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Options Leverage

November 29, 2005

The Smart Profits Report: Issue #262
Tuesday, November 29, 2005

Options Leverage - How to Use Delta to Maximize Leverage
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

The best weapon in the financial world is leverage. Applying this principle allows you to control a large amount of goods with a very small investment. That’s the smartest way to use your money. While you’re saving dollars on one investment, you can use them to buy more investments. And there’s no better way to apply this method than in the options arena. I’ve said this to many people time and again: If you want to buy stock, make sure you do it by using options, specifically deep-in-the-money options (DITM).

Buying call options in lieu of buying the actual stock is a great way to leverage your money. You pay the small upfront cost of the call option and you get to control the stock until option expiration. The up-front cost of the call option can sometimes be 20 times less than buying the stock. That’s leverage!

But with such fantastic leverage, you also need the stock to make a large move to become profitable. This is where picking the strike price is critical to balancing out your leverage with making a profitable trade.

Let’s take a closer look at how you can increase your leverage (and your profits) using deep-in-the-money calls.

How to Get Dollar-for-Dollar Moves on Your Options

Many investors will settle on buying an out-of-the-money (OTM) call option when they want to use leverage to get in on a bullish expectation for the stock. An OTM call option’s strike price is higher than the current level of the stock. For instance, if Intel (Nasdaq: INTC) is trading at $26.98, an OTM call option would be one whose strike price is $27.50 or higher. (See the option chain below.)

If you bought the July 2006 $30 call for $1.05, you wouldn’t see a profit until INTC gets above $31.05 (if held to option expiration). That’s how you calculate your breakeven point with options - you add the strike price to the cost of the options ($30 + $1.05 = $31.05). You’re certainly using leverage with this trade. Instead of buying the stock and shelling out $2,698 for every 100 shares, you would pay only $105 to control the same 100 shares. The only issue, as we just mentioned, is that you wouldn’t make any money until INTC goes up another $4.05 per share. This is fine for someone who wants to spend a little money on the hopes that INTC goes up that amount in the time allotted.

Now, let’s look at a different way to leverage your money and profit immediately when INTC makes any kind of move - using a deep-in-the-money call option. A DITM call option has a strike price far below the current price of the stock. In the case of Intel, we’d be looking at strike prices of $25 and lower. The key to having a successful trade with DITM call options is the “delta.” Delta shows you the correlation between the movement of the option to the movement of the stock. You want a delta value of at least 90 or higher.

Look at the Delta column in the option chain above. We see the July 2006 $15 call option has a Delta of 100. This tells us that the July 2006 $15 call will move 100% in tandem with any move that INTC makes (up or down). If INTC goes up $1, the $15 call should go up approximately $1. That’s what you want. You want your option to move just as much as the stock. So how much does the $15 call cost? According to the option chain, it costs $12.25 (splitting bid/ask). That’s $1,225 for one option contract. Yes, that’s about $1,100 more than it costs to buy the $30 call, but it’s still about $1,500 less than it costs to buy 100 shares of INTC outright.

Leverage Benefits of Buying Calls

Here are the benefits to buying the $15 call:

  • As we mentioned, it will cost you almost $1,500 less than buying INTC shares.
  • You’re going to get 100% of the same movement (up or down) as INTC.
  • With the $1,500 you saved, you can go out and buy some other DITM options on other stocks you might like.
  • The most you have at risk is your $1,225 initial investment. If for some unknown reason INTC tanks to $0 per share, the most you can lose is $1,225. All the holders of the stock can lose all of their investment.

With the $15 call, your break-even point, or cost basis, is $27.25 ($15 strike + $12.25 = $27.25). Contrast this with the $30 call where your break-even is $31.05. A much better deal in my opinion, even though the option costs more.

Weighing Your Cost vs. Your Profits

When you buy options, you need to weigh your cost versus your profitability. If you’re okay with waiting for INTC to get above $31.05 before seeing a profit, then the $30 call might be for you. But, if you want immediate gratification, then you should look to purchase a DITM. Remember, we want to substitute a call option for the stock. In order to do that, you must choose a strike price that has a very high Delta (90 or above). That is the key to giving you all the same movement for a fraction of the cost.

Come expiration time, you have two choices: You can sell the call back to the open market, and the trade will be over and done with. Or you can exercise the call, in which case you will be required to come up with the rest of the payment for the stock. The advantage of the DITM is that you only have to put up a small down payment up front. After you pay for the rest of the stock, you will see the 100 shares deposited into your trading account on the Monday following expiration.

In my opinion, this is a no-brainer. When interested in buying stock, why not buy some DITM call options which will cost you less, give you all the same movement, lower you total risk, and also allow you to put some of that saved money into other investments?

Good Trading,

Lee Lowell

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Today’s Smart Profits Cribsheet

  • Lee spent seven years in the options pits of the New York Mercantile Exchange. Check out his Market Maker Series (Smart Profits #241, #243, #247 and #252), which details the action on the floor of the exchange.
  • While today’s Smart Profits Report focuses on buying deep-in-the-money calls, Lee’s put together a special electronic report on how to profit when investors buy out-of-the-money options. The report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks, is a handbook that can be e-mailed right to your inbox… Click here.

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Option Prices

November 22, 2005

The Smart Profits Report: Issue #261
Tuesday, November 22, 2005

Option Prices: How to Get the Best Price on Your Options
By Steve McDonald
Options Specialist, Mt. Vernon Research

My first day as a stockbroker, my advisor told me what he loved about the business. “You learn something new every day,” he said. And he was right.

I often take for granted how much information stacks up over time. In the 20 years I’ve been trading, most of what I know is the result of having made every mistake imaginable… without somehow ending up broke or unemployed.

And one of the biggest lessons I’ve learned is that if you don’t get the right option prices, no matter how much homework you’ve done, you may never realize gains, even if the trade goes your way. But you don’t always have to pay a premium to buy your options contracts.

Today, I want to show you why the best way to get competitive options prices is with a full-service broker. Let me explain…

First Benefit of a Full-Service Broker: Accurate Option Pricing

I was putting together some option picks recently, and one of the option prices I found online was ridiculous. It had an ask of .55, a bid of .45, and was last traded for .10.

That didn’t seem right to me. Why would I pay .55 for an option that just sold for .10?

I wouldn’t. So in this case, I put the option on my waiting list with hopes its pricing would come down to reality.

As I always do, I checked several other sources online for several hours after the option started trading. No change. On a whim, I called one of the brokers I know to see if he could offer any help.

After giving him the symbol, he came back to me with an ask of .10. In fact, there were several offers on his screen at that price. So, what gives? Why is my screen telling me .55?

Brokers have access to all of the outstanding offers on the market. They can see what all the sellers are asking. So, even though the bid and ask online were far above the last trade, there were still plenty of offers at .10. None of this information was available on the usual online sources.

Not only could the broker tell me what the ask was, he knew how many I could buy at that price and what I would have to pay for more of it. That was news to me. We did not have that ability when I was a broker. We could see the bid, ask, last trade and volume. That’s it.

Guess what price you would have paid if you had put in a market order for this option? .55. And you would have had to pay the same price if you tried to buy five, 10 or even 20 contracts.

Second Benefit of a Full-Service Broker: Lower Option Pricing

Being able to buy anything in large quantities usually gets you a better price. Stocks and options are no different. Brokers can get more competitive pricing, but they can also fill larger orders… and get a discount.

Buying options in small numbers, five or 10 contracts, is the costliest way to trade. This is what is called a “booked trade.” A booked trade is where a small trade is put in by the trader, at the highest price they can legally give you. In the case of my example, that would have been .55. What a deal!

A broker is able to put out an offer to buy a certain number of options at a certain price. Usually, since he or she is buying for several of his clients, they are offering to buy more than an individual investor can. This gives the broker a huge price advantage.

In just about every instance, the broker will get you a better price than you can get online. Even if it’s only .05 less per trade, over a year of trading, that’s huge.

Third Benefit of a Full-Service Broker: A Safety Net

What none of us like to admit are the really big mistakes we’ve made investing. Yes, we saved a few dollars on the commissions doing it ourselves, and yes we lost 10 times that amount as a result of the errors we’ve made. I have some real horror stories about members who have lost thousands because they misunderstood an alert and sold an option instead of buying one.

The most common example I have is of people who buy way too much of a single option, and get crushed when it goes against them. This is almost always the result of inexperience.

Brokers are required by law to tell you when you are doing something that is not in your best interest. In fact, they are required by law to refuse to do something you ask them to do, if they know it is not in your best interest. You can ignore their advice, but you’re fixing something that isn’t broken.

They’re also responsible for any mistakes they make. If a broker enters a sell instead of a buy, it’s his problem, not yours. If they enter a trade for 100 contracts, instead of 10, which is quite easy to do with an online broker, the broker owns the other 90 contracts, not you.

With a full service broker, you have an advisor who can answer your questions about your personal investment issues. They are licensed by the federal government to do exactly that.

Trading options is a tough business. You need all the help you can get. Don’t start each trade in the hole.

Good Trading,

Steve McDonald

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Trading Index Options

November 18, 2005

The Smart Profits Report: Issue #260
Friday, November 18, 2005

Trading Index Options - Two Ways To Profit
By Steve McDonald
Options Specialist, Mt. Vernon Research

In the 20-plus years I’ve been trading index options and stocks, it seems the market always runs when you least expect it. Consider how long it’s been since we’ve had any good news. Not just about the market, but good news in general - Hurricanes, interest rate hikes, volatile gas prices, wars in Iraq and Afghanistan.

We’ve spent five years in a lackluster market, and it hasn’t been easy to hang in there. But every bit of my market sense tells me we are on the verge of a great ride…

  • Corporate earnings reports have been exceeding estimates two to one.
  • The Fed has done a great job of controlling inflation.
  • Energy prices are back to a reasonable level.
  • Interest rates are still at historic lows.

This looks like a very good place to start a run in stock prices.

Still, we’re not quite there yet, and a haunting voice in my head is whispering caution. In the meantime, then, how do I take advantage of uncertainty, without losing the farm?

In a tough market like this, index options are a great way to come out on top by using less cash up front. Let’s look at two ways to trade them for a profit…

Naked Calls and Strangles for Index Options Profits

The Nasdaq 100 Trust (Nasdaq: QQQQ) is the best way I know to follow the ups and downs of its namesake index. And it can be very volatile, which is good for trading.

The following is a play that makes a lot of sense to me for this type of market. (As always, this is just an example, meant to illustrate some of the techniques and mechanics of using this option. It is not a recommendation.)

On November 2, QQQQ was trading at $39.19, and we’ll use the pricing from that day in our example. Since we don’t want to be too aggressive and outsmart ourselves on the time value, let’s go out about eight months, to June of 2006, and look for an option in- or near-the-money.

The June 2006 call, with a strike price of $41 (QQQ FO), was trading at $1.65 on November 2. That’s a good buy because the strike price was $1.81 from the current price of the shares, which means you’d get a discount of 16 cents. If you wanted to be right at-the-money, you could have looked at the $40 strike for $1.95, but this had a hefty premium to it.

For a classic valuation, the QQQQ would have to move 4.6%, or $1.81, between now and June to reach our strike of $41. If I’m right about the market sitting on the edge of a solid run, a move of $1.81 in eight months is more than reasonable. Ideally, we’d like to see a move beyond the $41 price, which would give us a dollar-for-dollar move in our option above the $41 price. So, if the QQQQ moves up to $44, our option should be worth $3 from $1.65, plus any time value - an 81% gain in eight months.

That, of course, is if the market plays out the way I think it will. But what if you don’t see the market going one way or the other?

That’s where the second way to the index comes in…

How to Use a Strangle to Capitalize on Uncertainty

First, remember that with a strangle, you’re buying the calls and the puts with the same expiration, but with different strike prices.

Since we’ve already bought the call in our example, we need to buy a June put to complete the strangle. We’ll go with a strike of $37 (QQQ RK) that would have cost $1.05 on November 2.

Now that the strangle is in place, keep in mind that the trend is your friend. If the index starts moving up, it’s time to dump the put. Don’t dig yourself a hole by assuming you’re right and the market is wrong. Let the losing side of the trade go, and let your winner run… That’s the key to a strangle.

The QQQQ is only one of the indexes available. If you like the idea of using options to bet on market (or sector) moves, and think you’d like to get away from the tech-heavy Nasdaq, there are numerous ETFs (Exchange-Traded Funds) that allow you to implement the same type of strategy.

The bottom line is when you aren’t positive about the market’s direction, you can use options to play your hunches without betting the farm. I find I sleep better that way.

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Today’s Smart Profits Cribsheet

  • For more of Steve’s strangle and straddle tips, revisit Smart Profits #251 and #257
  • Lee Lowell, our Commodities Options Specialist at Mt. Vernon Research, explains different ways of trading ETF’s in Smart Profits #230, EMinis & ETFs - "Trade" E-minis With Less Risk Using ETFs.
  • You can always use our free Smart Profits Glossary to get up to speed on trading terminology like "strangle" or "index options."

Good trading,

Steve

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How to Use Puts and Calls

November 15, 2005

The Smart Profits Report: Issue # 259
Tuesday, November 15, 2005

How to Use Puts and Calls: For Systematic Short-Term Profits
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Benjamin Franklin once said that there are no sure things in life except death and taxes. I would tend to agree, but not completely. I know of one more sure thing: the uncertainty of the market. But until now, I didn’t think you could use this uncertainty to make much money.

The fact that market timing is a dangerous strategy is not breaking news. Events crop up every day that can throw a wrench into the best of plans. Add to that a list of hedge fund shenanigans, accounting irregularities, an overly aggressive Federal Reserve and nervous investors holding stocks for just a few days at a time, and you have an environment conducive to short-term trading, or trading on the cheap to minimize losses.

But you don’t necessarily have to know which way a stock is going on one particular day to make a lot of money. One type of trading focuses on short-term events, and it’s a way to beat the market at its own game. It allows for the short-term trade, such as using puts and calls, and it allows for explosive profits whether the shares move up or down. How explosive? Recent gains using this strategy have eclipsed 200% in a matter of days.

Today, we’ll take a look at this strategy, and how one of our own expert panelists has been getting it ready for release…

The Four Rules for Successful Short-Term Trading… and the System That Does it All

First, this strategy involves choosing stocks about to experience a specific event. And when this event occurs, the shares will either move up or down sharply. So, the shares must be volatile in nature to begin with.

You then take a “cheap option” position on both sides of the underlying shares - the puts AND the calls. If the shares spike up, we win. And if they sink lower, we win. The key is to know which stock to pick on which date and, most importantly, to be certain that the stock has the ability to make a big move. The only way to figure this out is to have a system that allows you to plug in the right factors.

Over the past few years, we have spent hours discussing the pitfalls and shortfalls in trading short-term options. Our conclusion is that if you are going to trade them, you’d better have a system in place. And to be successful, it must:

  • Know the stock’s volatility;
  • Find BIG events that are about to happen that could effect the share price;
  • Not be afraid to bet against the stock or company; and
  • Limit your dollar risk to a small amount for short-term trades.

The trick, of course, is to know how and when to put all of these together. And that’s where Steve comes in…

In a few weeks, our very own Steve McDonald, Options Specialist, Mt. Vernon Research, will be writing about this strategy in depth. But first, if you don’t know Steve, let me introduce him to you.

Over the past 20 years, he has been an avid investor and a strong follower of options systems and strategies. As a former Navy aviator - used to risk and action - Steve is a perfect fit for the options market.

Steve has been developing a system for a while now that takes advantage of a specific, recurring event in the stock market - something that happens on a regular, predetermined basis. Each time it happens, people make money. Well, not everyone, but those who know and follow these types of events are making some serious profits. And Steve is one of those people. His strategy wins with uncanny accuracy.

He has figured out - using short-term, cheap options - how to play the market on specific dates and with specific stocks. Now, I am the last person on the planet to espouse any type of short-term options trading, unless there is a bona fide system attached to it.

There are many very successful short-term systems, most of which use technical or quantitative analysis (like Dean Albrecht’s E.S.P. Profit System, see today’s crib sheet). Steve’s is the first one I have seen that is event-driven AND regular.

It’s Not All Smoke and Mirrors

Of course, there is always more to a system or strategy than is apparent on the surface. In the case of Steve’s, there are several additional factors that come into play. The companies have to have volatile share prices, the ability to make strong moves in a short period of time, and have a history of price volatility, among other things. This is the legwork behind the scenes.

I have been tracking the system for several months, and the returns have been nothing short of spectacular. Steve plays not just one side of the market, but both sides. He doesn’t care if the market is up or down - it has little impact on what he has discovered. In fact, he relishes the opportunity to make money regardless of which direction the shares move. They only have to move decisively in one direction.

What’s intriguing about the system, though, is that he is able to participate in these situations for literally pennies. Most of the options are low-priced with short holding periods - usually less than a week to 10 days. And the frequency is a trader’s dream. He has sent me several picks a week on occasion. There is no lack of opportunity.

In the coming weeks, he will be writing more about his strategy in The Smart Profits Report and in many other publications. His system is almost ready for launch, and that is exciting, to say the least. It is one of the few short-term options strategies that is well-tested and thought out. We look forward to sharing the details with you. Until then…

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Today’s Smart Profits Cribsheet

Good trading,

Karim

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Limit Order Diligence

November 10, 2005

The Smart Profits Report: Issue #258
Thursday, November 10, 2005

Limit Order Diligence - How to Limit Your “Excitement” for Winning Trades
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Whenever I issue an alert for my options trading services, I expect my readers to get excited. After all, if I’m not excited about a pick, I won’t write about it.

So, what makes me excited? A great market position for a company… an excellent price… a healthy profit target… and a chance to use limit orders.

But one of the most important factors is liquidity: “Can we get in and out with reasonable ease at the prices we want?”

If the answer is no, then I will not issue a pick, no matter how attractive. It makes absolutely no sense to “push” or influence the price of an option or stock, because at that point, the trades are artificial.

Today, I want to show you why it’s important to get the right price on every trade.

Three Reasons to Use a Limit Order

Regardless of the option, any short-term buying will have some influence on its price. If the market for a certain option has been inactive, any amount of activity will cause the price to move. But because there are six active options exchanges, not all of them list every option. So, there must be at least four exchanges that trade the option before I issue an alert. Further, each exchange posts the quantities available for buying and selling at various prices. If this “size” is not substantial, then it will not pass muster.

Finally, realizing that short-term buying will cause some movement, I allow a nickel or a dime either way when I make a recommendation. That is enough. Yet, there are still people who insist on paying more than the limit orders, and place market orders. How do I know? Because I watch the prices, and there are always trades beyond the limit price. This means that someone is too eager, too excited to wait to get into a play.

And here’s why trading this way can lose you money…

First, when I choose an option, I test its price against the options pricing model that I use. This model is pretty accurate at determining what the option “should be” trading for. If there is a big difference, I will wait before putting out the alert… or not put it out at all. The options market makers use similar models to determine prices, but they must also account for supply and demand - which is why I will allow some leeway.

Second, options are a decaying asset. If you do not understand this, you should not be trading them. Every day, an option loses some time value. This means that in the absence of any underlying movement in the price of a share, the option will lose value slightly each day.

Third, I can count on one hand the number of times the price of an option that I recommended went straight up or down (depending on whether I went long or short) and NEVER looked back. Stocks trade up and down, and so do options. When a stock goes up, an option will usually follow. The same is true on the way down.

Don’t Be An Eager Beaver

Your job is to be patient and to get filled at or below your limit order’s price. If you are patient, this will usually happen within a few days. I have seen this hundreds of times. What you should NEVER do is place a market order, unless you just want it in the worst way, or want to get rid of it in the worst way.

Instead, what you should always do is place a limit order and monitor it carefully. If the shares move lower, and the options do not follow, then REMOVE the order and wait until the option falls. If you leave a limit order in “good ’til cancel” status, the market maker will actually fill you at your price, and if the shares are falling, drop the price right after you are filled. He knows that the price of an option should change depending on the price of the shares - so should you.

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Today’s Smart Profits Cribsheet

Good trading,

Karim

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Options Strangle Tips

November 8, 2005

The Smart Profits Report: Issue #257
Tuesday, November 8, 2005

Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain
By Steve McDonald
Advisory Panelist, Mt. Vernon Research

In the 20 years that I’ve been trading, I’ve come to believe that getting a steady 30% to 40% return on options, within a short amount of time, is a reasonable expectation.

Of course, this takes into account that you’ve done your research, exercised discipline and have a thorough understanding of options and the strategies available to trade them. And there is no shortage to choose from: LEAPS, covered call writing, condors, spreads, straddles and butterflies, just to name a few…

Recently, I implemented one of my favorites - the options strangle - and reeled in a healthy 500%+ gain in 12 days.

While a return like that isn’t something you should come to expect, the characteristics of such a trade are worth a lot to us. Today, we’ll take a look at the three reasons I got into (and out of) the position, and how to line up a good strangle to keep those profits coming.

Finding the Option Strangle That’s Right For You

First of all, a strangle is a strategy that requires buying two options on the same stock - one for the calls and one for the puts. The calls and the puts have the same expiration date, but not the same strike price.

Let’s look at the trade I made, as an example.

On August 24, I bought the September $12.50 calls on Neoware Systems (Nasdaq: NWRE). I also bought the September $7.50 puts. The calls cost 15 cents per contract, and the puts cost 85 cents. At the time of the trade, both positions were just out of the money, by no more than a few dollars. The underlying share price was $10.80.

And here’s why I jumped in with a strangle…

  • The volatility was high. A strangle is a great way to capitalize on big swings in the underlying shares, especially when you don’t know which way they will move. In this case, NWRE was a crapshoot, with earnings about to be announced. If you’ve been around as long as I have in this business, you know there is no way to accurately predict what a stock will do before or after the earnings are released.
  • The price was right. This was a September strangle bought in the last week of August, so there was practically no time value left. That makes for a pretty inexpensive trade. I like to buy options at or in the money, which gives me the best opportunity to profit from a small move in the stock price. If you buy out-of-the-money options, you have to have a big move in the underlying stock to get any return.

    Trying to save a few dollars on the cost of an option by going too far out on the strike price is a sucker play. In other words, if the strike price in the money is $10, for example, you will get a cheaper price by buying the $12.50 or the $15 out-of-the-money contracts. The problem is, the strike prices that far out-of-the-money won’t move as quickly or as much as those closer to or in-the-money.

  • Volume was steady. Before I placed the trade, I checked the volume on the options and the underlying stock to see if there was a reasonable amount. I avoid options that are thinly traded. In the case of NWRE, there were several thousand open positions on the call and the put. The underlying stock also had a fair amount of interest.

So, when the volatility, the price and the volume are aligned, that’s when it’s time to strike. And with option strangles, how you execute the trade is the most important key to making profits.

How to Execute a Winning Strangle

When you’ve decided on your option strangle, you have to be able to follow through with both sides of the trade. We know that one position will move higher and the other will head south. Dumping your loser is the key to the strangle. You have to look for a positive net of the two sides of the play.

With NWRE, I saw the pattern emerge after the encouraging earnings release, and I dumped the losing half of the trade and held onto the winning side.

(One of the most important elements in using a strangle is to be able to cut your losses and take your profits. If you don’t have the discipline to get out of a play with a reasonable profit, strangles may not be for you.)

In the end, after 12 days, I lost 54% on the put contracts, but I made 512% on the calls. The earnings for NWRE were much better than expected. They exceeded all of Wall Street’s estimates, the company had a significant increase in revenue and the market reacted favorably. While we can always generate estimates, we would have needed a crystal ball to work this kind of information into our equation. And because strangles chase volatility, not great financials, you don’t have to look for stocks on the upswing.

In fact, there are almost as many examples of stocks going down after positive earnings news as there are of stocks going up, like NWRE. This is one of the strangest parts of this business. But, if you use a strangle, it can also be one of the most profitable.

Good Trading,

Steve

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Today’s Smart Profits Cribsheet

  • What’s the difference between strangles and straddles? Strangles are very close to straddles in the family tree of options strategies… The only difference is that in addition to having the same expiration date, the calls and the puts of a straddle must also have the same strike price. I recently wrote Smart Profits #251, Options Straddle - Using an Options Straddle to Harness “Uncertainty”
  • Check out the Smart Profits Glossary to help round out your options vocabulary with terms such as “strike price” or “straddle.”

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Market Maker Downtime

November 3, 2005

The Smart Profits Report #256
Thursday, November 3, 2005

Market Maker Downtime: How to Make $1,000 On a Slow Day In the Options Pit
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

The futures and options pits are usually loud, hectic and very stressful places to be. A majority of the time, you’ll see frantic traders yelling, screaming and flashing hand signals to buy and sell securities. On a busy day, many of them will not even have time to take a bathroom break, let alone catch a bite to eat.

Well, on the rare day that things get really slow in the pit, during downtime market makers come up with some very interesting things to do. Today, I thought I’d take a break from my usual educational piece and share with you some of the more fun moments I observed during my time in the option pits on the floor of the New York Mercantile Exchange (NYMEX).

When Volume’s Down, Humor’s In a Marked Uptrend

I learned never to tell them it’s your birthday - unless you’re a glutton for punishment. I usually took the day off on my birthday, not only because I feel everyone has that right to, but because of my fear of what might happen to me in the pit.

I saw it time and time again. The unsuspecting birthday boy - could be a market maker, could be a broker - is doing his job filling customer orders when all of a sudden, creeping up behind him is the sinister prankster. With everyone else watching what’s about to happen, BLAM! A plastic bag of shaving cream gets pulled over the birthday boy’s head, dousing him from top to bottom. The crowd goes wild and the roar sounds like someone just hit a home run to win the World Series. Happy Birthday!

Have you ever seen a New York City-size cockroach? Well, I have, and they’re scary. We’re talking grandpa-size, and they’re as big as rats. I never thought they could be worth more than the pleasure I’d get from stomping on them with my size-11 shoe. But, when traders take up a collection of $500 in cash for someone to eat the insect, it makes you think a little more.

I passed on the idea, but there was someone else who was up for the challenge. The money was collected, and the trader stood in the middle of the option pit that day. Three bites and it was down. First, he took off the head, crunched it up and swallowed. Midsection followed, and you could actually see some stringy things pulling apart. Finally, the rear section. Washed it down with a Coke and called it a day. That’s nice lunch money.

More Market Maker Downtime Party Tricks

How about $1,000 in cash to shave your head? Yes, another way to kill some down-time in the options pit. I added $20 to that pot. The victim (I mean broker) was a longtime member of the exchange and known for being a risk-taker. Someone went out and bought an electric razor, shaving cream and some disposables as well, to make sure it was a clean job. And it was. The guy looked like Freddy Krueger when it was over. Not a very good look for him. I heard his wife wasn’t too happy when he went home that night.

I never understood how I ended up with funny drawings on my sneakers and the back of my trading jacket until I became a more seasoned trader in the pit.

One of the brokers, who’s also been mentioned earlier in this article, would actually slink along the floor of the pit and doodle on everyone else’s shoes.

It was funny for a while, until it would happen to you. When you’re in the heat of battle making trades, you are very focused on that one task and you aren’t really aware of what might be happening to other parts of your body. I mean, catching an elbow in the eye from a fellow trader is an everyday occurrence in the pit. As well as getting spit on and stabbed in the arm multiple times with your neighbor’s pen. So, as those distractions take you away, there’s our friend drawing pictures on my shoes and jacket, and I never felt a thing. I went through many pairs of sneakers during my tenure, and it wasn’t always because they were worn out!

Those were some of the funnier moments I can recall from my time in the pits. As crazy and as stressful as it is on the exchange, everyone needs a good laugh from time to time. It helps keep you sane.

Good Trading,

Lee

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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, Market Makers - Hand Signals, Stress and Million-Dollar Trades, Smart Profits #247, Fair Value Sheets: Quote, Trade and Hedge… In Less Than 30 Seconds or Smart Profits #252, How the Market Makers Lose: Uneven Trades and Open Positions.
  • Also, check out the Smart Profits Glossary for definitions of terms like “market maker” or “NYMEX” found in today’s article.

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