What was the reasoning behind this trade? For one thing, youhad a bullish opinion on the stock. At the same time, you were wor-ried about your exposure to comparatively high volatility. If therewas suddenly a 10 percent correction in one week, the risk of buy-ing call positions without a hedge might be more than you wantedto handle. True, when you buy a call option, the most you could loseis the premium that you paid. But when volatility is high you mayhave paid more premium than you intended. By buying a bull callspread instead, you can reduce that risk by neutralizing the effectsof volatility and time decay, and still maintain a bullish stance.
Using this options model, if you move out 30 days, the call thatyou bought for 7% declines by 138 to 6% due to time decay. Now, say136 how I trade options
the stock goes up from $77 to $95. The $80 calls that you boughtare worth $15 at expiration, compared with the $7.75 you paid. Ifyou bought only the $80 calls, the net profit on that position wouldbe $7.25 a share. The person who did the spread trade, however,would have captured the $10 difference, minus the $3.50 a sharenet cost, for a profit of $6.50 or $6,500 on a 10-lot spread. That’ssome 90 percent of the profit potential from buying naked callswith only half the investment and a fraction of the downside riskdue to volatility and time decay.
That’s why big players, the brokerage houses such as Gold-man Sachs and Morgan Stanley, execute these kinds of strategies.But it’s not a strategy that’s limited to institutions and market mak-ers. Retail customers frequently make this kind of spread tradewhen market conditions make sense.
By the same token, a bear put spread is employed when you'rebearish on a stock for whatever reason. Maybe you think an “oldeconomy” stock is out of favor, or you're expecting a massive cor-rection in a “new economy” issue.
Here’s another example: MicroStrategy Inc. (MSTR) traded upto $333 on March 10, 2000. By comparison, in early 1999 it was a$15 stock. Even though many people thought MicroStrategy was agreat company, the stock fell from the $333-range to 85% in sixtrading days. There was no stock split to account for such a mas-sive stock price drop—just a market sentiment change after thecompany announced it was going to restate their earnings for theprevious years.
Now with the benefit of hindsight, when MicroStrategy wastrading in excess of $300 a share at the beginning of March 2000,you could have decided to buy an out-of-the-money put spread toguard against a correction. For example, you could have bought theJuly $250 put for $38 and sold the $200 puts for $19, for a net cost of$19 a share ($1,900 per spread). Again, the reasoning behind thistrade is that you have a short-term bearish opinion on the stock andyou are worried about a decline in the extreme volatility. If youbought the puts naked—without a put spread—you would be risk-ing a defined amount of money, in this case $38 a share or $3,800.But by doing the put spread, you would have to make only half theinvestment and you can lessen the impact of time decay and volatil-ity erosion (Figure 7.2).when to do what—and why! 137
 
Figure 7.2 long 1 July 250 put, short 1 July 200 put
 
 
 
 
Profit / Loss (Y) and MSTR Common Price (X) Risk Graph
 
 
—170 185 200 215 230 245 260 275 290
 
 
Source: Created by StockmarketWorkshop.com.
Bear Put Spread
Buy MSTR July $250 put for $38Sell MSTR July $200 put for $19Net cost of position, $19 a share
Now, suppose the volatility declines about 10 percent. The$250 puts that you bought would fall from $38 a share to $33 ashare, a loss of $5. The $200 puts that you sold would decline from$19 to $15, a $4 move in your favor. The net effect is that the valueof the spread trade declined by only $1 ($100 per spread), whereasif you had just bought the puts naked, you would face the $5 a share($500) loss.
The downside of doing a spread trade is that, while it de-creases the potential risk, it also reduces the profit potential. Sowhen MSTR fell from around $300 a share to $121, those $250 putsthat you bought are worth $135—a gain of $97 a share. At the sametime, the $200 puts that you sold for $19 are trading at $89, a $70move against you. The net effect, is a profit of $27 a share. Granted,138 how I trade options
that’s less than the $97 a share you would have made by simplybuying the puts. But you had far less money on the line.
At this point, another issue comes up. Once you’ve realized aprofit on a trade, what comes next? I always advise our traders andretail customers alike that I think it is important to take some ofthe money off the table. You don’t wait until the last possibleminute, hoping to squeeze the dime out of a trade. Because timedecay and decreases in volatility can change the nature of even asimple bull call or bear put spread and cause the trade to moveswiftly against you.
One possible strategy is to take a profit on this particularspread trade, and then put on a new position. After the decline to$121 a share on MSTR, you reassess your outlook. Let’s say you de-cide to switch sides and become bullish on MSTR. If you think it islikely to recover, you could put on a bull call spread three monthsout. Or, you could establish a more sophisticated version of thisstrategy with a relative of the bull call spread known as the diago-nal call spread, buying a July call, for example, and selling the Aprilcall against it. (Time decay, after all, favors the seller not the buyer,and the July option will decay significantly more slowly than thenear-term April option.)
If, on the other hand, you maintain your bearish outlook forMSTR, you could establish another bear put spread. You could alsodiagonalize the bear put spread by buying the further out in timeJuly puts and selling the pumped up April puts against it. As itturns out, this would have been the winning strategy as MSTR con-tinued to sink, falling to $20 a share in early May 2000.
Bull spreads and bears spreads are particularly good strate-gies when there has been some sort of disaster that results in astock being oversold, or a swift rise that indicates the stock is over-bought. One important thing to keep in mind is that when the mar-ket makes a dramatic move one way or another, it usually reflects apanic move. Perhaps there was some sort of disaster (rumored orotherwise) that took the stock price down sharply. Or, maybe therewas a short-squeeze in the stock and short sellers had to covertheir positions, driving the price dramatically higher. Whatever thereason for the panic, there is often an opportunity to take advan-tage of the imbalance that follows these wide swings in price.
But how do you know that a stock is overbought or oversold?There are a few rules to keep in mind: Most stocks will have troublewhen to do what—and why! 139
maintaining a rate of growth (when charted) that’s greater than a45-degree angle. Trees don’t grow to the sky; if they grow too tall,they will collapse under their own weight. By the same token, if astock rises in price at a sharper angle—70, 80, or 90 degrees (as didMSTR)—it is virtually unsustainable.
In these situations, it’s time for you to act like a card counterin Las Vegas. Let’s say you've recognized an overbought situation,so now you need to think, how can I move the odds further in myfavor? Perhaps, instead of selling calls naked—which could exposeyou to virtually unlimited loss—or even buying a put, you increaseyour chances of establishing a winning trade by creating a spreadtrade. So if you don’t believe that the performance in a stock suchas MSTR is sustainable, you can put on a spread. Just like the cardcounter who knows there are a lot of face cards left in the deck, youcan improve your odds of making a play by knowing that a stockrarely can maintain an 80 percent rate of growth in its share price.When you see that kind of increase in the share price, it’s a good in-dication that this stock is overbought and ripe for at least a short-term correction.
A person who speculates on, say, that downside potential witha spread trade is further decreasing the risk that must be shoul-dered. Those who trade this way are going to stay in the game farlonger than those who speculate that a high-flying stock is over-valued and is going to decline in price tomorrow.
Remember, the goal of trading is not to make a huge profit ona single trade. Rather, the aim is to have a limited amount of risk onthe table, which will help you to control potential losses while,hopefully, making a realistic profit. That’s exactly what you want todo. You want to manage your capital to be a long-term winner inthis game. .
Let’s consider another strategy—the iron Butterfly. As we dis-cussed previously, an iron butterfly is a strategy that’s often em-ployed when a stock or an index is trading in a range. A butterflyallows you to lock in a profit potential if a stock (or index) stayswithin a specified range, while offering protection from unex-pected upward or downward moves.
For example, if you expect the S&P cash market to stay in arange, say between 1350 and 1450, you might decide to put on abutterfly trade to capture the value of selling premium based onthis outlook. But first, you would have come to that conclusion by140 = how I trade options
tracking the performance of the index over time. You would seethat, despite the momentary upward and downward gyrations—re-member a diversified index such as the S&P 500 rarely moves in astraight line—the index tends to trend within a defined range. Andremember, since S&P 500 options, or SPX, are European-style, theonly time they can be exercised is at expiration. Moves within thelife of that option don’t amount to much, and should not cause toomuch concern. Further, since you’re dealing with an index withmultiple stocks, there is a smoothing effect compared with thevolatility of the individual issues.
Plus, there are certain times of the year that are more pronethan others for the market to trade in a range. There is tax time,when many individual investors have to commit their capital to pay-ing Uncle Sam instead of the market. During the summer, a lot offund managers, individual investors, and yes, even market makersgo on vacation, which keeps portfolio adjustments—including mas-sive flows into and out of certain stocks and sectors—to a mini-mum. Individual investors are also less likely to be active duringvacation time, which leads to the general expectation that the mar-ket will be duller in the summer. On the other hand, the mostvolatile times in the market are typically December, January, andFebruary. Late in the year, there are expectations of the “Januaryeffect” when a new year means new optimism, and, often, a bullishtone to the market. In January, you also have the funding of 401(k)sand individual retirement accounts (IRAs), which continues intoFebruary.
For some undefined reason, which may be put down as masspsychology, there is the October panic factor. People have a fear ofthe market going down in October and so, volatility usually picksup steam going into that cycle. Of course these fears aren’t totallyunfounded: there have been plenty of October crashes—1929, 1987,1989, and so forth. The market has a long memory when it comes tobad events. There is another factor that may have a fundamentaleffect on the October dynamics. Fund managers who want to pre-serve their good performance through the first nine or so monthsduring the year may want to reposition their portfolios to lock ingains and remain market neutral for the balance of the year.
Whatever the reason, there are times when the market is morelikely to trade in a range and times when its apt to move up or downsharply. Knowing these dynamics helps you determine if it’s a goodwhen to do what—and why! = 141
time to place a particular trade; it’s all about moving the odds ofsuccess into your favor.
Now, say you’re looking at the indexes: The Dow Jones, if youlook at 1999 performance, traded from 10,000 up to 11,000 and backto 10,000 and then up to 11,000. Early in the first quarter of 2000, itbroke through 10,000 to the downside, and then had a knee jerk riseto 11,000 in short order. So if I were putting on a trade based onthat range, I might target the upper end of an established range,say, 11,050, and a downside of the range around 10,000. Whenyou’re putting on a range-trade, the wider the spread the more pro-tection you have. Remember though, where there is less risk thereis less reward. But since the main goal of trading is always to stayin the game, make sure you pick a spread that is wide enough tooffer protection, while still offering a decent profit potential. Also,if you are trading small amounts, the commissions can eat up a sub-stantial part of your profits, which is all the more reason to widenthe upside and the downside price points.
Let’s say that, for the next month, I pick a range for the DowJones and, for this trade, I’m going to use the “Diamonds” (DIA isthe underlying symbol for the security which trades on the Amex)or DJX (the options traded at the CBOE), which trades at one-tenththe value of the Dow Jones Industrial Average. So I sell the 116 calls(equivalent to 11,600 in the DJIA) for 1% and buy the 118 calls(equivalent to 11,800) for %. That results in a net credit of % ($75per spread). For the downside, I sell the 106 puts (equivalent to10,600) for 1% and I buy the 104 puts (equivalent to 10,400) for 1,again taking a % net profit (also $75 per spread). (See Figure 7.3.)
Spread Trade
Sell DJX (based on DJIA) 116 call for 1%Buy DJX 118 call for %
Net Position Credit %4
Sell DJX 106 put for 1%
Buy DJX 104 put for 1
Net Position Credit, %
In both of these trades, I covered a $2 spread (116 to 118 and106 to 104). Plus, I took in a total of $1.50 in net premiums. That142 how I trade options
Figure 7.3 long 1 July 118 call, short 1 July 116 call; long 1 July 104 put,short 10 July 106 put
 
Profit / Loss (Y) and DJX Index Price (X) Risk Graph
 
Source: Created by StockmarketWorkshop.com.
means, the most I can lose is $0.50, and I've got 75 percent odds inmy favor.
If it trades between 106 where I sold puts and 116 where I soldcalls, I keep all the premium, collecting $150 per spread. If the mar-ket goes completely against us in either direction, all we can lose is$0.50 ($50 per spread), thanks to the protective wings I’ve put onmy butterfly by buying calls above that spread and puts below it. Inthe process, | locked in a livable spread trade that allowed me tosleep at night. Remember you never want to put yourself in tradesthat cause you to panic.
And in the interim, we know that Diamonds (DJX) are European-style options that can only be exercised at expiration. So during thecourse of the month, the index could break down to 10,000 or shootup to 11,200 and there would be no cause for alarm. | believe thismarket is going to be in a range for whatever timeframe and | thinkit’s likely to come back to that regardless of how much it fluctuatesin price. A price chart would tell me that I had good history on myside with a trade that was on either side of 10,500.
As was all too apparent in early 2000, volatility in the marketsis on the rise. Moves of 200 or 300 points in a market (DJIA orwhen to do what—and why! 143
Nasdaq), which would have been “stop-the-presses,” news-makingevents, are more and more commonplace. What does this mean foran options investor? Volatility impacts you two ways: If you’re anoptions buyer, increased volatility means you'll have to pay up forboth puts and calls. And if you’re selling options, you may exposeyourself to more risk than you intend. Hence, one possible solutionis to do a spread trade to neutralize the volatility and reduce theimpact of time decay.
Some people might shy away from spread trades simply be-cause they don’t understand them well enough. That will severelylimit the times in which you can participate in the options marketto merely when you believe an overvalued stock is going to fall(and you buy a put) or an undervalued one is going to rise (and youbuy a call). But when the price is bouncing around, you may be onthe sidelines with nowhere to go. Or, if you buy puts and callsblindly, you may be taken advantage of when volatility is high.Why? Because as a buyer, a sudden reduction in volatility willcause a sharp decline in the premium (or value) of the option youjust bought, and the acceleration of time decay will put a nail inyour financial coffin.
Rather, high volatility can be a great time to be a cash-securedput seller. As we discussed in Chapter 5, to be a cash-secured putseller you must be bullish on the stock. So, if the market does de-cline and the stock is put to you, you own it at what you see as afavorable price. (Remember the example of Frank, who sold cash-secured puts for Intel, which he believed would be a good stockover time. And if he liked Intel at $100 a share, he would really loveit if the stock were put to him at $90, at least that’s what he thoughtgoing into the trade. Remember, if your outlook changes, you canalways dump the stock or sell some covered options against it.)
But when your favorite stock has become volatile—or in thecase of Internet issues more volatile—you might consider cash-secured put selling. This strategy will enable you to (1) collect ahigher than normal premium due to the increased volatility, and(2) if stock is put to you, you'll end up with shares that you believehave good upside potential.
For instance, you may decide that eBay is a great stock. Forthe past few years, Wall Street and the investing public have lovedeBay. But there are some days when Wall Street doesn’t like itso much. Because of the great performance it’s had for the last144 how I trade options
few years, volatility tends to be sky-high. So if I were bullish oneBay and | wanted to buy options, I’d have to pay a hefty premiumfor calls.
But what if I took a look at a cash-secured put sale? As the op-tions seller, the ensuing time decay will work in my favor becausewith every passing day there is less time for the option I sold to be-come in-the-money and be exercised. If I sold the eBay 210 puts Icould collect $18 in premium. As long as eBay is above $210 at ex-piration, I keep the $18 premium ($1,800 per contract). If the pricedrops suddenly, I'm essentially buying the stock at $192 a share(the strike price of $210 minus the premium paid of $18). And if [’mbullish on eBay at $240 a share, how much better do I feel about thestock at $192?
Again, the most important things to remember in this tradeare that you must be bullish on the stock and you must believe theoption premiums are moderately to substantially above normal.
When you’re trading and using cash-secured put selling, a lotof people use technical analysis to help them determine when andat what price to get in. For example, looking at a chart of eBay (asof March 27, 2000), it appears there is good support around the$140 a share level and tremendous support at the $120 level. There-fore, if | wanted to be more conservative (which reduces both myrisk and my potential reward) I might want to sell the $130 puts orthe $120s, and so forth. ,
As outlined in Chapter 5, to do cash-secured put selling youmust have the money in your account to pay for the shares shouldthe stock be put to you. However, you could also take advantageof high premiums on a stock that you like with a less risky strategy.In this case, you could sell a very wide put spread, which essen-tially gives you a floor in case of a catastrophic price drop.
For example, you could sell the three-month-out 150 puts andcollect the $18 premium, and buy the $100 puts for $3. Essentially,you sold a $50 spread for $15. Your maximum loss is $45 a share,and your potential profit is $15 ($1,500 per spread). While that risk-reward ratio is not favorable on its own, it is a viable means to takeadvantage of the volatility of a stock while reducing the amount ofcapital you have to put up. To illustrate, if you sold 10 eBay three-month-out 150 puts, you would need to have $132 a share (the 150strike price minus the $18 premium you collected) in cash in yourwhen to do what—and why! 93145
account in case you had to buy the stock. To do this 10-contracttrade, you would need $132,000 in your account.
But if you're not that aggressive, and want to reduce both yourrisk and the money you have to invest, the put spread is a betterway to go. Selling the $150 puts and buying the $100 puts would re-quire $50,000 for 10 contracts (as opposed to $132,000 for cash-secured put selling). And in the case of cash-secured put selling,the most I could make on 10 contracts is $18,000 (the premium Icollected). For the put spread, my maximum profit potential is$15,000 for 10 contracts. That’s not a bad play to make—about 83percent of the profit potential with about one-quarter of the up-front cost.
As I’ve said repeatedly, our goal is to move the odds in ourfavor. And by doing the put spread, your potential reward is $15,000on a $35,000 investment, a 42 percent return with limited risk! Asfor the cash-secured put selling, your potential reward is only$18,000 on a $132,000 investment, or a return of a more pedestrian13 percent.
From a money-management and a risk/reward perspective, thespread makes more sense. Selling a put to collect a high premiumwhile buying a put to provide a floor under your potential lossesgives you disaster protection to keep you from getting wiped outshould there be a catastrophic event like the one that happenedto MSTR.
There is a lot of homework and study to do before you place atrade. You need to determine what strategy will work the best, andhow to improve both your money management and risk reward. Butthe work doesn’t end there. You must also know when to exit atrade, This may be especially important with winning trades. Therecomes a point when it’s better to exit rather than try to squeezeout one more point or two. Time decay, after all, is a buyer’s worstenemy.
For example, say you’ve been buying LEAP calls in a favoritestock and selling near-term calls. This is a good strategy when youhave an overall bullish bias for a stock. But there will come a pointwhen the risk/reward ratio for your trade will stop making sense. Atthat point, it’s time to close the trade.
Every day, I look at the risk/reward of all my ongoing trades.The question I must continually ask myself is would / buy or sell this146 how I trade options
option today. It doesn’t matter if I’ve already doubled or tripled mymoney as the stock rose and took the call premium with it. Therewill come a time when the existing trade I have no longer has agood risk/reward balance. The near-term calls that I’ve sold, for ex-ample, may not have sufficient premium to offset the appreciatedvalue of the LEAP calls that I've bought. That’s when it’s time toadjust or close out the trade.
As a professional trader, I want to have a very short memorywhen it comes to what I paid for something. If | bought a LEAP for$15 or $20 or $12 or whatever, I want to forget about that invest-ment as quickly as possible. Why? Because I need to address theoverall value of the trade, and not focus on the amount of money Ihave invested. Put another way, once I place a trade, it has to standon its own merit. As time goes on, I need to ask myself if this par-ticular trade still makes sense, given the price of the stock at thetime and the value of the options I have bought and sold. If the tradestill makes sense, I keep it; if it doesn’t, I close it.
Now, as a retail investor you have a slightly different motiva-tion. For one thing, I’m trading for pennies, in terms of commis-sions, which enables me to make thousands of trades a day for arelatively small amount of money. An active retail investor proba-bly trades several times a week or several times a month, and he orshe is trading for dollars and not pennies. In addition to commis-sions, the tax-implications of capital gains are more of a concern foran investor than for the professional trader. But there are definitesimilarities when it comes to concerns over existing trades. Boththe professional trader and the retail investor must monitor theirpositions to ensure their risk/reward balance is intact, and that thevalue of what they’ve bought or sold still makes sense for whatthey’re trying to accomplish—whether it’s offsetting portfolio riskor riding the upside of a stock.
Let’s say you’ve bought a one-year LEAP call for $10, againstwhich you’ve sold a short-term call option, collecting a $2.50 pre-mium. Now, as time decay takes the value out of the premium, theoptions that you’ve sold three weeks ago are worth $0.50. Thatdoesn’t mean you’ve made a bad trade. On the contrary, $2.00 ofthe $2.50 a share in premium you collected when you first soldthose cails is already in your pocket. But as these call options arenearing the time at which they will expire worthless (which foryou, the seller, is a good thing), it’s time to examine this trade.when to do what—and why! 147
Have you wrung out all the profit you can from this particulartrade? Do those short-term calls—10 days from expiration andworth $0.50—offer adequate protection for the LEAP that’s nowmaybe worth $11 or $12?
I'd say you’ve squeezed everything out of that particular tradethat you can. Rather than hang on for the last $0.50 in value, whynot buy back those short calls and sell something else with a higherpremium, which can better offset the LEAP that you’re holding?
As you evaluate an existing position, however, you can’t justlook at the premium prices. A strategy will continue to work for youonly if your basic premise hasn’t changed. Simply put, if you’re stillbullish about a particular stock, for example, then it makes senseto hold a LEAP. But if your opinion has changed, it’s time to closethat position and formulate a new plan.
How often should you evaluate your positions? Personally, Imonitor my positions at least daily and often more than once a day.At the moment, I have positions in 80 to 100 stocks. At least once aday, I look at my positions and decide, with computer printouts ofanalysis in hand, if I still like these positions.
For example, I saw in late March 2000 that Oracle (ORCL) hadrun straight up. During this run, I’ve sold a lot of near-term puts,expiring in April and May. By late March, some of these puts wereworth only $0.25. I had squeezed all the premium out of these puts,leaving me with no real reason to hold these positions any longer.If I were still bullish on Oracle, I could roll out of this position bybuying back the puts and selling other near-term puts that stillcarry a higher premium. Or, I could close out the position alto-gether and pick a different stock. Granted that’s easier for me thanfor a retail investor, most retail investors don’t have more than 10stocks to worry about, and most are probably going to have onlyfive or so stocks that they have option positions in. That’s a greatdeal easier than keeping track of hedged options positions in 100or more stocks.
But regardless of how many stocks you hold positions in, theprocess is the same. Every morning, I look at the positions I hold. Isee where I’m long and where I’m short, and I evaluate whether thesepositions still make sense, again not based on what | paid to enterthe positions but rather on the current economics. You can’t be mar-ried to any one position. You can’t say, “I paid $3.50 for these optionsso I’ve got to sell them for $4.00.” That’s a bad way to evaluate a148 how I trade options
trade. Know why you placed the trade, and see if that reasoning stillholds. If not, get out and move on to the next position. Keep in mindthat you don’t have a gun to your head to make trades constantly. Ifyou don’t see an opportunity to enter at prices that seem attrac-tive, stay on the sidelines. Professional traders don’t have that lux-ury. We have to trade, either through obligations to quotetwo-sided markets constantly or to keep the phone ringing with so-licitations from brokers. You don’t have to trade all the time.
As I said in Chapter 1, this sort of cut-your-losses attitude hasserved me well in life. Why else did my college career span so manydifferent schools? I wanted, above all, to play college football andthen move onto the professional ranks. If that wasn’t going to hap-pen at one university, I had to find a place where it would. I becameunemotional about my evaluation, not only of my opportunities,but also