unless the stock price moves inyour direction. But options, as we'll discuss in Chapter 5, also allowyou to make money if you believe a stock or an index will stay in atrading range.
There are many reasons stocks stagnate in a trading range,such as a recent acquisition, the cyclicality of its business, or a re-cent earnings announcement that leads Wall Street to believe thereare no surprises ahead in the short term. Not surprisingly, playing atrading range for an index is even more popular than playing therange for an individual equity. This is because the very nature of anindex is that its diversification of stocks smoothes the performanceand volatility of its individual components.
playing the downside
One of the clearest examples of why it’s better to use options in-stead of dealing with shares directly, is playing the “short side.” Ad-mittedly, there are many professional traders and “vulture funds”that make money by shorting stocks that they believe are going todecline in value. When you short a stock, in effect, you’re agreeingto sell shares at a certain price—say $10 a share—even though youdon’t already own the stock, because you believe the price is goingto decline and you'll be able to deliver those shares later at a lowercost—say, $8 a share.
Many retail customers think it’s “un-American” to short astock. They want share prices to go up; that’s why they buy a stock.They don’t want to think about stocks that might decline in value.But day-traders—particularly professional ones—know differently.They play the stock market from the short- and long-side. But to do50 how I trade options
that, you have to literally borrow the shares of the stock that youwant to short until the time that you can deliver the securities forwhich you’re obligated.
Problems may arise, however, if you need to “borrow” a stockthat has a very thin float, meaning there are only a few shares out-standing. In such a situation, a majority of the shares are in thehands of company “insiders” and institutions. Perhaps only 15 or 20percent of total shares are in the hands of the public, whereas 80 to85 percent of the float is held by company insiders and institutions.
With only a few shares around to “borrow,” it may be diffi-cult—and potentially very costly—to short the stock, adding toyour overall risk. As you’ll see, an easier way to play the short sidewould be to invest in put options. But first, let’s discuss how thestock-shorting scenario would play out.
You believe that Company XYZ shares are overvalued. If youactually owned the stock, it might be a good time to sell. But whatif you didn’t own the stock? One possibility would be to short thestock. When you short a stock, your brokerage firm has to go outand borrow stock certificates electronically. Remember, every timeshares are bought and sold, these certificates have to be sent to thebuyer. Instead of Brinks trucks full of stock certificates going toand fro, today it’s all done electronically. But these stock certifi-cates still have to change hands, they just do so with the click ofa mouse.
If you’re shorting the stock, certificates also have to changehands. But the process is far more complicated than a simple sale.When you short the stock, you’re promising to sell something youdon’t already own.
Here’s how it works: First the short-seller commits to sell 100shares of XYZ at a certain price, say $100 a share. In this scenario,the short-seller believes the shares are currently over-valued andwill be available for purchase in a few days or a few months at alower price. Once the commitment is made, the seller then hasthree days to settle the transaction. That means that the sellerneeds to fulfill the obligation to deliver to the buyer stock certifi-cates in three days. The seller’s clearing firm normally goes outand borrows the stock certificates from someone who owns thestock—often a larger brokerage or financial institution. But thoselenders don’t loan out their stock certificates as a “favor.” It’s oftena very lucrative transaction.a case for options 51
The brokerage or institution that agrees to lend the stock is al-ready charging some customer margin on the shares. For example,if 100 shares of XYZ are priced at $100 a share, you'd need to comeup with $10,000 or $5,000 on margin. In return for putting up that$5,000 on margin, the brokerage firm will charge an interest rateanywhere from 6 percent for a major trader to 12 percent for asmall investor.
But that margin interest is just part of the money the broker-age stands to make if they can lend the shares to a short-seller.The brokerage firm also earns interest on the proceeds of theshort sale. A large trader who makes a short sale collects the bulkof the interest on the sale proceeds, ofter 90 percent of the inter-est, while the brokerage firm that loaned the stock certificatescollects the other 10 percent. A smaller professional trader maykeep 70 percent of the interest, while the brokerage gets the other30 percent. And a retail investor who chooses to play this riskygame may get zero interest, while the brokerage keeps it all. (Thatinterest on the proceeds of the short sale is in addition to what-ever margin the brokerage house may also charge. Margin andinterest are some of the most lucrative businesses for brokeragefirms.)
The most dangerous thing that can happen when you sell astock short is what’s known as a “short squeeze.” That usually oc-curs when the lender demands the stock back. The short-seller thenhas no choice but to go to the market and buy shares at the prevail-ing market price. And if the short-seller doesn’t do it, the lender willdo it—perhaps at not the most competitive of prices. Take it fromme, every time a firm has bought me in on borrowed shares, theypaid the high of the day.
In options, we can usually tell when there’s a short squeeze ona stock because the puts become very inflated. The pricing modelmay show that a put should be trading at $6 a share; instead, it’s at$10. The reason is either a short squeeze in the stock or a back-endon a takeover deal, and in either case, protection seekers or arbi-trageurs, they’ll pay anything for puts.
When there’s a short squeeze on a stock, you face consider-able risk of the share price rising sharply—the exact opposite ofwhat you’d hoped would happen when you shorted the stock. (Re-member, in this scenario the short-seller committed to sell 100shares at $100, hoping that the share price would decline, enabling52 how I trade options
shares to be purchased at a lower price—say, $90 or $80 a share—to replace the borrowed certificates.)
You might even be right about the stock; it is overvalued andshares will eventually drop. But in the meantime, you can getcaught in a short squeeze.
A far better way to play a price decline in a stock is to buy putoptions. If you think a $100 stock is overvalued, you can buy putswith a strike price of $100, $95, $90, or lower. (Remember, the far-ther an option is “out of the money,” the less premium you'll have topay.) If the stock doesn’t go down as you expect, all you'll lose isthe premium. But if you short the stock and the market goes againstyou, your potential loss is almost unlimited. Put another way, if youshort sell 10,000 shares and the price goes up by $3, you’re facing a$30,000 loss.
avoiding margin calls on stock
An adverse move in the market may result in another problem forstock investors—margin calls. For example, if you buy 100 sharesof a $100 stock on margin, you agree to put up $5,000 while yourbrokerage puts up the other $5,000 (and charges you interest onthat loan). Now, say the stock declines sharply in value and the$5,000 you put up is virtually exhausted. The brokerage firm isgoing to demand more money to cover the difference, which isknown as a margin call. If the money isn’t immediately forthcom-ing, the brokerage will liquidate your position to cover that debit.Keep in mind that, with volatile shares such as Internet stocks,brokerage firms may demand the investor put up a higher per-centage—75 percent or 80 percent—instead of the usual 50 per-cent on margin.
In the worst-case scenario, a stock is bought on 50 percentmargin. Then, the share price declines dramatically, resulting in amargin call to cover the shortfall—plus the brokerage firm raisesthe percentage that an investor must put up to 75 percent or 80percent. You’d then be in the unenviable position of putting upmore money to hold onto a losing position.
That, in and of itself, is a good reason to own options insteadof stocks. Granted, options may be brand new territory for many in-vestors. But people “invest” in options all the time. Consider takingan “option to buy” in real estate, a common practice among manyacase for options 53
developers to secure the rights to several parcels of property be-fore buying. Or, consider insurance which, in its simplest form, isnothing more than a “put” option to protect you from downsiderisk—in this case decline in your property value because of damageor destruction.
In fact, the easiest way to understand how options work is tolook at puts. If you buy a put, you’re acquiring the right to sell astock at a given price within a certain timeframe. Let’s say a stockthat you hold in your portfolio is trading at $50 a share and you’reconcerned it may decline in value. To protect yourself, you can buya put to sell the stock at, say, $45 a share. So if it declines to belowyour target, you can exercise your right to sell at $45. (Remember,the theory behind all trading is to sell at the highest possible priceand to buy at the lowest.) If the price doesn’t go down, your stockportfolio will register the gain. And all you’d lose on the optionstrade is the premium that you paid for the put.
For that reason, options trading is analogous to purchasinginsurance. Think about it. Would you drive out of a dealership witha $12,000 Hyundai or a $130,000 Mercedes without insurance? Ofcourse not. But not every insurance policy is the same. The largerthe deductible, the smaller the premium that must be paid. And, itcosts more to insure the Mercedes than the Hyundai. But let’s as-sume that you have a $500 deductible on your $12,000 Hyundai,and the car is totaled in an accident. You only have to pay the first$500 in the loss. The other $11,500 is paid for by the insurancecompany. In options terminology, you paid $500 (the deductible) toguard against a $12,000 loss. When catastrophe strikes, the partythat sold the put—in this case the insurance company—pays thedifference.
If you drive for the life of your car without an accident, you’ve“lost” the premium you paid for the insurance policy. But you hadthe protection of that insurance policy just in case.
Legal requirements aside, no one would buy a car or a housewithout insurance. But people buy stock all the time without down-side protection. To most of us in the industry, this is as unfath-omable as owning a $400,000 home without an insurance policy.
Say you hold Microsoft, a blue-chip stock if ever there wasone. This champion only goes up, so why waste money on buyingprotection that will doubtless go unneeded. On the other hand, let’ssay you started to feel a little nervous about whether or not the54 how I trade options
government’s antitrust division could get the software giant declareda monopoly. | know that’s just silly supposition, but let’s say youwere feeling it was time to protect some of the thousands of sharesyou own that cost $5 a share but that are now trading at $90 a share.You’re willing to pay a $5 “deductible” in case of a loss, so you buy the$85 put. That put may be exercised any time during the life of that op-tion. But obviously, you would only want to exercise the right to sellMicrosoft at $85 a share when it’s trading below that price. And evenif Microsoft should trade to as low as $50 or $60 a share, by exercis-ing that put, you may sell at the $85 strike price—and the party thatsold you the $85 put must buy from you at that price.
What happens if Microsoft goes from $90 to $110 a share? Ob-viously, you’re not going to exercise that option to sell at $85. Allyou've lost is the premium you paid for that put option, which ex-pires worthless. But that option gave you the peace of mind to holdMicrosoft through $100 a share, knowing that you were covered ifthe market suddenly made an adverse move. There is no way youcan say that you “wasted” your money buying that put, any morethan you could say you “wasted” money on your homeowner’s pol-icy because your house didn’t burn down!
Options are more than just an insurance policy, though. Theyare also effective means to trade the market, regardless of whetheryou have a small or large stock portfolio. Options can bring balanceinto your holdings, helping you to guard against risk and minimizeexposure—and also to reap returns based on how you think a par-ticular stock will perform. Stated simply, you can use options tocapitalize on certain market moves—buying calls when you're bull-ish and puts when you're bearish. Options also provide leverage, in-creasing the buying power of your investment capital. And theyoffer greater diversity in your holdings.
For example, say you want to buy 1,000 shares of IBM, which istrading at $95 a share. To make the purchase outright, you'd need$95,000. Fully margined, you would need to put up $47,500. (In-vestors can buy stock on 50 percent margin, but you still must payinterest to the brokerage on the amount of money loaned to makethe purchase, as well as commissions. These fees are paid regard-less of whether your investment appreciates or declines in value.)
Or, you could participate in the upside potential of IBM bybuying the $95 call. This gives you the right to buy IBM for $95 aacase for options 55
share until that option expires. You could hold an option for aslittle as a day—if you buy one close to expiration—or as long astwo years. And in general, you want to hold an option long enoughto increase the chance of the market move that you’re anticipat-ing really happening. (There is a greater chance of a stock goingfrom $95 a share to, say, $110, over several months than in just afew days.)
Getting back to our example, let’s say you decided to buy $95IBM calls for a $6 a share premium. With each options contractrepresenting 100 shares of stock, they would cost $600 each—or$6,000 for 10 contracts, which is equivalent to 1,000 shares. Com-pare that with the cost of buying 1,000 shares outright for $95,000or $47,500 fully margined.
But there are some limitations. Your break-even price on theIBM stock is $101 a share (the $95 strike price plus $6 for the pre-mium). And you only participate in the upside potential of IBMfor the life of that option, or in this example one month. But withthe leverage inherent in options, you can make greater use of yourmoney by diversifying your holdings among options on several dif-ferent stocks instead of committing large portions of capital to theoutright purchase of shares in only one or two companies.
But remember when you buy an option, time is your enemy.You only have the right to control that stock for the term of thatcontract—the expiration cycle. If you don’t give yourself enoughtime for your outlook on the stock to prove correct, you’re going tolose. Most of the time people lose money in options because theydon’t give themselves enough time to be right. As a stock movesin your favor—either down if you hold a put or up if you bought acall—your option becomes “in the money.” For example, a $90 calloption when a stock is trading at $95 a share is “in the money.” An$85 call would be “deep in the money.” However, a $110 cali optionwhen the stock is trading at $95 a share would be “out of themoney.” And the further “out of the money,” the option is, thecheaper the premium.
But buying an out-of-the-money option that looks cheap on arelative basis—costing only $1 a share instead of $6 or $8 for an in-the-money option—is not a sure bet. The reason is that the furtherout of the money an option is, the more extraordinary a marketmove would have to be.56 how I trade options
Thus, time is a tricky component when you’re trading options.With the exception of the professional trader, investors should nothold an option until the very end of the expiration cycle because oftime decay, which accelerates as expiration nears. Time decay is sogreat when options are near expiration that you hear the traders“hissing” on the floor as they imitate the sound of air escaping aballoon. When an option is only a day or two away from expiration,there usually isn’t enough time for a significant market move thatwould bring an out-of-the-money option into the money.
It’s a far cry from the days when pricing models for optionswere very expensive and difficult to come by. In those early days,options were frequently mispriced, which led to an opportunityfor investors and professional traders to pick up a valuable optionat a bargain price, or sell an overvalued option at an inflatedprice. As pricing models have become more sophisticated andmore available—thanks, largely, to improvements in computingpower—options are much less frequently mispriced and the mis-pricings only last for seconds, not days. As a result, both public in-vestors and professional players have a greater sense of eachoption’s value.
As I wrote in Chapter 1, when I began trading options in 1981,I used to take hours to run the analysis on options prices—eventhough we only had 99 listed options in those days. I used to startprinting my option runs at 6:00 a.m. to be ready for the 9:00 a.m.opening. And when we went to the floor, we took reams of computerprintouts with us. Some traders carried saddle bags slung overtheir shoulders to carry several hundred pages of printouts of theo-retical values. The rest of us stuffed our pockets with the theoreti-cal values of options at varying price levels of the underlyingsecurities. All day, we flipped through those pages, comparing thecurrent quote with the optimum valuation, hoping to capitalize ona disparity in pricing. In 1981 and for the next several years, com-puters for option analysis were not allowed in the pits, as theywould give an unfair advantage to the most highly capitalized trad-ing firms.
Today, it’s a different story: Sophisticated handheld com-puters operate on wireless local area networks (LAN) or wirelessinfrared communicators connect the floor traders with the riskmanager upstairs and the outside world. Virtually every trader hasonboard analytics and access to the NYSE and Nasdaq markets, asacase for options 57
well as the burgeoning number of electronic communications net-works (ECNs). Thanks to such technology, the hedging, communi-cation, and trade analysis is virtually instantaneous.
Another obvious beneficiary of the tumbling cost of comput-ing power is the individual investor. For retail customers, the In-ternet makes a number of options pricing models available, oftenthrough discount, or full-service brokerage firms’ or other trad-ing sites.
The most basic way to price an option is to start with thestrike price. If IBM is trading, for example, at $90 a share, and youdecide to buy a call—or in Wall Street partance, to go long a call—at the $95 strike price, you are buying the right, but not the obliga-tion to own IBM for $95 a share until that option’s expiration. Now,take that $95 and multiply it times the interest rate that you wouldhave to pay if you borrowed money from the bank, say 8 percent. Ifyou’re not borrowing the money, multiply the strike price times theinterest rate you would get paid if you put your capital in a certifi-cate of deposit (CD) today, say 5.5 percent.
For the sake of illustration, let’s pick an interest rate of 8 per-cent to borrow money to buy the $95 call:
$95 x 0.08 = $7.60
Now, multiply that by the number of days for the life of the op-tion, such as 30 days for a one-month option:
$7.60 x 30 = $228.00
Now, divide that by 360, for the approximate number of daysin the year (you could use the exact 365, but nobody on Wall Streetdoes):
$228.00 + 360 = $0.63
This would give you the value for that $95 call, assuming therewere no volatility considerations.
But that’s like computing the value of a piece of propertybased on square footage alone—and not taking location into ac-count, like 500 square feet of land in a remote part of Utah versus500 square feet in Centra! Park.58 how I trade options
As market makers, professional traders, and sophisticated re-tail investors know, the biggest component in the price of an optionis volatility.
In the simplest of terms, volatility is a measure of risk. Themore volatile something is, the greater the risk. Put another way, ifthe price of something is bouncing around like crazy—up one dayand down the next—there is greater risk that you could be caughtshort or long with the price moving against you. That volatility in-creases your risk.
At the same time, volatility is an estimate of what the ex-pected range is for whatever stock or commodity you're trading.Again, if a stock has some pretty wild gyrations in price, such aseBay or AOL, it has a relatively high volatility and its projectedtrading range will likely be wide. By the same token, a stable stockwith little change in price, such as a utility stock, would have lowvolatility and a comparatively narrower expected price range.
Here’s another analogy to illustrate the concept of volatility.Everybody (particularly any parent) knows it costs more to insurea 16-year-old boy who is driving the family car than for the 30-year-old man who is married and is the father of two children. Why?Volatility!
The 30-year-old man with a wife and two kids is less likely toengage in “volatile” behavior such as drag-racing his friends downthe neighborhood streets or drinking and driving to impress hisgirlfriend. Thus, the range of expected events—in this case thechance of an auto accident—is far greater with the 16-year-old boy:than with the 30-year-old. So what does the auto insurance com-pany do? It charges more to insure the 16-year-old driver than the30-year-old driver because the likelihood of an accident (whichwould result in the insurance company having to pay for damagesand/or injuries) is greater with the young boy than the presumablymore mature and stable married father.
To bring our analogy back to the market, the 16-year-olddriver might be the equivalent of an Internet stock, the price ofwhich is bouncing around in a volatile fashion. The 30-year-old sta-tion wagon driving Dad might be IBM. IBM, with its far lower volatil-ity, usually will trade in a narrower range than the high-flyingInternet stock.
Based on the volatility, we can project how a stock is likely totrade in a day—say, with a price range of $3 a share. That volatilityacase for options 59
won't tell you the price at which the stock is likely to close. But itwill tell you where it’s likely to trade based on past price patternsand current volatility.
Using a bell curve model, you could predict that about 66 per-cent of the time, the stock would trade in a $3 range, 95 percent ofthe time in a $5 range, and 98.6 percent of the time in a $10 range.
Now, take the example of IBM. With the stock trading at $114,normal weekly volatility is around 40 percent. Its bell curve pointsare likely to show, for example, a $13 range 66 percent of the time, a$25 range 95 percent of the time, and a $39 range 98.6 percent of thetime (Figure 3.1).
But before earnings, IBM could reflect a weekly volatility ofaround 70 percent. At that time, its bell curve points are likely toshow, for example, a $22 range 66 percent of the time, a $45 range95 percent of the time, and a $67 range 98.6 percent of the time(Figure 3.2).
With higher volatility there is a greater probability that a par-ticular price point will be hit. (Think of the 16-year-old driver.What is the chance that the volatility of youth will result in afender-bender?)
 
Figure 3.1 IBM—$114 share, normal volatility 40 percent, weeklystandard deviation
 
——— ~~Three = Two ‘One Standard One Standard Two Three3D. 8.0, Deviation sits Deviation SD. $.D.$98 sre $102 $107 7/8 $120 112 $127 38 $134 5/8
Source: Chicago Board Option Exchange.60 how I trade options
 
Figure 3.2 IBM—$114 share, unusual volatility 70 percent, weeklystandard deviation
 
———! =Three = Two One Standard $114 ‘One Standard Two = Three$0, 8.0. Deviation Deviation 80. 8D.$8614 503778 $103 172 $128 v8 $138 we $152 1/2
Source: Chicago Board Option Exchange.
To buy an option on a volatile stock, you would have to pay ahigher premium than for a less volatile issue. Why? Because theseller—like the insurance company offering coverage on a teenagedriver—wants protection from the risk of an event. In the case of anoption, the seller wants to ensure that the premium paid will bal-ance the risk involved in hedging the exposure the seller takes onshould that option be exercised.
If the option is exercised, the seller may be obligated to sell thestock at a considerably lower price than the prevailing market (inthe case of the seller shorting a call option) or buy the stock at aconsiderably higher price (as could be the situation faced by a putseller) than the prevailing market.
As we'll discuss later, there are many different strategies to em-ploy when trading options. But with some 1,200 different issues onthe CBOE alone, there is the inevitable question of which options totrade. I don’t recommend particular stocks to people. Rather, my ad-vice is to trade what you know—whether it’s retailing, manufactur-ing, the Internet, or, in my case, medical technology. Peter Lynch oncerecommended investing in companies you know, whose products you60 how I trade options
 
Figure 3.2 IBM—$114 share, unusual volatility 70 percent, weeklystandard deviation
 
——~| —Three = two ‘One Standard $14 ‘One Standard Two Three$d. 8.D, Deviation Deviation 3.0, 8D.
$05 14 $93 778 $103 412 $126 Sie $isems $182 172
Source: Chicago Board Option Exchange.
To buy an option on a volatile stock, you would have to pay ahigher premium than for a less volatile issue. Why? Because theseller—like the insurance company offering coverage on a teenagedriver—wants protection from the risk of an event. In the case of anoption, the seller wants to ensure that the premium paid will bal-ance the risk involved in hedging the exposure the seller takes onshould that option be exercised.
If the option is exercised, the seller may be obligated to sell thestock at a considerably lower price than the prevailing market (inthe case of the seller shorting a call option) or buy the stock at aconsiderably higher price (as could be the situation faced by a putseller) than the prevailing market.
As we'll discuss later, there are many different strategies to em-ploy when trading options. But with some 1,200 different issues onthe CBOE alone, there is the inevitable question of which options totrade. I don’t recommend particular stocks to people. Rather, my ad-vice is to trade what you know—whether it’s retailing, manufactur-ing, the Internet, or, in my case, medical technology. Peter Lynch oncerecommended investing in companies you know, whose products you60 how I trade options
Figure 3.2 IBM—$114 share, unusual volatility 70 percent, weeklystandard deviation
 
————1 iThree = Two ‘One Standard One Standard Two ThreeSD. 8.0. Deviation sit4 Devietion 80. 8.0.
$8644 $0370 $103 42 $125 50 $130 ae $102 172
Source: Chicago Board Option Exchange.
To buy an option on a volatile stock, you would have to pay ahigher premium than for a less volatile issue. Why? Because theseller—like the insurance company offering coverage on a teenagedriver—wants protection from the risk of an event. In the case of anoption, the seller wants to ensure that the premium paid will bal-ance the risk involved in hedging the exposure the seller takes onshould that option be exercised.
If the option is exercised, the seller may be obligated to sell thestock at a considerably lower price than the prevailing market (inthe case of the seller shorting a call option) or buy the stock at aconsiderably higher price (as could be the situation faced by a putseller) than the prevailing market.
As we'll discuss later, there are many different strategies to em-ploy when trading options. But with some 1,200 different issues onthe CBOE alone, there is the inevitable question of which options totrade. I don’t recommend particular stocks to people. Rather, my ad-vice is to trade what you know—whether it’s retailing, manufactur-ing, the Internet, or, in my case, medical technology. Peter Lynch oncerecommended investing in companies you know, whose products youacase for options 61
use. If you love your HP printer or think Ford is really making a ter-rific truck, you may want to consider buying their stock.
Because of my father’s background as a transplant surgeon, |was active in biotechnology and medical device stocks. Why? I hada natural inclination toward medicine and medical technology. Plus,when I read that a company was developing a particular drug ordevice, for example, I could ask my father for his input. This, I be-lieved, gave me a bit of an edge over the average investor.
Similarly, when I do