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A while back I wrote an article titled 2009, The Year of Investing Differently. The thrust of that piece was to make the argument that the era of "the stock market always goes up" may not return for some time, and that investors may well need to adjust their approach to the markets and investing. Anyone who started putting money into an S&P 500 index fund in October of 1997 has probably already figured this out, since after almost eleven and a half years, this investment has generated a net return of just about 0%. Let's see, eleven plus years, no profit. Hmmm, not exactly the "road to riches" that many thought they had embarked upon during the great bull market of the 1990s. Still, at this point in time, most "stock market ensconced" "old dogs" are loathe to "bail out" given that the stock market averages have already suffered a hit of 50% and many individual stocks are off 70% or more. It would certainly seem that there must be a lot of bargains out there at the moment.

And there may well be. But first there is that pesky little matter of the stock market once and for all bottoming out and looking across the economic void to the next recovery. I keep reading about how the economy "should bottom out" in 2010 and therefore the stock market will begin to "anticipate" this "impending reversal" of economic fortune later in 2009. That all sounds swell, but two questions remain:

• How much lower will the stock market go before this "anticipation" begins?
• What if everything I have been reading is wrong?

In last week's article, Hope for the Best, Prepare for the Worst, I presented some of the "worst-case scenario gloom and doom" type stuff guaranteed to keep you awake at night. In a nutshell, if history proves a useful guide this time around, then the Dow could see something in the 6,000s later this year before any true bottom is reached (that's not a prediction by the way, just a possibility based on previous similar market action). Think that might finally shake some of those "old dogs" up enough to panic and dump their stock market holdings? In any event, not a happy thought. And "what if" the economy ends up getting worse than most are willing to consider? Well, let's just say that that is not a "happy" scenario.

What's an "Old Dog" To Do? Learn Some "New Tricks"

The possibilities laid out above are not intended to scare anyone. In fact, at the moment I am anticipating a decent stock market "pop" to the upside. However, I have no functioning crystal ball and personally do not have a good feel at the moment for whether things will get a lot better or a lot worse first. What I do know however, is that "waiting and hoping" is an extremely dangerous game to be playing at the moment. So let me once again implore you to consider beginning or improving your education regarding investments that involve doing more than just buying and holding a stocks and/or mutual funds.

There are three option strategies that I want to touch on this week that can allow investors to, a) avoid a lot of grief and aggravation (not to mention helping to keep them from losing a lot of money), and/or, b) to make money in situations where the vast majority of investors are losing money.

Playing It with Options #1: The Married Put

The first strategy is the hedging technique known as the "married put." This strategy involves simply buying one put option for every 100 shares held of a given stock. The result is a risk that resembles a long call option, with limited risk and unlimited profit potential. The beauty of the married put is that you retain unlimited profit potential, completely limit your downside risk to a certain dollar amount, and can continue to hold the underlying stock, as opposed to selling the stock and encountering all of the attendant tax related issues (not to mention having to decide if and when to get back in).

Figures 1 and 2 display a married put trade involving Exxon Mobil (XOM). Let's asume a trader is holding 100 shares of XOM and does not want to sell these shares but is concerned in the short-term as the stock has bounced quickly from a low of $56 to north of $80 a share. In this example, the trader can lock in a maximum risk of -$418 by buying the April 80 put option as shown.

Figure 1 - Exxon Mobil with married put

Figure 2 - Risk curves for XOM with married put

As you can see, the risk curves depicted in Figure 2 do in fact resemble those of a long call. If you are holding a stock that you simply do not wish to sell, but that stock is nearing an earnings announcement and you are concerned about the possibility of a very negative surprise, the married put can protect your downside for a period of time long enough to get past the earnings announcement.

Playing it with Options #2: The Long Collar

The long collar strategy is a favorite among Optionetics instructors and rightfully so. Done correctly, this strategy allows a trader to create a position with a very favorable reward-to-risk ratio and under the best circumstances, an extremely low dollar risk. To enter a long collar you either buy or already hold 100 shares of stock. You then sell a call option and buy a put option on that stock. This creates a position with a fixed reward-to-risk ratio that will last until the trade is exited or the options expire, whichever comes first. Figures 3 and 4 display a long collar trade involving options on Massey Energy.

Figure 3 - Long collar trade using Massey Energy



Figure 4 - Risk curves for MEE long collar

As you can see, this trade can make a maximum of $201, but at the same time the worst-case scenario is a loss of only -$49. Sophisticated option traders "adjust their collars" on a regular basis each time the stock moves by a meaningful amount. This allows them to retain a favorable reward-to-risk ratio and a limited dollar risk at all times.

Playing It with Options #3: The OTM Butterfly Spread

I have written about this strategy before and it is fast becoming a favorite of mine. The job of a speculator is to make money. Sometimes this entails the need to bet on market direction. The danger here is that if you guess wrong you run the risk of losing money. And the reality of trading is that you will be wrong a certain amount of the time. As a result one of the keys to long term success is simply this:

"When you make money, make a lot. When you lose money, lose a little."

Fewer concepts are more important to trading success. The OTM Butterfly (short of the out-of-the-money butterfly spread) can offer speculators a great opportunity to bet on a direction - in any timeframe, from short-term to long-term - while risking only a relatively small amount of money all the while obtaining a large reward-to-risk ratio.

Figures 5 and 6 display an OTM butterfly using options on GLD, which is an exchange-traded fund that tracks the price of gold. While this is a bullish trade (because it uses call options above the current price of the stock), the OTM butterfly can also be used to enter into a bearish position (by trading put options below the present price of the underlying security).

Figure 5 - OTM Butterfly using GLD options

Figure 6 - Risk curves for OTM Butterfly using GLD options

As you can see in Figures 5 and 6, if GLD breaks out to the upside and drifts higher at any point prior to option expiration, this trade enjoys a high probability of making money as there is a very wide range of profitability (from 88.38 on the low end to 111.62 on the upper end). In any event this position gives a trader the opportunity to profit from an advance in the price of gold while risking a maximum of just $338.

Summary

So once again I find myself repeating what I have stated often in the recent past. If you are something of an "old dog" when it comes to investing, i.e., if the sum total of your investment strategy for the past x-amount of years is to simply "dump" all of your money into the stock market, then you are most likely "hunkering down" at the moment, waiting for the economy stop disintegrating and for the stock market to "return to form" by moving higher. And truth be told, I'd be as happy as a clam if you got your wish. At the same time, I am hoping that you will meet me halfway and consider heeding my warning that the stock market may quite possibly not be the place to be for some time to come.

Look at it this way: if you learn some "new tricks" and I am right, then you stand to save yourself a great deal of pain and suffering (not to mention trading capital) by virtue of having learned to hedge positions and to speculate using only high reward-to-risk opportunities. On the other hand, if I am wrong (pssst, don't spread this around, but it's happened before" shhhh) you will have learned to hedge positions and to speculate using only high reward-to-risk opportunities.

Either way, you come out ahead.

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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