-- Posted Wednesday, 28 November 2007 | Digg This Article
| Source: GoldSeek.com
Rick’s Picks
Wednesday, November 28, 2007
“Phenomenally accurate forecasts”
Think there’s a chance the Dow Industrials will be trading at least one percent lower a couple of months from now? So do we. Now suppose someone was willing to give you 5-to-1 odds that it won’t happen – that the Dow will be at current levels or higher come late January. Would you take that bet? Of course you would. Now, you’re probably wondering who besides Abby Cohen or Larry Kudlow would take the other side of such an idiotic bet. Probably no one. But you could still get 5-to-1 odds by buying put spreads based on the prices reflected in the table below. It shows bid/asked quotes for January put options on the Diamonds as of yesterday’s close. The Diamonds, a trading vehicle that mimics the price action in the Dow Industrial Average, were trading for 129.32, about a tenth of the value of the actual cash Dow index.
Here’s how you could have placed your bet. With the Diamonds at 129.32, the DIA January 129-128 put spread was offered for 0.60. This means you could have bought a 129 put on the offer for 4.35 and shorted an offsetting 128 put on the bid for 3.75. Your net cash outlay would have been 0.60, or $60 per spread. Now let’s roll the calendar forward to January 21, when the options expire. With DIA trading 128 or lower – a drop of one percent from current levels -- your $1 vertical put spread would be worth 1.00 ($100). Your profit would be $40, but that would be no great shakes considering you risked $60 to begin with.
Improving Your Odds
But suppose you were able to buy the put spread at a better price. Look at how even a slightly better entry will enhance your odds. You would want to leg into the spread one side at a time, first bidding 4.15 for the January 129 put. When someone hits your bid, you would in turn hit someone else’s 3.75 bid in order to short a Jan 128 put. That would leave you long the Jan 129-128 put spread for a debit of 0.40 ($40), implying that the most you could lose is $40, but with the same shot at making $100 if the Diamonds are selling for 128 or less come January 21. Now your odds are at 2.5-to-one, meaning you can make as much as $2.50 for each dollar risked. Leg into the spread at the slightly better price of 0.20 (the price bid for the spread in the table above) and you have increased your odds to 5-to-1.
This is what we were attempting to do on the close yesterday, bidding 4.15 for some January 129 puts with the speculative goal of shorting some January 128 puts on Wednesday’s opening for 3.95. Of course, this tactic is considerably riskier than trying to nail down both sides of the spread at the same time as we've advised above. However, as you can see, without sticking one’s neck out, it would have been quite easy to leg into the spread for 0.40, yielding 5-to-2 odds. And if our speculative hunch that stocks will fall Wednesday morning proves correct, it’s even possible that we’ll be able to short the Jan 128 puts for as much as we paid for the Jan 129s. That would leave us holding a $1 vertical put spread with $100 of profit potential and no possible loss. Not a bad way to go.
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Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers’ initials will be used unless express written permission has been granted to the contrary. All Contents © 2007, Rick Ackerman. All Rights Reserved. www.rickackerman.com
-- Posted Wednesday, 28 November 2007 | Digg This Article | Source: GoldSeek.com
