may be exercised any time up to andon the day of expiration, the iron butterfly is a strategy that I like touse when a stock is in a range, such as right after earnings. If CiscoSystems has just announced earnings and there is no big tradeshow or other potential news-making event, then I know most ofthe information—good or bad—is probably out about Cisco. Thatmakes it a good time to look at establishing an iron butterflyspread. For example, let’s say Cisco announced its earnings oneweek ago and the stock was trading at $100 a share. If | thought theprospects were good for it settling into a range, I might do a spreadfrom the short side 101
such as selling the $110 call and collecting $5 a share, while buyingthe $120 call and paying $2 for that protective leg. On the other sideof the range, I’d sell the $90 puts for $3 and buy the $80 puts for $1.In total, I would collect $5 in premiums, and I'd have two 10-pointspreads covered (Figure 5.4).
The most I could lose in this position would be $5, the differ-ence between the $5 | collected and the $10 that either spreadcould hit at expiration. For example, if Cisco broke out of my pro-jected trading range and went to $130 a share, I would face net ex-posure of $10 a share on the call spread, which would be partiallyoffset by the $5 in premiums that I ccllected. If Cisco brokethrough the range on the downside and went to $70 a share, Iwould face a net exposure on the put spread of $10, which wouldagain be offset by the $5 in premiums that I collected. Keep in mindthat not only would CSCO have to trade up to $130, or downthrough $70, but it must stay above or below at expiration foreither spread to go the maximum $10. The stock can rock and rollup and down, but as long as Cisco finishes at expiration between$115 and $85 (the strike prices with premiums collected taken into
 
 
Figure 5.4 long 1 Jan 120 call, short 1 Jan 110 call; long 1 Jan 80 put,short 1 Jan 90 put
 
 
    
Profit / Loss (Y) and CSCO Common Price (X) Risk Graph
 
 
 
 
Source: Created by StockmarketWorkshop.com.102 how I trade options
consideration) I would win. And with Cisco trading at $100 a shareafter earnings, when things tend to relax, I like my odds of winningon this trade.
Cisco trading at $100 a share
Sell $110 call and collect $5 a share premiumBuy $120 call and pay $2 a share premiumSell $90 put and collect $3 a share premiumBuy $80 put and pay $1 a share
Picking the range for a stock is a combination of art and sci-ence. I try to use my own experience and gut instincts for whatrisk/reward ratio I’m comfortable with on a particular trade. This isalso an area in which I like to employ some technical analysis to de-termine likely trading support and resistance areas. Additionally, Itry not to do anything that is 3:1 against me. In other words, if allI can collect for selling two 10 point spreads is $2.50, or $3, I don’tlike my odds very much because I could lose $7 to $7.50 if I’ve mis-judged the trading range. Another thing I look for is a stock that hasmoved around a lot, because then you have the luxury of pickingamong many strike prices. For example, if Apple Computer runsfrom $40 a share to $110 and is presently trading at $90, you’ll havea myriad of strike prices to choose from above and below the mar-ket, which increases my choices of strategies.
Generally speaking, a static stock with low volatility, such asenergy companies and utilities, just don’t have enough strike pricesabove and below the market. So although they would be great can-didates for a range trading strategy such as the iron butterfly, thatlack of available strikes virtually rules out those sectors. The stockhas to have had some movement in it to establish strike prices,which will most effectively allow you to plot your strategy.
That’s one of the nice things about Internet stocks. By earlyFebruary 2000, Yahoo had a run from $260 to $500 a share in onemonth, and then came back down after its earnings to $330 a share.With that kind of movement, Yahoo options have a lot of strikeprices. Say that one month into the future I’m going to sell the 500calls and buy the 520s—a 20-point spread—and collect $2 a share.With Yahoo at $330 a share, I could sell $250 puts and buy $230puts, maybe for $3.102 how I trade options
consideration) I would win. And with Cisco trading at $100 a shareafter earnings, when things tend to relax, I like my odds of winningon this trade.
Cisco trading at $100 a share
Sell $110 call and collect $5 a share premiumBuy $120 call and pay $2 a share premiumSell $90 put and collect $3 a share premiumBuy $80 put and pay $1 a share
Picking the range for a stock is a combination of art and sci-ence. I try to use my own experience and gut instincts for whatrisk/reward ratio ’'m comfortable with on a particular trade. This isalso an area in which ] like to employ some technical analysis to de-termine likely trading support and resistance areas. Additionally, Itry not to do anything that is 3:1 against me. In other words, if allI can collect for selling two 10 point spreads is $2.50, or $3, I don’tlike my odds very much because I could lose $7 to $7.50 if I’ve mis-judged the trading range. Another thing I look for is a stock that hasmoved around a lot, because then you have the luxury of pickingamong many strike prices. For example, if Apple Computer runsfrom $40 a share to $110 and is presently trading at $90, you'll havea myriad of strike prices to choose from above and below the mar-ket, which increases my choices of strategies.
Generally speaking, a static stock with low volatility, such asenergy companies and utilities, just don’t have enough strike pricesabove and below the market. So although they would be great can-didates for a range trading strategy such as the iron butterfly, thatlack of available strikes virtually rules out those sectors. The stock ~has to have had some movement in it to establish strike prices,which will most effectively allow you to plot your strategy.
That’s one of the nice things about Internet stocks. By earlyFebruary 2000, Yahoo had a run from $260 to $500 a share in onemonth, and then came back down after its earnings to $330 a share.With that kind of movement, Yahoo options have a lot of strikeprices. Say that one month into the future I’m going to sell the 500calls and buy the 520s—a 20-point spread—and collect $2 a share.With Yahoo at $330 a share, I could sell $250 puts and buy $230puts, maybe for $3.102 how I trade options
consideration) I would win. And with Cisco trading at $100 a shareafter earnings, when things tend to relax, I like my odds of winningon this trade.
Cisco trading at $100 a share
Seil $110 call and collect $5 a share premiumBuy $120 call and pay $2 a share premiumSell $90 put and collect $3 a share premiumBuy $80 put and pay $1 a share
Picking the range for a stock is a combination of art and sci-ence. I try to use my own experience and gut instincts for whatrisk/reward ratio I’m comfortable with on a particular trade. This isalso an area in which I like to employ some technical analysis to de-termine likely trading support and resistance areas. Additionally, Itry not to do anything that is 3:1 against me. In other words, if allI can collect for selling two 10 point spreads is $2.50, or $3, I don’tlike my odds very much because | could lose $7 to $7.50 if I've mis-judged the trading range. Another thing I look for is a stock that hasmoved around a lot, because then you have the luxury of pickingamong many strike prices. For example, if Apple Computer runsfrom $40 a share to $110 and is presently trading at $90, you’ll havea myriad of strike prices to choose from above and below the mar-ket, which increases my choices of Strategies.
Generally speaking, a static stock with low volatility, such asenergy companies and utilities, just don’t have enough strike pricesabove and below the market. So although they would be great can-didates for a range trading strategy such as the iron butterfly, thatlack of available strikes virtually rules out those sectors. The stockhas to have had some movement in it to establish strike prices,which will most effectively allow you to plot your strategy.
That’s one of the nice things about Internet stocks. By earlyFebruary 2000, Yahoo had a run from $260 to $500 a share in onemonth, and then came back down after its earnings to $330 a share.With that kind of movement, Yahoo options have a lot of strikeprices. Say that one month into the future I’m going to sell the 500calls and buy the 520s—a 20-point spread—and collect $2 a share.With Yahoo at $330 a share, I could sell $250 puts and buy $230puts, maybe for $3.from the short side 103
If | have enough strikes above and below the market, | couldwithstand a 25 percent to 30 percent move. That’s a lot of marketmovement that I can withstand. I’d only get hurt if there was a 40percent or 50 percent move on Yahoo. Of course, that 50 percent+movement is exactly what happened to Yahoo and other membersof the Internet sector in March and April of 2000, which shows whyselling put and call spreads, with defined profits and losses, ismuch safer than the alternative of naked sales.
We call these spreads iron butterflies because they involveout-of-the-money puts and calls, which means they carry less risk(and therefore more protection) than butterflies of a differentbreed. But there are other butterflies that involve in-the-moneycalls and puts, which carry both a higher risk and a higher poten-tial reward.
Let’s say we’re trading Apple Computer, and | think there’s agood chance that Apple will finish right where it is at $110 a share.
I could then sell a straddle—meaning | would sell both the$110 call and the $110 put. Since these are both at-the-money, |sell the $110 call for $6 and the $110 put for $5.50. I’m taking in$11.50 a share ($1,150 per option spread), which means | couldwithstand a move of $11.50 in either direction. That’s a goodamount of premium to collect, but there is also a trade-off for thatkind of reward. | have almost unlimited risk if Apple were to an-nounce suddenly a new “iMac” computer that everybody just hasto have, and the stock moves to $200 a share on the announce-ment. Then the $11.50 in premiums I collected pale by comparisonto the upside risk I face.
To place a limit on the risk, I then do two other trades. Thoseother two trades become the wings, capping off the potential lossto either the upside or downside. The straddle we sold is the bodyof the butterfly. When you graph them out, they look like loopinglines, resembling wings around a circular body. (Hence, the termbutterfly.) I limit my upside loss by buying the $115 call for $4.00,and | put a floor on my downside risk by buying the $105 put for$3.50. Now, my net on the premiums is reduced from $11.50 to$4.00 a share (or $400 per option spread). But I have significantlyreduced my exposure in case of a surprise, adverse move (Fig-ure 5.5).
With this trade, we make money if Apple trades between $114 onthe upside ($4 above the straddle we sold) to $106 on the downside104 how I trade options
 
Figure 5.5 long 1 Aug 115 call, short 1 Aug 110 call; long 1 Aug 105 put,short 1 Aug 110 put
 
   
 
Profit / Loss (Y) and AAPL Common Price (X} Risk Graph
 
  
  
 
 
    
  
i H a i100 102.5 107.5 110 125 15 u7S
 
Source: Created by StockmarketWorkshop.com.
($4 below the straddle we sold). Outside of that spread, we couldonly lose a net of $1 a share as we have effectively sold the 110-115call spread and 110-105 put spread for $4 and the most either sidecould hit at expiration is $5.
Apple trading at $110 a share
Sell $110 call and collect $6 a share premiumSell $110 put and collect $5.50 a share premiumBuy $115 call and pay $4.00 a share premiumBuy $105 put and pay $3.50 share premium
With this kind of risk and reward, you would want to do thistrade to an almost unlimited amount. On occasion you can findsome butterfly trades with this kind of payout. But most of thetime, a butterfly spread will net you $2 or $3 a share for $5 butter-flies with a risk/reward ratio of roughly one-to-one.
The higher reward trades often occur when there is a biganomaly in the options pricing for some reason, placing a highfrom the short side 105
value on both the calls and puts around the current price. Maybethe Wall Street analysts are divided over the prospects for a stock.Ina classic analyst’s tug-of-war, three analysts have downgraded it,and two have upgraded it. Now you have people betting on both theupside and the downside of the same stock. In this situation, youmight be able to sell the body of the butterfly (the straddle portion,which involves the simultaneous selling of a call and put near or atthe same price). Then you buy the wings to give yourself upside anddownside protection, all of which puts you in a potentially veryprofitable position.
There are several factors that come up when you trade any ofthese multiple leg strategies. The iron butterfly has a greater range,but less profit potential, because it involves out-ofthe money op-tions and thus, you can withstand greater market movement. But-terflies, on the other hand, generally have more profit potential, butalso more risk because the options are at-the-money, which meansthe stock has to stay in a tighter range to allow you to keep the pre-miums you've collected. Additionally, you should keep in mind thatthese strategies will be more expensive to execute due to the multi-ple legs involved. Both butterflies and iron butterflies are com-prised of four options per complete spread, so commissions are abig factor. Also, finding a broker to execute butterflies can be moredifficult than finding the actual spreads. Make sure your broker un-derstands and has the capability of carrying out your wishes, asfewer and fewer brokers can execute such trades.
What we’ve discussed thus far are some very commonly usedspread strategies for options trading. There are many varieties andvariations of these trades, depending on your strategy, risk/rewardprofile, and the prevailing strike prices.
When you start out in options, you don’t need to do all thebutterflies and condors, which are a bigger version of the butterflyspreads. Rather, remember the KISS principle: Keep it simple,stupid. Simple works. Use simple strategies that you understand,particularly when it comes to the maximum profits and maximumlosses. Don’t get carried away by a complex trade that may lookgood or sound good when you describe it.
The people who lose are those who abuse options becausethey don’t understand what they're doing or how these instrumentswork. For virtually any educated investor (or investor who is will-ing to learn), there are a myriad of ways to make money in options.106 how I trade options
Among the strategies we've discussed thus far, the straddle—the simultaneous sale of a call and put—is among the most risky.(Remember a straddle is basically the body of a butterfly trade,without the wings to protect the upside and downside.)
Take Qualcomm (QCOM), for example. Let’s say that it’s trad-ing at $140 a share after its four-for-one split, which was effectiveat year-end 1999. What was basically a $25 stock in January 1999traded over $500 a share (on a presplit basis) that year. My firmtrades Qualcomm (QCOM) as well as other high-tech stocks, whichsoar very high at times, but also carry a lot of risk. A $500 or $600 ashare stock could easily move $50 or $60 in a day. Even on a post-split basis, Qualcomm could see a $15 move in a day.
This kind of movement illustrates the challenge to pick theprojected range for these high-tech stocks. That’s why it can bevery risky to use a straddle, since these strategies require a stockto stay in a range to be profitable.
As we'll discuss in later chapters, Internet and other high-techstocks have changed all the rules. Our marketplace has moved fromhaving 20,000 to 40,000 professional traders who move the market—both on the floor and upstairs in trading offices—along with thelarge hedge funds, to a democratization of the markets with legionsof retail traders. Online, discount brokerages have sparked not onlyan increase in stock trading, but also options trading. The Internethas leveled the playing field and widened the arena.
In today’s marketplace, we could very well see 10,000 cus-tomers or more trading 100 to 500 shares in Qualcomm. Plus, youcould have fund giants trading 200,000 shares.
Against that backdrop, let’s say you're looking to play optionsin Qualcomm (QCOM), which at $140 a share, is extremely activeand volatile—commanding a high premium in all of its options.That increases the profit potential—but also the risk—for doing atrade such as a one-month straddle, which is the simultaneous saleof a call and a put, both at the $140 strike price. You might collectas much as $50 a share, say, $27 for the call and $23 for the put.Then, as long as Qualcomm traded between $190 (the $140 strikeprice plus the $50 in premiums) on the upside and $90 on the down(the $140 premium minus the $50 in premiums), you’d win and beable to keep the entire premium you collected.
But if it trades outside of that range, you lose. And the chancesof that happening increase along with the volatility. With thefrom the short side 107
March and April Nasdaq debacle fresh in investor’s minds, its easyto see how being on the wrong side of a short straddle can be alife-changing event. Keep in mind that Qualcomm is a stock thathas made $100 moves at times. I remember the news report aboutthe trader who was asked to make a market for a $240 straddlewhen Qualcomm was trading at $260 and on its way to $600! Hesold the spread for what the firm thought was an outrageouspremium and in about two weeks the firm had lost somewhere be-tween $8 and $20 million. I’d call that a life-changing event,wouldn’t you! You can see the severity and volatility associatedwith options on this kind of stock.
The beauty is that by selling the straddle at $140 (after thesplit), you make money in a very wide range. In our example, thestraddle seller would have made money between $190 and $90—a100-point range. But the trade-off is: You have to have very high-risk tolerance, and be able to live with the battle scars from thesekind of trades. With Qualcomm at $140 a share, it could easilyrocket to $200. At $200, you could probably sell the straddle pre-mium for $70 a share because of the volatility!
This is perhaps an extreme example of why selling a straddleis the most risky strategy for selling premiums. As we stated be-fore, selling a straddle works best when you're convinced that astock or an index is in a range. Remember, a straddle is basicallythe body of a butterfly trade, without the wings to protect you. In ahigh-flying, volatile stock you better have those wings!
Because of this risk, I never recommend that customers sellstraddles—no matter how much money they have. It always is agood idea to buy some disaster-protection, even though this willcut down on your profit potential. (What price can you place onpeace of mind?) Maybe you’ll never need that risk-protection. Butit’s never wasted money to be able to sleep at night. I’ve tried toconvince my friend Frank to buy some out-the-money puts againsthis cash-secured put sales, but to no avail. Unfortunately, it proba-bly takes events like the Nasdaq calamity of 2000 to convince peo-ple that there are better ways to manage short premium.
A slightly less risky version of the straddle is its cousin, thestrangle. Again, let’s assume that Qualcomm is trading at $140 ashare. But instead of selling the $140 call and the $140 put (as in thestraddle), give yourself a wider spread. You sell the $150 call andthe $130 put, which widens out the range for which you'll be able to108 how I trade options
keep the premium you collect. Let’s say you sold the call and theput for about $15 and thus collected $30 a share ($3,000 per stran-gle). That means, between $180 on the upside and $100 on thedownside you make money. But if you're wrong, it’s still going to bepainful. The farther out you spread the strangle, the more opportu-nity you'll have to keep the premium you collect.
As the options you choose move from at-the-money to out-of-the-money, the premium you receive will be reduced. For example,if Qualcomm is trading at $140, you could decide to sell the $180call and the $100 put, collecting maybe a total of $15 in premiums($1,500 per strangle). Your risk is spread over a wider price range,but you’d still be in for a lot of pain if Qualcomm skyrocketed to$250 a share.
Deciding upon the best strategy to take will depend mostly onyour risk tolerance and your outlook for the stock—as well as yourexperience. Most people begin speculating in options with coveredwrites, because it is the most analogous to buying a stock outright.Then they typically graduate to bull call spreads because, like mostretail investors, they speculate with a bullish bias.
But in time, investors want to make money when a stock is inarange or to take advantage of changes in volatility. That’s whenother spread trades come into play.
For example, consider the AOL-Time Warner merger. As an In-ternet stock, AOL used to have a Price/Equity (P/E) ratio of 400.More established Time Warner, with media holdings that includeradio, television, and some high-speed digital cable, had a P/E of 90.After the deal, AOL will no longer be viewed by the street as thefast-growth, Internet high-flyer it once was because, in effect, it’sbecoming a more mature company, carrying the overhead thatcomes with the Time Warner properties. When the deal was an-nounced, I expected we'd see a big drop in volatility in AOL, whichused to trade around 80 percent. Now, a volatility of 50 percent oreven 30 percent (which would put it more in line with stocks likeIBM) is more likely.
To me, that means the pricing for AOL could also move down.
Still, there are plenty of options plans in AOL, although I mustnow take into account this change in fundamentals. If AOL beginsto trade in a range, it’s time to look at the spread trades, with theappropriate counter measures to guard against upside and down-side risk.from the short side 109
Whatever the scenario, it’s important you understand every-thing that’s happening with a particular stock. You can’t just buy acall tomorrow because you heard a stock mentioned on the televi-sion or in a chat room today. You need to do your homework and de-vise your plan. Then you go to your options toolbox, and select thebest strategy. chapter 6
playing thebroad market
Individual stocks aren’t the only way to participate in the optionsmarket. The most efficient way you can play in the broader marketis through index options. Increasingly, index options, which used tobe used mostly by institutions to hedge portfolios, present an op-portunity for retail investors.
In 1983, 10 years after the founding of the CBOE, the Exchangelaunched options on broad-based stock indexes. The first was anindex of 100 of the biggest capitalized stocks listed on the CBOEand dubbed the Options Exchange Index, called by some theStandard & Poor’s 100 Index, which has the ticker symbol OEX. Sev-enteen years later, the OEX is still one of the most active indexproducts on the market, trading an average of more than 130,000contracts per day in 1999. The CBOE also trades options on theStandard & Poor’s 500 index (SPX), which is based on the currentor “cash” value of the S&P 500. (Note: This should not be confusedwith the options on S&P 500 futures contract, which trades at theChicago Mercantile Exchange, where S&P futures are also traded.)
For years before the launch of these products, indexes hadbeen tracked and traded by institutions. But most of that trade hadoccurred without a consolidated market. For instance, a customerwould call an investment banking firm or trading company such asGoldman Sachs and ask for a “market” for cash value of the S&P112 how I trade options
500. Goldman Sachs would quote a price at which it would buy thefuture price of the S&P 500 if the customer were selling, or the priceit would sell the future price of the S&P 500 if the customer werebuying. A transaction would be conducted which was off-exchangeor over-the-counter.
But that kind of transaction, which still takes place in certaincustomized options and other off-the-exchange products, presenteda large risk, known as contra-party risk. That means, by doing anover-the-counter trade, you have to bear the full credit risk of theperson or party with whom you traded. Thus, if that other partyhad other obligations that caused losses, it might not be able to ful-fill the obligation to you under terms of the trade you made. Like-wise, that other party had to deal with your potential credit risks,in case the situation arose that you could not financially fulfill yourobligations.
This crédit risk posed by party-to-party, over-the-countertrades and the sheer size of the market for index options were thecatalysts that prompted the creation of options exchanges in thefirst place. Before the exchanges were created, options on individ-ual stocks had traded over-the-counter for years. Likewise, the cat-alyst for index options was partially the burgeoning OTC trading ofindex options, as well as the initial success of the index futures con-tracts listed first by the Kansas City Board of Trade, which broughtout the Value Line Index and the Chicago Mercantile Exchange’ssubsequent listing of the S&P 500 futures contract. Since indexesare generally made up of anywhere from 10 to 1,000 stocks, over-the-counter trading of these options dwarfed the dollar-value—and,therefore, the potential risk—of equity options trading.
For example, let’s say IBM is trading at $105 a share. The S&P500 might be trading at $1,450 a share. That would be $1,450 times250. (When the S&P Index contract was launched, the multiplier forthe value of the overall S&P contract was 500. About two years ago,the size of the S&P contract was cut in half, reducing the multiplierto 250.) That means that a single contract for the S&P 500 wouldrepresent an underlying value of $1,450 times 250, or $362,500. Bythe same token, at $105 a share, a single contract trade in IBMwould represent an underlying value of $105 times 100, or $10,500.
That difference—$362,500 for one S&P contract versus about$10,000 for one equity contract—underscores the need for contra-party credit risk protection for index options trading—the size gets112 how I trade options
500. Goldman Sachs would quote a price at which it would buy thefuture price of the S&P 500 if the customer were selling, or the priceit would sell the future price of the S&P 500 if the customer werebuying. A transaction would be conducted which was off-exchangeor over-the-counter.
But that kind of transaction, which still takes place in certaincustomized options and other off-the-exchange products, presenteda large risk, known as contra-party risk. That means, by doing anover-the-counter trade, you have to bear the full credit risk of theperson or party with whom you traded. Thus, if that other partyhad other obligations that caused losses, it might not be able to ful-fill the obligation to you under terms of the trade you made. Like-wise, that other party had to deal with your potential credit risks,in case the situation arose that you could not financially fulfill yourobligations.
This credit risk posed by party-to-party, over-the-countertrades and the sheer size of the market for index options were thecatalysts that prompted the creation of options exchanges in thefirst place. Before the exchanges were created, options on individ-ual stocks had traded over-the-counter for years. Likewise, the cat-alyst for index options was partially the burgeoning OTC trading ofindex options, as well as the initial success of the index futures con-tracts listed first by the Kansas City Board of Trade, which broughtout the Value Line Index and the Chicago Mercantile Exchange’ssubsequent listing of the S&P 500 futures contract. Since indexesare generally made up of anywhere from 10 to 1,000 stocks, over-the-counter trading of these options dwarfed the dollar-value—and,therefore, the potential risk—of equity options trading