Options 3 07-02-99

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Greetings, fellow Pro-fundity team members -
7-2-99 Page

This week's Editorial Guidepost:

Last week we covered our second installment on conservative option plays. We will continue with that important trading strategy with the third session this week but first discuss a particular stock we included in this week picks. Take a look at the recent price chart for Safety-Kleen (SK) from the New York Stock Exchange (NYSE).

SK - Price Bar Chart

Why would we include a ticker with this price pattern on a "Rolling Stocks" web offering? A brilliant question deserving a careful answer! Let's ask some basic questions:
- What is more important, finding a ticker that has rolled in the past, or a stock poised for a near-term up-tick?
- Do we want to make money or satisfy some philosophical strategic argument?
Our response:
- During our years trading rolling stocks we have found it difficult to find those perfect rollers.
- We have many such stocks on watch lists that continue to perform, albeit not at a rate with which we are comfortable.
- So, do we sit on the porch and wait for those perfect rollers to arrive at the preset buy point, or do we jump into the action and aggressively pursue opportunity?
We have chosen the latter. Let's understand why we see "opportunity" in the ticker SK. The following chart shows the same price pattern with the Stochastics lines. This confirms how inadequate this indicator is during markets that are moving up or moving down (trending). Remember, Stochastics provide great buy/sell triggers during sideways (trendless) markets. This chart is not trendless!

SK - Price Bar Chart with Indicators

The indicators suggest the following:

Stochastics (middle window, red & blue)are just moving sideways through June, no signal of value here.

Balance of Power (middle window, green bars) strong systematic buying.

RSI (top window, red) also moving sideways, but no evidence of an over-bought condition

TSV (bottom window, yellow with gray moving average) is far above the center line, confirming the BOP buying pressure. It has also been above its moving average until Friday's activity. Looking at its relationship with its moving average through June reduces fears of any strong change.

One more view of the price chart with the MACD indicator strengthens our case for a near-term up-tick.

SK - Price Bar Chart with MACD

Remember, the MACD is another oscillator with no pre-set limits for over-sold and over-bought conditions (The other two important oscillators have pre-set limits for these conditions: Stochastics - 20% & 80%, RSI - 30% and 70%). What is more important for the MACD indicator is the relationship of the indicator (red) and it moving average (green). When the red crosses up through the green, it suggests a buy is in order. The opposite occurs when the red crosses down through the green. Notice what happened the first of June. This adds to our case of strength, that this stock price is headed for a near-term up-tick.

These items are important to the technical analyst, the "when" to take a position in a stock. This is but one tier of our four-tiered process for stock selection. The fundamental analyst looks at the fundamental ratings of this stock (SK) and sees the following:

Earnings Per Share - SK's bottom-line earnings result are in the top 26% of the more than 7000 corporations being measured. Earnings power and growth are the most basic measures of a company's success.
Relative Price Strength - The market's cold and realistic appraisal of this stock outperformed 82% of all other common stocks last year.
Industry Group Relative Strength - This is currently in the highest rating for an industry group (sector). Remember, 70% of a stock's performance is tied to the market, in this case the market sector.
Sales+Profit Margins+R.O.E - This is the best measure of management performance and is rated high for our picks.
Accumulation/Distribution - This measurement tells us if the stock is under accumulation (institutional buying) or distribution (institutional selling). We avoid stocks under distribution.

Added to the Technical and Fundamental tiers are our proprietary Rolling Analysis and News. This unique four-tiered selection criteria is our way of pushing the chips to our side of the table. Does it mean we will win all the time? No! It means we will win more than we will lose. Then, using appropriate trading strategies we limit the losses and magnify the wins.

It is for these reasons we have included this stock in our picks this week. Careful study of other picks may suggest similar reasoning. Are they guaranteed to go up this week? What have we said about guarantees? Death & taxes... However, we are arming ourselves with the tools and understandings to increase our odds of success. This is not a gamble, it is just good business. Remember, the best way to gain confidence in this arena is with dozens of paper trades. There is no better education: Take positions, observe the results, study ways to correct mistakes and do it all again. We have included forms for paper trades in our book, Provident Investing.

We've been asked why we show a scorecard of success and failure on a weekly basis. Any market pundit will tell us we set ourselves up for almost certain failure trying to predict market moves in the short term. We understand that hazard but choose to put our head on the line. We hope members will understand the nature of our rolling analysis and what we're trying to achieve. It is only by stepping into the battle we will ever achieve greatly. We choose this opportunity to honor those who have gone before to create this great free market place in which we can try! Independence is one of the greatest blessings (and responsibilities) we share together. May we all pay our respects on this holiday weekend. Drive carefully.

Options:

This represents the third installment in our series on conservative options plays. This week we will demonstrate why many find Options trading so exciting. We will then review the risks and finally learn how option premiums are determined before we begin writing covered calls, the least risky options strategy.

We showed you two weeks ago (6/18/99 Page) an actual Options quote on Fore Systems Inc., FORE, from newspapers dated 1/7/99. This showed the role "time" plays in the premiums paid for the options. In the following, we repeat a portion of the 1/7/99 quote and a later quote, 1/20/99, from the Investors Business Daily. This shows graphically the reason many find options trading so exciting.

Point 3 in the summary two weeks ago: Changes in the stock price are magnified in the price of the option!

Date $22.5 Feb C Close

1/20/99 $1.63 (1 5/8) $21.06

1/7/99 $1.13 (1 1/8) $19.25

Difference $0.50 (44%) $1.81 (9%)

Dealing strictly with options, had I bought a $22.50 February Call (naked) on 1/7/99 and sold it thirteen days later I would have realized a 44% gain (1235% APR)! If that isn't exciting you need oxygen.

But what's the down side? The manic nature of the market, particularly where severe volatility is the norm, heightens the risk. That kind of an upward swing has its counterpart in the opposite direction. Look at the next figure, showing two similar stock quotes for the Borders Group (BRG).

Date $20 Feb C Close

12/30/98 $5.50 $25.13

1/7/99 $0.75 $18.56

Difference -$4.75 (-86%) -$6.57 (-26%)

So it goes both ways. This is a great example of the Risk/Reward ratio, how they go up or down together. We will take advantage of the leveraging feature of options (Reward) with a calculated uncertainty (Risk) and try to tilt the Risk/Reward ratio in our favor. But first, let's understand how option prices are determined.

We said earlier that the option premiums were based on value and time. Since an option is a fixed-time investment, the time portion of the price decreases as the expiration date approaches. The value portion depends on what the stock price is doing.

The important issue: Where the stock price is relative to the strike price.

We have three possibilities (and names) for a call option:
1. The stock price equals strike price. At-the-Money
2. Stock price is above the strike price In-the-Money
3. Stock price is below the strike price Out-of-the -Money
  
  For example:
  
  If the call option strike price is $22.50, we have for the stock price ;
  $23.25: In-the-Money (any price above $22.50)
  
  $22.50: At-the- Money
  
  $19.85: Out-of-the-Money (any price below $25.50)
  
  Case 1: Regarding our covered call strategy: If we bought 100 shares (1 contract) of FORE when the price was $19.25 ($1925) on 1/7/99, we could turn right around and sell a call on the stock we now own. A $22.50 Call for February would have brought into our account (the very next day) 100 x 1 1/8 = $112. That's cash we can spend or put to work! We lose control over the stock we just purchased until the 3rd Friday in February. If the stock moves above the strike price we will be called out at $22.50 realizing $437 profit in 6 weeks ($2250 [what we sold the stock for] - $1925 [less what we paid for it] + $112 [what we made selling the option], less commissions). That's about a 22% return (190% APR). If we aren't called out, we regain control of the stock and may choose to sell another call. (Our example shows a one-contract transaction. Commission costs will be less for larger volume but must be considered in finding actual return)
  Case 2: Let's change our sequence a bit by buying the stock as before but waiting for the stock price to increase before selling the call. In the quotes on FORE above, the price for the call on 1/20/99 was 1 5/8 ($1.63). Had we waited two weeks while the stock price strengthened, our return would have been $51 higher ($163 - $112), with the return of 25% (instead of the 22% in the last example). This may not seem a lot but it is this level of detail that spells the difference between home runs and ho-hums.
  
  Now let's look at an example of option prices as the stock price moves up. Look at three quotes, taken from the IDB on three dates, for Iomega (IOM). This shows the stock price, the option premium and the time left to expiration on each date for an In-the-money call option. Also shown is the open interest on each date. Take a minute and study this table to find these.
  
  In this example we can see how the premium changes as time approaches expiration. Initially, the premium has both time and value content. In this, an In-the-money call, the premium has intrinsic value because the stock price is already above the strike price.
  
  However, the option premium is larger than this intrinsic value, because of the added time value. As time approaches expiration, the time value goes to zero and the premium is all intrinsic value. In this example, as the time value decreased, its intrinsic value increased with the increasing stock price.
  
  Take another look a t Iomega with an Out-of-the-money call for the same time period:
  
  $10 January Call
  In this case, the premium is not so easily defined. There is no intrinsic value and the premium is much less, primarily only time value. Expiration day was the 15th of Febr uary, the third Friday. The reason the premium has any value at all in Table 2 is the newspaper date was 1/15/99, but it reported Thursdays prices on the 14th. The premiu m would be worthless on Friday without a dramatic rise in stock price that day.
  
  To further lock these ideas in, look at the February calls for Iomega during the same time frame showing both the $7.50 C and $10.00 C in the table below.
  Notice how the premiums compare to the January calls. In each case they are higher for the February calls. Everything else is equal, only the time to expiration is longer. There is more time for the stock to react in the way we want it to. There is more time value.
  
  In next weeks editorial, we will put all this information into a stock play to make it clear why we're spending this much t ime on the preliminaries.
  
  I want you to take time before next week to consider the Open Interest shown in the tables above. That is, consider where the greatest open interest is. Open interest is the number of contracts that are outstanding, those tha t have been created but not exercised. The higher the open interest, the easier it would b e to either buy or sell (write) large numbers of contracts. This is termed increased liquidity. The level of open interest tells you just that, where are most investors interested. What I'd like you to consider is why the interest is higher in one position th an another.
  
  Summary:
  1. Understanding how options are priced will incr ease our confidence in venturing into the options market.
  2. An option premium is basically made up of two parts:
    Intrinsic value - the portion of the premium that is e qual to the degree that it is In-the-money. If I own a $15.00 February Call and the stock p rice is $16.50, I can exercise the option for $15.00, sell it on the market and pocket $1.50 . The option has an intrinsic value of $1.50.
    Time value - related to the "hope" that the stock will react in the right way for us. The more time to expiration, the more c hance of this taking place. Therefore, time value decreases to zero at expiration date.
  3. Several factors contribute to the exact time value. Three important factors are:
    
    Stock price - Options on a $100 stock will have greater time value than one tradi ng at $20.
    Volatility - The greater the movement of stock price, the higher the time-premium.
    Supply & Demand - The more people trying to buy, the higher the time value.
  4. Because the price of an option will increase tick for tick with the sto ck after it becomes In-the-money, the leverage of option trades is its most attractive featu re. We can control expensive stocks with a relatively small investment and take advantage o f the increases that follow even blue chippers.
  5. Leverage requires a stock to react in th e way we want. If we buy a call, the stock must increase for us to benefit.
  6. The risk of buying a call is that the stock may not increase, or even go down. We can lose all of our investment because the option is a fixed time vehicle. It not only has to go in the right direction, but it must do so within a specific amount of time.
  7. If we own a stock, we can write (sell) a call for a premium and agree to sell it if it reaches a specified pric e, called the strike price, anytime before a specified expiration date. We limit our risk i n this case because if the stock does not move in the way we want, we still own the stock an d can keep the premium received for selling the call. Our risk is in not being able to capt ure all the profits, beyond the strike price, if the stock move dramatically upward.
  8. Coming attractions: