120 45-day calls and collected $3.75 premium
BOUGHT: One-year LEAP with strike price of $120 for $17premium
Stock rose from $111 to $120.
Since stock is not trading above strike price (for option to beexercised, shares would have to trade at the equivalent of the strikeprice plus the premium) you keep the $3.75 premium:
Premium on one-year LEAP increases from $17 to $20.Total net profit on trade $6.75 per share.
Total investment was $17 minus $3.75, or $13.25 less com-missions.
Return on that $13.25 investment is 50 percent.
Let’s assume the stock rises to $125, and the 45-day option you soldis exercised. Now, you're obliged to deliver stock at $120, for a $5beyond the basics 75
loss per share. However, you collected a $3.75 per share premiumon that option, which helps offsets that loss, reducing it to $1.25 ashare. Meanwhile, the LEAP you hold has seen an appreciation invalue from a $17 premium to $22 a share. The total net profit on thetrade is $3.75 a share:
BOUGHT: One-year LEAP with strike price of $120 for $17premium
Stock rose from $110 to $125 a share.
Your 45-day option is exercised, obligating delivery of stockfor $120 a share, $5 less than current price. That loss is partiallyoffset by $3.75 premium, for net loss on short-term option of $1.25.
Premium on one-year LEAP increases from $17 to $22, a gainof $5.
There is a loss of $1.25 on the 45-day call written.Total net profit on trade is $3.75.
Another variation on this theme is the Covered Write, meaningyou sell a short-term call and either already own the stock or yougo and buy the stock outright. Personally, | prefer that investors usethe LEAP-Covered Write, which allows them to participate in theupside potential of a stock through a long-term call or LEAP, whiletaking advantage of the leverage inherent in options and the timedecay of short-term options selling.
The Covered LEAP and the Covered Write are best used if youare bullish on a stock. By bullish I mean that you think the stockwill outperform the market. If not, then why not just buy a Spider(S&P Depository Receipts), Nasdaq QQQ, or DJIA Diamond, sincethey will give you absolute performance of each of those recogniza-ble indices.
And, as an investor, you can use the Covered Call Strategy aspart of your portfolio management. Let’s say you have $100,000 toinvest and you’re interested in technology stocks. Instead of buy-ing shares outright, you can use the LEAP-Covered Calls to invest aportion—say 10 or 15 percent—of the money to participate in theupside potential of a stock. The remaining 85 to 90 percent of yourprinciple can then be put into a Treasury bill making a modest76 how I trade options
6 percent. That locks in a minimum profit for the bulk of themoney, while your upside is the potential for that LEAP. UsingLEAPS, you can then participate in several stocks at once, givingyou, in effect, “several fishing lines in the water at once.” This isespecially effective within a sector. In technology, this might in-clude LEAPS for IBM, Hewlett-Packard, Texas Instruments, SunMicrosystems, and so forth. With the leverage inherent in options,you can participate in a broader number of stocks—albeit for thetime period defined by the duration of the options—than yourcapital would otherwise allow.
Working several stocks together you can, in the vernacular ofthe trading floor, avoid the “sin” commonly known as “right church,wrong pew.” At times, stock investors can pick the right industry,but they buy the wrong stock within that sector. For example, youmight want to participate in the Internet, but you pick Excite in-stead of Yahoo. (I have nothing against Excite, but remember onDecember 7, 1999, Yahoo rose an unbelievable 67%¢ a share after itwas included in the S&P 500.)
Using this LEAP strategy, you can participate in the upsidepotential of several different stocks with the same investment thatyou'd need to buy only a few hundred shares of just one company.Then, for up to two years, you can participate in the upside poten-tial of several companies—and not just Internet stocks. Maybeyou're interested in telecommunications, but which stock to buy?AT&T? Quest? Global Crossing? WorldCom? You can leverage yourmoney across a sector with LEAPS and, in effect, sit in many differ-ent pews in the same church. And with exposure across severaldifferent stocks, you can potentially improve your returns—espe-cially if you happen to catch a fast-rising issue, such as Yahooor Quest.
Similarly, you can use the LEAP strategy to participate acrossseveral sectors. Maybe you've enjoyed a good run in telecommuni-cations stocks, but you don’t want to sell, for example, WorldCombecause it’s done so well. And if you do sell it out, you would havetax exposure due to capital gains. (Your tax exposure and best taxstrategy are something that’s best left to you and your tax profes-sional. My comments here are by way of illustration.)
So, you can leave your WorldCom stock and borrow against iton margin from your brokerage firm, and put that margined moneyinto other LEAPS on stocks in other sectors. This is a very effectivebeyond the basics 77
strategy for getting additional capital and freeing up capital fordiversifications in other investments. That includes investmentswithin a sector and across sectors.
There are variations on this theme. You could buy an in-the-money LEAP call, which would work much more like a CoveredWrite (in a Covered Write, you buy the stock and sell a short-termcall), because an in-the-money option tends to move like the stock.Or you could buy an out-of-the-money option that track somewherebetween 50 percent to 30 percent of movement of that particularstock. With out-of-the-money options, you don’t get the full appre-ciation of the stock movement, but you pay less money.
The pricing of these options reflects both the intrinsic and ex-trinsic value. Here’s an illustration: If a stock is trading at $110 ashare and you buy a call with a strike price of $105, it’s $5 in-the-money. That $5 is also reflective of the intrinsic value or the differ-ence between the strike price of an in-the-money option and theprice at which the stock is trading.
The extrinsic value is the amount of the premium in excess ofthe intrinsic value. For example, if you bought this option for $15,then the extrinsic value would be equal to $10. (The stock was trad-ing at $110 and the strike price was $105, so that $5 is intrinsicvalue and the additional $10 was time premium or extrinsic value.)
But if you bought an out-of-the-money $120 LEAP call, it wouldhave no intrinsic value, because the call is above the current mar-ket price of the stock. Therefore, the premium you pay is all extrin-sic value. In other words, the price you're paying is all hope, andtime for that hope to pan out. The longer that time horizon, ofcourse, the more premium an option will normally hold.
Your strategy to use in-the-money options or the out-of-the-money variety depends largely upon your own plan and risk param-eters. If you tell me that you want to own IBM, the best bet is not anout-of-the-money call, as the stock would have to make a dramaticmove to reward you for your investment. Rather, if you want to ownthe stock, you'd be better off buying a LEAP call that will movemost like the stock . If the stock is trading at $110, then a $110 callwill move more in step with the underlying shares than an optionwith a strike price at $115 or $120.
With LEAPS, an investor can take advantage of a long-termtime horizon, which, at least in theory, increases the chances of astock move occurring. But one thing to remember, these LEAPS are78 how I trade options
not designed to take advantage of short-term moves in the market.Consider Yahoo's one-day rocket rise, up nearly 24 percent to $348a share on December 7, 1999, the final session before the stock wasadded to the Standard & Poor’s 500 Stock Index—and S&P Indexfund managers would be obliged to own Yahoo as of that date.
As a long-term instrument, a LEAP would not be the best placeto take advantage of that kind of price movement. Rather, you’d bemore interested in the movement of the stock over a longer timehorizon of, say, two to three months to two or three years. (Profit-taking on December 8, 1999, took $28.38 out of the stock, closingthat day at $319.63.)
The LEAP-Covered Call strategy is used, when an investor isbullish on a stock over a time horizon of at least a few months. Intheory, the same sort of strategy could be used with puts—buyingthe long-term and selling the short-term—if you had long-term bear-ish prospects for a company. But generally speaking, investorsrarely employ such a put strategy. Puts are bought primarily fordownside protection. Although vulture investors do actively specu-late in put options, very rarely do most investors buy puts to beton the downside of a company the way they buy calls to speculateon the upside.
Another options investment strategy is the Bull Spread, which,as the name implies, may be used if you have a bullish bias for astock. Let’s say you're interested in the Internet auction companyeBay, which is trading at $150 a share. Buying 1,000 shares wouldrequire a staggering investment of $150,000. Instead, an investormight buy $150 at-the-money calls that expire in two months, andsell the $160 calis against them. You paid a premium of $11 a sharefor the $150 calls and collected $8.25 for the $160 calls, for a netcost of $2.75 a share. On a 10 lot (1,000 shares), that’s a net price of$2,750 (Figure 4.3). :
Now, instead of investing $150,000 outright to buy 1,000shares of eBay, you have a $2,750 net investment. Here’s what hap-pens under two possible scenarios:
BOUGHT: $150 calls for $11 premiumSOLD: $160 calls for $8.25 premium
Within two months, eBay falls to $125 a share. The $150call that was purchased is worthless. You keep the $8.25 premiumbeyond the basics 79
Figure 4.3 long 10 Aug 150 calls, short 10 Aug 160 calls
Profit / Loss (Y) and EBAY Common Price (X) Risk Graph
 
 
 
 
 
 
Source: Created by StockmarketWorkshop.com.
collected on the $160 calls. The net loss is $2.75 a share, or $2,750—the maximum that can be lost regardless of how far the stock drops.However, if you had purchased the 1,000 shares outright, you wouldhave lost $25 a share or $25,000 under this scenario.
BOUGHT: $150 calls for $11 premiumSOLD: $160 calls for $8.25
Within two months, the stock trades up to $175 a share. The$150 calls that you purchased are worth $25, reflecting their intrin-sic value (the stock is $25 over the strike price). Similarly, the $160calls that you sold are worth $15. Thus, the spread between thosetwo options has gone to $10 a share or $10,000. Your net cost, how-ever, was $2.75 a share or $2,750 (which is the maximum you canlose on the trade). Thus, you’re looking at a net profit of $7,250—nearly tripling your initial investment amount. The stock investor,however, made $25,000, which based on a $150,000 outright pur-chase of shares, is a return of about 17 percent. So based on therates of return and the ability to sleep at night because of a limit on80 how I trade options
risk, it’s easy to see why options spreads like this one are so popu-lar with knowledgeable investors.
The advent of high-flying Internet stocks has encouraged theuse of options as a speculative vehicle, particularly in recent years.Unlike some of the better-known Blue Chips, it’s not uncommon forInternet stocks to trade at $300 or $400 a share or more. With thiskind of price volatility, it’s no wonder that investors are migratingto options for risk control and capital preservation. And, as we’vediscussed previously, as leveraged instruments, options allow youto participate in the upside of a stock (albeit for a defined period oftime) for less capital than if you bought the shares outright.
But there is a mitigating factor (1 don’t want to call it a down-side) when you use a strategy such as the Bull Spread, and that isthe upside is limited by the strike price for the option that you sold.Using this example of buying $150 calls and selling $160 calis, evenif the stock trades $25 a share higher, your upside is capped by thedifferential between the strikes of the two options. Yet, this seemsto be a reasonable trade-off for taking on far less risk than purchas-ing the stock outright.
The examples we've discussed thus far for the Bull Spreadhave involved fairly static scenarios, meaning you bought a call atone price and sold a call at another and the stock moved in one di-rection or the other. But since the market is constantly moving,you should re-evaluate your position based on your view of thestock. Using our eBay example, say, as we discussed earlier, youbuy $150 calls and sell $160 calls about two months out. Then 10days later, the stock is at $165. You’ve made a profit on the $150calls, but you still have the $160 calls that you sold to consider. At$165, the $160 calls with a premium of $8.25 won't be exercised asyet. But the more the stock moves, the greater the chance you'llhave to deliver shares at $160 if the option is exercised. Whatshould you do?
It depends on what your outlook for eBay is with the stock nowtrading at $165. You may decide that eBay still has considerablymore upside and you don’t want your profit limited by this $160 callthat you sold. In this instance, you could buy back the $160 call,and sell a call at a higher strike such as the $170 or $175, or what-ever you believe to be a price at or above the upside potential of thestock.beyond the basics 81
Whatever your decision, make sure you have a plan that in-cludes a price goal for the stock. If the stock hits or comes close tothat goal faster than you anticipated, you have to reassess thatplan. You may say to yourself that, based on what you’re readingand hearing about the company’s sales targets and so forth, you'revery bullish. Then you re-evaluate your strategy and move yourprice target. If there’s nothing compelling to cause you to re-evaluateyour previous goal for the stock, then it’s time to exit.
Wall Street’s stars do it all the time. A stock moves higher totheir price targets and they either suggest investors take profits andleave, or they move the target higher. And it’s okay for you, a retailinvestor, to do the same thing. You can always re-assess your plan,as long as you're doing your homework on the stock. Maybe youroption has doubled in value; now you think it might triple as thestock moves higher.
With options, there is always a way to lock in your potentialprofit as part of your strategy. But rarely, after a substantial move,would you simply keep a winning position on and let it ride.
Let’s say you re-evaluate your goal for eBay, and come up witha target of $175. You’ve bought a $150 call. To raise your upsideprofit potential, you buy back the $160 calls and sell the $165 calls.But eBay runs up to $170 a share in 10 days—not the two-monthtime horizon that you used to evaluate your options. So, you re-assess your position.
If you believe that $170 a share is the top for the short-term,you can “close the spread” and take your profit. To do that, you sellthe $150 call and buy back the $165 call. Then you look for an op-portunity in another stock to play the Bull Spread.
Or, you may decide eBay is going higher and the new target isnow $200 a share. So, you may sell the spread—pulling the moneythat you’ve already made off the table—and put on a completelynew trade. For example, you might decide to buy the in-the-money$195 call for $12 a share and sell the $210 call, collecting a $5 ashare premium, two months out. The total risk for that spread is $7a share, the difference between the premium you paid and the pre-mium you collected.
The mirror-opposite of the Bull Call Spread is another popularstrategy called the Bear Call Spread. These spreads are popular be-cause they allow a retail investor to collect a premium, or credit,82 how I trade options
for doing the spread. The downside, in my opinion, is that therisk/reward ratio for the Bear Call Spread is not favorable. Theamount that you can lose in most Bear Call Spreads is far greaterthan the amount you can win.
Let’s take a look at an example. In the case of a Bull CallSpread, if you buy the $65 call and sell the $75 call, that’s a 10-pointspread. If the stock goes up to $80 a share, the $65 call will beworth $15, and the $75 call will be worth $5. Since I sold the $75call, that $5 goes against me for a net profit of $15. It’s called a BullCall Spread because you make this trade when you're bullish ona stock.
Now let’s turn it around and say that you’re bearish on astock. So you sell the call spread. You sell the $65 call and buy the$75 call. If the stock declines, as you anticipate, you'll keep the pre-mium on the $65 call. The problem is, as the seller of that callspread, you’ll lose money if the stock goes up, although the $75 callthat you bought will put a cap on that loss.
Let’s go through another example. As in the example of theBull Call Spread, say eBay is trading for $150 a share. You think thatthe stock is overvalued, so you establish a Bear Call Spread by sell-ing the $150 call and collecting the $11 a share premium. Next, youbuy the $160 call for $8.25, for a net credit of $2.75. Since each op-tion contract represents 100 shares, you collect $275 for each timeyou do this Bear Call Spread (Figure 4.4).
You're betting that eBay will trade at $152.75 a share (yourbreakeven) or lower. As long as eBay finishes at expiration at aprice no higher than $150 a share, you get to keep the premium youcollected. The problem is the maximum you can make on this BearCall Spread is $275, or $2,750 if you did this trade 10 times.
The maximum you could lose on this spread is $10 (the differ-ence between the two calls) less the $2.75 you collected, or $7.25 ashare. That means a loss on a one contract spread of $725, or $7,525on a 10-contract spread.
_ Personally, I don’t like this spread from a purely risk/rewardstandpoint. I don’t like the fact that my maximum profit is $2.75 ashare, while I could lose $7.25 a share if I’m wrong. For me, as atrader, I try to find strategies that are just the opposite—with a re-ward that is at least twice the risk.
The appeal of the Bear Call Spread, though, is that it is alimited-risk trade. Instead of selling calls outright, which exposesbeyond the basics 83
Figure 4.4 long 10 Aug 160 calls, short 10 Aug 150 calls
 
Profit / Loss (Y) and EBAY Common Price {X) Risk Graph
 
 
 
Source: Created by StockmarketWorkshop.com.
you to virtually unlimited risk, you can lose only $7.25 a share—even if eBay goes from $150 to $200 a share. By comparison, theperson who has sold the stock at $150 a shares loses $50 a share inthat same move.
A better risk/reward strategy to play the downside of a stockyou consider to be overvalued, is to buy put spreads, which we’lldiscuss in Chapter 5.
As you evaluate your option strategies—including Bull andBear Call Spreads—the question becomes how you assess andreassess your stock outlook. The answer will depend on what re-sources you have. Professional traders and firms pay a lot of moneyfor information, particularly if we’re trying to gain a short-termedge. For example, my firm subscribes to services such as FirstCall, which lists brokerage upgrades and downgrades virtually assoon as they’re issued. That may gain us a 20-minute to two-houredge versus when you hear about a change in a stock recommenda-tion by a brokerage firm on a free service such as CNBC.
Interestingly, the Internet and the media in general—withthe advent of the all-day financial news shows such as CNN andCNBC—have really leveled the playing field for available knowledge,84 how I trade options
information, and intelligence gathering. So for instance, as a stockis running out of steam, you’ll probably hear about it on CNBC—ifyou don't see it before then through a casual perusal of an informa-tion site such as Reuters, Bloomberg, CNN-FN, or our own site at1010WallStreet.com. :
In addition to the stocks that are in the news that day, youmust do your own technical and fundamental analysis of the com-pany. Plus, you must learn to use what I call the “gut meter.” Whatdo you sense about this company? Is it out there in the news still orhas it faded from the spotlight? If it has faded from attention, has ittopped out in price or is it within the top of its range?
Another thing to watch for are the tails of the bell-shapedcurve, those “99.5 percent moves,” the once-in-a-lifetime kind ofrises or falls in the price of a stock. If you’re a trader on the floor orfull-time at the screen, you'll be able to watch those gyrations—but most retail investors haven’t given up their day jobs. So, theymight be limited to watching the stock only occasionally duringthe day, usually via the Internet. Or, you might be willing to give upsome control to your stockbroker, if he or she is knowledgeableabout options. You could instruct your broker with specific direc-tions or guidelines for where you would like to take a profit on aparticular stock.
Say you were playing December calls in Yahoo on December 7,when the stock gained some 24 percent and options rose 39% to49% on Chicago Board Options Exchange volume of 10,726 con-tracts. (“Options Report: Traders Take Profits in Yahoo! as StockSoars and Then Bid Up Ciena Calls in Heavy Trading,” by Steven M.Sears, Wall Street Journal, December, 8, 1999). If you didn’t noticewhat was happening during the day, your short-term profit poten-tial on those December calls would have evaporated as traders tookprofits after Yahoo’s big run.
Now, lest you think that professional traders always have theedge over retail investors, here’s what we did in Yahoo on the dayof its now-legendary run up in price. We bought at $290 a share andsold at $293. We bought again at $310 and sold at $312... That'swhat we do, in and out of a stock for a quick profit. But this time, in-stead of scalping (or making a short-term trade for a quick profit)for an % or a 4, we were scalping for dollars. The stock was movingSo fast that day, we bought at $290 and sold at $293 some 35 sec-onds later. Our longest trade that day latest about two minutes. Webeyond the basics 8&5
did okay, in fact, better than “okay.” But as short-term scalpers instocks, our profit was far from the full 24 percent buy-and-hold-all-day potential that the shares experienced.
We also traded Yahoo options, which were moving as fast asthe stock, but much of our activity took place later in the day. Quitehonestly, we didn’t expect a 70-point run in options; they had al-ready run 25 points the day before and 17 points the day beforethat . . . We did our analysis but, alas, in hindsight we were short ofthe mark. Even with the best analysis, sometimes a stock does notmove according to your plan. When that happens, you either takeyour profits and say thanks or cut your !osses quickly, reassessyour strategy, and move ahead with the next trade.
So at the end of the day, we bought puts in the last half hour,expecting a sell-off in the stock. We started buying puts whenYahoo was at $340 a share (it traded as high as $351 earlier) andheld them overnight. But volatility was lower the next day and, as aresult, the premium was coming down. We sold out of those putsquickly for a profit, but not as large as it could have been.
We’re not the designated primary market maker for Yahoo.Instead, we were speculating as professionals—and taking profitsquickly as a professional normally would. But in hindsight, we kickourselves for being too disciplined. The profits could have been farlarger, but nobody ever went broke taking profits.
But when you buy an option, you have to have a short mem-ory. Here’s what I mean. You have to forget what you paid for thatput or call when you re-evaluate you strategy. You can’t say, “Oh, Ibought this call for only $2 and now it’s trading at $17. I only have$2 into it so why don’t I hang on?” Rather, you have to ask yourselfwhether or not you would buy that option at $17. If the answer is“yes,” then hold it for a while. But if the answer is “no,” then getout. Take your money off the table and, from your profits, establisha new position if you’re still bullish, or take your money to the side-lines and wait for another opportunity. If you won’t buy an optionfor $17, then why hold it when it’s at $17? The risk/reward ratiosimply isn’t there.
Sometimes this is easier said than done, particularly whenyou look at a five-, six-, seven-, eight-fold profit. It’s so tempting tohold out and squeeze every last dime out of the profit. But you can’tlet greed motivate you. Instead, you have to use discipline to devisea strategy and then follow your plan.86 how I trade options
I believe discipline is the number one factor any trader—be it aprofessional or a retail investor—must have. It may be fairly easy toget into a trade, particularly if you’re a buyer and the market movesin your direction. But getting out with a profit once your target ishit can require a lot of discipline. And if it turns out that you leftsome money on the table, you can’t fault yourself. Constantly askyourself those crucial questions that all disciplined traders mustpose: “Would I buy this option here? If not, then why would I hold itat this price?”
Admittedly, there are times when it’s boring to be disciplined.But even if you’re the luckiest person alive, you’re not going to keepyour profits if you’re not disciplined. It also helps to have a disci-plined mind that can do research on a company or industry andthen apply what you’re learned. This kind of research is even morecritical for investors who have a longer term timeframe than atrader who might be scalping during the day. In fact, the closer youmove to a floor trader-style of trading, the less you have to careabout what a company does or any other fundamental factors. Allyou’re looking for is price opportunity and opportunities to exploitvolatility swings.
As a professional off-the-floor trader, I take a hybrid view. I domake scalp trades when opportunities arise. But at the same time, |do plenty of research—something which I enjoy—to find trading op-portunities. For example, if] see oil prices rallying, I like to short theairline stocks either by buying puts or by selling calls. (Rememberfuel is second only to labor as the biggest direct costs for airlines.)Or if bonds are up or down 12 or 14 ticks, then I have to evaluate thefinancial stocks. Or you watch the market sectors and look for stockopportunities among stocks that are not moving in step with theothers. Here’s a recent example. I noticed that while drug stocks, ingeneral, were lower, Johnson & Johnson had not declined as much.When I determined that it was not event-related (none of the drugcompanies had just reported earnings or finished a new product in-troduction, for example) I decided that it was only a matter of timebefore Johnson & Johnson declined. So, I started accumulating ashort position in Johnson & Johnson by buying put options whenthe stock was trading at $97 a share. We began buying $95 put op-tions over a three-day period. Over the next three months, the stockwas down nearly $25 a share. Through that decline, we sold putsbeyond the hasics 87
into the slide, taking profits and establishing put spreads to furtherprofit from a continued slide.
At year-end, we typically look for stocks that might comeunder some pressure because of tax concerns. Investors might takea loss now for this tax year and then buy shares back 30 days later(to avoid the IRS’s washed sale rule) for anticipated gains for nextyear. As we look for these opportunities, we might be short a par-ticular stock in the last two weeks of the year, and then trade fromthe long-side for the first two to three months of the new year. Withoptions, it takes a relatively small amount of risk and capital to getinto these opportunistic positions. ’
Stocks in late 1999 that fit that description included WasteManagement, Xerox, and BancOne. All of them were beat up andunderperformed over the year, and as a result saw some aggressives