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

Market Update

It has been another volatile week for the markets. After a quiet and uneventful session Monday, Apple disappointed investors after the close. Even though the company easily beat its earnings target, it provided a weak forecast for the current quarter, causing stocks to retreat Tuesday morning. Helped by lower oil prices, the main indexes managed to reverse course to close in the green, with the Nasdaq Composite swinging from a 1.2% intraday loss to a 1.1% gain by day's end. Better-than-expected earnings report from such bellwether companies as AT&T and McDonald's combined with another retreat in the price of oil to give stocks a boost on Wednesday, even though a good chunk of the gains were given back by the close. Action turned out to be much more negative the next day, as all major averages closed sharply lower on news that existing home sales fell by 2.6% in June, far more than expected, and that jobless claims rose 34,000 last week, four times more than anticipated. The S&P 500 posted a 2.3% daily loss as a result. A better-than-expected reading on consumer sentiment helped stocks finish the week on a positive note, as all major averages closed higher on Friday. Tech stocks were especially strong, as the Nasdaq 100 posted a 1.6% daily gain.

For the week, the Nasdaq 100 (QQQQ) and Russell 2000 (IWM) respectively gained 1.53% and 2.61% while the S&P 500 (SPY) lost 0.40%. The Nasdaq 100 and S&P 500 are still located below both their 50-day and 200-day exponential moving averages (EMAs) while the Russell 2000 has crossed back back above its 50-day EMA but remains below its 200-day EMA.

For its part, our World portfolio underperformed its U.S. counterparts this week with a 3.16% loss. The portfolio consists of the 5 top-ranked world ETFs as of July 18, 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

Using options to implement the TimingCube strategies

Earlier this month in our Trend Timing Schools we established a common base of understanding about options investing and terminology, we can now proceed to the main course which is how to implement our strategies with options. Specifically, we will present how options can offer a very effective substitute for short selling and margin trading while at the same time reducing our market risk. Furthermore, the securities and techniques described here, being authorized in IRAs, provide such retirement accounts with viable alternatives to bull/bear mutual funds and ETFs. Note that since brokers make their own rules and regulations, some of them may not allow such instruments or transactions in your account, so make sure to check with yours directly.

The examples provided in the table below illustrate the steps for both Buy and Sell signals, and compare the options scenarios with the corresponding equity approach. As you would expect, we use QQQQ as the guinea pig, and apply the real prices as of July 23, 2008. You can find option quotes on financial sites like Yahoo! Finance, and usually from your broker account. After entering a ticker symbol you can access the "Option Chain". The option chain is the entire list of strike prices and expiration dates for the underlying interest (QQQQ in this case). The CBOE web site which we mentioned in past articles also provides a very complete Symbol Directory for equity options, index options and LEAPs.

Selecting the type of option transaction. To initiate a position on a Buy signal we will buy a QQQQ call option contract which gives us the right to buy 100 shares of QQQQ, at the selected strike price, before the expiration date. As you will see below, our intention is not to acquire the QQQQ shares by exercising the option but rather to gain by selling the option at a higher price. Buying the call option is similar to buying QQQQ because its value will increase when the price of QQQQ rises and drops when QQQQ falls.
Conversely, in the case of a Sell signal we will buy a QQQQ put option contract which gives us the right to sell 100 shares of QQQQ, at the selected strike price, before the expiration date. Again, we have no intention of selling QQQQ shares. The net effect of a put option is similar to selling QQQQ short because if the price of QQQQ drops, our option will be worth more, and vice versa.

Selecting an expiration month. There is a broad spectrum of option expiration date choices ranging from the extremely short-term (i.e. a August 2008 option), to LEAPs which can have expiration dates of up to three years out. However, since the TimingCube Model issues signals an average of about three times per year, for average trade durations of about four months, the most appropriate options for our strategies are the ones expiring about six months out. From July, six months brings us to January 09. Note that sometimes there is no option available exactly six months out, in such situation, since we never want to hold an option during its expiration month, we would select an expiration date a month or two later.

Selecting a strike price. The January 2009 option strike prices currently range from $30 to $75, offering a selections from deep in-the-money to severely out-of-the money. There are many option investing styles and preferences but for our purposes we like the options that are slightly in-the-money (10% to 15%). This corresponds nicely to the possible drawdowns of our Model, but also tends to be easier on emotions by not being in the red at the slightest pullback, or even due to the shrinking time value. In-the-money options are more expensive to buy but they carry intrinsic value. For a call option, strike prices below the underlying interest price are in-the-money, while for puts, strike prices above the underlying are in-the-money.
In our example, in order to find the strike price for the call options in the Buy signal scenario, we multiply $44.85 (the price of a QQQQ share at July 23 open) by 0.9, and select the nearest strike available: $40. For the put options in the Sell scenario, we multiply $44.85 by 1.1, and select the closest strike: $49. Looking up these strike prices for the January 2009 QQQQ calls and puts, we obtain the respective symbols QQQAN and QQQMW.

In this example, the price of the call option is more expensive than the put option ($7.12 versus $4.97) for a couple of reasons. First, the call is slightly deeper in the money with an intrinsic value of $4.85, versus $4.15 for the put. As can be seen in the table, the call also has a much higher extrinsic value (also called time value) of $2.27 versus $0.82 for the put. The extrinsic value is a function of the duration remaining until expiration but also of investor expectations. The current "surcharge" for the call is an indication that investors are expecting QQQQ to go up in the coming months.

Selecting the number of contracts to buy. In our example we have a $100,000 nest egg to invest. If we purchased (or shorted) the QQQQ shares without leverage, we would buy (or short) 2,200 shares ($100,000 / $44.85 rounded down to the nearest 100). To achieve a comparable return with options we would simply buy 22 contracts (each contract represents 100 shares). In our Buy signal situation, we would buy 22 QQQAN call option contracts for $15,664, and for a Sell signal, we would buy 22 QQQMW put option contracts for $10,934.

Applying leverage. Now that we have the basic mechanics down to emulate a Long and Short strategy, all that remains is to apply margin. Given that the 22 call or put options in our example will tend to move up and down at about the same rate as QQQQ does in dollar terms (except for the time value fluctuations), all we need to do to achieve a 2x leverage (full margin) is to buy double the number of contracts. Be aware that we only mention full margin as an example, and as we explained in last week Trend Timing School "On the margin", most of us get enough volatility investing in the main U.S. markets and strongest world markets, without leverage. If you are tempted to increase the risk/reward scales of your trades, we do not recommend applying leverage to more thatn 20% of your portfolio.

Monitoring and managing our position. Clearly, the intent is to keep the options until the next signal, at which time we would sell them for a profit if the market goes in the direction of our signal. However, we need to be on the lookout for signals of longer duration which could bring us close to our option’s expiration date. Since during the last month of an option the time value rapidly shrinks, you are increasingly unlikely to find a buyer at a good price. This is why we always want to sell the options no later than a full month prior to expiration (remembering that options expire on the third Friday of the month). After such a sale, we would then use the proceeds to buy another option as described above, and keep repeating the entire process until the next signal is issued.

Managing risk. Besides being able to replicate the effects of short selling in our retirement accounts, the example plainly illustrates the risk reduction that options can bring. Where trading the QQQQ shares potentially places all of our capital at risk (and possibly more if you short, as losses on short sales are theoretically infinite), trading with options only exposes between 10% and 15% of our capital (double when seeking 2x leverage). In addition, the balance of our cash can be placed in interest bearing instruments such as money market or bond funds.

Comparing equity and option investing
Assumptions:	- $100,000 starting capital - Commissions not included - QQQQ price is $44.85 (7/23/2008 open price)

	Buy Signal		Sell Signal
	Using equities	Using options	Using equities	Using options
Type of option transaction	-	Buy QQQQ calls	-	Buy QQQQ puts
Type of equity transaction	Buy QQQQ shares	-	Sell QQQQ shares short	-
Selected expiration month	-	January 2009	-	January 2009
Selected strike price	-	$40 (44.85 x 0.9 = 40.36)	-	$49 (44.85 x 1.1 = 49.33)
Symbol	QQQQ	QQQAN	QQQQ	QQQMW
Option price (ask)	-	$7.12	-	$4.97
Intrinsic value	-	$4.85 ($44.85 - $40)	-	$4.15 (49 - $44.85)
Time value (extrinsic value)	-	$2.27 ($7.12 - $4.85)	-	$0.82 ($4.97 - $4.15)
Contract price	-	$712	-	$497
Order placed	Buy 2,200 QQQQ shares	Buy 22 QQQAN	Sell short 2,200 QQQQ shares	Buy 22 QQQMW
Cost	$98,670 (2,200 x $44.85)	$15,664 (22 x $712)	$98,670 (2,200 x $44.85)	$10,934 (22 x $497)
Capital at risk	98.67%	15.66%	Infinite (theoretically)	10.93%

Since option investing is not an exact science, the numbers and figures used in the examples above can fluctuate, and the range of choices and permutations are nearly infinite. Use this article as a guideline only, and do not forget that you should never trade in instruments you do not fully understand, and always apply a solid dose of good judgment because it is not very difficult to outsmart yourself when trading options (e.g. "Why not buy options with my entire capital?" Because you will lose it all if the market goes against the signal, smart one!). If you like what we wrote about options but it made your head spin too fast, or you do not feel you are ready for the do-it-yourself approach, do not forget that our friends, the professionals at MARKETTREND Advisors, can take care of the heavy lifting for you.

FAQ of the Week

Question: What is a triple witching day?

The term triple or quadruple witching day, in Wall Street lingo, means a Friday on which many types of options expire. Specifically, the triple represents the stock index futures, stock index options, and stock options. The quadruple adds the single stock futures.

The reason witching days are carefully monitored is that they skew the volume numbers by creating many trades that have nothing to do with the market fundamentals but rather with the mechanics of options trading. Large volume spikes on such days are typically discounted as irrelevant.

Warm wishes and until next week.

The TimingCube Staff