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Derivatives Markets

October 27, 2005

The Smart Profits Report: Issue # 254
Thursday, October 27, 2005

Derivatives Markets: “Textbook” Trades Don’t Always Win
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Last week, I spoke to economics students at Rollins College, in Winter Park, Florida, my alma mater. The topic was the derivatives markets - those that deal with futures and options. The professor who invited me was Dr. Harry Kypraios - the same teacher who taught me some 23 years ago.

I tried to think back to my first exposure to derivatives, and how much I hated the topic. I’m sure many of you have kids or grandkids who are in college right now, wishing they could just make it through courses in derivatives, calculus, statistics, etc. These are not high on the favorites list for many of us. I tried to be humorous in my talk, exposing the group to the “real-life” experiences of trading derivatives, versus learning about them.

In the real world, I lectured, derivatives trading is much more complex than theory. There are a host of factors that the textbooks just don’t cover. For example, they don’t mention market makers, news events, market manipulation, uneven bid/ask spreads, bad brokers, bad traders, and contra-accounts that have been the downfall of many trading houses like Barings. Textbooks don’t mention that the derivatives markets are run by a sort of “brotherhood” of traders and exchanges whose motivation is profits… and not advancing education.

Then I explained the importance of cynicism… I admit, it may have been callus of me to reveal some truths about investing at such an early and tender age.

Getting Sacked By An “Enron,” Then Back for More?

Since I received my graduate and postgraduate degrees, I have become much more cynical, too cynical, as my significant other constantly reminds me. I remind her that my cynicism is borne of experience, not from reading too much.

Cynicism is, in my opinion, one of the strongest tools an investor should possess. The market is not made up of cute and cuddly textbook writers who were comfy in their professorial responsibilities before deciding to cave into the pressures of their department chairs and write college textbooks. Rather, it is made up of profit-hungry specialists whose aim is to part you from your money.

Derivatives Markets: Bastions of Wealth

The derivatives markets as well as the other markets are the foremost bastions of the greatest legal transfer of wealth in the world today. Each day you make bets on what you think are wholesome and legitimate enterprises. Then comes the reality - Refco, Worldcom, Enron, Hedge Funds, Mutual Fund kickbacks, non-existent corporate governance. We shake our collective heads, and the next day we start again, blindly pledging our trust to a system that we know is stacked against us.

Cynical? You bet I am. Contrarian? Yes sir, that’s me. It has served me and my readers well to not believe everything we read or hear. I don’t regret a moment of my education, from boarding school in England, to university in the States. What I do regret is the lack of textbook writers who write from experience, with candor and fortitude, and tell it like is… and not like it should be.

Good Trading,

Karim

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Today’s Smart Profits Cribsheet

  • While textbooks don’t beat experience, there is an options book I highly recommend. And you can get it for free… Characteristics and Risks of Standard Options is a valuable title - and you can’t beat the price. To get your copy, just call 888.OPTIONS, or write to the Options Clearing Corporation, One North Wacker Dr., Suite 500, Chicago, IL 60606.
  • Check out the Smart Profits Glossary for definitions of words like “derivatives” or “market maker” found in today’s article.

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Options Trading Strategy

October 25, 2005

The Smart Profits Report: Issue # 253
Tuesday, October 25, 2005

Options Trading Strategy: A Five-Question Screen to Find the Perfect Option
By Dean Albrecht
Advisory Panelist, Mt. Vernon Research

When I speak at options conferences around the country, investors often have questions about how I approach the markets… I mean, where do you start?

There are more than 9,000 publicly traded companies in the U.S., and a good number of them have options. Plus, the broad market isn’t exactly on fire right now; nor is it tanking.

So, how do you find a good trade with so many companies out there…and what type of options trading strategy do you employ…especially when your overall view of the market is neutral?

You have to find a way to narrow your focus.

That’s what I’m going to show you today: how to hone in and isolate options trading opportunities in a sensible way… so that you know why you’re trading (long or short) and how to give yourself the best chance at success.

Start Your Options Trading Strategy Using Three Economic Indicators

First, remember that we can go long or short using calls and puts. Then, ask yourself the following questions before deciding your strategy:

  • Are interest rates moving up or down, and are we close to the bottom or top of the acceptable range?
  • Is inflation moving up or down, and how much farther is there to go?
  • Are commodity prices cheap or expensive, relative to cyclical and historical prices, and relative to future perceived demand?

In terms of defining “acceptable” interest rates, that’s a judgment call, and it’s up to you to decide. Same thing with determining how much farther you think inflation will rise or fall. And where you think commodities as a sector are headed.

Yes, you’ll have to think about these things a bit… But for me, this kind of critical thought is an absolute must if you’re looking to explore options trading and become a great investor.

So what’s next? Well, a few more questions…

ETFs or Individual Stocks? Pinpointing Sectors and Profits

Based on our answers to the first three questions, we should be better prepared to answer this one:

  • What sectors are growing or offering new investment opportunities in light of the three big factors above: interest rates, inflation and commodity prices?

Once you determine a sector that makes sense, you can consider a sector play like an ETF (exchange traded fund), or you can get even more specific. For example, researching one business within a sector. But how do you determine which companies to consider, and which to reject? Ask yourself:

  • Is this just a “cool” company, or does it have a scalable business model that gives it real potential for enormous growth?

I’ve had plenty of “cool” ideas. But most of them never see the light of day, and for good reason. There’s a critical hole in the concept that would keep it from making money in the real world.

Unlike the dot-com boom - when companies had promises, but readily admitted they wouldn’t be profitable for years - 2005 has brought a different type of investor to the ground level. For the most part, today’s investor is looking for profitability. Imagine that: people looking to invest in companies that actually make money, or are looking to make money, in a reasonable amount of time.

Let’s take a look at the potential areas for profits in our trading strategy at this moment…and the companies that have been making us money - on the short and the long side of options.

A 40% Win Shorting Homebuilders

My staff and I are narrowly focused on real estate, car manufacturers and airlines to the short side. And high-end vacation clubs, diamond mining, mobile technology and microprocessors for mobile technology to the long side.

Four months ago, we thought homebuilders were good shorts. We bought put options on several individual stocks in the sector, such as Toll Brothers (NYSE: TOL), Pulte Homes (NYSE: PHM), KB Home (NYSE: KBH) and others. This options trading play has developed fast, with these stocks down as much as 40%.

We’re also looking at the semiconductor sector in our options line of attack. If I were choosing stocks instead of the Semiconductor HLDR (AMEX: SMH) ETF, I would look for microprocessor manufacturers.

Getting a sharper angle on the market can mean finding companies poised to tank and buying puts, or finding companies ready to run and buying calls.

But long or short, you can always find a way into the markets by asking yourself the questions in today’s report. How you answer them is, of course, up to you!

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Today’s Smart Profits Cribsheet

  • Check out the Smart Profits Glossary for definitions on words such as “ETF” or “strike prices” along with articles that help explain these concepts.

Good trading,

Dean

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How the Market Makers Lose

October 20, 2005

The Smart Profits Report: Issue #252
Thursday, October 20, 2005

How the Market Makers Lose: Uneven Trades and Open Positions
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

You might think that market makers are out to get you, but after spending seven years in a NYMEX options pit, I can safely say they have much bigger problems to deal with., such as how these market makers lose money.

Continuing my Market Maker series, I’d like to share some of the hardships these traders face in their day-to-day operations. And I hope it will make you feel better about them.

Today, we’ll look at two issues that can wreak havoc on the option market maker: “one-way” positions and “pin risk.” During my time in the options pit, these two issues were some of my biggest stresses.

Here’s why…

Three No-Win Choices… At the Broker’s Mercy

When an options market maker makes a trade, he usually does the transaction with a pit broker, and sometimes with other market makers. That initial position will give them a long or short directional bias, which they offset with a futures transaction to keep the risk neutral. Besides keeping the directional (delta) risk neutral, option traders also need to balance out their gamma, vega and theta risk. I won’t go into detail on these, but suffice it to say, these are just as important measures of risk as delta.

Many times, multiple brokers in the pit will get very similar orders to take positions in the same options. It is the market makers’ job to take the other side of those trades. When many of the brokers are doing the same trades for their customers, the market makers can end up with lopsided positions, heavily weighted in one direction with respect to delta, gamma, vega and theta. They’re stuck on a “one-way” street.

The Market Makers Position: Long or Short?

This means that a market maker’s position can be extremely short or long options, and that can be very damaging to his profit/loss scenario. But they have no choice. They have to make the markets and trade with the brokers. If the markets end up doing what the broker’s customers thought it would, the market makers are on the other side of those trades… and the losses can add up very quickly.

So, what’s the market maker to do in this case? Often, they have no choice but to ride out the storm and see if the market helps or hurts them. They can also wait to see if the brokers decide to turn tail and unwind all the positions they just initiated. Other times, the market makers are forced to make trades that will balance out their lopsided positions, but at unattractive prices.

Now, let’s look at the second way a market maker can end up too heavy…

Overly Exposed With 100 Open Contracts

“Pin risk” occurs when the market maker has a sizable stake in a conversion or reversal position. These are three-sided trades that include a long and short option position of the same strike price, offset by a corresponding futures trade. The trader is either long a call and short a put with a short futures trade, or short a call and long a put with a long futures position. These are riskless trades that the market makers place for fractions of points, and they only cause trouble when the futures contract settles exactly at the strike price on expiration day.

Let me give you an example…

Let’s say the current price of a November crude oil futures contract is $63.77. Our market maker is long 100 crude oil $64 calls, short 100 crude oil $64 puts, and short 100 futures contracts. On expiration day, if the futures price is above $64, he will exercise his long calls, which will be offset by his short futures contracts, leaving him with a zero position. If the futures price is below $64 on expiration day, he will be assigned on his short puts, which requires the market maker to become long on the futures contracts. Again, this will be offset by his short futures contracts already in the account, thus leaving him with a zero position.

Market Maker’s Choices: To Lose Or Not To Lose

But, what happens when the futures price settles exactly at $64 on option expiration day? Does the market maker exercise his long calls, or does he think that he will get assigned on his short puts? Nobody knows. And the problem is that this must be done by a cutoff time, and there is no way of knowing beforehand what the other side is going to do.

If the market maker decides to exercise his long calls, but also gets assigned on his short puts, he will be long 200 futures contracts that will only be offset by his original short 100 futures position, thus leaving him with an open position of long 100 futures contracts. This is a very dangerous situation. Nobody wants to be left with a large open position like that over the weekend.

If this happens, he’s forced to make a judgment call on how many contracts he thinks will be assigned, versus how many of his long calls he should exercise. He only has 100 futures contracts in this case, so he needs to balance out the amount he thinks he should exercise against what he thinks he will be assigned. Sometimes this is done on a Friday expiration day, and he won’t find out until Monday morning what position he’s left with. It can be very hairy at times.

These are two of the most stressful position-management situations that I had to contend with during my days as an options market maker, and they still trouble many of the traders working on the exchanges today. You might think the market makers are always out to get you, but sometimes they have bigger problems to deal with.

Good trading,

Lee

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=”normal”>The Smart Profits Report: Issue # 254
Thursday, October 27, 2005

Derivatives Markets: “Textbook” Trades Don’t Always Win
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Last week, I spoke to economics students at Rollins College, in Winter Park, Florida, my alma mater. The topic was the derivatives markets - those that deal with futures and options. The professor who invited me was Dr. Harry Kypraios - the same teacher who taught me some 23 years ago.

I tried to think back to my first exposure to derivatives, and how much I hated the topic. I’m sure many of you have kids or grandkids who are in college right now, wishing they could just make it through courses in derivatives, calculus, statistics, etc. These are not high on the favorites list for many of us. I tried to be humorous in my talk, exposing the group to the “real-life” experiences of trading derivatives, versus learning about them.

In the real world, I lectured, derivatives trading is much more complex than theory. There are a host of factors that the textbooks just don’t cover. For example, they don’t mention market makers, news events, market manipulation, uneven bid/ask spreads, bad brokers, bad traders, and contra-accounts that have been the downfall of many trading houses like Barings. Textbooks don’t mention that the derivatives markets are run by a sort of “brotherhood” of traders and exchanges whose motivation is profits… and not advancing education.

Then I explained the importance of cynicism… I admit, it may have been callus of me to reveal some truths about investing at such an early and tender age.

Getting Sacked By An “Enron,” Then Back for More?

Since I received my graduate and postgraduate degrees, I have become much more cynical, too cynical, as my significant other constantly reminds me. I remind her that my cynicism is borne of experience, not from reading too much.

Cynicism is, in my opinion, one of the strongest tools an investor should possess. The market is not made up of cute and cuddly textbook writers who were comfy in their professorial responsibilities before deciding to cave into the pressures of their department chairs and write college textbooks. Rather, it is made up of profit-hungry specialists whose aim is to part you from your money.

Derivatives Markets: Bastions of Wealth

The derivatives markets as well as the other markets are the foremost bastions of the greatest legal transfer of wealth in the world today. Each day you make bets on what you think are wholesome and legitimate enterprises. Then comes the reality - Refco, Worldcom, Enron, Hedge Funds, Mutual Fund kickbacks, non-existent corporate governance. We shake our collective heads, and the next day we start again, blindly pledging our trust to a system that we know is stacked against us.

Cynical? You bet I am. Contrarian? Yes sir, that’s me. It has served me and my readers well to not believe everything we read or hear. I don’t regret a moment of my education, from boarding school in England, to university in the States. What I do regret is the lack of textbook writers who write from experience, with candor and fortitude, and tell it like is… and not like it should be.

Good Trading,

Karim

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Today’s Smart Profits Cribsheet

  • While textbooks don’t beat experience, there is an options book I highly recommend. And you can get it for free… Characteristics and Risks of Standard Options is a valuable title - and you can’t beat the price. To get your copy, just call 888.OPTIONS, or write to the Options Clearing Corporation, One North Wacker Dr., Suite 500, Chicago, IL 60606.
  • Check out the Smart Profits Glossary for definitions of words like “derivatives” or “market maker” found in today’s article.

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Options Straddle

October 18, 2005

The Smart Profits Report: Issue #251
Tuesday, October 18, 2005

Options Straddle: Using A Straddle to Harness “Uncertainty”
By Steve McDonald
Advisory Panelist, Mt. Vernon Research

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…

Here’s the secret:

The solution to profiting from uncertainty is to create an options straddle.

You see, the entire point of a straddle is to allow you to remain in the market, with limited risk, when you aren’t sure which way a stock is going.

Take earnings, for example. Most people, even analysts, can’t accurately predict corporate earnings on a regular basis. And, even if you could predict them, sometimes Wall Street can react in a completely bizarre manor. A stock can have blowout numbers and still go down.

An options straddle is a simple solution to a complicated problem. By definition, a straddle is created when an investor buys or sells the same number of puts and calls, with the same expiration, and same strike price.

The key to an effective straddle is knowing that the stock is setting up to make a “large move.” Think FDA approval, merger or earnings - big events. In these instances, options straddles can help reduce risk, while allowing you to participate in an event that will likely trigger a substantial sell-off, or breakout!

Make a Straddle Work in Reality

On September 1, 2005, Chiron (Nasdaq: CHIR) gapped up (just before the closing bell) from $36.44 to $42.93 on speculation that the company is a tasty takeover candidate. Since then, the stock has been pegged in an extremely tight range, between $43 and $44. It’s hard to say whether a merger might happen. After all, Chiron already turned down a $4.5 billion offer by Novartis AG (NYSE: NVS).

Taking a look at the option chain below, you can see that the January 06 $42.50 puts are trading at $1.10, while the January 06 $42.50 calls are $2.15. (Please keep in mind that this is only an example, and NOT a recommended trade.) If you were to buy both the January ‘06 $42.50 calls and puts, you’d pay (for one contract on each side) $325, not including transaction costs.

options straddle

With this straddle, you would be betting that Chiron is going to publicize some sort of merger news before expiration, and that the announcement of such will trigger a move greater than the principal paid. Which brings us to risks.

The Two Types of Risk With Options Straddles

Though the trade seems exciting, there are two separate sets of risk here.

  • Chiron will not announce merger news before expiration, and the stock will continue to trade laterally, causing you to sell your positions before they expire worthless. In this case, you lose money on the difference between what you bought and sold the puts and calls for.
  • Chiron does announce merger news, but the stock does not move enough to outweigh the principal paid in opening the positions.

On the other hand (purely as an example), what if Chiron announces there will be no takeover, and Wall Street decides to dump the stock back to where it was prior to September 1?

Assuming the stock gaps down to the September 1 close, the net profit would be the strike price minus the gap down price, less the opening prices paid. (Please remember, this example is NOT including transaction costs.) With the example given, the investor would gross $2.81 - or an 86% gain. The math looks like: $42.50 minus $36.11 = $6.06 minus ($1.10+2.15) = $2.81 - $2.81/$3.25 = 0.864.

It’s pretty easy to see why you would implement an options straddle, and how the position can be considerably profitable. However, it is vitally important to remember that straddles are generally NOT effective strategies for stocks in strong up or down trends. Options straddles are most effective when a stock has been traveling sideways, in a very tight range, ahead of a significant news event.

Good Trading,

Steve McDonald

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  • Our Smart Profits Glossary is chock full of option terminology in case you are a bit unsure of terminology used above such as “straddle” or “strangle.”

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Two Days at the “Center of the Options World”

October 13, 2005

The Smart Profits Report: Issue #250
Thursday, October 13, 2005

Two Days at the “Center of the Options World”
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I just returned from a great options conference in Chicago. Aside from being one of my favorite cities in the U.S., Chicago is also one of the most important financial centers in the world. Its “middle of the country” location has allowed it to prosper and age gracefully.

As the host of the Agora Wealth Options Conference, a series of conferences I founded a few years ago, I have a unique responsibility to make sure that the attendees get their money’s worth… and more.

More is what we got this year, as we were treated to a behind-the-scenes tour of the Chicago Board Options Exchange - an invitation-only excursion that almost every attendee participated in.

We had a mock trading session right on the floor - a once-in-a-lifetime experience for most people. Since 9/11, the exchange has not been offering private tours, but with our inside connections (thanks, Scott), we managed to get into this bastion of options capitalism… the center of the options world.

But for now, back to the conference…

An All-Star Cast of Profit-Makers

Without a doubt, the team from Mt. Vernon Research was the life of the party. Lee Lowell was up first, and he gave an in-depth presentation on trading puts, and the life and times of a market maker and professional trader. He was followed by our newest addition, Steve McDonald, who offered a great presentation on how to trade without falling into traps that could leave you much “poorer.”

Steve’s background in psychology is an invaluable tool for our team at Mt. Vernon. Especially interesting was his list of “trading” mistakes that everyone should avoid - of course, you have to be able to spot them first. I will get Steve to put some of his thoughts on paper in a future edition of the Xcelerated Profits Report - which, by the way, is the best $49 you will ever spend. Steve also teased the audience with some clues about his trading system, which I have finally convinced him to share with us. But more on this in a later SOER…

Dean Albrecht was next, and I am glad he made his time slot. The night before, a gang of shoe shiners accosted him on Michigan Avenue. Dean is adventurous and decided to let them have a go at his dirty loafers. They did… and wanted $8 per shoe. He gave them a buck and walked away carefully!

Dean presented his Quant-based system. For more than an hour, he explained with clarity how his system is as close as you can get to accurately predicting the movement of stocks and their underlying options - something he shows his subscribers with regularity.

Then it was my turn. I spent an hour lamenting on how my favorite system, The Income Trader - A Covered Call Strategy, is the ugly stepchild of trading services. It has an excellent track record - more than a 75% winning percentage in the past five years - but it only offers boring double-digit returns and not the triple-digit profits that we are all SO USED TO! I explained the system in detail, as I did for The LEAPS Options Trader.

The rest of the conference was composed of excellent presentations from the likes of Bob Meier (on commodities and geo-political options plays), Eric Roseman (on using options in international and ETF investing), Lou Bass, of The Oxford Club (on the use of options in take-over situations), and a host of other speakers and topics.

I must say, I am ecstatic about the team assembled at the conference. There were many professionals in the audience - traders from the CBOT, trading houses and just regular folks who wanted to learn more. Upon reading the post-conference evaluations, all I can say is, “See you in Chicago next year!”

Good trading,

Karim

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Bull Spreads

October 7, 2005

The Smart Profits Report: Issue #248
Friday, October 07, 2005

Bull Spreads - Bagging a 66% Return on Lexar
By Karim Rahemtulla
Chairman, Mt. Vernon Research

This week, subscribers to my trading service notched some fat profits - about 66% in just under six months, on a company called Lexar Media.

Lexar is a manufacturer of memory chips that are used in electronics. What is more important is the strategy we used (and which you can use), and why we used this particular strategy.

First, we used a strategy called a “bull spread.”

A bull spread involves buying an option at one strike price and selling another option at a higher strike price against it - kind of like covered calls, where you buy a stock and sell an option against the shares. But in this case it was an options-only trade.

Breaking Down the Lexar Bull Spread

In the case of Lexar, we bought the $5 calls for $2.65 and sold the $7.50 calls for $1.90. This means we had a net debit or cost of $0.75 ($2.65 minus $1.90). It also means that our upside was limited to the spread: the difference between the two strike prices, or $2.50.

So, we invested $0.75 to make $2.50.

This week, we bought back the $7.50 calls for $2.75 and we sold our $5 calls for $4, for a net gain of $1.25. Now, you subtract your original investment of $0.75 and you have a net profit of $0.50 on the trade, on a total of $0.75 at risk, for a gain of 66%.

We closed this position early - by more than a year. Why?

One of my favorite sayings is “a bird in hand is worth two in the bush,” or something like that. That is the reason we covered early.

Why We Chose a Bull Spread In This Case

Now, the reason why we used the spread to begin with…

When an option is very expensive relative to its share price, I always look for ways of reducing our cost. In this case, the $5 option was trading at almost 50% of the share price - quite steep.

But, that also means that the other options at different strikes would be expensive, as well. So while I limited my upside, I also substantially reduced my downside.

I also knew that I would be able to cover early if the shares moved higher, because the options that were closer to the strike would gain more as we moved past the strike price than the options that were out of the money, since one would be building intrinsic value.

And, finally, I don’t like to risk more than 10% to 15% of the underlying share price on any LEAPS trade, and the only way to achieve it on Lexar was to use a spread. The next time you find yourself looking at a similar situation, consider using a bull spread.

Good trading,

Karim Rahemtulla

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  • Also, check out the Smart Profits Glossary, chock full of over 150 terms such as “bull spread” and “strike price.”

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Fair Value Sheets

October 4, 2005

The Smart Profits Report: Issue #247
Tuesday, October 4, 2005

Fair Value Sheets: Quote, Trade and Hedge… In Less Than 30 Seconds
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

Before becoming an options market-maker on the NYMEX, I never anticipated the initial pain that my legs would feel after having stood in the same spot for five and a half hours a day. That’s what pit traders do. They stand in the pit all day long, giving bids and offers to brokers in hopes of doing a trade with them.

As part of my series of articles on the life of a market maker, this piece will focus on the actual mechanics of what happens when an option order hits the pit, how to read fair value sheets and how the market maker plays a role in the action. Remember, everything that I explain in this article relates to my experiences as it happened on the NYMEX.

The First & Fastest Market Maker To Check The “Sheets”

The opening bell would ring at the NYMEX at 9:45 a.m. EST and close at 3:10 p.m. EST (pre-9/11). Within those five and a half hours, it was every market maker’s job to be the first - and the fastest - to give a specific broker a bid and ask quote that they needed for their customer.

Let’s say, for example, the upstairs Merrill Lynch desk (customer) needed a bid/ask market for the October 2005 Crude Oil $66 call option. The Merrill Lynch broker in the pit would randomly shout out to no one in particular, “How’s the Oct. $66 call?” That’s the market maker’s cue to check the corresponding futures market price and then check their “sheets” to see what a fair bid/ask market would be to yell back to the broker (and yes, everyone really is yelling at each other).

The reason for checking the corresponding crude oil futures market price is that if the market maker actually does an option trade with the option broker, the market maker will then immediately place an offsetting delta-hedge trade in the futures market to eliminate any immediate directional risk. Market makers are not there to pick a direction; they are there to capture a non-directional edge on the trade. I’ll explain that in a bit.

So, before actually giving the option broker his bid/ask market, you would see the 20-some market makers in the pit all waving to their “point man” in the futures pit for a quote on the futures market. The point man would hand-signal back to the options market maker approximately where the futures prices are trading (the options pit and the futures pit are two separate pits that sit side by side). Once the option market maker has a decent idea of the futures price level, he can then give the broker an accurate quote after checking his “sheets.”

How to Read “Fair Value” Sheets… And Keep Brokers On Your Side

The graphic below is a very simplified version of what an option market maker’s “fair value sheets” would look like. The one below contains the “fair value” and “delta” calculations for various futures and option prices for crude oil options as of October 3, 2005, with a fictional expiration date of October 21, 2005.

Here’s how it works: Along the left-hand side are prices for the front-month crude oil futures market in 5-cent increments. In this example, we’re only seeing prices for the futures at $65.45, $65.50, and $65.55. A typical trader’s sheet would contain many dollars worth of prices, so you would literally see market makers coming into the pit with thick booklets of trading sheets, sometimes for more than one commodity. You should see what the floor of the exchange looks like at the end of the day. Actually, you wouldn’t be able to see the floor because every inch ends up covered with obsolete trading sheets.

The “P/C” column indicates whether you are looking at a put or call, and the “VOL” column represents the volatility level you are using to help price the options. The top row of the sheets shows the strike prices that are available to trade in that particular commodity. Here we see strike prices for crude oil options ranging from $62 to $67. The last pieces of the puzzle are the “Fair” and “Delta” Columns. These represent the fair market value for each put or call at the corresponding futures price along the left-hand side, and the delta column lets the trader know how many futures contracts are needed to offset any option trade to balance out the directional risk.

Market Maker's Fair Value Sheet

The broker was asking for a market on the $66 calls and we find out that the futures are trading at $65.50 at that moment in time. We check our sheets on the left-hand side for the “calls” at the 65.50 mark with a volatility of 38%, and then we move along the top until we intersect with the 66 strike of the “Fair” column. We see that the fair market value of the $66 calls at a corresponding futures price of $65.50 comes out to be $1.828.

Any attentive market maker in the options pit would now yell back to the broker, “$1.80 bid at $1.85.” This means that the market makers are willing to buy that option at a price of $1.80, or sell it at $1.85. At this point, we don’t know if the broker is a buyer or seller, so we always have to give both sides of the market (we don’t care if we buy it or sell it).

Now, if the broker decides to buy the option from us at our price of $1.85, we have to tell him how many option contracts we want to sell. To make it simple, the delta sheets are based on a trade of 100 contracts. If we are lucky enough to sell 100 contracts to the broker, we look at our sheets again and see that the delta is .46. In order to offset our initial directional risk, we would hand signal back to our point man to buy us 46 futures contracts. Since we are selling call options to the broker, our initial delta is short 46 potential futures contracts, therefore we need to buy 46 futures contracts to keep our delta at zero.

The Paycheck’s in the “Edge”

Delta tells us a few different things:

  • It tells us how much an option price will move for a corresponding $1 move in the underlying security; and
  • How many shares or contracts of the underlying security must be bought or sold to offset any directional risk from an options position.

As I mentioned earlier, the option market maker is looking for an edge, not a directional trade. If that $66 call is valued at approximately $1.83, and we get to sell it at $1.85, then that’s what we call getting an edge. Our best-case scenario is that someone wants to sell that option now, and we would be able to buy it back for $1.80. That’s how market makers try to make their money. They continuously try to buy for less than what their sheets are telling them, and to sell it for more than what their sheets are telling them.

Unfortunately, it’s not as easy as that, but that’s the main thrust of the market maker’s job. The whole process of getting the futures quote, checking the sheets, doing the trade, and doing the hedge all happen in a matter of seconds. It sounds like a long process, but it’s not. The faster you are, the more trades you do. Speed is key!

So, do that everyday for five and a half hours without sitting down and/or not taking a break for lunch, and you, too, might be saying, “Man, my legs are tired.”

Good trading,

Lee

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Out of the Money Options

October 1, 2005

The Smart Profits Report #255
Tuesday, November 1, 2005

Out of the Money Options - Buyer Beware, Seller… Take The Money
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

About a year and a half into my days as an options market maker on the floor of the New York Mercantile Exchange (NYMEX), I discovered the strategy of selling short-term, out-of-the-money options (OTM).

For anyone who’s not familiar with the term “out of the money,” these are put options with strike prices that are lower than the price of the underlying futures contract. Call options that are out of the money have strike prices that are higher than the price of the underlying futures contract.

Selling these options is a great way to generate some income by taking advantage of options that expire worthless - while someone else is taking on the risk. Let me explain…

How to Pocket Cash From Traders Losing Their Bets

From 1991 to 1998, the years I spent on the floor, crude oil energy futures stayed mostly in the range of $15-$25 per barrel. I noticed that many people would pay good money for options that were well above and well below the current price of the nearest futures contract.

If oil was at $20 per barrel, people would buy options on the $15 puts and/or the $30 calls, hoping the price of oil would get to one of those two levels by the time the options expired. What I noticed was that these options were expiring worthless most of the time, because of the large distance that the futures contract had to move for the option to become profitable, plus the fact that the options had such a short life span.

So, I decided to start selling these options, which allowed me to pocket the money from the buyers. All I had to do was wait for expiration to see these options expire worthless.

Over time, I realized that due to the increasing potential of unrest in the Middle East, and the effect that OPEC had on the price of oil, I knew that there could possibly be more violent movements to the upside than to the downside. At that time, I started restricting my out of the money option selling tactics to just the put options.

People were still paying high premiums for these, and I was willing to sell them. What I didn’t realize at the time was that not only was I taking in monthly premium income, but I was also setting myself up to possibly buy crude oil at unheard-of cheap prices.

In the early ’90s, I was selling put options with strike prices from $15 all the way down to $9. If I was ever assigned on my short put options (meaning that the buyer executes his right to sell crude oil futures to me), I would be buying crude oil at very cheap levels - not such a bad thing to do with a worldwide commodity in such high demand. Turns out, I was never assigned on any of my short options, and that was mostly due to the short life span and large distance of being out of the money.

A Reliable Income Strategy

Over the years, I became the market maker that most of the brokers would come to when their clients needed to buy some out of the money put options. Other traders would shy away from these selling tactics, claiming the “unlimited loss potential” of short options. They said I was crossing over to the “Dark Side.”

But for me, the strategy was sound:

  • I was taking in good premium,
  • I could possibly buy crude oil at unbelievably low levels,
  • And I had risk-management plans in place.

The NYMEX futures contracts would trade electronically during the night after the open-outcry session closed, so if I had to protect myself, I could buy or sell futures contracts if need be.

After I left the NYMEX, I started a trading business from my own home office. I began trading stock options with the same methodology. I would sell put options below the market (out of the money) on stocks that I really wanted to own. This would allow me to collect the premium upfront, and potentially allow me to buy them at a great price.

When you are looking to buy a favorite stock at a cheaper level, selling put options is a viable strategy to potentially set a limit price while earning income in the meantime. The way I was using it on the NYMEX was mostly to collect the steady monthly premium income, but when applying it to the stock market, you are potentially setting yourself up to buy a great stock at a great price.

Good Trading,

Lee Lowell

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Today’s Smart Profits Cribsheet

  • To follow Lee’s background in the NYMEX, catch up on his Market Maker Series with Smart Profits # 241, # 243, # 247 and # 252.
  • Lee’s put together a special electronic report on today’s topic, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks. It’s a handbook that can be e-mailed right to your inbox… Click here.
  • Check out our Smart Profits Glossary for definitions such as “out of the money” or “deep in the money.”

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