Investing With Options in 2008

I hope Santa was good to everyone this year and that each of you has taken some time to reflect upon the blessings we each received in 2007 and begin laying plans for a prosperous 2008.

As we begin this new year, the markets are quite problematic. The odds are that we will see further declines. That should not be much of a surprise to read here. After all, there are many folks sounding the bearish warning.

The real question is how shall we position ourselves in expectation of further selling, while not becoming directionally over committed. I'll share some insight, and if you have thoughts I encourage you to add your own commentary.

To make money in troubled markets, you need to have cash. By maintaining or building a cash reserve, you have the ability to buy assets as they decline in value. I'm not talking about "catching a falling knife," but about getting long the market at favorable price points.

There are many ways to raise cash. The easiest is to simply sell out of your stock positions. The problem created by this is that if the market rallies from here, you'll be sidelined and re-entry risks buying a top.

I have two alternatives to offer, which can be applied to your portfolio individually or in tandem with each other. Take some time to work through these methods before incorporating them into your investing or trading strategy, because these techniques are not appropriate for everyone.

The first is to replace your current equity holdings with LEAPS options. I would suggest taking a look at in-the-money contracts with a high delta, as these contracts will more closely approximate stock. Even a deep-in-the-money contract is likely to cost but a fraction of the underlying stock. The objective is to approximate your current stock holdings by purchasing sufficient option contracts to give you an equivalent delta to your current stock position.

For example, let's assume you own 200 shares of IWM, which tracks the Russell 2000. The delta of stock is always 1, so with 200 shares you would have a delta of 200. The Jan. '10 LEAPS are now available, and we can buy the Jan. '10 $60 strike for $22.40. Compare this with the current share price for IWM, which is $75.92.

These options currently carry a delta of .81. Buying two Jan. '10 $60 strike LEAPS, gives us a delta of 162.17, which approximates 162 shares of stock. Buying three contracts would approximate 243 shares of stock.

The total cost of buying two of these options is $2,240 per contract, so we can pick up two or three LEAPS for $4,480 to $6,720. Swapping out the stock for the options provides us with a net credit of $8,464 to$10,704, depending upon whether you go with 2 or 3 options.

What you have done is reduced your total risk of loss, while still providing yourself the opportunity to participate in upside gains. You have also raised cash, allowing yourself the opportunity to go long the market at a more favorable price point.

The second technique is to hedge your current stock positions by purchasing puts on the primary indexes. You might choose put options on ETF products like the DIA, IWM, or SPY. My recommendation is to select one or more indexes that approximate the makeup of your portfolio. For example, if you're mostly in big cap stocks I'd take a look at the SPY or DIA as these track the S&P 500 and DJIA, respectively. If you're heavy in technology stocks, the QQQQ might provide a better hedge.

If the sell-off materializes, those puts can be sold at a profit and converted to cash. That cash can then be used to finance the purchase of stock, or options, for the purpose of going long the market.

Now, I am not a market timer. My personal preference is to focus upon index products, like ETF's, and look for opportunities to buy them at favorable price levels. I hedge my long-term bullish positions with shorter term bearish positions, which may involve the purchase of put options or the sale of call options. The objective is to hedge losses during corrections and raise cash for later use.

These are some of the things I am looking at for my own portfolio as I contemplate and look forward to the coming year. I have also been thinking about TheOptionClub.com and where it will take us this coming year. There should be some exciting new things, which I will share with you as they transition from the planning phase to actuality.

I hope all of you have had a profitable 2007, and I wish each of you an even more prosperous and joyous 2008. If I can help in some small way, please feel free to post a message on our discussion board, a comment here on the blog, or just shoot me an e-mail.

Happy New Year, and good trading!

Christopher Smith
TheOptionClub.com