1. The demise of the very widely held Enron, World Com, Lucent, and others has taught investors, and rightly so, that stocks can indeed go to zero. No matter what the company, or how fancy or contrived the rhetoric from the management, there has always been a finite risk that a company’s stock would be worthless some day. Traditionally investors have underestimated this risk, but recently events may have served, in my opinion, to cause people to overestimate this doomsday risk for most companies.
        

2. The fairly recent practice of after hours trading, combined with most companies current policy of delivering announcements after the close, may cause stocks to fall more than they should initially. I have no empirical studies to back this belief, but it certainly seems that orders to sell millions of shares 2 or 3 hours after the market closes might find a lower price than necessary. The old practice of stopping trade in the stock during trading hours, making the announcement, and pairing up buyers and sellers when everyone is available seems a much better system.
         

3. Call me a conspiracy theorist, but at certain times in today’s ludicrous executive compensation world, there are times when an overly low stock price can benefit today’s managers. If I am a manager blessed with a Board of Directors foolish enough to continue to re-price my stock options downward to retain my “incentive”, it certainly would benefit me to have the stock priced too low, at least for a little while.

The trick in trading the bounce in these “fallen angels” effectively is to keep your investment small relative to your investment portfolio, and to divide your total outlay over many such stocks. It also helps to use your option knowledge to find positions that more effectively create an appropriate risk-reward curve than an outright stock purchase. Let’s look at an example from today.

Continuing concerns about risks in their credit card division have caused Sears stock to make another large move down today, down $2.18 to $20.52 at 1:30 on Nov. 13, 2002. This price represents a nineteen year low, a price/earnings ratio of less than 5, and the incredible recent history of having traded $48 on 9/17/02. If this seems low to me, and it does, what can I do to profit by my opinion if I am right and not get killed if wrong? Here are a few examples.

1. Buy the stock at $20.52 and sell April 20 calls at $3.90. This position has a maximum profit of $3.38, a maximum loss of $16.62 if the stock goes to zero, and a downside break-even of $16.62. This position provides protection of almost 20%, and if the stock stays over $20 the return is 20.3% for 5 months. 
        

2. Buy the January 04 20-30 call spread for $3.40. The total risk in this position is $3.40, and the break-even price in January 04 is $23.40. If the stock recovers to $30 in the next 14 months the position returns $6.60 profit, or 193%. In this spread, unlike the previous, the stock does have to move to make a profit.
        

3. A more interesting spread, and one I like better, is to buy the Jan. 10 of 2005 calls for $11.60 and sell the April 20’s of 2003 at $3.90. The total outlay, and total risk, is $7.70. If the stock is over $20 next April the total profit will be at least $3.30, for a 5 month return of 43%. The stock does not have to move up for this return, as long as it stays above $20. If the stock does go down, we have the chance to sell calls against the long $10 calls for 20 months in an effort to recoup the $7.70 outlay.

Some other candidates for long-term strategies may include Citigroup, Ford, Tyco (may have missed this one), Nvidia, Tenet Health Care, and General Electric. If there is interest we can schedule a teleconference on the intricacies of using LEAP options that far out. Especially in this environment, the behavior of the LEAP options in regards to changes in interest rates and dividend streams should be understood. In the Sears example, it would certainly be interesting to see how increases in interest rates and possible cuts in dividends could have a positive effect on the price of the LEAP call, even though a negative effect could be expected on the stock price. Please e-mail us or call if you are interested in a learning more about this topic (800.821.4968 or Tom@PTISecurities.com) . 
      

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