a seminar in the San Francisco Bay area,many of those who attend work for technology companies or are in-terested in technology. For them, the stocks they’re likely to trackare Sun Microsystems, Cisco, eBay, and other similar stocks. Why?Because they know stocks in that industry.
Trade what you know. If you’re involved in a particular indus-try, you'll know the important events. If you follow technology,you'll know that the Comdex computer trade show is the venue atwhich many of the new technologies and products are unveiled. Ifyou follow Apple Computer, you know about MacWorld in January.And if you don’t know about it, don’t trade Apple! You’d be betteroff throwing darts to pick your stocks.
Follow the stocks for which you have a natural affinity. Tradinginvolves in-depth research into an industry, specific companies,and the trends that affect them. You need to know all you can abouta company, including the kind of news events that will affect a par-ticular stock. If Company A announces a new product, it will likelyhave an impact on the value of its stock. But what about its com-petitors? Will that new product put Company B at a competitivedisadvantage? Or is Company B working on a new version of itsproducts that will put it light years ahead of Company A?
For part of the late 1990s and in early 2000, momentum invest-ing was the rage. What does advanced DotGizmo do? Who cares!People weren’t investing, they were trading. If you feel compelled tojoin their ranks, it’s okay, just don’t kid yourself into believingyou're investing. You’re not. There is no shortcut to investing, butthere are better, safer ways to do it. You can’t trade without doingyour homework. The easiest and most enjoyable way to trade is tofollow those companies and industries that interest you.
When you're trading options as a retail investor, you can’t relyon pricing models alone. If you believe, for example, that the March2000 call is undervalued and therefore a good buy, it’s not enough.62 how I trade options
As a retail investor, you’re looking at more than just the relativevalue of an option, hoping to turn a quick profit on a put or a call,buying an option at, say, $3 and selling it at $3.75. Retail investorsmust have a longer time horizon than floor traders. As I jokinglytell investors at my seminars, floor traders like me have about a15-second attention span. It doesn’t matter what I’m doing, I canonly focus for 15 seconds.
That usually gets a laugh out of people, but a floor trader (re-member the emphasis is on TRADER, not INVESTOR) is competingagainst dozens of other traders to hedge each purchase or sale asquickly as possible. Why? Because the quickest traders will remem-ber the resting orders in the brokers deck from 10 minutes or twohours ago and hit those orders as the market rallies or dives. Oncethe resting orders are gone, the last resort is to hedge with the un-derlying security and when the stock specialist or Nasdaq marketmaker see hundreds or thousands of shares of buyers or sellers hit-ting the market they run. Being 15 seconds late in my world is aneternity. The complete picture of the stock can change in half thattime, so speed is of the essence.
Additionally, floor traders usually have a very rapid turnover.When a floor trader buys an option, we are not buying for investingpurposes, we are taking on inventory and hopefully, capturingsome of the bid-ask spread. That is the spread between my postedbid of say 4% and my posted offer of 4%. Due to the competitionbetween upstairs traders and the other market makers in my pit, Ican rarely capture that full 4 point. Rather, traders seek to lock in¥e ($.03), or 46 ($.06) by hitting a resting option, or selling the un-derlying stock. Active market makers will make hundreds of tradesper day, running in front of bulidozers to scoop up pennies. That’swhy floor traders can “day trade,” entering and exiting positions—ideally, hundreds of positions—within the same day. Paying retailcommissions, retail investors are better off taking a longer time-frame—anywhere from several days to a few months—for trading.
Conversely, floor traders could never use such a long-termtimeframe, largely because they are continually obligated to make atwo-sided market, which means selling even when they’re bullishand buying even when they’re bearish.
Because of our rapid turnover of positions, options are not azero sum game. You don’t have to lose for the market maker to win.You may buy a call option from me, and I may buy stock to hedgeacase for options 63
that sale. Let’s say that Micron goes up $5. You make money onyour call and if I hedged properly, I made money on my stock pur-chase. As long as we continually hedge and monitor our risk, themarket maker can provide a liquid market for the customer and apotentially lucrative market for himself.
A floor trader also has much tighter parameters on trades thatturn out to be a little “early.” For example, you may believe an op-tion priced at 3% is undervalued and is worth closer to 4 or 5. Butafloor trader, trading with a very short time horizon, will sell out andcut his loss the minute that option drops to 33s—even if it rises to 4or 5 within a few days. A retail investor, on the other hand, willprobably ride through the drop from 3% to 3% or even 3, if that’spart of the strategy, on the belief that the option will appreciate invalue before expiration.
Because of the short timeframe for floor traders and for pro-fessional off-the-floor traders, fundamental analysis into a com-pany’s operation is not as much a concern as theoretical analysison the relative pricing of options. If someone on the floor is daytrading, they could care less about what the company does. They’renot trading the fundamentals of a company’s bottom line or thestrength of its industry. Instead, they’re trading volatility, takingadvantage of price swings and trading momentum. Or they’re trad- |ing psychology when the market is panicked and oversold, in whichcase they’re looking for an opportunity to buy, or when it’s over-ex-tended, and they’re looking to sell.
So if you’re set on day-trading as a retail investor, remember Iam your competition. In this case, your decision to day-trade op-tions is like playing a game of chance in Las Vegas; the odds are in-evitably stacked against you. Let’s put it this way, I] pay penniesper trade, have instantaneous access to the market (I just have toyell), and don’t have to finance the same margins that a customerdoes. No matter how big a player you are, you’re still paying dol-lars, have to wait several seconds to several minutes to access themarket, and have considerably higher cash demands. How can youpossibly beat me on a per trade basis? Investing for a day, a week,or a month, sure, you can make money. If you use various spreadstrategies you can drastically reduce time-decay and volatilityrisk. But day-trading options against the floor is a loser’s bet.
Having said that market makers don’t have the same margin re-quirements that customers do, I must remind you that the leverage I64 how I trade options
use means I can make 100 times as much money on a trade than theaverage investor—and I can lose 100 times as much money.
Here’s an example: Let’s say the $95 IBM calls are trading at$6, and I—as the professional market maker—sell you 20 of thosecalls. I’m now obligated to deliver 2,000 shares of IBM at $95 if theoption is exercised. Let’s say I bought 1,500 share of IBM at $95against this option sale as a hedge.
If the stock pops in one day up to $97 a share, the option mycustomer bought is worth $7. The customer may opt to sell that op-tion and make a tidy, one-day profit of $1 per contract. On the otherhand, I bought 1,500 shares because I’m just as bullish as the cus-tomer and I wanted to hedge my upside exposure to that call sale.When the stock goes up to $97, I lose $1 on every option that I sold(assuming no leverage), for a $2,000 loss on 20 contracts. But |made $3,000 on that stock investment, for a net profit of $1,000. Mycustomer, on the other hand, made $2,000 on those 20 contracts.Please keep in mind that most market makers will have turned oversuch a trade multiple times during that one-day period, but I amsimplifying the relationship to show that both sides could have sim-ilar outlooks, and both profit despite being on opposite sides of thesame trade.
As a market maker, I’m obliged to make a two-sided market,even though the customer and I were both bullish on the stock. Theadvantage for me, however, is that with my margin and such in-significant commissions, | can trade multiple times a day like this—hopefully netting a few dollars each time! But more importantly,because of our different roles, fee structure, margin requirements,and so forth, the customer and I are not competitors.
The only way I can effectively gain an edge as a professional isto equip myself with professional tools. For example, I have accessto all the news feeds and brokerage upgrades and downgrades, notjust a few tidbits offered from online services. In fact, my firm payssome $30,000 a month for all the news feeds, computers, and otherservices that we use. The wonders of the amazing Internet havehelped level the field for the retail investor in terms of quick accessto information, but if a retail investor has an inch of information, aprudent professional has a yard.
If you’re an investor, you need to take a longer term time hori-zon of at least a week and preferably a minimum of one month.And, to move the odds in your favor, you need to rely somewhatacase for options 65
on fundamental analysis. Again, I'll use the blackjack analogy. If youwere a card counter, would you be satisfied with an ability to countonly one deck to determine how many “face cards” (with a value of10) are left in the deck? Or would you train yourself to count three,four, or five decks, which simulates the way most blackjack tablesat large casinos play. Obviously, you'd need to count multipledecks to move the odds into your favor. Otherwise, you are reallyjust gambling.
When you're investing, either with stocks or options, youshould become a student of the game and strive to know all you canabout a particular company. This knowledge will act as an edge tohelp you take a more controlled amount of risk. Why? Because fun-damental analysis, when used in concert with technical analysis,will help you determine whether or not a stock is likely to make aparticular price move within a particular timeframe.
The question then becomes how many stocks you can possiblytrack with research and price models? If you’re not doing this fulltime, you could still have anywhere from 10 to several dozen posi-tions in options. With stock you have a potential undefined amountof price risk for each company in which you invest. But in options,your risk can be defined exactly when you enter the trade. If youare an option buyer, your loss is confined by the amount of pre-mium that you paid. This assumes that you are either buying op-tions or doing spread trades that put limits on your exposure,instead of selling “naked” or unhedged puts and calls. For example,if you buy 10 calls (each representing 100 shares of stock) for a $2premium, you know that the most you could lose is $2,000 if the op-tion expires worthless. And you would still have a chance to cutthat loss, even if the stock made an adverse move, by selling thosecalls before expiration, say for $1 or $0.75.
In fact, I do not recommend that retail investors hold an optionuntil expiration. Even if a stock is moving strongly in your favor,you probably want to get out of that position—either by takingyour profit and initiating a new position, or by rolling the optioninto another expiration—before the option expires.
But at what point do you get out of a winning trade? Or inother words, how much is enough? Remember, when it comes tooptions, the variable is not just price—it’s also time. You may holda six-month out-of-the-money (meaning the stock is trading belowin the case of a call or above the current price in the case of an66 how I trade options
out-of-the-money put) option that becomes in-the-money far morequickly than you anticipated. Perhaps the $2 call you bought isnow worth $4 or even $6 in just a few weeks or even days. What doyou do now?
It all goes back to your original plan. Your decision to buy thatcall was based on your analysis that either the option was under-valued or the stock was poised for a move—or both. As part of thatplan, you had a price target for the stock. When that target isreached, it’s time to re-evaluate and decide what the next step willbe. Most likely, if you’ve doubled, tripled, or quadrupled yourmoney, you'll want to take a profit. You pull that money off the tableand establish a new position based on where you think that stockwill go from this point. If you're still bullish, you'll buy another callwith a higher strike price. But you don’t just let it ride in hopes ofturning $2 into $10. You take a profit once your target is reachedand re-evaluate your plan. Remember, it’s not the house’s money ifit’s in your account; it’s your money!
For example, say IBM is trading at $100 a share and I’m bullishon the stock. An at-the-money 100 call would have a premium ofabout $5. (That means the stock would have to rise above $105 ashare—the strike price plus the premium—for this trade to be prof-itable at expiration.) The $110 out-of-the-money call would haveabout a $2 premium (and profitable above $112 a share at expira-tion). And, let’s say the $120 calls have a premium of $0.75. Now, as-sume my research indicates to me that IBM is likely to run from$100 to $130 a share in two months, based in part on the company’sfundamentals and the strength of technology stocks in general. IfI'm right, the $120 call could go from $0.75 to $10 a share, the $110call could go from $2 to $20, and the $100 call could go from $5 to$25. Let’s take a closer look at the scenario: The $2 and $0.75 callsrise roughly 10-fold, while the $5 call has a five-fold increase. Sothe biggest gains are in the $110 call (with a $2 premium) and the$120 call (with a $0.75 premium).
How do you choose your strategy? With the current price of$100 a share, if I bought the $0.75 call—which is the cheapest—Iwould miss out on part of that run. Specifically, my out-of-the-money $120 call would not see a significant gain on the run from$100 until $110 or so. Therefore, the best value would be to buy the$110 call for $2. If, one month from now, the stock has moved from$100 a share to $115, that premium has increased from $2 to $6 oracase for options 67
even $8. That gives me the opportunity to sell that option out, tak-ing a profit, and initiating another position. As I stated before, ifyou're still bullish based on your plan, you may decide to buy the$115 or the $120 calls, paying the premium with the portion of theprofits made on the previous trade. In that way, you’re preservingyour capital and playing with the house’s money, just make sureyou pull some off the table for yourself.
Also, keep in mind what your initial investment was. If youbought 10 of the 110 calls for $2, you invested $2,000. The run to$115 brought in a profit of $4,000 ($2 paid for the 110 calls minusthe sale price of $6 one month later). If ycu still are bullish on IBM,you may want to still limit your next investment to $2,000.
Take a look at another IBM scenario. Let’s say you bought the$95 IBM calls for $6 and thus, your breakeven at expiration is $101.Then in three days, the stock moves from $95 to $112 a share—a$17 move. We “own” from $101 (our break-even price) all the way to$112. Our option has increased in value sharply—especially as anoption moves deeper into the money.
The premium on an at-the-money option generally moves$0.50 for every dollar that the stock moves in favor of the option(rising in the case of calls and declining in the case of puts). Whenit’s deep in the money, the premium option begins to move $0.75 tothe dollar and keeps on tracking closer and closer to 100 percent (adollar increase in option value per each dollar increase in the un-derlying security). That everchanging differential between thechange in value of the option and the movement of the stock isknown as the delta. Because of deltas, you must evaluate your op-tion trades differently. You may see a $2.50 gain in premium on a$97 call as the stock rises from, say, $95 to $100. But from $100 to$110, that premium increases $9. So at that level a $6 call is worth$17.50.
Under our “take the money off the table” scenario, you couldsell the $95 calls and, if you’re still bullish, buy the $115 call optionsthat have a $3 premium. Or, if you think it’s going down because thestock is overbought, you could buy puts with a strike price belowthe current market. Again, it all goes back to your constantly up-dated plan.
Whatever the scenario, it’s important to have a game plan andto follow it. If you think IBM will go up 10 percent or 20 percent, youmust know where you would exit the trade. And, you’re constantly68 how I ade options
reassessing that game plan based on the market movements and therelative value of the premiums. That’s why the homework phase oftrading is so important. You must know not only what looks like anundervalued or overvalued option, but also the salient fundamentalsimpacting the price of the underlying stock. As simple as it maysound, you must know when earnings are coming out. Four times ayear, a company announces earnings and it’s always a major occur-rence. Plus there are major industry conferences and brokerage-sponsored events at which time the stock is likely to be upgradedor downgraded. Based on that constantly updated plan, you makeyour decisions in regards to the options in your portfolio.
Trade what you know. Trade what interests you. That’s whyinvestment clubs work well in options strategies. Each member ofthe club brings his or her expertise and interests. Maybe one guy isa doctor who knows medical devices. Someone else works for anInternet company and is familiar with breakthroughs in that tech-nology. Investment clubs give you leverage of time and expertise.And, in the future, I believe investment clubs—and their use of op-tions—are a partnered explosion waiting to happen.chapter 4
beyond the basics
You’ve got the basics down. You know how options work and youunderstand the marketplace. You’re ready to trade. There is farmore to options trading than just buying a put or a call and waitingfor the market to move. In fact, once retail investors learn theropes, they can quickly become adept at using basic strategies tocontrol risk and enhance potential profits.
The options plays you execute will depend largely upon twothings: your risk tolerance and your portfolio goals. Risk and re-ward are directly proportional—the higher one is, the higher theother is as well. If you have a high risk-tolerance and your aim is tomake 200 percent on your money, then you’re probably going to fol-low an aggressive option strategy. If your risk tolerance and yourinvestment goals are more middle-of-the-road—meaning, you'll besatisfied with, say, a 30 percent return and don’t want to risk morecapital than is absolutely necessary—then you’re likely to adhereto a more conservative spreading technique.
Spreading, which involves selling one type of option and buy-ing another, is one of the most common ways to create positionsthat match your outlook for a given stock or index and limit yourrisk. Depending on the type of strategy you choose, these spreadscan limit your upside potential as well. But the trade-off of cappingyour risk, in return for a limit on the upside, usually is one thatmany investors are willing to make. Consider, for example, buyingan out-of-the-money (OTM) call at the 55 strike with a $5 premiumthat’s two months out and selling a nearby OTM call at the 65 strike70 how I trade options
for $2. The worst thing that can happen, no matter how much themarket moves, is you might lose $3, the difference between the $5you paid and the $2 you received. And the most you can make, nomatter if the stock doubles in price, is $7, the difference in price be-tween the strike you purchased and the strike you sold.
The strategies discussed in this chapter involve stock optionsthat, by definition, are American-style options, meaning they maybe exercised at the buyer’s discretion at any time, from the mo-ment of purchase until expiration. Again, the buyer of the option,not the seller, may elect to take these actions. Usually, the only timean American-style option—such as a stock option—is exercised atexpiration is when the strike price is in-the-money (ITM).
The other type of option contracts are known as European-style options, which are “frozen” and can only be exercised on theday of expiration. These options involve mostly stock indexes in theUnited States, such as options on the Standard & Poor’s 500 StockIndex, which are traded at the Chicago Board Options Exchange.This type of option is popular with institutions that normally wantto stay in their short positions until expiration.
Because American-style stock options can be exercised at anytime, it’s imperative that you are hedged, particularly if you areselling an option. Again, the only time we advocate retail investorsselling options is as part of a spread. If you are not adequatelyhedged, there is a risk that, if you’re a seller of an option, the buyermay “call” the stock from you or “put” the stock to you when thatoption is in the money. And even if you are unhedged or “naked” oneven one options contract, you could have a very bad day if thestock moves against you.
For that reason, spreading is a very appealing way of control-ling risks, hedging positions, and ultimately, preserving capital. Ibelieve it is a less risky way to speculate in a stock, rather than justbuying the shares outright. For example, say IBM is trading at $100a share. Do you want to hold the stock and commit that much ofyour capital? Or do you want to buy a call to be long IBM for a $5premium (each option is 100 shares, so such a position would cost100 x 5 or $500 per contract), which you hope will increase in valueas the stock price rises and the option moves further into themoney. Or, do you want to take the next step, and not only buy the$100 call for a $5 premium, but sell a $110 call and collect a $2 pre-mium (Figure 4.1).beyond the basics 71
 
Figure 4.1 long 1 July 100 call, short 1 July 110 call
 
 
Profit / Loss (¥) and IBM Common Price (X) Risk Graph
 
 
 
85 90 95 100 105 110 115 120 125 130
 
Source: Created by StockmarketWorkshop.com.
I do not advocate retail investors selling options naked, butusing conservative strategies, such as this bull-call spread, the in-vestor owns one option for each he or she has sold, so they are notnaked any contracts. Collecting the premium when you sell an op-tion may look as easy as picking up dimes on the pavement. But ifyou’re not careful, a bulldozer rumbling down the street couldknock you down. The only time a retail investor should sell optionsis when it’s part of a carefully constructed spreading strategy.
Another popular hedged strategy is known as the covered cailspread, in which the investor sells an option against stock that theyown. As we stated before, the value of an option erodes veryquickly in its last weeks and days. This time decay, as we call it, notonly eats away at the premium, it also helps move the odds in yourfavor, as the option has fewer days to move against the seller.
As the seller of an option, you are granting the right for some-one else to be long Cif you sell a call) or short (if you sell a put).For example, let’s say you sell a call with a $100 strike price andcollect a $4 premium. That means when the stock rises above$104 and the holder of that option exercises it, you are obliged todeliver shares at $100. Unless you purchased the stock previously,72 ~=how I trade options
you are obligated to deliver shares that you must now purchase inthe open market for $104. If the stock is trading higher than $104,you are still obligated to deliver 100 shares per short option, butany price higher than $104 means you’re losing money, as you onlytook in $4 for the 100 call. Now remember that every option isworth 100 shares. If you sell four calls, you may have to buy 400shares, and if that stock is trading over $104, then the loss com-pounds four times as fast. That’s how risk compounds quickly withuncovered options,
But when you sell a call as part of a spread trade, that potentialloss can be defined when you enter the trade and offset by the callsin your own portfolio. And, in a covered call strategy, most of usprefer to sell calls that are ready to expire. Remember, time is theenemy for the options buyer. As time runs out, there is less and lessopportunity for an option to be in the money for the buyer. (If astock is at $50 a share and you have bought a call with a $60 strikeprice and it’s a week to expiration, what are the chances you'll beable to exercise that option?) But time is the options seller’s friend!(if a stock is at $50 a share and you've sold the call with a $60 strikeprice and it’s a week to expiration, what are the chances that optionwill be exercised, obligating you to deliver stock?)
Thus, with a covered call, your strategy is to buy an optionwith a longer time horizon of at least several months—and perhapsone to two years, known as a long-term equity anticipation security(LEAP)—and sell one with only a few weeks left to expiration.
Here’s an example: IBM is trading at $111 a share. A two-yearcall option to buy IBM for $120 a share is selling for $23, and a one-year $120 call is selling for $17. Let’s take a look at this. The pricedifferential for two years versus one year is $6. So for $6 more ($23vs. $17) you can control the stock for an extra year. As a buyer of acall, you must determine which is the better buy—the one-year orthe two-year, depending on your outlook for the stock and your ex-pectation for how much the call option could appreciate in value.
Now let’s take a look at the short-term options. A $120 call op-tion that has 45 days left to expiration has a premium of $3.75.(When you consider that eight purchases of such a 45-day option—which would represent one year of purchases of a 45-day option—would cost $27.60, you can see why the LEAP is such an attractivealternative.) The same call option that expires in two weeks ispriced at %. The shortest-term option is the cheapest because youbeyond the basics 73
only have two weeks for a $9-a-share move to occur (from $111 to$120). So as the seller of the option, that limited amount of time andtime erosion are your friends.
Among these various options, you must then find the bestvalue. In general, your strategy will be to buy the long-term calloption and sell a short-term one against it. So you buy 10 of the$120 calls for a premium of $17 a share. That’s equivalent to get-ting 7-to-1 leverage (120/17) for the equivalent of 1,000 shares ofIBM. You then turn around and quickly sell the $120 call that ex-pires in 45 days and collect the $3% premium (Figure 4.2).
Now, let’s say in the next 45 days IBM shares rise from $111 to$117. The 45-day call you sold for 3% expires worthless, and you getto keep all the premium. Meanwhile, the one-year $120 call youbought for $17 may have lost a little value to, say, $15. But the $2lost on that LEAP is more than offset by the $3.75 in premium thatyou kept from the short-term call that you sold:
BOUGHT: $120 one-year LEAPS for $17 premiumSOLD: $120 45-day calls and collected $3.75 premium
Figure 4.2 long 10 Jan (02) calls, short 10 Aug 120 calls
 
 
Source: Created by StockmarketWorkshop.com.74 how | trade options
With this strategy, known as a time-spread, the calls that you buyand sell always have the same strike price:
Stock rose from $111 to $117
45-day calls expire, allowing you (the seller) to keep the $3.75premium.
Premium on one-year LEAP declines from $17 to $15.
Total net profit on this trade $1.75 per share.
Remember: The key to the time-spread strategy is to buy along-term option or LEAP that has slow time decay, and sell a short-term option that has fast time decay.
Here’s another scenario: Let’s suppose the stock rallies andcloses at $120 a share by the time the short-term call expires. Sinceit didn’t rise to $123.75 (the break-even point for a $120 call with a$3.75 premium), we still get to keep all the premium. Plus, the LEAPmay have appreciated in value from, say, a premium of $17 to $20,since the stock rose by $10 a share. The entire profit on the tradereflects the $3 gain on the LEAP and the $3.75 pocketed from theshort-term option that was sold.
SOLD: $