A lesson from a master trader...

Over time, my (Porter) preference for being a long-term investor in high-quality franchise businesses has grown and grown.

The key to understanding why these businesses are so successful is pretty simple. You have to choose a business that can raise its prices faster than inflation and doesn't have to commit that capital to growth.

And when you can buy them at a price around 10 times earnings, you have to take advantage of it because you don't get that opportunity very often.

In this week's Friday Digest… we take a breather from worry.

No fretting about debts or government policies. No watching interest rates rise with bated breath. No concern about the large and growing list of big companies (more than $10 billion in market cap) trading at absurd valuations (over 10 times annual sales).

No... in today's Friday Digest, we're going to show you something that you can use to make money in any market, at any time, whether stocks are going up or down.

As always, our predictable warning before we begin... We know few things in life for certain. The love and dedication of our mother, for example, is something we can always count on. The loyalty of our dog (the ever-faithful vizsla, Ruby) is another… Last summer, Ruby took a rattlesnake bite to the face while protecting our children, who were playing in the backyard of our mountain cabin. That's a damn good dog.

We know, with almost as much certainty, that if you teach someone about trading options safely, he will sooner or later give into greed. He will take the safe strategies and morph them into the most risky strategies imaginable. Great losses will follow.

Therefore... before you read today's Digest… you should be aware of two things. First, we are going to analyze a call-option recommendation that Jeff Clark made in April of this year on Seabridge Gold.

As you'll see, Jeff's trade was very profitable. That's significant because during the course of this year, Seabridge's share price has gone down a lot. The stock started the year trading around $20 per share... but fell to less than $9. (You can only make a profit buying a call if the stock goes up. You lose money if the stock goes nowhere or down.)

The other thing you have to know is that Jeff followed up on his initial recommendation (which he made to subscribers of both his S&A Short Report and S&A Pro Trader) to buy a call option on Seabridge Gold with a series of other trades in the S&A Pro Trader. The S&A Pro Trader is designed for traders who are comfortable executing advanced options-trading strategies.

The chart below explains the facts of what happened. Gold stocks entered a terrible bear market this year. Seabridge, which owns a large undeveloped gold asset, sold off heavily. (The black line in the chart represents the share price of Seabridge gold.)

Jeff noticed the volatility. Using a variety of tools, he determined Seabridge had become heavily "oversold."

To represent the conditions in the market, we've included a basic moving average convergence/divergence (MACD) graph below the share price. Jeff actually uses a different primary indicator of sentiment, but the MACD is close enough to show you what was happening in the market.

Without going into the technical details, the MACD is a momentum-based technical indicator that displays the strength or weakness behind a stock's trend. If the MACD is rising while the stock is advancing (or falling while a stock declines), then the trend is strong and likely to continue.

But if the direction of the MACD diverges from the price trend – meaning it rallies while the stock price falls or vice versa – the price trend is weak and likely to turn the other way.

Looking primarily at the market's trading dynamics (not the fundamental value of the business), Jeff decided Seabridge shares were due for a short-term rebound. So on April 4, he recommended subscribers pay $1.90 a share to buy a Seabridge call option with a strike price of $13…

The call gave holders the right to buy Seabridge shares at $13, regardless of what the stock was doing in the market. The higher Seabridge shares rose, the more valuable the call would get. (Of course, if the stock fell to less than $13 a share, the call would lose value and investors risked losing the money they paid for it.)

He was making a bet that Seabridge's price would pop higher as the market sentiment improved. And it did. Seabridge shares traded up from $13.52 to $14.28.

Rather than closing the position and taking profits, Jeff put out an alert recommending S&A Pro Trader subscribers "hedge" the position by selling an out-of-the-money call, with an $18 strike price and an identical expiration date on the same underlying stock (Seabridge). The cash generated by selling this option – called the "premium" – allowed Jeff's subscribers to immediately recoup nearly 60% of their capital in this trade. (Of course, anyone who sold the call was obligated to sell the stock if it traded for more than $18 a share by the time it expired in January 2014.)

Hedging the position was brilliant because what happened next was brutal. The stock fell dramatically as sentiment got worse and worse. By mid-July, investors had become as soured on gold stocks as I've ever seen in my entire career. Seabridge was trading for less than $9 a share.

The original calls he recommended buying at $1.90 (with a strike of $13) were now worth just $0.43 a share. For many people, holding onto a position showing this size loss would have been impossible to bear...

Except that S&A Pro Trader subscribers had collected $1.10 by selling the other option on April 10. By adding the $1.10 they had collected in call premium to the $0.43 the options were still worth, subscribers were sitting on a 19% loss rather than a 77% loss. In short, what could have been a catastrophic loss was turned into a minor bump in the road.

Following the most recent low in the stock… Jeff's indicators told him Seabridge was likely to rebound. To generate more "premium," he recommended selling a put option on the stock with an $8 strike price and collecting $1.25 in premium. Remember, selling a put option would obligate subscribers to buy the stock at $8 a share if Seabridge traded for less than that by the time the options expire. If the shares rebounded back to above $10, Jeff's traders would keep all of this money they received for selling the $8 put.

So... over the last few months, as Seabridge mostly fell... Jeff collected total options premiums of $2.35 (the call option he sold plus the put option he sold). This income greatly reduced his expense on the call option he'd bought earlier in the year. Generating this capital from selling options was critical – or else Jeff would have stopped out of the trade.

Two days ago, Jeff closed out one of his hedges, the $8 put. He bought it back for $0.15, leaving his traders with $1.10 in profit on the put.

The other two legs of the trade remain open. With Seabridge trading today for a little more than $16 a share, the $13 call option Jeff recommended for $1.90 is now worth $4. That equals $2.10 in profit on the $13 call.

The $18 call option Jeff sold at $1.10 is now trading at $1.54. If Jeff were to close this out today, he'd book a $0.44 loss on the $18 call.

Closing out everything today, Jeff's traders could collect net profits of $2.76 ($3.20 in profits minus $0.44).

The return generated on this series of trades would be greatly influenced by the amount of capital individual brokers would have required upfront. (To show you can cover the obligation to buy shares… brokers will require put-sellers to deposit some cash upfront. That's called "margin.")

Assuming a conservative amount of margin, investors would have earned at least a 173% return in about five months. That's pretty incredible. Keep in mind... these trades all occurred in an asset that went mostly down.

At S&A, we have a long track record of showing subscribers how to make safe, profitable options trades…

In his Retirement Trader advisory, Dr. David "Doc" Eifrig has now closed out 129 profitable options positions in a row. He's never closed a losing position since we started this advisory in July 2010. The average return (based on capital at risk, not margin) is around 5% with average duration of two to three months. These are unbelievably large and consistent gains.

In my options service, Stansberry Alpha, my team has recommended 10 positions since last December. We've either closed out at a profit or we are solidly in the black on nine out of these 10 trades. Our average gain (based on capital at risk, not margin) is 13%. The average duration has been four months. Again, these are unbelievably large and consistent profits.

Many of Jeff's recommendations in S&A Pro Trader (like his Seabridge trades)… all of our Stansberry Alpha positions… and Doc's Retirement Trader recommendations require selling options. The ability to sell options is critical. This allows investors to generate capital that can be used to reduce risk.

Strangely, many discount brokers will not allow clients to sell options. If your broker won't let you sell options, share this e-mail with him. Explain that we're selling options to reduce our risk. If he won't give you permission to use options in this way, find a new broker. (You could try calling a full-service broker. He will charge you more than the online services. But he may also help you gain the experience you need to qualify for an options-selling account with a discount broker.)

Whatever you do... know that selling options indiscriminately can be extremely risky. Make sure you don't go chasing premium by selling puts on risky stocks. Never, ever, sell a put on a stock you don't want to own at a price that you believe is a bargain. Following this simple rule is the key to reducing risk when selling options…

If you've had success with the S&A Pro Trader, Retirement Trader, or with my Stansberry Alpha, I hope you'll take a minute to let us know what you've learned and how you've done with our options recommendations. Most people believe that options are always risky. They don't realize that for most active investors, options are an excellent low-risk way to generate high returns. And... if you want to make a lot of money in stocks... that's the key to success.

If you'd like to learn more about Jeff's options strategies... I encourage you to try a subscription to his S&A Pro Trader. A subscription comes with excellent educational material explaining the details of safe, profitable options trading. And if you sign up now, you get a year of Jeff's S&A Short Report along with your S&A Pro Trader subscription. To learn more, click here.

Before you enjoy the rest of your weekend... I wanted to share a funny story about hedge-fund manager David Einhorn and Steve Ballmer, the CEO of Microsoft.

For many years, Einhorn had a large position in Microsoft stock. He'd bought shares for his fund in 2006. When the stock was a laggard (which it has been for many years), Einhorn began to publicly advocate for Ballmer's firing. Eventually, Einhorn gave up. He recently announced that his fund sold out of all of its Microsoft shares in the most recent quarter. News of this shift became public knowledge about a week ago.

Today, Ballmer announced he's going to retire. The stock soared. What do you bet that Ballmer was just waiting for Einhorn to sell in order to announce his retirement?

New 52-week highs (as of 8/22/13): Chesapeake Energy (CHK), iShares Germany Fund (EWG), and Constellation Brands (STZ).

In today's mailbag, one subscriber tells Porter to grow up... Send your notes to feedback@stansberryresearch.com.

"Porter, no matter what Baa says or do it would be the wrong thing as fair as your thinking goes. You and a bunch of other Republicans are like a bunch of fifty dogs nipping at his feet. And don't tell me you are neither Republicans or Democrat that pitiful excuse will not float. And don't tell anyone you will not run for President when you would if you could, the only problem is you are just not smart enough, so get over it.

"What you and all the others have is just plain old racism and deliciously. You have no respect for the office of President are this country for all that goes.

"You like to pop up all over the web and make a bigger ass out of your self than you have already, it's becoming reducilus to take pot shots at the president with the mind set of a twelve year old child. Wake up and smell the roses. watch this man and wonder at all he goes through and tries to do and with a bunch of cur dogs nipping at his feet while he is trying to do the best he can.

"You need to be shipped off to S, Korea and made live there a couple of years, who knows you might just come back acting like a grown man if that's possible. I am a white man and I am probably twenty five years older than you, as a child I set and listened to Franklin D Roosevelt on the radio and people like you just didn't exist, how I long for those days" – Paid-up subscriber Robert Gifford

Regards,

Porter Stansberry
Baltimore, Maryland
August 23, 2013