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Beating the Market Makers

May 26, 2005

The Smart Profits Report: Issue #212
Thursday, May 26, 2005

Beating the Market Makers: Never Pay Full Price
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I want to let you in on a little secret: I beat the market makers by never paying 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 maker goons, 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.

Beating The Market Maker Works Something Like This…

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.

And in reality, the spreads may be even wider. But even in a normal 5- and 10-cent situation, the spread is a big cost to overcome. Think about it. If the prices on a stock are $10 bid and $10.01 ask, 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:

  • 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

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Maximum Fear

May 24, 2005

The Smart Profits Report: Issue #211
Tuesday, May 24, 2005

Maximum Fear: How to Turn “Maximum Fear” Into Maximum Profits

By Dean Albrecht

Fear and greed are timeless emotions. They’ve been around since caveman days, and they’ll be around for a long time to come.  Particularly when it comes to buying and selling options…  Fear and greed motivate us as traders and, to a slightly lesser degree, as investors.

When the market or a stock is headed up, people are getting “greedy”; when the market or a stock is going down, they’re feeling “fearful.” Considering that options tend to move with stocks, understanding and reading fear and greed can be to your advantage as an options trader.

For example, just by buying an option on a “maximum fear” day instead of a few days later when greed is kicking back in, you could easily wind up with a 20% gain versus a 20% loss…

Even better, there are ways of drastically improving your chances of buying on a maximum fear day.

Let me explain…

When a Stock Has Reached a Low - Strike!

As a quantitative analysis-based investor, I look at numbers to determine which direction a position is headed. But what I’m really tracking are fear and greed as they ripple through the markets.

As I look at the numbers, the trends, I’m using an algorithm that is seeking extreme levels of fear and greed within the normal oscillations of the market.

I’m looking for percentage moves up, percentage moves down, and the oscillation of price - and ultimately I’m looking to find direction.

On a monthly basis, for example, the markets move anywhere from 6% to 10%, up and down. Individual stocks tend to move between 10% to 20% each month.

So for short-term traders, the key is getting in when the stock’s headed up that 10-20%, instead of when it’s headed down.

In other words, you want to determine when maximum fear has hit - and the crowd has finished selling out of a position - and that’s when you want to buy. How do you do that? By identifying attractive stocks at the bottom of their normal trading range…

Maximum Fear: Look for Stocks at the Bottom of Their Range

When markets and sectors and stocks are down at the lower range of our expectation, we start taking notice. And of course, this is when I would tend to look to get into a long position.

(The opposite is true for stocks people are greedy for - their higher prices make them good shorting opportunities.)

On a very basic level, you can see when the market’s fearful about a particular stock by looking at its 52-week range… If the company’s trading on the low end of its 52-week range, it could be a sign that maximum fear is driving investors.

Here’s an example using IBM:

Using Maximum Fear to Find Stocks At A Low Range

You can see that IBM hit a 52-week high of $99.10 in January… and today it’s trading around $76.59.

So should you rush out and buy IBM right now because it’s trading on the lower end of its 52-week range ($71.85 to $99.10) - because there’s fear in the market? No.

But considering the fear factor, you might consider IBM…(Of course, the quantitative analysis systems I use are taking in a number of factors, not just one.)

But be assured that learning all the different ways of reading fear and greed can help you:

  • Take advantage of the markets rather than letting the markets take advantage of you

  • Preserve capital by telling you when to stay on the sidelines

Indeed, when a stock is ebbing on maximum fear in the markets, it could be time to strike. And buy your options accordingly…

Good trading,

Dean Albrecht

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Today’s Smart Profits Cribsheet

  • Check out our Smart Profits Glossary for definitions of option terms like “trend” or “daily range” along with related articles and other option terminology.

  • For a deeper look into the mind of Dean Albrecht, check out Smart Profits #161, Quantitative Research: An Interview with Dean Albrecht.

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Options Books for Serious Traders

May 17, 2005

The Smart Profits Report: Issue #209
Tuesday, May 17, 2005

Options Books for Serious Traders
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

Over the past few weeks, I’ve picked up a few new fun options books for serious traders. And believe it or not, I actually want to tell you about them!

My longtime readers may know I am generally loathe to recommend any options books because, frankly, they tend to be boring. But since options are getting more popular, there are more books written in an exciting and engaging fashion making their way to the market.

The selection I purchased ran the gamut from elementary to advanced.

Here are the best ideas from the best options books I’ve read lately… and that you might want to make part of your trading library…

A Great Options Book for Beginners

If you are looking for a starter book on options, I would recommend - please don’t be offended - A Complete Idiot’s Guide to Options and Futures, by Scott Barrie.

This book is written in a fun style and goes over options basics as well as an explanation of strategies.

Scott was a former trader and now runs an educational service targeted at new options investors. He’s particularly adept when it comes to putting the strategies out there in plain English.

And I think his take on how to calculate returns in an understandable fashion was dead-on. Scott makes a good point about bull-spread trades, for instance, something we frequently do in our LEAPS Option Trader… And that is: You must understand the concept of “net debit” in order to know how much you’re really making with each trade.

Here’s the secret, as Scott reveals: When you sell an option against another option, the result of that sale is money back into your account and a reduced basis for calculating returns at expiration. That’s hedging power at work, and it’s one of the things that make options worth trading…

If You Want to Trade Online, Read This…

The second book I really loved is by George Fontanills… It’s called Trade Options On-line.

Fontanills is the man behind Optionetics, a well-known options group that spends a lot of time and money on advertising its prowess. (I have seen some infomercials very late at night about his products.)

Fontanills’ book is an interesting read and contains some valuable information and advice… the best of which is: Don’t let yourself be trapped into one type of options trading.

There are myriad options strategies available to the “ordinary” investor, and I agree with Fontanills that you should keep your options open (no pun intended) when it comes to options strategies.

While brokers might want to keep you SOLELY focused on covered calls, for example, Fontanills reminds us that there are countless ways to profit from options: vertical spreads, covered calls, bull spreads, bear spreads, you name it. Fontanills also explains each in a very clear and concise manner. And I highly recommend his book.

Options Books: Getting Better as the Market Grows

These two books just go to show you that the options world is expanding. No longer do traders have to rely on boring, stodgy or plain wrong-headed books that are best used as paperweights.

They represent a nice leap forward from the options tomes of old…

Still, what I would love to see is more books from experienced options traders, real information coupled with real-life experiences - kind of what you get from Smart Profits for free.

Good trading,

Karim Rahemtulla

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Today’s Smart Profits Cribsheet

  • I am reading another two books and will update you on those in a couple of weeks. But before you read any of these ones, you should check out Understanding Options. I helped put this manual together - along with fellow pro traders like Mt. Vernon Research Team, Lee Lowell and Dean Albrecht - and it’s a great introduction to options trading. Experienced traders will also find it an indispensable reference… Order Your Copy Now!
  • For definitions of the options terms used in today’s Smart Profits Report, check out our handy Smart Options Glossary

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Market Maker Tactics

May 2, 2005

The Smart Profits Report: Issue #205
Monday, May 2, 2005

Market Maker Tactics: What Market Makers Really Do
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

Got a bad fill on a trade? Must’ve been the market maker tactics, ie. playing their games. Got filled on a stop loss right at the bottom, only to see the market turn around and go in your favor… without you?

Must’ve been the market makers playing their games again, right?

Well, I’m here to tell you that it’s not always the market makers who are playing the games. I should know: I was one of them.

For six years I slugged it out in the pits of the New York Mercantile Exchange (NYMEX). Being a market maker (or local, as we sometimes called each other) doesn’t always get you a good rap.

Let me give you the skinny on the life of one of these guys.

The Ultimate NYMEX Insider Speaks

The experiences that I recount here pertain to the pits of one of the largest commodities exchanges in the world, the NYMEX. While I’m convinced that most market makers play similar roles, I can’t speak for the guys who trade on the floors of the stock exchanges around the world.

  • The NYMEX is a global center for the trading of energy futures and options. These energy contracts consist of such products as crude oil, heating oil, unleaded gasoline and natural gas.
  • The NYMEX also houses the COMEX, which trades in metal futures and options consisting of gold, silver, platinum and palladium.

What Does A Market Maker Actually Do?

In the simplest terms, a market maker helps facilitate the execution of a trade by providing a continuous bid-and-ask market for a futures or options contract to any interested party.

You want to buy a futures contract for July Natural Gas? Who do you think gives your broker a quote for the most current price of that contract? Looking to get a market on the April Crude Oil $48/$49 call spread? It’s the market makers who provide you with a bid/ask quote on that call spread.

In stark contrast to how most off-floor retail players trade, the market makers usually don’t trade with a prediction about the direction of a particular market.

The market makers are purely there to try and buy a contract on their bid price, and then either try to sell that same contract on their offer price, or hedge their delta risk immediately if they can’t offset the original trade.

Relax… Most Market Maker Tactics Aren’t Out to “Get You”

When you ask your broker for a quote from the floor (which you should always do before placing ANY futures option trade), the market makers don’t know whether you want to buy or sell, so their tactics aren’t “out to get you.”

They don’t have a hidden agenda in which they try to rob you of all your money. In fact, the market makers try really hard to give good, accurate and fair quotes because, quite frankly, the ones who give the best markets are the ones who get involved with the most trades.

If you’re the type who gives very wide bid/ask quotes, or someone who doesn’t honor his markets if a broker wants to buy or sell from you, then you won’t be around for very long.

It’s a market maker’s job to be tactically involved with as many trades as possible, while getting a small edge with each one of those trades.

The tighter and fairer you make a quote, the more the brokers will trade with you. This is how market makers earn a living - by providing continuous, tight and fair quotes.

This Tactical Seat Costs $1.8 Million - Why Waste It?

It is a privilege to trade on any exchange. And in exchange for that privilege, the market makers must outright buy their own seat on that exchange, or they must lease a seat.

The last time I checked, a seat lease on the NYMEX cost about $17,000 a month, and a seat to buy cost $1.8 million! If you’re a market maker who leases a seat, you’re already in the hole $17,500 come the first of the month.

That’s a tough nut to crack month after month. And that’s why it’s in the best interests of the market makers tactics to provide a continuous flow of good, fair and quality quotes.

So the next time you get a bad fill on a trade, the market maker might not be to blame.

Good luck,

Lee Lowell

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Today’s Smart Profits Cribsheet

  • For more on the Market Maker series by Lee Lowell, check out Smart Profits #243, Market Maker Survival: The Options Pit “Caste System” Revealed.

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