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Steve Sjuggerud's note: Contributing today's essay is our colleague Jeff Clark. When it comes to making short-term profits in the market, Jeff is among the best traders I've ever seen. Read on for his top opportunity right now...

A Handicapper's Guide to Options Trading

By Jeff Clark, editor, Advanced Income
Wednesday, March 21, 2007

I was just eight years old when my uncle brought me to the horse races for the first time. It was a beautiful springtime day at Golden Gate Fields, and we arrived just in time for the fourth race.
 
"Which one do you like?" my uncle asked as the horses paraded just a few feet in front of us.
 
I didn't look at the horses. I just glanced back and forth repeatedly at the racing sheet and at the big electronic sign in the middle of the field.
 
"Number four," I said, "Chile's Pride looks like a winner to me." I handed over $2 – which was an entire week's allowance and real money back in 1973 – so my uncle could place a bet for me.
 
When he returned with my betting slip, I asked my uncle which horse he put his money on. "I always bet the favorite" he said, "That's your best chance of winning." 
 
I looked up at the big electronic sign... it showed my uncle's horse was a 5:4 favorite to win – meaning he'd win $5 on a $4 bet. My horse, Chile's Pride, was a 20:1 long shot – meaning I'd win $40 on my puny $2 bet. But the chance of that happening was slim.
 
The starter's gun sounded, and the race was on. All the people around me jumped to their feet and started shouting. My uncle was the loudest of them all. I was too small to see what was happening, but the collective groan of the crowd told me when the race was over – and it was obvious that the favorite didn't win.
 
I was afraid to turn and look at my uncle. He was a towering man, about 6-foot 4-inches tall and 230 pounds, with a temper that could frighten the hair off of a pit bull. And he didn't like to lose.
 
Two strong hands grabbed my shoulders from behind and spun me around. "Let's go get your money," shouted my uncle – grinning from ear to ear, "Chile's Pride is a winner!" 
 
We watched seven more races that day. My uncle kept betting the favorites, and I stuck to the system that worked so well for me on the first bet. My uncle won a couple of times. But on the drive home, he confided that he lost about $100 – and that I shouldn't say anything to my aunt.
 
I won one more time as well – an 8:1 bet that more than paid for all the other losing bets for the day. And I still had the two crisp new $20 bills.
 
My uncle finally asked me how I picked the winners, and I told him, "It's simple. I just compare the odds on the racing sheet to the odds on the big electronic sign in the middle of the field. I find the horse where the sign is offering the biggest difference and go with that one." 
 
I didn't know it at the time, but that was my first foray into the world ofcontrarian investing. You see, mathematicians and statisticians compile the odds on the racing form by crunching the numbers and determining the probability of a horse winning against the field. The odds on the big electronic screen reflect the betting public's opinion of the odds on the racing form.
 
If the betting public gives the horse better odds of winning than what's on the racing form, then the payoff is less than what the mathematicians figured it should be. And, that's a bad bet.
 
On the other hand, if the betting public shuns the horse and offers higher odds than what's on the racing form, then the payoff is bigger than the statistical probability. And that makes for a good bet.
 
The same is true in the world of options trading...
 
Three weeks ago, the trading public became fearful and started bidding up the prices of bearish put options. And now, buying puts is kind of like betting on the favorite horse at the track. The probability of a win is high, but the payoff is too small to adequately compensate for the risk.
 
Bets on rising stock prices – called call options – on the other hand, are about as popular as a gimp horse with a fat jockey. Calls are cheap. They're priced with long-shot odds, but the chance of a win is much higher.
 
From a trader's perspective, it's still too soon to declare an end to the correction that has pressured stock prices for the past few weeks.
 
But if you're looking to make a few low-risk speculations, it's not too soon to buy a few cheap call options on some beaten-down value stocks right now. (I recommend looking at semiconductors and oil-service providers).
 
Who knows? You might even win your first Daily Double.
 
Best regards and good trading,
 
Jeff Clark
 




Market Notes


RUSSIA GETS CRUSHED, AS PREDICTED

As we predicted in December, the Templeton Russia Fund (TRF) has been obliterated this year.

One of DailyWealth's favorite "risk gauges," Russia is prone to wild swings in investor sentiment and asset prices.

Considering Russia's huge natural resource base, it's no wonder. The country is home to the world's largest natural gas reserves and currently ranks second in crude oil production, just behind Saudi Arabia. Russia also has huge stores of nickel, iron ore, and platinum, and is home to approximately 22% of the world's timber. And let's face it, the country's leaders are known for being as crooked as a dog's hind leg.

As we speculated in December, the Russia Fund's overvaluation has led to a gigantic decline. The fund has fallen 27% from its December high, crushing those late to the party. As with most every emerging market, the damage done in Russia will take a long time to work off...



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