Stock Option Trading with ETFs...

Tip #7 - Trading ETF Options

Exchange-Traded Funds, or ETFs, are index funds that trade just like stocks on major stock exchanges. All the major stock indexes have ETFs based on them, including: Dow Jones Industrial Average (DIA), Standard & Poor's 500 Index (SPX), and Nasdaq 100 Composite (QQQQ).

In addition, just about every major industry has an ETF for investors who wish to select an entire industry rather than individual stocks.

ETFs differ fundamentally from traditional mutual funds, which do not trade midday. Traditional mutual funds take orders during Wall Street trading hours, but the transactions actually occur at the close of the market. The price they receive is the sum of the closing day prices of all the stocks contained in the fund. Not so for ETFs, which trade instantaneously all day long (just like ordinary stock).

Since ETFs trade all day, options are available on them.  These options provide interesting opportunities for certain strategies, including what I call the 10K Strategy, which is the major strategy offered by Terry’s Tips .

Oil Service Holders, Trust (OIH) is run by Merrill Lynch. It is made up of 18 component companies, all of whom serve some aspect of the oil and gas industry, such as exploration, drilling, and production. Here are the component companies ranked according to their relative importance to OIH --

Baker Hughes Inc. (BHI)
Schlumberger Ltd. (SLB)
Halliburton Co. (HAL)
BBJ Services Co. (BJS)
Global Santa Fe Corp. (GSF)
Nabors Industries (NBR)
Transocean Sedco Forex Inc. (RIG)
Noble Drilling Corp. (NE)
Smith International Inc. (SII)
Weatherford International LTD (WFT)
Diamond Offshore Drilling Inc. (DO)
Ensco International Inc. (ESV)
Grant Prideco Inc. (GRP)
Rowan Cos Inc. (RDC)
National Oilwell Varco (NOV)
Hanover Compressor Co. (HC)
Tidewater Inc. (TDW)
Cooper Cameron Corp. (CAM)

If you like OIH, you should like OIH options even more (if you manage them right).  In 2005, I ran 8 actual option portfolios using several different underlying stocks for my subscribers, and the average annualized gain for these portfolios was 103%.  Only one portfolio lost money, and that was less than $600 (while several portfolios gained 10 or 15 times that much).

Two of the 8 portfolios used OIH as the underlying, and they had the highest annualized return of all 8.

Why Oil Service Holders Trust (OIH) is my favorite ETF.

I absolutely love this ETF, and my option portfolio has made 100% on it in the last six months. With expanding need for oil, the companies that comprise this ETF are having a field day.  They can’t keep up with the demand for their services.

Over the past six months as I write this (as of the middle of April 2006), OIH went up about 33%, a great run.  But my option portfolio did about three times as well.

Even better, my options portfolio would have made 100% even if OIH had not enjoyed such a good run.  I would made just as much money, maybe even more, if the ETF had stayed flat.  That is a unique feature of the 10K Strategy – it does best when the stock price does not fluctuate a lot

A hedged strategy: The options strategy I used with OIH in the last year is a hedged strategy. In many respects, this strategy involved taking less risk than if i had just purchased OIH stock. Half the options were “long”, meaning they benefited when OIH moved in one particular direction, while half were “short”, meaning that they benefited if OIH moved in the other direction.   No matter which way OIH moved, half the options would benefit from the change in stock price.

Last year, I created two actual option portfolios for my Insiders who liked OIH to mirror if they wished.  The first portfolio started on September 9, 2005 with $10,000. Here is how an investment would have fared for this portfolio compared to the same amount of money invested in the stock (OIH):

A second portfolio was set up on October 24, 2005 with a starting value of $5000 in response to Terry’s Tips  Insiders who liked OIH, and who wanted to mirror my trades with a smaller starting investment amount.  Here are the results for this second portfolio for its first six months of operation:

On April 18, 2006, just under 6 months from the portfolio being started, it had doubled in value!

OIH options can be better than OIH stock.  I must admit that I am an options guy, not a stock guy.  No matter how much I like OIH (and I do), I know that I can make a whole lot more with the options than I ever can with the stock.  And I can do it with a strategy that is “hedged”.  I can make money with OIH even if the stock does not go up.  Usually, I can even make money when it goes down, (just as long as it doesn’t go down too much, too fast).

If you trade actively in options, and particularly if you are hedged (meaning that you are putting on many different positions rather than speculating with the simple purchase of puts or calls), it is important to look at the options market for the underlying security.  Option markets for individual companies, except for a very few extremely active stocks, often have large spreads between the bid and asked price.  In many cases, a single market maker sets the prices, and it is difficult to get good executions when you trade. 

This means that every time you buy an option, you pay more than you would if the options were more actively traded, and when you sell, you receive less than you would in an active options market.  The options market for OIH is liquid.  Bid-asked spreads are small, and you can successfully execute spread orders and count on getting decent prices regardless of whether you are buying or selling.

I call my system the 10K Strategy.  It is somewhere between a boring buy-and-hold strategy and day-trading.  It is not a marathon – you do not have to wait forever to see results.  Neither is it a sprint, dependent on short-term increases in the price of the stock.  Like any race, it takes a little effort to execute.  But the extraordinary profit potential makes it all worth while, at least to my way of thinking.

A Simple Options Strategy: The 10K Strategy is based on the simple fact that all options become less valuable every day (if the stock stays flat), but short-term options go down in value (decay) at a faster rate than long-term options.  I purchase slower-decaying long-term options and use them as collateral to sell faster-decaying short-term options to someone else.  If the stock stays flat, I always win.  Guaranteed!

But as we know, all stocks do not stay flat.  Some good stocks, like OIH, actually go up much of the time.  Having a good feeling about a stock (and being right) makes the 10K Strategy even more profitable than just enjoying the option decay advantage.  If the stock goes up, I can make more with the 10K Strategy than I ever could with the stock alone.

If the 10K Strategy is so simple, why doesn’t everybody follow it?  First of all, only Terry’s Tips Insiders know about it.  That’s a pretty small, but growing, universe.  Second, it really isn’t as simple as the basic underlying concept makes it seem.  The strategy consists of calendar spreads at several different strike prices (both above and below the stock price), with differing numbers of spreads at different strikes (depending on your personal risk tolerance), often involves puts rather than calls (even if you are bullish on the stock), and is governed by a strict set of Trading Rules that determine when adjustments need to be made.

Does the 10K Strategy make money all the time?  I’m afraid that nothing could be quite that good.  But it is close.  In 2005, I managed 9 different portfolios using the 10K Strategy.  Each portfolio was set up in an actual brokerage account all by itself, and the positions (and every trade) updated each week for Terry’s Tips  Insiders .   Only one portfolio lost money, and that was a measly $594 loss. One portfolio went from a starting value of $10,000 to $20,000 in only four months.  The average of all 9 portfolios recorded a 103% annualized gain for the year. 

It all sounds too complicated – can you manage the 10K Strategy for me?  Unfortunately, I can’t manage your money.  I publish an options newsletter, and am not a licensed investment advisor.  But through a mechanism called Auto-Trade, many brokerage firms will execute my recommendations in your account for you.  Auto-Trade programs are available at OptionsXpress, thinkorswim, Questrade (for Canadians), and several other brokers as well. 

Why is OIH better than trading individual companies?  It has nothing to do with the company.  Rather, it has to do with the price behavior of most individual companies.  The 10K Strategy does best when the stock does not gyrate wildly.  At certain times, most individual companies are subject to sudden wide swings in their stock prices.  Earnings are announced, and the company either exceeds (or fails to meet) expected results, and the stock moves accordingly.  An analyst upgrades (or downgrades) the stock unexpectedly, and the stock makes a big move.   Sudden price changes in the stock can result in losses when using the 10K Strategy, so we prefer to trade on a basket of stocks (like OIH) rather than an individual company.  That way, if one company has a big swing in stock price, the effect on the total basket of stocks is usually minimal.  (If the companies are all in the same industry, sometimes one company’s gain is another’s loss, so the net effect on the basket of stocks is zero).

Of course, we do trade in some individual stock options, like Google (GOOG), Apple  (AAPL) and Sears (SHLD), but we know that these companies will be extremely volatile at times, and need to take special care to protect against such volatility.  Most of the time we are successful, but not all of the time.  In 2005, for example, one of our Google portfolios gained over 100% in six months before losing nearly half its value when earnings deviated significantly from expectations.  Most of us don’t like that kind of emotional roller coaster ride, and prefer a basket of stocks like OIH that is not dependent on a single company’s results.  (That Google portfolio did manage to make 57% for the year, however, in spite of the set-back).

How Much Does It Cost to Learn All About the 10K Strategy?  The White Paper costs less than a meal for two at a decent restaurant.  It gives you all the information you will need to execute the 10K Strategy, and set up, and maintain, a portfolio that matches the degree of risk that you are comfortable taking.  Complete Trading Rules for every risk level portfolio are included as well.

And there is more.  First, you will receive a free Stock Options Tutorial which will acquaint you with the basics of option trading, including a simple explanation of the often-intimidating “Greeks.”  Second, you will receive a free two-month subscription to our Insiders Newsletter, where you can watch our actual portfolios unfold each week (and receive Trading Alerts whenever a change is made in a portfolio).  If you wish, you can mirror one or more of these portfolios in your own account, or sign up for Auto-Trade with your broker and have the trades made for you.

And there is still more, like a list of 20 “Lazy Way” companies which allow you to make two trades at the beginning, and do nothing more for two full years.  At the end of this period, you will have earned a minimum 100% on your investment, mathematically guaranteed, if the stock stays flat or goes up by any amount.  In most cases, it can even fall by 5% and you make at least 100%, and it can fall by 25% and a small profit still results.  (You can figure out all these numbers precisely, before you make the investment.)

Once you have become an Insider (by buying the White Paper), you will have access to several valuable reports on a variety of option strategies, many of which you will not be able to find in any books on options.

All this for less than the cost of a meal for two at a decent restaurant.  And once you put the strategy to work, you might well be spending many pleasant evenings at better-than-decent restaurants for the rest of your life.  Who knows?  In could happen.  It did to me, and I want to pass on my learning experiences to you.

So here’s my offer:

Become a Terry’s Tips Insider, pay only $79.95, and receive my 72 page White Paper which describes 4 unique trading strategies with complete Trading Rules for each, including the 10K Strategy that earned an average of 103% for 8 portfolios in 2005, and get all these additional benefits absolutely free:

• My Stock Options Tutorial Program service, fourteen separate lessons which provide a sound background for options trading (a $29.90 value).

• A list of 20 “Lazy Way” companies which make 100% mathematically guaranteed in 2 years if the stock stays flat, goes up by any amount, or falls by less than 5%.  The “Lazy Way” strategy involves making two trades up front, and then sitting back and waiting for 2 years for your 100% to come in.

• Two free months of the Insiders weekly reports (a $49.90 value) – with updates on several actual portfolio accounts with every trade ever made in each one.  Each account is a real-time unfolding of one of the basic strategies developed in the White Paper.  Different underlyings or investment amounts are used for each portfolio.

• If you would like, I will email you with every trade I make in each of these accounts, so you can make those same trades yourself if you wish, maybe at even better prices.

Here is the link that could change the way you invest your money for the rest of your life - https://www.terrystips.com/secure/order.php.

If you are not convinced that now is the right time to make this investment in yourself, at least sign up for my free newsletter. In your first issue, I will show you how I used the 10K Strategy to make 124% on Fannie Mae in a year when the stock fell by over 8%.

For more information about the "Lazy Way" strategy to double your money, click Tip #5.

For more information about how you can use the 10K Strategy in your IRA, click Tip #4.

For more information about options in general, click Tip #1.

But the most important link is right here - https://www.terrystips.com/secure/order.php. That is where you can order my White Paper and maybe change how you ever thought about investing for the rest of your life.

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