Option Plays for Year-End

11/16/2007 12:00 am EST

Focus: OPTIONS

Jon said options are great hedging instruments when used to protect your portfolio, but many traders don’t own stocks; they trade options to participate on both the up and down sides of the market. His advice for traders just starting out: don’t get complex; just focus on one-to-two basic strategies.

One area that he focuses on is open interest, or how many options contracts have been written. If interest is building, it means more people are speculating and could be a sign that the big institutional money is flowing in. Jon cautioned that investors and traders need to find out which months the institutions are buying. He often invests based on breakouts in open interest.

Tim asked Jon how to play the Dow right now. Jon noted that since mid-October through options expiration in November, institutions were buying lots of puts to protect themselves due to the problems in financial stocks. By mid-November, the contracts started being taken off. Jon surmised that we are not out of the dark yet, but he is seeing some light. And when the December options expire, most of the aggressive bets on the downside will be gone.

To determine if there will be a Santa Claus rally at the end of the year, Jon suggested watching the retailers for call buying. He hasn’t yet seen a big build-up. If it comes, it will be a positive surprise.

Tim turned the conversation to foreign exchange and asked Jon to comment. He noted that large multinational corporations commonly trade currency options and the weak dollar has been a boon for them. However, if the dollar gains strength, the exporters will be hurt and will need to hedge.

For the individual trader, Jon suggested you make sure, if you buy a call, to give yourself enough time to be right, at least two-to-three months into the future. If you want a play directly on the dollar, buy calls that will increase as the dollar increases or puts on the Euro. He believes the European Central Bank will accelerate the dollar’s climb by cutting rates in Europe, which will make dollar deposits attractive—a comeback that may last at least a year or two.

Switching gears, Tim asked Jon about actions to take for year-end, and Jon recommended keeping your eye on tax-loss selling. Investors traditionally match up their gains against their losses at year-end, selling their losers between the first and third weeks of December, and sometimes buying them back mid-January (in compliance with the wash-sale rule).  Astute traders and investors can make money on both sides—first by buying puts or selling the stocks short, and then, perhaps going long before the buybacks begin in January.

Tim then asked about buying options on some of the more expensive stocks like Google (NASDAQ: GOOG), instead of the stocks themselves. Jon said that three out of the four horsemen of the NASDAQ—Google (GOOG), Apple (AAPL), and Research in Motion (RIMM), were all good candidates for options, as the stocks are all trading in the double-digits. For that matter, the 4th horseman—Amazon (AMZN)—at more than $88 per share, would also be a good candidate. The volatility in these shares—as well as their lofty prices—make them great opportunities for options trading.

Jon reiterated that the cardinal sin of options trading is not giving yourself enough time to be right, so buy options 30-60 days out.

Lastly, Jon mentioned that he finds plenty of ways to play energy, outside of oil and other products, like gas, that we consume. For example, he finds solar and wind attractive, and especially likes to buy solar when oil rises, as the big institutions start throwing money at solar companies during those times. Some of the companies he mentioned include, SunPower (NASDAQ: SPWR), First Solar (NASDAQ: FSLR), Evergreen Solar (NASDAQ: ESLR), and even General Electric (NYSE: GE) and Siemens (NYSE: SI), although they are not pure plays for solar or wind.

The smaller companies are trading with growing volumes with an active options market, but they are very volatile, which requires discipline.

Jon suggested that buying and selling different options on the same stock lets you control the stock without buying the shares outright—the best of both worlds.

Related Articles on OPTIONS