Stock options are a great way to make big money from short-term stock moves. But with nearly 5,000 stocks out there, how do you zero in on the few that would make great option plays?

Well, I use a series of proprietary stock screeners and charts to narrow things down. Throw in some fundamental analysis and some other tricks, and I’m often able to find a few good candidates for speculation.

Of course, very few people have the time and will to examine the markets like I do. In fact, many prefer to ignore individual stocks and simply focus on the big picture. And thanks to recent innovations in the options markets, it’s now possible to speculate on the big picture, too. You probably won’t see the kind of returns you could enjoy with regular stock options — but it’s a useful short cut without worrying about individual stocks.

I’m sure you’ve heard of index funds — securities that represent an entire index, giving you an easy but inexpensive way to cash in on that index’s move. For instance, SPIDERS cover the S&P 500 Index. DIAMONDS (DIA) cover the Dow Jones Industrial Average.

There are even funds for some lesser-known indexes, like the Powershares QQQ Trust (QQQQ), which follows the Nasdaq 100 or the iShares Russell 2000 Fund (IWM).

Now, keep in mind, these are NOT mutual funds. When you buy a mutual fund, the fund manager uses your money to buy more shares of the stocks that the fund holds. Index funds, on the other hand, are closed-end funds. That means each share represents a fixed amount of stock on the index — and that’s why they are as easy to buy and sell as stocks.

They’re also cheap — usually valued at around 1/10th or 1/100th of the index price. So with the Dow around 13,200, the DIAMONDS sell for about $132. When the Russell 200 is at 830, the iShares are priced around $83. (Because of the nature of closed-end funds, the ratio isn’t always exact — but it will be close.)

You can’t find a better bet for the long-term direction of the market than these index funds. However, you can also rack up some nice short-term gains with them, too. That’s because you can buy options on the index funds, just like with most other stocks. Index fund options behave the same way, too…giving you the power to use Superleverage on the entire market.

Superleverage is the art of using options to make phenomenal gains from small price moves. Buying options on index funds essentially lets you bet on which direction the index will go. And with put options, you can even bet that the index will go down.

For example, if the Dow is at 13,000 but you think a fall is in the cards, you can buy a put on DIAMONDS. Remember, DIAMONDS are valued at 1/100th of the Dow. So if you think the Dow will fall to 12,000, you would buy a put option with a strike price of $120.

As I type, the Dow is sitting at 13,264. More importantly, the Dow DIAMONDS are at $132.74, and $120 puts on DIAMONDS (DIA) with an expiration date in September are selling for 85 cents a share — or $85 a position. (Please note, I am not recommending this option — it’s just easier to illustrate the potential using actual numbers.)

Now, if the DIAMONDS aren’t selling for less than $120 when the puts’ expiration date rolls around in September, the options will expire worthless. But if the Dow even starts to slip, the puts should increase in value. And every dollar the DIAMONDS fall below $120 is an extra $100 of profit.

So if the Dow falls to 11,900, DIAMONDS should be at $119 — giving the DIA puts a value of at least $100 — good for an 18% return. And it just gets better from there. A Dow at 11,000 means a $110 DIAMOND — and a $1,000 put…a 1,076% gain. Of course, if you expect the Dow’s upswing to continue for a little while yet, you can buy a call option. Right now a September DIAMOND call with a strike price of $135 (predicting a Dow 13,500 or higher) are going for $280. If the Dow continues its impressive run and shoots to 14,000, the DIAMOND calls will have a value of $500 — good for 78%.

This process can be repeated for just about every index you can name. It can even be used on entire countries, regions or industries. For instance, you can trade options on the iShares Japan Index (EWJ), a fund featuring a representative pool of Japanese stocks. Or try bet on the entire Asia region with options on the Vanguard Pacific Fund (VPL). Or bet on the medical industry with the Healthcare Select Sector SPDR (XLV).

The Chicago Board Options Exchange has an entire list of closed-end funds you can buy options on at http://www.cboe.com/Products/OptionsOnETFs.aspx.

As always, options are risky — and you should never buy options with money you can’t afford to lose. But for macro-analysts who want to speculate, these kind of options are a dream come true.

Instead of winnowing your analysis down to a single stock, you can stop your search at the index level.

Of course, there are pros and cons to this approach. With an option on a single stock, you’re taking an all-or-nothing approach. If you’re right about the stock’s prospects, there’s a big payoff. But there’s also a 50% chance you’ll be wrong…and the option will lose.

With an index option, you don’t have to be completely right — just mostly right. That’s because the price of the index fund reflects what’s happening to all the stocks in the fund. So, if say the price of oil plummets, you’d expect oil companies to take a hit — lowering the value of something like the Oil Service HOLDR Trust (OIH). But it’s unlikely that all the stocks will fall the same amount. Some will plummet, while others drop a little. A couple may even stay even…and a precious few could even rise.

The point is, enough of the fund’s stocks have to fall to make a difference in the fund’s price. And with so many factors determining each individual stock’s price, a lower fund price isn’t a slam-dunk. You may find you could have made more betting against a particular stock in the fund.

I’ll admit, sometimes I when I can’t find a good option on a single stock, I’ll recommend an index fund option. But I prefer to take the extra step to work my way down to the single-stock level.

Then again, I have an entire week to analyze the market from every angle. Most people don’t have that kind of time. So using index fund options can be an economical short-cut to find great speculations.

Sincerely,
Steve Sarnoff
May 10, 2007

P.S.: For those who are interested, I run a service that recommends one specific option per week. I’ve been running this service for eight years, and I’d like to think I’ve been helping my readers tremendously.

Steve Sarnoff

Steve Sarnoff has been picking winning options plays for his Options Hotline readers since 1995. He is a seasoned professional with years of experience in the markets researching trends. His concise recommendations prove his experience and demonstrate his exceptional capabilities to predict great option plays.

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