You may have to addmore money temporarily to your account to stay in the trade.
If  money  were  absolutely  no  object  whatsoever—go  ahead  anddream  big—then  you  wouldn’t  care  if  you  had  to  feed  your  account.You’d probably be better off if your option side was the one working be-cause of the long gamma. For example, let’s say you initiate a delta neu-tral  trade  with  ATM  options.  As  the  market  goes  up,  your  options  aregetting longer and longer, which is deﬁnitely the preferable position to bein. Unfortunately, for most of us money is not only an object, but also thedriving force behind many of our decisions each and every day.
When you are choosing which side to concentrate on—the long sideor the short side for your futures—keep in mind that you may have to addmore money. This is why it is sometimes beneﬁcial to try to forecast mar-ket  direction.  Loans  against  your  securities  do  not  have  any  scheduledpayments. Therefore, you can pay back your loan on your terms. Borrow-ing  from  your  margin  account  also  has  tax  considerations  if  you  havestock that you do not want to sell.
If the perceived risk of your trade increases, then the margin require-ment  will  also  increase.  If  you  have  enough  money  in  your  account  tocover the increased perceived risk, then you won’t be required to put upany  additional  cash.  However,  if  you  do  not  have  the  cash  required  tocover this additional perceived risk, then you will get a margin call. A mar-gin call is a call from your broker requiring you to place additional fundsin  your  account.  If  you  do  not  place  these  additional  funds  in  your  ac-count, your position will be liquidated. (If you bought something it will besold, and if you sold something it will be repurchased. This will close outyour position.)
Why  should  you  be  concerned  about  margin?  Most  new  investorsand traders rarely consider the margin other than from the standpoint ofhow much money they have to put up initially. However, an investor ortrader should look at margin as a cost of doing business. There may alsobe  opportunity  costs  incurred  by  placing  a  trade.  In  other  words,  thebest way to make money over the long term is to use limited resources(capital)  to  achieve  the  highest  return  with  the  lowest  risk  over  theshortest  period  of  time.  You  may  have  a  chance  to  put  on  10  different
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trades, each with different risk/reward and timing proﬁles. Each poten-tial trade should be placed in order of the highest return on capital withthe least risk.
New investors or traders need time to ﬁgure this out. However, onceyou reach a level of proﬁciency sufﬁcient to understand and numericallycalculate these levels and categorize them, you will achieve your goal ofgenerating the highest return while minimizing your risk.
Let’s take a look at the established general margin requirements. Then
we will explore some examples of capital analysis.
MARGIN REQUIREMENTS
One of the most common questions asked by new traders when openingup a trading account deals with margin requirements. However, before weget started, let me state that there are minimum rules set by the NASD thatgovern margin accounts. Each ﬁrm, however, can set more stringent rules,so  it  is  important  that  traders  check  with  the  brokerage  ﬁrm  they  areopening an account with to ﬁnd out its speciﬁc rules.
As previously mentioned, a margin account is a type of account thatallows  traders  to  borrow  money  from  the  broker  to  leverage  theirtrades. This seems like a great thing, and it can be; but margin can alsowork in reverse. It also means that a margin call might be made to tellyou to put more money in to cover the losses. This is where margin ac-counts  can  become  dangerous.  If  the  stocks  in  your  account  dropsharply, like during a market crash, you can lose more money than youoriginally invested. This was one of the main causes of the stock marketcrash in 1929, because the margin requirement was only 10 percent atthe time.
Some traders might notice that even retirement accounts sometimesuse  margin  accounts.  This  isn’t  because  you  have  the  ability  to  borrowmoney in these accounts, but because a margin account is needed to placethe capital to trade strategies that have higher risk than the initial debit.This is another reason why I teach traders not to use naked option strate-gies.  Not  only  is  the  risk  unlimited  with  these  strategies,  but  also  theamount of capital needed to trade them is very high.
Many traders might wonder what the margin requirements are for dif-ferent strategies. This varies according to broker, but the easiest way toﬁgure  it  is  to  calculate  the  risk  the  broker  has.  Whatever  the  maximumrisk is will be the minimum amount of money the broker will want in yourmargin  account.  If  you  have  any  speciﬁc  questions  about  the  marginneeded, just pick up the phone and call your broker.
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Based  on  the  rules  of  the  Securities  and  Exchange  Commission  and  theclearing ﬁrms, margin equals 50 percent of the amount of the trade usingstock. For example, if 100 shares of IBM at $100 cost $10,000, then you arerequired to have a minimum of $5,000 on deposit in your margin account.There  are  other  levels,  but  the  general  public  rule  of  thumb  is  leverageequals two to one. If the price of the stock rises, then everyone wins. If theprice of the stock falls below 75 percent of the total value of the invest-ment, the trader receives a margin call from the broker requesting addi-tional funds to be placed in the margin account. Brokerages may set theirown margin requirements, but it is never less than 75 percent, which is theamount required by the Fed.
Margin on selling stocks short is extremely expensive. You have to beable to cover the entire cost of the stock plus 50 percent more. This valuewill change as the market price ﬂuctuates. For example, if you wanted toshort sell 100 shares of IBM at $100 each, you would need to have $15,000as  margin  in  your  account—that’s  $10,000  plus  50  percent  more.  If  themarket price falls, you can buy back the shares at the lower price to repaythe  loan  from  your  broker  and  pocket  the  difference.  If  the  stock  pricerises, you will be required to post additional margin. Exactly how much isup to the discretion of your broker.
Futures
Margin requirements for futures vary signiﬁcantly from market to marketdue to the volatility of the markets as well as the current price. A compre-hensive margin commodity table detailing a variety of futures margins canbe found at the Chicago Board of Trade (www.cbot.com) and the ChicagoMercantile  Exchange  (www.cme.com)  web  sites.  You  can  also  consultyour broker for current margin requirements.
Options
Margin is used in a slightly different manner by options traders. Optionsare not marginable, meaning that the broker requires payment in full foran option purchase. However, when we trade a strategy that could cost usmore than the original debit, we must have a margin account. The easiestway to look at this is to ﬁgure what the risk is to the broker. For example,let’s say that I want to enter a bear call spread using 40 and 50 strike calls.I would sell the 40 call and buy the 50 call for a credit. Let’s assume thiscredit is $2. This means that if the stock stays below $40 at expiration, Iget to keep the entire premium. However, if the stock rises above $40 and
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ultimately moves above $50, I have reached my maximum loss, which isﬁgured  by  taking  the  difference  in  strikes  minus  the  initial  credit.  Thus,my maximum loss would be 8 points or $800 per contract. If I don’t wantto  put  this  money  in  the  account  up  front,  I  can  use  a  margin  account.However,  the  margin  requirement  should  not  be  very  large  because  thebroker is at risk for only $800. This is where it is important to choose anappropriate broker. There are many brokers who will require an accountvalue of $50,000 or more just to give you margin on an $800 trade. Mostbrokers who cater to option traders have less stringent demands; but it’simportant to ﬁnd out ahead of time how much the broker you are investi-gating requires to open a brokerage account.
Selling  naked  options—placing  a  trade  with  unlimited  risk—has  thehighest  margin  requirements.  (I  highly  recommend  that  you  never  sellnaked options. All short options should have a corresponding long optionor stock to cover you against unlimited risk.)
Combination Trades
If you are hedging options, then the use of margin is up to your broker’sdiscretion.  While  combining  the  buying  and  selling  of  options,  stocks,and/or futures creates a more complex calculation, it can also reduce yourmargin requirements dramatically. These days, you have to ﬁnd a brokerwho caters to option traders to make it in the volatile twenty-ﬁrst centurymarkets. An important rule of thumb: If you’re worried about the marginat  the  onset  of  the  trade,  you  should  not  be  doing  the  trade.  This  rulekeeps me away from putting on positions that are much larger than I canreally  handle.  Obviously,  the  larger  your  capital  base  becomes,  the  lessyou worry about margin. However, it’s always in your best interest to lookfor  the  best  trade—one  with  the  highest  return  and  the  lowest  risk—nomatter how much money you have available in your account. Individualswith large investment accounts may be tempted to make trades that aretoo big for their knowledge level. Start small. Build your account intelli-gently as you build your knowledge base.
RISK, CONTROL, AND BALANCE
When we have positions in the markets, we usually want to have a way ofprotecting  ourselves  from  the  worst  possible  scenario  that  could  occur.The reason is so that we can preserve our capital and manage our risk ex-posure to the markets. But, why do we want to do this? Do we trade so thatwe can have an added element of risk in our lives? And, if the answer were
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yes, why would we want to limit that amount of risk? I think the answermay lie in what I call the balance between risk and control. This may alsoprovide some insight into what compels a person to trade the markets.
I remember as a child hearing stories about wild animals that, for onereason  or  another,  came  into  the  custodial  care  of  a  person.  Maybe  theperson was trying to nurse the animal back to health or turn the animalinto a pet. The thing that interested me most about these stories was thatthe animals would sometimes starve to death even though they had foodto  eat  in  front  of  them.  One  of  reasons  was  that  the  animals  needed  tohunt their own food. Why? To me, it seemed obvious that it would be eas-ier for the animal to eat the food in front of it than it would be to have togo  through  the  difﬁculties  of  hunting  for  its  food  in  the  wild.  Is  the  ani-mal’s  need  to  hunt  greater  than  its  need  for  food?  I  will  leave  that  lastquestion for the psychologists to answer. However, I think that we couldagree  that  the  animal  would  experience  a  higher  degree  of  uncertaintyand risk if it had to search for its own food.
I think this need for the element of risk extends to people, but we alsowant to have a degree of control. I remember watching a television pro-gram several years ago about people bungee jumping off a bridge. A fewmonths later, some entrepreneurs had set up platforms for bungee jump-ing in vacant lots of large cities. For a small fee, the thrill seeker would geta few moments of an adrenaline rush and the experience was over. Whilemany of my friends classiﬁed this as a “faked suicide attempt,” I wonderedif there was much difference between this and a roller coaster ride at anamusement park. There was an element of risk and control that each par-ticipant agreed to before either event occurred.
Why is all of this important to trading? Most traders do not considertheir reasons for trading. This is probably because they have never consid-ered  what  their  values  and  beliefs  are  about  taking  ﬁnancial  risks.  Theyalso seem to pay little attention to the parts of trading that they have con-trol over. I am usually reminded of this fact when I talk with a trader abouthis  methodology  for  trading.  When  the  subject  of  risk  and  stop-lossescomes  up,  there  may  be  some  element  of  apprehension  that  develops.This  usually  means  that  their  stop-loss  rules  change  from  day-to-day  orthat no rules exist in their methodology. As a result, the limit for risk thatthe trader has is left for the markets to decide. This is because the traderhas made a decision not to exercise control over the only thing that can becontrolled once he or she is in the market: the protective stop-loss order.The only things that you have control over in the markets are your ordersto enter or exit the markets and when you place the orders. Unless youhave a risk-free options trade, there is never a guarantee of proﬁts.
There  are  three  basic  types  of  protective  stop-losses  for  optionstraders: time, premium, and the price related to the stock. Most options
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traders should consider using all three techniques for each of their posi-tions. Also, you should note that these techniques are elements of a trad-ing plan that a trader has to act on. In that respect, these parameters aredifferent than the typical stop-loss orders for buying or selling stocks. Theprotective stop-loss order for a stock may be placed immediately after theposition  is  entered  and  may  get  automatically  triggered  days  or  weekslater if the market moves against his position. This is different from thetype of stop-loss protection that I am talking about for options. For the op-tion’s protective stop-loss, the order to exit the option’s position is placedwith the broker after the stop-loss parameter is exceeded.
The time stop-loss may be triggered when you have purchased an op-tion and you want to exit the position in the last 30 to 45 days before expi-ration.  This  approach  helps  a  trader  exit  the  position  when  the  optionswill  experience  the  most  time  decay.  However,  this  would  probably  notapply for all options spreads. For example, you would likely want a creditspread to expire in order to receive the full credit potential of the spread.If you are trading debit and credit spreads, you will likely have differenttime stop-loss parameters for both in your trading plan.
Stop-loss parameters may also be based on  options premium. Whenyou have purchased an option or an option spread, you may want to exitthe spread if the value of the position depreciates to a certain level. Also,you may want to distinguish between making this decision based on theoption’s theoretical value or its actual value. If the option that you tradedlast  week  is  no  longer  at-the-money,  there  may  not  be  a  lot  of  volumetraded on the day you look at the markets. As a result the last traded pricemay not be relevant to the current market conditions.
The  third  method  would  be  based  on  the  value  of  underlying  stock.This method is usually employed when the trader has used some elementof technical analysis in his or her decision to trade the stock. Since techni-cal analysis is based on the stock price, the trader is able to determine theprice at which the decision to trade the stock is no longer valid. This deci-sion could be related to a moving average or a particular chart pattern. Ithelps the trader to quantify the price where the trader should exit the op-tions spread.
The effective use of protective stop-loss parameters in a trading planhas a correlation to the beliefs and values that the trader has about riskand control. When traders begin learning about the markets, they tend tolook at the analysis part of the endeavor and as a result have a very left-brain approach to trading. This leaves the trader open to self-sabotage be-cause  the  very  emotions,  beliefs,  and  values  that  compel  him  or  her  totrade are not included in the initial training and assessment of the tradingplan. We have all heard that trading is both an art and a science. Integra-tion of the right-brain beliefs and values with the left-brain analytics helps
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the trader to create a trading plan where success is a function of technicaldecisions more closely aligned with their tolerance for risk.
A ﬁnal consideration when trying to mitigate risk is to avoid invest-ing all or even half of your trading capital to one trade—even if you’recertain  that  it’s  a  sure  thing.  Allocate  maybe  5  or  10  percent  to  eachtrade.  That  way,  by  diversifying  and  spreading  your  risk  across  manydifferent strategies, one bad trade or idea will not clean out your wholeaccount.
CONCLUSION
As  a  trader  you  must  be  aware  of  all  the  risks—as  well  as  potential  re-wards—of every trade you place. Understanding the risks, and most im-portantly,  learning  how  to  intelligently  protect  yourself  are  essential  tosuccessful investing and trading. To achieve success, you must become anavid risk manager. In the beginning, this will not be easy. That’s why it’s soimportant to start small. Mistakes will be made and you don’t want youraccount to be wiped out before you get the chance to spread your wings.Since learning to protect yourself through creative risk management is themost vital part of successful trading, take the time to practice the art ofrisk management by setting up paper trades.
Options  are  one  of  the  most  ﬂexible  ﬁnancial  instruments  ever  in-vented. They can be employed to reduce your risk exposure and poten-tially  increase  your  returns,  especially  when  playing  the  securities  thathave  been  beaten  up  without  mercy.  As  Calvin  Coolidge  once  said,“Those who trust to chance must abide by the results of chance.” Under-standing how options interrelate and respond in different scenarios is theﬁrst  step  to  managing  risk  while  taking  advantage  of  the  opportunitiesthat the current market presents.
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CHAPTER 15
A Short Coursein EconomicAnalyses
T he global ﬁnancial marketplace strikes a delicate balance between a
vast network of business interests. Fascinating events in one area ofthe global economy, such as energy prices, can trigger a reaction inother markets, like bonds, and the ripple effect can spread to other com-modities  and  stocks.  With  technology  helping  to  speed  up  the  decision-making  process  and  allowing  traders  to  execute  trades  at  the  speed  oflight, capital can and often does shift from one country’s ﬁnancial marketsto the next. All of this movement in money and investments securities isoften based on international events, the global economy, and the outlookfor various ﬁnancial markets around the world.
Understanding the relationship among stocks, bonds, and economicevents helps traders to obtain a better understanding of what is happen-ing in the world, the daily movements in the ﬁnancial markets as well asthe long-term trends. This type of broad market analysis allows us to bet-ter  understand  the  risk-reward  proﬁles  of  various  directional  trades  be-fore we actually put money on the line and pull the trigger. This chapterseeks  to  assess  the  general  behavior  of  and  interrelationships  amongstocks,  bonds,  and  interest  rates  and  how  various  economic  conditionsimpact all three.
Historically, two factors have caused the stock market to crash: warand long-term interest rates. If bond prices drop too much, interest ratescan climb too high because there is an inverse relationship between bondsand interest rates, or yields. If so, it can devastate the stock market. A 7.5percent yield on the benchmark long-term Treasury bond has been a cata-lyst for a decline in the stock market, because it creates competition for in-vestor  money.  For  example,  if  bonds  offer  an  attractive  yield,  a  large
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institution might change its asset allocation from 60 percent of the moneyinvested in stocks and 40 percent in bonds to 60 percent in bonds and 40percent in shares.
In addition, when bond yields go up, companies have to pay more toborrow from banks, which hurts their proﬁts. As a result, the stock mar-ket  is  affected.  In  addition  to  bond  yield  concerns,  investors  also  worryabout  the  earnings  of  a  company.  If  earnings  are  better  than  expected,they  can  override  rising  bond  yields,  which  can  cause  stocks  to  go  up.When  stocks  aren’t  focused  on  earnings,  which  are  released  quarterly,they sometimes focus on bond yields.
These  interrelationships  are  both  dynamic  and  constantly  evolving.Here are 11 salient relationships I look for when developing a broad mar-ket analysis:
1. Lower bond rates help companies make more proﬁts.2. Short covering in the bond market can boost the Dow Jones Industrial
Average.
3. Falling bond yields can contribute to strength in ﬁnancial stocks.4. Bond yields follow the economy. If the economic indicators are com-ing in strong, bond yields will rise; if they are coming in weak, bondyields will fall.
5. Inﬂation is not only the enemy of the bond market—it’s also the en-emy  of  the  stock  market  because  a  rise  in  prices  affects  corporateproﬁts.
6. Shares  are  driven  by  corporate  proﬁts,  and  proﬁts  are  driven  by  a
healthy economy with low inﬂation.
7. The inﬂation reports such as the Producer Price Index and the Con-sumer Price Index will affect both stocks and bonds the same way.8. With  steady  economic  growth,  stocks  can  increase  even  if  earnings
aren’t outstanding.
9. When the Fed hikes interest rates, this can cause the yield on the long
bond to increase, which will create competition for shares.
10. If the Fed raises rates too high, this can cause a recession and can re-duce  inﬂation,  during  which  time,  bonds,  and  interest  rate–sensitivestocks will rise.
11. When the dollar is strong, U.S. exports cost more; as the dollar falls,
import prices rise, which is inﬂationary.
If some of these relationships do not hold, then it behooves the traderto  analyze  the  reasons  for  this  divergence  and  look  for  opportunities  to
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make  money  under  the  circumstances.  Dissecting  these  11  factors  willgive the trader a good feel for the current environment as we develop ourbroad market analysis scenario, which is always an excellent ﬁrst stepbefore implementing a particular directional strategy at the micro level.
INTEREST RATES, BONDS, AND STOCKS
Forecasting market direction is never a sure thing. Luckily, there are a feweconomic interrelationships that can help you to make consistent proﬁts.One  of  the  most  important  of  these  is  the  relationship  between  interestrates and bond prices. The following table illustrates the typical interrela-tionship of the change in interest rates to the price of a bond and the sub-sequent effect on the stock market.
Interest Rates
Bond Prices
Stock Prices
UpDownSideways
DownUpSideways
DownUpUp
Although these relationships are relatively stable, occasionally thereare deviations from typical economic behavior, referred to as divergences.This table, however, illustrates the normal expected action based on eco-nomic theory.
A bond is a debt instrument sold by governments or corporations toraise money for various reasons. The bond most widely considered by in-vestors and traders is the 30-year Treasury bond. It has a correspondingfutures contract that is traded at the Chicago Board of Trade and reﬂectsone  very  important  aspect  of  many  Americans’  lives:  mortgage  interestrates.  Bonds  are  rarely  held  by  the  same  buyer  until  maturity.  Instead,they are traded at a price that ﬂuctuates according to interest rates and in-ﬂation. Since a bond’s interest rate stays the same until maturity, its realvalue  at  maturity  depends  on  inﬂation’s  actual  value  of  the  dollars  atrepayment. In general, interest rates are also tied to inﬂation.
According to economic theory, if interest rates go up, bond prices godown;  and  if  interest  rates  go  down,  bond  prices  rise.  Why  does  this  in-verse  relationship  hold  true?  Let’s  say  that  you  decide  you  are  going  tolend me $1,000 for a ﬁve-year period. I agree to pay you interest at a rateof 8 percent each year, which happens to be the market rate for interestcharges. Therefore, I will pay you $80 per year interest. The very next day,interest rates jump to 10 percent. Now you could lend $1,000 and receive10 percent interest, which would bring in $100 per year, but you have lost
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the opportunity of lending that ﬁrst $1,000 at the higher rate of interest.Did the value of the ﬁrst loan go up or down with the rise in interest rates?The ﬁrst loan’s value went down. If you want to sell that 8 percent loan asan investment to someone else, you will ﬁnd that its value has decreased.A loan with a 10 percent interest rate has a greater value than one with 8percent. Therefore, when interest rates go up, bond (loan) prices fall.
Let’s examine the converse situation: When interest rates go down,bond prices rise. If interest rates drop from 8 percent to 5 percent, aninvestor  could  receive  only  $50  on  the  $1,000  investment.  A  previousloan  with  an  8  percent  interest  rate  would  now  increase  in  value,  be-cause it would make the investor $80 a year instead of just $50. In gen-eral,  ﬂuctuations  in  interest  rates  stimulate  the  bond  market.  Tradingbond  options  can  also  be  quite  lucrative  if  you  pay  close  attention  tointerest rates and inﬂation.
It is also a good practice to monitor certain bond markets’ yield to ma-turity. This measurement predicts a bond’s return over time by assessingits interest rate, price, par value, and time until maturity. To access thisinformation, please consult our web site at www.optionetics.com.
In general terms, the same inverse relationship exists between inter-est rates and shares as between interest rates and bond prices. Thus, bondprices and the stock market usually move in the same direction. Assumeyour company has to buy $10,000 worth of equipment. You don’t want topay cash for the equipment; therefore, you have to ﬁnance the purchase.In this case, you will pay 8 percent interest—$800 per year. Interest is anexpense that gets subtracted from what you earn. Therefore, if you earn$20,000 before interest, you will have earned $19,200 after interest is paid.If the interest rate were 10 percent for the same $10,000 loan you wouldpay  $1,000  per  year  and  your  earnings  would  drop  to  $19,000  after  yousubtracted interest. Once again, we see an inverse relationship, this timebetween  interest  rates  and  earnings—the  higher  your  interest  rate,  theless money ﬂows to your earnings. If your company has reduced its earn-ings  due  to  a  higher  interest  expense,  then  your  company’s  value  de-creases.  This  affects  your  company’s  stock  price.  Therefore,  an  interestrate increase (bond prices fall) usually decreases stock prices.
This  inverse  relationship  does  not  always hold.  There  are  periodswhen a divergence will occur and a company’s earnings will