Options Trading Strategy

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Options Trading Strategy: A Five-Question Screen to Find the Perfect Option

By Dean Albrecht, Contributing Editor
Tuesday, October 25, 2005: Issue # 253

When I speak at options conferences around the country, investors often have questions about how I approach the markets… I mean, where do you start?

There are more than 9,000 publicly traded companies in the U.S., and a good number of them have options. Plus, the broad market isn’t exactly on fire right now; nor is it tanking.

So, how do you find a good trade with so many companies out there…and what type of options trading strategy do you employ…especially when your overall view of the market is neutral?

You have to find a way to narrow your focus.

That’s what I’m going to show you today: how to hone in and isolate options trading opportunities in a sensible way… so that you know why you’re trading (long or short) and how to give yourself the best chance at success.

Start Your Options Trading Strategy Using Three Economic Indicators

First, remember that we can go long or short using calls and puts. Then, ask yourself the following questions before deciding your strategy:

Are interest rates moving up or down, and are we close to the bottom or top of the acceptable range?
Is inflation moving up or down, and how much farther is there to go?
Are commodity prices cheap or expensive, relative to cyclical and historical prices, and relative to future perceived demand?

In terms of defining “acceptable” interest rates, that’s a judgment call, and it’s up to you to decide. Same thing with determining how much farther you think inflation will rise or fall. And where you think commodities as a sector are headed.

Yes, you’ll have to think about these things a bit… But for me, this kind of critical thought is an absolute must if you’re looking to explore options trading and become a great investor.

So what’s next? Well, a few more questions…

ETFs or Individual Stocks? Pinpointing Sectors and Profits

Based on our answers to the first three questions, we should be better prepared to answer this one:

What sectors are growing or offering new investment opportunities in light of the three big factors above: interest rates, inflation and commodity prices?

Once you determine a sector that makes sense, you can consider a sector play like an ETF (exchange traded fund), or you can get even more specific. For example, researching one business within a sector. But how do you determine which companies to consider, and which to reject? Ask yourself:

Is this just a “cool” company, or does it have a scalable business model that gives it real potential for enormous growth?

I’ve had plenty of “cool” ideas. But most of them never see the light of day, and for good reason. There’s a critical hole in the concept that would keep it from making money in the real world.

Unlike the dot-com boom – when companies had promises, but readily admitted they wouldn’t be profitable for years – 2005 has brought a different type of investor to the ground level. For the most part, today’s investor is looking for profitability. Imagine that: people looking to invest in companies that actually make money, or are looking to make money, in a reasonable amount of time.

Let’s take a look at the potential areas for profits in our trading strategy at this moment…and the companies that have been making us money – on the short and the long side of options.

A 40% Win Shorting Homebuilders

My staff and I are narrowly focused on real estate, car manufacturers and airlines to the short side. And high-end vacation clubs, diamond mining, mobile technology and microprocessors for mobile technology to the long side.

Four months ago, we thought homebuilders were good shorts. We bought put options on several individual stocks in the sector, such as Toll Brothers (NYSE: TOL), Pulte Homes (NYSE: PHM), KB Home (NYSE: KBH) and others. This options trading play has developed fast, with these stocks down as much as 40%.

We’re also looking at the semiconductor sector in our options line of attack. If I were choosing stocks instead of the Semiconductor HLDR (AMEX: SMH) ETF, I would look for microprocessor manufacturers.

Getting a sharper angle on the market can mean finding companies poised to tank and buying puts, or finding companies ready to run and buying calls.

But long or short, you can always find a way into the markets by asking yourself the questions in today’s report. How you answer them is, of course, up to you!

Good trading,

Dean