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What's the Trade?   March 28, 2012

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This Week's Education Tip

Butterflies and Condors are trades intended to take advantage of a neutral outlook and/or high implied volatility. They involve buying two options, at a net debit, to establish a position which profits if the underlying stays within a given range. Learn more in our free Education section.
Many experienced options traders never actually own stock, at least not for long. And there's good reason for that.

The flash crash of May 2010 scared many out of the market, especially retail investors. And last week saw a big drop in shares of Apple, falling to $542.80 from nearly $600 on Friday morning. Now that may have been just a "fat-fingered" mistake or a computer glitch, but some recent research has looked at the significant number of mini-flash crashes in individual equities.

We know that the market can drop quickly and gap lower. Stop-loss orders or trailing stops make sense for stocks, but they may get filled at much lower prices on a quick move or low liquidity. 

Many traders use collars for protection, selling calls and buying puts to limit losses while keeping the hedge costs low. That is a good idea for those who must be long equities, as we noted in a recent column about the famed "Cuban collar."

But a bull call spread is essentially identical to collaring a long stock position and doesn't require owning any shares, so it has a much lower margin requirement. More important, this option position will not get crushed in a flash crash.

Another strategy that can make sense is a bullish butterfly. This trade has greater commission fees and is exposed to more bid/ask spreads, so limit orders are a must, but it can be hugely profitable on stocks that are grinding higher. (I discussed just such a strategy on Apple in this February column.)

Bull call spreads or bullish butterflies preclude the need for hedging because they are already hedged. The potential gains are limited, but these positions will provide much-needed protection if stocks drop dramatically in a matter of minutes or seconds.

The same long option strategies can be used in VIX-based exchange-traded funds and notes. Or better yet, in put spreads for those with a bearish inclination or wanting some balance in their portfolios.

While the issues surrounding collapse of the TVIX can be argued til the cows come home, those who had long VIX calls or VXX call spreads did not see half of their positions disappear in two days, as those who owned TVIX did last week.

A good strategy is one that can make money if the underlying assets rise but has a small risk and an asymmetrical payout. That is exactly what call verticals and butterflies can do for you, without costing a huge premium for protection. (See our Education section)

So even though options are more complex than stocks and do require more education, they are well worth the effort both for returns and risk management.

Let me begin this column with a proviso: Almost everything is going up now because we appear to be at the start of a new bull market. After a decade of being hated, equities are hugely underowned and the economic cycle is now in its expansionary sweet spot. And unlike the last recession, the next contraction will probably be less painful than 2007-2009 because it likely won't involve a debt implosion.

As I outlined last month, the easiest way to make money right now might simply be to own the Nasdaq. It's in the midst of an amazing run thanks to modest valuations and solid fundamentals for its large-cap members. But we've all been there and know it's hard to buy something that's going straight up. So I understand if you're reluctant to chase it at these levels. (However, if we get a nice pullback -- say to $65 on the QQQs -- game on!)

For those readers with the natural tendency to hunt for sectors that are still cheap, banks and bullion look to be the best bets. And it's partially thanks to Ben Bernanke and his unending policy of "accommodation."

I think the run in financials is far, far from over. As I argued two weeks ago, they remain cheap from every perspective and are now on the cusp of real earnings growth, rather than simply coming back from a crisis. And, we have continued to see bullish upside activity since that column. For instance, yesterday an investor bought 80,000 June 29 calls in the SPDR S&P Bank exchange-traded fund (KBE), which broadly tracks all banks. That implies a move of 20 percent in the next three months. Pete also cited bullish activity in JPMorgan Chase's April contracts.

The financial space is awash in buying opportunities. Consider, for instance, Puerto Rican lender Popular (BPOP). It's trading at barely half book value and looks like it could easily return to $2.50 or $2.60 before hitting resistance. Regions Financial (RF) trades at about 0.6 times book value and is consolidating above its key levels from last June and July. And then we also have the behemoth Bank of America (BAC) trading at less than half its book value.

These names look attractive around current levels. However, the broader market is showing some signs of toppiness in the near term, so it also makes sense to save some cash for a pullback. For instance, one might consider programming limit orders of $1.95 on BPOP, $5.98 on RF and $8.60 on BAC. If we do retreat, the buying window on these stocks will likely be hours rather than days.

Gold is also interesting because it's in a long-term uptrend and currently offers an easy entry point.

The yellow metal tends to rally and consolidate, rally and consolidate. It often exits consolidation phases by breaking out of bullish-flag patterns, which seems to be happening now on this chart of the SPDR Gold Shares exchange-traded fund (GLD). It's worth buying incrementally in the short term, realizing that GLD could potentially drop to $153 before rallying. If it breaks above $175, there's probably no going back.

GLD

This also makes gold miners attractive. This group has been hated for the last year, but they're extremely cheap based on fundamentals, with long-term price/earnings growth ratios of less than 0.5 times. The Market Vectors Gold Miners fund (GDX) is now at an entry point where you can set a stop loss 6-8 percent to the downside and target gains of 20-30 percent. I know it doesn't feel good, but based on risk/reward it makes sense.

(Chart courtesy of tradeMONSTER)





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