Options are the greatest way possible to invest in the stock market.

There are a number of reasons why. My favorite happens to be the fact that you can dramatically decrease risk without decreasing potential reward.

My second-favorite is that, no matter what the market is doing, you can insulate yourself from activity in the broader market and even position yourself to profit from it!

If you know anyone who knows, for sure, what's going to happen to this market next, please shoot me an e-mail and I'll bankroll the rest of your life. But one thing that's very possible is, while the economy is working out some very serious long-term problems, the stock market will reflect that process.

This means that, while the market will encounter spikes and drops, it just might end up in the same long-term range for quite some time.

Does that sound unrealistic? Actually, it's happened several times.

Check out this chart of the Dow Jones Industrial Average from 1965 to 1981.

But, does the current state of the broader market matter to me? The answer is simply NO. 

Why? Because when you're trading stock option contracts, it's possible to take advantage of "direction" or "fear" ("implied volatility"), or both. 

For example: In the chart above, you can imagine (and many of you can remember) how fearful investors were in 1970 after the Dow declined by about 35% and bounced up to the red dot. Using options in a situation like this, you can profit in two ways:

1. By betting on the market trading higher.
2. By betting the amount of fear in the market will decline.

One strategy you would use in this case could be selling a vertical put spread.

Typically, the two things will happen at the same time (a reduction in fear when the market moves higher). But what if the market traded sideways for a period of time instead of moving higher?

What would likely happen in that case is the fear in the market would still decline, which means you would have generated a profit even when the market didn't budge!

You would do the opposite in 1973 where you see the green dot. Using options in a situation like this, you can profit in two ways:

1. By betting on the market trading lower.
2. By betting the amount of fear in the market will increase.

Typically, the two things will happen at the same time (the market moves lower while fear increases). You can see on the chart that the market dropped by 40% relatively fast.

This would cause a double-whammy for people who owned put options. They would become more expensive as the market traded lower, but since it happened so fast, the fear level in the market absolutely exploded!

What if the fear level didn't explode? If the market just gradually lost value, you would still profit because you were right about the direction. 

What's amazing about options is it doesn't have to be a 50% bet on direction and a 50% bet on fear. Depending on the option you choose to trade (in this case, the put option you decide to buy) you can bet more on the direction and less on fear or vice-versa. If you want to bet more on the "directional play" you would do what I like to do: buy deep in-the-money puts.

On the flipside, what if you were betting the market would move higher by buying call options? Well the smartest way to make that bet is to buy deep in-the-money (ITM) call options. But if you made that bet at the green dot on the chart, you would probably have lost money.

However, since fear increases when the market declines, your "ITM call option" would decline, but by a lesser amount than the underlying stock would. 

If a stock declined by 5 points and you owned 1,000 shares, then you would lose $5,000.00. But if, instead of buying 1,000 shares, you bought 10 call option contracts (representing 1,000 shares) you would probably only lose 3.5 or possibly 4 points.

Why would the option trade down by so much less? Because options become more expensive when the level of fear increases. 

I'll give you another reason why options are the greatest tool for investing.

You can use them in conjunction with your current stock holdings. If the market trades sideways, causing most of your stocks to trade sideways for the next several years, you can make a fortune by selling covered calls on the stock positions. 

See the little black dots? Your timing doesn't have to be absolutely perfect. But if you sell covered calls on the positions when you think the market is a bit too high, you will continue to collect income on your positions.

This way, even if the market trades about 13 years without making even 1% (like it did from 1968-'81), you can still profit from your stock positions. In fact, by selling covered calls each month or even every other month, you can get paid to own your stocks!

One last reason why I think options are the greatest tool on earth:

What if you have cash on the sidelines and you think it's the greatest time to buy because the stock market has sold off enormously? You've always heard about how dangerous it is to try to "catch a falling dagger."

On the other hand, you know the best times to buy, historically, is when everyone was fearful and nobody thought it would trade up.

What do you do?

Do you see the black rectangle on the chart? That's about where you would be thinking about this. 

Remember, using options you can trade both direction and fear. When fear is at its highest, options on the stock market are at the most expensive prices.

Not only am I making a case for options, but I'm also making the case for trading. The "buy and hold" approach isn't always the right way to play, as we can see in the 1968-'81 chart of the Dow.

You'd probably be pretty upset if you just hunker down for five or 10 years, watching the market trade up and down 50%, only to end up right back to where it started from.

Ask anyone who bought and held from '68 to '81, or from 2003 through NOW!



“Profit from the Trend”

Chris Rowe
Chief Investment Officer
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TUESDAY, SEPT. 29

9 a.m. Conference Board Consumer Confidence

    * Importance (A-F): This release merits a B-.
    * Source: The Conference Board.
    * Release Time: 10 a.m. Eastern on the last Tuesday of the month (data for current month).
    * Raw Data Available At: http://www.tcb-indicators.org

The index consists of two subindexes -- consumers' appraisal of current conditions and their expectations for the future. Expectations make up 60% of the total index, with current conditions accounting for the other 40%. The expectations index is typically seen as having better leading indicator qualities than the current conditions index.

Highlights

    * The Conference Board's consumer confidence indicator soared above the consensus forecast of 47.9 by posting a strong rebound to 54.1 from 47.4 in August. The jump follows two consecutive dismal results.

    * The increase in consumer confidence was due to the Expectation Index increasing from 63.4 in July to 73.5. The index is at its highest level since the beginning of the recession in December 2007.

    * The Present Situation index rose a more modest 1.6 units to 24.9.

    * The number of respondents who think business conditions are currently "bad" declined approximately 1 percentage point to 45.6%.

    * Consumers are also a little more upbeat on the job market with 45.1% of respondents believing jobs are hard to get, a decline of 3.4% from June, and 4.2% of respondents saying jobs are plentiful, an increase of 0.5%.

Key Factors

    * It's no surprise that the consumer confidence numbers were pushed higher by the Expectations Index. The index is highly correlated with the number of positive/negative news reports. All of the talk in the media about economic growth returning by the beginning of Q3, including a Newsweek Magazine cover announcing the end of recession is here,  helped alleviate a lot of the consumer's concern about the future.

    * The more telling sign of the consumer holdback is from the Present Situation Index. Consumers are currently not seeing seeing strong growth and they may continue holding off on major purchases until they witness evidence of the economy rebounding.

Big Picture

    * Consumer sentiment indices get way too much attention.  The simple fact is that sentiment does not correlate strongly with consumer spending and thus has little predictive value.  Consumer spending correlates more closely with income.  Sentiment tends to reflect well known factors such as unemployment rates and gas prices more than it predicts future spending patterns.


WEDNESDAY, SEPT. 30

9:45 a.m. Chicago Purchasing Managers Index

    * Importance (A-F): The Chicago PMI merits a B.
    * Source: Kingsbury Int'l Ltd. and Institute for Supply Management–Chicago Inc.
    * Release Time: Typically the last business day of the month at 9:45 a.m. Eastern

There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region. The New York and Philadelphia Fed's surveys are the first each month, followed by the Chicago purchasing managers' report on the last day of each month. The purchasing managers' reports are measured like the national Institute for Supply Management data -- 50% marks the breakeven line between an expanding and contracting manufacturing sector. For the New York, Philadelphia and Atlanta Fed indexes, 0 is the breakeven mark. These surveys can be of some help in forecasting the national ISM.

Highlights

    * According to the Institute of Supply Management-Chicago and Kingsbury International Ltd., the Chicago Purchasing Managers Index increased to 50.0 in August (consensus 48.0) from 43.4 in July.

    * Both production and new orders jumped above the 50.0 threshold, the point where the sector signals positive growth, to 52.9 and 52.5, respectively.

    * Prices paid jumped to 50.0 as well and eased some deflation worries.

    * Both employment and inventories remain weak, but the contraction eased slightly as the indices rose to 38.7 and 27.5 respectively.

    * Other components of the PMI show improvement as order backlogs rose to 52.5 from 48.0 and supplier deliveries increased from 49.6 to 54.6.

Key Factors

    * The August report ends 10 consecutive months of contraction and sets the stage for a recovery in the manufacturing sector in the near future.

    * The report follows the positive new orders data reported by the Census Bureau last week. Unfortunately, the PMI does not break down and explain which sectors within the manufacturing sector are growing. Growth in durable orders were due to unsustainable output in the aircraft sector. Similar readings could temporarily push up the PMI and provide a false growth signal.

Big Picture

    * The Chicago PMI has little overall economic value, and is only watched by the financial markets because it is usually released one day in advance of the similar national ISM manufacturing survey.  A significant move in this regional survey will therefore sometimes be seen as having predictive value for the ISM index.


THURSDAY, OCT. 1

10 a.m. Institute for Supply Management

    * Importance (A-F): This release merits an A-.
    * Source: Institute for Supply Management
    * Release Time: 10 a.m. Eastern on the first business day of the month for the prior month.
    * Raw Data Available At: http://www.ism.ws

The ISM report is a national survey of purchasing managers that covers such indicators as new orders, production, employment, inventories, delivery times, prices, export orders and import orders. Diffusion indexes are produced for each of these categories, with a reading over 50% indicating expansion relative to the prior month, and a sub-50% reading indicating contraction.

The total index is calculated based on a weighted average of the following five sub-indexes, with weights in parentheses: new orders (30%), production (25%), employment (20%), deliveries (15%) and inventories (10%).

The ISM is one of the first comprehensive economic releases of the month, typically preceding the employment report. Though it covers only the manufacturing sector, it can often provide accurate hints regarding the tone of subsequent releases. During periods of inflation concerns, the prices paid and vendor deliveries indexes often determine the bond market's reaction to the report.

Highlights

    * The ISM manufacturing index broke through the 50.0 threshold and signaled the end to the contraction in manufacturing phase of the recession.

    * The index rose 4 points to 52.9, well-above the consensus estimate of 50.5 in August and marked the eighth consecutive month the index increased from the prior month.

    * There are many encouraging signs reported in the data. New orders jumped 9.6% to 64.9 as the expansion clearly takes hold. Deliveries strengthened 5.1% to 57.1.

    * Inventory restocking continues to be a problem. Inventories contracted for the 40th consecutive month and customer inventories have dropped for the fifth consecutive month.

    * Export growth rose 5.0% to 55.5 while imports began a slight contraction phase as growth declined 0.5% to 49.5.

    * Prices rose 10.0% to 65.0. While inflation is not expected anytime soon, such a large price increase will increase the worries of inflation hawks.

Key Factors

    * Overall the index shows a strong rebound in the manufacturing sector.

    * Only 6 of the 18 manufacturing industries reported contraction in August, and 2 of the 6 sectors, primary metals and plastics and rubber products, should post positive growth as the automobile sector revs up.

Big Picture

    * This is a highly overrated index.  It is merely a survey of purchasing managers.  It is a diffusion index, which means that it reflects the number of people saying conditions are better compared to the number saying conditions are worse.  It does not weight for size of the firm, or for the degree of better/worse.  It can therefore underestimate conditions if there is a great deal of strength in a few firms.  The data have thus not been either a good forecasting tool or a good read on current conditions during this business cycle.  It must be recognized that the index is not hard data of any kind, but simply a survey that provides broad indications of trends.


FRIDAY, OCT. 2

8:30 a.m. The Employment Report

    * Importance (A-F): This release merits an A.
    * Source: Bureau of Labor Statistics, U.S. Department of Labor.
    * Release Time: First Friday of the month at 8:30 a.m. Eastern for the prior month
    * Raw Data Available At: http://stats.bls.gov/news.release/empsit.toc.htm

The employment report is actually two separate reports which are the results of two separate surveys. The household survey is a survey of roughly 60,000 households. This survey produces the unemployment rate. The establishment survey is a survey of 375,000 businesses. This survey produces the nonfarm payrolls, average workweek, and average hourly earnings figures, to name a few. Both surveys cover the payroll period that includes the 12th of each month.

The reports both measure employment levels, just from different angles. Due to the vastly different size of the survey samples (the establishment survey not only surveys more businesses, but each business employs many individuals), the measures of employment may differ markedly from month to month. The household survey is used only for the unemployment measure - the market focusses primarily on the more comprehensive establishment survey. Together, these two surveys make up the employment report, the most timely and broad indicator of economic activity released each month.

Highlights

    * The employment report showed mixed data in August compared to consensus expectations. One one hand, payrolls declined less than expected at -216K compared to the consensus forecast of -230K. On the other hand, the unemployment report jumped to 9.7% after the consensus forecast a more moderate 9.5%.

    * Average hourly earnings rose a better-than-expected 0.3% (consensus 0.2%).

    * The average workweek stayed the same at 33.1 hours. The manufacturing workweek also held steady at 39.8 hours. We expect the manufacturing workweek to increase slightly over the next few months as manufacturing factories come back on-line to restock depleted inventories.

    * The construction sector shed 65K jobs in August, much slower than the -117K per month average over the last 6 months. The construction sector has declined by 1.4 million jobs since the beginning of the recession. In other sectors, manufacturing employment dropped 63K; financial activities lost 28K and wholesale trade declined 17K. The retail trade sector, professional and business services sector, transportation and warehousing sectors, and leisure and hospitality sectors all stayed relatively the same from last month. The health care sector continues to gain jobs, up 28K.

    * The "real" unemployment rate, all unemployed, underemployed, and discouraged workers, ticked up 0.5 percentage points to 16.8%.

Key Factors

    * This report did nothing to show an ease in labor market conditions as we are now on the verge of topping the latest long-term unemployment forecast. The consensus forecast a peak rate of 9.9% by the middle of 2010, and, if trends continue, 9.9% will be reached before the end of the year.

    * It's strange to see payrolls moderate while the unemployment rate increases more than expected. One explanation would be for more people entering the labor force. However, the labor force only rose by 73K people. During normal market conditions, the labor force is expected to increase between 110K-120K. Further, the number of discouraged workers jumped 143K. If the increase in the labor force was the reason for the jump in the unemployment we would see a larger than 120K increase in the labor force and possibly a decline in the number of discouraged workers.

    * The more likely explanation is that the household survey finally caught up to the large declines shown by the establishment survey. While the two surveys are distinctly different in what they are attempting to analyze, the data from both surveys should correlate fairly well. For the last few months, the unemployment rate decline has slowed even though the payrolls data suggested large declines in available jobs. This month, the household survey showed an increase in the number of unemployed persons by 466K which is in-line with the initial claims reports over the last four weeks.

Big Picture

    * Weekly claims for unemployment have to drop below 400,000 before payrolls will stabilize.

    * Limited wage growth and declining payroll levels are a recipe for very poor consumer confidence and sluggish consumer spending.

Source: Briefing.com