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How to Trade Options in this Market
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Friday, 14 March 2008
Rick Pendergraft
I received a few emails this week regarding my IDE article on Monday talking about the trade I recommended to K.I.S.S. subscribers.  The emails agreed with the article, saying that the way to play this market is with short-term trades and with options.     
As a follow-up to that article, I wanted to show you how beneficial trading options can be in a market like this.

First, options should not be the only investment vehicle you use.  I recommend that you keep the bulk of your money (75-80 percent) in long-term investments and use the rest to trade options.

If we look at last week’s trade, you can see how this would have worked had you been following such a strategy.

For illustration purposes only, let’s say that you have $100,000.  Portfolio A allocates 75 percent to an index fund and the rest to options.  Portfolio B is allocated entirely to an index fund.

During the course of time when K.I.S.S. subscribers were holding puts on the AMEX Diamonds Trust (DIA), the Dow fell just over five percent.  Let’s use a table showing the returns of each portfolio.

Portfolio A value on February 2

Gain/Loss

Portfolio A value on March 4

$75,000 in Dow Fund

($3,750)

$71,250 in Dow Fund

$25,000 in options (20 percent allocated to DIA puts= $5,000)

$6,100

$31,100 in options

$100,000 total value

  

$102,350 total value
     

Portfolio B value on February 27

  

Portfolio B value on March 4

$100,000 in Dow Fund

($5,000)

$95,000 in Dow Fund

As you can see in the table, you don’t want to invest more than 20 percent of your options portfolio into any one trade.  Even with only $5,000 dedicated to this trade, Portfolio A gained 2.35 percent over the course of the week.  Meanwhile, Portfolio B lost five percent over the course of the week.

As I said before, these portfolios are for illustration purposes only, but the recommendation to K.I.S.S. subscribers was real, as was the five-percent drop in the Dow.  This example shows how the leverage of options can work for you, even while you keep the bulk of your money in longer-term investments.
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Respectfully,

Rick Pendergraft

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