writing  down  exactly  whatyou  are  going  to  say  to  your  broker,  you  can  avoid  making  costly  mis-takes. In addition, keeping a trading journal is an excellent way of learn-ing from your successes and mistakes as well as staying organized.
Long Synthetic Straddle Example
Trade: 2 Long September XYZ 40 Calls and Short 100 Shares of XYZ Stock.Place the order by saying: “I have a delta neutral spread order. Shareswith options. I am buying two Labor Day September XYZ 40 calls and I amselling 100 shares of XYZ stock at the market.”
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Explanation: We say “Labor Day” because “September” and “December”sometimes sound alike, especially when spoken loudly. You also want torequest that the order be placed as one ticket to give you a better chanceof execution. Whenever you use ATM calls, you will probably ﬁnd it easierto get the order ﬁlled.
These examples are simply guides for entering delta neutral trades. Re-member,  the  ratio  does  not  make  any  difference.  You  could  be  doing 2 calls and 100 shares or 20 calls and 1,000 shares. Although you need to specify the number, all the other important factors remain the same.Again,  it  does  not  make  a  difference  what  kind  of  order  you  wish  to enter.  Just  specify  the  quantity,  the  month,  the  commodity,  and  then if  there  is  an  option,  what  kind  and  the  price.  These  examples  are basic market orders. Let’s switch gears and try something a little morecomplicated.
Bull Call Spread Example
Trade: Long  1  June  XYZ  35  Call  @  13.95  and  Short  1  June  XYZ  40  Call @ 11.05.Place  the  order  by  saying: “I  have  a  spread  order.  I  am  buying  oneJune XYZ 35 call and selling one June XYZ 40 call at a debit of 2.90 tothe buy side.”Explanation: A plain old bull call spread will enable you to understandthe  debit  and  credit  side  of  a  trade.  In  this  example,  we  are  going  toplace the order as a limit order. We are not going to do it at-the-market.Just  for  a  little  calculation,  let’s  say  the  premium  on  the  buy  side  was13.95  and  the  premium  on  the  sell  side  was  11.05.  This  is  where  theyclosed. We come in and want to do it at whatever price they closed at.On the buy side, we are out-of-pocket paying 13.95; and on the sell side,we are receiving 11.05. What is the point difference? We are paying 2.90more than we are getting. This is just an ordinary bull call spread wherewe buy the lower strike call and sell the higher strike call. The trick isto ﬁgure out an acceptable limit order based on the premium on the buyside (debit) and the premium on the sell side (credit).
This process is pretty easy and would be the same if you were doing a10 × 10, a 20 × 20, a 100 × 100, or a 2 × 2, as long as it is a 1-to-1 ratio. Thereis no other calculation than just doing the simple math. This would be thesame  process  if  you  were  doing  a  put  spread.  You  would  need  to  deter-mine  both  the  debit  and  the  credit  and  net  them  out.  If  you  are  takingmoney  out-of-pocket,  it  is  a  debit  to  the  buy  side.  If  you  are  receivingmoney, it is a credit to the sell side.
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Put Ratio Backspread Example
Trade: Long  10  July  XYZ  35  Puts  @  11.05  and  Short  5  July  XYZ  40  Puts @ 13.95.Place the order by saying: “This is a put ratio backspread. I am buying10 July XYZ 35 puts. I am selling 5 July XYZ 40 puts for a 8.15 debit to thebuy side.”Explanation: Perhaps you have a speciﬁc idea—particularly when youare  doing  ratios—of  a  certain  price  you  are  willing  to  pay.  Maybe  thisspread  is  trading  at  8.15  but  you  are  only  willing  to  pay  7.50.  You  canput  that  order  in;  however,  it  may  not  get  ﬁlled.  The  point  is  that  youcan enter a trade at whatever prices you like. The previous prices werejust  used  to  demonstrate  the  calculations.  If  you  are  debiting  the  buyside, you don’t say “credit” because you are actually taking money out-of-pocket. This is a debit. A credit means that you are taking money in.It  is  something  that  goes  on  the  sell  side  of  the  ticket.  A  debit  meansthat  you  are  taking  money  out.  It  is  something  you  are  paying  on  thebuy side.
Don’t  worry  about  the  prices.  Just  make  sure  you  get  the  rightspread to make the trade work the way you want it to. If you want to doa credit of 5, do you care whether you do it at 15 and 20 or 5 and 10? No,you don’t care what those prices are. All you care about is the differen-tial between the two prices. The ﬂoor will not ﬁll a limit order if you givethem premium prices on each side.
Before you place a trade, write the order in a trading journal to keepan accurate account of every trade you make and glean as much knowl-edge as possible from your trading experiences.
AVOIDING COSTLY ORDERING MISTAKES
Option  trading  can  sometimes  be  very  complex;  some  positions  may  beconstructed  using  a  couple  of  different  instruments.  If  adjustments  areadded to an existing position, then the complexity of the matter can be-come  even  greater.  Even  seasoned  traders  can  become  confused  whendealing with the trades that they have created. It’s just the nature of thebeast. But confusion can lead to placing a trade incorrectly. You may endup  putting  yourself  in  a  position  where  you  are  exposed  to  a  greateramount of risk than what you originally intended. The severity of the mis-take will determine the course of action that is required to ﬁx it. This topicreally hits home with me since I just went through an experience of con-fusing strike prices, which caused me to make a mistake on the long and
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short options that I wanted to trade. If I had followed the advice in thischapter, perhaps the mistake could have been avoided completely.
Let’s  go  through  a  couple  of  different  scenarios.  Let’s  say  you  re-ceive  the  conﬁrmation  from  your  brokerage  ﬁrm  and  then  realize  thatyou placed the wrong trade. Unfortunately, in this business you can’t goback  and  say,  “Hey,  “I  really  didn’t  mean  to  place  the  trade  this  way.”However, if you are able to call your broker immediately after the tradewas executed and tell him or her that you need to “bust” the trade, thenthey  may  be  able  to  accommodate  you;  but  that  certainly  is  not  thenorm.  Fortunately,  I  was  able  to  have  my  trade  busted  and  I  certainlylearned my lesson!
Scenario #1
Let’s say that you intended to get into a Cisco Systems (CSCO) bull callspread using the 20/40 strike prices for a small debit. However, the sym-bols that you gave your broker were incorrect and you ended up with the20/30 bull call spread for that same debit. This is not a complete disasterbecause  the  risk  proﬁle  is  going  to  be  similar  to  what  you  originallywanted. You have a couple of different actions that you can take in this sit-uation. First, you can just sit with the trade and see what happens. If youroriginal assumptions were correct and the stock moves higher, then youshould be okay. The position just won’t move as quickly as the intendedtrade. Another alternative is just to exit the trade immediately and realizethe loss that you will incur because of the bid-ask spread. All other thingsbeing equal, I would probably stick with the erroneous trade, since thereis plenty of time for the trade to work out.
Scenario #2
Now let’s look at a situation that’s a little more serious that requires immedi-ate attention. Let’s say that you had a synthetic straddle on Best Buy (BBY),and you have been trading it very aggressively—as the stock moves, you arebuying  and  selling  off  shares  in  order  to  lock  in  proﬁts  and  remain  deltaneutral. Another adjustment that you could make to the position is to sellcalls against the long stock. In the process of doing this, you neglect to dou-ble-check the number of shares that you were long. You end up selling morecalls than you have long stock. This is a very serious situation, because theposition now has an unlimited amount of risk due to the greater number ofshort calls compared to the number of long shares available to hedge thetrade. The reason to trade a synthetic straddle is to limit risk, not create anunlimited liability. The action to take here is to immediately buy back the
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appropriate number of calls that were sold short. This action eliminates theunlimited  risk  that  became  part  of  the  position,  which  is  exactly  the  goalwhen dealing with this type of scenario.
As you can imagine, there are many different types of mistakes that can bemade when placing orders; some mistakes are more serious than others. Itis up to the trader to discern what has happened and determine how therisk  characteristics  of  the  position  have  changed,  and  then  act  accord-ingly.  Maybe  you  will  just  stick  with  the  trade  or  maybe  something  willneed to be done immediately.
The best way to keep yourself from getting into these problem situa-tions is to be well prepared when you trade. There are ﬁve steps that I al-ways  go  through  before  placing  a  trade.  This  process  should  help  youcatch any of the possible mistakes that are easy to make.
1. Write out the trade exactly that you want to place, including the ap-propriate actions (buy/sell), the number of contracts, the months, thestrike prices, the appropriate option symbols, as well as the net pricefor the overall trade.
2. Write  out  the  various  characteristics  of  the  trade.  Know  and  under-stand the margin requirements that the brokerage ﬁrm is going to re-quire once you’re in the trade.
3. Use an options analysis software package to view the risk proﬁle.4. Know  your  exit  strategy  or  at  what  point  the  next  adjustment  will
need to be made.
5. Place the trade with conﬁdence.
Hopefully, some of these ideas will help you to avoid panicking if yourealize that a mistake has been made with one of your trades, as well as toprovide some ideas on how to prevent mistakes from occurring.
POINTS TO REMEMBER
The typical brokerage ﬁrm ticket has the buy side of the trade on the leftand  the  sell  on  the  right.  Generally,  we  would  always  start  from  left  toright, writing down your buy side ﬁrst. You would say, “I have a straddleorder. I am going to buy three of the June XYZ 45 calls and buy three JuneXYZ  45  puts  at  ______”  at  the  market  or  as  a  limit  order  with  a  certainnumber of points to the buy side.
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With a spread order, always give the quantity, the month, the under-lying instrument, the price, and the strategy: “I am buying three [quan-tity]  June  [month]  XYZ  (stock)  45  [strike  price]  straddles  [strategy].”The  other  half  of  the  order  would  be,  “I  am  buying  three  June  XYZ 45 puts. I am buying three June XYZ 45 calls.”
Now we have to calculate the cost. It is either a debit, a credit, or at even. If it is at even, you do not want to receive a debit or a credit.You want to stay at net cost of zero. I prefer to do my trades at even orbetter.  However,  a  straddle  is  a  debit  strategy  because  you  are  buyingboth legs.
If you are not comfortable with the speciﬁc language of straddles andspreads, then state each part of the trade instead. Tell your broker, “I wantto buy three of the June XYZ 45 puts. I want to buy three of the June XYZ45 calls.” Spell out the whole thing if you are more comfortable doing itthat  way.  In  fact,  you  don’t  even  have  to  say  “straddle”  and  “strangle”  ifyou are not comfortable with those terms. In the beginning, it is a goodidea to be speciﬁc about each leg to make sure you get it right. Once youhave experience in these types of trades, it will become second nature toproperly state your orders correctly.
If  you  are  trying  to  get  a  credit,  do  not  state  the  credit  as  a  dollarvalue. You do not say, “I want $200.” You specify the credit, if that is whatyou desire, at the point level you want. So $200 is actually 2 points. Youneed to specify the trade in the terminology used by the ﬂoor. Most impor-tantly, it has to always be in tick values or point values, not in dollar termsof how much you want to spend or take in.
You can go into any market at whatever price you want. The ﬂoor willeither execute the trade at that price or it won’t. You could say that youwant the trade at even, but if the market is not at even, your order will notget ﬁlled. At one point during the day, perhaps the market does get to evenand  you  ﬁnally  get  what  you  want.  Bottom  line:  If  you  don’t  enter,  youcan’t win. If you want it at a certain price, put the order in as a limit or-der. Then wait to see if you get the trade ﬁlled. If you do not get yourcredit price or at even, try the trade at some other time. Do not chasethe trade.
The more volatile the market is, the wider the bid-ask spread will be.If the market is pretty quiet that day, the bid-ask spread will be smaller.The bid-ask will be smaller for the at-the-money (ATM) options and for thebody of the trade and greater for the wings. Floor prices primarily dependon  volatility  and  liquidity.  In  addition,  the  longer  the  time  your  optionshave until expiration, the wider the spread. Floor traders will widen thespread when there is a greater chance of their being wrong due to time,volatility, and volume.
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The  progression  of  an  order  through  the  trading  system  is  a  fascinatingprocess.  It  has  come  a  long  way  from  the  days  in  the  late  1700s  whentraders met under a buttonwood tree on Wall Street. Today’s ﬂoor tradersrun an average of 12 miles each trading day just to get the job done. Al-though many traders never set foot in an exchange, it is important to un-derstand the process your order goes through before returning to you as aproﬁt or a loss. As we progress further into the twenty-ﬁrst century, thisprocess will undoubtedly become even more electronically synchronized.As the information superhighway speeds up, it will be very interesting tosee how it changes and if the nature of the game itself remains the same.
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CHAPTER 14
MarginandRisk
W hen we refer to risk management, we speak of the ability to han-
dle with a degree of skill the possibility of loss. Of course, whendealing  with  trading  and  the  market,  there  are  many  kinds  ofrisks. Overall, what we are trying to do is make money while at the sametime managing the possibility of loss. This deﬁnition could be consideredthe Optionetics motto.
Risk management isn’t the sexiest of terms; people don’t run out andstudy everything they can on the subject when they hear it. This has todo  with  the  fact  that  risk  management  often  discusses  how  to  avoidlosses,  not  how  to  make  huge  returns.  Newsletters  and  stock-pickingsites post claims of high returns on individual plays, but rarely state theycontrolled their losses with proper risk management. It just doesn’t sell.Baseball  has  taught  us  that  people  prefer  a  home  run  to  four  straightbase hits, but a knowledgeable coach or trader knows that it’s the basehits that win games.
Everyone wants to talk about the option play that made him or her1,000  percent.  But  do  these  same  people  tell  you  about  the  other  ﬁveplays that they lost everything on? Of course they don’t. Does risk man-agement mean you can’t make large returns on your money? No, it doesnot. It means avoiding risks that do not make sense over the long term.Maybe the most common reason why option traders don’t last long is be-cause they take too many risks. Even though they win occasionally, theyend up running out of capital before the next home run is hit. Once youare down 5–0 in the ninth inning, that one home run is not going to winthe game for you.
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I believe one of the most helpful concepts to understand is compoundinterest. Most of us profess to understand this concept, but if we did, wewouldn’t  be  so  quick  to  take  the  risks  we  often  do.  Let  me  explain  thiswith an example.
If  I  put  $1,000  in  a  trade  and  it  returns  1,000  percent,  I  now  have$10,000. Now that I have this extra capital, I decide to place $2,500 in fourdifferent trades, but each of these loses 50 percent of their value. I nowhave $5,000 left. If I had made just a 50 percent proﬁt on each trade andcompounded  this  growth  each  time,  I  would  have  more  than  $11,000.This is because of the compounding effect on my money. This is a veryrough example. Obviously, taking all your winnings and playing it on onetrade  is  not  advised;  but  the  point  is  that  smaller  proﬁts  that  are  com-pounded  will  create  a  larger  account  than  risking  too  much  to  hit  thehome run. When was the last time you got a 1,000 percent return, anyway?In order to accomplish this task, too much risk is normally taken.
At Optionetics, we teach that hedging in case of a loss is as importantas getting out with a proﬁt. None of us want to entertain the thought thatwe  might  be  wrong  about  a  trade,  but  the  fact  is  that  we  will  be  wrongsometime and we need to be prepared for that event. On every trade weplace,  we  should  ﬁgure  what  our  risk/reward  ratio  is.  If  we  are  risking$500 to make $100, is that a good risk/reward ratio? In general, the answerwould be no. However, it really depends on the probability that the $100would be made or the $500 would be lost. For example, what if you see anoption trade that has a risk of $500, but this would occur only if a stock at50 drops all the way to 35 in the next two weeks? The odds would proba-bly say this risk is worth the reward because this drop is not likely to hap-pen. This same philosophy holds true when looking at risk/reward of, let’ssay, 10–1. This looks great, but if the stock needs to move 75 percent in amonth to get this reward, is it really a promising risk?
Clearly, there is a lot to risk management. The underlying theme is tomake certain you analyze the relationship between risk and reward. Un-derstand that taking fewer risks and not holding on for the home run willbeneﬁt  each  of  you  in  the  long  run.  The  Optionetics  Platinum  site  hastools  to  help  traders  ﬁgure  probabilities  and  risk/reward  ratios  that  canmake better traders of us all.
So  before  you  start  visualizing  that  new  car  from  the  proﬁts  of  onetrade, realistically analyze the situation and make sure it really is the bestmove to make.
THE CONTEXT OF RISK
When you put on a trade, you need to look at the worst-case scenario todetermine just how much your investment could possibly lose. Then you
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have  to  decide  just  how  much  you  are  willing  to  risk—$100,  $1,000,  or$10,000? When professional traders put on a trade, the ﬁrst thing they lookat (if they know what they’re doing) is the risk.
For example, if you’re a trader with a large bank trading in currencies,you’re not trading just $100. You’re trading $10 million per contract. To beable to proﬁtably handle such sums, these traders have to be able to man-age their risk. The most proﬁtable trades have two key elements: limitedrisk and unlimited reward. After all, you can create trades with limited riskall day long, but most of them will also have a limited reward. A $100 riskfor a $100 reward is simply not acceptable. No one wants to risk $100 to get$100, even if you win 50 percent of the time. Only if you increase your win-ning  percentage  will  it  be  an  acceptable  risk-to-reward  ratio.  Would  youtake a $100 risk for a $500 reward? I would. But how many times are yougoing to be right? That’s why it’s imperative to ﬁnd trades with limited riskand strong rewards with a high probability of being correct.
I am frequently asked, “What will it cost me to invest?” This is a difﬁ-cult question to answer. The necessary amount depends on a number offactors. The most important factors are the size of the transaction (num-ber of shares/futures or options) and the risk calculated on the trade.
As we discussed brieﬂy in an earlier chapter, there are two types oftransactions—cash and margin. Cash trades require you to put up 100 per-cent of the money. Margin trades allow you to put up a percentage of thecalculated amount in cash, and the rest is on account. Both types of ac-counts  are  set  up  to  settle  trades  and  payments  for  trades,  yet  they  arequite different. With a cash account, all transactions are paid in full by set-tlement day. Most of the time, the cash is already in the account before thetrade is placed. If you bought 100 shares of IBM at $100, this trade wouldcost $10,000 plus commissions paid out of your cash account. If IBM wereto rise to $110, your account would then show an open position proﬁt of$1,000, or a 10 percent rise in the account. Let’s take a closer look at mar-gin and how it can help improve the risk-reward ratio.
WHAT IS MARGIN?
Margin  is  deﬁned  as  the  required  amount  of  cash  on  deposit  with  yourclearing ﬁrm to secure the integrity of a trade. Most traders and investorsprefer  margin  accounts  in  order  to  leverage  their  assets  to  produce  ahigher return. The amount of margin required on every trade is the calcu-lated  ﬁgure  required  by  securities  and  commodities  regulators,  ex-changes, and brokers to protect them from default. Margin is the amountrequired to protect these various parties against your “falling off the faceof the earth.”
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A margin account allows the trader to borrow against the securitiesowned. In order to set up a margin account, you are required to ﬁll out ad-ditional  applications  with  your  broker.  You  can  use  the  money  for  any-thing  you  want;  however,  many  traders  use  it  as  a  type  of  leveragingvehicle with which to buy more stock. Margin accounts allow a trader toextract up to 50 percent of the cash value of securities, or to have two-to-one  leverage  in  buying  stocks.  This  means  that  for  every  share  of  stockyou  own,  the  brokerage  ﬁrm  will  lend  you  money  to  buy  another  share.This doubles your reward, but also doubles your risk.
If  you  buy  200  shares  of  IBM  at  $100  using  a  margin  account,  thistrade will cost $10,000 plus commissions ($20,000 ÷ 2), since the broker-age  ﬁrm  loans  you  the  money  to  purchase  half  of  this  position.  If  IBMwere  to  rise  to  $110,  the  margin  account  would  show  an  open  positionproﬁt of $2,000, or a 20 percent rise in the account, while you still haveonly $10,000 invested in this position.
The margins on futures are signiﬁcantly lower than the margins onstocks.  The  increased  leverage  that  futures  markets  offer  has  con-tributed to their rise in popularity. As previously discussed, the marginrequirements  for  futures  vary  from  market  to  market.  These  require-ments change frequently as the price of the commodity ﬂuctuates. Youshould check with your broker to determine the current margin require-ment for any futures you are considering trading. In most cases, if yourtrade starts to lose money, you will receive a margin call from your bro-ker,  which  requires  you  to  increase  your  margin  deposit  to  maintainyour position.
When  trading  a  margin  account,  brokerage  ﬁrms  charge  interestagainst the cash loaned to the trader. The interest rate is usually brokercall  rate  plus  the  ﬁrm’s  add-on  points.  The  rate  is  lower  than  for  mostloans due to the fact that it is a secure loan. The broker has your stock,and in most cases will get cash back before you get your stock back.
Keeping your margin requirement low is essential to lowering stress.Many people ﬁnd it difﬁcult to stay in a high-stress trade. They think aboutit too much, fretting about how they might lose $5,000. After all, it tookthem two months to earn that $5,000. Suddenly, they’re out of the game.Lowering your stress gives you a clear mind with which to make good de-cisions. When you put on a trade, try to keep the cost of capital as low aspossible and the return on your investment as high as possible. Maintain-ing a low margin is the natural extension of limiting your risk.
If you are buying options as part of your delta neutral strategy, ordoing futures with options, your margins should be pretty close to zero.You will, however, have to pay for the options in full. Now, as the tradestarts working, if your futures side makes money, you shouldn’t reallyhave to add any more money to your margin account. However, if your
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futures side is losing money, you may have to. There’s nothing like re-ceiving  a  margin  call  in  the  early  hours  of  the  morning  to  ruin  yourwhole day.
If  you  have  a  $100,000  account  and  you  spend  $50,000  on  your  op-tions, there is still $50,000 in your account to support a losing futures posi-tion.  The  problem  is  that  in  the  options  market  you  cannot  touch  yourlong  option  value,  although  it  is  probably  keeping  pace  with  the  futuresloss. It is almost like it’s in escrow. It’s there, but you cannot touch it. Theonly way you can get to it is to exit your position.