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Beware the 'Sell High, Buy Low' Lure

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Sell high, buy low. It's a great way to go -- sometimes, anyway.

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If you watch enough business television, you will have seen a commercial for Channeling Stocks. I have no idea how well they do, but it seems like they've spent a small fortune on commercials in which a rather preppy guy is happily leaving his job because he's made such a killing using this service.

The premise they sell you on (other than that you can make a fast fortune and leave your life behind, too) is that stocks trade in channels. And as long as you buy at the dip in the channel and sell at the peak, you can supposedly make Bill Gates look like a pauper.

If only it were so easy!

We've all seen bottoms of the channel fail to hold and shrewd buys become big losers. Likewise, tops aren't always tops, so shorting at highs -- even in these crazy markets -- isn't always a lock to make money.

But there is a cadre of professional traders using this technique to make millions of dollars in the options markets nearly every expiration cycle. Those traders are premium sellers, but as attractive as it may seem to make big money selling options, you have to have very deep pockets as well as the tolerance for massive losses when the bets go against you.

Premium Sellers Conjuring Up Volume, Profits

Just like Channeling Stocks, this strategy isn't for everyone, but here's a snapshot of how the game is played.

Options-trading activity has grown threefold since December 2000, when average daily volume was 3.1 million contracts, versus May 2006 when the six options exchanges averaged upward of 9 million contracts per day. Much of the credit for that exponential growth has come from mutual funds and hedge funds, which were attracted by both the leverage and the liquidity in these fast-moving markets.

On the surface, you might assume these fund traders would be trading equity options, with the occasional index thrown in for good measure. But quite the opposite is true. These pros judiciously trade equity options, and that's what we pick up with our HeatSeeker program (which looks for off-the-charts trading activity that's in excess of an option's normal volume), but it's the index action that has many of these huge funds trading with what might appear to be reckless abandon.

This feeding frenzy is evidenced by the incredible surge in index option activity. For comparison purposes, volumes for index contracts in December 2000 averaged a little more than 200,000 contracts per day, but in May 2006 that daily volume was nearly 1 million contracts!

Selling Into Volatility

Some of the most sophisticated funds use channeling principles to sell option premiums (both calls and puts) when volatility is high and to buy back those shorts when the storm clouds pass. A great recent example is what took place June 14, when a gigantic premium seller stepped into the S&P 500 and S&P 100 options.

Throughout the prior five days, the average daily index volume was 720,000 contracts per day and volatility (as measured by the Chicago Board Options Exchange's Volatility Index, or the VIX) was hovering between 17 and 20, which is moderately high.

But as the S&P 500 tumbled from 1,260 down to 1,220, panic gripped the markets. And as always happens when a panic hits, volatility (or, the amount of investor uncertainty and market risk) spikes.

The VIX for the S&P 500 ran from a reading of 18 to nearly 24 and that jump brought in the institutional sellers, who were practically drooling over the prospect of selling options at that ludicrously high level (as higher volatility brings higher premiums). The combination of the panic in the markets plus the fast-money greed more than doubled the volume in the index complex to 1.7 million contracts!

Three trading days later, on June 19, the markets had settled down and volatility had dropped precipitously, all the way back to 17 and guess what? That's right, the sellers came back in and covered their shorts.

Sell high, buy low. It's a great way to go -- sometimes, anyway.



A Word of Caution

Before you rush out and try this when volatility again rockets up to the stratosphere, consider this: Selling insurance when the hurricane is just offshore is easier said than done. In hindsight, this looks like a sure bet, but when the world is in meltdown phase, it takes a combination of guts and stupidity to pull the trigger on such trades.

Well, that, and a couple of billion dollars' worth of other people's money!
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No positions in stocks mentioned.
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