Forming a Market Top - Understanding the “Put” Option
I have the prestigious honor (of being selected) to give a TED talk at CMU on Easter Sunday. The theme is ‘FearLess’ and my topic is: “Fearless Investing.” The event is being streamed – and for those of you wishing to watch (and I would be indeed honored) – you can turn to: www.TEDxCMU.com/watch
If you believe (as I do) that we’re in the final stages of forming a ‘market top’ – then let’s explore ways to take advantage of a market decline – one of those ways is buying the “PUT” option. An ‘Option’ is the ‘Right’ to do something. Think of it this way: suppose you are driving home and you see a car for sale parked in a yard. It's a real beauty and you know from experience that it should sell for about $25,000. You walk over and the sign reads "One owner, 1,000 miles, perfect condition - $10,000." Thinking this must be a mistake you run up to the house to inquire. The owner says the deal is for real – he just wants it gone. So you say to the owner: "I would love this car, but I'm not sure my wife would approve of me spending $10K without her, so I would like to give you $100 dollars to hold this deal until tomorrow. If my wife says ‘yes’, then I will take the car for the $10K, but if she says no, you can keep my $100 dollars for all the trouble."
That is an option! You have the right, but not the obligation to purchase something within a specific period of time. But why use an option instead of just buying the stock itself – you ask? The answer is that a small amount of money can control a much higher priced issue. In our example, $100 controls a $25,000 car. In stocks - $2 to $10 options will control $10 to $100 stocks – but more importantly ... if you trade that option you can make some incredible profits.
Back to our example – if we purchase the car for $10,000 and let’s assume we can sell the car for $20,000 – that gives us 100% profit on the transaction. But on the other hand, suppose you sold your option? Let's say you went to a car dealer known for selling that brand of car and said ... "I have the option of buying this car which you sell on the lot for $25,000, for $10,000. I don’t want all the hassles associated with buying and re-selling a car - will you give me $1,000 for my option to buy that car?” If he agrees to buy your option – you purchased the option for $100, and sold the option for $1,000 – that’s a 1,000% return on your money – and you never had to take possession of the asset. So for the most part we don't buy options to actually "execute" them (or go through with the underlying purchase) - we buy them to trade them as their value increases.
The above is called a “CALL” option – the ability to purchase something at a pre-determined price. On the other side of the coin is the "PUT" option – the ability to SELL something at a pre-determined price. We buy a PUT if we think the asset is going to fall. So let's say you think the XYZ company is going to sink because their sales are slipping. XYZ is currently trading at $50 dollars per share. You could buy the August $50 dollar PUT option (for $5) and if you are correct and XYZ falls to $44 dollars per share, your PUT option will probably have almost doubled. You would then sell the PUT option and pocket the profit. (Naturally if the stock rises instead of falls, the option you paid $5 for is going to be worth less in a hurry). So with a PUT option – you have the ‘right’ to sell a stock at a pre-determined price – which means the PUT option increases in value if the stock actually falls.
So – if you thought that this market was just way out of whack and should lose a lot of it’s value - you could buy the January 2011 DIA PUTS. That would give you 8 full months for your option to work. In fact, during 90% of the calendar year 2008, we were holding long term PUTS against the market. Some of those PUTS gained almost 500% as the DOW fell from 14K to under 9K. Next week we’ll talk about inverse ETFs.
This market action is very indicative of two things. One, by every measurable metric the market is well overdone to the upside. So, there's two ways to work off an overbought situation. The market can fall (a sin according to Bernanke) or tread water "sideways" – which is basically what it’s doing. Secondly, after months of moving higher, the market often gets into a pattern of "sucking in late comers". Many people have watched the market move higher without them, so they finally decide to get in. They send in market orders before they go to work, the market makers open the market higher and fill those orders, then later in the day they let it fall, effectively taking the late comers money. This is also happening.
Now this week we had Friday’s Jobs Report – and in it we found out: Economy adds 162,000 nonfarm payroll jobs - biggest U.S. employment rise since March 2007. Now before we get too excited about the report, thanks to Steve Forbes for writing:
- ADP, a payroll services firm, said the private sector shed 23,000 jobs in March.
- The number of long-term unemployed workers (those out of work for 6 months or longer) - increased by 414,000 during March to 6.5 million.
- 44.1% of unemployed workers have been jobless for 6 months or more.
- A Gallup Daily survey found that the underemployment rate - edged up to 20.3% in March, from 19.8% in February.
- Construction spending in February tumbled 1.3% to a seasonally adjusted rate of $846.2 billion, down from $857.8 billion in January.
- AVERAGE HOURLY WAGES fell – which is further indication that good jobs are leaving but we’re still hiring: “Do you want fries with that?”
We think we are in a market topping action – and give us this week to potentially see the turn.
Jacob Hawkinson wrote this week concerning Copper: “With copper at a 2 year high – currently good traders are playing copper from the short side, however the length of their holding periods and success of their trades are inversely correlated’ – excellent comment – don’t marry it – date it!
James Taylor writes about AGI – Alamos Gold – Encouraging Reserve Increase Highlights Exploration Potential. He rates it a ‘Strong Buy’ with a price target of $19 vs the closing price of $13.57 – You know me and GOLD - I’m looking at it for sure.
If you’d like to view my actual stock trades - feel free to sign up as a twitter follower – “taylorpamm” is my nickname on Twitter – fyi.
Remember the Blog http://rfcfinancialnews.blogspot.com/
Until next week – be safe.