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American Options, European Options Synthetic Options

June 28, 2004

American Options, European Options & Synthetic OptionsThe Smart Profits Report: Issue #122
Monday, June 28, 2004

American Options, European Options & Synthetic Options: Threefold Profit Potential
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

At a conference many years ago, an audience member asked me a question about options types. That was a first. As far as I was concerned, back in my uneducated days, there was only one type of option: the one that lost you money!

In the years since then I have learned better. There are many types of options. Most fall into three categories, which are: American options, European options & Synthetic options.

And knowing the difference between the three will put you at a major competitive advantage over options traders who don’t.

Let me explain…

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Stock Option LEAPS

June 24, 2004

The Smart Profits Report: Issue #121
Thursday, June 24, 2004

Stock Option LEAPS: Buying LEAPS Or Stocks… What You Should Do
by Karim Rahemtulla
Investment Director, Mt. Vernon Research

Okay, I need you to be brutally honest. How long do you hold a stock, on average, after you buy it? Or sell it short?

I have been asking that question at all of my seminars, and the answer that I get is either a couple of months, or until a 20% or 30% gain is made. That answer is given by about 90% of the audience. And, who can blame them, after the last five years of corporate shenanigans… investment banking fraud… portfolio decimation… geopolitical problems… war… you name it?

So, here’s the deal. If you have a choice of buying stock option LEAPS vs. owning the stock, what should you do? My solution, and one that I have used very successfully is to buy LEAPS - Long-term Equity Anticipation Securities - instead of shares. These are long-term options. Here’s my thinking:

LEAPS vs. Stocks: Owning Almost Any Stock for Pennies

Say you want to buy 1,000 shares of Cisco because you think it is headed higher, from $22 a share. You can spend $22,000 and own the shares in the conventional way. Or, you can buy a Cisco stock option LEAPS.

First you have to think about the pros and cons and how you’ll handle the trade. Let’s say you are shooting for a 30% return on Cisco, and you are going to use a 20% stop loss. You’ll get out automatically if the shares drop 20% below your entry price.

And, to complete the picture, let’s say you are a reasonable person. You are going to give yourself one full year (or until your stop or target has been reached) for the shares to reach your target.

Here’s how that works out for the shares (dollar values are rough estimates):

  • Cisco is at $22.
  • Your target is $29.
  • And your downside stop is at $17.60.

So you are looking to make $7,000 (and you’re willing to lose $4,400) on this trade.

Now, here is an alternative:

  • You could buy a Cisco one-year LEAPS stock option.
  • With a $22.50 strike price and pay about $2.50 per share.

Your total investment using the LEAPS option would be $2,500.

LEAPS $2K vs. Stocks $22k: Which Investment Is Better?

With the stock option LEAPS, you have invested $2,500 instead of $22,000 for the shares. However, your downside on the LEAPS is $2,500 versus $4,400 for the shares. Definitely a better deal with the LEAPS options if Cisco falls 20%.

Now let’s compare the upside. With the shares you stand to make $7,000, or 30%, if you hit your target. But you have to put $22,500 at risk to get it.

With the stock option LEAPS you stand to make $4,000 ($29 minus $22.50, minus the $2.50 cost for the option per share, since your 10 contracts control 1,000 shares.)

This amounts to a 160% return on your $2,500 cost for the LEAPS - more than five times the 30% you were seeking by owning the shares. And, the actual dollar return of $4,000, while lower than $7,000, is HUGE considering you only had $2,500 at risk instead of $22,000.

LEAPS Any Day Of The Week

In the current environment I advocate LEAPS stock options over owning shares, any day of the week. You can limit your downside, have unlimited upside, and have only 10% to 15% of your money at risk instead of 100%. If you use a sell-stop on your LEAPS, you can make that equation more favorable.

One more thing: In order to make money on your stock option LEAPS, the shares have to move very little. More on that to come…

Good trading,

Karim Rahemtulla

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Investment Speculation

June 22, 2004

The Smart Profits Report: Issue #120
Tuesday, June 22, 2004

Investment Speculation: 6 Secrets to Creating a ‘300%-Return System’ Using Stock Options
by Karim Rahemtulla
Investment Director, Mt. Vernon Research

Everybody gets the urge to speculate once in awhile. Some people do it all the time. Unfortunately, investors who fall into the category of investment speculation generally don’t last very long. Unless they are using a system…

A quick example…

One of the companies that I follow closely, Hewlett Packard, was due to come out with quarterly earnings. The shares were stuck at $20, right at an available strike price, and the stock options were going to expire just three days after the earnings release.

The markets were swooning under interest rate concerns at the time. Still, the planets appeared to be lined up just right for some options speculation.

I had little doubt that that HP would report better-than-expected numbers. But, lately, even that was not enough. HP had to report blowout numbers, and the market had to turn at the same time. That was a tall order… and shows just how much must go right when you speculating on investments.

Investment Speculation & A System Nets Me 300% Returns - In One Day

The situation with HP was all very speculative, indeed. So even after deciding that the conditions were ripe, I needed one other requirement to be met: a low price. I didn’t want to spend enough to worry about a loss.

Fortunately, because of the overall market negativity, the options were cheap, and I bought in for just $0.25. The next day, HP came out with record numbers, the market did rally, and I cashed out at $1 for a 300% return.

Now, while I was speculating on this investment, I was doing so with several conditions in my favor. I was speculating using a system that required that:

  • I was familiar with the company.
  • The options were cheap.
  • I was at or very close to the strike that would move the most (close to the current trading price).
  • A major event that could affect the share price (earnings) was about to happen.
  • The market was poised for a big turn.
  • Most important, I was using money that I could afford to place at high risk, because the news - or the reaction to it - could have gone against me.

Investment Speculating: How to Lose 80% of the Time… Or Win 80% of the Time

So, if you are going to speculate on investments, use a system. It has to be objective, and based on facts and probabilities - not on hunches. (”This is a good company, it’s bound to go up,” is not a system.)

If you speculate without a system, then be ready to lose 80% of the time.

In my case, when I use investment speculation, it is for a short-term gain. I look for a quick “pop” predicated on a major event. In most cases, the only predictable major event is earnings.

I don’t speculate often, only on stocks I follow or know well, and only when I have a “reading” on market conditions.

That’s part of what allows me to have an 80%-plus winning percentage on my stock options trades over the last year.

Just remember, if you are going to investment speculate like Warren Buffett is doing in currencies, or George Soros is doing on the U.S. election, you must be able to justify your investment speculation by something other than a rumor or second-hand news.

Good trading,

Karim Rahemtulla

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Options Market Makers

June 17, 2004

The Smart Profits Report: Issue #119
Thursday, June 17, 2004

Options Market Makers: Two Rules for Beating the Market Makers
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

The options market makers are at the top of the food chain - and they aren’t shy about exercising their Darwinian advantage. Like their brothers at the stock exchanges, they create and control a market for buyers and sellers.

In stocks, we typically call that “an orderly market.” With options, it’s more freewheeling: the stronger against the weaker, the more knowledgeable against the naive.

Until recently, options market makers operated in relative obscurity, doing most of their business with large institutional clients who use the options markets for investing and hedging.

The Coming of the Speculators

But now that the general public has realized the power of trading options, the market makers have found fresh prey.

Most of these new investors aren’t calmly hedging their portfolios against losses, like fund managers and big companies have done for years. The new players are there to speculate, and they’re in a hurry. You may be there to speculate as well… It is, after all, a profitable pastime.

But you need some “institutional” calm if you want to win. To beat the options market makers at their own game, you need to slow down and understand who they are, how options are supposed to work, and what actually happens in real life.

Kevin Rubash of Bradley University looked into the work of options market makers in his “Study of Options Pricing Models.” Although options pricing is mathematically complex, he found:

“Financial analysts have reached the point where they are able to calculate, with alarming accuracy, the value of a stock option. Most of the models and techniques employed by today’s analysts are rooted in a model developed by Fischer Black and Myron Scholes in 1973.“

We will be discussing the fine points of the Black-Scholes model later, so that you can decode it (which turns out to be fairly simple) and use it to your profit. For now, what you need to know is that the Black-Scholes model is the basis for options valuations both in the markets and at individual corporations that issue employee stock options. I will refer to it as the BS (no pun intended) model.

The word I want you to pay attention to is “value,” which I highlighted in Rubash’s quote.

Position Yourself for Trading-Floor Reality

While the BS model is an accurate predictor of value, it doesn’t reflect the truth of the options market at the level of day-to-day practice. And once you learn where the aberrations are, you can use them to profit, just like the pros do.

The truth is that the options market bases the initial value of an option using the BS model. After that, anything goes. The market makers step in and mess with the prices.

For you, the game is to find and exploit the inefficiencies and oddities. And to beat the market makers.

The options market makers are masters at pricing stock options. This is how they make money. They follow the news, they gauge sentiment, they have groupies who feed them information. With that information, they can guess where demand is going to pop up, and then move the prices on offer to their advantage. These factors are not in the BS model. These are the profit-margin factors.

Option Market Makers Are Watching: How CNBC Can Cost You Profits

For example, if a talking head on CNBC recommends a stock that happens to have an option attached to it, the market makers automatically inflate their offer price by a dime or 15 cents. You pay a little extra; they make a little more profit

But here’s the big crunch. The bid does not change. And the spread between the bid and offer grows wider. So not only do you pay more to get in (the offer or ask price), you’ll get less when you sell at the bid price.

The market makers understand that a good number of investors who sit glued to CNBC for tips are pure speculators - and typically not sophisticated enough to know they are signaling their intent by staying with the crowd. Easy pickings.

Media hype and the artificial demand it creates is not only short-term in nature… it is not accounted for in the BS options pricing model. The price of an option, say a call, “shouldn’t” go up unless the underlying stock does, according to BS. Only one component of the BS model, the “current stock price,” is affected by the pile-on of CNBC-driven buyers. But in real life, demand does give the options market maker room to play.

The effect snowballs and continues to hurt the unwary even after the pulse of sudden demand is over for the option. Eventually, with all the media-driven interest, investors may buy enough of the stock to move the price up. But does the option become more valuable? Often not. It was overpriced earlier and it stays right there even though the stock rises.

Don’t Travel In the Middle of the Crowd

If you get caught in this movement, it will go against you. Sometimes, you will see the offer price of your option go back down even if the stock doesn’t change… And sometimes it will go back down even if the stock moves up a little bit. Worse, the real value of the option to you now - the bid price - has not budged. You are effectively losing money right away.

There’s always a spread between the bid and ask (what the option is worth in your hands and what you have to pay for it). But after an event like this, that spread becomes wider than usual. It will take a strong movement in the stock to overcome that hurdle.

Here’s an example…

  • Let’s say you buy 10 contracts of an option right after a CNBC report or other such news. You might find the bid at $1.70 and the offer (or ask) at $2. So you’ll pay $200 per contract, or $2,000 total. If you had to liquidate, you would sell at the bid.
  • Ouch! That is only $1.70, or $170 per contract and $1,700 back in your pocket if you get out of the whole position. You just lost $300 right away - without any movement in the underlying share price. You’re already 15% down.
  • But if you’d gotten there before the CNBC crowd, you’d have done better. You might have found the option was trading at $1.70 by $1.80, only a 5.5% spread to overcome. Even waiting a day or two after the big rush may bring the spread back in your favor.

The extra 20 cents on the offer price after the CNBC tout was pure manipulation by the market maker. Knowing demand was coming, he moved the offer from $1.80 to $2, just like that.

Two Rules to Turn the Tables - And Make an Options Killing

So how do you beat the market maker?

  • Use your limit orders. You’ll either get in at a better price, or you won’t get a fill, which is fine because you don’t want to pay too much anyway.
  • If there’s unusual volume, wait a bit until the flurry dies down. Most of the time, you’ll find better prices the next day. Of course, you may miss getting in. But again, if you pay too much and accept too wide a spread, chances are you would have lost money anyway.

Professional options traders don’t trade on emotion. A good trait to emulate.

Good Trading,

Karim Rahemtulla

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  • For further definitions of options terms such as “bid & ask” and “volume,” visit the Smart Profits Glossary.

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Liquidity Of Options

June 8, 2004

The Smart Profits Report: Issue #116
Tuesday, June 8, 2004

Liquidity of Options: Protect Yourself Using Limit Orders When Trading
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

One of the questions that people considering options ask me all the time is, “Are options liquid?” It happened again just a couple of weeks ago at one of the conferences I was helping to host. And here’s my answer… Some are, some aren’t. And it makes a difference to your results.

The liquidity of options, or ability to buy and sell an option at a fair price and reasonable spread, is directly related to the underlying security. If the security is liquid then nine times out of 10 the option will be, too.

For instance, in one of my trading services, I recently recommended buying and selling Toll Brothers put options. We were betting that interest rates would move up and housing shares would fall. We were right about that. Housing shares did fall as rates moved up. But the Toll Brothers option was not as liquid as the underlying stock.

There were two reasons for that:

  • First, the option was one that not many people knew about or owned, so it was relatively thinly traded, even though the stock has a good following.
  • Second, the underlying stock is extremely volatile, which resulted in a very large spread between the bid and the ask. A large spread is an indication that the option may not be as liquid as you think.

We prevailed over the wide spread, however, by using strict limit orders as I’ve discussed in earlier Smart Profits Reports.

In fact, limit orders will likely become one of the most powerful weapons in your options arsenal, both offensively and defensively… Let me explain…

Liquidity, Spreads & The Market Maker

Large spreads usually mean that the market maker is glad to see you coming. He’ll tweak the price as high as possible. But he’ll still set it so that you’ll be willing to enter the trade.

It’s when you’re ready to exit that he clips you. Illiquid options usually mean there are few other interested buyers and sellers. And when it’s just you and the market maker in a face-off, you’re at a big disadvantage. If you’re in a hurry to exit at any price, he feels your desperation and will move the bid lower aggressively. Or you may see the dreaded “no bid.”

The antidote if you find yourself in this situation is that all-around good practice, the limit order.

At the very least, you will protect yourself when getting into a trade with a limit order. It will ensure that if you get filled on your order, it will be at or below your limit price.

And if you don’t? Good! It is far better to miss a trade than to pay so much you have very little chance of profiting even if you are right about the underlying stock.

Don’t fall into the trap of “playing options.” Remember, the goal is to MAKE MONEY. If you don’t get a fill, it was probably a good thing because you probably wouldn’t have been able to exit gracefully, either.

Use Limit Orders for Entering AND Exiting a Trade

And when you close your trade, use a limit order again. But be reasonable. This time, you don’t want to risk not getting your order filled. You have to sell to make a profit. So set your limit midway between the bid and ask, or slightly higher than the bid, if there’s a wide spread.

If the spread is reasonable, set it at the current bid just to ensure the market maker doesn’t start dropping his bid as soon as you show up.

I make this a practice, even when there aren’t any apparent liquidity problems.

For instance, a few days ago we bought call options on another company in my trading service (I can’t reveal the name of the stock, since it is an open position).

In this case we had used a strict limit order to buy the options at the current offer price. We weren’t so much interested in shaving a few cents off the price of the option as avoiding having the market maker start raising it when he saw the volume of orders coming.

It worked very well. I would estimate, judging by the volume, that all of my readers were filled at or below the limit price within a couple of hours of the recommendation. This issue was extremely liquid with over 2,000 contracts offered at our limit price across all exchanges. But the same practice is even more important when fewer contracts trade.

Rest assured, a good trading service will not recommend illiquid issues. It makes no sense to recommend that you invest in something that you cannot buy. It is bad faith on the part of the editor and a very poor business decision to boot.

Good Trading,

Karim

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Margin

June 3, 2004

The Smart Profits Report: Issue #115
Thursday, June 03, 2004

Margin: How to Turn a 10% Bump into a 50% Jump
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

In the crude oil futures contract example from our last installment, our buyer, Joe, bought a NYMEX crude oil contract for $30 per barrel, and our seller, Sue, sold a crude oil contract for $30 per barrel. Yet no money changed hands.

So, how did they consummate the transaction? Both “posted margin” with their respective brokers.

Margin requirements are set by the individual exchanges and, for the most part, are based upon volatility and not price. Unlike buying margin on stocks (that is, “shorting” a stock), margin to trade a futures contract is not a down payment on a loan. It is a performance bond that guarantees to your broker that you are good for a fixed amount of losses.

Receiving Margin Interest Instead of Paying It - Using T-Bills

Because it is a performance bond and not a down payment, you do not have to pay any interest on your margin deposit. Instead, you can actually receive interest while using the money to back up your positions.

How? By posting margin with your broker in the form of a U.S. Treasury bill. Since the T-bill is backed by the U.S. government, it is nearly as good as cash, so most commodity brokers accept it in lieu of cash. Meanwhile, you get to keep the interest.

As of this writing, the margin (or performance bond) required to trade a crude oil futures contract is $6,000. Both the buyer Joe and the seller Sue have to post $6,000 with their brokers for each crude oil futures contract they want to trade. As prices change, money will be physically added to and/or subtracted from their accounts to reflect their ongoing gains or losses.

Important Point: Unlike stocks or the purchase of options, there is no such thing as a paper gain or loss in futures. Both are realized immediately. Gains are physically added to your account (and can be withdrawn) each day, and losses are physically deducted even though you may still hold the contract.

This is where the concept of leverage comes in…

How to Increase Your Take by 500%

A 10% rise in the 1,000-barrel NYMEX crude oil contract, from $30 to $33, will result in $3,000 being credited to buyer Joe’s account. That’s a 50% return on his $6,000 margin. Similarly, that same 10% rise will cause $3 per barrel (or $3,000 total) to be deducted from Sue’s account, causing a 50% loss on her margin. If crude moved far enough against either, that account could go into negative territory.

Either party could be required to add more money to the account in order to meet the minimum margin (performance bond) requirement. This is known as a “margin call.”

If the price of crude oil moved far enough against their respective positions to exhaust the amount of cash in either party’s trading account, that position would be liquidated and that individual would be responsible for any additional money required to bring the account back to zero.

The commission to do this trade should cost no more than $80 per contract. Futures commissions are typically quoted “round-turn,” which includes both the buy AND sell. In our example, both Joe and Sue were able to trade crude oil directly without having to fully pay for the $30,000 it would have cost to purchase 1,000 barrels of crude oil outright. They didn’t have to pay the costs of storage and delivery either.

1,000 Barrels of Crude… On Your Front Lawn? Not Likely

Meanwhile, the mere fact that delivery could take place means the price of the futures contract has to track the actual price of crude oil very closely. The vast majority of futures transactions (upwards of 90%) DO NOT result in delivery. Long and short positions are exited prior to the delivery period.

Crude oil is no different. Indeed, the ease and low cost of trading crude oil futures has made them the most liquid (no pun intended) oil market in the world - to the point where many analysts believe the futures markets actually set the cash price.

As with all futures contracts, crude futures traders do not need to worry about counter-party risk. Each exchange acts as a clearinghouse: It is the seller to all buyers and the buyer to all sellers.

The exchanges perform the same clearinghouse function with futures options. Where options are different is in the amount of risk involved. Unlike futures contracts themselves, when you buy futures options your risk is limited to the amount you pay for them.

Good trading,

Karim Rahemtulla

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  • If you’d like to check out the commodity scene yourself, there’s no better introduction than the Chicago Board of Trade’s (CBOT) website. To access its price updates, news stories and history, just visit www.cbot.com.
  • Check out our Smart Profits Glossary concerning options terminology, like “margin” or “leverage“.

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