Naked Options
August 30, 2005
The Smart Profits Report: Issue #238
Tuesday, August 30, 2005
Naked Options: Words of Caution for a Lucrative Options Strategy
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Readers frequently ask me about the potential downside to options investing. Questions like… How much can I really lose? More than I invested? If my options bottom out, will my broker swing by after dinner… for the keys to my house?
If you’ve ever seen the movie Trading Places starring Eddie Murphy, you’ll remember the end when the Duke brothers lost it all… and more… in the futures markets. In their case, the house keys were only the first things to go.
Heavy losses can happen, but only in certain situations. Today I’ll introduce you to naked options, an options strategy that can make you a ton of money if you know what you’re doing… or, if you don’t, simply treat you to the thrill of high-stakes losing.
Here’s what I mean…
How You Win Big or Lose Big With Naked Options
When you buy an option, a put or a call, you have the RIGHT, but not the OBLIGATION, to buy or sell the underlying shares. This means that your losses, if any, are limited to the amount you invested when you bought the option. Period.
But, when you get a little naughty and want to do some naked stuff (by not covering your positions), you can either make great returns - or find yourself in a mess.
For example, if you SELL a put option, you are obligating yourself to buy the underlying stock or commodity at a specific price on a specific date. So, if the underlying vehicle tanks, you’re on the hook for every bit of the loss.
At this point, you have two choices:
- Take a hit and buy back the option, or…
- Buy the underlying stock or commodity, and sell it for a loss.
An Example Of a Naked Option
Here’s and example of a naked option play. If you sold a $90 put on XYZ when it was at $100, you are obligating yourself to buy XYZ at $90, if it’s still trading at $90 or less at expiration. For carrying this risk you receive a premium. Assume for a moment that one day after the market closes, XYZ announced that it was declaring bankruptcy. The next day the shares open at $2. You are now on the hook for an $88 loss per share ($90 minus $2).
That’s quite a chink of change. But obviously, if the trade goes your way… that’s a handsome win.
So, the lesson is to know what type of options strategy you’re engaging in to determine your maximum loss potential. Just because something sounds neat - like people talking about “free money” from selling puts with naked options - the reality can be different. In the options market, as in any other market, there is no free lunch.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- To get the most out of your options trades, you have to use a system. To read more about options trading strategies, check out Smart Profits #213, Options Trading Tools: Six Key Tools for Trading Options. Smart Profits #226 by Lee Lowell is also a great one, Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options.
- Check out our Smart Profits Glossary for definitions of words like “naked option” or “put option” found in today’s article.
Related Articles:
- Uncovered Options: A Win-Win Trade that “Puts” You In the “Bookie’s” Seat
- Limit Orders vs. Naked Puts: Getting Paid to Place Them On Your Favorite Stock
- Short-Term Options: Two Ways to Make Them Work
Market Maker Manipulation
August 26, 2005
The Smart Profits Report: Issue #237
Friday, August 26, 2005
Market Maker Manipulation: Are Market Makers Playing Games With Our Profits?
By Karim Rahemtulla
Chairman, Mt. Vernon Research
It’s happened to all of us. We’re tracking our position like a hawk. It’s going our way, we’re deep in the money, and the ask price keeps trucking along… Life is good.
But wait! Where’s the bid? It’s lagging behind and the gap keeps growing. And our profits, our hard-earned profits, lie trapped within the spread. The difference between the ask and bid prices can turn huge gains into tiny ones - or even losses. Unfortunately, we’re at the mercy of the spreads… and market maker manipulation.
The market makers’ job is to make bid/ask prices as tight as possible, giving us the best, most competitive pricing. But if they’re not right on top of these price movements, well, we don’t get a chance to cash in.
But here’s the good news: While the market makers manipulate spreads, and trim our gains, it doesn’t mean we can’t beat them. Today, I’ll show you the best way to never lose out on the spread… and get the prices you want.
Here’s How You “Limit” the Market Makers Manipulation
Let me explain.
I execute very disciplined limits when I buy or sell options, just so the market makers don’t play games. Ninety-nine percent of the time, the trades I recommend in my covered call service are in very liquid options, and the buying is as easy as the selling. In the case of a D.R. Horton play, my readers made a small profit, but it was harder than it should have been.
Despite being ahead with the January 2008 $25 puts, which I recommended a few weeks ago, I couldn’t wait to get out of it.
According to the options-pricing models that I use, the options should have been trading at least 40% to 50% higher than they were. But because of the liquidity in this particular issue, the market makers manipulated and widened the spread… and slashed my profits. We just barely managed to get out.
But that’s just one example of how a spread can cut into your profits…
Wide Spreads Can Be Good And Bad
Years ago, I sold options on DaimlerBenz (before it was DaimlerChrysler.) They were trading at a high premium. The shares were at $20 and the $15 calls were trading at $7 two months before their expiration.
I thought I was in heaven - remember, I love deep in the money covered call trading. I bought the stock and I hit the bid. After an hour and several calls to my broker, the market maker honored the price and the order was filled. Immediately, the market maker corrected this overlooked bargain and the option dropped to $5.25 for a premium of only $0.25 versus $2. I snuck in just in time.
It was one of the few times I have been able to catch the market maker asleep at the switch.
Unfortunately, it is usually not in the investor’s favor.
Once I made the mistake of executing a very large trade based on the options prices on my screen. After buying the shares, I sold the options. But, instead of filling the order for 100 contracts at the quote I had, only 10 were filled. Several minutes passed, I got upset, and canceled my order with the intention of re-entering it in a few minutes.
The minute I cancelled, the bid that was good for 100 contracts suddenly dropped 20 cents. The offer did not change. Now I could either sell at a lower price or hold on until another day. Meanwhile, the share prices actually edged UP a few cents.
Expect Future Improvements
The options markets are not as easy to trade as the stock markets. But this is changing. Ten years ago, I would run into a problem with 10 out of every 100 trades. Today I may encounter just one.
Because of increasing competition in the market by new exchanges, and more investors getting involved, the pressure is on to create a more efficient and reliable market. They’re just not up to snuff when it comes to regulations. But regulators will be forced to monitor the market makers manipulation more closely. It just may be awhile.
I believe that the options market is less than five years away from becoming as dependable as the major stock markets. Until then:
- Use a limit price
- Or limit orders
- And take your time.
If you’re trading liquid options, you will get your orders filled most of the time. Try it - you will be pleasantly surprised.
Good trading,
Karim
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of words like “market maker” or “spreads” found in today’s article.
- For more on Market Makers, check out Smart Profits #243, Market Maker Survival: The Options Pit “Caste System” Revealed
Related Articles:
- Liquidity & Limit Orders: An Option Balancing Act
- Limit Orders vs. Naked Puts - Getting Paid to Place Them On Your Favorite Stock
- Limit Order Diligence - How to Limit Your “Excitement” for Winning Trades
Stock Options Books
August 24, 2005
The Smart Profits Report: Issue #236
Wednesday, August 24, 2005
Stock Options Books: How to Get the World’s Best Options Book - Free
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Homer’s Iliad, Tolkien’s Silmarillion, Kipling’s Jungle Book, Herbert’s Dune, the Options Clearing Corp.’s Characteristics and Risks of Standard Options… Which one would you rather sit in your comfy chair and read on a rainy Sunday afternoon? If you picked the last one, I have to congratulate you for being a dedicated investor. You will do well in life and your children will be prosperous, and… well, get a life!
I’ve read hundreds of stock options books, wasted thousands of dollars looking for something I could give to a beginning options trader with a clear conscience. Even the best ones skip over key insights as they focus either on explaining the mechanics of trading or obscure points of questionable systems.
What they all lack are the ground-level practicalities that investors new to options need to know. For instance, none of these books explains how or why to use limit orders, yet that’s a key tool every professional trader knows. Nor do any of them talk about the role of the market maker in any helpful depth, as we have in this space.
That said, of all the books, pamphlets and other material I’ve read about options, the "Characteristics and Risks of Standard Options" is actually at or near the top of the list. And I’ll tell you in a second exactly how to get your own copy free of charge.
Before I give details, let me first address the issue of options books in general. Specifically, why do they tend to be so damned boring?
If Books Could Kill, They’d Probably Be About Options
Yep, "Characteristics" is the best… But it, too, is also a tad boring - even to someone who enjoys options. Not that the other books and pamphlets about options are any prizes, including the many attempts to jazz up the subject and make it easy to read.
Serious books on investing in general are about as exciting as shaving corns from your big toe. Options books are worse. Not only ugly, but downright painful, as well.
They are written, for the most part, by academics who frown on excitement. After the first few pages, you find yourself scouring the trash can looking for the receipt so you can get your money back. If publishers of these books were smart, they would make sure that there was no money-back guarantee.
Rockets Are Exciting, But Who Wants to Read a Physics Textbook?
It’s not the subject matter’s fault - well, not entirely.
Options are a very exciting investment tool, but you really do have to be a techno nerd to grasp each and every nuance and formula involved in understanding the value, trading and performance characteristics of options. The theory of options is abstract and math-driven. No fun to read at all.
So, instead you have me.
I do the dirty work for you, the boring reading, plugging in numbers to get hypothetical outcomes, trudging through the highly entertaining and humorous writing style of someone who probably still has his first grade homework in a plastic sleeve, and then I will try to relate what he/she is saying to you, but in English.
In the meantime take my advice and get the free guide by contacting one of the options exchanges. Or you can just contact the Options Clearing Corporation directly (contact information is in today’s Crib Sheet, below).
It’s a valuable little book - and you can’t beat the price.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- To get your copy of Characteristics and Risks of Standard Options, just call 888.OPTIONS, or write to the Options Clearing Corporation, One North Wacker Dr., Suite 500, Chicago, IL 60606.
- To learn more about any options terminology used in today’s report, just check out the Smart Profits Glossary.
Related Articles:
- Options Books for Serious Traders
- Options Trading Books: The Only Realistic Options Book at Barnes & Noble
- The Smart Profits Report Recommended Option Books Listing
Secrets to Getting Started In Options
August 11, 2005
The Smart Profits Report: Issue #233
Thursday, August 11, 2005
Secrets to Getting Started In Options
By Karim Rahemtulla
Chairman, Mt. Vernon Research
As I pointed out in the last letter, being mature, sensible and experienced is not the magic secret to getting started in options. Many brokers make it hard for you to get in. And when the salesman - I mean broker - that you deal with isn’t comfortable with options himself, expect lots of resistance.
There are times when Smith, Smith and Smith will tell clients in the Roanoke office they can’t trade options, yet the same firm’s Boston office is approving people just like them.
I’ve heard from investors with million-dollar portfolios who were turned down. They could easily afford to put some of their money to work at higher risk for higher potential returns.
Most of the time, it’s the broker who is wrong. Occasionally, the broker is right. The customer who is on the phone with panicked questions every time one of his stocks drops 50 cents is not going to be a good options candidate. If you’ve been over-nervous and showing it, better cure that habit before trying to get an options account.
But if you are ready to go and the broker is the only thing standing in the way, then fight back. Even if you’re an experienced options trader, you can use the three techniques below to ensure you get the treatment you deserve from your broker…
Let’s take a look…
#1: Fire Every Broker Who Gets in Your Way
Okay! Getting started trading options can present some challenges. That’s reality, but it’s not very hard to overcome. So what can you do if you want to trade options but are rebuffed by your firm? Plenty.
First, check with two or three brokers. Each brokerage firm is different. They want your money and some may be willing to cut some slack when it comes to qualifying you. This is the best way to get in. It’s quickest and costs the least amount of money and time while you make your point.
But if that doesn’t work, you will have to establish your reputation by proving yourself a trustworthy customer. (Of course, you are a trustworthy customer, but I mean from the brokerage’s viewpoint - one who presents no trouble and keeps sending money.) So your second choice if you’ve been locked out of the options world is to force your way in…
#2: Break Down the Door to Options Trading…
If you didn’t find a willing broker by shopping around to several, go to the second strategy. Set up an account that allows you to trade covered calls - at least you will now have a starting point and be in the options system.
Once you have that account, you should start with very low-risk covered call trading. This means buying 100 shares of a steady company like GE and selling a very deep-in-the-money call against it. You may only make 1% or 2% on this trade, but you will begin to develop some options history.
#3: Or, Take Your Business to a Seasoned Pro…
Finally, once you’ve gotten established, even if it’s just with covered calls, you can go to a better solution. Contact broker Greg Long at GunnAllen Financial (800.329.1984) and see if you are qualified to trade options with his firm.
You will still have to qualify, but you won’t be dealing with a wet-behind-the-ears beginner. Greg has been in the business for a long time and gives the kind of service you’d want, even if you were so experienced any broker would beg you to do business with him.
Once you’ve developed your history, you can answer that all-important “experience” question on the form truthfully by saying that you do have options-trading experience. That will open the door to trading all types of options in the future - including the ones that can produce triple- and even quadruple-digit returns.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Above I talk about using a broker like Greg Long at GunnAllen Financial. Greg’s a very solid guy and I personally use his company’s services. You can call Greg at the number I mentioned earlier, or visit GunnAllen.
- If you’re new to the world of options trading, or even if you’ve been around awhile, all the terminology can get a bit confusing… To help keep it clear, use our free, online Smart Options Glossary.
Related Articles:
- When You Don’t Get Filled, This Broker Can Help
- How to Get the Best Price on Your Options
- Smart Profits Report Recommended Brokers Listing
How To Effectively Handle Any Broker
August 9, 2005
The Smart Profits Report: Issue #232
Tuesday, August 9, 2005
How To Effectively Handle Any Broker: Secrets to Getting Started In Options
By Karim Rahemtulla
Chairman, Mt. Vernon Research
You’ve never seen this written anywhere, but if you’ve looked into trading options, you’ve heard it, even if phrased with devious politeness…
- “You don’t have a clue about options. For that matter, you don’t have a clue about investing.”
- “I do. I am a broker. To get to where I am, I had to pass an exam, on my third attempt. And, now I can tell you if you are qualified to trade options.”
- “What? Don’t you get it? You don’t understand money unless you are a broker. Oh, by the way, if I screw up, then you MUST use arbitration (run by a committee of insiders who love my company) to try and recover any funds from me…”
If nobody ever said those exact words to you, be sure it’s exactly what 99% of brokers think. That, in my opinion, is what the disclosure SHOULD say at the bottom of every stock and options agreement that you must sign before you can trade. And you might even throw in this:
- “Good luck, and thanks for leaving your hard-earned money with me to control - and, of course, collect a piece of - every time you decide that you know better.”
Fact is, I talk to people all the time at trading conferences (like the one I’m at now in Vancouver) who have yet to trade their first options contract… If you’re in their position, today’s report could save you some serious grief getting started. But even if you’re an experienced options trader, I’ll reveal how you can more effectively handle any broker.
Let’s get right to it…
You’re Bright, Rational and Have the Money… Not Enough!
You would think that a 50-year-old person of sound mind and body with 30 years of investing experience would know more than an 18-year-old just out of high school.
But, no, brokers are often in a position to say that YOU just may not be “suitable” to trade options. And while there are good brokers out there, the majority of brokers are just not qualified to determine your suitability to trade options.
Yet they do, and on a regular basis…
The suspicion that every customer is incompetent is a rampant myth in the brokerage world.
It’s rather like getting that first job. To get one, you have to prove you’ve done well at your last job, so you have to get a job to get a job! If you have never traded options before, you may not get the chance to participate in this emerging market until you can prove you’ve participated before.
The Process Begins With You on the Defensive
Here’s how it works: In order to trade options, you must fill out an application. The application asks you pointed questions. And, unless you answer that (1) yes, you are willing to lose everything and (2) you won’t get upset if you do and (3) you won’t sue the brokerage firms regardless of how negligent they are, you’re in trouble. Chances are you will not be allowed to trade any options except covered call plays.
Okay, so I am exaggerating a bit. A little bit. In reality, the options agreement is reviewed by each firm’s options department to see whether you should be allowed to trade different options strategies. You may be able to buy puts and calls, but not engage in straddles (I’ll explain a straddle in a later issue.)
But more likely, as a beginning options trader, you may not be allowed to do anything except trading covered calls. Why? Because there is absolutely no risk to the broker if you are trading against a stock you already own.
At the start, your chances are best if you have had a regular account for a while, have plenty in it and are willing to sign the form saying that you are willing to lose money and understand the risk.
Some brokerages make it hard. Others make it easy.
So, You Wanna Be an Options Trader…
But ask yourself this question: “If I’m squeamish about playing options, do I really want to do this?” Options are higher-risk than stocks. When you buy a stock and it goes south, at least you have your shares and can unload them to recover part of your money. Very few stocks go from good to zero in a day. But options can.
Think hard about how much risk you can stand. If you can take a little bit of a hit, then the broker is probably right. Covered calls are probably your best strategy.
But what if you’re all set to go mentally and the broker still stands in your way? Then you have to take charge. I’ll tell you how to get around this hurdle in the next report…
Good trading,
Karim
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Related Articles:
- Why Your Broker Drives a Porsche and You Drive a Chevy
- Why Choose A Full-Service Broker: Get Your Option Prices Filled Everytime
E-Minis & ETFs
August 2, 2005
The Smart Profits Report: Issue #230
Tuesday, August 2, 2005
E-Minis & ETFs: “Trade” E-Minis With Less Risk Using ETFs
By Lee Lowell
The E-mini Futures on ETFs like the S&P 500 (ES) and the Nasdaq (NQ) have completely taken over as favorite vehicles for day traders and short-term swing traders.
It’s easy to see why: great movement, ease of entry and exit, completely electronic, and relatively low commissions.
It’s fun, exciting, and simple to trade. I didn’t say “simple to make a profit,” I said simple to trade. There’s a difference.
Easy to Trade, Harder to Profit
The smallest-tick movement on the S&P E-Mini (ES) is 1/4 of 1 point.
For example, as of this writing, the September S&P 500 E-Mini Future (ESU5) is trading at 1234.50. The next possible trade could be 1234.25 or 1234.75, 1/4 point either way.
That 1/4-point movement is the equivalent of $12.50. In the NQ E-Mini Futures, the smallest tick is 1/2-point and that equals $10. The current price of the September Nasdaq E-Mini Future (NQU5) is 1605.00 and the next trade could either be 1604.50 or 1605.50.
Those small dollar movements are enticing to many traders because they will try to scalp anywhere from a quarter-point to 1 point on many contracts, many times during the day. Sounds easy, but it isn’t for some. I’ve tried it and it never works for me. I put in my dues and realized that this was not the market for me.
How to Mirror E-Mini Performance With Increased Safety
For people who would like to get into the game of E-mini Futures trading, but are afraid of the size and dollar value, there are a few alternatives. The two most common ETFs (exchange traded funds) are the SPYs and QQQQs.
These two ETFs mimic the movement of the S&P 500 and the Nasdaq Composite Index throughout the day. ETFs trade just like stocks and can be bought and sold all day long in any amount of shares.
The good thing about ETFs is that you can figure out the equivalent amount of shares it takes to duplicate the E-mini Futures, and you don’t have to open up a separate futures trading account, as you would when trading E-mini futures.
You can trade ETFs right from your stock brokerage account. The current price for the SPY is $123.50 and the current price for the QQQQ is $39.40.
Based on the equivalent ratios, I calculated that 500 shares of the SPY equals 1 ES E-mini future, and 800 shares of the QQQQs equal 1 NQ E-mini Future. That’s a great thing because now you can tailor your trading size based on those ratios.
If you’re comfortable trading smaller amounts of shares, you now know that 250 SPYs would equal 1/2 of an ES E-mini future, or that 200 QQQQs would equal 1/4 of an NQ E-mini future. This way you’re not stuck just trading the E-minis, and you can lower your risk levels when you don’t feel as confident in your market bias.
I’ve also calculated the equivalent point ratios. Ten full ES points equals 1 full SPY dollar. For instance, if the ES were to move from 1234.50 to 1224.50 (10 points), the SPY would approximately move from 123.50 to 122.50. So if you were trading 1 ES E-mini future, that move of 10 points would equal $500, and the full dollar move in the SPY would also equal $500 if you were trading 500 shares.
For the NQ E-mini future, 40 full NQ points equals 1 full QQQQ dollar. A move in the NQ from 1605 to 1565 would equal $800 on 1 contract, as would a move in the QQQQ from 39.40 to 38.40, assuming you are trading 800 shares of the QQQQ.
E-minis and ETFs - Perfect for Options Traders
The last great thing about the E-mini Futures and ETFs is that many of them now have options associated with them. The QQQQs, SPYs, ES and NQ all have options trading available. This is a great thing because you can really tailor your risk/reward levels to an even greater degree - using LEAPS, covered calls, etc. - plus you get all the leverage associated with options trading.
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Today’s Smart Profits Cribsheet
- There are many more E-mini futures contracts and ETFs available other than the ones I’ve discussed here. One of my favorites is the $5 Mini Dow Futures and Options. These trade under the symbol of YM. The equivalent of the Mini Dow is the DIA. This is another ETF based on the movement of the Dow Jones Industrial Index.
- To get an idea of just how many other E-mini futures and ETFs are available, go to www.cme.com and www.amex.com to see the lists of other products offered. There’s probably one for almost every sector out there today and your choices are huge. Take a look. You’ll be pleasantly surprised.
- Log onto our handy Smart Profits Glossary if you’d like more information on any terms used in today’s report, like “ETFs” or “futures.”
Good Luck…
Lee
Related Articles:
- Index Options - A Billionaire’s Trading Tool Anyone Can Use
- Trading Index Options - Two Ways to Profit
- Deep-In-The-Money Covered Calls - How to Beat Stocks with Way Less Risk
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