Bypass the "Bear" Trap (Part 3)

09/10/2008 12:00 am EST

Focus: STRATEGIES

Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

Build your own ETF.

Sure, you can buy exchange traded funds, which represent a group of stocks in a particular sector. You can even buy ETF options. But I encourage you to look very carefully at the specific names within an ETF, and how they are weighted. Some components might be doing well, but if there's a big loser on the list, it's going to drag down your trade.

I like to simulate owning an ETF simply by casting a net over the top three-to-five names. My criteria are simple: I want to see big-volume trading in companies that had a stellar last quarter (i.e., they beat estimates, raised forward guidance and maintained/raised their dividend, if they have one), and are confident that they can up the good work.

Even better for us, it's earnings season, so the time is now to get a clear picture of how they did during some very tough months, and how they're planning to do three months from now.

Pick good story stocks, but avoid the fairytales.

For the most part, companies try to be forthcoming with where they see their businesses heading in the coming quarters. Remember, Wall Street is also making its own bets on their performance, so even if a company has a spectacular quarter, but it falls short of analysts' estimates by a penny or two, it can sink the stock.

So, sure, a company can make any old projections that it wants to (case in point, many of the banks that still haven't fully reported how big their losses and subsequent write-downs will be). But for the most part, if a company says it's going to do well—barring any major disasters, of course—chances are, it will or, at least come very close.

Separating the wheat from the chaff.

The best part of doing your homework and picking the names with the best potential, other than making money on your own terms, is that you designate the time frame, because that's what options trading is all about—if any of your picks don't live up to your expectations, you can cut them loose .

So, if you're holding on to some winning names and you bank profits in them, and maybe even go back to the well a couple more times because there's nothing wrong with going back and betting on your winning horses, keep in mind that they might be names you want to own.

Buying call options gives you the right to buy stock at the option's strike price. And that's why I like to buy deep in-the-money calls. If you're riding a stock and it shoots up ten or twenty points while you're in your options trade, you can exercise your right to own the stock at any time during the life of your options contract, and at the price you agreed to pay (the strike, or exercise price).

More in part 4 tomorrow.

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