Tag: schaeffer’s investment research

4 Ways Options Are Better than Stocks

Posted on by The INO.com Team

Just why are options so great in the first place? If you're still on the fence about trying your hand at options, this is a must-read article provided by Elizabeth Harrow of Schaeffer's Investment Research. If you enjoy this article and want to learn more about options you may even want to check out their options newsletter!

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Options are cheaper than stocks.

In this economy, everybody's trying to save money. So, forgive me for pandering, but it's a fact that options are significantly less expensive than the securities on which they're based. Each option contract gives you control of 100 shares of equity, yet the cost to purchase an option contract is nowhere near the expense of buying an equivalent chunk of stock.

Premium: The price of an option contract that the buyer of the option pays to the option seller for the rights conveyed by the option contract.

When you purchase an option contract, you pay a premium to enter the trade. This premium is known as the ask price, if you're buying to open, and it's determined in the traditional manner by supply and demand.

By way of example, let's take a look at options on imaginary retailer You-Can't-Afford-It Stores Inc. (POSH). Let's say POSH closed yesterday at $46.39. It would cost you $4,639 to purchase 100 shares. By comparison, POSH's May 47.50 call closed yesterday at $1.83. (Hey, it's my imaginary case study: I get to pick the numbers.) In other words, it would cost you just $183 to purchase this call option granting you control of 100 shares of POSH.

As fair warning, I'm not a math expert, but I'm pretty sure you could save about $4,456 by purchasing the call option rather than investing in the shares outright.

Maximize your profits through the amazing power of leverage.

In addition to being cheaper than stocks, options also provide you with the magic of leverage. This nifty feature allows you to collect profits that are, in the best-case scenario, way out of proportion to your initial investment.

Leverage: The control of a larger number of shares with a smaller amount of capital. Leverage provides an option buyer greater profit potential using fewer dollars compared to holding a long or short stock position.

Sticking with our POSH example from above, let's say that Jill Trader purchased 100 shares at $46.39 for a total cash outlay of $4,639. Meanwhile, Susie Speculator bought to open 1 May $47.50 call for a total outlay of $183 ($1.83 x 100 shares per contract).

OK, bear with me, because we're going to have to use our imaginations for this next bit. Let's pretend that POSH rallies up to $55 per share by May expiration. Jill Trader unloads her 100 shares for $5,500, content in the knowledge that she's netted a profit of $861 (which translates to 18.6% of her initial investment).

Meanwhile, Susie Speculator sells to close her option contract, which is now worth $750. Susie's profit is $567, or 322.7% of her initial investment. Not only did Susie invest less capital than Jill, she more than tripled her trading dollars. Not too shabby, right?

And, if you can believe it, there are even more reasons why options are inherently superior to stocks…

Downside risk is limited in many option strategies.

At the risk of beating a dead horse, let's reverse our earlier scenario. Pretend that POSH shares plunge during the next 6 weeks, and by the time May-dated options expire, they're wallowing at $33 per share.

When you buy to open an option that expires worthless, your loss on the trade is limited to your initial cash outlay.

Our hypothetical investors have a very different reaction to the stock's slide. Jill Trader is panicking, because she's already lost $1,339 on paper, and the decline doesn't show any signs of slowing. She's faced with the choice of swallowing a big loss, or waiting it out and hoping the shares turns around.

Elsewhere, Susie's disappointed, but not devastated. She simply allows her out-of-the-money call to expire worthless, which means that her total loss on the trade amounts to no more than her initial investment of $183. It's not her best trading result ever, but it's definitely a more palatable outcome than Jill's.

Feel free to stop caring about price/earnings ratios.

At this point, I'm going to stop throwing math problems at you. Frankly, I find it exhausting, and I'm quite sure my endlessly patient colleague, Jocelynn Drake, is tired of checking my numbers. However, we will be discussing a few specific figures, namely: price/earnings ratio, price/book ratio, price/sales ratio… the list goes on.

Now, if you're used to investing in stocks, you're no doubt accustomed to researching the aforementioned ratios. These metrics offer clues as to whether a stock is overvalued or undervalued at current levels, and many traders will analyze these fundamentals before entering a position.

For all the reasons mentioned above(plus a few more), you have my full permission to throw these fundamentals out the window(well, mostly) when trading options. The fact is, these metrics simply don't matter as much to an option trader as they do to a buy-and-hold stock investor.

Let me explain. Thanks to your lowered initial investment, as well as the magic of leverage, you have a simple goal when you buy a call option. You want the share price to rise above the strike price prior to expiration, allowing you to collect your profit and exit the trade.

So, since you're not investing in the company for the long run, the traditional trading metrics shouldn't have much bearing on your analysis. So what if POSH's price/earnings ratio of 19 is higher than the average for its peer group? Even if the shares are expensive now, you can still reap a profit as long as they're more expensive by the time your option expires.

Instead, since we want the stock's price to make a fast, aggressive move in the right direction, we favor the Expectational Analysis method. By combining technical analysis with sentiment analysis, you can pinpoint equities that are poised to rally...or plunge, if you're playing puts.

Of course, fundamentals do play a part. If you're buying options ahead of earnings, you should be aware that premiums might be inflated by rising implied volatility. Or, if the pharmaceutical firm that you're buying calls on is due to release trial data within the next week, you should definitely have that event on your radar, too.

But, beyond the basics, you can really stop sweating the fundamentals. If you love crunching the numbers, though, don't worry. With put/call volume ratios, put/call open interest ratios, and more, there are still plenty of metrics for an option trader to play with.

Click here for 6 months free of Bernie Schaeffer's Option Advisor and A Crash Course in Top Gun Trading Techniques.

Best of luck to you with your options trading,
Schaeffer's Investment Research Team

Major indexes fall more than 6 percent for week

Posted on by The INO.com Team

Major indexes fall more than 6 percent for week

By TIM PARADIS – 2 hours ago

NEW YORK (AP) — Wall Street ended another terrible week Friday, leaving major indexes down more than 6 percent as investors worried that the recession will persist for at least the rest of the year and that government intervention will do little to hasten a recovery.

Investors shaved 100 points off the Dow Jones industrial average just a day after the market's best-known indicator dropped to its lowest level since the depths of the last bear market, in 2002. Stocks of struggling financial companies were among the hardest hit.

The Standard & Poor's 500 index, the barometer most closely watched by market pros, came close to its lowest point in nearly 12 years.

"Right now, more than a crisis in mortgages or in housing, we have a crisis in confidence. That is biggest problem in trying to analyze the current market," said James Stack, president of market research firm InvesTech Research in Whitefish, Mont. "You cannot analyze psychology."

Wall Street has been sinking lower as investors come to terms with the fact that the optimism behind a late-2008 rally was clearly unfounded. Companies' forecasts for this year, on top of a dismal series of fourth-quarter earnings reports, pounded home the reality that no one can determine when the recession will end.

"It was a market that was built on that hope, and what we're seeing now is an unwinding of that," said Todd Salamone, director of trading and vice president of research at Schaeffer's Investment Research in Cincinnati, of the rally from late November to early January.

The disappointment seen this week arose from the market's growing recognition that the Obama administration's multibillion-dollar stimulus and bailout programs are unlikely to turn the economy around anytime soon.

"There were a lot of people that were banking on Washington to get us out of this. I don't know if there is anything Washington can do," Salamone said. He said the global economy is going through the tedious process of reducing borrowing and working through bad debt — something government help can't speed up.

With the week erasing whatever shreds of hope the market had, there is virtually no chance of a rally on Wall Street. What the market might see is a blip upward — but blips tend to evaporate quickly.

That's what happened Friday. Stocks erased some of their losses after White House press secretary Robert Gibbs doused fears that the government would nationalize crippled banks. Investors who worried about seeing their shares wiped out by a government takeover welcomed the news, but it didn't ease broader concerns about the economy.

The Dow Jones industrials briefly went into positive territory, but quickly turned down again.

Salamone said investors had been too hopeful in late 2008 and at the start of this year that the new administration would be able to swiftly disentangle the economy.

The Dow industrials fell 100.28 points, or 1.3 percent, to 7,365.67 after earlier falling more than 215 points. On Thursday, the Dow broke through its Nov. 20 low of 7,552.29, and closed at its lowest level since Oct. 9, 2002.

The Dow's 6.2 percent slide for the week was its worst performance since the week ended Oct. 10, when it lost 18.2 percent.

The Standard & Poor's 500 index on Friday fell 8.89, or 1.14 percent, to 770.05. The benchmark most watched by traders came within less than 2 points of its Nov. 20 close of 752.44, which was its lowest since April 1997. It remains above its Nov. 21 trading low of 741.02.

The Nasdaq composite index fell 1.59, or 0.11 percent, to 1,441.23.

For the week, the S&P fell 6.9 percent, while the Nasdaq lost 6.1 percent.

Declining issues outnumbered advancers by about 3 to 1 on the New York Stock Exchange, where consolidated volume came to a heavy 8.12 billion shares as options contracts expired. Volume on Thursday came to 5.64 billion shares.

The Russell 2000 index of smaller companies fell 5.75, or 1.4 percent, to 410.96.

Other world indicators also fell sharply. Britain's FTSE 100 declined 3.2 percent, Germany's DAX index tumbled 4.8 percent, and France's CAC-40 fell 4.3 percent.

Shares of financial bellwethers Citigroup Inc. and Bank of America Corp. fell on worries the government will have to take control of them. Citigroup tumbled 22 percent, while Bank of America fell 3.6 percent. The stocks were down as much as 36 percent during the session.

The fears about the banks are hurting shareholders of those companies and dragging down the rest of the market because the broader economy can't function properly when banks are unable to lend at more normal levels.

"Financing is the blood which runs through our nation's veins. It's what keeps us alive," said Lawrence Creatura, a portfolio manager at Federated Clover Investment Advisors.

He said the talk of nationalizing banks only underscores the troubles with the economy.

"Things are clearly not normal. It's not healthy. The patient was on life support, and now what we're talking about getting out the paddle with respect to nationalization," Creatura said.

As investors dropped out of stocks, safer investments like Treasury debt and gold rose. The price of the benchmark 10-year Treasury note rose sharply, sending its yield down to 2.79 percent from 2.86 percent. The yield on the three-month T-bill, considered one of the safest investments, fell to 0.26 percent from 0.30 percent late Thursday.

Gold broke above $1,000, closing at $1,002.20 an ounce on the New York Mercantile Exchange.

Investors are looking desperately at any safe havens simply because the stock market, which rises and falls on investors' expectations for the future, sees only trouble ahead.

"There's still a big fear factor syndrome," said Michael Strauss, chief economist and market strategist at Commonfund. "There is a focus on what is happening here and now instead of six months to nine months from now."

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The Dow Jones industrial average closed the week down 484.74, or 6.2 percent, at 7,365.67. The Standard & Poor's 500 index fell 56.79, or 6.9 percent, to 770.05. The Nasdaq composite index fell 93.13, or 6.1 percent, closing at 1,441.23.

The Russell 2000 index, which tracks the performance of small company stocks, declined 37.40, or 8.3 percent, to 410.96.

The Dow Jones Wilshire 5000 Composite Index — a free-float weighted index that measures 5,000 U.S. based companies — ended at 7,802.27, down 583.47, or 6.96 percent, for the week. A year ago, the index was at 13,758.35.