Getting an Edge on Jim Cramer

For more than a year, I took Mad Money host Jim Cramer’s investing ideas and gave them a thumbs up or thumbs down according my own technical analysis and views. Here at OptionsHouse, it’s not about telling you what to do, but rather offering some strategies for you to explore based on your own individual opinions.

We all have a right to agree or disagree with Cramer and while I have great respect for the man, I can’t say that I am in full agreement with all of his recommendations. Furthermore, as options traders, we can take his thesis and augment it into acceptable risk for our individual personalities and risk tolerances.

Watching my DVR recording of Friday’s program, I actually liked what Cramer had to say about investing after the crash (I think this was taped earlier). He talked about the difference between trading and investing and how today’s market participants perhaps need to be an amalgam of the two. I happen to agree with Cramer’s suggestion that traders learn as much as they can about a company, although even with soup-to-nuts knowledge of a company and its business, you can still find yourself in a losing position. This is due to factors beyond the quality of a company’s product or their ability to sell that product or service to the public. Cramer noted this when he talked about a company’s stock price becoming “un-glued” from its fundamentals.

Frankly, while I agree that huge variances from typical price-to-earnings (p/e) ratios may be a reason to buy or sell a stock, it still doesn’t ensure success. It may, however, increase the probability of a longer-term trade coming into profitability because of the anticipated “reversion to the mean” an overbought or oversold stock may experience.

There is no perfect answer or method to trading, but I admire Cramer for attempting to instill confidence in his viewers by teaching a specific technique (fundamental analysis), even though this technique is inherently flawed, as are all investment strategies.

The beauty about being an options trader is that we get to choose our level of risk and, to an extent, the price at which we would be comfortable being long a stock. With spreads, we can also adjust our profit/loss sensitivity to a stock’s movement.

Cramer also made some suggestions (as he always does) in his last “Lightning Round” on June 30. I wanted to take a bullish and bearish case and offer you two options alternatives should you agree with Cramer’s thesis.

Note: Prices as of Tuesday morning

Cramer said that he is bullish on Starwood Hotels & Resorts HOT. He believes that Starwood’s success right now is proof that the economy isn’t as bad as people say it is. If you agree with this and want to reduce your risk, while at the same time increasing your statistical chance of success (with limited profit potential), you could sell an out-of-the-money bull put spread in August as opposed to buying the stock for $42.00.

Selling an August 38/33 put spread for $0.90 (selling the 38 put, buying the 33 put) would limit your profit to that credit received ($0.90), but at the same time would reduce your total risk in the trade to $4.10 (the difference between strike prices minus the credit). It would also lower your breakeven in the trade to $37.20 and as long as HOT stays above 38 by August expiration, you could potentially realize a 22% percent return on risk in 45 days (an annualized return of roughly 178%).

If you are looking for a bearish trade, Cramer isn’t so hot on Amazon.com AMZN. The stock is currently trading for about $111 and certainly has room to fall if you were to take a short position in the stock. However, shorting stock has unlimited theoretical risk and limited reward as well (in this case, $111, if AMZN were to fall to zero).

In reality, the likelihood of Amazon going to zero in about six weeks is probably unlikely as they are still a relatively healthy company. This doesn’t mean they can’t struggle to move higher or maybe even move slightly lower. Again, as an options trader, one of the strategies at your disposal is the vertical spread, much like the one I described in the bullish example.

In the case of Amazon, if you felt that AMZN would have a tough time getting above $120 by August expiration, you could employ a bear call spread and sell the August 120 call, while simultaneously buying a call with a higher-strike price. If you want to take more risk, you widen your spread; for less risk, keep the spread tight. Something like selling the August 120/130 call spread for $2.35 limits your profit to the $2.35 collected, but also reduces your risk from unlimited in the stock to $7.65 in the spread. If AMZN stays below 120, you have the potential to make 31% return on your risk in the trade (or about 251% return annualized). Keep in mind that AMZN is expected to release earnings on July 22, which could be a catalyst for heightened volatility.

There are many great ideas floating around out there (as well as some bad ones). In uncertain markets, as well as in trending ones, options can offer a certain unique flexibility that you just can’t get with stocks alone.

Photo Credit: Allison Cooke

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