What Are Options?

Options are agreements that give you the ability to buy or sell a specific stock at a specific price (the strike price). In other words, you’ve got a locked-in price… I’ll get into the specifics in a minute.

Options are derivatives, which means that their values are tied to those of other securities…in this case, stocks. So when a company’s stock price changes, so will the prices of the company’s options.

Just like with stocks, you can buy and sell options through your online broker. It’s important to keep in mind, though, that your broker may charge more to buy or sell options than they would for stocks — you’ll have to ask to find out.

Unlike stocks, however, options aren’t necessarily put out there on the market by the company…often, they’re put out by third parties like investment banks.

What Kind of Options Are Out There?

There are basically two different kinds of options out there — call options and put options. Call options give the owner the right to buy shares of a stock they believe will increase in value, but at a lower price.

If you think that Apple (AAPL: NASDAQ) is going to see $200 again, you could buy a call option with a strike price of $142, and own the right to buy Apple at $142 after it hits $200 — that’s a nice locked in gain!

If your hunch was wrong and Apple slides to $110, you can choose not to buy the shares at $142, and only be out what you paid for the option.

Put options give you the right to sell shares of a stock you believe will decrease in value, but in this case, at a higher price. Going back to the same example…

If you think Apple’s set up for a fall, you could buy a put option with that $142 strike price, and own the right to sell Apple shares at $142 after it falls.

Remember, though, options give you the right, not the obligation to buy or sell a stock at a specific price… You’re not required to exercise the option.

If a stock doesn’t end up doing what you expected, you can still just let your options expire and only be out the price you paid for the options themselves.

Who Uses Options?

These days, everybody uses options — and for good reason… Options are a great way to hedge, or insure, your investments against downside. If you like Apple for a long-term play, but aren’t so sure about its short-term risks, you can buy AAPL stock along side put options for the company. That way, if the stock does take a hit, you can offset your losses on the stock with the money you make on the options.

If you end up not needing the option play, you’re still only out the price of the option. Just consider that cost an insurance premium for your portfolio.

In the big leagues of investing, you can bet that plenty of portfolio managers use options to hedge against losses, but don’t think that only financial companies use hedging!

Southwest Airlines has long been a darling stock in an industry that’s seen crippling losses. How’d they do it? Southwest saved their skin by investing in derivatives that were tied to oil prices. Southwest limited their exposure to soaring jet fuel prices while other airlines felt the bite.

It’s Not a Bad Option

When it comes to maximizing your portfolio’s profitability, using options is a pretty good…umm…option. Investing in options shouldn’t be taken lightly of course — making the wrong options plays can open you up to some big downsides.

Cheers,

Jonas Elmerraji
April 7, 2008

P.S.: There is another technique that works like options but is even safer. In fact, many of the richest people in the world grew their fortunes using this secret technique.

Investing in Options was originally featured in the Penny Sleuth.

When I first wrote to you about the weakness I saw in the Dow Jones Utilities Average, the index was testing its 200-day moving average.  Since that time, the Dow Utilities has risen and fallen.  As I write this column, the index is once again challenging its key 200-day long-term support line.  The ups and downs of the last month have resulted in this averaging trace out the right shoulder of a head and shoulders chart pattern.  The neckline of the head and shoulders pattern is roughly in the area of the 200-day moving average.

Sleuthers, this sector is weak!  It might bounce again.  But I’m telling you, a good stiff market wind is likely to shut the power off on this corner of the equities world.

My last Technical Tuesday column two weeks ago was a perfect time to take a position on the short-side in utilities.  However, given the way the average has traded, there looks to be more downside ahead for this sector.  So, if you don’t know how to attempt to profit from the potential weakness in this sector, let me give you some different trading or investment approaches to consider.

First, you can simply buy a put option contract on the index itself.  That’s the purest play.  But if you aren’t an options player — or if you don’t find these options that attractive (they’re not that liquid) — there are a number of other avenues you could consider.

One approach is to short one or more of the stocks of the companies that comprise the Dow Utilities.  As I mentioned in my February 28 article on this sector, there are fifteen companies in the Dow Jones Utility Average.  Those companies are:

American Electric Power Co. (AEP:NYSE)
AES Corp. (AES:NYSE)
CenterPoint Energy (CNP:NYSE)
Dominion Resources (D:NYSE)
Duke Energy (DUK:NYSE)
Consolidated Edison (ED:NYSE)
Edison International (EIX:NYSE)
Exelon Corp. (EXC:NYSE)
FirstEnergy Corp. (FE:NYSE)
NiSource Inc. (NI:NYSE)
PG&E Corp. (PCG:NYSE)
Public Service Enterprise Group Inc. (PEG:NYSE)
Southern Company (SO:NYSE)
TXU Corp. (TXU:NYSE)
Williams Companies Inc. (WMB:NYSE)

If shorting is not your game — or if you would like the leverage or clearly limited risk offered by the options market — you could buy puts on one or more of these stocks.  All of them offer options.  In the interest of full disclosure, I should mention that I suggested in the March 7 issue of MST Trader that subscribers add CenterPoint Energy to their short-side Watch List for a possible put play.

If you are seeking more of a play on the entire utilities industry — where you can take a position in a single instrument that closely replicates the performance of the sector — there are a number of other possibilities you can choose from.  All of the underlying securities I am going to mention are traded on the American Stock Exchange.

One of these securities is what’s known as a HOLDRS — which stands for Holding Company Depository Receipts.  These Depository Receipts are designed to replicate the performance of specific companies within a particular industry, sector, or group in one security.  According to the American Stock Exchange’s website –- http://www.amex.com – there are currently seventeen different HOLDRS traded.  These HOLDRS are liquid and are actively traded. 

One of these securities is the Utilities HOLDRS (UTH:AMEX).  The UTH consists of the stocks of the following nineteen companies — most of which you will notice are also part of the Dow Jones Utility Average:

American Electric Power Co. (AEP:NYSE)
CenterPoint Energy (CNP:NYSE)
Consolidated Edison (ED:NYSE)
Dominion Resources (D:NYSE)
Duke Energy (DUK:NYSE)
Dynegy, Inc. (DYN:NYSE)
Edison International (EIX:NYSE)
El Paso Corp. (EP:NYSE)
Entergy Corp. (ETR:NYSE)
Exelon Corp. (EXC:NYSE)
FirstEnergy Corp. (FE:NYSE)
FPL Group, Inc. (FPL:NYSE)
PG&E Corp. (PCG:NYSE)
Progress Energy Inc. (PGN:NYSE)
Public Service Enterprise Group Inc. (PEG:NYSE)
Reliant Energy Inc. (RRI:NYSE)
Southern Company (SO:NYSE)
TXU Corp. (TXU:NYSE)
Williams Companies Inc. (WMB:NYSE)

You have several different alternatives here.  One possibility is to simply take a short position in the Utilities HOLDRS itself.  What’s nice about shorting the UTH is that — unlike stocks that trade on the New York Stock Exchange — it is not necessary to wait for an uptick in the price of the security for your open short order to be executed.  Alternatively, you can pinpoint one or more of the nineteen stocks in the UTH you think to be particularly weak and establish your short
position(s).

Again, if you are not comfortable with the concept of shorting — or the theoretical unlimited risk inherent in this method of trading and investing — you can purchase a put option.  You can either purchase a put on the UTF itself or on any of the individual UTH components listed above. 

In case I haven’t described enough alternatives for you, there is yet another way to bet on the downside in utilities.  There are a few other utilities-specific investment vehicles known as Exchange Traded Funds (ETFs as they is commonly referred to).   Unlike the Utilities HOLDRS — which is composed of a fixed list of stocks — the companies contained in an ETF change over time.  Thus, these securities are is more analogous to a mutual fund than a market index. 

However, Exchange Traded Funds share two important characteristics with the HOLDRS.  First, all of the ETFs related to the utilities sector may be shorted without an uptick.  Second, all these ETFs have options. 

There are several Exchange Traded Funds traded on the American Stock Exchange that are specifically tailored to the performance of the utilities sector.  One series of ETFs is known as iShares.  Thirteen of these iShares that trade on the American Stock Exchange were created by Dow Jones & Company to represent the performance of different market sectors.  One of these iShares is the Dow Jones U.S. Utilities Sector Index Fund (IDU:AMEX). 

What is interesting about the IDU is that its results are intended to correlate generally with the Dow Jones Utilities Average.  So, if your intent is to find a security that most closely tracks the performance of the Dow Utilities, the IDU is probably your ticket.

Another popular ETF created to track utilities industry stocks is the Utilities Select Sector SPDR (XLU:AMEX).  The Utilities Select Sector SPDR is one of nine different Select Sector SPDR Funds that trade on the American Stock Exchange.  These funds consist of a portfolio of stocks designed to reflect the performance of a particular sector’s companies within the S&P 500 Index.

There are two other Exchange Traded Funds trading on the American Stock Exchange intended to reflect the general performance of stocks in the utilities industry — the PowerShares Dynamic Portfolio (PUI:AMEX) and the Vanguard Utilities VIPERs (VPU:AMEX).  Both of these Exchange Traded Funds have options.  However, both of these securities have much lighter volume than the ETFs or the HOLDRS mentioned above.  And the options on both of these ETFs lack the liquidity of the alternatives described earlier.  So, you would be better off sticking with other, more actively traded investment vehicles.

There may be other ways you can play the vulnerability inherent in the utilities sector.  However, I have listed a host of possible choices from which you can design a successful short-side strategy.  Just decide upon the method with which you are most comfortable, pick a good entry point, choose you risk threshold, and select a profit target.  Then, go after it — before they shut the power on these utilities stocks.

Trade well,

Mark Bail
March 14, 2006

Short-Side Utilities Choices for When They Shut Down the Power was originally featured in the Penny Sleuth.

Hello again, Sleuths,

If you have been a devoted reader of my Technical Tuesday columns in Penny Sleuth, you know that my outlook for stocks in 2006 is — to put it mildly — bearish. If 2006 turns out to be a down year for equities, it will be more of a challenge to extract money from the market.

So the question becomes: how do you actually make money in a rocky market environment? One way is to subscribe to one or more of our newsletters we publish here at Agora Financial. We’ve got a diverse team of accomplished financial editors who regularly uncover special situations that can make you money in any market climate.

Another way to pull out profits from a struggling market is to find the sector or sectors that are able to buck the trend. In fact, you may recall that I devoted two columns last December to point out the profit potential just waiting to be plucked in the gold and precious metals markets. Boy, did that turn out to be an understatement!

Downside of the Market: Looking for Golden Opportunities… Besides Gold

I hope you took advantage of that information to pad your trading or investment account. Needless to say, gold stocks exceeded my expectations and put a ton of money in the pockets of astute traders and investors in a hurry. Or maybe a more accurate way to put it is that the gold sector reached the 2006 goals I laid out for it in a little over a month.

Gold has pulled back quite a bit from its lofty heights of two weeks ago. But I think there are still more profits to be had in this shiny corner of the market. So, Sleuthers, I suggest you continue to keep an eye on it.

But there is another way to make money in a down market. Remember the old saying, “The trend is your friend”? While it’s gratifying — and profitable — to buck the trend by ferreting out the few sectors able to soar in a down market, it’s actually easier to put your money in a sector that’s traveling in tandem with most other equities. And if I’m right about 2006, that trend will be pointing south.

What I’m getting at is that there is still another way to score gains while the market is taking a header. Why not take a walk on the short side and trade or invest in areas of the market where prospects appear poor and where equities are likely to suffer alongside the market averages?

Doesn’t it make sense — if the market proves to be as weak as I think it may be — to locate an anemic corner of the investment world and implement a trading or investing strategy that seeks to profit from continued weakness in that sector? It’s not as conventional an approach for most people as buying stocks. But it can be just as lucrative.

How can you attempt to profit from trading or investing on the short side of the market? There are several ways you can do it.

Downside of the Market: Short Funds

First, you don’t even need to look at specific market sectors. You can simply invest your money on the overall downside of the market. There are a number of ways to do this.

You can short an exchange-traded fund (ETF) that acts as a proxy for a broad or well-known market index. There are several of these ETFs that have been created to mimic the return of different broad-based market indexes. Three of the better-known market-based ETFs are the SPDRs (SPY:AMEX), which tracks the S&P 500; the Nasdaq 100 Trust Shares (QQQQ:NASDAQ), which follows the Nasdaq 100; and the DIAMONDS Trust, Series 1 (DIA:AMEX), which mirrors the return of the Dow Jones Industrials. But there are others as well.

If you are not comfortable — or are unfamiliar — with the concept of shorting, you can buy put options on a major index or broad-based ETF. There are two advantages of purchasing a put option. First, unlike shorting a security, your risk of loss when purchasing an option is limited to the amount of your investment. Second, you have the opportunity to earn outsized profits from relatively modest market moves through the concept of leverage.

But options aren’t for everyone. So there is another way you can capitalize on negative market moves. And it’s more conservative — and simpler — than either of the two alternatives I just mentioned. You can invest in a mutual fund.

Now, what’s different about this type of mutual fund from others you may have purchased is that it seeks to profit by a decline in the market. There are a number of mutual fund companies that offer funds that are inversely correlated to a specific market index. In other words, if you think a particular market average is going to decline, you can invest in a mutual fund that is inversely correlated to that index. If your assessment is correct and the index drops, your mutual fund should correspondingly increase in value.

Some mutual fund companies even offer funds that are leveraged so you can reap magnified rewards from market moves in your favor. For example, certain funds enable you to earn 1.5% or 2% for every percentage point decline in the market index you have a bearish outlook on. Just keep in mind that if you invest in one of these leveraged market-indexed mutual funds, not only is your potential for gains heightened, but so is your risk of loss.

Now, if you want to really get in gear with the market trend and attempt to profit from a correct negative market forecast — and stack the odds of success more firmly in your favor — you could bet on the downside of a particular sector or industry. I find this approach to be a particularly attractive one. I say that because it’s my philosophy that the best way to make money in equities is to buy the strong stocks and short the weak ones.

Downside of the Market: ETFs

The approaches you could employ to exploit the perceived weakness of a certain market sector are similar to those I just described for capitalizing on a general market move south — with the exception of investing in bearish mutual funds. There are a host of ETFs tailored to specific market sectors that you could elect to short. You can also buy puts on several of those ETFs. Or you can target a handful of stocks within a market sector to either short or to buy puts on.

Whichever approach you choose, you will likely be rewarded if your bearish assessment of a particular sector proves to be accurate. And if you act on that forecast while overall market conditions are also poor — you will have further increased your chances of success.

So what sector looks ripe for a fall if the overall market should take a powder in 2006? Ah, dear Sleuths, for the answer to that question you will have to read my next column in two weeks. At that time, I’ll take the technical temperature of one corner of the equities world whose prospects over the next several months appear dim. Until then, if the market seas do turn rough and you are wondering how to turn a profit — you may want to consider taking a walk on the short side.

Trade well,

Mark Bail
February 14, 2006

Downside of the Market: Take a Walk on the Short Side was originally featured in the Penny Sleuth.