11:45pm (EST)

1. Market Summary

2. An Introduction to LEAPs          

3. What’s Wrong With CBOE?           

4. Strangle Trade Update   

5. Earnings  

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1. Market Summary

It was another classic battle last week as the bulls and bears pushed the action with Wall Street on vacation.  As the summer grinds down, a lot of traders like to take the last week of August off which usually brings extra volatility and chaos.  The market certainly got that and then some.  The trend had been down heading into the week, but the bulls started a major rally off the lows on Tuesday and powered the market past key resistance levels by Friday.

Of course, both sides were nervous taking positions ahead of Friday’s unemployment update but the bears were sideswiped when the market got “good news” as the total number of new jobs added came in at of 67,000 while the jobless rate rose to 9.6% from 9.5% in July.  We all know the labor market is struggling, and the fact that jobs opportunities are not keeping up with demand doesn’t help matters, but the bulls used the positive number to push the bears into a corner.

Last week we told you there was a chance we could test the upper end of the current trading range so let’s see where we are at.

The Dow surged 128 points, or 1.2%, to close at 10,447.  For the week, the index added 297 points, or 2.9%, and snapped a 3-week losing streak in the process.  The bears were trying to hold the 10,400 level and we said that sometimes resistance gets stretched but the bulls are now pushing for 10,600-10,800.

The S&P added 14 points, or 1.3% to finish at 1,104 and for the five days, the index popped 40 points, 3.8%.  We had a feeling the 1,100 level would come into play and the bulls have to feel good about taking out this number.  The next stop appears to be 1,125 with a run to 1,150 if the momentum continues.

The Nasdaq jumped 34 points, or 1.5%, and settled at 2,233.  Tech had a huge week as it rallied 80 points, or 3.7%.  Our target for the Nasdaq had been 2,200 with a possible push to 2,250.  If the bulls continue with their momentum, it is possible they make a run at 2,300-2,350.

We mentioned last Thursday the bulls could test resistance and the fact that the major indexes closed above these levels is impressive.  We also told our subscribers that Friday would bring a triple-digit move in the Dow and the day after Labor Day is usually pretty bullish as the Dow has rallied 12 out of the last 15 years. 

So what does this all mean?  Are we at the start of another bull market?  Or are the bears setting a classic bull trap?  We should know this week…

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2.  An Introduction to LEAPs 

We wanted to take some time this week to talk about Long-Term Equity Anticipation or LEAP options.  LEAPs are simply call or put options where the original term can go as far out as two years from the issue date of the contract.  We have profiled some of these types of options in the past and wanted to discuss how you can use them when looking to add them in your investment portfolio.

One of the great advantages of LEAPs is because the term of the option contract is so long, these types of options can be great for protection to hedge against a large stock position.  For instance, let’s say you believe in Bank of America (BAC, $13.50, up $0.22) and feel the stock is cheap (like we told you a few weeks ago) at current levels.  Just last Tuesday, shares touched a 52-week low of $12.18 and it would have been hard to buy at the lows but let’s say you agreed with us and believed in the company’s long-term prospects.

We have been following the January 17.50 (2012) calls (BAC120121C000175000, $1.20, up $0.08) for a few weeks now and you could use these options as was way to lower your cost basis in the stock. 

If you went to the market and bought 1,000 shares of BAC it would cost you $13,500 if we use Friday’s closing price.  You can then sell the aforementioned call options (10 contracts) and collect $1,200 into your account which lowers your basis to $12,300. 

By doing this, you also limit your upside potential because the stock might get “called” away from you if shares are trading above $17.50 by January 21, 2012, or 16 months away.  However, because your cost basis was $12,300 instead of $13,500, your return is 42% instead of 30% had you just bought shares.

Of course, you could also buy the call options straight up without buying the stock and shelling out $1,200 for 10 contracts.  The beauty of this trade would be if shares are at $20 in 16 months.  The options would be worth a minimum of $2.50, or a 100% return from current levels.

This is one way to use LEAPs if you are bullish on a company. 

If you are bearish on BAC then you could use LEAP put options.  

If you believe BAC is a ticking time bomb waiting to explode and shares are headed below $10 then you could use the January 10 (2012) puts (BAC120121P00010000, $1.15, down $0.05).  If shares are at $7.50 in 16 months then these puts would also double.

LEAPs are also useful when you believe an event will dramatically move a stock but the exact timing is unknown.  A great example is a takeover target.  If you believe a company is going to catch a bid from another but you are not sure of the timing AND you believe the stock will command a heavy premium, call LEAPs could be used. 

-OR -

If the company has a dying business model (Blockbuster Video) or is losing market share and you think shares are going to get a 50% haircut then you could use put LEAPs.

One of the drawbacks of LEAPs is that they are so far out in terms of time frame, if you don’t get a decent move in the stock, you may not have the LEAP move enough to justify the trade.  Generally, you are not going to be making an 1,000% return with LEAPs even if you do get the event you are looking for but we have seen some LEAPs soar in the past.

If Bank of America is at $25 in 16 months, your return would be 525%.

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3.  What’s Wrong With CBOE?

The Chicago Board Options Exchange (CBOE, $22.17, up $0.50) is a recent initial public offering (IPO) we briefly highlighted in mid-June and a stock we have kept on our Watch List.  The IPO priced at $29, hit a high of $33.75, and closed at $32.49 on its first day of trading. 

We mentioned at the time there were some litigation issues facing the company and those were resolved in early July after the company won a huge high-stakes legal battle to maintain its exclusive rights to trade index-based options contracts.  Shares were trading near $30 when the good news came out but have since hit a 52-week low of $20.25 before rebounding nearly 10% last week.

The 50% haircut (before the bounce) had peaked our curiosity so we did a little more digging.  As you can imagine from its name, the company is basically an option exchange, with businesses in futures contracts and cash equities.  As far as volume, the exchange averaged 4.5 million contracts on trading days in 2009, although recently that volume has been lower.  CBOE is projected to do $440 million in revenue this year.

Despite the recent legal win, one of the reasons for the drift down has been the anemic volume the market has experienced for much of the summer.  Although the overall trend for options over the last few years has been higher as more and more people use them in the portfolio, the summer months usually bring lower volume.  All of the exchanges make money on volume, and the recent dip in the lack of participation on stocks has hurt the option markets, CBOE included.

This could all change soon no matter which way the market heads from here as we are almost certain to see higher volume in September and October.  These are typically volatile months for the market and volatility typically means more trading volume.  In addition, many Wall Street traders will be back at their desks on Tuesday after taking last week off.  The bond market has been just as volatile and could be crumbling if there really is an asset switch going on.

This stock is also a takeover target, so keep an ear out for rumors.  Shares are reasonably valued at this point, and as we mentioned, the long term trend in option volume is upward.

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4.  Strangle Trade Update  

We are usually pretty good with deadlines and we told you we had a great example to show you on how sweet strangle option trades can be.  We did not get the article out in time for our Weekly Wrap but we ran this in our Monday Morning update at 9am, before the market opened (quotes from that day):

“We wanted to take some time to talk about a strangle option trade this morning that we were going to cover over the weekend but didn’t.  The stock we were going to cover is a good candidate because we are expecting shares to move at least 10% or more over the next few weeks.

To find an attractive candidate, you need volatility and Freeport-McMoRan (FCX, $70.36, down $0.84) fits the bill.  The strangle option trade can be used for a stock that you feel will be making a big move but you are unsure of the direction. 

If you look at a chart for FCX, you will notice shares are easily capable of moving $10 in a week and that is the action we are looking for.  The company is mainly a Copper ETF but has some exposure to gold and although we are in a downtrend, we would use call options to protect us if the stock moved higher. 

September options expiration is only 18 days away, so you could use the September 65 puts (FCX100918P00065000, $0.81, up $0.08) and the September 75 calls (FCX100918C00075000, $0.95, down $0.25) as a way to play a big move in the stock.  If we let this trade run down to the wire we would need shares of FCX to be under $64 or over $76 for us to make a decent return.  The goal would be to make enough on one side of the trade to offset the other side of the trade. 

If the stock makes a quick 5% move either way, the calls or puts would double and hopefully give you an overall gain of 10% or more.  Then you would have the other side of the trade to wait for a rebound and possibly get out of the other side with a profit.  That is not often the case but it does happen.

These trades are also known as “chicken trades” or you can use the 70 strike price and make the trade a “straddle” option trade.  This trade is not an official recommendation because we don’t like the risk/ reward setup for this one but we will track it to show you why it did work or didn’t.  This trade is for educational purposes only.” (END)

Well, we explained how the market rebounded this past week and shares of Freeport CLOSED at $78.55 (up $1.59) on Friday.  The trade was up 25% by our Monday afternoon update buy let’s check where the options closed at:

September 75 calls (FCX100918C00075000, $4.40, up $0.95)

September 65 puts (FCX100918P00065000, $0.13, down $0.04) 

These call options opened at 80 cents last Monday while the puts opened at 87 cents.  The calls are now up 450% while the puts are down 85%.  The overall return would be 171% at current prices.

Now, what happens if the market tanks this week and Freeport suddenly drops to $64.  The puts would be worth a buck and it would be added gravy to a nice return.

Although we did not participate in this trade, the good news is that there will be more strangle option trades coming that we will be making official recommendations on!

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5.  Earnings   

TUESDAY – Caseys General Stores (CASY, $38.90, up $0.20), Energy XXI (EXXI, $20.90, up $0.38), Pep Boys-Manny, Moe & Jack (PBY, $10.05, up $0.11) and Phillips-Van Heusen (PVH, $51.10, up $0.77).

WEDNESDAY – Men’s Wearhouse (MW, $21.36, up $1.09), Navistar International (NAV, $46.05, up $1.04), Smithfield Foods (SFD, $16.72, up $0.35), Shanda Interactive Entertainment (SNDA, $41.79, up $0.23) and United Natural Foods (UNFI, $36.09, up $0.49)

THURSDAY – National Beverage (FIZZ, $14.99, up $0.09), Hooker Furniture (HOFT, $10.76, up $0.33) and National Semiconductor (NSM, $13.26, up $0.07).

FRIDAY – Brady Corp. (BRC, $26.51, up $0.20) and Lululemon Athletica (LULU, $35.11, up $0.75).

We will be back Tuesday morning at 9am with our next update!