atility
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will often dictate which strategy is best in any given situation. We have al-ready explored what volatility is and the relationship between two typesof volatility: implied and historical volatility. Now let us correlate the rela-tive implied volatility levels to the inventory of available option strategiesusing a strategy matrix. It will provide some guidelines on how to best usethis valuable strategy-driving indicator.
Before  presenting  a  comprehensive  table  of  implied  volatility  levelsand option strategies, let’s review the deﬁnitions of each strategy. Thesedeﬁnitions  serve  only  to  facilitate  an  understanding  of  the  table  so  thatyou may refer to it when needed with clarity. Although most of the strate-gies have been covered in this book, the reader is encouraged to investi-gate additional educational resources that offer a more in-depth analysison any or all of the strategies. You may want to ﬁnd one or two that seemto make the most sense to you, and start paper trading them until you un-derstand them thoroughly. For now, here are some basic deﬁnitions of theoption strategies covered in this book:
Call Gives the buyer the right, but not the obligation, to buy the un-derlying stock at a certain price on or before a speciﬁc date. The sellerof a call option is obligated to deliver 100 shares of the underlying stockat a certain price on or before a speciﬁc date if the call is assigned.Put Gives the buyer the right, but not the obligation, to sell the un-derlying  stock  at  a  speciﬁc  price  on  or  before  a  speciﬁc  date.  Theseller of a put option is obligated to buy a stock at a speciﬁc price ifthe put is assigned.Covered call Sell an out-of-the-money call option while simultane-ously owning 100 shares of the underlying stock.Covered put Sell an out-of-the-money put option while simultane-ously selling 100 shares of the underlying stock.Bull  put  spread Long  the  lower  strike  puts  and  short  the  higherstrike puts with the same expiration date using the same number ofcontracts, all done for a net credit.Bull  call  spread Short  the  higher  strike  calls  and  long  the  lowerstrike calls with the same expiration date using the same number ofcontracts, all done for a net debit.Bear  put  spread Long  the  higher  strike  puts  and  short  the  lowerstrike puts with the same expiration date using the same number ofcontracts, all done for a net debit.Bear  call  spread Long the higher strike calls and short the lowerstrike calls with the same expiration date using the same number ofcontracts, all done for a net credit.
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Long straddle Long both an at-the-money call and an at-the-moneyput  with  the  same  number  of  contracts,  identical  strike  price  andexpiration date.Long  strangle Long  both  a  higher  strike  OTM  call  and  a  lowerstrike  OTM  put  with  the  same  number  of  contracts  and  same expiration date.Call ratio backspread Short the lower strike calls that are at-the-money or in-the-money and simultaneously buy multiple higher strikecalls with the same expiration date in a ratio less than .67.Put ratio backspread Short the higher strike puts that are at-the-money or in-the-money and simultaneously buy multiple lower strikeputs with the same expiration date in a ratio less than .67.Call  butterﬂy  spread Sell  two  at-the-money  middle  strike  callsand buy one call on each wing. The trade is a combination of a bullcall spread and a bear call spread.Put butterﬂy spread Sell two at-the-money middle strike puts andbuy  one  put  on  each  wing.  The  trade  is  a  combination  of  a  bull  putspread and a bear put spread.Long iron butterﬂy Long a lower strike out-of-the-money put; longa  higher  strike  out-of-the-money  call;  short  a  middle  strike  at-the-money call; short a middle strike at-the-money put.Condor Long  a  lower  strike  option  at  support;  sell  a  higher  strikeoption,  and  an  even  higher  strike  option;  and  buy  an  even  higherstrike option at resistance (all calls or all puts).Call  calendar  spread Buy  a  long-term  call  and  sell  a  short-termcall against it for the same strike price and same number of contracts,using different expiration months.Put calendar spread Buy a long-term put and sell a short-term putagainst it for the same strike price and same number of contracts, us-ing different expiration months.Diagonal spread Buy a long-term option and sell a short-term op-tion with different strikes and as small a net debit as possible.Collar Purchase stock and sell a call against it usually for a yearor longer. With the premium received for selling the call, buy a pro-tective put.
In order to determine which strategy is best in any given situation, it is
useful to consider volatility. Recall that there are two types:
1. Historical  volatility. Measures  a  stock’s  tendency  for  movementbased on the stock’s past price action during a speciﬁc time period.
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2. Implied  volatility. Approximates how much the marketplace thinksprices  will  move.  It  is  derived  from  the  option  prices  in  the  marketand an option pricing model.
Option strategists often use historical volatility as a guide, or a barom-eter, to determine if implied volatility is high or low. Table 19.1 shows thevarious strategies that can be used in high and low implied volatility situa-tions.  In  this  case,  the  implied  volatility  level  column  on  the  right-handside  of  the  table  is  referring  to  the  relationship  of  the  current  impliedvolatility  reading  to  the  stock’s  historical  volatility.  If  it  is  low,  this  sug-gests  that  implied  volatility  is  less  than  statistical  volatility.  If  it  is  high,this suggests that implied volatility is greater than historical volatility.
Current Implied Volatility Level
• High—Current  implied  volatility  is  signiﬁcantly  above  historical
volatility.
• Low—Current  implied  volatility  is  signiﬁcantly  below  historical
volatility.
• Average—Current implied volatility is at or near historical volatility.
To use the strategy matrix effectively, the trader needs to select the di-rectional bias of the stock, evaluate the implied volatility level, and thenmatch this information up with the available strategies. For example, if Iam bullish and the underlying stock has an average implied volatility level,then by using the selection matrix, I can select either a long call or a shortput for my options strategy. On the other hand, if I am bearish and impliedvolatility is high, I might consider a bear call spread or a bear put spread.In conclusion, the table is a guide to help you understand your alter-natives and subsequently determine which strategy works best in any im-plied volatility situation: high, average, or low. Use it not only as a quickreference chart convenient for choosing the appropriate strategy, but alsoto develop a fundamental appreciation for the role implied volatility playsin the selection process.
SUCCESSFUL INVESTMENT MAXIMS FROM WALL STREET LEGENDS
Let’s  take  a  look  at  the  various  investment  principles,  practices,  andphilosophies  of  some  of  the  most  successful  equity  investors  on  WallStreet. Most of these names you have certainly heard of; however, thereare others who do not have quite as much notoriety. But as you will see,
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TABLE 19.1 Strategies for High, Low, and Average Implied Volatility Situations
Bullish
Buy call
Directional Bias
Neutral
Buy straddle
Bearish
Buy put
Protective put
Buy strangle
Protective call
Bull call spread
Bull put spread
Short ITM call butterﬂy spread
Short OTM put butterﬂy spread
Long OTM call calendar spread
Long ITM put calendar spread
Long call
Short put
Short put
Covered call
Short ATM call butterﬂy
Short ATM put butterﬂy
Call ratio backspread
Put ratio backspread
Short ATM call calendar spread
Short ATM put calendar spread
No trade
No trade
Short straddle
Long ATM call calendar spread
Bear call spread
Bear put spread
Short OTM call butterﬂy
Short ITM put butterﬂy
Long ITM call calendar spread
Long OTM put calendar spread
Long put
Short call
Short call
Covered put
Bull call spread
Short strangle
Bear call spread
Bull put spread
Long OTM call butterﬂy spread
Long ITM putbutterﬂy spread
Short ITM call calendar spread
Short OTM put calendar spread
Collar spread
Long ATM call butterﬂy spread
Long ATM put butterﬂy spread
Iron butterﬂyspread
Condor spread
Put and call ratio spreads
Long ATM put calendar spread
Bear put spread
Long ITM call butterﬂy spread
Long OTM put butterﬂy spread
Short OTM call calendar spread
Short ITM put calendar spread
No trade
ImpliedVolatilityLevel
Low
Low
Low
Low
Low
Low
Low
Low
Average
Average
High
High
High
High
High
High
High
High
High
Note: The following abbreviations are used in the table: ATM = At-the-money, ITM = In-the-money, OTM = Out-of-the-money.
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they all offer something valuable and different that can be applied to yourown equity investing.
The ﬁrst legendary investor I am sure most of you have heard of is War-ren Buffett. Buffett has a famous quote when describing his approach to themarket: “Rule number 1: Never lose money. Rule number 2: Never forget rulenumber 1.” Buffett has often said when entering a stock trade that he is notattempting to make money but operates on the assumption that they couldclose the market the next day and not reopen it for ﬁve years. He asserts thathe does not invest in stocks but rather in businesses and feels that one of thedumbest reasons to purchase a stock is because it is going up.
Buffett  feels  that  investors  should  draw  a  circle  around  the  busi-nesses they understand and then ﬁlter out those that fail to qualify on thebasis of value, good management, and ability to endure hard times. Thisclassic fundamentalist has another famous quote that drives home his phi-losophy: “You should invest in a business that even a fool can run, becausesomeday a fool will.”
Another Wall Street legend for whom even Warren Buffett has a lot ofpraise is Phillip Carret. Carret lived from 1896 to 1998. He founded one ofthe ﬁrst mutual fund, the Pioneer fund, in 1928. Carret insisted an investorshould never hold fewer than 10 different securities covering ﬁve differentbusiness sectors and at least once in six months should reappraise everysecurity  held.  He  maintained  if  one  were  to  do  it  more  frequently  onewould be more apt to sell it sooner than one should because many times ittakes years for a stock price to reﬂect the value of the company.
Carret always was aware of his surroundings when trying to uncoverproﬁtable opportunities. For example, when staying at a hotel in Bostonhe used Neutrogena soap and was so elated with the product that he pur-chased  the  stock.  A  few  years  later  Johnson  &  Johnson  bought  Neutro-gena  and  Carret  made  a  fortune  from  his  original  investment.  He  alsoliked options and felt that an investor should set aside a small proportionof available funds for the purchase of long-term stock options of promis-ing companies whenever available.
Peter Lynch is also an investor who has had a fabulous career on WallStreet.  One  of  his  key  rules  is  to  absolutely  understand  the  nature  of  thecompanies you own as well as the speciﬁc reasons for holding the equity. Hemaintains that if investors would put their stocks into categories they wouldhave a better idea of what to expect from them. Even though Peter Lynchmight visit more than 400 companies in a year, some of his best investmentshave come from using the company’s product. For example, he purchasedTaco Bell after trying and enjoying one of their burritos during his travels.
Some of his other investment maxims include the observation that bigcompanies have small moves and small companies have big moves. Also,
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he says it’s better to miss the ﬁrst move in a stock and wait to see if a com-pany’s plans are actually working out. Mr. Lynch likes to invest in simplecompanies that appear dull and out of favor with Wall Street.
He asserts that you should look for companies that consistently buyback their own shares and views insider buying as a positive sign, espe-cially when several individuals are buying at once. As a true fundamental-ist, he carefully considers the price-earnings ratio. It is his belief that if thestock  is  extremely  overpriced,  even  if  everything  else  goes  right,  youwon’t make any money.
Another Wall Street wizard is Sir John Templeton, who is an expert atuncovering  international  investment  opportunities.  To  illustrate,  by  themid-1960s, Templeton and his famous Templeton Funds were invested inJapan, where stocks were trading at 4 times earnings whereas U.S. stockswere at 16. He believes that for all long-term investors, there is only oneobjective: maximum total return after taxes.
Much of his investment philosophy is predicated on the belief that it isimpossible to produce a superior performance unless you do somethingdifferent from the majority. He goes on to explain that a time of extremepessimism is a great buying opportunity, and a time of extreme optimismis the best time to sell. He is indeed a classic contrarian. The crux of hisapproach  is  that  if  you  search  for  investments  worldwide,  you  will  ﬁndmore deals and better bargains than by analyzing only one country. Inaddition, you gain the safety of diversiﬁcation.
One very colorful ﬁgure who had an exceptional career on Wall Streetwas Bernard Baruch, who lived from 1870 to 1965. In his investments headopted a skeptical philosophy, always trying to separate facts from emo-tion. He insisted that to successfully speculate in the markets it must be afull-time  job.  Baruch  viewed  relying  on  inside  information  or  hot  stocktips as a very dangerous way to invest.
Before  purchasing  any  stock,  Baruch  would  make  sure  he  kneweverything he could about the company: its competitors, its management,and  its  earnings  growth  potential.  He  never  attempted  to  pick  tops  andbottoms and was always quick to take losses. In addition, Mr. Baruch triedto be in just a few investments at one time so the trades could be bettermanaged.  He  would  periodically  analyze  all  of  his  investments  to  see  ifnew developments had changed his original outlook.
One of his key habits to which he attributed much of his success wasthat he constantly would analyze his losses to determine his mistakes. Hewould often get away from the hustle and bustle of Wall Street to performthis review. He always concluded this exercise with a self-examination ofhis trading decisions to better understand his own failings.
Another impressive investment guru is John Bogle, who founded theVanguard Group, a mutual funds company in 1974. The cornerstone of his
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investment approach is that investing is not complicated and can be donequite successfully by just employing a little common sense. He contendsthe investor can do very well by doing just a few things right and avoidingserious mistakes.
He  believes  in  taking  reasonable  risks  to  achieve  higher  long-termrates of return and that one’s portfolio should be well diversiﬁed. This di-versiﬁcation maxim is why Bogle feels that mutual funds are so valuable.He contends that a set of diversiﬁed investments in stocks and bonds onlyhas market risk versus the greater risk of being in just one or two stocks.Finally, he emphasizes thinking for the long term and that stocks may re-main overvalued or undervalued for years, so staying the course is one ofhis key trading rules. He feels that patience and consistency are the mostvaluable assets an investor can possess.
Henry Clews, a famous investor who lived from 1834 to 1923, was avery  successful  trader  who  practiced  his  craft  in  the  very  early  days  ofWall Street after coming to New York from England in 1850. Mr. Clews al-ways felt investment experts should be sought out to manage portfolios,asserting that if one needed legal help one would see a lawyer and if oneneeded medical help one would not hesitate to see a doctor; thus if need-ing investment advice one should seek out a professional.
Much  of  Mr.  Clews’  advice  centers  on  what  types  of  people  to  avoidwhen seeking your investment fortune. Some of the characteristics he citesinclude  individuals  who  unjustly  accuse  others  of  bad  deeds,  who  neverhave  a  good  word  for  anybody,  who  won’t  work  for  an  honest  living,  orwho run into debt with no apparent intention of repaying. He asserts thatby prudently avoiding these types of people and selecting only associateswithout these characteristics your life and fortune will be a lot better off.
I  am  sure  most  of  you  have  heard  of  this  next  investment  legend,Charles Schwab. He founded Charles Schwab & Company in 1974. Afterselling a controlling interest in the ﬁrm to BankAmerica in 1983, he boughtit back in 1987 and took the company public that same year. Some of hisinvestment wisdom for selecting stocks and mutual funds includes whenreading ﬁnancial papers to always pay attention to the advertisements asthere might be an investing opportunity behind the ad.
Mr.  Schwab  considers  mutual  funds  to  be  the  best  investment  formost people and claims index funds are a great way to invest for both thenovice and the veteran investor. In addition, he feels that one should con-sider only no-load mutual funds with good performance records, not onlyfor the current year but also over the life of the fund. Mr. Schwab stronglyrecommends  that  investors  include  an  international  component  in  theirasset allocation plan.
Another  brilliant  trader,  Linda  Bradford  Raschke,  currently  the  presi-dent of LBRGroup, began her professional trading career in 1981 as a market
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maker in equity options. After seven years on the trading ﬂoor, she left theexchange  to  expand  her  trading  program  in  the  futures  markets.  LindaRaschke has since been a principal trader for several hedge funds and runscommercial  hedging  programs  in  the  metals  markets.  She  has  pioneeredwork  on  volatility-based  trading  indicators,  which  were  incorporated  intoher daily trading programs and her overall approach to the markets.
Linda  Raschke  is  a  very  successful  short-term  trader  who  uses  aswing  trading  methodology  as  the  cornerstone  of  her  success.  Her  ap-proach  is  a  combination  of  monitoring  intraday  news  and  economic  re-ports  along  with  pattern  recognition  on  charts  that  signal  potentiallyexplosive  moves.  Linda  use  the  Average  Directional  Index  (ADX)  as  hercore indicator to signal direction and examines market volatility to deter-mine where best to apply her ADX tool.
Traders who have employed these short-term tools have increased theproﬁt probability of their positions dramatically. In fact, this is the maintheme of Linda’s trading philosophy. She requires that the probability ofproﬁt for any trade she considers placing is deﬁnitely in her corner beforeever  pulling  the  trigger.  The  effectiveness  of  this  approach  is  obvious,given her long-term success in the business and that she was featured inJack Schwager’s book, The New Market Wizards (HarperBusiness, 1992).Linda  Raschke’s  high-probability  short-term  trading  strategies  are  worthlearning for any trader wishing to proﬁt from swings and volatility in themarketplace. As a technical trader, she has contributed a wealth of knowl-edge  in  this  area  and  through  her  lectures  and  publications  has  helpedmany people become better market timers.
I hope you have enjoyed this information about these Wall Street gu-rus. Even though they have different styles and have invested in differenteras, each one has some very invaluable investment insights that can beintegrated into your own approach to the markets.
TRADING PERFECTIONISM
In  the  trading  arena,  you  will  ﬁnd  endless  sources  of  ﬁnancial  achieve-ment and accolades, which often go hand-in-hand. In general, our culturerespects  achievement.  Our  daily  lives  are  full  of  pressures  to  be  better,faster, and more accurate. Of course the ultimate achievement would beto attain total perfection. The logical extension of better is best, and theultimate  best  is  perfect.  Many  times  we  carry  this  burden  of  impossibleexpectations into our trading, where it can be quite detrimental.
Knowing and understanding these self-imposed problems might notbanish  your  temptation  to  seek  unrealistic  goals,  but  awareness  of
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forces  working  on  you  can  help  you  develop  emotional  discipline.  Forexample,  many  people  allow  others  to  deﬁne  their  expectations  andgoals—the old “keeping up with the Joneses” syndrome. Many people of-ten care way too much about what others think about their trading. In-stead  you  should  spend  your  time  determining  your  own  personalﬁnancial goals. Trading is challenging enough without loading it up withthis type of emotional baggage.
Also, people have widely differing levels of comfort with uncertainty.Some people have no fear and will try just about anything. There are othersfor whom making decisions without 100 percent certainty is a nightmare.
Trading decisions are made emotionally difﬁcult because we:
• Are keenly aware of our chancy surroundings;• Accurately  predict  that  waiting  will  afford  us  some  additional 
information;
• Our  precision-dominated  world  makes  us  believe  a  perfect  answer
might actually exist.
So  we  recoil  from  decisions  in  the  realization  that  our  odds  of  lessthan ideal results are high. It seems we must always ﬁght our aversion touncertainty and get on with our investment lives as best we can.
Which brings us to envy. This major enemy is constantly poised to de-feat  our  trading  endeavors.  We  see  the  rich  and  famous  and  read  of  thefabulous successes of a very few traders, but we fail to focus on their sta-tus as exceptions to the norm. By allowing envy to deﬁne the exceptionalperformance of others as our own standard, we help to defeat ourselves.Such self-imposed frustration leaves us concentrating on the difﬁculty ofour task rather on the task itself.
For many traders, for whom no amount of gain is enough, greed is asuccess killer. Whether by long actual experience or merely by consider-ing the odds, we know that we will not sell at the highest price. And yetwe seem to always hold on for that last extra point. Are we greedy in ourtrading because we think that an even bigger gain will stroke our egos andpad our pockets even more? Do we hold on because this particular stockhas treated us well and we are willing to stay in the trade rather than riskselecting another trade? Whatever the reasons for and operating dynamicsof our greed, it will defeat us. Greed is merely another way of expressing adriving need for perfectionism.
Ego is another key barrier to trading success. We seem to want tobe right and be the best even if there are no other observers. Our egosfeel  better  when  we  are  right  and  worse  when  we  are  wrong.  So,  inthinking  about  buying,  we  become  frozen  into  indecision  by  realizingwe might make a mistake, which would in turn injure our egos. When
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looking  at  holding  versus  selling,  we  subconsciously  provide  our  egoswith more chances for stroking and forestall the known immediate painof an ego injury by doing nothing. That way, our possibilities for furthergain, for reducing or recovering a loss, and for avoiding the pain of notselling at the top are left open.
Here we have perfectionism again making our ego feel good and urg-ing us to do nothing. Knowing your ego’s tendency to get in the way, andobserving in real time your own behaviors that indicate this is happening,can help you to come to terms with perfectionism. It is probably not to-tally curable, but can be managed by constant attention.
There are some trading tips one can follow to minimize the occurrenceof  these  self-imposed  problems.  Databases  and  experts  are  wonderfulsources of ﬁnancial information. However, the more sources you consult,the higher the likelihood that the information will conﬂict. Such conﬂictswill confuse you, allowing information overload to drive up your anxietylevel. It is important for you to use as much information as you can easilyhandle. You need to develop a trading approach that feels comfortable andthen  stick  to  it.  For  example,  if  you  are  more  attracted  to  value  thangrowth  investing  then  go  for  it.  If  fundamentals  make  more  sense  intu-itively than technical analysis, so be it, and vice versa. Go with what youcan reasonably handle and ignore the latest fundamental or technical toolsthat come out. As a trader, this will help you to stay focused, follow yourplan, and concentrate on making consistent proﬁts.
TRADING TIPS FOR SUCCESS
Becoming a trader who consistently wins in the options market requiresthree key elements:
1. A bargain-hunting instinct with the ability to identify undervalued and
overvalued options.
2. A sound and well-designed game plan that provides consistent action
over time and that prospers in all market conditions.
3. The  discipline  to  follow  the  game  plan.  (Plan  your  trade  and  trade
your plan.)
In applying this formula for success in the options market, the ﬁrstelement is simple: You must always seek to buy underpriced options andsell  overpriced  options.  Most  option  investors  do  not  follow  this  basicrule of option investing. They spend far too much time studying the un-derlying  stocks  and  following  the  market,  and  base  their  option  pur-chases only on these factors, ignoring the price and implied volatility of
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the option. If you do not buy underpriced options or sell overpriced op-tions, you are going to lose eventually.
You  must  also  create  a  good  game  plan.  In  the  options  market,  thegame  plan  is  far  more  important  than  in  other  markets  because  thingshappen so quickly that you must be prepared before you play. Then, youhave to follow your game plan.
A good trading plan involves a gradual program for investing in theoptions  market  versus  the  elephant  approach,  where  you  take  all  ofyour money and invest it all at one time, all on one side of the market.In  addition,  your  portfolio  must  be  balanced,  investing  money  in  bothputs and calls. As you become more familiar with the different tradingtactics, you can further diversify among directional, sideways, and deltaneutral  strategies.  Also,  be  sure  to  diversify  among  different  sectorsover time.
Set  aside  a  speculative  fund  for  options,  realizing  you  could  loseeverything because of the short-term expiring nature of these investmentvehicles. Most importantly, this speculative cash must be money you canafford to lose. If you play in the options market with money you cannot af-ford to lose, your emotions are guaranteed to overwhelm you