The LEAPS Option Trader
105 W. Monument Street
Baltimore, MD 21201
Friday, July 23, 2004
Email – #183
** Risk $1.25 to Triple Your Money in 1 1/2 Years
There is an option strategy called a “bull spread” that can be highly effective in making a bunch on money while significantly reducing your risk.
Here is how it works: You buy one option at one strike price and you sell another option at a high strike price. This is called a bull spread because you are betting that the shares are going higher. When you sell the option against the option that you purchased, you reduce your cost by the proceeds received. So for limiting your downside, you are paying the price by capping your upside.
Now, this strategy is worthless if you are employing it on a very low volatile situation. In order to win, you have to be in a highly volatile stock or sector that has the chance of moving substantially in a limited period of time. This trade can be closed at any time for a small gain if the shares are moving higher. On the downside, you can only lose what you have at risk and no more.
After scouring the stock universe that I follow, I have come up with a play that requires a net investment of $1.25 with a return potential of $3.75, or three times your money, in a highly volatile sector. In fact, to make this money we have over 1 1/2 years and the underlying shares would not have to reach a new high for us to achieve this.
As you know, we are in the midst of a very uncertain market. Bearish sentiment is increasing daily. We are acting defensively, holding QQQ puts, selling calls against established positions, holding energy and gold. However, the economy is humming, Asia is strong and Japan is also in recovery mode. So barring a meltdown somewhere, this market could reverse course any day. Yes, even though I think valuations are high, that does not mean that the other 200 million investors worldwide share my belief.
The sector that has been soundly trashed is the semiconductor sector. From Intel on down, the shares in this group have been hammered mercilessly over the past few weeks. This happens about every six months or so in this sector. It goes from hero to zero overnight. But it is this type of volatility that makes the following play possible. If the semis don’t meltdown, and they manage to hold their inventories down, while the economy continues to hum, then we have a chance for recovery next year.
Summertime is the worst time for techs and this summer is proving to be quite normal for this sector. If we have a recovery in techs, it will be the semis that lead the way. If the market melts down, we will most likely lose. However, I believe that when the opportunity to make three times your money comes up, there has to be risk as well.
Here is what I recommend:
We will be making a play on the Semiconductor Holders Trust (AMEX: SMH), which is a basket of semiconductor stocks.
To do a bull spread on SMH you need to BUY the January 2006 $40 call options (YRH-AH) – these are trading for about $2.90. Against this trade you need to SELL the January 2006 $45 call options (YRH-AI) – they are currently at $1.25.
When you buy the $40 calls and sell the $45 calls, you will have a net cost of $1.25 ($2.90 minus $1.65.) Your upside is $5 ($45 minus $40.) Your maximum profit potential is $3.75 ($5 minus your cost of $1.25) or three times your investment.
Right now we will institute a MENTAL STOP at $0.50 – a stop that I will update if the need arises. Execute the trade as long as your net cost does not exceed $1.35.
If your broker cannot execute this trade then you should open an account with Greg Long at Gunn Allan Financial, 1.800.329.1984. He is a broker I know can do this type of trade.
Regards,
Karim Rahemtulla
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Bio:
Karim Rahemtulla is the former Investment Director of The Oxford Club. The editor of The Smart Options E-Report, The Income Trader – A Covered Call Strategy and The LEAPS Option Trader, Karim is also a regular contributor to The Oxford Club Communiqué. His highly successful trading systems use covered calls and LEAPS to boost returns on blue chip stocks, and during the bear markets of 2000 and 2001, his picks outperformed the major market averages. Educated in England, Canada and the U.S. and fluent in several languages, Karim travels the world to find the best investment opportunities for our members.
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