ardays. The days-in-trade numbers in Figure 9.13  are calendar  days. This  distinctionis  a  programming  convenience  rather  than  an  analytical  necessity.4 For these rules trading Crude. It needn’t always be this result.
202  Minimum  Favorable  Excursion
Campaigning  203
Even  more  essential  is  continuing  to  grasp  the  overall  point  ofthe  program:  equity  growth.  For  that,  portfolio  management  soft-ware is essential as each new opportunity will be taken with refer-ence  to  total  capital  available.  The  campaigner  may  include  openequity  in  that  figure,  but  the  conservative  will  not.  The  more  con-servative would include only the negative open equity.
Moving  Up  Stops
This chapter looked at using favorable excursion to find a place tomove  up  stops.  It  turned  out  that  there  were  few  opportunities  todo this in  Crude.s  If a trade went south, it took out the MAE stoppretty  quickly.  If  it  went  north  decisively,  as  measured  by  MinFE,the experiential probability was very high that it would be a winner,which could be at risk by moving the stop up, especially during thefirst ten days of the trade.
That left a gray area that held only three trades or less than 10%of  the  small  sample.  These  trades  were  those  that  essentially  wentnowhere, so they were little danger to our capital (see Table 9.1).
TABLE  9.1 CAMPAIGN  TRADING  PROFITABILITYNEW  YORK  LIGHT  CRUDE,  1984-1994
Mode
TrendTrendTrendTrendRangeRangeRallge
RLk
stop  Level
Two moving averages
Add-on 
day-trades
trades
Add-on  position ReversalTrade  into  rangeReverse  out  of  rangeCut  off  losing  reversal  trades
.31.31.31.31.31.51.31
Profit/Loss(points)
3,6002,5006401,8275502,2290
5  Without  documenting  it,  I’d  say  this  is  my  experience  I’m  a  small  fan  of  movingup  stops.
FIGURE  9.17 CLOSE  UP:  WINNERS  BY  DAY.  Winners  in  contrast  tolosers,  rarely  spend  much  time  in  the  minus  column.  Although  they  dowallow around the  +.4 area losers visit, they steadily move upward.
Second,  campaigners  will  not  sell  their  positions  at  the  top  ofthe  channel  and  they’ll  be  reluctant  to  buy  more  positions  at  thebottom.  Arbitrarily  adding  positions  as  the  trade  advances  in  be-tween the upper and lower boundaries can be achieved as describedin earlier chapters. Perhaps when doing so it’s enough to see the un-derlying  reversal  trade  in  question  is  proceeding  according  toform-or  not.  For  example,  an  add-on  trade  when  the  underlyingreversal  trade  is  on  the  bottom  of  the  channel  might  be  forgone.I’ve  never  tested  this  logic,  but  having  read  eight  chapters  of  mymethods, you can well imagine how I’d go about it.
CAMPAIGNING
By now the typical trader has his or her hands full monitoring mar-ket  modes,  trading  tactics,  trading  situations,  and  capital  require-ments  for  several  different  regimens  ii  just  one  tradable.  If  youmultiply  this  by  tens  or  hundreds  of  tradables,  the  need  for  au-tomation  of  trading  is  clear.
204  Minimum  Favorable  Excursion
Despite  the  lack  of  profit,  there  were  some  distinct  behavioralcharacteristics  of  trades  reversing  out  of  ranges.  Observationstaken along these lines can be done for trending trades and their re-versals as well. Who knows? There may be some value to movingup stops when trading those rules,
10 wShifting the Odds:
Using  Options
A  campaigning  trader  will  wish  to  turn  every  advantage  his  or  herway, particularly since the costs of trading and the working of timewill  generally  run  against  the  trader.  In  addition,  the  market  is  gen-erally  perverse  and  usually  will  do  whatever  it  takes  to  frustratemost  of  the  participant-and  one  of  the  most  frustrating  things  isgetting  your  stop  picked  off  by  a  point  or  three.  Keeping  in  mindthat such a price extreme is likely to be very lightly traded by every-one but you only adds irritation to your losses.
Also,  generally,  time  is  not  the  trader’s  friend.  The  longer  thingsgo  on,  the  more  opportunity  there  is  for  things  to  go  wrong.  Sinceonly one of three possible outcomes (favorable excursion, no excur-sion,  or  adverse  excursion)  is  possible  and  two  of  them  are  badnews,’  a  campaigner  will  constantly  seek  tactics  that  minimize  thecosts  of  this  fundamental  problem.  In  this  chapter,  I  suggest  look-ing at options.*
thereby  losing  the  opportunity  COST
’  Adverse  excursion  generates  a  loss  and  nonexcursion   puts  capital  at  risk  for  noreturn, 2  Options  traders  are  due  all  respect  for  their  particular  niche,  of  which  I  am  not  apart! Those wanting expertise  in options I refer to Larry McMillan, Options us a
  of  the  capital.
205
206
Shifting  the  Odds:  Using  Options
RATIONALE  FOR  USING  OPTIONS
The  disadvantages  to  using  options  spring  to  mind  immediately.They  are  more  thinly  traded,  their  mathematics  is  intimidating,  andtheir  management-given  their  plethora--can  cause  real  pain  andconfusion.
One  plus  is  the  potential  to  convert  one-third  of  your  possibleoutcomes  to  wins  rather  than  losses.  That’s  worth  something,  buthow  can  it  be?  Simply  put,  options’  decaying  earns  money  overtime.  If  that  time  is  the  period  when  you  have  a  directional  bias,you  have  the  potential  to  earn  some  time  premium  instead  of  los-ing the opportunity cost of your money.
Where  but  in  options  can  you  sell  something  you  may  not  own,that’s wasting away, and if you’re in futures options, that’s a wast-ing  option  on  a  contract  with  its  own  time  decay’?  It’s  a  deal,  butselling  time  premium  with  a  view  of  the  underlying’s  movement  isan  ongoing,  intensively  managed  process  that  is  beyond  the  scopeof  this  book.  I  believe  it’s  really  only  suitable  for  full-time  profes-sionals,  adequately  financed,  who  can  constantly  roll  (that  is,  closeand  resell  at  different  strikes  and  maturities)  their  positions  as  theunderlying’s  movements  dictate.  For  such  professionals,  MAEstops  are  indicators  to  terminate  their  view  of  the  underlying’s  di-rection
The  other  plus  to  options  is  that  using  an  option  to  stop  or  re-verse  a  position  is  more  flexible  than  a  clear  stop.  The  material  inthis  book  has  worked  out  a  process  to  estimate  where  stopsshould  go,  but  I  don’t  pretend  that  this  estimate  is  precise  or  thatthe  future  will  behave  precisely  as  has  the  past.  For  example,  de-termining  that  the  stop  should  be  placed  precisely  18  ticks  fromthe  entry  is  not  precise  at  all;  it  is  an  estimate  as  vague  as  thedata  that  generated  it.  An  options’s  flexibility  may  help  with  thissituation.
Strategic  Investment,  3d  ed.  (New  York:  New  York  Institute  of  Finance,  1993);Options Laboratory. software developed by  Mantic Software, (970)  679.1630:  andOptions Simulator, software by Bay Options, (510) 845.6425.
Setting  Up  to  Use  Options
207
I  liken  the  market  to  the  statistician’s  traditional  urn,  only  thisurn  is  full  of  multicolored  balls.  Each  day  in  the  market,  an  eventwe are monitoring occurs. Perhaps it is the adverse price movementfrom a given point of entry. As it happens, we have the records ofthe  past, 
let’s  say,  1,175  adverse  price  movements.
Just so, we could have an urn of 1,175 colored balls. Each day anew  colored  ball  could  be  added  to  the  urn,  just  as  a  new  pricemovement is added to our collected history. If we sample the urn’sballs,  we’re  going  to  come  up  with  a  distribution  of  colors,  just  aswe’ve come up with a distribution of adverse price movements. Thetroubles are, we don’t know what’s generating the balls or how thecolor  (the  price)  is  determined.  Something  uncertain  is  changingthe number and colors of the balls and we don’t know how uncer-tain it is.
Similarly,  we  don’t  know  what  changes  the  market’s  prices,  forthe most part.  Plug  we don’t know how much the price change willbe, if any. This should keep fresh in our minds the vagueness of ourestimates  of  the  future.
SETTING  UP  TO  USE  OPTIONS
Before  diving  into  options,  preparation  is  important.  Particularly  ifyou plan to sell options and hold the positions over time, you’re go-ing  to  manage  a  fairly  complex  process  of  rolling  positions  for  ad-vantage.  Frankly,  you’ll  need  hardware  and  software  to  price  andplan  your  options  positions,  monitor  their  current  status,  and  ac-count  for  their  profit  and  loss.  Although  good  analytical  softwareis  available  for  this,  it’s  not  easy  to  use.3   Plan  on  training  for  amonth or so to gain facility.
3  OptionVue  IV  is  probably  the  best  all-around  choice  for  a  retail  trader’s  day-to-day use. Option Simulator, either off line  01  real  time,  currently  has  a  better  inter-face  but  no  portfolio  management   capabilities.  For  learning  about  options  and  ba-sic  position  exploration,  try  Options  Lab.  Experienced  options  traders  frominstitutional  settings  might  go  with  Optionomics  and  a  separate  portfolio  manage-ment  program.
208
Shifting  the  Odds:  Using  Options
Skipping  Stops,  Using  Options
209
liquidity
There  are  also  some  mechanics  to  options  trading  that  may  nothave  come  up  in  your  trading  the  underlying  instrument,  whether  itwas a stock, an index, or a futures contract. The major problem islack of liquidity, which means that the pricing you receive may pro-hibit  putting  on  the  position  you  want,  particularly  if  you  are  try-ing to manage an effective stop precisely.
As it  happen&   Crude  oil  has  a  very  liquid  market  in  its  options,as  do  Eurodollars,  Treasury  bonds,  D-marks,  the  OEX,  and  theS&P 100. Stocks are all over the ballpark, but only the biggest con-sistently have heavy volume and that around the current price. Ide-ally, you’d see 10,000 or more a day in the option you’d like to usebut, realistically, you’re more likely to find 300 to 500.
Although  you  can  use  limit  orders,  the  other  side  of  the  tradeprobably isn’t interested in giving you a good deal, so be realistic. Itmay  be  that  using  an  option  for  some  of  the  purposes  describedhere  just  can’t  be  done.
Lack  of  liquidity  away  from  the  heavily  traded  vehicles  alsoaffects stops. Specifically, they are less likely to be executed whereyou  place  them,  if  you  use  them.  While  I  haven’t  seen  them  spuri-ously  picked  off  in  the  few  markets  I  trade,  their  slack  executionseems to make it unlikely you’ll get the price you expected.
particularly  if  your  broker’s  parlance  is  slightly  different  from  thesoftware’s,
Monitoring  Positions
Because options trade less frequently, there will be a lot less infor-mation coming down the data pipe or being displayed in the news-paper. Your option might not even be quoted in the WSJ or IBD.At  other  times  the  price  shown  in  the  paper  may  only  remotely  beclose to what, if any, trades went down.
In  this  situation,  your  software  and  your  inputs  to  the  softwarebecome critical to your knowing where you are. Software that canprice  your  portfolio  from  the  underlying  and  its  volatility  will  saveyou a lot of agony. Portfolio software that instead uses a price fromtwo days ago may show a very unrealistic value for your option(s).You  should  take  any  unexpected  portfolio  values  with  cautionand  learn  how  to  check  them  out  on  your  own.  Given  that  youknow  where  the  underlying  is,  have  a  good  volatility  history,  andhave  an  accurate  interest  rate  inserted,  your  software  should  comeup  with  a  good  estimate  of  current  value,  fairly  comparable  to  theprices  reported.  If  not,  suspect  your  software  on  your  inputs  first;market makers rarely get too far from reality.
Orders
SKIPPING  STOPS,  USING  OPTIONS
For  many,  simply  the  issuance  of  options  orders,  particularlyspreads,  is  confusing.  As  in  all  trading,  there’s  no  getting  aroundthis  homework.  If  you  issue  a  confusing  order  to  your  broker,  hewill  try  to  feed  it  back  to  you  until  it  makes  sense  to  him.  At  thatpoint, it may or may not make sense to  you,  and if you let it slide,what you get may not be what you thought you ordered.
Know what you’re doing before you get involved. Practice con-structing the positions with your software, as well as preparing andreading  out  the  orders.  Some  software  will  actually  print  the  orderfor  you,  but  you  should  also  be~able   to  place  your  order  verbally,
One  of  the  nice  things  that  comes  out  of  seeing  your  tradablethrough  the  lens  of  your  trading  rules  is  that  you’ll  probably  findout pretty quickly whether you’re correct about the market’s direc-tion.  Crude  oil’s  losing  trades  run  longer  than  I’ve  experienced  infinancials   but  still  are  significantly  shorter  than  winning  trades,rarely going more than ten days.
In  terms  of  options,  that  means  that  the  runoff  of  premium  maynot be as much a problem as it would be if your options positionswere going to last for several months. An option purchased to pro-tect a position until we know whether it’s a winner will be in position
210
Shifting  the  Odds:  Using  Options
Skipping  Stops,  Using  Options
2 1 1
only for a matter of days, sometimes only one or two days. Time de-cay  is  not  usually  a  problem  for  short-term  hedges;  much  more  ofthe price change comes from changes in the underlying issue.
Profit
Calculating  Equivalent  Positions
Once  the  MAE  stop  has  been  calculated,  the  straightforward  ap-proach is to put it in place and let it work for you. If, in your  judg-ment,4  you expect a stop to be inadvisable (perhaps because it endsup  at  a  location  many  other  traders  are  likely  to  pick,  or  becausethe  market  is  experiencing  abnormal  gaps  and  daily  ranges  thatcould cause gross slippage, or because a sharp breakout is likely),’you  can  sidestep  that  difficulty  by  purchasing  an  option.  If  yourunderlying  position  is  long,  purchase  a  put  that  will  make  moneyon the downside and won’t be hit by a stop in the underlying mar-ket.  If  short,  a  call  will  make  money  if  the  trade  goes  against  youand  likewise  won’t  be  hit  by  a  stop.
Of course, you give up something by buying insurance: the profityou  could  make  on  your  underlying  transaction  will  be  reduced  bythe loss on your option, your insurance.
As  an  example,  Figure  10.1  shows  the  traditional  options  dia-grammatic  format  with  a  long  position  and  our  MAE  stop.  Thisdiagram  shows  that  as  the  price  of  the  underlying  tradable  rises,the  value  of  the  long  position  naturally  rises.  As  it  falls,  the  valuedeclines  until  the  price  reaches  the  point  at  which  an  MAE  stophas  been  inserted.  The  loss  taken  from  the  stop’s  being  triggeredis shown by the dashed arrow extending to the left toward the ver-tical  axis.  The  virtue  of  this  tack  is  simplicity  and  the  cheap  na-ture  of  stops:  without  slippage,  the  cost  is  simply  that  of  a  com-mission.
4 After all, you didn’t include your judgment in your back testing. To start using itnow is certainly questionable and alters the size of the losses  you?e  going  to  take.The  central  conclusion  from  the  evidence  gathered  was  that  winning  trades  sel-dom go against you as far as the MAE stop.
j As data in Chapter 8 suggested for reversals  out of ranges.
Value of long position
Price of Underlying
Entry price of underlying
LONG  THE  UNDERLYING.  Transformed  to  options
FIGURE  10.1format, the position, if it goes bad, it stopped out at the MAE stop levelfor  a 
loss.
The  alternative  to  a  stop  for  an  underlying  long  is  buying  a  put.Actually,  in  going  long  and  buying  a  put,  you’ve  just  constructed  asynthetic  option,  a  call.  The  long  position  with  the  purchased  putis  equivalent  to  a  simple  purchased  call,  (A  short  position  with  apurchased  call  is  equivalent  to  a  simple  purchased  put.)  Yes,  itwould be simpler to just buy a call if you want to go long (or a putif  you  want  to  go  short),  and  there  will  be  fewer  lines  on  the  dia-gram if we use the call only. Figure 10.2 diagrams the options posi-tion  at  expiration,  a  purchased  (i.e.,  long)  call,  which  is  equivalentto a long underlying plus a purchased put.
The  diagrams  in  Figures  10.1  and  10.2  should  look  very  similarto you. Both slant upward as the price of the underlying increases.As the underlying’s price decreases, the option’s value comes to aminimum  because  you  can’t  lose  more  than  the  cost  of  the  option.The  loss  on  the  long  position  is  indicated  on  the  vertical  axis  tothe  left.
The difference between the two is that the options position endsin  the  hole  by  the  amount  of  the  premium  in  the  option.  This  isshown  by  the  option’s  value  being  negative  at  the  point  of  entry  in
212
Shifting  the  Odds:  Using  Options
Skipping  Stops,  Using  Options
213
k- Value of  Option
Position
Price  of  Underlying
Entry  price  of  underlying
LONG  THE  OPTION.  Use  of  an  option  creates  a
FIGURE  10.2profit/loss  graph  of  roughly  the  same  shape  as  an  outright  position  witha  stop.  The  option’s  cost  is  the  space  between  the  price  of  theunderlying and the lower line of the option’s value.
the  underlying.  As  a  result,  the  underlying  must  advance  enough  topay for this cost before you break even. This is the cost of the in-surance  you’ve  purchased  (instead  of  just  using  the  “free”  MAEstop). Figure 10.3 shows the two diagrams together.
If  the  question  is  whether  to  use  an  option,  then  when  is  theoption  position  equivalent  to  the  MAE  stop?  In  Figure  10.4,  theMAE  stop  level  is  drawn  at  the  price  of  the  underlying  thatwould  generate  an  exit  at  the  same  level  as  the  cost  of  the  optionat  expiration.  This  is  an  extreme  situation:  you  buy  the  optionand  hold  it  until  expiration,  incurring  the  full  cost  of  the  pre-mium.  Usually,  we  wouldn’t  do  this  if  we  knew  the  underlyingtrade’s  risky  time  horizon  was  five  to  ten  days  as  it  was  in  Chap-ter  9.  Usually,  the  cost  of  the  premium  will  be  less  than  shown  inFigure  10.4.6
To elaborate, the cost of using the option grows over time. If youbought  the  option  and  sold  it  tomorrow,  without  price  movement,
6  That  is,  the  horizontal  loss  line  for  the  option  will  be   higher  on  the  Y  axis,  closerto  zero.
Entry  pricp  of  underlying
Value  of  Underlying  Position
Value  of  Option  Position
Price  of  Underlying
Cost  of  Option
tLOSS
LESS  PROFIT.  Although  the  shapes  of  the  two  positions
FIGURE  10.3are  similar,  the  two  choices’  outcomes  at  the  option’s  expiration  aredifferent  by  the  cost  of  the  premium,  assuming  commissions  areroughly similar. The option position’s value is less than that of theunderlying’s  if  we  let  it  run  to  expiration-which  knowledgeabletraders don’t need to do.
Value  of  Underlying  Position
Starting  Value  of  Option  Position
*Price   of  Underlying
I-AE  stop LevelI
‘ILOSS
STOP  VS.  OPTION.  When  would  the  cost  of  the  optionFIGURE  10.4be equivalent to the probable cost of the stop? While overly simplified,this  diagram  depicts  the  tradeoff  between  the  two.
214
Shifting  the  Odds:  Using  Options
Skipping  Stops,  Using  Options
215
Profit
2w
150
100
50
0
-50
-100
-150
-200
Profit
1OfJtl
Value  of
/I/+  Option’s  Value
SProfit  0I  loss on position VL SPrice
FIGURE  10.5 VALUES  AT  OPENING.  Without  price  movement,  on  theday you open the option position, its liquidation will  cost you  littlepremium.
there’d be very little difference in the selling and buying prices (seeFigure 10.5). If you sold the option after one-third of its remaininglife,  without  underlying  price  movement,  there’d  be  a  bigger  differ-ence (see Figure 10.6). If you sold it close to expiration, there’d bequite a big difference (see Figure 10.7).
This  is  good  news.  When  looking  at  a  stop  versus  an  option,keep  in  mind  that  our  horizon  for  insurance  coverage  is  10  to  20days and  our  price  range  30  to  40  ticks.  The  premium  decay  islikely to be  small7  If so, the cost of using the option (in this exam-ple,  buying  a  call)  isn’t  going  to  be  the  full  premium.  Our  knowl-
’  Unless  we’ve  used  an  option  expiring  in  the  next  20  OI   30  days
Loss
SProfit or loss  on position YI. $Price
FIGURE  10.6 AFTER  ONE-THIRD  OF  OPTION’S  LIFE.  (18  days.)  Ifyou  liquidate  the  option  now,  you  will  get  back  less  as  the  gap  betweenthe original price and the current price widens. After 18 days, the cost ofthe  option  is  still  small.
edge of the amount of the loss to be covered and the time frame inwhich we’re trading opens an opportunity for  us.
That  said,  we  still  need  to  make  the  comparison  between  theknown  amount  of  the  stop  (times  its  probability  of  exercise)  andthe probable cost of the option if it’s exercised. Your options soft-ware can deal with your specific situation in depth. Here, we’ll ex-plore  the  alternatives  generically.
Before  getting  into  that,  however,  let’s  consider  commissions.The  costs  of  buying  a  call  instead  of  going  long  the  underlying  andpurchasing  a  put  are  compared  in  Table  10.1,  demonstrating  thatit’s slightly cheaper to just do the option,
216
Shifting  the  Odds:  Using  Options
Profit
15tM  -.
Ima  -.
Value of  Underlying
:
: 
: 
; : 110
: 
:  : 115 
,  priceofUnderlying
Premium Cost
FIGURE  10.7 ALMOST  AT  EXPIRATION.  (54  days.)  Just  2  days  beforeliquidating  the  option  with  the  underlying  still  at  100  wouldexpiration, cost  almost  the  entire  premium.
losers
Now let’s see how this works in practice. Figure 10.2 is a compari-son  of  outcomes  for  losing  trades,  the  ones  likely  to  hit  the  MAEstop.  One  case  would  be  where  the  trade  hits  the  MAE  stop  andgoes  on  to  become,  as  we  expect,  a  loser.  The  other  case  we’re
TABLE  10.1 COST FACTORS WHEN COVERING TRADES
Outrightwith MAEstop
OutrightCovered  byOption Hedge
Entry  and  stopexecution
Entry  andoption  purchase
None
Negligible
OptionEauivalent
Optionpurchase
Negligible
Commissions
Premiumdecay
Skipping  Stops,  Using  Options
217
TABLE  10.2
ROUGH  COMPARISON  OF  COVERING  COSTS
OutrightLong  withMAE  Stop
Position soldat  MAE  stopfor  loss  of .3.
Position soldat  MAE  stopfor a loss of .30
Outright 
Long
Covered  byPut  Costing  .38
Profit  onunderlyingreduced  byloss  on  option(up to  .38).9
Loss of .40on  theunderlyingless  a  gain  of.19   on  theput” = netloss of .21.
Case
Underlyingfalls to MAEstop  level but  not  to  .40.Recovers  to  win.
.30
Underlyingfalls to MAEstop  level.30 and fallsto  .40  belowentry  beforewe  close  outat  a  loss.
OptionEquivalent:a  PurchasedCall  at .38
Profit  onposition  upto .38  lessthanoutright.‘0
Loss of .5 x=.19onthe  call.
greedily trying to save is the one where it hits the stop but goes onto  become  a  winner.  Table  10.2  shows  tabular  outcomes  for  eachcase, excluding commissions, assuming we want to be long with anMAE stop of  .30.*
Seen  this  way,  options  take  the  steam  out  of  a  fall  to  the  downside