Options Strangle
April 28, 2005
The Smart Profits Report: Issue #204
Thursday, April 28, 2005
Options Strangle: How to Strangle Profits Out of an Imperfect Market
By Mt. Vernon Research Team
A few issues ago, we talked about an invaluable option trading technique called the straddle, in which you buy a put and call on the same option, each having the same strike price and expiration date.
The straddle is a widely known technique, not like the options strangle, and it has proven itself to be a moneymaker when executed properly.
The key to the straddle is taking the same strike price for each option - which should be as close to the stock’s current price as you can get. One straddle equals one put plus one call. Ideally, you want both the put and the call to be right at the money or one of the options to be only slightly in the money. As an example, if a stock is at $29.32, then you would do a $30 straddle.
Sometimes, though, the options on a popular stock - or one that’s apt to make a lot of big moves - cost too much. For instance, if your potential reward is $5 and the straddle will cost $3 for the put and $3.50 for the call, that’s not a winning trade no matter how right you prove to be.
If that’s the case, you back off and make a very similar, but much cheaper trade - a strangle. While not as famous as its counterpart, the strangle lets you go against the crowd by taking a little more risk - for a lot more potential returns.
Here’s how it works…
The Bargain Lover’s Alternative to the Straddle
A strangle is set up just like a straddle: You buy one put and one call. And you buy them for the same expiration month. The difference is in the strike prices.
To set up a strangle, you avoid the expensive at-the-money or close-to-the-money strike prices and go for an out-of-the-money one.
Here’s an example. Take a stock at $29.32. This would be a great $30 straddle, you think, but on investigation you find the $30 strike options cost too much. So you go one strike further out each way.
On the downside, you move to a $25 put. On the upside, you move to a $35 call. Now you have loosely surrounded the stock price and you are ready to profit on a breakout in either direction.
A strangle will have a somewhat lower chance of profiting because the stock has to make a bigger move to influence the action in the out-of-the-money strikes. But that’s precisely the reason a straddle will cost too much for popular stocks when they are especially active.
Going Against the Crowd, for Greater Profits
On the plus side, the reward potential can be even greater with a strangle because you are doing something more unexpected. Going against the crowd and being right is always more rewarding.
Now for the cons…
As with its cousin, the straddle, a strangle will cost more than a simple put or call, and that will reduce your returns compared to being exactly right on the direction. And the profits are apt to be modest because of the costs involved.
So why use these techniques at all? They seem to offer you higher costs and lower rewards…
When There’s No Trend, These Techniques Are Your Friend
Yes, but the stock market is only in a strong trend 30-40% of the time. The same goes for most individual stocks.
For the rest of the time, if you want to trade options, the strangle will help you pry profits out of seemingly hopeless markets and directionless stocks.
Sure, perfect markets are more fun. But the adept options trader isn’t limited by needing perfect conditions. That’s for amateurs. The real trader works to develop a few tools that will work in all kinds of markets. And if you only make 21% on the workhorses like straddles and strangles, remember that you are far better off than those who are making nothing. Or less than nothing.
Great trading,
Mt. Vernon Research
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Today’s Smart Profits Crib Sheet
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For another great example of when to use a strangle, click on over to Smart Profits #282, Option Trading Strategies: Options That “Earn” Their Keep.
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Check out our Smart Profits Glossary for great explanations and articles about terms like “strangle” or “straddle.”
Related Articles:
-
Options Strangle: Your Stock Is Poised For A Big Move… So Strangle Some Profits From It
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Options Straddle - Using A Straddle to Harness “Uncertainty”
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Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain
Straddle Options
April 26, 2005
The Smart Profits Report: Issue #203
Tuesday, April 26, 2005
Straddle Options: Using a Straddle for Safe, Double-Digit Gains in a Cagey Market
By Mt. Vernon Research Team
When it comes to options, my favorite market is the run-up to a big, big over-the-top bubble, or its exact opposite… the going-deeper-down-every-day bear rout.
Direction is one of the three things you need to specify when you trade an option, especially straddle options. And the more definite, the better…
As you know from these bulletins, if not from your own trading, you have to be very specific about an option trade. You have to declare the direction: Will that be a put or a call? Oh yes, and exactly how far will that be - up $10, to the $45 strike, or down $5 to $30, do you think? And, as if that weren’t enough of a challenge, you have to name your month!
Straddling The Markets
So markets where stocks, or at least a few sectors, sail upward are naturally a gift to the trader. You pretty much know the market is going to give you a lift. All you have to do is avoid paying so much for your option that you price yourself out of any gains. (Ditto markets that are falling like drunks.)
But what about the times when the market is not in any clear trend but wallowing side to side? And what about the stocks that should have gone somewhere, anywhere, but are defying gravity by sitting still for weeks on end?
That’s when you play both sides of the fence. It’s not necessary to be bullish or bearish all the time. Sometimes the market is simply on hold. Sometimes stocks are just caught in a range while investors are waiting to see how a situation works out or how the next quarterly report looks.
If you have reason to believe a stock is going to move, but you don’t know which way, it’s time to investigate the straddle. In cases like this, it’s often the straddle players who are the ONLY ones in position to make a high-probability run at a double-digit profits.
Let me explain…
Playing BOTH Sides of the Fence - For Maximum Gains
A straddle play is just what it sounds like: You straddle the price. You buy a put and a call - both the same strike price and month.
If the stock makes a breakout, one of them is going to pay off for you.
I did this recently with Rite Aid (NYSE: RAD) in one of our newsletters and it’s a good example of how to eke something out of a most trying situation. Rite Aid has evidently been featured as a great turnaround story by someone… or several someones. But it’s not really doing well.
So the stock tries to break out on hope, always to falter and stumble back again. Sometimes, investors get depressed and start selling, but then someone thinks this venerable old company HAS to go up. Surely, it’s a bargain at less than $4 a share and a P/E ratio of 9… and back the buyers come. Again.
Since last September, Rite Aid has largely rattled around in a trench between $3.40 and $3.80, only to almost break out and get caught in a slightly higher range, from $3.60 to $4.20 for the past two months.
Now, it’s true that the range from top to bottom gives enough room for some profits - the trouble with Rite Aid was that it was impossible to tell whether the stock was going to stick in the range, stall or break out.
You would have to time your entry perfectly, getting in and out, to catch 100% of the largest swing. And the risk of the stock swinging back against your direction was extremely high.
Smart traders don’t go into high-risk, low-reward trades!
That’s why a straddle made sense here: Suddenly, you could change the situation to a low-risk, moderate-reward trade.
Of course, there is no $4 call or $3.80 put. So in the real world, to take an option on Rite Aid, you have to choose between a $2.50 strike or a $5 strike, the standard prices for options. With little chance of this turgid stock shooting to $5, I took a $2.50 put and call on Rite Aid.
The Right Move(s) on Rite-Aid
This trade took weeks - weeks! - to work out. Finally, the stock feebly reached upward enough to make a 21% gain on the cost of both options. The call had gone up nicely, making enough money for both options. The put was basically worthless. So far…
In fact, there’s time left, and should Rite Aid stumble badly, that worthless put might regain some stature yet, since it doesn’t expire until July.
The Straddle Option: A True Gift to Traders
The straddle is a gift to traders in situations like this. There are a lot of people trading Rite Aid and getting lost in the confusion. The average daily volume is nearly 5 million shares, amazing for a stock that is doing nothing. Some people are shorting it; some are hoping for that big turnaround story to come true. Neither side has gotten its wish so far.
Options traders are the only ones who have made any money on this stock in the last few months. And with the stock as ready to break out of its range in either direction, only the straddle players were really making the high-probability run at a double-digit profit.
In the next issue, I’ll tell you about another options trade that - like the straddle - can give you an edge over other traders. It’s called a strangle. And while it’s a very powerful tool, it costs less to execute than the straddle we talked about today.
Until next time,
Mt. Vernon Research
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Today’s Smart Profits CribSheet
- You can make money in the stock market, even when you don’t know whether a stock is going up or down. The pros do it, and so can you… The solution to profiting from uncertainty is to create an options straddle. The entire point of a straddle is to allow you to remain in the market, with limited risk, learn more in Smart Profits #251, Options Straddle: Using A Straddle to Harness "Uncertainty."
- Look at it this way: Good decisions make money. And people who are making money are generally happy. With a strangle, you play the long and short side of a stock by buying both calls and puts. Okay, it's not the simplest options strategy, but it's certainly one of the safest, and one of the most profitable. Find out more information on strangles in Smart Profits #305, Reliable Option Strangles For a 70% Win Rate.
- Having trouble getting a grasp on these option strategies? Click on over to the Smart Profits Glossary for definitions on terms like "straddle" & "strangle."
Related Articles:
- The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options
- Options Strangle Tips: Extracting Three Strangle Tips From a 515% Gain
- Derivatives: Take the Big Guys’ Money With Their Own Weapons
Stock Options
April 20, 2005
The Smart Profits Report: Issue #202
Wednesday, April 20, 2005
Stock Options: How to Buy $2,446 Worth of MSFT for $1,270
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
Why would anyone want to pay $2,446 for something they could get for $1,270? That’s a great question, and for the life of me I still can’t figure out why people are doing it every day.
Since I’ve been in the trading business for 15 years now, I get many requests for which stock people should buy, or what I think of a stock that they recently purchased. I usually decline when asked to recommend a stock for someone, but I know I can get more bang for my buck by purchasing stock options instead of buying the stock outright.
That’s why I immediately go into my speech about how buying options is superior to buying a stock outright, not only because it will cost less, but there is less downside risk as well.
My modus operandi has always been about how I can save money on everything I do. It’s not that I’m a cheapskate, but if there is a way to buy exactly what I want for a cheaper price, then for sure I’m going to do it. That includes clipping coupons, using employee discounts, buying on eBay or Priceline, and sure enough, buying stock options instead of actual stock.
Buying a Blue Chip at a 50% Discount
How do we pay $1,270 for something that’s worth $2,446 and end up with the same product for less risk? In the financial world that problem is solved by using stock options instead of actual stock.
Take a look at this example using Microsoft (Nasdaq: MSFT)…
As of the close on April 17, 2005, MSFT ended the day trading at $24.46. Anyone who wanted to buy 100 shares of MSFT would pay a total of $2,446. The total risk in this trade if MSFT ever happens to fall to ZERO will be $2,446. We know that’s an unlikely scenario, but that’s the total risk.
Our breakeven price is $24.46. Anything above $24.46 is profit; anything below $24.46 is a loss (excluding commissions).
The option chain lists all the available options for MSFT with an expiration date of January 2007, almost two years away. Looking at the "Bid" and "Ask" columns, the $12 call finished with a value of $12.70 (splitting the bid/ask).
If you buy this option, it will cost you $1,270, almost 50% cheaper than buying MSFT shares outright. Our total downside risk in this case is $1,270, which is what it cost us to buy this option. Our breakeven price on this trade is $24.70. In order to find the breakeven price, we must add the option premium of $12.70 to the strike price of $12, which equals $24.70. (When dealing with option prices, you must multiply the premium by the $100 multiplier to get your total cost - in this case, $12.70 x $100 = $1,270).
Stock Option Advantages
Okay, so our breakeven price with the option is 24 cents higher than if we actually bought the shares outright. No big deal. But let’s look at the advantages to buying the option.
- It cost us less actual dollars to buy it - $1176 less dollars to be exact, almost 50% cheaper than buying the stock.
- Our total downside risk is only $1,270.
- And one of our biggest advantages is that we’ll get to participate in the same amount of movement that MSFT has during every trading day.
How do we know we’ll benefit from moves in the underlying stock? Delta, baby!
The Secret of Delta - Stock/Option Price Correlations Explained
Look at the column labeled "Delta." That number tells us, percentage-wise, how much the option price will move in conjunction with a move in the underlying stock. The $12 call is giving us a Delta of 100%. That means the option will move practically penny for penny with the stock. If MSFT moves up 50 cents, the $12 call should increase in value by 50 cents, as well (give or take a few pennies).
It also works to the downside as well. If MSFT goes down 80 cents, the option will fall about 80 cents as well.
Just in case you’re wondering what the $12 call does for us… It allows you to buy MSFT for $12/share anytime until the option expires in January 2007. But in order to buy MSFT at $12/share, you must pay up the initial $1,270, which is the option’s premium.
As we said earlier, you breakeven price is now $24.70, and the most you have at risk is $1,270. As with any option purchase, the most you can lose is the cost of the option.
Looking at the "Drawbacks" - And Finding None
Are there any drawbacks to this strategy? In my opinion, not really, but I’ll tell you what other people might think are drawbacks…
When buying options, you do not get to receive dividends that any company may pay. Is that a reason to not buy the options? Not for me. I’ll gladly settle for an investment that costs me almost 50% less in total dollars, half as many total dollars at risk, and the opportunity to participate in all the same movement.
Remember, dividends don’t always cushion the fall of a stock in a downtrend. The other drawback may be the limited life span of the options. I don’t know about you, but if a stock I own doesn’t make the move I anticipated within two years’ time, I think it’s time to find another stock. In terms of drawbacks, that’s all I can think of.
So the next time you’re thinking of buying stock, make sure you check your options (literally).
Good luck,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Check out our Smart Profits Glossary for definitions of terms like "delta" or "trend" found in today’s article.
Related Articles:
- Options Leverage - How to Use Delta to Maximize Leverage
- Options On ETFs: Increased Safety and Profit Potential
- Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run
Bill Gross
April 18, 2005
The Smart Profits Report: Issue #201
Monday, April 18, 2005
What Does Bill Gross Know?
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Normally we talk about options or ETFs in this space. But today’s opportunity, while outside of those sectors, is just too good NOT to talk about.
So let’s get right to it…
Bill Gross is the managing director of PIMCO, the huge bond management company based in California.
He makes his money two ways: First, he advises institutions and other clients about bonds, and second, he invests his hard-earned income.
At PIMCO, Gross has an effect on some $40 billion under management - that is more than the GDP of 80% of the countries on earth. And when he speaks, people listen.
I would argue that, second to Alan Greenspan, Gross is the most influential person when it comes to prognosticating about bonds and the future of interest rates.
So far, he has been on the money and PIMCO has been rolling in profits for shareholders, investors AND managing directors.
Right now, Gross sees trouble… but that’s spelling a good opportunity for investors.
With Inflation Looming, Where to Invest?
In fact, Gross and I share a similar opinion about the future of interest rates. We both see interest rates as a limiting factor on economic growth. In simple terms, if rates move too much higher, too quickly, this credit-based economy of ours could plunge into recession.
The market is saying as much, also. If you look at the action in long bonds - 5 years and up - their yields are comparable to where they were four interest rate hikes ago.
Short rates are higher now, but the long rates are lower. This signals that the bond market - which is generally the more sophisticated money - is saying that while there is growth and inflation in the near term, the long-term picture is darker.
Long-term growth of the economy will be moderate at best, and inflation will still be a problem that holds the economy back.
So what does that mean for YOUR money?
A Fearless Interest-Rate Prediction
I think it means that you may see short-term rates reach 4% by the end of this year, and longer-term rates may touch 5%. And that’s it. There may be spikes along the way, but nothing that will sustain higher rates. Higher rates would put too much pressure on the economy… causing rates to fall.
So what should you do with your money?
Well, if you were Bill Gross, you would put hundreds of thousands of dollars into PIMCO’s closed-end municipal-bond funds.
Following Gross’s lead, I have been investing cash into these funds with good success for the past year or so. The current yield is about 7%, free of federal taxes. Some are for states that have income taxes - if you invest in one of the funds that invests in your own state, it’s free of state taxes, too. (If you are in the 33% tax bracket, that 7% is equal to getting over 9.3% on a taxable bond!)
If you live in a state like Florida that has no state income tax, then you may want to consider the funds that are national (they do not have the name of a state in their heading). Of course, it makes no sense to own these in a retirement account either since those accounts are tax deferred anyway.
The only caveat is that these specific closed-end muni-bond funds from PIMCO use leverage. This means they try to earn more income on the assets they have under management by using derivatives, interest rate swaps, and spreads to generate a greater return. This makes their prices volatile and subject to movement on a daily basis.
One Caveat: A Little Volatility
Over the past year, I have seen the prices swing by 2% to 3% in a day based on trading pressures and the outlook for rates in general. So if you don’t have the stomach for some risk or volatility, OR if you think rates are heading to the moon, THESE FUNDS ARE NOT FOR YOU!
As for me, I think that Bill Gross is a very intelligent investor who has his ear to the ground, and if he is putting his money, and LOTS of it, into these PIMCO closed-end muni funds, then I don’t mind taking the risk with him.
There are several of these funds available. They are all pretty similar in yield. And they’re certainly worth a look right now.
Good investing,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet:
- Of course, there are many companies that provide closed-end funds. I chose PIMCO because it has a level of expertise that has been proven over the years. Here is a link to a site that lists its selection of funds: http://www.allianzinvestors.com/closedEndFunds/
Related Articles:
- Option Market Makers: Beating the Market Makers on Price
- Double Your Money: The Truth About Making 300% Overnight in Options
- Limit Orders: Dodging The Market Maker’s Bullet & Side Stepping The Liquidity Trap
Volume
April 14, 2005
The Smart Profits Report: Issue #200
Thursday, April 14, 2005
Volume: Reading Volume to Find 20% Gains… In 45 Minutes
By Mt. Vernon Research Team
Mt. Vernon Research
Pundits need to talk about something, and a favorite on the daily market commentary circuit is reporting "who’s in charge." Some days the buyers are in control. Sometimes sellers rule the market. Every day, every trade has two sides and both sides are in agreement. How can anyone be in charge?
This is an important question when it comes to trading, because technical systems are based on the idea that you can spot whether buyers or sellers have control. Without knowing that, you couldn’t tell whether a stock was likely to head up or down - and you certainly couldn’t survive the options market without knowing that, which brings us to volume.
Sometimes when you look at a chart, it will be quite obvious what is happening. The prices are clearly trending upward or downward.
But then for some reason, with no real news, the price line will start going the other way. Instead of continuing upward, the bullish chart turns bearish. Instead of falling closer to zero, the bearish chart gets bullish. Maybe what was clear wasn’t so helpful, after all.
Reading Volume - A Quick Trick for Identifying Trends
Very often the astute technical analyst could have told you that change was about to happen. There are lots of methods for detecting these "buying and selling climaxes." Candlestick charts have dozens of patterns. Regular charts have well-known formations like the "head and shoulders" top or "inverted head and shoulders" bottom.
Point-and-figure charts will meet their targets. A stock might cross a moving average. There are literally hundreds of specialized technical systems that will give signals, not to mention discrepancies between signals that have meanings as well.
But if you want a quick take on whether a trend is still strong, the best clue will be in volume. That’s where I would advise the beginning technical trader to focus.
For instance, Priceline.com (Nasdaq: PCLN) has been bullish since early February. But in late March, its usual choppiness looked like it was turning into a serious change of direction. The stock was trending down consistently. For seven days it was dropping, all but once closing lower than the day before.
Was the bull run over? Had the sellers taken charge? The chart direction looked very much as if that was the case.
But if you looked at the volume, you would have drawn an entirely different conclusion. During that whole period when the price was falling, volume was growing weaker and weaker. Finally, hardly anyone was coming out to play. The daily volume was only a third of normal.
That was a good sign that selling pressure was drying up. Those who wanted to sell at whatever price they could get had largely sold. At this point, on Friday, I sent out a bulletin to my trading service to take a call on Priceline. The chart was still dropping, but my reading was bullish because of the weak volume.
About two hours later, the stock had turned around - hard. At 2:30, the stock that had been dropping 10 to 20 cents a day did an about-face and rose $1.50 in the next 45 minutes. Needless to say, the option responded with a big spike, too, gaining 20% that fast.
Generally, Right Is Good Enough
There was luck involved in that trade, I’ll admit. It was mighty darned lucky that I decided to finish writing the bulletin before going down the street for a cup of coffee!
I’m not kidding, either. I could not have pinpointed that the change in direction would come at precisely 2:30 p.m. that very day, or even by the next day. Nor did I think it would get so big so fast. But I would have called it an 80% probability that the change was coming fairly soon.
The chart had already told me the basic story. Sellers were tired. The stock was dropping weakly on lower and lower volumes, and it was time for the buyers to come back home.
The next time you are tempted to buy a stock that has been rising, be sure the volume still supports it. And if you are thinking of selling a stock that’s been falling, make sure you’re not the last seller. If the volume has gone too low, you’ll probably wish you’d held on.
Good Trading,
Mt. Vernon Research Team
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Today’s Smart Profits CribSheet
- For more on volume in the markets, check out Smart Profits #273, Common Option Mistakes: Four Options Resolutions to Make Today.
- Check out our Smart Profits Glossary, chock full of over 150 option terms, like "volume" & "straddle."
Related Articles:
- Market Volume & Liquidity: When to Buy the Stock And NOT the Option
- Google Stock Options: What Happens When A High Volume Stock Has Half An Ounce Of Credibility
- Options Straddle - Using a Straddle for Safe, Double-Digit Gains in a Cagey Market
Why Choose A Full-Service Broker
April 12, 2005
The Smart Profits Report: Issue #199
Tuesday, April 12, 2005
Why Choose A Full-Service Broker: Get Your Option Prices Filled Everytime
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
A few weeks ago, I wrote about the “secret bid” that sometimes crops up when you place an order in the options marketplace. This “secret bid” appears when you place an order to buy an option at a price other than the offer. For example, let’s say an option is bidding 5 cents and offering 20 cents. You decide to bid 10 cents. And as soon as you put your order in, a magical bid order appears alongside yours.
What the market maker was trying to do was to buy the options at 5 cents with no competition. However, as soon as you showed up with a reasonable bid, he showed his real cards. There isn’t a lot you can do in this situation, and the chances of you getting filled before the market maker are slim to none.
On another type of order, however, there is something you can do. I’m talking about cases where you simply don’t get filled, even though the option hit your bid price. When that happens, you can take your business to the ONLY person on the planet who can help when you don’t get filled: the full-service broker.
Let me explain, starting with an example…
Don’t Accept this Line of BS from Your Brokerage
Let’s say you see an option trading at 5 cents on the bid and 20 cents on the offer. You put in an order to buy at 20 cents expecting to get filled. However, you don’t get filled.
In fact, your order is in for 10 minutes, the offer doesn’t change, and you still don’t get filled. Then all of a sudden, the offer moves higher and your order is now basically in limbo.
If you get upset and call your discount broker, he’ll probably say one of the following:
- There was no activity in the options so there is no real price.
- The order was directed to a different exchange and now the offer has moved up.
- The options market is not the same as the stock market and there is nothing we can do.
Insisting on Your Rights… What Rights?
Now, most people would just hang up at this point and swear that the market was fixed.
What is your remedy? As a reader who sent me a letter pointed out, you could ask the broker to provide you with a historical record of the bid and offer and a record of what time you placed the order to see if you are OWED A FILL.
This sounds wonderful, right? There is no doubt that you placed the order when the price was what you thought it was.
The broker, after much hemming and hawing, might then produce a time sheet that shows your order indeed was placed while the offer was where you thought it was. This confirms that you’re owed the fill!
Not so fast, he’ll say. Just because the order was placed and it has been recorded as being placed does NOT mean that you will be filled. Period.
And that’s the end of the debate…
You can argue till you are blue in the face, threaten to pull your account, speak to a manager and even threaten to call the SEC. But you still will not likely get filled.
It turns out that in the options market you are at the mercy of the market maker. And unfortunately, the level of regulation that exists in the stock market just does not exist for the options market. I hate to say that, because options are my bread and butter, but it is the truth.
The Solution: Why Full-Service Brokers Might Be Worth It
So what can you do? Well, you can dump that discount broker and go with a full-service broker instead.
Full-service brokers charge more, yes, but that’s exactly what gives them greater incentive to go to bat for you and argue your case with their trading department.
At discount and online brokers, you are just a number and that is how you are treated for the most part in a dispute. Not so with full-service brokers.
In order to earn that extra money, they’ll sometimes go the extra mile for their client (you). In some cases, if you are a good client, the broker will actually eat part of the cost of the trade just to make you happy - yes, they will actually dip into their own profits to make your trade work. (Of course it depends on the size of the trade and the amount of money involved.)
So while it might be hard to stomach the fees, they might seem cheap compared to the opportunity cost of NOT being filled.
Full-Service or Discount, Let Them Know When They Screw Up!
Finally, if squawking long and loud doesn’t get your orders filled - regardless of whether you use a discount or full-service broker - it’s not useless, either.
I believe that the days of market-maker shenanigans are numbered in the options world. As more people get involved in the market and volumes increase, so will complaints. And it is these complaints that ultimately get the regulators involved.
In this case, more regulation is sorely needed to increase the level of confidence in the options market.
So the next time you are owed a fill, don’t back off lightly, make a case out of it - you may not get satisfaction, but maybe the pressure from one more complaint could finally make the options market come clean.
Great Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- In today’s letter, I refer back to a piece I wrote recently on “secret bids.” To read more about these market curiosities - and how to deal with them - check out Smart Options #191, Market Maker Bids: Outmaneuvering the Market Maker’s “Hidden Bid.”
- For more on the option terms used in today’s report, visit our free Smart Options Glossary.
Related Articles:
- Why Your Broker Drives a Porsche and You Drive a Chevy
- Market Maker Survival: The Options Pit “Caste System” Revealed
- How to Open an Options Account: Not Always a Simple Task
Option Losses
April 7, 2005
The Smart Profits Report: Issue #198
Thursday, April 7, 2005
Option Losses: How to Grow Rich From Your Options Losses
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Now, I know that most newsletter editors will not admit to mistakes. It makes for terrible marketing copy.
But guess what… I think that having option losses and admitting to them has an important educational and therapeutic effect.
- First, analyzing losses helps me to better understand the statistical relationships between LEAPS and the underlying shares in various scenarios.
- Second, acknowledging a loss humbles me before the market gods. It’s good to be humbled every so often - because nobody is more set up for catastrophic losses than an arrogant trader.
The Markets Educated Me…
Some fellow investors and I entered into a two-year LEAPS play. We bought the LEAPS for $2.65. The underlying shares were trading for $27. So for 1,000 shares we could have spent $27,000 - or to control the same 1,000 shares for TWO YEARS, we could pay $2,650.
Because I am convinced that no one holds shares for more than a few months these days - let alone two years - I chose the LEAPS option (forgive the pun).
Stay Humble Before the Market Gods
Well, three days into the trade, the shares moved up 7%. Our LEAPS were up 30%. I should have sold! I have learned this lesson before. I should have pulled the trigger.
With a one-year LEAP I would have pulled the trigger. But with TWO YEARS left, I felt a little greed would be allowable. Bad call…
On the fourth day of the trade, the company came out with bad news. The news was unexpected and unpredictable. The shares plunged at the open, falling to $24 from $28.70. That is close to 20%.
The news was bad enough that it changed my outlook on the future of the company. Sometimes bad news can have a short-term effect and we don’t sell. I mean, we usually have two YEARS left on our long-term options. We should not react to news that may not have long-term impact.
This case was different. I issued a sell. Since all of my buy and sell prices come from ACTUAL customer trades (sent to me by our recommended broker based on trades made by dozens of REAL customers), I was happy to learn that his customers were able to exit the position at $2.25 on average.
How It Could Have Been Much Worse…
This means our losses were limited to 40 cents - I am sure some of my readers did better and some did worse.
But if you look at the numbers, we lost 40 cents on this trade compared to more than $3 for the investor who bought the shares at the same time. In fact, the MOST we could have lost was less than the actual amount lost by stock-only investors.
As I try to explain to my readers and attendees at seminars, LEAPS offer you not only superior upside potential compared to shares, they also offer you SUPERIOR downside real-dollar-loss protection.
So, while I NEVER like to lose money (fortunately, we made $2.40 per share the week before on another trade, more than making up for our small loss here), it is important that you realize that using LEAPS is not just a speculative options strategy. It makes sense much more often than not.
And even when LEAPS go south on us, we’re still in position to lose less than common stock traders.
Great trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of words like “LEAPS” or “long position” found in today’s article.
Related Articles:
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- Derivatives: Take the Big Guys’ Money With Their Own Weapons
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Bear Spreads
April 5, 2005
The Smart Profits Report: Issue #197
Tuesday, April 5, 2005
Bear Spreads: Totally Risk-Free Profits Shorting Crude Oil
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
A few weeks ago in my trading service, we shorted crude oil using the Energy Select Spyder and exchange-traded fund XLE (AMEX: XLE.)
The XLE is a composite of gas and oil refiners, producers and explorers. It was a timely short. Oil prices fell almost 10% during our holding period. That was enough to return 30%-plus on our put position.
However, that is not the real story. The real story is how we turned an 8% drop in oil prices into a free lunch: a rare bear spreads trade opportunity in which we literally had zero downside risk, with nice upside potential.
And such opportunities will arise in the future. You just need to know how to recognize them and, once you do, you need to pounce…
Let me explain…
The Art of the Bear Spread
All our lives we have heard that there is no such thing as a free lunch. For the most part that is true. So, when we do get a chance at a free lunch, we should take it. And that is what many of my subscribers did.
Last week I issued the following recommendation to my readers:
- Take your profits of 30%-plus on the position…
- Or enter into a bear spread.
I would say, judging by the volume, that it was about 50/50 between those who took profits and those who engaged in the spread.
Here is how the spread worked…
We started with a simple trade. We bought the $39 strike LEAPS put on the XLE for $2.45. This option gave us the right to be short the XLE at $39 until expiration in 2007. If oil prices went down over the next two years, we would make money.
Fortunately, oil prices went down sooner than expected, and as I have mentioned before, the power of LEAPS is that they exaggerate the moves that the underlying security makes in your direction in the short term. Hence the 30% gain on our option from an 8% move in the ETF.
Going Back for Seconds
Because the XLE moved down so rapidly, this trade was ripe for extending into a bear spread. To do that, we would keep our initial LEAPS put and sell another one at a lower strike. I looked at the other options that were available. It turns out that the $37 Put LEAPS with the same 2007 expiration was trading for $2.55 on the bid at the time of the recommendation. I scrambled to get the play out - knowing how volatile the market for oil is.
We ended up selling the $37 option against our $39 option, and received at least $2.45 for our effort. Some of my subscribers did even better. But when we received that $2.45 from selling the $37 put, it was a return of our initial $2.45 invested in buying the first put at $39.
That left our amount at risk at ZERO. This means that in the worst-case scenario - if oil goes to $100 a barrel and the XLE soars to $75 instead of falling as we hope - even if we hold the position until expiration, we still will lose nothing, nada, zilch. We can be completely wrong and not lose a dime.
And if we are right, it’s all free money.
Now, if oil were to fall as we are betting it will - say to $45 per barrel at expiration two years from now (or before then) - we could cash out the option.
Breaking Down the Bear Spread Numbers
Here’s how this would work if we held until expiration and oil prices were lower in January 2007 then they are today.
The put we sold at $37 would surely be in the money, and we would have to meet our obligation to buy XLE shares at $37. But we own the right to sell the XLE at $39 per share - because of the $39 put that we bought.
So, we’d buy shares at $37 and sell shares at $39, for a gain of $2 per option if the XLE were to close at $37 or lower at expiration.
Actually, anything below $39 would make us money - but our gain would be limited to $2 ($39 minus $37) when the XLE falls to $37 and lower. Our at-risk money is $0.00 - you can figure out the return on your money at risk if we win!
Now, if oil prices go up and the XLE follows, we will make nothing… but we will lose nothing either.
We have done many bull spreads in the past, but this was the first bear spread we engaged in. Most often a bear or bull spread is entered into at the beginning of a trade. However, we turn trades into spreads after we have a confirmed profit in our original position, most of the time. That’s a way to mitigate risk substantially while maintaining a VERY healthy upside for profits.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Hang onto your hat, because we’re going to dive headlong into the low-risk, profitable world of option spread trading today - both bear spreads and bull spreads. The mere mention of terms like these can intimidate some investors and dissuade them from making the trade. Don’t be one of them. You’d be missing out on a great, low-risk way to grab profits, so check out Smart Profits #330, Option Spread Trading: How a Bear Spread Can Make You More Than One Put Options Trade.
- While it might seem odd that you don’t have to be right on your market call in order to still enjoy a winning trade, hear me out… because today, I’m going to give you one of the best options strategies that relies more on picking where the market won’t go, rather than where it will go. Interested? If so, check out Smart Profits #348, Credit Spreads With Options: How Option Credit Spreads Give You a Better Chance to Win.
- One of the core principles that separates the top traders from the mediocre ones is the need to take responsibility for all their trading-related actions.We must take responsibility for our own investment performance. And if you want to enjoy bigger, more consistent profits, this means making some real changes in the areas that matter most. So take some time to read Smart Profits #389, Improve Your Investing Results: Your 8-Step Checklist To More Successful Investing.
Related Articles:
- Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth
- Spread Trading: Lower Your Cost And Hedge Your Risk In One Profitable Bull Spread Trade
- Bull Spreads: Bagging a 66% Return on Lexar
