The Options Bid
January 31, 2006
The Smart Profits Report: Issue #279
Tuesday, January 31, 2006
The Options Bid - “The Bid, the Bid, Always the Bid”
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
The legendary Vince Lombardi won five national football titles as head coach of the Green Bay Packers. And the most common challenge he faced was dealing with the injury list… “The knee, the knee, always the knee,” he lamented.
It’s safe to say that anyone who has played professional football has some type of knee problem. Considering the nature of the game, it’s almost unavoidable.
Like knee injuries to a football player, all options traders have at some point lost money to a common “injury” - a profit-eating “option bid.”
Knowing what an option will sell for, or getting what an option is worth, is one aspect of option trading that may require the most finesse. Let me explain…
Close the Bid Spread With Limit Orders
Forget the “ask” and the “last.” Once you own an option, the only number that counts is the bid. The money you will realize is the amount quoted in this price.
Unfortunately, the bid is also the one value that market makers can - and will - manipulate to profit the most. The less they pay you at the bid, or the wider the spread, the more they make. So, it is a “them” against “us” situation. And you might want to look at it that way if you plan to make money at this.
Take a look at two options I’m following at this writing (please note that these are not recommendations):
1. The February 2006 $15 put options on Oakley, Inc. (NYSE: OO). The stock is trading around $15, and the option quote is as follows:
Symbol: OONC
Last: .55
Ask: .55
Bid: .40
2. The February 2006 $37.50 call options on Agilent Tech, Inc. (NYSE: A). The stock is trading around $35. And the option quote:
Symbol: ABUX
Last: .55
Ask: .50
Bid: .45
Here’s why 90% of options lose money…
A novice looks at these quotes and pays .55 for the Oakley option and .55 for the Agilent option. He’s already down 37% on Oakley and 22% on the Agilent. The options are only worth the bid, so you’re in a hole even before you start.
The Last Thing You Want to Forget
If you learn nothing else about options this year, remember this: Use limit orders. It’s the only way to bring some pressure on the market makers to be reasonable in their spreads and the only way to avoid falling into their trap. When rookies buy or sell options at the market, large red signs flash on the exchange floors that say, “SUCKER.”
If a large number of buyers make offers at .45, instead of .40, the market maker may change the bid to fill the orders. In this case, we have affected the market. But, if folks are willing to accept the lower price, why should the market maker change anything?
Offering options for sale at .45 or .50 may take more time, but it’s the only way to close the difference between the bid and the ask.
The larger the order, of course, the better the chance of getting your price. If you’re trading five and 10 contracts at a time, you’re at a disadvantage. The big boys always have, and always will, get the deals. That’s why using a full service broker will help you with this (see today’s Crib Sheet for more on full service brokers).
Will you always get your price with a limit order? No. But when it does go in your favor, you make more money. And that’s really the game.
Why did Vince Lombardi win as much as he did at Green Bay? Injuries may have hobbled the team from time to time, but discipline was a hallmark of Lombardi’s winning ways. None of his players had good things to say about him during training camp. He was a tough taskmaster. But discipline wins football games.
Discipline is how you win at options, too. Learn the discipline of using limit orders, study how the market makers play with the spreads, understand how to use the information in an option quote, and win more often.
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Today’s Smart Profits Cribsheet
- Today’s report offers details about the options buying process. Smart Profits #261, How to Get the Best Price on Your Options, explains the three major benefits of using a full-service brokerage firm when dealing with the options markets.
- Check out the Smart Profits Glossary, chock full of over 150 option terms, like “option bid and ask” and “limit order” found in today’s article.
- Get a market maker’s perspective! Lee Lowell, fellow Advisory Panelist of Mt. Vernon Research, spent seven years in the options pits of the New York Mercantile Exchange as a market maker. He’s put together an entire series for the Smart Profits readers - #241, #243, and #247.
Good Trading,
Steve
Related Articles:
- Using a Probability Calculator - Know Your Trade’s Exact Chance of Success Up Front
- How to Increase Your Options Understanding Ten-fold
- Liquidity & Limit Orders - An Options Balancing Act
Selling Naked Puts
January 26, 2006
The Smart Profits Report: Issue #278
Thursday, January 26, 2006
Selling Naked Puts - Get Paid Now To Buy Your Favorite Stocks Later… At A Bargain
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
How would you like to get paid today just for the opportunity to buy Intel when it bottoms out? Think it can’t be done? Brokering your own commission is easier than it sounds.
Intel (Nasdaq: INTC) recently plunged 11% in one day, after reporting disappointing earnings. The stock hasn’t fared much better since then. Sellers have shaved four points off its share price. But for anyone who has held off owning shares of INTC, now could be the time to get in.
There are multiple ways of taking advantage of a situation like this, but let’s look at a defensive strategy for getting in like selling naked puts…
Pocket Cash By Using a Naked Put
Time and time again, I’ve seen shares of good companies get hammered just like INTC, only to work their way higher over the course of the following few weeks or months. This is the perma-bullish attitude of the majority of the market. What’s more, Intel is not some fly-by-night operation. I’m not willing to bet against a company that controls about 95% of the computer chip market. Its microprocessors are being installed in just about every new PC that’s manufactured.
Having said that, I think Intel may well be heading lower over the next few weeks and months before its rebound. So, there’s the short-term and long-term equation.
Here’s a monthly chart of INTC going back to 1997:
Other than the dip to about $12.95/share in 2002, INTC has had pretty good support in the $15-$20 range. As of today, INTC is trading around $21.60/share.
Here’s the good news: If you’re looking to buy Intel at, say, $20/share (and please note, this an example, not a recommendation), selling naked puts is a great way to 1) own the shares if they do in fact reach $20, and 2) get compensated while you’re waiting. Here’s how selling naked puts works…
You pick a price level that you would like to pay for the stock - in this case, $20. Then you sell put option contracts that correspond as closely to that level as possible. When you sell naked put options, you have an obligation to buy 100 shares of stock for every option contract you sell.
Right now, INTC is at $21.60/share, but if it trades lower than $20, you’ll be forced to buy 100 shares at $20 no matter how much lower INTC may be. If INTC falls down to $18, you’re still obligated to buy the shares at $20. But that’s okay, as that is what you set out to do in the first place - own shares at a lower price.
One of the great benefits of selling naked put options is that you collect the premium from selling the options to the buyer. You get this money up front and it’s deposited into your trading account. Once the trade is executed, all you have to do is wait to see if INTC falls below the strike by option expiration. If it does, you will be assigned on your trade, meaning you will have to purchase 100 shares of stock at the stated strike price.
If the stock does not fall below your strike price by option expiration, the trade is dead, but you get to keep the premium you were paid up front. So, at least you’re compensated for your time to see if you ever get assigned the shares.
Be warned, this is not a strategy for everybody, and not everyone can be approved to sell naked options. The reason for the warning is because someone might get caught up in the frenzy of selling options just to take in the premium. Don’t do this!
Only sell naked puts on stocks that you definitely have a desire to keep in your portfolio. And don’t sell more put option contracts than you’re comfortable owning. If you normally trade in 500 share stock increments, don’t sell more than five put options.
Check with your brokerage firm to see if you can be approved for naked put selling in your trading account. (Brokerage houses consider selling naked options taboo and have strict guidelines for the type of account you must have in order to do this.) In my view, it’s not a risky strategy as long as you don’t abuse it. It’s no more risky than selling covered calls, and brokerage houses consider covered calls as safe as you can get.
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Today’s Smart Profits Cribsheet
- Today we’ve looked at how to get the desired price for a stock you’ve been waiting to own. To learn how to make money by taking advantage of options that expire worthless, check out Smart Profits #255, Out of the Money Options - Buyer Beware, Seller… Take The Money.
- Check out the Smart Profits Glossary, chock full of over 150 options terms, like “naked option” or “strike price” from the article above.
- While we’re on the subject of selling naked puts, I’d like to mention that I’ve put together a special electronic report on how you can profit from investors buying options out-of-the-money. 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…
Good Trading,
Lee
Related Articles:
- Sell First, Buy Second for 50% Better Odds
- Limit Orders vs. Naked Puts - Getting Paid to Place Them On Your Favorite Stock
- Short Selling - Beating the Government By Going Short
Short Selling
January 24, 2006
The Smart Profits Report: Issue #277
Tuesday, January 24, 2006
Short Selling - Beating the Government By Going Short
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
I don’t always appreciate government regulations. Many are burdensome and unnecessary. But I accept why the rules governing Individual Retirement Accounts and most pension accounts prohibit short selling. In theory, when selling short, your gains are limited while your losses are unlimited.
That can be a fool’s choice if you don’t know how to make money from stocks that are struggling. It also means that if you want to make money in your retirement account from a declining or volatile market, you need to know how to use put options. This “derivative” can be tricky. It uses a completely different set of rules than a stock or mutual fund.
Okay. So you’ve decided that a company’s stock is heading south. Its exports are off, new opportunities for growth are stymied and marketing is flat. What to do? Buy a put, right?
Well, yes. But what put? And when?
Don’t Be Fooled By That Sexy Price Tag
The potential problem here is that many novices buy at- or out-of-the-money short-term puts, which means that not only do they have to be right about the direction of the underlying stock, but they also have to know how long it will take to reach their price objective. That’s option buying with a crystal ball.
Most of the option volume on a particular stock takes place at- or just-out-of-the-money. These are usually lower-priced options, with a hefty time premium, that are bought and sold by speculators and novices who are looking for a lot of leverage and a big score.
But why get hemmed when you can give yourself a fair chance to come out ahead?
I’ve developed a technique over the past 10 years for my clients’ retirement accounts that produces just about the same results and has a slightly lower risk than a short sale. It also mitigates the common problem of time erosion that most options carry.
Let me show you how it works…
When Google Plunges, Your Short Option Will Multiply
If you look at an option chain, you will find that the options that are deep in the money carry virtually no time premium, even ones that expire months down the road.
I’ll use Google (Nasdaq: GOOG) and the June 2006 puts as an example because Google has a high price and high volatility. And the June expiration gives us a sizable time premium.
On Friday, January 13, 2006, GOOG closed at $466.25. Let’s say that you thought GOOG would drop to $400 over the next few months. In a regular account, you can execute a short sale at $466 in your margin account and your requirement (what you’d have to come up with) would be $233 per share. Once executed, you’d put in a stop loss order (we’ll use $500 for this example) and forget about it.
But in a retirement account, you are forced to use the options market in order to benefit from a drop in GOOG shares.
Most investors, especially ones without much option experience, would look at the June 2006 puts with a strike price around $460 or lower. The GOOG June $460 put closed at $40, which is a $46 time premium that equals 10% of the value of the underlying stock. That means that GOOG would have to drop $46 (about 10%) just to break even.
That’s too much, so let’s take a look deeper into the option chain.
The GOOG June $650 put closed at $185, which means that the time premium is just $1 per share ($650-$185= $465), and to break even, the stock only needs to drop $1 (2/10 of 1%). More importantly, the option will move dollar-for-dollar with the price of GOOG.
Using a deep-in-the-money put such as this creates a “synthetic short sale” because, like short selling, this option offers a reward when the underlying stock drops. But, if used properly, the deep-in-the money put offers more protection against losses.
The important point is that choosing the right time element is as important as selecting the right put option. I’ve used this technique to give myself a better opportunity to profit… there’s no reason you shouldn’t do the same.
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of words used in the above article like, “short selling” or “option chain.”
- We’ve talked about getting the best price for a put option. Fellow Mt. Vernon Research Advisory Panelist, Lee Lowell, illuminates us on using the battle-axe of the financial world: leverage. Lee explains how to apply one of the most intelligent - and profitable - ways you can invest your money. For all the details, see Smart Profits #262, Options Leverage - How to Use Delta to Maximize Leverage.
- Find out what 99% of brokers are really thinking when you ask them about trading options… Karim Rahemtulla, Chairman of Mt. Vernon Research, has a few must-read notes if you’re just getting started with these investment vehicles. Smart Profits #232 and #233 comprise Karim’s two-part series, Secrets to Getting Started In Options.
Good Trading,
Jim Stanton
Related Articles
- Understanding Options Leverage - The Power of Leverage Is Bigger than You Think
- Strike Price - Increase Your Odds by 99%
- Sell First, Buy Second for 50% Better Odds
Strike Prices
January 19, 2006
The Smart Profits Report: Issue #276
Thursday, January 19, 2006
Strike Prices - Increase Your Odds by 99%
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
In 1982, I traded my first option. And that same trade handed me my first loss - a pretty healthy one, too.
As I remember, it was an S&P 100 Index option that ran in exactly the opposite direction of where I thought the market was headed. It was a call, and the market did its best imitation of a falling rock.
The sad fact is that I continued to lose money with options until I learned some simple truths. But perhaps the most important lesson was learning to pick good - and profitable - strike prices. That’s when the ink on my trading statements changed from deep red to shiny black…
Of course, the underlying share price has the biggest impact on your option price. But the strike price will determine the size of your gain or loss… and it can mean the difference between a 1% gain and 200% cause for celebration.
Right now, let’s see how to pick the strike price that has the greatest chance of making you money…
Tight Strike Price Ranges That Payoff
Strike prices just in- or out-of-the-money have always gotten me the best return on my short-term options plays.
Once an option is in the money, it moves dollar-for-dollar with the underlying stock. So, if the options you’re following are about to cross into in-the-money territory, you’ve found a great opportunity to cash in as they make that move.
Last month, anyone holding just in- or our-of-the-money puts on DuPont (NYSE: DD), for example, walked away with a substantial gain…
The night before this writing, January 10, DuPont cut its earnings estimates from $0.25 per share to $0.10 per share.
The stock went from $44 to $41.47 when trading began the next day. Ouch! A 5% drop for a stock like DuPont is huge. Talk about a falling-rock imitation.
Take a look at the option chain for DuPont’s January 2006 puts at the close on the following trading day, January 11, after the market digested the earnings estimates:
Remember, these are put contracts, so the black options are out-of-the-money. The blue contracts are in-the-money because they represent the option to sell DuPont for a higher price than what the stock trades at - $41.47 at this writing. The $42.50 contract is considered to be at-the-money, or the first in-the-money option.
Notice that the second option out-of-the-money, with the $37.50 strike, didn’t make a cent, despite the 5% drop in the stock price that day. But the other options made significant moves…
Since I don’t like to take a lot of risk with money, let’s use a conservative strategy to see how we could have positioned ourselves to cash in on a situation like this. Here’s a play you might not have considered…
The Right Strike Price For A 217% Gain
Let’s suppose we have owned DuPont stock for a long time. Our cost basis is very low and we are happy with the company. And we aren’t planning to take our profits in the near future.
About a week ago, we read something in the Journal that gave us a not-so-good feeling for the company, near term, and we wanted to brace ourselves for a pullback.
Buying put options is a good way to go since we own the stock and want some downside protection in the event there is some bad news.
If the stock drops, as it did here, we make a ton of money on the puts we are holding. It softens the blow and reduces our loss.
But choosing the right strike price is where it gets tricky…
Why pay more than $0.05 for an option, right? The $37.50 strike was only a few dollars below the at-the-money and in-the-money options, and it was cheap. We would have had to pay $1 to $2 more per option to get an in-the-money strike. Does a strike price just $2.50 or $5 out-of-the-money make much of a difference?
Absolutely.
As I have said before in previous articles, buying too far out-of-the-money on short-term options reduces your chances of winning by as much as 99%.
Look what the $37.50 option did - a big nothing. It was one step too far and a waste of money. A very easy mistake to make. We all want a bargain.
What about the reverse? What if we bought the $45 strike?
Look At The Percentages…
The $45 strike, which cost $2.20 when the market opened, returned 61% ($3.60 - $1.40 = $2.20, $1.40/$2.20 = 61%). Not bad, but…
The first out-of-the-money option, the $42.50 strike, returned 212%, ($1.35-$0.85 = $0.40, $0.85/$0.40 = 212%). Remember, the stock was about $44 when we bought our options last week, so the $42.50 was the first out-of-the-money strike. The cost of the option was about $0.40.
I’ll take 212% over 61% any day.
I could go through 10 more examples and they’d all produce the same result.
As a novice, I was always shopping for bargains. Buy lots of cheap options for less and really clean up, I thought. Gamble on the stock moving enough to make the play pay. But the only thing that got cleaned out was my brokerage account.
In an average week, I follow about 20 straddles. That’s 40 options. The winning scenario I described above works 90% of the time. Now, those are what I call good odds.
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Today’s Smart Profits Cribsheet
- Very shortly, I’ll be unveiling a new, exciting trading service that is scoring triple-digit gains. It’s geared for investors who want to profit from overreactions in the market, on the long and short sides. The system, which requires little cash, has been years in the making and already has performed like the successful veteran services. Stay tuned for the release of this elite strategy…
- In this letter I discussed how to maximize your upside gains. But as any seasoned options trader knows, protecting your downside can be just as important. To learn more about how to protect your investments, read our Smart Profits #268, How to Defend Your Principal From a 50% Bomb.
- Also for any questions about the terminology used in this article, like “strike prices” or “in the money options“, check out our Smart Profits Glossary.
Good Trading,
Steve McDonald
Related Articles:
- The Backspread Options Strategy - A Trade With Unlimited Profit Potential
- Options Leverage - How to Use Delta to Maximize Leverage
- Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain
Using LEAPS
January 17, 2006
The Smart Profits Report: Issue #275
Tuesday, January 17, 2006
Using LEAPS: These Options Are Set to Run Full Tilt
By Karim Rahemtulla
Chairman, Mt. Vernon Research
That’s what most options traders are begging for right now: Movement for some profits. After all, last year was dismal for options, and for one big reason: There was little volatility in the markets. If stocks in general go up by 3%, there’s little room to make money with options. For an options trader, taking away volatility is like detoxing off adrenaline. The thrill is gone…
That’s because options traders live for volatility, or sharp movement in share prices. When share prices start to move, options prices often roar full tilt. That’s because most options move much faster than the underlying stock price. It’s how we hit the triple-digit gainers…
Lucky for us, that scenario is playing out now. We’re likely to see more market movement in 2006 - and we don’t care if the movement is up or down. We can play the options either way. And right now, my favorite play is using LEAPS (which stands Long-Term Equity Anticipation Securities). And let me tell you why…
Two Years To Be Right Is a Great Margin For Error…
One of my oft-repeated themes at seminars is that LEAPS allow us to be “pretend” investors. We do not have to be right in a week or a month, like those frazzled, short-term traders. We just have to be right in two or three years.
Right now, the market looks VERY promising, jumping around like a banshee. Interest rates are low, home prices have not collapsed, China is still growing and the geo-political situation around the globe stinks. Why is this promising? For options traders, nothing is better than uncertainty and instability.
I know it sounds insane, but stocks are as likely to gain double digits this year as they are to drop by the same amount. That’s a very positive setup for options, and why my recommendation is NOT to invest in stocks…
Take 90% Of Your Money Out Of Harm’s Way With LEAPS
This is where LEAPS options come in… Why risk 100% when you can take 90% of your money off the table? Here’s the skinny on using LEAPS, for those of you who are new to the term.
LEAPS are one-, two- and three-year options that give you control of the underlying shares through the purchase of PUTS (short) and CALLS (long). The cost of a LEAPS option bought with a strike price close to where the shares are trading is usually no more than 15% - and often less than 10% of the underlying share price.
A couple of months ago, for example, we went long on Sun Microsystems (Nasdaq: SUNW). We could have paid $4 for the shares, but we chose to pay $0.75 for a two-year LEAPS contract. It cost us less - nearly 85% less - it gave us time and it limited our losses to the amount we had at risk. If we bought the stock and used a 25% trailing stop or stop loss, we would have risked more.
I chose the $5 strike price, less than the 52-week high, and I was looking for the shares to move just 10% to 20% within a few months to make some good money.
With a tech stock like SUNW, which has traded within a 40% range annually for the past few years, it was a sound bet. And it paid off. We just closed out our SUNW position for a 60% gain, in a staid market.
In short, LEAPS allow for three positive results:
- You have less money at risk. The money you don’t have at risk can actually offset some or all of the premium you paid for the option.
- The most you can lose is what you have at risk in the option - the price you paid. This is always less than the 20% or 25% stop loss typically used by traders on a stock.
- LEAPS can actually return MORE than the underlying shares in real AND dollar returns if the underlying shares move strongly in your direction.
The only question is whether to invest in one-, two- or three-year LEAPS.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- In just the last week, subscribers to my LEAPS Options Trader have banked four winning trades with gains from 25% to 80% in sectors ranging from technology to gold. And since we choose to invest using LEAPS, we had the luxury of time to watch these trends take off. We have initiated new short positions, new long positions, and are looking at two spreads, as well. I encourage you to learn more about my LEAPS Option Trader.
- Uncertainty and instability aren’t the only indicators pointing toward a lucrative LEAPS environment… There’s a “human” indicator that’s been hard at work, as well. Click here for Smart Profits #272, Inverted Yield Curve: Now’s the Perfect Time For LEAPS Options.
- Check out the Smart Profits Glossary for definitions of terms like “volatility” or “LEAPS” found in today’s article.
Related Articles:
- LEAP Options: The Pro Strategy That Provides Protection And 177% Profits
- LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns
- LEAPS Option Strategies: A Gold Strategy That Beats Stocks, Bullion or Coins
The Backspread Options Strategy
January 12, 2006
The Smart Profits Report: Issue #274
Thursday, January 12, 2006
The Backspread Options Strategy - A Trade With Unlimited Profit PotentialBy Lee Lowell
Advisory Panelist, Mt. Vernon Research
Think you have a feeling that a stock or commodity is going to move big in a certain direction? Using options instead of the stock or commodity is a great way to leverage your money and cut down on your risk.
But what strategy should you use? Many people would simply buy a call or put option, or maybe even a straddle or strangle if they weren’t sure which direction it was going to make the big move. Although the problem these traders sometimes face is that they end up losing their option investment because they picked the wrong strike price or the wrong expiration, or just the fact that they had to pay out two premiums for a straddle trade.
I’ve got an options strategy that can potentially alleviate all of these symptoms, and it won’t cost you a dime to put on the trade. It’s called a “backspread,” and here’s how it works…
Buy Twice As Many Options As You Sell… And Pile On the Gains
The backspread is an option-spread type of play where you buy and sell different amounts of options on each leg. You will take in more premium than you shell out; hence, you will receive a credit at the beginning of the trade. The only downside to the backspread is that the stock or commodity MUST make the big move you anticipated, or else the position will start to slowly lose money.
The profit potential is unlimited, and if your market direction is completely wrong, you can still walk away unscathed. Let’s look at an example.
Let’s assume we’re bullish on IBM and we expect a significant up-move over the next year. Instead of buying 100 shares of stock that will cost us $8,400, we’re going to put on an option play in the form of a call backspread. This type of spread consists of more long options than short, but we’re going to sell option strikes that are in the money (ITM) and buy more options that are at the money (ATM).
A typical backspread is usually done in a 1 x 2 fashion. In other words, buy twice as many options than you sell. We always want to initiate the spread for a credit, which assures us of starting with money added to our trading account.
In our fictional trade, we’re going to sell five of the IBM January 2007 $70 calls for $17.90 (splitting bid/ask) and buy 10 of the January 2007 $85 calls for $7.60 (splitting bid/ask). This will give us a credit of $8,950 ($17.90 x 5 x $100) from the sale of the calls and incur a debit of $7,600 ($7.60 x 10 x $100) from the buy side, for a net credit into our account of $1,350 (a $8,950 credit minus a $7,600 debit). Now we sit and wait.
Here’s a breakdown of our potential profit/loss scenario at option expiration in January 2007:
Our break-even point, or where we start to make money on our spread, is somewhere between $95 and $100, as seen in the “Net P/L” column. That means we need IBM to go up at least another $13 over the next year to break even on the trade. Once we get above that level, our profits start to add up rather quickly. Since we’re very bullish, this type of trade can work extremely well if our prediction is right.
One great thing about the backspread is that if we’re completely wrong about our price prediction and IBM tanks below $70, we’ll still make money by keeping our initial credit of $1,350. The only time we’ll run into a problem is if IBM stays right around its price of $84 throughout the trade.
If you look at the P/L spreadsheet, you’ll see that our greatest potential loss is right around the $85 mark. So, in order to use proper money management, we want to be out of the trade somewhere within the last few months before expiration. If IBM is not making the anticipated move by that time, we’ll most likely be able to come out unscathed as spreads usually take the full time allotted to reach their maximum loss or profit potential.
The backspread is a great trade if you’ve got a real good feeling of a large directional move. You get to initiate the trade for a credit, and have lots of time to wait for the trade to mature. Even if you’re completely wrong in your directional assessment, you may still come out ahead in the profit/loss column. Remember, if the trade is not working for you by the last few months before option expiration, think about unwinding the trade.
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Today’s Smart Profits Cribsheet
- Need an explanation of a straddle or strangle from above? Check out Smart Profits #260, Two Ways to Profit Trading Index Options and Smart Profits #257, Extracting Three Strangle Tips From a 515% Gain.
- For definitions of words like “leverage“or “backspread“, you can also visit the Smart Profits Glossary.
- If you haven’t had a chance to look into my special electronic report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks, now is a great time to do so. It outlines specific techniques I picked up in my seven years on the floor of the New York Mercantile Exchange. It’s a handbook we can e-mail right to your inbox… Click here to learn more.
Good Luck,
Lee
Related Articles:
- Make 1,000% or More by “Spreading” the Wealth
- Truly Risk-Free Profits - Shorting Crude Oil
- Two Valuable Options Lessons From Boston
Common Option Mistakes
January 10, 2006
The Smart Profits Report: Issue #273
Tuesday, January 10, 2006
Common Option Mistakes: Four Options Resolutions to Make Today
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
It’s that time of year again. Time to take a look at our lives and change for the better. This year, let’s try to make some changes that will make us more money. Now that’s something we can really sink our teeth into.
Let’s look at four common options mistakes that can drag down account balances, and make 2006 the year we put them behind us for good…
Common Option Mistake #1: Don’t Buy Out-of-the-Money
When picking an option, the most tempting thing to do is to get it cheap. We tend to think we are getting a better deal that way, but 99% of the time, we’re not. Let’s use the Intel (Nasdaq: INTC) January calls as an example:
A few weeks ago, INTC stock was trading at $25.33. The $25 call was in the money and traded for $1.35. But the $30 call was only five cents! Seems too good to pass up… Why pay $1.35 for a call when you can get one a few more dollars out-of-the-money for a lot less?
Well, experience tells us that buying the $25 call is a much better bet. The option will move dollar-for-dollar with the underlying stock. So, if the INTC goes to $27, the call should go up $2, too. The out-of-the-money options almost never move until the stock has reached, or almost reached, the strike price. Chances are, you will end up with another loser.
As a novice, I bought many options out of the money, thinking I was getting a better buy. I was wrong 99% of the time. Buy out-of-the-money options and you have about a 1% chance of making money.
Common Option Mistake #2: Cut Your Losses Early
When an option starts to tank, it is most likely going to continue its losing ways. The same is true for winners. If a stock is moving up, the option normally follows, but it’s the losers we remember.
When I have a list of options I am following, I cut my losers early. They usually don’t come back - at least not for me. Maybe you have better luck than I do, but the “80/20 Rule” applies here for me.
The 80/20 Rule:
- 80% of options that have a significant drop in price.
- 25% or greater, don’t come back.
I would prefer to cut my losses early and give up the other 20% that might turn into winners, than chase the dogs to death.
Remember, only cars and options eventually are guaranteed to be worthless.
Common Option Mistake #3: Don’t Bet the Farm
There shouldn’t be too many questions about this one. This is the guaranteed red-face maker. The urge to jump in with both feet is just too great for most of us.
The typical scenario that leads to a big loss is to buy an option and have it move up a little. Let’s say we buy at $.25 and it’s at $.35 on the bid. That’s a 40% move. What we should do is take the money and run, but most of us just can’t take a profit. Most people will say to themselves, “It’s only been a few weeks and I have a lot of time left on this one; why not, let’s buy some more and make a killing.”
This is the “Moon Shot” method of investing. We know this one is going all the way. Next stop: retirement. We put more money into what has been, until now, a winning position. Our average cost goes up and our odds of wining go down.
Why should we avoid this? Because the traders who run this business know what you’re thinking before you think it. The hook has been set and you’re about to learn a very expensive lesson.
Watch a lot of options and how they move and you’ll see that they rarely go straight up. There are lots of dips along the way. These dips are where we usually get scared and jump out to cut our losses.
Not everyone will agree with me, but my 25 years of option trading tell me to cash out and not look back. Never put too much money into one option. Avoid the urge to buy as it moves up. There are lots of plays to come, don’t get piggish.
Common Option Mistake #4: Avoid Low Volume
Remember when your parents told you it’s not okay to do something just because everyone else is? They never traded options.
When I am picking an option, it has to have a lot of volume, preferably several thousand open positions. Every time I have ignored this rule, it has come back to bite me.
With a stock as popular as INTC, there is no problem with interest. Most options don’t have this kind of volume. You really have to be disciplined about this. No matter how good it looks, if you are one of the few people interested, there is probably a very good reason.
The other issue with volume is how recently investors have been buying the position. When you enter your buy in your portfolio, it should tell you when the last trade was placed. Too many times, I have picked an option and watched it do nothing for a couple of days, just to realize there hasn’t been any activity for a week. Not a pretty sight, and it always costs me money.
Volume is essential when picking a winner. If no one is buying it, you won’t make any money on it.
Good Luck in the New Year,
Steve
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Today’s Smart Profits Cribsheet
- There are more than four ways to improve your trades, of course. Check out some of my previous ideas on how to save money and protect your portfolio - Smart Profits #261, Option Prices: How to Get the Best Price on Your Options, and Smart Profits #268, Principal Protection: How to “Defend” Your Principal From a 50% “Bomb.”
- And speaking of not betting the farm on your options trades, Karim has some great tips on position sizing here - Smart Profits #229, Option Position Sizing: How Much to Invest In Each Option Trade.
- I mentioned today that when you buy out-of-the-money options, you win about 1% of the time… So, what does that say about your odds when you sell the same options? Find out how Lee Lowell, fellow Mt. Vernon Research member, uses this fact to his advantage… Smart Profits #270, Selling Covered Calls: Getting Cash for Stocks You Already Own… Without Giving Them Up.
- Check out the Smart Profits Glossary for definitions of words like “in the money,” “out of the money” or “volume” found in today’s article.
Related Articles:
- Volume: Reading Volume to Find 20% Gains… In 45 Minutes
- In the Money Options: Make Mondays Your Discount Stock-Buying Day
- Liquidity & Limit Orders: An Options Balancing Act
Inverted Yield Curve
January 5, 2006
The Smart Profits Report: Issue #272
Thursday, January 5, 2006
Inverted Yield Curve: Now’s the Perfect Time For LEAPS Options
by Karim Rahemtulla
Chairman, Mt. Vernon Research
A couple of weeks ago, I let you in on Bill Gross’ latest insider buying spree. He was picking up shares of two Pimco floating-rate funds (PFN) and (PFL). Since that communiqué, both closed-end funds have risen nicely. And, since then, Bill has added to his positions in the funds. Both of them have paid a nice monthly dividend for December, as well.
I also took a look at the performance of Pimco’s closed-end municipal funds, which I recommended to you early last year when Gross was loading up on shares of those. They are up close to 20% (PMX, PML, PMF) across the board, including dividends.
So, what does this buying from Gross tell us?
Let’s take a look at the inverted yield curve as well as the type of market his actions are predicting, and then find out how to set up your options portfolio to get ready for it…
Preparing For the Inverted Yield Curve
There is little doubt in Gross’ mind that interest rates in the U.S. are getting close to their peak. He is betting that getting 6.4% tax-free on municipal bonds and 8.4% on taxable funds is a great deal. But, the implications of his buying are much more serious.
If rates do peak in the next few months - the yield curve is almost inverted as I write this - then we are headed for a difficult time.
Low rates usually equate to boom times for the economy, but when short-term rates move higher than long-term rates, this usually means that economic confidence will be short-lived.
In a normal boom cycle, long-term rates should move higher along with short rates. Higher rates in the long-term indicate that borrowing costs are increasing based on the assumption that economic activity should, in the normal course, force the cost of borrowing higher as well. In other words, you should have to pay more to make more.
The current environment is saying that long-term rates are low because they must be low to invigorate a flagging economy. Yet, the numbers from the government suggest that the economy is flying along at 4%-plus annual GDP growth. Something is wrong here. And, the market knows it.
Over time, the bond market has been an excellent predictor of economic cycles. In this case, it is pointing to a slowdown in the months ahead… for whatever reason.
Here’s Where You Need LEAPS To Take Action…
In such an environment, it would be prudent to manage your portfolio in a way that you account for a possible downturn. One way to take advantage of this is to shift some of your capital out of stocks and into LEAPS options.
LEAPS allow you to take much of your dollar risk off the table, while still maintaining upside potential for a period of one, two or three years. In other words, you can put your money into a safer vehicle while still enjoying a higher overall portfolio return… with less risk.
You could also use LEAPS to short certain sectors, like retail and housing - two sectors that will be hit by a consumer slowdown. Or, you could use them to hedge against a general market downturn by buying LEAPS puts.
For example, in my service (see today’s Crib Sheet for details), we recently shorted Tiffany. We bought LEAPS puts for $3.50 ($3,500 for 10 contracts), which gave us the right to sell the shares at $35.
Short Selling vs. Options
If we wanted to “short sell” Tiffany stock, we would have had to put up nearly $40,000 to control the same position. And, if the trade moved against us, we would face potentially unlimited losses, in the worst case. But by owning the options, our worst-case scenario is what we have invested in the options - that is the most we have at risk.
In the LEAPS Options Trader, we make bets on individual stocks and sectors using these options. Right now, we are long gold (and have been for quite a while), short retail, long natural gas (a 17-month play that is about to expire) and long select technology shares.
I make no secret for liking and using LEAPS options in this type of market. After all, if you were faced with day-to-day uncertainty in the U.S. and global markets, would you rather risk 100% of your capital, or 10%?
Good Trading,
Karim
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Today’s Smart Profits Crib Sheet
- For more on LEAPS, take a look at Smart Profits #165, LEAPS Options Strategies: A Gold Strategy That Beats Stocks, Bullion or Coins, or Smart Profits #173, How to Grow Rich From Your Options Losses.
- Check out our Smart Profits Glossary for definitions of words like “yield curve” or “hedge” found in today’s article.
- The LEAPS Option Trader is a trading service of mine that subscribers use to generate above-average gains, like our recent bull spread winner in Intel. That trade returned a net investment risk of 185%… in about a year. For more information…
Related Articles:
- What Does Bill Gross Know?
- LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns
- Derivatives: Take the Big Guys’ Money With Their Own Weapons
Uncovered Options
January 3, 2006
The Smart Profits Report: Issue #271
Tuesday, January 3, 2006
Uncovered Options: A Win-Win Trade that “Puts” You In the “Bookie’s” Seat
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
The world of options trading has undergone some major changes in the last decade. Consider these two:
- First, the volume on the Chicago Board of Options Exchange has increased by more than 50% since 1998. This fact alone has produced better price efficiency (tighter spreads), which in turn, has attracted more players.
- Second, not only are there more players, there are better tools for them to use - the biggest and most improved, of course, is the computer. It’s given traders an entirely new set of ways to implement options strategies. There are so many different strategies that, at times, it can make your head spin.
So, how do we know which strategy to use? Well, it’s not enough to pick the right strategy. The key is using the right strategy at the right time. Let’s look at one of my favorite combinations of these two elements, namely uncovered options also called naked options…
The Right Strategy at the Right Time
The outright buying of puts or calls gives you the most leverage, but there are times when selling uncovered options (naked) makes more sense.
I have always been a fan of selling options instead of buying them, for a couple of reasons. As the seller, you collect the time premium instead of paying it, and if the underlying stock goes into a holding pattern, you can still make money on the trade.
In short, you are now booking the bet instead of making the bet… and we all know who consistently makes money in the long run.
Since getting my broker’s license in the early 1980s, I have seen and/or used options for just about any scenario you can imagine. But late summer is the time of year that I implement one of my favorite strategies.
Get a Discount On Your Long Stock… And Get Paid Along the Way
Historically, the stock market enjoys a summertime rally, which, in most cases is followed by a period of weakness that usually ends in the September-October time frame.
This strategy requires the intermediate-term outlook for the market to be neutral to bullish and that you use this (or any other) historically weak period to add to your long positions. Once these conditions are met, the next step is to choose which stock or stocks you would like to buy and the price at which you would be willing to purchase them.
You then sell an out-of-the-money put, with the intention of having the stock “put” to you (buying the stock) below the current market value at a price at which you are willing to pay.
Uncovered Options In A Summertime Rally
For this example, I will use the current stock and option prices for Genentech (NYSE: DNA), but we’ll assume that it’s mid-to-late August - a good time for a summertime rally to run out of steam.
DNA recently traded at $94, but you wouldn’t want to pay more than $88. The $90 put options that expire two months from now were recently trading around $3. You could short those options for a $3 credit, and if the stock falls below $90, and the option is exercised, your net cost is $87 per share. ($90 cost minus the $3 credit).
Since you wanted to own the stock at $88 or better, you got your wish. If the stock does not trade below $90, you would not have been filled at your price anyway, and the $3 premium is yours to keep. As a safeguard against an unexpected market meltdown, I always use a safety stop on the stock once the uncovered option trade is executed.
You can implement these trades in any corrective move within a bull market. It’s a win-win situation… and who doesn’t like those kinds of odds?
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- Speaking of options strategies, take a look back at Smart Profits #175, Limit Prices: Tip the Odds on Options Trades In Your Favor. Karim talks about how important it is to use limit orders with all of your options trades.
- Visit our free Smart Profits Glossary for definitions of words like “leverage,” “uncovered options” or “market order” found in today’s article.
Related Articles:
- Out of the Money Options: Buyer Beware, Seller… Take The Money
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- Option Credit Spreads: Sell First, Buy Second for 50% Better Odds
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