By Lee Lowell, Advisory Panelist
Friday, October 5, 2007: Issue #462

“Wow, you see what the market’s doing today?” “Hey, check out Stock X – it’s flying!” Boy, if I collected a dollar for every time someone said this to me whenever a market/stock makes a big move, I’d probably be kicking back on a beach right now.

If you’re in the investment world like we are, you hear this all the time – and this past Monday was a good example. Talk about getting a fresh start… the stock market shook off its third quarter woes and leapt into the fourth quarter with an impressive peformance. The Dow sprinted past 14,000 and set an all-time high, while the Nasdaq 100 galloped to new six-year highs. As many stocks sucked up Wall Street money and charged ahead, many investors simply looked on and admired the rally, wishing they were a part of it.

But you know what the professionals were doing? They were making money from it. And they were doing so using a very sophisticated, yet easy-when-you-know-how investment technique, called an strangle option, that is invaluable when assets make big moves. And today, I’m going to show you how to do it, too…

Straddle The Fence… Then Jump Down On The Profit Side

In this column we gave you the nuts and bolts of an option trading strategy known as an “options straddle.” It’s the type of play where you buy both a call option and put option at the same time with the same expiration date and the same strike price.

You execute it when you want to take advantage of an explosive move in the underlying shares. And here’s the beauty: It doesn’t matter which direction the stock goes. You’re not making a bet on that – you’re simply betting that the move is going to be big, regardless of which direction. As long as the move is large enough to offset both option premiums that you’ve paid, you’ll have yourself a winner.

We Straddled A (Hypothetical) Win On Google… Now We’re Going To Strangle Some Gains, Too

When I discussed straddles, I used a hypothetical example on Google (Nasdaq: GOOG) options that expire this month. Specifically, we bought the $550 straddle ($550 was our strike price) that cost us a total of $35.80 for both options combined. This equated to a dollar value of $3,580 for one straddle purchase. Working on the theory that Google could see a large move, regardless of direction, we bought both the call and the put.

Right now, that straddle is worth $51. That means we could cash out for a hypothetical gain of $1,520 per straddle and a 42% return on investment in just a few short days. Not too shabby!

But the straddle play has a brother. It’s called the “strangle.” It’s exactly the same as a straddle, except that the strike price levels for the calls and puts are different.

There is one other key difference, too. While it’s best to pick at-the-money options with straddles, when playing strangles, we choose options that are out-of-the-money (OTM). This means the overall cost will be less than the straddle because OTM options are cheaper to buy.

While this sounds great on the surface, be warned… the cheaper cost comes with a caveat: Since the options are OTM, it’s going to take a bigger move in order to see a profit. But if you’re confident of a large move, the strangle can give you a larger return.

So let’s see how it works in reality, again using Google as an example…

At-The-Money For Option Straddles… Out-Of-The-Money For Option Strangles

Take a look at the Google option chain below and we’ll construct a hypothetical strangle options play.

While we played the October options for the straddle, we’re going to go out to November for the strangle. The price of GOOG at the time of this screen capture was $585, so we would pick OTM strikes to form the strangle.

You could pick whichever OTM strikes agree with your wallet, but for the typical strangle, you want to focus on strikes that are roughly equidistant from the current price of the stock. So for this example, we’re going to use the $600 call (GOO-KT) and the $570 put (GOP-WQ), which are both $15 OTM and equidistant from GOOG’s price of $585. The cost to buy both options at their “ask” prices would give us a total cost of $35.20 for the strangle ($19 for the call + $16.20 for the put), or $3,520 in total dollars.

Next step… figuring out your breakeven level…

Crunching The Numbers… Finding Your Breakeven And Profit Levels

You always want to know what your breakeven prices will be if you are going to hold onto this play until option expiration. This lets you know how far GOOG must go before you’re profitable. All you do is add the total strangle price to the call strike and subtract it from the put strike to find your breakeven levels.

So we have $600 + 35.20 = $635.20

… and $570 – $35.20 = $534.80.

Bottom line: Until/unless GOOG gets past either level, you won’t be profitable if you held until expiration. The graphic below shows you how the breakevens look on a chart.

Of course, you don’t need to hold until expiration. You can sell at any time. So if GOOG makes a large move soon after you buy the strangle (just as it did with our hypothetical straddle play), you could easily sell it for a profit.

Take a look at the profit & loss table below to see how the strangle will fare on expiration day at various GOOG share prices.

You can see from the chart and the spreadsheet that if GOOG stays between $570 and $600, you will lose the maximum amount. However, that can be no more than what you paid for the strangle.

But once you move either lower than $570 or higher than $600, you’ll see your losses decrease. And once you get past the breakeven points of $534.80 or $635.20, you’ll move into profitability.

**Please note that the Google example above is just an example of how a strangle works, not an actual recommendation.

Don’t Let An Options Strangle Choke Your Profits

Of course, there are a couple of downsides to buying a strangle – and you need to know about them before you execute this options play.

First of all, remember that you’re buying two different options and paying two premiums. So instead of just buying the call or put and hoping it makes the move you anticipated in one direction, GOOG needs to make a very large move in order for you to profit. In fact, GOOG must make double the move in either direction to offset the total $35.20 premium.

So one thing you might want to consider is to execute an options strangle strategy on a stock that has shown the ability to make big moves. That certainly applies to Google. However, while it could move past either breakeven level and become profitable, keep in mind that it can also trade in unprofitable areas. It’s essential that you keep an eye on the underlying stock’s activity, so you can book profits quickly before you lose them.

Lastly, since the options for a strangle play are OTM, GOOG has to move a little more than it would need to for a straddle. The tradeoff to that larger move is the strangle will always cost less than a straddle. Bottom line: You need to strike a balance between how big you expect the move to be and what you can afford to risk.

Good investing,

Lee Lowell

PR: wait… I: wait… L: wait… LD: wait… I: wait… wait… Rank: wait… Traffic: wait… Price: wait… C: wait…

by Lee Lowell, Commodities Specialist, Mt. Vernon Research
Wednesday, August 15, 2007: Issue #701

Editor’s Note: Lee Lowell is one of the smartest commodity investors I know. For six years, he worked on the floor of the New York Mercantile Exchange as a market maker, and for the last 11, he’s been making a living trading his own money in commodities. He’s exceptionally good at it, too
More than 80% of the trades in his commodity advisory service have been profitable.

I talked to Lee this morning, and he’s looking at three possible trades right now. So as stocks continue to ricochet down Wall Street, here’s a way to make some money in commodities

A. Williams
Managing Editor, Investment U

I’ve been an active commodities trader for 16 years, both on the floor and off. And one of the reasons I like this market so much is that there are only 15 to 20 commodities that are truly worth trading.

When the number is that small, you really get to know the market’s behavior and seasonal tendencies. This allows you to become intimately familiar with each commodity, and that makes trading them much more profitable over time.

I’m always scanning these 15 to 20 commodities to see if any new trading opportunities exist. And at the moment, there are three I’m close to pulling the trigger on. But first, let’s look at how the commodities market works, and the best way individual investors can play it.

The Commodities Market is Pure Supply & Demand

The commodity markets tend to move in more predictable and smoother patterns over the long run, compared to stocks. That’s because they truly end up making their moves based on supply and demand

There are no firms and CEOs running the commodity markets. There are no quarterly earnings reports. And the Fed isn’t trying to intervene.

Many physical commodities are food-based in nature and tend to move according to growing patterns, seasonal tendencies and weather. We’re talking about corn, wheat, soybeans, coffee, sugar, cocoa, orange juice, crude oil, natural gas, etc. Prices are based on how well the crops are growing and how much supply of the product is currently in storage.

Although there are some government reports to contend with, they typically only give us a clue as to how the crop is progressing in the growing cycle. Even though you may read about a hedge fund or two trying to control a certain futures contract, the commodities market is so large and so deep, that the hedge fund may only have a very short-term effect.

With that said, if you’ve never traded commodities before, you may be wondering how you can get involved. It’s actually pretty easy

How To Buy and Sell Commodities

Commodity trading is actually just as easy as stock trading. The best way to get involved is through futures contracts and futures options contracts. Purchasing and selling these is the same as trading stocks or stock options.

Other than buying orange juice or coffee at the local grocery store, speculating on the future movement of physical commodities can be done by buying and selling futures and futures options contracts that trade on one of the designated commodities exchanges around the U.S.

The most notable futures exchanges are the New York Mercantile Exchange (NYMEX), the Chicago Board Of Trade (CBOT), the Chicago Mercantile Exchange (CME) and the New York Board Of Trade (NYBOT).

You can trade both futures contracts and futures options contracts at these exchanges. The only thing you would need to do is open a commodity trading account with a registered commodity broker. (See today’s Crib Sheet for a list.) This is no different than opening a stock trading account.

Once your account is open, you can trade commodities the same way that you trade stocks. Do your research, look at the charts, check the fundamentals, and then enter the trade. For me, the only way to play commodities is through the use of options contracts, for a couple of reasons

• Options keep your risk limited at all times, but the gains can be unlimited. This lets you sleep soundly at night, as you never have to worry about unlimited risk, like the risk associated with short selling stock.
  
• With options, you don’t need to be correct on your directional assessment of the market to have a profitable trade. It’s true. You can be totally wrong on the direction, but your options can still produce a profit. (Selling “option credit spreads” is the strategy that can do this.)

Now let’s take a look at three potential plays I’m keeping my eye on right now

Three Ways to Play the Current Commodities Market

1. Natural Gas

The natural gas market has taken a big beating to the downside over the last two months. My sources in the option pits tell me there might have been another troubled hedge fund that was liquidating futures contracts that led to the big decline.

The other reason is that the large amount of natural gas supplies in storage has been weighing on the market. But, as we have learned over the last few summers, we’re about to hit the major portion of hurricane season, and not too many people want to get caught short this market when hurricanes do decide to come our way.

The chart below shows that natural gas futures have most likely made a bottom and will probably trend higher from here, or at least not retrace much lower.

2. Coffee

Here’s a chart of the December 2007 coffee futures:

Although a major portion of coffee is grown in South America and its winter season is winding down, we’re seeing a push here to the upside that may keep going. If it can stay above the resistance line that I’ve drawn for the next few days, it might be ripe for a bullish trade.

3. Orange Juice

Lastly, we have the orange juice market

Although orange juice is not known for its high volume or huge following, we do know that during hurricane season we can see major moves to the upside.

This is a highly speculative play, but if Florida gets whacked with a few hurricanes over the next two months, we could see the orange juice futures move to all-time new high levels. Considering the massive drop the orange juice market has endured since the spring, taking a limited-risk bullish option position could be the smart play.

Good investing,

Lee

Editor’s Note: To learn more about Lee’s commodity advisory service, and to get his recommended trades delivered to your inbox, here’s how it works.

Today’s Investment U Crib Sheet

Here are three commodities brokers you can use to get started. All of them know Lee, and are familiar with his strategies. We receive no compensation from these groups. This list is for your benefit only:

• 5perside.com
  www.5perside.com
  800.523.7357
  If you contact them, ask for George Sampogna or Chris Brooks.

 

• RMB Group
  www.rmbgroup.com
  800.345.7026
  Ask for Bob Meier or Steve Belmont.

 

• Foremost Trading, LLC
  www.TheFuturesBroker.com
  888.262.6455
  Ask for Bob Miller.