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Option Market Makers

April 29, 2004

The Smart Profits Report: Issue #106
Thursday, April 29, 2004

Option Market Makers: Beating the Market Makers on Price
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I want to let you in on a little secret: I never pay full price. That is, I never buy options at the offer (or ask) price. Nor do I sell at the bid price. The option market makers, of course, want you to pay full price - and they know that impatient investors will. But don’t fall for it. It’s a mistake.

That’s because with stocks, paying “full price” is not nearly as damaging as it is with options. With options, paying “full price” can cost you. Here’s why:

Stocks usually trade with a 1-cent spread between the bid and the ask (the price you pay to buy the stock). But options trade with a 5-cent step in the spread if the options are under $3 a share, and 10 cents if it is over $3 a share. This difference in the spread on a $3 option versus an under-$3 option is called the “rip-off spread”… well, not really, but it might as well be.

It works something like this…

Option Market Makers Ripping Off The Bid

Say Applied Materials calls are 1.95 bid… then you can expect the ask to be at least 2.00. Obviously, 5 or 10 cents is a bigger punishment than 1 cent. At best, if you immediately sold your option back at the same price, you’d only get the bid price - and you’d be down 5 to 10 cents right away. That’s a rip-off.

But in reality, the spreads may be even wider. For instance, news just broke that Carlos Slim - Mexico’s answer to Warren Buffett - has bought 9.1% of Global Crossing. Needless to say, the rest of the market is ready to pile on - and Global Crossing options are getting big interest. The market makers are getting rich on it. The June $15 options are going for $2.70 bid and $3.20 ask. Do I need to provide any further evidence that the market makers are one step above… (you fill in the adjective)?

But even in the normal 5- and 10-cent situations, the spread is a big cost to overcome. Think about it. If the prices on a stock are $10 bid and ask is $10.01, that penny difference amounts to less than 1/100 of the stock price - just a tenth of a percent.

On an option that’s trading at $0.60 bid and $0.70 offer, the spread is 16.6%. You’re in the hole by double digits right away. If the spread comes to 16%, then the option has to move MORE than 16% for you to just break even on the trade.

That’s not all your costs, either. Add in an extra couple percent for commissions and deteriorating time value, and you could find yourself digging out of a hole within a few hours of your purchase.

How To Buy an Option at the Right Price

So, how can you protect yourself from starting out so far in the hole and reduce some of your cost in the process? Here’s a set of rules that you should always follow for beating the option market makers:

  • Never buy an option at the offer price or with a market order. Use a limit price that falls between the bid and offer. Take your time. If the underlying shares do not move then the option price will fall. If you have the time, place the order at the bid. If it is a liquid option, like a QQQQ index option, you WILL get filled most of the time. Try it - you will be pleasantly surprised.
  • Never buy an option that has an expiration of one month or less, UNLESS you know that it is nothing more than a speculation and that YOU WILL lose your investment 80% of the time.
  • Never pay more than $40 to ANY broker to execute a 10-contract trade.
  • Even if you are going to speculate using options, take a look at the prices for options that are two or three months away from expiration. They may be more expensive, but you will have more time for things to go your way. Unless you are the Amazing Kreskin, chances are you cannot predict what a stock will do in an hour, let alone over a week or two.

If you follow the four rules of options trading above, you’ll reduce your cost, your risk - and you’ll be poised for profits.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Crib Sheet

  • To learn more about any options terms from today’s report, please visit the Smart Profits Glossary.
  • Frequently Asked Dangerous Question: “I lost most of my retirement in the bear market and I’d like to get back to even pretty quickly trading options. Is that possible?”
    • KR: Sure, if your idea of being a millionaire is starting with two million and losing half! Otherwise, no way. Short-term options, the ones with the most explosive gains, are not suitable for retirement money… nor are they suitable for any funds except a small portion you set aside for speculation. (This means you are most likely going to lose it, so take this money and buy yourself something that you can enjoy for some time.)

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The Brokerage Industry

April 26, 2004

The Smart Profits Report: Issue #105
Monday, April 26, 2004

The Brokerage Industry: Why Your Broker Drives a Porsche and You Drive a Chevy
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I began my financial career in the brokerage industry. I was not a broker, but the financial officer of a holding company that owned a small regional firm.

What I learned, I could write a book about.

You should know what brokers think about commissions and options. Consider this a primer to the whole financial industry - full-service and the online do-it-yourself brokers alike.

The brokers who worked for my company loved options traders. They were the wild ones - 99% had no system, no experience and no idea about what they were getting into. These were the Saturday night specials - the ones who went to the convenience store an hour before the Lotto machines closed down for the Saturday-night drawing.

Instead of warning these perennial losers not to trade options - and considering their results, somebody should have warned them - the brokers encouraged them to keep it up. Why?

Brokers Love Commissions

Because options expire. That means commissions on a regular basis . . .

Here’s the deal: When you buy a call or a put, you pay a base commission and a dollar amount per contract. This per-contract amount varies from $1 to $2. Then, when you sell the option, you pay a similar commission again. Some brokers even have the gall to charge you a higher price per contract depending on the price of the option. This is pure BS.

When you buy an option, let’s say 10 contracts, you should not be paying more than $25 with an online broker and no more than $40 with a full-service broker… regardless of the contract price. That’s it. Nada mas. Period. If you are paying more, then you are being RIPPED OFF.

Brokers and Options - A Love Affair

Why do brokers love options? That’s an easy one. Options trading means big commissions on a frequent basis.

Tell me: If you were a broker whose sole source of income was commissions, what type of customer would you rather have? Would you like customer “A”, who buys a couple of positions a year and just sits on the stock? Or would you like the options jockey who not only loves the quick in and out, but has positions that have MANDATORY EXPIRATIONS every month or two?

If you’re an options trader - even a good one - YOU are the pot of gold at the end of the rainbow. What can you do about this?

You can find a broker - online/discount or full-service - who can fulfill your options trading needs without taking you to the cleaners at the same time.

Commissions are a part of doing business. And in this business, you get what you pay for-some of the time. But many of the most expensive brokers are not especially good at options trading. And some of the least expensive are great. Price is important, but unfortunately, it’s no guide to quality. So, here’s a shortcut: a listing of recommended brokers. Each one satisfies a particular type of investor.

The Best Brokers I Know…

  • If you are a do-it-yourself investor, use a discount broker. They have good execution and very low commissions.
  • A good full-service recommendation is GunnAllen Financial. Oxford Club members have been using Greg and Ron for a while. For a listing of other full-service brokers, click here.

Which Is Best? It depends. A discount/online broker is just a transaction service. You are a number. But, if you know what you are doing and have the time to decide on every trade yourself and put in the order, then you should use an online full-service broker.

Good Trading,

Karim Rahemtulla

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Smart Options Trading

April 22, 2004

The Smart Profits Report: Issue #104
Thursday, April 22, 2004

Smart Options Trading: Four Critical Truths About Derivatives
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I’d say it’s a safe bet that if you’re reading this column right now you own a range of stocks (domestic and international), bonds, index funds, perhaps even gold and other hard assets.

After working with thousands of investors over the years, I’ve found that each individual investor has a unique way of managing his portfolio… a unique outlook on return, risk, and other factors.

But most of us spend so much time focusing on stocks and other “traditional financial vehicles,” that the move into smart options trading gives us a little pause… And it most certainly should.

Derivatives & Smart Option Trading

That’s because options are indeed derivatives. And derivatives, in a sense, are not real investments… They are contractual rights that are “derived” from an underlying investment. As is the case with a stock option, it’s “derived” from an underlying stock.

When you buy a stock option, you don’t own a single share of a stock. The same goes for options on bonds, indexes, gold or any other security.

All derivatives - even ones so complex and risky, like interest-rate swaps, that we’d never consider them - are contracts. All you get when you buy an option is a set of rights.

This is a very important point. If you begin to think of your options as investments - instead of trades using contracts - you can run into trouble. I have seen people do it. They put too much money in options, forgetting that they have no actual securities in hand. Then they go on vacation and leave options open, sometimes to disastrous results.

The Four Options Truths… And How to Use Them

However, by keeping four key truths in mind, you can begin to harness the incredible power of options, safely - and for serious profits that stock-only traders will never even sniff.

  • You need a price target more than usual - Option contracts always specify a strike price. You need to hit it or come close to make money. With a stock, you have a real security, you can wait forever to be right, and every penny of gain is a real penny’s worth of profit. You don’t even have to have a firm target in mind with a stock - if it is simply going up, you are gaining. Expecting that with an option is a deadly error because…
  • Options expire. Not only do they become worthless if they don’t hit your strike price in time, the closer they get to that date, the faster they lose value. Because of this, you could be right about where the stock was headed and still lose money because it didn’t move fast enough.
  • You need to choose a definite direction. You have to decide whether you are expecting the security to go up or down by the time of expiration. That determines which kind of option you will buy or sell. With a stock, you can simply own it and do fine if the direction goes a bit against you. It might come back later. In fact, stocks on decent companies usually do. Or at least you can get out with a minor loss. With an option, it takes relatively little adverse movement to create big trouble.
  • You don’t get your money back if you are wrong. With a stock, if it drops, you can easily sell when it hits your trailing stop. With an option, you can also exit early - most of the time. But because of the leverage that magnifies moves, you have to act quickly to get out of a deteriorating situation. If you are too slow, you can see your option go to “no bid,” even if there’s still a lot of time left on the contract.

I’ve just listed a lot of risks… It’s enough to make a careful person think twice. And you should.

However, once you’ve gotten the lay of the land, starting with absorbing these four truths about options, not only will you be able to trade options for double-, or even triple-digit percentage gains - you can actually do it with a degree of safety that will let you sleep at night.

Good Trading,

Karim Rahemtulla

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Understanding Options Leverage

April 19, 2004

The Smart Profits Report: Issue #103
Monday, April 19, 2004

Understanding Options Leverage - The Power of Leverage Is Bigger than You Think
By Karim Rahemtulla
Chairman, Mt. Vernon Research

At my last seminar in New Orleans, I talked at length about understanding options leverage - and afterwards fielded a good number of questions from the audience.

It was clear that a lot of investors didn’t really understand the concept, or how they even use it in their own investing.

More importantly, almost none of them understood how options offer a leverage tool with phenomenal strength to bring dramatic returns. After all, options are leverage. That’s their power. If you can control 1,000 shares of a stock for a dollar a share, why pay $50 a share? Leverage is how a lot of people have made a ton of money.

Leverage - Knowing More Than You Realize

Leverage is something you use every day - very likely without even knowing it. And I’m not just talking about prying the lids off paint cans with a screwdriver. Each time you buy something on credit, make a house payment or a car payment you are using financial leverage. You are giving yourself the ability to control something big, or own something very expensive, for a relatively small amount of money.

While a home may be worth $1 million, with today’s interest-only loans, you could actually live in it for just a few thousand dollars a month. That is leverage.

The same type of thinking applies to the options market. I hate to say that because most people use options just like they use their credit cards - with reckless abandon.

When you buy a put or a call, your goal is to make money, lots of it. But instead of buying the shares outright, you want to employ leverage by using an option. Let’s see what the allure actually is…

Now Enter The Options Player

Say you are bullish on Microsoft. You can buy 1,000 shares of Mr. Softie for $25,000 ($25 per share). Your target is $35 in 10 months. So, you stand to make $10K.

He takes the same $25,000 (humor me for this example) and buys 100 contracts of MSFT options (each contract is 100 shares, at, let’s say, $2.50 a share) with a 10-month expiration and a $25 strike price. When MSFT hits $35 in 10 months, his position will be worth $35 minus $25 minus $2.50… which comes to $7.50 per share.

So, at 7.50 per share he has tripled his investment, or made $50,000 in net profit from the $25,000 option investment. That is five times the $10,000 the stock trader made with the same money. That’s the good news.

The bad news is that this type of win only happens once every 10 or 20 times… unless you employ a strategy that can boost your odds.

So, now you know the lure of options, you might be considering calling your broker to begin to speculate using this powerful tool. Don’t do it… not yet anyway. There is much more good and bad to know about options, the options market and options brokers - all of which I’ll be covering in upcoming letters.

One last thought… if you are really insane, you could actually increase your leverage even more by buying options on margin. If that strategy interests you, make sure the gun under your mattress is not loaded…

Good trading,

Karim Rahemtulla

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  • Visit our handy Smart Profits Glossary for detailed definitions of “options leverage,” “bid and ask,” or any other concept of options trading.
  • Check out Smart Profits #262, by Lee Lowell, Options Leverage - How to Use Delta to Maximize Leverage.

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Put Options

April 14, 2004

The Smart Profits Report: Issue #102
Wednesday, April 14, 2004

Put Options: Why Short a Stock when You Can Buy a Put?
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Are you getting everything you can out of the market? Most investors aren’t. They miss thousands of opportunities because they are chronically bullish. The market, however, isn’t. Not only do the market AND individual stocks fall, but their drops tend to be dramatic and rapid.

Knowing how to capture this “other” side of the profit equation increases your ability to make money in all conditions. Some investors who are wise to this do it by shorting stocks (see definition below). But I have a better suggestion: Buy put options when you think a stock or index will fall. Puts allow you to “short” a stock with much less risk.

Put Options Offer Less Risk & More Profit Potential

If there is an opportunity to buy a put option versus shorting a stock outright, I will always use a put. Let me show you why:

  • When you buy a put, your loss - if you have one - is limited ONLY to the amount you have invested in the put option.

Think back to the Internet stock boom. Back then, individual stock prices were moving $20 to $50 in a week. They became terribly overvalued, and at some point that bubble had to burst.

If you shorted Amazon at $100, the stock might have gone up to $150 a week later. As a short trader, that would have hit you with a huge loss.

To short a stock, you borrow shares from a brokerage account and sell them into the market. But you’re not done. In order to close out your position, or “cover,” you must replace those borrowed shares. You do that by buying shares yourself at whatever price they are trading for.

Shorting the Stock vs. Put Options

That’s fine if the shares have gone down as you expected. But in our Amazon case, you would have had to buy shares at $150 a week later - a major loss. Yes, you would have received $100,000 when you shorted a thousand shares of Amazon. But when you covered, you would have spent $150,000 to buy the replacement shares. That’s a $50,000 loss. Trust me, it happened to lots of people.

So when you short a stock, you can lose MORE than 100%. Remember that Amazon climbed from $45 to $143 from June to July 1998. Imagine that poor short seller. He would have lost 217% (plus margin costs) and nearly a $100,000 dollars shorting a thousand shares of Amazon then.

But if he’d bought a put option for $5 or less, even if he was totally wrong, his maximum loss would have been only $5,000 (because generally you buy options in “lots” of 1,000).

By the way, after that run, Amazon fell from $143 to $76 over the next six weeks. The smart trader with the put option could have made anywhere from 500% to over 10,000% depending on which option month he took; while the guy who shorted made “only” 46%.

Popping Profitable Bubbles Every Day

You don’t need another Internet bubble to make money on puts. These opportunities arise all the time. Some weeks ago I shorted Martha Stewart Omnimedia twice: I shorted the shares before the verdict and then right after.

But I did it with puts, instead of selling the shares short. And I made money. I bought my first puts at $0.25 a share and got out early. They went as high as $1.60 a share. On the second set of puts, right after the verdict, I made 40% in two days.

That was a special case for me. I don’t usually buy puts for an overnight trade. But, in this case I knew one thing for sure: I had a 50-50 chance to make money on the trades. And a firm limit on how much I could lose. (Those odds are significantly better than buying or selling a short-term option without any significant upcoming event.)

Now, I am not sharing the Martha trade to brag about a win. I want to point out that if I had shorted the stock, as many people did, I would have lost a lot of money if the jury had decided Martha was not guilty. And while it’s true that buying puts in the face of a Martha victory likely would have resulted in a loss, too, it wouldn’t have been nearly as damaging to my portfolio.

Regardless, this was a winning trade for us.

If you recall, the shares were halted at $16 when the verdict came out. The shares moved $3 on the day, and fell $6 after the verdict. That was good for the short sellers - even better for us option traders with puts. (But again, if the verdict had gone the other way, the shares could have rocketed up to open at $20 or $25, resulting in a huge loss.)

Double Your Market Agility & Your Number of Opportunities With Put Options

This is the lesson: If you want to double your market agility immediately, you need to think about making money on negatives, too. And if you want to short a stock, using a put option will limit your loss and offer you unlimited upside.

If you haven’t been thinking in the negative, start now. Follow some stocks that you think are overpriced. Look for news that will drive them down. In coming letters, I’ll show you how to follow through on those ideas and turn them into good option trades.

Good Trading,

Karim

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  • For a detailed definition of “put option” or “volatility,” just visit our handy Smart Profits Glossary.
  • Check out Smart Profits #131, Put/Call Ratio - When this Number Jumps, It’s Time to Trade, to learn how to watch for changes to come in your positions.

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Call Options

April 12, 2004

The Smart Profits Report: Issue #101
Monday, April 12, 2004

Call Options: Why Would Anyone Buy a Call?
By Karim Rahemtulla
Chairman, Mt. Vernon Research

About five years ago, when I first started trading options in earnest, I remember pausing to think: Why would anyone buy a call option - as in, ever?

After all, options are volatile. Their prices can change rapidly - both up and down. You have to be right about which direction prices are headed and how fast, or you can get nuked in the short term.

Plus, call options can expire worthless if you are wrong about the move of the underlying stock. Despite the big numbers you hear about, it still seems like a big risk. But sometimes, not taking risk with your “risk money” is the riskiest decision of all.

Let me explain…

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The Smart Profits Report

April 7, 2004

The Smart Profits Report: Issue #100
Wednesday, April 07, 2004

The Smart Profits Report: Become Smarter than 98% of Investors…
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Welcome to the first issue of The Smart Profits Report!

This world of options may be new to you, but give it a few weeks and it will be old hat. You’ll know more about options than 98% of the investing public. As a bonus you’ll also get inside information on investing in commodities and futures from some of the best minds in the business.

And you’ll be poised to profit. Options have very strong leverages, and that means you can make substantial gains very quickly. Not long ago, for instance, Alexander Green, Investment Director of The Oxford Club, recommended a “put” option on a fundamentally weak company, Sealed Air (SEE-VE), for $1.20 when the price of the stock was $33.50.

It didn’t take long for the company’s problems to come to light, and over the next two weeks the stock declined. The crowning event came when a legal ruling broadsided Sealed Air. The stock dropped 41% in one day.

We exited the position when the stock bellied at $18. We sold the “put” option for $8.80… nine days after the initial purchase… for a 633% profit.

How exactly did this work? You’ll find out as we begin our exploration of the power options can bring to your trading portfolio.

Smart Profits Strategies Let You Choose Your Risk Level

What the smartest options traders do is directly related to what we all do as regular stock investors. We look for stocks that go up… and we look for stocks that go down. You’ll learn how to spot the rising stars as well the emerging losers - and how to make money from both. You’ll learn how to buy and sell, take advantage of key trading plays, and end up in the top 2% of all investors when it comes to potential returns.

I have learned and now use options strategies that are not only deemed safe enough for an IRA account, but have proven more consistently profitable than you might imagine. Last year, one of those strategies (covered calls) was profitable 88% of the time.

For comparison, in an average year, only 40 to 60% of the stocks listed on U.S. exchanges post net gains.

Even a conservative investor can routinely make money in the options market. Sure, there was a time when I didn’t believe this myself. I used to have a negative view about options, especially after seeing “gamblers” fritter away their cash. But once I started harvesting regular gains from options, I changed my mind. And that’s because…

It Took a Smart Profits Strategy to Show Me the Money

Seven years ago I met a man - I’ll call him Herb - while researching a company in his industry. Herb was an accomplished investor. He sat me down in his office, along with his chief trader, and showed me how he was making money hand-over-fist in the markets… without undue risk.

I expected savvy stock investing and in-depth industry analysis from Herb. He was known to be a bright and successful guy. I was astounded when I learned how he and his chief trader REALLY earned their livings… by using their in-depth understanding of stocks to buy profitable options. Herb’s winning “investment strategies” were all options based.

It opened my eyes, and I decided to try a modified version of the strategy they showed me on my own. It proved so powerful that at one point I had more than 80% of my portfolio invested in the system - and I am not one to go overboard on any wild idea.

Over the past five years, I’ve had a winning percentage of close to 80%, and last year alone I managed to win 86% of the time.

In all, my trading goal - no matter what options play I’ll recommend - is simple: the lowest possible risk for regular, good returns. And in the coming letters, you’ll get all the nuts and bolts to know exactly how to take advantage of the market… to know if you’re timing badly… investing with the wrong (or no) strategy… not covering the spreads… or even if you have a questionable broker.

In all, I’ll show you how to avoid the pitfalls of options investing AND make extraordinary returns on your own. You’ll be in the top 2% of investors - the ones who are able to make options work for them.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Crib Sheet

  • If you’re unsure about a “contract price,” a “short position,” “spread” or any other concept of options trading, just visit our Smart Profits Glossary.
  • For more in-depth background on trading options, check out the book Understanding Options: Your Best Chance at 633% or More in Just Days. For more information or to order a copy call 888.384.8339 or 410.230.1200, or visit http://www.oxfordclub.com/Bookstore/Options.html

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