Short-Term Options
September 29, 2005
The Smart Profits Report: Issue #246
Thursday, September 29, 2005
Short-Term Options - Two Ways to Make Them Work
By Karim Rahemtulla
Chairman, Mt. Vernon Research
A couple of letters ago, I wrote that I used short-term options for event-specific investing. Short-term options, as opposed to LEAPS, lose value very quickly because they’re close to expiration. They are a far riskier bet on the movement of the underlying share price.
The example I gave for my most recent short-term option play was buying put options on insurance giant Allstate just before Hurricane Rita was upgraded from a category 1 to a category 4. That was for a protective trade. I also bought some short-term QQQQ put options in case of a worst-case scenario for the markets.
The Allstate trade returned triple digit returns. The QQQQ trade broke even. There are other situations where short-term options make sense. And these are centered on earnings releases.
Today I want to tell you about the only other ways I’m comfortable trading short-term options.
Quick Profits Using the Experts’ Homework
The markets today are NOT very volatile. In fact, they are pretty range-bound, with most indexes up less than a few percentage points on the year. But a range-bound market does not imply less volatility in certain situations.
The only other methods that I feel comfortable with when it comes to short-term trading of options is using technical analysis and quantitative research.
Lee Lowell takes a technical approach, looking closely at volatility to check on whether an option is a bargain or too expensive. Volatility is one of six variables used to price options, but it’s the only one that’s not universally accepted by all market participants. So it’s a must-know factor.
Calculating options volatility can be done in various ways. Some traders like to use a 10-day, 30-day, or 50-day historical volatility in pricing options, while others like to use the current at-the-money implied volatility of the front-month options. However it’s calculated, the idea is to buy when the volatility is low.
Quantitative research is the machinery behind Dean Albrecht’s ESP Profit System, which predicts stock movements based on leading indicators, moving averages and price momentum. The system filters the stock universe using three strategies - stock correlation, cycles, and distressed or event-driven swings.
Short-Term Options Strategies For You
It’s a focused, finely tuned data machine that crunches dynamic market behavior and produces an easy-to-follow indication of future price movements. And it’s geared toward big, short-term profits.
Because both methods use the least amount of subjective criteria, they eliminate the "emotional" short-term plays that often result in losses.
In the coming weeks, we will explore some of these short-term trading strategies in more depth, and explain the mechanics of how the experts use these systems.
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Today’s Smart Profits Cribsheet
- Check out our Smart Profits Glossary if you have any questions about terminology used above like, "short-term options" or "volatility."
Good trading,
Karim
Related Articles:
- How to Beat the "Volatility Premium" on Options
- Using a Probability Calculator - Know Your Trade’s Exact Chance of Success Up Front
- How I Use ESP to Make Millions for My Clients
Implied Volatility
September 27, 2005
The Smart Profits Report: Issue #245
Tuesday, September 27, 2005
Implied Volatility: The Impact of Beta on Your Option Positions
By Mark Whistler
Research Analyst, Mt. Vernon Research
If only we could predict emotional reactions of people in stressful situations - life would be so much easier.
Just imagine if people had volatility meters… something like a little number on their chest that alerted you to the way they generally react to conditions. A volatility reading of “1″ would indicate the person is rational. Anything below hints that they are very mellow, while a number above 1 alludes to the fact that the person you’re dealing with generally overreacts in any situation.
Your Uncle John would probably have a volatility reading of 1.5, indicating that he generally reacts excessively to any given situation by 50%. He’s tough to go anywhere with. Aunt Peggy has a volatility number of 0.5. She’s half-interested in anything you say. Sometimes you wonder if she even has a pulse.
Though in reality we don’t have volatility numbers for our families, we do have a volatility number for stocks - and it’s called implied volatility or beta. Today I’m going to explain exactly how to use beta as a volatility meter… and how to then use that volatility meter to greatly improve your chances of making money at options. Let’s get right to it…
Beta’s Relationship to the S&P 500
Beta is a statistic that measures an underlying stock’s volatility (risk) in relation to the broad market. It tells us if a stock is more volatile or less volatile than the S&P 500.
- If a stock has a beta of 1, its price moves as much as the S&P.
- A beta greater than 1 means a stock is more volatile than the S&P.
- A beta below 1 implies less volatility.
It’s really very simple. If a stock has a beta of 1.5, than it’s 50% more volatile than the S&P on any given day. If a stock has a beta of 0.50, it is 50% less volatile.
(It’s very important to note that while beta attempts to predict a stock’s volatility in relation to the S&P 500, it doesn’t ALWAYS do so. By this, I mean that even if a stock has a beta of 1.5, it won’t always move 50% more than the S&P.)
In general, safer, slower stocks like utilities have lower betas - usually less than 1. More risky equities though, like Internet stocks, have betas greater than 1.
Pay Less for Options Using Beta
So how can beta help in options trading?
First, remember that beta is a measurement of volatility. When volatility is low, premiums are also mundane. But when volatility is high, options cost more. Why? Higher volatility means there is more risk that the option will be exercised. Thus, the writer of the option will generally demand additional premium for the risk he is taking on.
In the Black-Scholes Model, volatility is measured as the annual standard deviation of the stock price, otherwise known as “statistical volatility” - don’t get it confused with beta.
Beta is “implied volatility,” meaning it is volatility in relation to the current market consensus of the stock, and can be specifically insightful when it comes to “at-the-money” options. If you’re thinking about purchasing an at-the-money option, and the premium is excessively high, more than likely, the stock has a high beta.
So in flat markets, if you have significant insight into a stock, and are fairly sure of its movement before expiration (and the stock has a low beta), you’ve probably found a particularly tasty position, because you will generally pay less in premium.
Watch Out for Low Betas…
Of course, a lower beta indicates more risk, as the underlying stock will most likely not have any dramatic moves. You should be certain of your reason for implementing the position before making any transactions.
In addition, if you implement a position in a LEAPS with a low underlying beta - and you are SURE (read: you’ve done your research) the stock will slowly hit its strike several years out, you’ve probably made a good decision, as the premium will most likely be low.
Remember that beta is a measurement of an underlying stock’s implied volatility and gives you insight into a stock’s potential volatility.
Simply put, you wouldn’t want to buy a short-term, deep out-of-the-money option where the underlying stock has a low beta. While the option would certainly be cheap, the stock would probably never move enough to make your option position worth anything.
Good Trading,
Mark Whistler
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Today’s Smart Profits Crib Sheet
- Check out our Smart Profits Glossary for more information on such terms as “beta” or “implied volatility.”
- For more on the relationship between beta and implied volatility within the options markets, check out Smart Profits #188, Understanding Options Risk: How to Beat the “Volatility Premium” on Options.
Related Articles:
- Option Volatility: A Free Tool for Finding the Best Option Bargains
- Stock Market Volatility: Three Ways to Combat Volatility’s “Radical” Shift
- Fast and Furious Volatility is Back in a Big Way: How To Profit Using Leg Spreads & The VIX
Event Driven Markets
September 23, 2005
The Smart Profits Report: Issue #244
Friday, September 23, 2005
Event Driven Markets: The ONE Case for Using Short-Term Options
By Karim Rahemtulla
Chairman, Mt. Vernon Research
It never fails… Whenever I leave town for a seminar or meeting over the summer, a hurricane pops up on the screen. As a Florida resident who suffered through four hurricanes last year, my anxiety level always increases between August and October.
I recently spoke to friends in New Orleans who are just now tabulating the damage left by Katrina, only to be told that they must re-evacuate because of Hurricane Rita. The damage from Katrina devastated not only the poor, but all strata of New Orleans society.
The other certainty regarding hurricane season is massive market volatility. The only time I advocate using short-term options is during event driven markets.
Triple-Digit Option Profits Shorting Allstate
This year we are seeing the energy markets go bananas on a daily basis. The other sector that gyrates is the insurance sector. Last year I wrote about my “hurricane play,” shorting insurance companies like Allstate, using short-term options.
This year, again, I have bought short-term puts on Allstate. And this year, again, I have been able to record triple-digit profits in a very short time.
However, these are returns that I am not looking forward to. I use the puts on the insurance companies, and others that I buy on the major indexes, as hedges against losses that might occur in the rest of my portfolio.
So what might sound like a macabre recommendation at the outset actually becomes a smart way to hedge against personal financial catastrophe.
Don’t Be Paralyzed by Events
Options are important investment vehicles that are often overlooked by paralyzed investors during crisis situations. It is critical that you learn about and use these vehicles, as I do, during times of uncertainty and crisis.
Short-term options are risky investments, to be sure, but one can argue that not having insurance is even more risky.
Good trading,
Karim
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “put options” or “hedging” found in today’s article.
- For Karim’s article from 2004 about his “hurricane play,” check out Smart Profits #140, Damage Control: The Perfect Option Play for Hurricane Season.
Related Articles:
- How to Use Puts and Calls: For Systematic Short-Term Profits
- LEAP Option Investing: The Best Options Play on eBay
- Option Investing: The Hottest Ticket On Wall Street
Market Maker Survival
September 20, 2005
The Smart Profits Report: Issue #243
Tuesday, September 20, 2005
Market Maker Survival: The Options Pit “Caste System” Revealed
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
So you want to know what market maker survival is all about? What it’s like being a market maker? Well, you’ve come to right place… I spent many years as a market maker on the floor of the New York Mercantile Exchange (NYMEX).
And today, I’m going to give you the breakdown of how a market maker thinks, acts and operates when an option order hits the pit. On top of that, I’ll explain the fierce Darwinian struggle that takes place day in, day out at markets like the NYMEX.
This will give you a better understanding of who’s taking the other side of your trade, and why that person isn’t always trying to “take you.” You’ll also see who holds the advantage in getting your options orders filled.
Remember, these facts and stories only apply to my experience during my days on the NYMEX. Let’s get right to it…
How Market Makers Are Like Gladiators
First, we need to understand the makeup of the options pit and how market makers fit into that arena. Believe it or not, there is a sort of hierarchy, or caste system, that prevails in the options and futures pits.
The days of a newbie market maker are not all that much fun. You are essentially the low man on the totem pole in that ring. You need to prove yourself not only to the other market makers, but to the brokers as well.
An options or futures pit on an exchange floor is made up of three or four concentric circles, with a raised rim or step along the outer edge of each circle. Each circle is elevated higher and wider than the next so there are people standing on higher or lower steps in relation to their front-side or backside neighbor.
Just think of a sports stadium without the seats, where everyone has to stand instead of sit.
These steps form the pit hierarchy. The brokers are the ones who get to be on the highest step. This is because they need to be near their phones, which are installed in small wooden booths that align the outer edge of the top step. The brokers are the ones who have all the orders. They get their orders from either retail customers (you and me), or from their in-house traders who take positions for the firm (Goldman Sachs, Merrill Lynch, Citibank, etc.), or from other big institutional firms.
Stay Close to the Brokers
Make no mistake, you want to be in good with the brokers, and you want to be as close to them as physically possible. A market maker is only as good as the amount of orders he/she can get involved with. If you’re a market maker and you don’t make any trades, how are you going to make any money?
To make sure they do, here are two of their missions:
- Just try to survive.
- Eventually move yourself up in the pit to be as accessible to the brokers as possible.
Sounds easy, but it’s not. You have to contend with other market makers who have been standing in the same spot for years, and they’re certainly not going to let some green rookie take their place.
Why You Want Your Broker to Be Big and Loud
I remember the first two words I heard the very first day I stepped into the pit as a market maker, “fresh meat.” That’s right, market makers and brokers will prey on the new guy as a sort of initiation. It happened to me, and will most likely happen to every other new guy as well.
Most of the new market makers will start on the lowest step, which is the farthest place from the brokers, or they just try to squeeze into a space wherever they can. Being timid or shy at this point is not a good thing. You need to assert yourself as quickly as possible.
I think the exchanges are one of the last places in the work field where being physically big and loud has a huge advantage for you. That is what gets you noticed. That’s why sometimes you’ll see many former ball players getting jobs as brokers or other types of floor traders.
How Market Makers Survive
Nevertheless, all new market makers will be feeding off the scraps of orders that were not taken by all the bigger, faster, louder and more senior traders in the ring. You take what you can get at first and work your way from there. It’s tough being at the bottom, but if you’re good, you can move up quickly.
So there’s the true insider view of the options markets and how the market makers survive. As you can see, they’re just guys trying to make a living. And if you have a good one working for you, he can help you make a good deal of money, as well.
In the next installment of this semi-regular series on market makers, I’ll explain exactly how an option order gets filled from start to finish, and how the market maker fits into that equation.
Until then…
Good trading,
Lee
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Today’s Smart Profits Cribsheet
- For more of my background in the NYMEX, read Smart Profits #241, Market Makers - Hand Signals, Stress and Million-Dollar Trades.
- Check out the Smart Profits Glossary for definitions of “NYMEX” or “market maker” found in today’s article.
Related Articles:
- Fair Value Sheets: Quote, Trade and Hedge… In Less Than 30 Seconds
- Market Maker Manipulation: Are Market Makers Playing Games With Our Profits?
- Options Market Makers: Two Rules for Beating the Market Makers
Smart Profits Quiz
September 16, 2005
The Smart Profits Report: Issue #242
Friday, September 16, 2005
Smart Profits Quiz: Test Your Options Knowledge
By Karim Rahemtulla
Chairman, Mt. Vernon Research
You’ve been reading this newsletter for some time now… And just aching to jump into some trades - LEAPS, puts, calls and more. Options greatness is just around the corner… At least I hope so.
But just to test the water, I’ve put together five questions to keep you on your toes, just to see how far we’ve come.
Take a moment to take this Smart Profits quiz. When you’re finished, hop down to the answers below to see how “smart” you really are… Good luck.
Smart Profits Pop Quiz
- What is covered call writing?
a. An option bought over the phone with your broker.
b. Buying a stock and selling options against the same issue.
c. The printed contract you receive in the mail after your trade is placed.
d. A paper trading exercise your broker requires before you’re given an options account.
- What are LEAPS?
a. Call or put options that don’t expire for at least nine months.
b. A contract with a “bridge” feature for down-market trends.
c. “Leveraged Agent Put Signals”
d. “Leased Earnings Price Swap”
- Say you purchased a November $30 put on XYZ, and it cost you $1.50. What happens to the value of that put when XYZ has a strong week and trades at $35?
a. It powers forward at a greater pace due to its increased leverage.
b. Your put’s value stays the same because it doesn’t expire until November.
c. The IRS calls you immediately.
d. The value decreases.
- What’s the best way to place an options order?
a. Use limit orders.
b. Only buy options with expirations more than a month away.
c. Pay less than $40 in commissions.
d. Up your buying power with a lump sum from your 401k.
- Which of the following is an advantage of buying call options?
a. They give you the right to sell a stock before you lose.
b. Buying calls gets you more respect in the trading world.
c. Calls let you buy expensive stocks at a fraction of the cost.
d. Calls require less attention than stocks because of their smaller price movements.
Answers:
1. B: Covered call writing is a way to take advantage of options’ risk-reducing functions. We do this by placing two trades: 1) We purchase the actual stock, and 2) we sell options against that same stock (I like selling deep-in-the-money calls). Now, we’re not only reducing our cost (reduced risk) of the first trade by adding money in our accounts, we’re also poised to win if the stock moves higher, lower, or even stays flat. Revisit Smart Profits #128, Writing Covered Calls - How to Double Your Stock Profits with Options or check out our Smart Profits Glossary for more on covered calls.
2. A: LEAPS are Long-term Equity Anticipation Securities - they are no less than nine months from expiration. They are great for taking a position in a stock you “anticipate” moving higher over a longer period of time, and, like all options, they allow us to use less cash up front than stocks. There’s a strategy I really like called Swap Trading that uses LEAPS, which I explain in Smart Profits #159, LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns.
3. D: Your put value decreases because it represents the option to sell the underlying stock at $30. If the stock headed south, for example, and hit $25, then our option to sell it at $30 would be pretty attractive, and would give us a healthy win. I talk more about buying puts in Smart Profits #102, Put Options: Why Short a Stock when You Can Buy a Put?
4. A, B and C: These are great tips. For examples of these three winning rules for placing option orders, and one other one, see Smart Profits #212, Beating the Market Makers: Never Pay Full Price.
5. C: Call options are great ways to get into a position without using a lot of your principal. Let’s say I like stock XYZ again, and it’s trading at $100 per share now, with the January 2007 $120 LEAPS trading at $1.75. If I want 500 shares of the actual stock, we’re talking about a very big number just to get in - $50,000, to be exact. But, if I buy the LEAPS option, my cost to get in just dropped to $750 to control the same number of shares. That’s a big difference! Check out Smart Profits #101, Call Options: Why Would Anyone Buy A Call?
What’s your score?
5 - Hedge Fund Manager
4 - Options Analyst
3 - Account Maintenance Specialist at your favorite brokerage firm
2 - Trading Workshop Attendee
1 - Run to the doughnut shop to get your superior’s coffee and crullers.
Good trading,
Karim
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Related Articles:
- Option Investing: The Hottest Ticket On Wall Street
- Basic Trading Rules: The Four Rules of All “Smart Money”
- Option Trading Strategies - Option Plays That “Earn” Their Keep
Market Makers
September 9, 2005
The Smart Profits Report: Issue #241
Friday, September 9, 2005
Market Makers - Hand Signals, Stress and Million-Dollar Trades
By Lee Lowell
Investment Advisory Panelist, Mt. Vernon Research
Bottom line: Market makers matter…
If you’ve been reading the articles that I’ve written for the Smart Profits Report, you know that I was a market maker in the crude oil and natural gas options pit on the floor of the New York Mercantile Exchange (NYMEX).
These are commodity options that I’m talking about. So all of the facts that I tell you here today only relate to my experiences at the NYMEX.
I know many traders are somewhat familiar with the idea of market makers from the stock exchanges, and I believe they function a little differently from the guys in the commodity option pits. They also get more airtime from the media, so that’s why the public hears about them more.
But we’re all performing similar functions - and it’s important for any options trader to know exactly what those functions are… Why? Because without knowing exactly what market makers do, you’ll never be able to beat them at their own game - making money on the options markets.
Today, I’ll tell you how the market maker gets paid, where he fits into the options world in relation to you… and why it’s important to understand it if you want to consistently make money in options. Let’s get right to it…
A Hard-Earned 50/50 Split
The market maker generally comes in two types: One that works for a market-making firm, or one that works for himself. I had the distinction of doing both. A market-making firm can be a large company, or wealthy individuals, who will hire traders to become market makers for them in different commodity pits.
Examples of firms like this are Susquehanna Investment Group (SIG), Chicago Research & Trading (CRT), or the one I was employed by, First Continental Trading (FCT). FCT was started by an individual who made lots of his money by trading in some of the Chicago markets. He then hired other traders to work - and make money - for him.
The market-making firms put up the financial backing for these other traders. By that I mean, the actual market makers need to have an account in order to trade on the exchange, and that account needs to be funded. The firm puts the money in the account and lets the market maker go to work.
A typical agreement would have the market maker earning a small monthly draw for living expenses, and then all the trading profits (if there were any) would usually be split 50/50 after expenses. A pretty sweet deal to have someone drop a few hundred thousand dollars into an account for you to try and make more of it. It takes a very confident (and wealthy) person to allow others to use his money on market-making activities.
The market makers are spread out amongst the various pits on the exchanges so the firms could have a wide exposure to all the different markets. I worked in the options pit, but we also had guys working in the futures pit as well. (I will explain the relationship between those two in a subsequent article.) At the time, FCT was based in Chicago, and already had a set-up in London. They wanted to break into the New York market, and I happened to be in the right place at the right time. They opened up shop sometime in the summer of 1990 just before the first Gulf War had started. I joined them the following summer as the fourth employee of the New York branch.
A Gutsy Proposition Worth 100% of the Profit
The other type of market maker, as I mentioned earlier, is the self-employed type who uses personal money for financial backing. In 1995, I had enough experience to think about being in business for myself… and enough money built up that I didn’t need anyone to fund me with cash. Now I could keep 100% of my profits. An exciting, but scary endeavor… to say the least.
Of course, there was no small salary, no company health insurance, and no other co-workers to share the load with. But it was worth it.
When you become a self-employed market maker, you are usually referred to as a floor “local.” This just denotes that you are an individual and not really associated with any bigger firm.
The way that the market maker gets hired, or actually gets to be a market maker, is different for each company. But the one thing that market makers all have in common is that they have to start out as a floor clerk. If you get hired by one of the bigger market-making firms, your time as a floor clerk could be years. Most of them give the clerks intensive training on their trading philosophy and how to actually learn the mechanics of being a market maker.
I will say that being a floor clerk was one of the most emotionally stressful jobs I’ve ever experienced. One flash of the wrong hand signal (which I’ll also explain in a subsequent article) can cause a loss of hundreds, if not millions of dollars.
These were all lessons I never would have learned without working in the options pit. And of course, next time I’ll show you trading techniques that take advantage of this firsthand knowledge.
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Today’s Smart Profits Crib Sheet
- Check out the Smart Profits Report Site Map for more articles about market makers, like Smart Profits #247, Quote, Trade and Hedge… In Less Than 30 Seconds.
- Check out our Smart Profits Glossary, chock full of over 150 option terms if you are looking for options definitions for words like “market maker” or “liquidity.”
Good trading,
Lee
Related Articles:
- How the Market Makers Lose - Uneven Trades and Open Positions
- What Market Makers Really Do
- Two Rules for Beating the Market Makers
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