Last weekend I wrote about the use of stops in general and in high volatility markets such as those we are currently facing. A reader pointed out that I didn't know what I was talking about since it was his view that stops don't work in high volatility markets and the only thing worthwhile to protect positions was the protective put. First, I want to point out that at the worst, it is far better to have a stop than to have nothing to protect the downside. I agree with the most recent critic that stops are more difficult in highly volatile markets and as I indicated last week, more latitude is necessary in placing them than in less volatile situations.

Truth be told, I am a great believer in protective puts as well. In fact, I just spoke about them a couple of weeks ago at the Trader's Library event, went into great detail about them in my book, "Trade Your Way to Wealth," and have previously written articles about them here and elsewhere. For those who may be unfamiliar with options, a put option is a contract in which the buyer of the put obtains the right (but has no obligation) to force someone to buy his stock at a predetermined price (the strike price) anytime until the put expires. In exchange, the buyer of the put pays the seller of the put a premium. In return for the premium, the seller of the put has the obligation to buy the stock at the strike price if assigned (put) to him anytime before expiration. For example, suppose I owned XYZ, an optionable stock which I bought at $30 a share. I could buy a put at a $25 or $30 strike price that expires a month or two or maybe even a year from now. The longer away the expiration, the more expensive the premium would be and the higher the strike price I bought, the more expensive it would also be. In the example, suppose I bought the $30 strike price with an expiration 4 months out and the premium was $5 a share. Now, no matter how far the stock might fall, I could force someone to pay me $30 a share if I exercised my put any time before expiration. Naturally, if I did that, I would be out the $5 a share, but I would be able to sell the stock, itself, for exactly what I had paid (less commissions on the stock and on the purchase of the puts).

One thing for which I suspect the critic of stops failed to account is the relative cost of puts. At times like the present, for example, where the implied volatility is very high, options are very expensive. Buying options may not be the wisest things to do at times when volatilities are extremely high. To look at a real life present day example (as of close on Wednesday, November 12, 2008), DUG closed at $45.26. Suppose we bought 100 shares at the close and also bought the at the money $45 protective puts. We could have bought the Jan 45 puts for $11.90 a share. Now we would be able to force someone to buy our stock for $45 a share anytime between now and the third Friday in January for $45. It would have cost us $11.90 a share to obtain that protection so come the third Friday in January, the stock would have to be up $11.90 a share (+ $0.26 since the stock would lose 26 cents a share if we sold it for $45 a share) plus commissions for us to break even. That is one choice we could have made and it is a legitimate one. However, we should be aware that the premium we are paying is quite high because of the high current implied volatility. On the other hand, we might have chosen to place a stop loss below the uptrend line on the stock at $37. If the stock dipped to $37, our position would be closed and if closed around the $37 mark, we would have lost $8.26, a number significantly less than the cost of the put premium. Of course, one problem with stops is that there is no guarantee that we will get the stop price if it is hit.

The stop simply means that our stock will be sold if the stock price hits or goes below the amount at which the stop is set. If, for example, the stock gapped down at the open to let's say $20, our $37 stop would be hit but we would probably only get around $20 a share. With the put in our example, no matter what the stock price, we could still assign it for $45 if we had paid the $11.90 a share premium. The real point is to look at the alternatives available to us. Sometimes the stop is the better choice, sometimes the protective put.

The fellow who decided I was so foolish to discuss stops last week and took the position that anyone with a brain should only buy protective puts also failed to acknowledge that many stocks are not optionable and if one holds a position in such an issue, buying a protective put is an alternative that simply does not exist.

Returning to the subject of a seminar, although there has been a fair amount of interest, I have decided not to do one for pay. Instead, I am going to do a free event for those who have been one-on-one coaching students. I will contact those individuals privately. I also am offering those who indicated an interest in the seminar the opportunity to have a private coaching session for the same price as I offered the seminar (i.e. $2,100 for paid subscribers and $2,500 for non-paying Newsletter subscribers). This offer is open ONLY to those who have already written evidencing a desire and willingness to participate in the seminar. Please contact Earleen at MarketFN (866-756-2656 ext. 1) if you would like the private coaching and she has agreed to put you in direct contact with me. The private coaching sessions are designed to address the specific individual's needs and goals and are geared to his or her level of knowledge and experience. I sincerely believe these sessions are even more valuable than a general seminar and they have been quite popular in the past. Other than free seminars for previous coaching students which I hope to do on an annual or biennial basis, I do not expect to do any other seminars now or in the foreseeable future.

Good Trading!
Bill Kraft

November 15, 2008

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