Market Maker Insight
April 29, 2006
The Smart Profits Report: Issue #304
Saturday, April 29, 2006
Market Maker Insight: Three Reasons They’re Not Enemies
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
As I was speaking at an options seminar in Puerto Vallarta a few weeks ago, I had a chance to meet a lot of the attendees face-to- face after the first day of presentations.
Many of them were intrigued by what life was like working as an actual market maker and wanted some market maker insight. Lots of attendees were surprised when I told them that the job wasn’t that easy.
Contrary to what many off-floor traders think, the market maker isn’t really the enemy. In fact, they are to thank for making options trading possible for investors like us. Here’s how they do it…
Market Makers: They Are Not Out To Get You
First of all, it’s not a glamorous life. I saw my fair share of floor traders come and go while trading in the Crude Oil options pits on the New York Mercantile Exchange (NYMEX). Being a market maker is a learned skill, just like any other job. If you can’t figure out how to do it, your life expectancy on the floor is going to be very short. Not every trader that walks into the pit is going to be successful.
The way the market maker truly makes money is by having a balanced portfolio of buys and sells, all with an “edge” locked in. The edge is the difference between what an option trader’s “theoretical trading sheets” are telling him to buy or sell an option at, and what price he actually ends up buying or selling it for in the marketplace. The wider the difference between “sheets” and actual prices, the bigger the profit will be.
These trading sheets are the lifeblood of the trader. They are run off of sophisticated option-pricing models that tell the trader what each option strike is worth at any moment in time. Their job is to buy the option under “theoretical price” and sell it for more.
A lopsided position will occur when all the brokers want to buy or sell the same position, leaving the market maker with too many buys or too many sells in their portfolio. If the market moves in the direction that all the brokers want, the market maker will be the one taking the losses. You just can’t avoid that situation if you’re a market maker. It just happens.
At that point, you will see market makers doing all they can just to even out their portfolio. Many times, this can entail either selling or buying below fair value just to balance out the risk. I’ve done it, and I saw many of my fellow market makers do it, too.
Three Challenges The Market Maker Faces
- Getting Speedy, Spot-On Quotes
Most off-floor participants think the market maker is always responsible for their bad fill prices. Believe me, you as an individual trader are the farthest thing on the mind of any option’s market maker. They are more worried about how fast they can supply the brokers with accurate quotes, how many contracts they can get from those brokers, and how fast they can lay off the delta hedge with their point man (the guy that helps the option traders get their futures trades done).
- Managing Directional Risk
Market makers aren’t on the floor to pick a direction on a stock or commodity and then hope it moves in that direction. They are not in direct competition with you on that level. The market makers are there to supply the brokers with bid and ask quotes all day long, hoping to buy on their bid price and/or sell it back on their ask price.
If they can’t immediately sell something that they just bought, or buy something back that they sold previously, the option market makers must lay off their directional risk of that trade with an opposing trade in the futures market. At that point, the option trader is at the mercy of the futures market being at the same level as when they initiated the option trade. Any movement in the wrong direction of the futures market, and the option trader starts losing the “edge” on that trade.
And the “edge,” like these other obstacles, is what makes the life - and profitability - of a market maker very difficult…
They have no idea that you, Joe Smith Trader, are on the other side of a trade. All they know is that your broker is executing lots of contracts for either a large customer or for many traders who want to get in on the same trade. The only way the option trader will take the other side of that trade is if he knows he can lay off his risk with an opposing trade in the futures market.
The point man is responsible for accurately quoting - with hand signals - where the futures market is at all times. The risk comes at this point of whether the option trader can execute the hedge trade at the same level he was quoted by his point man. All it takes is a few seconds to execute the option trade and send the order to the point man, but those few seconds are sometimes long enough for the futures market to move adversely and leave the option trader with an unprofitable trade.
- Always At the Mercy Of The Market
One of the other obstacles standing in the way of the market maker being profitable is the fact that he must always be there ready to make a market and trade under any condition.
The problem in this scenario is that many of the broker’s customers will initiate the same trade at the same time, sometimes all day long. The market maker is obligated to keep selling or buying those options from the brokers, leaving the market makers with a very one-sided position consisting of all long positions or all short positions in the same strike price. That is a potentially life-threatening situation - financially - for a trader.
Insight Into The Market Maker’s Minds
Believe me, market makers are not concerned with whether you think orange juice is going up or whether coffee is coming down in price. They just want to make sure they can give accurate quotes to the broker, get involved with as many trades as they can, and be able to effectively get their futures trade executed at the desired level.
That’s how it’s done, and if the market maker sways from that plan, he will not be around that long. Instead of thinking of them as the enemy, think of them as the ones who make it possible for you to trade any option at any time.
Good Trading,
Lee Lowell
|
Today’s Smart Profits Cribsheet
- Lee’s put together a series about his days on the floor of the New York Mercantile Exchange. What goes on in the “pits” during market hours? How “big” is the money that crosses the floor? Do seconds really matter? Find out by taking a look at his Smart Profits Report #241, Market Makers: Hand Signals, Stress and Million-Dollar Trades in the NYMEX Options Pit.
- As always, check out the Smart Profits Glossary for definitions of words like “market maker” or “bid & ask” found in today’s article.
- If you’ve been paying attention to gold prices lately, you’re no doubt intrigued by $630 an ounce. Just last week, expert trader D.R. Barton, the Chairman of Trader’s U, put together a detailed action plan if you’re holding gold now or thinking about adding it to your portfolio. I urge you to take a look - Today’s Gold Prices: Is There Still Time To Jump In and Invest? (Don’t Get Burned by the New Gold Rush).
Related Articles:
- Market Maker Tactics: What Market Makers Really Do
- How the Market Makers Lose: Uneven Trades and Open Positions
- Options Market Makers: Two Rules for Beating the Market Makers
International Securities Exchange Options
April 26, 2006
The Smart Profits Report: Issue #303
Wednesday, April 26, 2006
ISE Options: Two Strategies For Getting Runaway Stocks On the Cheap
By Karim Rahemtulla
Chairman, Mt. Vernon Research
A few weeks back, the International Securities Exchange (NYSE: ISE), the premier electronic options exchange, was hitting 52-week highs and trading around $50. I have always liked ISE, and I’ve recommended it both as an IPO play and a covered call play.
However, I was not fond of the shares at the $50 level. They had shot up on the back of all the exchange run-ups… the Chicago Mercantile Exchange, the New York Stock Exchange, the Nasdaq and the Intercontinental Exchange. There is a feeding frenzy for exchange-related shares, and I just don’t like diving in from such heights.
What to do? I got on the phone with my friend and fellow Mt. Vernon Research Advisor, Lee Lowell…
The Tale Of Two Strategies
Lee and I got to talking about how we would approach the International Securities Exchange. Lee loves selling puts. I love covered calls. Essentially, we are doing the same thing, but with different dynamics. I like covered call writing because I do most of my investing in a tax-deferred retirement account. And, in that type of account, most brokerage firms will only allow covered call writing (there are some exceptions, but not many).
But in order to trade a covered call, I must first buy the stock and then sell the option of my choice against it. Usually, I will rake in a little more premium than the put seller. Also, if there are any dividends, I get them - the put seller does not.
Lee, on the other hand, likes the fact that he can sell puts and not have to put up much in the way of capital for the trade, unless he “gets put” (he can also buy back the put in lieu of buying the shares). Because of his immense experience in the real world of investing, as a market maker and trader on a major global exchange, Lee has what it takes to be a great put seller. He understands the risks and ramifications better than anyone I know. And, I can’t wait until he begins a trading service later this summer. Imagine… Having the ultimate insider on your team!
Own A $44 Stock For Less Than $30
The one thing that we did that was exactly the same was this: We used a deep-in-the-money strategy to mitigate as much risk as possible. Both Lee and I abhor risk. And we have both developed systems that allow us to manage our risk and still produce better-than-market returns.
I went diving deep in the money. I did not like ISE at $50, but I liked it at $40. Still, I really only wanted to own it if it was below $30. Well, with the shares trading at $44, it would be a long wait. But what if I could get paid handsomely for waiting for the shares to come down to my price? I ended up selling the $30 call options against the shares, raking in enough premium to reduce my cost to the $27 level. So, I would either own the shares for $27, or I would get paid more than 10% for hanging around - my type of trade.
Lee decided to sell the lower-strike puts. He picked up some great premium and would be obligated to buy the shares if they fell more than 50%. While he did not bring in as much in cash, he also took less risk by using a lower strike and not owning the shares. In the end, we both should make out like bandits - either by owning a $44 stock at less than $30, or by taking in a nice chunk of change just for trying.
Good Trading,
Karim
|
Today’s Smart Profits Cribsheet
- If you are a subscriber to The Income Trader - A Covered Call Strategy, look for a similar type of trade to come your way soon… Learn more about The Income Trader’s profit potential.
- Selling out-of-the-money puts, one of Lee’s favorite moneymakers, allows you to cash in on investors making big, unrealistic bets that a stock will take off… But what happens when their options never move into in-the-money territory? Find out how Lee puts this strategy to work full-time in Smart Profits #255, Out of the Money Options: Buyer Beware, Seller… Take The Money.
- Visit the Smart Profits Glossary for definitions of option terms like “covered calls” or “deep-in-the-money” found in today’s article.
Related Articles:
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- The Chicago Board of Options Exchange: The Website Every Options Trader Should Know
- ISE’s IPO: Finding Value in ISE’s Upcoming IPO
Buying In-the-Money Options
April 18, 2006
The Smart Profits Report: Issue #301
Tuesday, April 18, 2006
Buying In-the-Money Options: A Profitable Exit Strategy for Expiration Week
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
I’ve hit a number of home runs in the option market over the years using cheap, out-of-the-money puts and calls. But believe me, the number of options that expire worthless using this method far exceeds the number of profitable ones. And that’s why I’m a bigger fan of buying in-the-money options.
But if you’re holding in-the-money options - and sitting on gains - selling them at a fair price can be a chore all by itself.
Today’s column covers an exit strategy for profitable, in-the-money options going into expiration week. When the options are bidding below their intrinsic value (the difference between the stock and strike price), sometimes you have to get creative to realize your gains. Let me show you how…
Don’t Fight the Market Maker
When looking at any option chain, the most active options are usually slightly out-of-the-money and have the tightest bid/ask spread. But with deeper in-the-money options - especially in stocks that are less active - the bid/ask spread is wider. This is not only true in the weeks prior to expiration. I’ve seen it many times during expiration week, too.
One would think that with the heightened interest in options these days, and the sophisticated software available, the spreads would have improved over the years. But in the end, it comes down to the risk that the market makers are willing to take, and that’s a function of volume and how greedy or risk-averse the market maker is.
While option-pricing models say that an in-the-money option should not trade below intrinsic value (minus commissions) on expiration day, in real life, that’s not always the case.
Most traders accept the discounted bid price and go on to the next trade. But they don’t have to…
Capturing All Your Profit Buying In the Money Options
Let’s assume that on April 21, 2006 (expiration day) stock XYZ is trading at $50.50. Let’s also assume you own 20 of the April $45 in-the-money calls and want to sell the position. The intrinsic value is $5.50 ($50.50 minus $45), but if the stock and option are thinly traded, the bid/ask may be $5/$5.60 with very little volume. By selling at the bid price, your proceeds would be:
$5 x 20 x 100 (shares per contract) = $10,000
You could attempt to use a limit order at around $5.40 or $5.50, but the market maker knows you probably need to sell. So, unless he gets an offsetting order, you probably won’t get filled. If this occurs, you have to take on the role of arbitrager. Here’s how it’s done.
Instead of selling the call at a discounted bid, sell 2,000 shares of the stock (the number of shares 20 contracts controls) at $50.50 and immediately alert your broker that you are exercising the 20 option contracts. You will receive $50.50 for the stock and then buy it for $45 as per the exercise agreement. The proceeds would be the following:
- The return from selling the stock (2,000 x $50.50 = $101,000)
- Minus the return from buying it back (2,000 x $45.00 = $90,000)
- Nets $11,000.
That puts an extra $1,000, or 10% more, into your account. You will pay an extra commission using this strategy, but the commissions have gotten so cheap, especially when trading online, that your net should be close to $950.
No Mercy For The Market Maker
I would not sell the stock short because of the uptick rule, which means it’s possible you won’t get filled and could be subject to additional SEC regulations. Make sure the firm you are dealing with is aware of your strategy. It should not require that you put up additional funds for the stock sale as long as you do the sale and exercise on the same day. That way the settlement day for both transactions is the same.
If you are long an in-the-money put option, which is trading below the intrinsic value, the strategy is done in reverse. Buy the stock and exercise the put on the same day.
In either situation, you will get very close to what your in-the-money options are really worth and not be at the mercy of the market maker, only the market itself.
Good Trading,
Jim
|
Today’s Smart Profits Cribsheet
- In options trading, there are many variables beyond your control, and the bid and the ask prices, as we’ve seen today, are some of them. But we’ve also seen that there’s a way to maximize your trades despite the market maker’s influence. Another way to optimize your options trading is by practicing superior money management. Check out Smart Profits #286, Understanding Option Trading: Cut Your Losses… And Watch Your Winners Run for profitable money management tactics.
- Remember, there are at-, out-, and in-the-money options. An option is “at-the-money” when the strike price of the option equals the market price of its underlying security. An example: If Nike is trading at $75, then the Nike $75 call option would be “at-the-money,” essentially at a break-even point. For more helpful terms, see the Smart Profits Glossary.
Related Articles:
- In the Money Options: Make Mondays Your Discount Stock-Buying Day
- Options Trading Strategy: A Five-Question Screen to Find the Perfect Option
- Position Sizing: The Most Powerful Investment Concept
Time Stops Strategy
April 13, 2006
The Smart Profits Report: Issue #300
Thursday, April 13, 2006
Time Stops Strategy: Your 10-Day Profit Test
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
Time may not be on your side in every option play. But it should certainly be on your mind.
A stop loss, or the predetermined price at which one sells a stock or option to avoid a major loss, is an invaluable tool for protecting your principal. But in the world of options trading, “time stops strategies” are becoming more commonplace to head off unprofitable plays and collect quick gains.
Just as they sound, “time stops” have more to do with when you get out of a trade than at what price to close the position. And some of the most reputable options strategists around are using them to increase their profits.
Today, let’s look at these moneymakers more closely…
Option Price Trends Form Early
A buy-and-hold strategy has its place. Just ask Warren Buffett. Over time, a sound company that posts quarterly earnings of 15% or more above the same quarter for the previous year is considered a good play, all other things being equal.
In options management, that strategy can work, too. Long-term options, known as LEAPS, can last up to two years.
But short-term options fall into a different category. They are likely more volatile, which can work in your favor. But they can work against you if you use a wait-and-see attitude adopted by long-term strategists.
In the past, I have had a vague timeline for selling options. My mental stop is at around 15 to 20 days before expiration. That’s when value erosion accelerates if you are out-of-the-money. This doesn’t necessarily apply if you’re in-the-money.
“Opt” In With Short-Term Options
A few weeks ago, I was in Chicago meeting with several options strategists at a major brokerage firm. Their view, which is just starting to take hold in the options world, is that short-term option traders should “opt” out of their options if the play is not moving in their favor at the seven- to 10-day mark.
At first, that seemed premature, hardly enough time for the option to make a run or gain momentum. But when I returned to my office, I went through my option picks for the previous six months. Here’s what I found:
Most of my winners - those in which I captured a 20% gain or more on a play - started making their run within two weeks.
The losers were consistently flat or down almost from the first day of the play.
For more years than I care to mention, I have held options until their price movement proved them beyond a reasonable doubt to be losers. Now, there may be an entirely different way to control losses and pocket quick gains. Obviously, time erosion is always a concern, but controlling time as tightly as price fluctuation is going to take some practice.
I’ve started tracking my results using the parameters of the time stop strategy, and I will keep you up-to-date on the findings.
Good Trading,
Steve
|
Today’s Smart Profits Cribsheet
- “Time decay,” also known as theta, begins to develop in options in the last 60 to 30 days before expiration. If an option is deep in-the-money, it will happen more rapidly; holders may discount the time value, attracting buyers and realizing intrinsic value. For more useful terms, see the Smart Profits Glossary.
- So, we’ve looked at when to close a position based on “time stops.” But when your time stop or stop loss hits, there’s one vital rule to selling your current options. And it all comes down to getting the best price when you close the trade. Smart Profits #279, The Options Bid: “The Bid, the Bid, Always the Bid,” shows you how to get the most profitable execution on your options.
Related Articles:
- Option Losses: How to Grow Rich From Your Options Losses
- Trailing Stops: How to Give Your Options Room to Grow
- Limit Prices: Tip the Odds on Options Trades In Your Favor
Covered Call Options
April 11, 2006
The Smart Profits Report: Issue #299
Tuesday, April 11, 2006
Covered Call Options: Turning A Stagnant Stock Into An ATM
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
Many stockholders in Microsoft (Nasdaq: MSFT) have had little cause for celebration. For five years running, the company’s stock has been stuck in a tight trading range, bobbing and weaving between $20 and $30.
But some people are making a lot of money on the stock, and I’m not referring to billionaire Bill Gates… You see, when a stock you own is not performing or isn’t moving, you can increase your cash flow from it by using a very simple tool - “rental” income.
The strategy, of course, is “selling covered call options” or “writing covered call option,” and it’s employed by just a fraction of those who own stock. But it is one of the surest paths to making money from your investments. Here’s how it works…
How to “Rent Out” Your Stock For Extra Cash
Let me start off with the one catch (but don’t worry, it’s a good one). In exchange for someone paying you cash today to “rent” your stock, you have to enter into an agreement with them to possibly sell them your shares at a pre-determined price by a pre-determined date.
If the conditions for selling your stock don’t materialize by the pre-determined date, then you are off the hook and you get to keep the money you were paid upfront. In addition, you get to keep your shares of stock and the trade is over and done with. You are free to do whatever you want or you can enter into another contract.
The reason you buy stock in the first place is to gain capital appreciation and/or dividend income. But for much of the time, your stock may sit idle, or retreat, possibly leaving you with a loss. Selling call options against your existing shares allows you to take in money that you don’t have to give back. This money can be a cushion against your shares if they happen to fall in price. It also reduces your cost basis.
Here’s an example:
Above is a monthly chart of Microsoft going back to 2001. As you can see, the stock has been stuck in a 10-point range between $20 and $30. If you’ve owned any shares during that time, did you gain any long-term appreciation? Most likely not.
So, in those five years of bobbing and weaving, what could you have done to supplement your income? Sell covered call options. Let’s suppose that you own 300 shares of Microsoft. A stock option contract covers 100 shares of stock, so you’d be able to sell three covered call contracts. Let’s see what kind of money we could receive in today’s market for selling covered call contracts with MSFT stock trading at $27.64/share.
An Example of Selling Covered Call Options
Below are the option prices for MSFT for October 2006 expiration. When selling covered call options, you have to make a decision about the strike price. Since a majority of people would like to keep their shares for the long haul, we want to focus on strike prices that are at a level the stock is not likely to reach by expiration. These are called “out-of-the-money” (OTM) options.
We can sell the MSFT October 2006 $30 calls for $0.50 each, netting us $150 for our 300 shares of MSFT. That’s roughly a six-month holding period (from now until October). If MSFT never gets - or stays - above $30 by October expiration, we get to keep our $150 as well as our 300 shares of MSFT. At that point, we can repeat the trade again, like clockwork. The idea is to routinely write covered call options on the same stock.
Two Ways To Profit With Covered Call Options
If MSFT ends above $30 by expiration, we have two choices:
- We let our stock get called away from us and we are happy that we finally got to sell MSFT for $30/share (a level that hasn’t been seen in over four years!). Not only do we get to keep our $150, but we also got another $708 in appreciation from the move from $27.64 when we initiated the trade to our sell point of $30.
- If you are having second thoughts about having your shares called away, you can always buy back the option and your obligation to sell the shares disappears. This is not detrimental. Most people think that buying options back means taking a loss. But it is offset by the larger profit from the shares. So, even though you might take a loss on the options, your gain on the stock will be larger.
The bottom line is this: There’s an opportunity for you to make more money on your stock than just if the price goes up. Someone is willing to pay you money today for the possibility of taking your shares away from you at a higher level. Think of it as another perk to owning stock.
It’s even better if you think of it as a cushion against a potential downturn in the price of your stock. And, in the case of MSFT, you can do the trade twice a year and net $300.
If you did that over the last five years when the stock was trading sideways, you would have collected an extra $1,500. Not to mention that if you write enough covered call options, your cost basis for the stock could eventually become zero.
Good Trading,
Lee
|
Today’s Smart Profits Cribsheet
- Remember, a deep-in-the-money option has a strike price significantly below (call) or above (put) the market price of the underlying asset. Investing in this type of option is similar to investing in the actual asset, except the buyer will benefit from lower prices, more leverage and more profit potential. For more important terms, see the Smart Profits Glossary.
- I’ve put together a special electronic report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks. And if you own stock right now, I urge you to learn more about it. It’s a handbook that can be e-mailed right to your inbox… just click here.
Related Articles:
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- Defensive Covered Call Strategy: What’s Better Than Making Money? Keeping It
- Buy-Write: Predict Your Profits With 99.7% Accuracy
The Search for a Good Broker
April 10, 2006
The Smart Profits Report: Issue #302
Thursday, April 20, 2006
The Search for a Good Broker: Five Tip-Offs Your Broker’s A Fraud
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
Working in the money business has some disadvantages. For one, your friends and family ask your advice, but rarely follow it.
And last weekend, a friend asked me to clear up some confusion about her brokerage account. What caught my eye first was that she had a new broker. I asked if she was acquainted with him. She said no, but added she was certain that her former broker would choose a successor who was reputable, instead of making her search for a good broker.
“Oh, really,” I said. “Did you know that when a broker retires he sells his clients to another broker?” My friend said she wasn’t aware of that. But here’s why she should be…
Rules of the Road When Searching For a Good Broker
Sadly, most people are not aware of the behind-the-scenes activity of their brokers or the brokerage industry at large. But the personal hand-holding that many brokers claim as their stock in trade is one of the first broken promises.
In looking over my friend’s experience, I came away unimpressed by her broker’s performance.
Five red flags popped up…
- Superficiality - The new broker had sent her what I refer to as typical boilerplate preprinted material. It included colorful pie charts and groupings of equities and graphs that illustrated hypothetical results based on apportionment of investments. This was flashy stuff intended to appeal to one’s eye. It’s meant to convey that the broker did a lot of work on your behalf. He didn’t. He spent about five minutes plugging material into a computer. Voila!
- No “Getting to Know You” - My friend’s account had in excess of $500,000. With that hefty amount, you’d think she’d at least get a visit from her broker. But she didn’t. Just a business card.
- What? No Prospectus? -The new broker had sent his new client a list of all the mutual funds he was recommending, but failed to provide a prospectus or list the costs of investing in them. This is not just bad business, but potentially illegal.
- Where Are My Stocks? - Despite the fact that my friend had six open stock positions, her broker was recommending mutual funds over stocks. With some diligence and hard work, he could have helped her diversify her stock portfolio. Why was he recommending mutual funds over individual stocks? Could it have anything to do with the higher payouts to the broker?
- Flashy Titles - Does anyone know what a “Private Client Group” refers to? Nothing. The broker claimed to work in this group. But more than likely no such group exists. The broker is a broker. Period. Everyone is either a broker or on the administrative side of the business. Titles mean nothing unless they say President or CEO before someone’s name. The flashier the title, the more likely that people are trying to convince you they’re something they’re not.
There are good brokers and there are questionable ones. I get the sense that this guy is one of the latter. I think he’s looking for a big payout on several mutual fund sales from the large cash position in my friend’s account.
Signs Of A Great Broker
Here’s what I would look for in someone who’s going to manage my money:
- Clear, understandable information and the willingness to work with me to make it clear.
- Recommendations based on the appropriate amount of risk.
- Realistic expectations.
- As little flash as possible.
Full-service brokers will get you better execution and usually better pricing on options. They’ll also take necessary action in critical situations when you’re unavailable. As with everything else, you need to know with whom you’re doing business.
Good Trading,
Steve
|
Today’s Smart Profits Cribsheet
- If you’re getting ready to start trading options, this report from Karim Rahemtulla could save you some serious grief. And even if you’re an experienced options trader, he’ll reveal how you can more effectively handle any broker. The details are in Smart Profits #232, Secrets to Getting Started In Options.
- When considering choosing a broker, make sure he understands how bonds could fit into your overall investment strategy. For an explanation of bonds and one of the foremost leaders in the trade, see Smart Profits #266, A Bond Play: Now, Something Completely Different. Karim Rahemtulla examines the expertise of Bill Gross, whose views are particularly timely given that the Fed is expected to put the brakes on rising interest rates.
- As always, check out the Smart Profits Glossary for any option terminology you are unfamiliar with such as the differences between American options and European options or exactly what fungibles are.
Related Articles:
- Maximum Fear: How to Turn “Maximum Fear” Into Maximum Profits
- Stocks With No Options: A Cautionary Tale About TZOO
- Opening An Options Account: Smart Profits Basics Part 1
LEAP Spread Trading
April 7, 2006
The Smart Profits Report: Issue #298
Friday, April 7, 2006
LEAP Spread Trading: Gold’s Hot And It’s Time To “Spread” Out Your Fortune…
By Karim Rahemtulla
Chairman, Mt. Vernon Research, Mt. Vernon Research
It’s no longer a secret that metal stocks have been going through the roof. Gold futures reached $600 yesterday, a huge milestone. And we have been there to enjoy the gains all the way up, with Goldcorp, Silver Wheaton, Couer D’Alene, Kinross and Bema, to name a few.
But with these gems approaching gains not seen in metals since the early 1980s, is now a good time to get in on the festivities? The outlook for metals is strong. Fundamentals are good, technicals are where they should be and there’s ample marketplace excitement.
However, as in any hot market, prudent investors should pay close attention. There are several ways to put the odds in your favor, like using LEAP spread trades and trailing stops, just in case there is a meltdown. Let’s take a look…
How to Avoid A Steep Market Correction
Here are two things you should consider immediately to protect your investment and continue making money from this run without taking undue risk.
- Begin by using trailing stops on your positions. Choose a number that you’re comfortable with, whether it’s 10%, 20% or more. Monitor your positions and place mental stops each day. If a position falls to your predetermined level, it is time to sell. In this small but disciplined way you are preserving your profits and marking the price from higher levels. Precious metals stocks tend to be more volatile. So, you might want to adjust your trailing stop accordingly.
- In this strong market for metals, you should start using spread trades. By definition, they offer you insurance against huge swings that can wipe our your profits. That’s because you buy one option at a specific strike price and sell another option at a higher strike price against your initial buy. When using LEAP options you have time on your side, a year or more.
Why Enter A Spread & Which One To Choose?
Let’s say you like Goldcorp (NYSE: GG). It’s trading at about $30 a share right now. The options are very pricey, as is the stock. So you can either risk a lot of money by buying the stock or the option, or you can mitigate the dollars at risk by initiating a spread.
Many options traders will say, “yeah, but doing so limits my upside.” To which I say, “yes, that’s true. But it also may be limiting your downside” Besides, this is just one part of an overall investment strategy. In other words, you are not precluded from owning the shares or options in another trade. The spread merely helps you to diversify your dollar risk.
Back to Goldcorp. You would enter a BULL SPREAD if you think that the shares are going higher, but you don’t want to risk a bundle. So, you need to set a target price. Let’s suppose that $40 is your target. That would net a $10 gain on the shares. However, you’d have $30 at risk.
An Example of a LEAP Spread Trade
Using a hypothetical example, if you use a spread, you could buy a one-year LEAP option with a $30 strike for $5. Against this position you would sell the $40 calls and receive back $2. Your cost is now $3. That is your at-risk capital, not $30. If the shares close at $40 or higher, you would make $7 on your $3 investment ($40 minus $30 minus $3 = $7.) That would more than double your money. More importantly, you would have taken a prudent position by reducing your dollars at risk.
Some investors might feel just as comfortable using a trailing stop. The device would lower their dollars at risk in the stock position. But it would not be as effective as the spread. Here’s why…
Let’s suppose that Goldcorp was trading at $30 and you were using a 20% trailing stop. If that level were breached, you would lose $6 per share. By using a spread your loss would be cut in half, to just $3. As I said before by using LEAPS, you have time on your side - a year or more to accomplish your goal.
So, the next time you take a leap of faith with stocks, make sure that you’ve covered all your options.
Good Trading,
Karim
|
Today’s Smart Profits Cribsheet
- I cover a fundamental investing technique that can make a tremendous difference in your results. Here are two quick rules before you click through to the full story: 1) There is no sure thing in investing; and 2) don’t forget rule #1. Check out Smart Profits #249, Position Sizing: The Most Powerful Investment Concept.
- Check out the Smart Profits Glossary for definitions of words like “LEAP” or “spread trade” found in today’s article.
Related Articles:
- Bull Spreads: Bagging a 66% Return on Lexar
- LEAP Options: The Intel Bargain & A Potential 566% Return
- Trailing Stops: How to Give Your Options Room to Grow
Option Contracts
April 4, 2006
The Smart Profits Report: Issue #297
Tuesday, April 4, 2006
Options Contracts: An Options Myth Unraveled - 90% Of Contracts Don’t Expire
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
Many of you have, no doubt, heard the oft-repeated claim “90% of all option contracts expire worthless.” That statement alone should keep any sensible trader from buying puts or calls.
But we’ve done some research and the reality is far different. While 80%-90% of option contracts that are held until expiration do become worthless, only 30% of all options are held until expiration. Another 60% are sold or offset, and 10% are exercised. This means that 25% of all option contracts - not 90% of them - expire worthless.
That finding should bring some comfort to options buyers. But it does not mitigate the risk in the options arena.
Trading Option Contracts Is Not the Lottery
In my view, successful option trading depends on two factors: the strike price and the timeframe.
If you’re looking to hit home runs with option contracts in the market, try the lottery. Many novices buy some of the least expensive, out-of-the-money options, which expire three weeks later, in a quest to hit one out of the park. This strategy pays off every so often. Over the long run, though, these consist of the majority of contracts that become “worthless” at expiration.
When buying cheap, out-of-the-money calls, time is our fiercest enemy. Every day, even if the underlying stock is unchanged or up a fraction, the time premium is slowly slipping away. As time goes by, our fear of losing more money increases. That fear can cause sleepless nights and make us do odd things, such as selling the option contracts to salvage what we have left just before it becomes profitable. Being right but losing money is one of the worst feelings an option trader can experience.
Don’t Watch $400,000 Vanish
I made all of the normal mistakes when I began trading options. But losing money and sleep, along with selling some puts for a slight loss (the fear factor) two days before I could have made over $400,000, has changed the way I play the options market.
My technique begins with simple technical analysis of the underlying stock. This can be as easy as determining the overall trend of the stock using 50- and/or 200-day moving averages, along with support and resistance levels (previous highs or lows, moving averages, retracement levels, etc.).
The essence is to buy a call as close to support as possible, or buy a put as close to resistance as possible. That way, your risk is minimal because a break below support or above resistance gets you out of the trade with a reasonable loss.
Once I’ve declared my option strategy, choosing the strike price and time to expiration are paramount. Time decay is one of my main concerns. So, I look at the options chain to determine which in-the-money-option with little or no time premium is closest to the price of the underlying stock. Below is a daily chart of Safeco (Nasdaq: SAFC).
Chart Courtesy of Trade Navigator Software (http://www.genesisft.com)
In late January, SAFC triggered a sell signal and the RSI (relative strength) fell below 50. It then dropped below its 50- and 200-day moving averages. The stock could not make much headway after reaching its February lows, despite a strong showing by the Dow and S&P. So, I looked for a spot to buy some puts.
On March 19, SAFC traded up to its 50-day moving average and the RSI was close to the 50 line (bullish above, bearish below). The stock was trading at $52.70 and the April $55 put was $2.30-$2.60. Although I did pay a 30-cent time premium, the leverage was much better than buying the April $60 put.
Less Liquidity With In-the-Money Option Contracts
The only problem with playing in-the-money option contracts more than one month out is that the liquidity can be low. That can mean a large spread between the bid and ask. In cases like that, you may have to choose an option that is not ideal. All we can do is use the best strategy available.
I made this trade 11 days ago. My exit point would be a break above $53.50, which would produce about a $1 loss. But if it reaches my target of about $49.40, it should produce more than a 100% gain.
Needless to say, I have not had trouble sleeping.
Good Trading,
Jim
|
Today’s Smart Profits Cribsheet
- We’ve learned that 90% of options do not, in fact, expire worthless, but that short-term, out-of-the-money contracts usually do. So, why not sell them? Selling these options is a great way to generate some income by taking advantage of the options buyers with the false expectation of hitting home runs. Smart Profits #255, Out of the Money Options: Buyer Beware, Seller… Take The Money by expert panelist Lee Lowell, covers this strategy in detail.
- And if you haven’t looked into Lee’s 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’s a handbook that can be e-mailed right to your inbox.
- Check out the Smart Profits Glossary for definitions of words like “time decay,” “option contract” or “in-the-money” found in today’s article.
Related Articles:
- Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run
- Breakout & Resistance: How to Anticipate and Profit From These Twin Concepts
- The Backspread Options Strategy: A Trade With Unlimited Profit Potential
Hear It From Our Premium Members...
I sold ½ of the stock per your recommendation, which returned my original investment.
I sold the remaining stock under my regular account on 4/13/2008 for $32.19 and a gain of over $4000.
On May 21, 2008, I sold remaining shares in my IRA account at $39.75 for a gain of over $5,000.
Thanks for your recommendation on this stock."
~R. M. Raga
-
Recent Articles
Recent Smart Profits Blog Posts
What Others Have To Say...
~ Bob C., Smyrna, GA
