On May 3, the energy sector was flying high and hitting new multi-year highs; several TES Portfolio recommendations were sitting on gains of 30 to 50 percent since the beginning of 2006. I sent out to all subscribers a flash alert entitled “Hold ‘Em or Fold ‘Em,” recommending ways to lock in some of those profits and hedge the risk of a pullback or correction for the energy patch. One of the key strategies outlined in that report was a way of hedging winners using the options market.

I don’t track options hedge recommendations in the portfolio tables because they tend to have a shorter shelf life than stock recommendations and would be irrelevant and confusing for newer subscribers. But in that flash alert, I promised to periodically review these recommendations and offer my updated advice. I know that many subscribers entered these recommendations–I’ve received calls and/or e-mails from several that have–and it’s now high time for a review.

Please note, however, that most of the specific positions and recommendations I discuss in this report are only valid for subscribers who got into the options recommendations outlined in the May 3 report. Whether or not you took the recommended options positions, I highly recommend that all subscribers review that flash alert; I may recommend a similar hedge in future and the basic strategy has proven its worth on countless occasions. In that flash alert, I also outline a number of other key risk-reduction strategies I follow in the newsletter that don’t involve the options market.

I’m often asked how I can recommend a hedging strategy when I’m bullish longer term on the energy market. The answer is simple: While the energy markets are locked in a long-term, multi-year bull market, there will be periodic corrections within that uptrend. As a believer in the energy bull market, I spend my time looking for the best plays in the energy patch and the strongest trends for the long term, but I can’t afford to ignore the short-term gyrations entirely.

The same has been true of every great bull market in history; even the Nasdaq Composite saw 30 percent-plus corrections in the 1990s on its way to a whopping 800 percent-plus gain for the decade. The same was true of gold in the ’70s and the railroad stocks back in the 19th century. When you look at a long-term chart of these great bull markets, those corrections hardly register as even a temporary blip; as corrections unfold, however, they can bring plenty of short-term pain.

One unfortunate consequence of that pain is a tendency to want to bail out at just the wrong time. As corrections unfold and traders watch some of their hard-won gains disappear, it’s only human nature that they’ll consider jumping ship and selling out of their best-performing stocks. I’ve never met anyone totally immune to that impulse; even the best traders and investors in history have made this mistake and admitted to it in their writings about the market. While I certainly can’t promise a magic bullet to cure the tendency to take profits too soon and jump out of bull trends, put options can help to eliminate the discomfort of holding positions through corrections.

In the May 3 flash alert, I recommended put hedge recommendations on four Portfolio recommendations that were among the biggest winners in the letter. I also recommended two potential broader hedges against a decline in the energy patch using the Oil Services HOLDRs (AMEX: OIH). The best way to illustrate the effect of these hedges and my current recommendation is with an example from the May 3 flash alert–the Peabody Energy (NYSE: BTU) and its December 2006 $65 put options (Options Symbol: BTU XM). See the May 3 report for an explanation of this options contract.

An Options Example

On May 3, Peabody was trading just under $70 per share and the December 65 puts were trading at about $6.50 ($650 per contract). I originally recommended Peabody back in late 2005 at around $42.16 (split-adjusted). Therefore, on May 3, Peabody was showing a profit of about 66 percent.

If you purchased 200 shares of Peabody on my original recommendation, your investment cost $8,432 (200 x $42.16). On May 3, that investment was worth around $14,000 (200 x $70), a gain of about $5,568 on 200 shares. To protect that profit, I recommended buying one December 65 put option contract for each 100 shares owned; options contracts represent 100 shares of underlying stock. To hedge your 200 shares, you’d need to purchase two contracts worth roughly $1,300 total. For those interested, these calculations are more fully detailed in the May 3 report.

In early May, I had no way to know for sure that Peabody would top out just eight days later on May 11 at $76.29. I had, however, become worried about the dramatic run-up in all my recommended coal stocks throughout the month of April. Peabody ran up nearly $14 per share in April–a 28 percent gain in a single month.

I outlined at some depth in the April 26 issue of The Energy Strategist, “Earnings, Earnings, Earnings,” that I felt this was a dramatic overreaction to the company’s bullish first quarter earnings report. While Peabody remains one of my favorite coal mining companies in the US, it was long overdue a pullback by early May and I had cut my recommendation to a hold. This was why I recommended hedging the position and/or taking some profits.

Now, a little more than three months later, Peabody is sitting around $48, roughly the same level as back in early April but considerably under its May peak. Assuming you purchased the recommended puts and continued to hold your 200 shares of Peabody, your current positions would look like this:

• Your 200 shares of Peabody at $48 per share are worth $9,600. Based on my original recommendation of $42.16, your profit is $1,168 on the stock (roughly 14 percent).


• The December $65 puts are now trading at $17.50 ($1,750 per contract). Therefore, your two put contracts are now worth $3,500, about a $2,200 total profit on the initial entry price.


• Your total paper profit would be the current profit on the stock of $1,168 plus the current profit on the puts of $2,200—about $3,368 all told. This is equal to a 40 percent profit on your original 200-share investment ($8,432) last year.

Notice that the put hedge significantly immunized this recommendation against the May-July pullback in Peabody. If you’d simply held on to your 200-share position with no put hedge, you’d be sitting on just $1,168 in profit against the $5,500 profit that you had on May 3. Few investors, no matter how patient, could hold on while gains of that sort–more than $4,000 on 200 shares–evaporate. Using the puts, however, the profit giveback was far less severe–about $2,000 on 200 shares. If you’d taken some profits on Peabody in late April and hedged your remaining position with puts, your overall gain in the stock would be even more impressive.

Keep on Rolling

But this analysis just tells us what the recommended put options would have done for you had you entered them back in May. The broader question for those in this hedge recommendation remains what to do with the puts now. The strategy I recommend is what’s known as rolling down. It’s actually a lot simpler than it sounds.

As I outlined at some length in the August 9 issue of TES, “Playing Defense,” I continue to like Peabody Energy longer term. I think that it’s the best-run coal mining stock in the US and has a superior asset base with superior production possibilities. As the largest coal miner in the western US, it sits on what’s perhaps the most-compelling coal mining growth play in the world today.

While down considerably from its May highs, Peabody continues to outperform its eastern-focused peer group; Massey Energy (NYSE: MEE) and James River Coal (NYSE: JRCC), for example, are both rated sells in How They Rate. These names are down 31.4 and 61.2 percent, respectively, this year, while Peabody is still up more than 17 percent in 2006. Note: For a full, more complete treatment of the fundamentals of the coal mining firms, check out the January 11issue of TES, “Playing it Safe.”

Nonetheless, despite that glowing long-term picture, I’m not ready to recommend jumping back into Peabody Coal in the TES Portfolios just yet. I continue to rate both Arch Coal and Peabody Energy as holds in How They Rate. My prime concern remains further weakness for the coal miners this autumn as the energy markets continue to price in a global economic slowdown. Moreover, we’re still seeing the fallout of last year’s warm winter in coal prices; the next big catalyst for the group will come once the weather starts cooling off again in the autumn. Bottom line: There will be a much better buying opportunity this autumn for Peabody and Arch.

That said, those subscribers who continue to hold Peabody and the December puts have an excellent opportunity right now to lock in some of the profits on their put positions while continuing to hold on to Peabody and have upside exposure to any further gains in the stock this fall. For those in the December $65 puts, I recommend rolling down and out into the January 2007 $45 put options (Symbol: BTU MI, $3.90). This trade involves three steps:

• Sell the December $65 puts for a significant profit. Depending on your exact entry, the profit should be anywhere from $950 to $1,300 per contract purchased.


• Purchase the January 2007 options for about $390 per contract. Purchase one contract for every 100 shares of Peabody you own.


• Continue holding your Peabody Energy stock.

Using my 200-share example above, this would entail selling the two December puts for a total of about $3,500 (about $2,200 profit) and using those proceeds to purchase two January $45 puts for about $780 ($390 x 2).