traders. I've been burned too many times to use only that indicator. I'm not saying "don't use Stochastics," I'm saying use all the resources you can get your hands on and look for confirmations between indicators. Think of the odds in your favor if you have two, three or more indicators supporting a buy-signal from the Stochastics."
6. Let's share an example to illustrate the point. In searching for stocks to pick for this weeks page, we came across the drug company, Alpharma Inc. (ALO). This ticker passed several screens but was not chosen because it was a little pricey and was sending mixed messages. The first chart shows the price chart with Balance of Power and Money Stream sending a very positive signal. Based on this message, what should we do?
ALO - BOP & CMS
7. The BOP shouts of strong buying pressure with over a 25 degree divergence in the money stream. Remember, the indicators usually win this price/indicator battle. The next chart shows how the TSV is responding.




ALO - Time Segmented Volume (TSV)
8. TSV moves above both the zero line and its moving average the first of June and seems to be going off the chart. This confirms the BOP & CMS of the previous chart. A look at the next chart has two messages, first the On-balance Volume (OBV) in support of the last two charts but with the oscillators putting on the brakes.




ALO - OBV, RSI & Stochastics
9. The OBV (green) is laid over the Price chart to show the underlying volume support. This is the same pressure that helped make the previous indicators so positive. But the bottom picture showing the Stochastics (red & blue) and Wilder's RSI (yellow) would have us sell. What is the right answer? This is one you can watch yourself. We chose to stay out of this foray.
10. The reader had a good question. It is by asking the questions that we get ever-better as a trader. We welcome questions and will share with the team those that can help us become better at the business.

Options: We've received many requests for information on "Writing Covered Calls," a conservative money-making strategy we covered many months ago. We will re-issue this four-segment series with current updates starting now through the next three weeks.

1. This series of simple tutorials on options and how they can play an important role in a relatively low-risk way to support rolling stock efforts. There are those who say using the terms low-risk and options in the same sentence is an oxymoron. Read on, good people...
2. No one should ever invest in a market they do not understand. Before investing a penny in any market, it is essential we understand the risks, opportunities, rules and terms. Only then are we able to make the kinds of informed judgements necessary for success, and success in any market is all about judgement. That said, let's consider the "O" word, Options.
3. While stock market trading has been around since recorded history, options have only been traded on a formal exchange since 1973. We do not have parents who were long time options investors, teaching us the ins and outs of the discipline. The "terms" used in these transactions are not familiar to many of us. This vocabulary has not been tapped nor captured by a very large segment of particularly small investors. (Peter Lynch asks what is the "small" investor, someone under 5 ft. tall?) I mean the inexperienced investor trying to increase his net worth in $100 to $5000 increments. Not to exclude those fat cats with a lot more, but this "smaller" group has been neglected and is missing some fruitful opportunities.
4. There must always be an edge of caution with the unknown (and a need for educated caution with the known). The result of the "unknown" element in options is a mystique, fueled by horror stories about money lost and how risky the options market is. The option market is risky, as is the stock market. The key to either success is knowledge, understanding what the risks are and in tilting the playing field in our direction. For instance, when I buy a stock, I don't know the price will go up. But if I buy when the price trend is favorable,the technicals suggest strong upward support, the fundamentals of the company convince me it isn't entering bankruptcy soon, and the real driver of market opinion, "News," has no clouds on the horizon, I will have improved my odds of a good return. That is not gambling, it's smart business!
5. That does not mean I will always be right. It means I will be right more times than I am wrong.
6. So, what does the term "option" mean? I purchased a home many years ago. Initially, I leased the home for x.$ per month with wording added to the contract: "the option to purchase the home anytime before the end of the lease for a y.$ price." I owned an option to buy the home at a specific price before the end of the contract. This example contains the elements of what we term an "option." It is a "right" secured by a legal piece of paper, in this case the lease/option contract. I then "owned" the right to exercise that option. If I chose to exercise the option, I would have to come up with the price agreed upon to purchase the home. If I chose not to exercise the option, upon expiration of the contract, it would expire worthless. I had paid for the right to "buy" the property for a specified price during the term of the lease, the cost of that option being included in the lease payments.
7. During the time of the lease, if property values skyrocketed up or drifted down, I could still buy the home for the agreed-upon fixed price as secured by the option. On the other hand, the owner, by receiving money for this option, was "obligated" to sell me the house if I exercised my "right" to buy it.
8. Terms:

   • Option: "A contract that permits its owner to buy or to sell an asset at a fixed price until a specified date." The option is the contract, the piece of paper, giving its owner the "right" to buy or sell, for a certain amount of time. In the property example above, I, as the person paying the lease, could also arrange in the contract the right to sell my option to buy the home if I could find an interested buyer, and receive some commission or reward for finding the buyer. That is, I could treat the option as a commodity to sell for whatever the market would allow.
   • Call: "An option permitting the holder (it's owner) the right to buy a specific asset at a pre-determined price until a certain date."

9. In any free-market transaction, there is always a buyer and a seller. The option can be bought or sold. The "call" option is an instrument giving its owner a "right" to buy an asset. In the case of the market, that asset will be a stock. When I "buy" a call, I have paid for the "right," but I am not obligated to purchase the stock. The person who sold me the option, the seller, by taking my money, is "obligated" to sell me the asset (stock) if I choose to exercise the option.
10. In the property example above I would be holding a "call" option since I had secured the right to buy the property. However, I was not obligated. The owner of the property was obligated to sell me the home if I chose to exercise the option. I did, he did. In the stock market, I can pay for the right to purchase a particular stock by buying a "call" option, giving me the right, for a certain time, to pay a specified price to buy the stock. Now why are we doing this?
11. We would only buy a "call" to purchase a stock sometime in the future if we thought its price would go up in the meantime. That is, if we could pay for the right to purchase a stock for $12.50 a share (the strike price) within two months when we felt it was going up to $15.00 in that time, that would be a good investment. If the stock did go to $15.00, we could buy it for $12.50, sell it on the market for $15.00 and pocket $2.50.
12. If the price of purchasing the "call" in this example were $1, our net return would be $1.50. We have controlled a large amount of the stock with a small amount of money. We are able to trademore expensive stocks investing a fraction of the price. Sound good? What is the down-side?
13. Because an option is a fixed-time investment, we lose whatever we paid for the call if it is not exercised by its expiration date. What if the stock does not go up as anticipated? Oops! What if the stock drops in price? Double oops. (future editorials will discuss the use of "puts" when stock prices are expected to go down. But that will be for a later editorial)
• Derivative: "An asset that derives its value from another asset"
14. A call option on a stock is a derivative security that obtains its value from the shares of the stock purchased with the call option. All options are derivative securities. The market value of an option is affected by changes in the value of the underlying asset. What this means is the value of the option changes along with the value of the stock. The importance for us here is understanding that a change in stock price is magnified in the price of the option. A small change in the price of IBM can cause a large price change in a call option on that security. It is this "leveraging" feature that makes options trading such an attractive way to invest money. In fact, we can turn around and sell the option we purchased on a stock, make a profit, and never see or own the stock.
15. An option price depends on two important factors, value and time. (We will devote a later editorial to the "intrinsic" and "time" values of the option price) For our example here, Fore Systems Inc. (FORE) closed at $19.25 (19 1/4) on 1/7/99. A January call option for a $20 strike price was quoted at $0.63 (5/8). A February call option at the same $20 strike price was quoted at $1.94 (1 15/16). The reason these two prices are different will be covered later, just understand here that timing plays in important role in the premiums paid for options.
• Definition 1: An option is always quoted at a time and a price.
16. Quotes on FORE in the newspaper would look like this:
    

17. These two examples from the WSJ and IDB are exactly as shown in the paper. They only show a fraction of the option combinations available. They do not even show the same ones and are not easy to decode. We said that FORE closed on that date at 19 1/4. This appears under the name of the stock in the WSJ, and in the IDB after the term Close on the same line as the name of the stock. WSJ shows three call options: January $20 strike price with the contracts traded (3845) and the last quoted price for the option, 5/8 ($0.63); April $20, 690 contracts at 3 1/8 ($3.13); April $25 call, 423 contracts at 1 3/4 ($1.7). IDB shows us nine call options; three each for January, February and April. We will cover "puts" as seen in the WSJ later.
• Definition 2: Strike Price - The price at which the owner of a call option can purchase the underlying stock. Strike (exercise) prices are standardized into intervals, starting at $5, increasing at $2.50 increments until $25, then increasing at $5 increments until $200, then at $10 beyond $200. We see in the IDB example above the three strike prices shown are 17.50, $20.00, and $22.50. We cannot buy a $21.00 option.
• Definition 3: All option contracts expire at the close of trading on the third Friday of a month. That is, a July option would expire at 4:30pm EST on 7/16/99 this year.
• Definition 4: Contract - Options are only purchased in "contracts," each contract representing 100 shares of the stock. "c" in the IDB version represents a "call option." The $17.50 January call option traded 111 contracts (11100 shares) at price of $2.25 on the day before.
18. We learn from these two newspaper examples that a $20 call option that expires on the 3rd Friday in January traded 3845 contracts the previous day and will cost us 5/8 ($0.625) per share, or $62.50 per contract. If we make this purchase, we have the right to buy how ever many contracts we paid for at $20 per share up till January 15th.
19. To summarize:
    • An option is a derivative of an underlying stock, it derives its value from the stock.
    • The price of an option changes as the price of the underlying stock changes.
    • This price change is a magnified version of the change in stock price. Small changes in the stock price create large percentage changes in the option price. This is the good news.
    • We can invest in high-flier big ticket stocks with a small amount of money (the Intel's, the Microsoft's, etc.). This is more good news.
    • The "call" is the right to buy, or to call away a stock at a pre-arranged price within some fixed time.
    • An option is a fixed time investment, that is, it expires! This is the bad news.
    • We can be engaged in buying and selling options without ever taking possession of the stock. (When approved for that level by our broker)

20. How all this comes together in a coherent trading strategy will be the focus of the next several editorials. We introduced the concept of "buying" call options in anticipation of stock price increases. The next couple of sessions will be spent punching up the very conservative trategy of "selling" calls" on stocks we own (writing covered calls). This is the safest play with options and the one that should be mastered first!
21. Remember, our objective is to reduce risk. There are really some exciting ways to do this with options.

In coming weeks we will continue the series on Options (Writing Covered Calls) and take more stocks chosen as picks discussing their analysis to help increase our understanding. Stay tuned.

It is our intent to help our readers understand market strategies well enough to make informed decisions and understand the risks.

We provide TC-2000 tutorials to members. See the Member Login page.