Market News

June 4, 2012  Mon 8:50 AM CT

Blah. That's about how I feel about the market right now. It's been knocked down and there are plenty of reasons to expect a slow and frustrating period of consolidation in coming weeks and months.

Before considering how to trade it, I'd like to briefly explain my view on sentiment now. The first concern is the global economy, which is grappling with crisis in Europe and a potential slowdown in China. There are no clear solutions to either of these problems.

The next issue is that several key charts are flashing warning signs: Treasury yields, for instance, remain near long-term lows and could stay there well into the future. The euro, once a proxy for risk appetite, has also taken a beating and shows no signs of recovering anytime soon.

Oil doesn't look much better. At the same time, the Japanese yen has proven much more resilient than I had expected.

On the bright side, however, valuations are extremely low and stocks are underowned. The S&P 500 also seems to be finding support above its 200-day moving average and is in the process of making a higher low versus 2011 and 2010. Bearish momentum from earlier in the month makes a quick rally unlikely, but it also looks as if the bottom is in.

Selling options is usually a good policy when the market is grinding sideways. This is especially true when premiums are higher than they should be and stocks are due for a bounce.

So today I am considering "strangled longs," which entails buying shares and selling options. This can let you leg into a position while avoiding the angst that often occurs when attempting to time an entry.

Let's consider Imax, which is in the midst of a long-term growth cycle as its cinema technology spreads around the world. The stock has pulled back to key support above $21 and yesterday we saw bullish call buying, so it looks potentially attractive from the long side.

Say you want to own 200 shares. Instead of doing the full amount, buy only 100 and also sell 1 contract each in the June 20 puts and the June 23 calls. The stock costs about $21.50, while the options bring in $0.45 and $0.40, respectively, reducing your cost basis to $20.65.

You now have a built-in cushion of $0.85. If IMAX climbs above $23 in the next 2-1/2 weeks, you'll have to unload your shares for $23. Not a huge profit, but not bad either. Alternatively, if the stock drops below $20, you'd have to purchase 100 shares for that price. But at that price you might well want to add to the position anyway. (Remember, we're trying to build a position of 200 shares.)

The benefit of this strategy is that the credit earned from selling the strangle reduces risk. And the fact you're short puts effectively programs a buy order if the stock falls, saving you the difficulty of calling a bottom. The drawback is that it relinquishes big profits if a big rally takes place in a hurry--but I don't expect such a move anyway, given the bearish macro factors cited above.

Strangled longs also make a lot of sense in fertilizer names such as Potash (POT) and Mosaic (MOS). This sector has been beaten down hard, but recent reports suggest that demand is finally starting to rise. Juniper Networks (JNPR) and Morgan Stanley (MS) could also make sense at these long-term support levels.

Kodiak Oil & Gas, which is bouncing at its 200-day moving average, is another to consider. The only difference in KOG is that it would be better to go one month further into the future using the July 8/9 strangle, which could bring in a full $1 of income.

If you decide to pursue this strategy, just remember to only buy half the number of shares initially and then let the options do the rest of the work!

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of May 30.)
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