Signal Type	Trade Date	Return since issued
		World	U.S.
			Nasdaq 100 (QQQQ) Russell 2000 (IWM) S&P 500 (SPY)

Market Update

Stocks experienced a lot of volatility again this week but did not move much overall. A seesaw session on Monday resulted in the main indexes posting modest losses despite a drop in oil prices. As the price of crude continued its retreat the next day, stocks were able to post a solid advance, with the Nasdaq Composite moving up 2.3%. The gains were surrendered on Wednesday, however, as the main averages sold off following renewed concerns over the shape of the financial sector. Despite resurging oil prices and the disclosure by a Fed official that mortgage-lending institutions Fannie Mae and Freddie Mac may be on the verge of collapse, stocks were able to move higher Thursday, with the S&P 500 posting a 0.7% gain. Facing the same head winds Friday and a new all-time high for oil prices above $147 a barrel, the main averages moved significantly lower before a late-day rally helped stocks recover a good chunk of the session's losses.

For the week, the Nasdaq 100 (QQQQ) and S&P 500 (SPY) respectively lost 0.16% and 1.96%. Small caps did better as the Russell 2000 (IWM) finished the week 1.11% higher. All 3 ETFs are still located below both their 50-day and 200-day exponential moving averages (EMAs).

For its part, our World portfolio posted a 0.79% loss this week. The portfolio consists of the 5 top-ranked world ETFs as of June 20, which marked the beginning of the current 4-week holding period. Please note that since we now have an active Cash signal, the World approach calls for selling your holdings if you follow the "Long Only" or "Long and Short" strategy. Only if you follow the "Buy and Rebalance" strategy should you remain invested in the top 5 ETFs, as the strategy calls for staying invested at all times. Please go to the "Our Service" page for all the details.

Our current Cash signal remains in effect.

Trend Timing School

Option trades

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 TimingCube strategies in qualified accounts. We will stay away from option transaction types that are more complicated, 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 two weeks ago in the TrendTiming School: "Trading options", 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 July 11, 2008 the XYZ equity is worth $80 and for the sake of our example and simplicity of understanding, let's assume that the trend is up; so we decide to buy an XYZ December 74 Call at a cost of $8.55 (the premium). The 'XYZ December 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 3^rd Friday of December 2008. 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 October, 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 3 months. In comparison, had we invested directly in XYZ by purchasing 100 shares, our paper gain in October 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. In the next editorial about options trading, we will look at the practical solutions for implementing our favorite TimingCube strategies.

FAQ of the Week

Question: Can I improve my returns while in cash?

Subscribers that implement the Long Only strategy can spend extended periods of time in cash mode during Sell signals and, when the Model issues a Cash signal, we are all facing the same situation. All our published results assume a 0% return while our money is parked in cash, but in general you should try to do better than that.

The most basic choice of cash equivalent fund that your broker offers (this is frequently the default option) is called something like "cash reserves", pays no interest and can even sometimes have expenses. So between expenses and inflation you are actually losing money. We feel that the minimum acceptable is a "money market fund" that pays interest that at least exceeds the fund's costs. Yields for money market funds vary from one broker to another and, depending on the size of your account, your broker may let you access some funds or not.

If you want to be more aggressive you can chose from a wide range of "bond funds". Bond funds invest in various debt instruments issued by governments and corporations and come in tax-free or taxable flavors. Besides offering higher yields than cash equivalent funds, bond funds also come with risks to your capital, meaning that despite any earned interest you could end up with less money than you started with. This is due to several factors such as issuer default risk, inflation risk, but first and foremost interest rate risk. The price of bonds is inversely related to changes in market yields. When interest rates go up, the price of bonds goes down and vice-versa.

While it is possible to find bond funds that yield anywhere from a couple of percentage points all the way to 15% per year or more, you want to be very careful with the higher yield funds. In order to achieve the higher returns the fund manager has to invest in lower grade issues frequently referred to as "junk bonds" (where the issuer has low credit worthiness), and take higher risks through leverage (where the interest rate induced price fluctuations are amplified).

The bottom line is that you want to balance your quest for higher yields with the level of risk to your capital.

Warm wishes and until next week.

The TimingCube Staff