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Turbo Model
Classic Model




Signal Update
Current Signal Performance as of
Signal Type
Trade Date
Index
Return since issued
Nasdaq 100
Russell 2000
S&P 500
QQQQ

Cumulative Returns since First TimingCube Live Signal () as of
Index
Long Only
Long Only
with
Margin
Long & Short
Long & Short
with
Margin
Buy & Hold
Nasdaq 100
Russell 2000
S&P 500
QQQQ

Note: QQQQ returns are included for continuity sake.

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Market Update
The market tone was much improved this week. We have no way to know for sure if the tide has turned, but there are signs that it may indeed be the case. First, all major indices hit a bottom on Monday and then proceeded to move higher from there, a welcome change from the action of the previous weeks. Second, the indices managed to stay above their 200-day moving average, a key level that is often approached right before a rebound. Third, the Nasdaq Composite closed higher on increased volume for two days in a row (Wednesday and Thursday), while volume decreased during Friday's decline. This indicates that the selling pressure may be abating. Finally, as bears tried to push the market down on Thursday and Friday, indices managed to shake off the pressure and finish well off their lows, a marked change from the negative action we have experienced for most of January. On the earnings front, results have been positive overall, as illustrated by bellwether Microsoft: the company reported better-than-expected revenues and profits on Thursday. As for the economy, GDP numbers released on Friday showed that the economy grew by 3.1% in the last quarter. Worries related to the elections in Iraq will be lifted this week-end, which should be a positive for stocks going forward.

For the week, the Nasdaq 100 lost 0.28%. The Russell 2000 and S&P 500 did better, respectively gaining 0.31% and 0.30%. There is no change for our Model and our active Buy signal remains in effect.

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Trend Timing School
Simple option trades and strategies

Options are extremely versatile instruments and they can be used as speculatively or as conservatively as one would like. Since our ultimate goal in this options investing series is to present an alternative investment vehicle to implement the four TimingCube strategies in qualified retirement accounts where shorting and margin trading is not allowed, we will stay away from option transaction types that are not generally permitted there either, such as writing uncovered calls. Conversely, as always, we will continue to strive for simplicity and risk management to the expense of some of the more sophisticated and highly leveraged (as in high-risk) strategies.

Let us start at the beginning with the most basic option transaction which is that of buying a call option contract. A call option, as we learned last week, conveys to its owner the right to buy 100 shares of the underlying equity, at the strike price, no later than the expiration date. If you believe that a particular index or equity will go up you can either buy the security itself (i.e. the ETF which mirrors that index) or you could buy a call based on that security or index.

After selecting the underlying security, XYZ in our example, and the type of option (a call in this case), we must select the strike price and the expiration date.

At this point we need to expand our options language a little further with new option terminology. The cost of an option (the price you pay when buying the option, or receive when selling the option) is called the 'premium'. This premium is influenced by market forces but is mostly a factor of the strike price, the underlying security price, and time remaining until expiration. The premium is often expressed as the 'intrinsic value' plus the 'time value'.

The intrinsic value for a call option is the difference between the underlying security price and the strike price. For a put option it is the difference between the strike price and the underlying security price. In either case the intrinsic value cannot be negative, it only goes to zero, but it is not limited on the upside. If an option has an intrinsic value of more than zero it is said to be 'in-the-money', as would be the case for a call option with a strike price that is below the current market value of the underlying equity. Similar to in-the-money, an option can be said to be 'at-the-money' when the strike price equals the underlying security price, or 'out-of-the-money' if the strike price is above the underlying security price.

The time value, sometimes also referred to as the 'extrinsic value', is primarily a function of how much time remains until expiration of the option. The closer the option gets to expiration, the smaller the time value.

But enough with theory, let's return to our XYZ-based call option example. Today, on January 28, 2005 the XYZ equity is worth $80 and because we know the trend is up we decide to buy an XYZ September 74 Call at a cost of $8.55 (the premium). The 'XYZ September 74 Call' expression means that we purchase the right to buy 100 shares of XYZ at the strike price of $74 before the contract's expiration on the 3rd Friday of September 2005. Forgetting commissions, our price for this contract is $8.55 x 100 = $855. This is an 'in-the-money' option because the price of the XYZ security is $6 above the strike price. Generally speaking, in-the-money options are more conservative than out-of-the-money options, but more expensive.

A few months go by and in June, XYZ has risen to $88 and our option's premium has increased to $15.25. Our paper profit on the contract can be calculated as ($15.25 - $8.55) x 100 = $670, or an almost 80% gain on our initial $855 investment in just 5 months. In comparison, had we invested directly in XYZ by purchasing 100 shares, our paper gain in June would be 10% on an $8,000 investment, which clearly demonstrates the potential leverage that can be achieved through the use of options.

At this juncture we could decide to a) exercise our option and receive the 100 XYZ shares for $74 each, which we could keep or turn around and sell for $88, or b) realize our gain by closing the position, also called 'trading out', by selling the options contract for $1,525, or c) let it ride if we believe it has more room to appreciate before expiration. In practice most option contracts are never exercised but traded until they finally expire.

This example can of course not be complete without visiting the other possible scenario which is that the price of XYZ drops instead of increasing. Since we started with an in-the-money option we have a built-in safety margin as the contract will at least retain some intrinsic value as long as XYZ trades above our $74 strike price. If by the expiration date XYZ trades below $74 our option will expire worthless, and our $855 investment is a net loss (minus 100%), which also very clearly demonstrates some of the potential risks of options trading.

Having mastered the ins and outs of buying a call option contract, we will now be able to expand our horizons to buying put options (which is the same in reverse), selling options, or implementing more sophisticated option transactions. Next week we will begin in earnest with practical solutions for implementing our favorite TimingCube strategies.

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FAQ of the Week
Question: Is this a pullback or a correction?

We are in a pullback. The common financial industry definition for pullbacks is 0 to 10% from a recent top, followed by corrections in the 10% to 20% range, and bear markets beyond that (see the April 2, 2004 Trend Timing School article entitled "Bull markets, pullbacks, and corrections"). As of the close of the market today the Nasdaq Composite index has fallen about 6.54% from its December 30, 2004 closing high. For the three indices we primarily invest in, the Nasdaq 100 leads the decline with a 7.87% pullback, while the Russell declined by 6.35%, and the S&P 500 by 3.48% from their respective highs.

The key to success in Trend Timing is to act only in response to changes in the broad market trend and not to attempt trading every pullback or even all corrections.

Warm wishes and until next week.

The TimingCube Staff

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