From a trading perspective, I usually put more emphasis on how the market closes than how it opens, so based on Friday’s late-day swoon, I was surprised to see futures higher last night and especially this morning.

I would have preferred to see some weakness at the beginning and strength into the close, but the higher open started to fade quickly, so we did get some selling that took the S&P 500 from 2,018 shortly after the open down to 1,982 just before noon ET before bouncing back up close to 2,000. It will be interesting to see if the bounce can hold heading into the close. If so, it could set the stage for a generally positive week, which is historically the case in this particular week before the holidays.

I continue to see financials as the most important indicator for how the market could finish the year. They, too, got hit Friday and fell with the market this morning. As we’ve talked about, financials should do well with the prospect of higher interest rates, but lower oil prices have weighed on them because banks provide loans to oil companies, and the fear is that low oil prices will make it difficult for some companies – mostly smaller and highly leveraged oil companies – to cover their debts.

Looking ahead to this week, the big event on the calendar is the Federal Reserve’s last meeting of 2014, which starts tomorrow. I expect the Fed to continue setting up the path to higher rates, which should ultimately be a positive for financials and could lead to some stabilization in the market. Improvement in this sector could go a long way to driving a year-end rally, so I’ll be watching it closely. Conversely, if the market is unable to balance out, this could throw some cold water on a year-end rally.

Given the current trading environment, we’ll continue to stay selective and take each trading day one at a time until the market firms up. As we’ve talked about, I’m wary of direct plays on oil stocks. This sector remains a wild card, as does Europe, which could provide a shot in the arm if it comes out with some stimulus comments later this week, but that’s not the current expectation. Instead, we’ll focus on companies that are not tied to commodities and less impacted by the overall market direction, but rather trading on their own merit and in their own established trends.

As always, if we need to make any moves I’ll be in touch right away with a Trade Alert. And don’t forget to keep an eye on the Update Center, as I’ll continue to post my updated thinking on our open positions if we see a sudden swing in price.

Ask Hilary: Picking the Strike Price

Hi Hilary, what criteria do you use for picking the strike price? I’ve noticed that most of your picks seem to be way in the money. – Dean

Hi Dean, thanks for the question! Yes, you are correct. For the most part, our High Octane trades are in-the-money plays. As a reminder, options are considered in the money when they have intrinsic value. For a call option, this occurs when the strike price is below the market price of the underlying stock. If a stock is trading for $13 and we own calls with a strike price of $10, they are worth $3 because we would have the option of paying $10 to call the stock away and then selling it for $13. Out of the money is the reverse, when the strike price is above the market price (the opposite is true for put options).

I prefer in-the-money trades for several reasons. First, they are less risky than out-of-the money puts. Second, when you buy out-of-the-money options, they have no intrinsic value, so you are paying only premium. I like to avoid paying premium as much as possible because it can lower your profits and it can change in a heartbeat, much faster than an in-the-money option. Owning in-the-0money options lets the contract “tick with the stock.” So if the stock moves up $1, the options generally move up $1 as well.

Take Hershey (HSY), for example. If HSY is trading at $97 and we buy the $95 calls, we know we’ll make a dollar if the stock moves up to $98. Now if we bought the $100 calls, we would be paying all premium, so even if the stock moved up $1, the options might not move with it. It’s much more speculative that way.

While going out-of-the-money can sometimes mean bigger returns, I like benefitting from stock movement right away rather than having to wait for the stock make a big move to the upside for me to make money. I also like that we can have a much higher percentage of winning trades. Studies have shown that the majority of out-of-the-money options tend to expire worthless, so they are exponentially riskier.

Now, that’s not to say that we won’t ever own out-of-the money options. I just like to be highly selective when we do. One area you may see this is when we spot highly unusual trading activity on a cheap option that signals a big announcement could be coming. Sometimes the trend is strong enough that we can go out of the money and make a nice return in a very short amount of time and then get back out.

I hope this helps answer your question and lends some insight into my trading process. If you want to learn more about my trading strategy, make sure to check out my special report here! To learn more about options terms, I also recommend that you read my Quick-Start Tutorial for an overview of the basics.

Review of Our Current Position

The recent market movement has hurt our call positions, so let’s take a look at where I see them heading next.

The iShares Russell 2000 ETF (IWM) has weakened the last few days. One reason we went with this trade is because the small caps tend to benefit more directly from the U.S. economy and less so from oil and commodities, but the weakness has still managed to spill over. I am watching our call position closely and believe we may see a bounce ahead of expiration on Friday to give us a better exit point. Today’s trading action will reveal a lot about it is set up for the weak ahead, so I’ll keep you updated on my outlook. For now, continue to hold the IWM December $116 calls (@IWM 141220C00116000).

Bank of America (BAC) is being hurt by the fears we discussed above. However, BAC is not as exposed to debt with oil companies, so an oil-related crisis should not be as big an issue for it as say a Goldman-Sachs (GS). With another week until expiration, I want to give our call options a little more time to play out, especially with the Fed meeting on Wednesday. Hold the BAC December $16.50 calls (@BAC 141226C00016500).

Microsoft (MSFT) has bounced around a bit, turning positive before pulling back with the broader market. Despite the weakness, I remain bullish on the name and recommend holding the MSFT December $45 calls (@MSFT 141226C00045000).

Facebook (FB) is also moving with the broader market, opening higher this morning before weakening. I’d like to give our calls a chance to rebound prior to expiration on Friday, and recommend maintaining the limit order we set last week. If we need to make any changes, I will send you a Flash Alert. Maintain your $4.10 limit order on the FB December $74 calls (@FB 141220C00075000).

Sincerely,

Hilary Kramer
Editor, High Octane Trader

P.S. Effective January 1, 2015, you will need a personalized user name and password to log in to High Octane Trader site. To create your own now, please click here.