Tutorial

How I buy AAPL for 12% down without using margin!

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I thought you might like to know a way to buy a stock for little money down using deep in-the-money call options.   I became aware of this option (pun intended!) by reading Lee Lowell’s wonderful book on ways to get rich from options. A call option provides someone the right (but not the obligation) to buy 100 shares of a stock at a particular price (strike price) for a period of time (until option expiration).   Most people gamble with call options and try to buy a cheap call that is far out-of-the-money.   For example, if one goes to yahoo finance and enters AAPL and then selects options, one can get a whole table of possible call and put options for AAPL.

Looking at this table of May options on Sunday evening, I see that I could buy an out-of-the-money call on AAPL with a strike price of   $270 for about $2.47 per share or $247 total for 100 shares (excluding commissions).   This call gives me the right to buy 100 shares of AAPL at $270 per share through May option expiration (3rd Friday of each month).   Since AAPL stock is trading at $247.40, this option is far out-of-the-money.   It would have no real value to anyone until AAPL is above $270 per share (strike price).   The reason people are willing to buy the option for $2.47 per share is that they hope (and are betting) that AAPL will be above $270 by option expiration.   The money they are paying for what is currently a worthless option is   called time premium. In fact, this option buyer would have no profit at expiration unless the stock is selling at $270 + $2.47 (price paid for option) = $272.47   This is gambling.   But remember, if AAPL closes at, say $280 per share by option expiration, the option that was bought for $2.47 per share would now be selling around $10 per share, a quadrupling of the initial investment!   This is because one could execute the option and buy the 100 shares at $270 per share and then turn around and sell them immediately in the market for $280 per share.   One does not need to buy the shares, however, to reap the profit.   Before the option expires, one could just sell the option in the option market for around $10 per share ($1,000 total) in this example.

But an unusual characteristic of options is that as the option is deeper in-the-money, the time premium becomes very small and a small rise in the stock can make the option profitable to a buyer.   For example, the May call option with a strike price of $220 is offered at $29.40 per share, or $2940 for 100 shares.   This means that I could pay $2940 to control $24,700 worth of AAPL through May expiration.   Since AAPL is trading at $247.40, the May $220 call already has real (intrinsic value) value of $27.40 per share ($247.40-220.00).   Since the option would cost me $29.40 per share, the stock only needs to rise $2.00 to $249.40 before I begin to make money as AAPL rises.   Thus, for an investment of $2940 I get to reap the benefit of the gains in a $24,700 stock.   This equals about a 12% down payment, without the need to go on margin and pay interest!

What is the down-side?   Since I pay $2940 for the option, if AAPL closes below the strike price of $220, the option would expire worthless (why would someone buy the right to buy a stock at $220 if at expiration the stock   is   trading below $220?)   So, one can lose the entire investment if the stock falls a lot.   But this strategy loses less money than if one had paid full price for 100 shares   and then seen it fall far below $220!   The most one can lose is what they paid for the option. The big temptation to be avoided here is using the leverage to buy options on more shares than one could have bought outright. That is the way to make a huge bet and lose a lot of money.   I use this option strategy to buy the right to purchase about the same number of shares I would   have been able to purchase.

If you like this strategy, I suggest you read Lowell’s chapter on this topic.   Also, read up on how to open an options account and trade options. By the way, I would not even consider buying AAPL call options until after the earnings come out this week.   Look what happened to other high fliers last week, after they reported great earnings.

Now, the GMI and GMI-R are still at their maximum values.   However, the action in ISRG and GOOG led me to sell out some positions on Friday.   I think it is a warning sign when the leaders crack like that.   Remember, as trend followers, we only tend to exit the market after the trend has changed.   Thus far, the markets remain in an up-trend.   However, I am moving my stops up and am ready to get defensive. Friday was the 4oth day of the current QQQQ short term up-trend.   The last time the QQQQ closed below its 10 day average was February 23rd! That moving average is now at 49.17, only .36 below the current value of QQQQ.   It would not take much of a decline in QQQQ   to break below this important moving average. Note that the Worden T2108 Indicator is now below 80% and may be getting ready to decline.   Be careful out there.   Things probably can’t get much better.

Jim Cramer on stop loss orders–terribly wrong again! KCI soars; How I trade the 3X ETF’s

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I am dumbfounded!     I recently taped some of Cramer’s shows and reviewed Friday’s show this weekend.   At about 10 minutes into his show, Cramer responded to a caller who asked him about the use of stop loss orders.   Cramer ranted on about how he did not want his “home gamers” to put their orders on “automatic.”   Stop losses, he said, were okay for professional traders but not for his listeners who are part-time traders not glued to the market, and who are not robots.   I had to listen to him several times to make sure I heard what he was saying, because his advice was exactly opposite to what I think people should do.   His reason for not using stop losses was that one might get whipsawed–buy a stock at 60, put in a stop loss order to sell if it falls to 59 and then have the stock fall to 58 and be sold out, only to reverse and close back above 60. But it is precisely the part-time traders who are not watching the market every minute who need to have automatic stop-loss orders. Traders who are glued to their monitors can watch their stock closely and manually sell when they want to. It is the part-time trader who get his head handed to him when his stock plummets while he is at work or in a meeting. In 2005, I lost a lot of $$$ profits when I went to a business meeting thinking I did not have to put a stop in on a very strong stock (TASR) I was holding. That mistake cost me big–the market always exacts its tuition, and we must learn from our mistakes.

I could not disagree more with Cramer’s advice.   Before I buy a stock, I calmly decide how much I will let it fall before I think I am wrong and how much of a loss I will tolerate.   In this way, this “home gamer” who   has a full time job, does not have to be glued to the monitor like a professional trader and can go about my business knowing that if my stock falls to my sell level I am immediately and automatically sold out.   Once I have my stop loss order in place, I have taken my emotion out of the trade. If the stock falls and I have taken a small loss, I can always go back in and buy it back if it shows renewed strength–now that’s smart trading!   Every small loss bring me to my next big gain.   It was the   use of stop losses that helped the great Nicolas Darvas (see his book below) to make a fortune in the market in just 18 months. It is how one keeps his losses small.

Put this advice along side a lot of other bad Cramer advice, including calling chartists morons and recommending stocks based on fundamentals alone that were later devastated by the 2008 market decline. (I think Cramer started showing charts for a while after he found that a lot of his fundamental/value choices tanked).

So, how do I put in a stop order?   Before I buy a stock I determine at what level I will have been wrong.   Since I am buying the stock at what I believe is the right time and assuming that it is in an up-trend, I should not tolerate much of a decline below my purchase price.   The best way to enter a trade is to assume it will go wrong, so that I can calmly prepare my risk control strategy in advance.   I select a price level based on prior support, at a moving average or a recent reaction low.   As soon as my buy order is executed, I   place an order to sell my newly purchased shares on stop at my predetermined loss price.   I typically place a GTC (good til canceled order) so that I do not have to put a new stop order in every day.   A day order expires at the close each day.   Now, once the stock trades at the stop price level I put in, the broker automatically sends the order in to sell my shares at the market.   I may or may not sell the stock at the stop order price.   The order goes in line behind other market orders and gets executed in turn at the best price offered.   The greatest risk from using a stop loss order is that if the stock suddenly trades far below the stop price (as in a gap down at the open the next day) one   gets only the best price that someone is willing to pay.   A good strategy is to cancel the stop order after the stock has advanced enough and to put a new sell stop order in at a higher exit price     to ensure I do not give back all of my profit. I do not use automatic trailing stop orders because I prefer to raise the stop price manually after carefully reviewing the stock’s technicals. If I am stopped out and the stock rises again I love to buy it back at a higher price than I sold it.   Such trades often are quite profitable because during the whipsaw, as the   shares decline, they are bought by others who then hold on for a larger advance. Many large advances begin after a sudden decline…….

Meanwhile, the GMI and GMI-R remain at their maximum levels.   As the table below shows,

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How to use IBD 100 and New America stocks and TC2007 to find potential rocket stocks; Market rally begins

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I am writing this post primarily to teach my students how I search for potential rocket stocks–stocks that have been launched and appear headed towards new peaks.   As I said in class this week, it makes the most sense to buy stocks that have the best fundamentals and technicals.   This strategy has been advocated both by Nicolas Darvas and William O’Neil in their extraordinary books (listed at lower right of this blog).   Darvas,   made a fortune trading in growth stocks in the late 19050’s and said that he liked to buy stocks that were trading at all-time highs and that had already doubled in the past year.   So, I am going to show you how I use the great TC2007 stock charting and analysis program to find   potential rocket stocks that I research further before buying.

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