one else seems to think it is the right time to do so, or it mightinvolve a more intricate but no less obvious thing, such as a hedgedopportunity. We look for them in our newsletter all the time. Here isan example from several years ago.In 1980, gold stocks were very popular, and the price of gold was near itsall-time high. It came to my attention—rather luckily—that the SouthAfrican gold stocks were all paying unusually high dividends in the summerof 1980. The only reason that I even noticed these dividend increases wasthat I had bought a few of these stocks for my children, and I saw the dividends hitting their accounts.Now, ASA Limited (at the time known as American South African) is aclosed-end mutual fund of South African gold stocks that trades on theNYSE. ASA would collect dividends from the stocks it owned all year. However, it would pay a “normal,” small dividend in February, May, and August.Then, if there was any excess dividend income, it would pay it out in theform of a special dividend in November. For several years, the special dividend had been 50 cents each year. However, by getting the report of ASA’sholdings and calculating how much they were receiving in dividends, itappeared that they would have to pay a special dividend in excess of $2.50in order to pay out most of the unusual dividend income they were receivingthat year.I checked this information with a small research firm with whom wehad a friendly working relationship, and they concurred with my analysis.However, the option market had not factored this information in at all. Ifyou know there is going to be a special dividend, then the puts should beexpensive and the calls cheap, to reflect the fact that the stock will go exdividend with no corresponding benefit to the option holders. In reality, theoptions were priced exactly as if the special dividend was going to be 50cents, as usual.Trading the arbitrage account for Thomson McKinnon, we establishedrisk-free conversions by buying stock, buying puts, and selling calls. Wewere paying only 50 cents for the special dividend portion of the conver-
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sion, however. As we established these conversions, market makers andothers taking the other side made it quite obvious that they thought we werefools for overpaying for the arbitrage. If you have a truly original idea, this isthe point where you must gather yourself and ignore the “traditional” information. By the time we had set up 100,000 shares, the markets adjusted,and some of the bigger market makers had come to see our point of view.Eventually, the big day came. ASA Limited held their dividend meetingin New York on a Thursday morning and did indeed decide to declare a$2.50 special dividend. However, they only made a brief press release andheaded out for lunch. Reuters News Service picked up the release and issueda one-line message; but Dow Jones would not publish the news because theyneeded confirmation (a company policy), and no one was at the ASAoffices—they were all at lunch! This caused us consternation because, inthose days, very few people—not us—had Reuters News; Dow Jones wasthe news “king.” So we had to wait through the lunch hour in order to besure that we were going to officially make our profits. We succeeded.
What was especially amazing was that this strategy worked forthe next several years, but never to the same degree. It only “disappeared” when the price of gold got into a real bear market and theSouth African stocks stopped paying large dividends in the mid1980s. In retrospect, it appears that the reason that this strategyworked was twofold: (1) not many people were interested in it, and(2) the information regarding the South African dividends was notwidely published, although it was certainly available to anyone whobothered to look for it.You can see the difference between the Disney example and theASA example: one was an obvious fact that everyone knew, whilethe other was a public fact that no one was paying any attention to.When we refer to serious research that you must stand behind, evenif no one else is believing it or acting upon it, we are referring tosomething akin to the ASA example.Lest you feel that those sorts of things only happened in the earlydays of options, when people were less sophisticated, I want todescribe the potential available in two-tiered tender offers. The similarities between the St. Joe Minerals takeover in 1981 and the Chiron takeover in 1994 are striking.
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Both takeovers involved partial-tender offers, with a residualstock trading after the partial tender. This is sometimes referred to asa “two-tier” deal. Before getting into the actual historical examples, ageneral one explaining two-tier deals and how options can be usedwith them might be useful.Example: In a two-tier deal, the company doing the buyout usually makesa cash tender offer for a percentage of the company to be acquired, something like 50 percent or so; this initial tender is called the front end, whilewhatever happens afterwards is called the back end. After the front-endtender is completed, the remainder of the company to be acquired, calledthe stub, trades freely in the marketplace, sometimes with a differentname. In the 1980s, the acquiring company could then make a tenderoffer for the stub as well; but laws were changed, so currently the stub hasto trade as stock.While the first part of the two-tier deal—the cash tender offer—is takingplace, the stock being acquired will trade at a price that reflects the totalvalue of both parts of the deal. Suppose that ABC is going to buy XYZ in atwo-tier deal. It is going to offer $100 a share for 50 percent of the company; after that, the remaining stub, which represents 50 percent of theoriginal XYZ, will trade freely in the marketplace. Furthermore, supposethat analysts place the value of the stub at $60 per share.We would then see XYZ trading at about 77 per share; for if youbought 100 shares of XYZ and tendered them, you would get 100 for 50shares, and the other 50 shares would be worth 60 (if the analysts’ estimates are correct), which you could sell in the open market. Thus, youwould sell the XYZ for an average of $80 per share (half at 100 and half at60). The reason that XYZ sells for slightly less than 80 is that some carryingcost is built into the current price, since it takes time for the tender to becompleted and for the stub to begin trading. As the actual date of the cashtender approaches, XYZ will drift upward toward 80.
Before reading on, with XYZ at 77, what price would you expecta put with a striking price of 80 to sell for in the preceding example?The answer is at the end of the next paragraph.In-the-money calls on XYZ in the example would be trading atparity prior to the first part of the deal, the cash tender offer. Theywouldn’t have any time value premium because the stock will drop 20
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points (from 80 to 60) as soon as the first part of the deal is over. If youowned calls on XYZ in this example, you could always exercise themand tender the stock you got via the exercise. If you didn't, your callswould lose a tremendous amount of value (you can’t tender calls, onlystock). Puts, on the other hand, reflect the value of the stub. So, sincethe stub is supposedly going to be trading at 60, a put with a strikingprice of 80 would have to sell for at least 20 points. This is an importantconcept that is not readily understood by the average option trader.The two-tier deal just described was not new to Wall Street in1981, when Fluor Corporation decided to bid for St. Joe Minerals.However, since puts had only been listed for a short while at thattime (they were first listed in 1977), this may have been the first twotier deal in which the company to be acquired—St. Joe Minerals—had listed puts available.Fluor Corporation made a two-tiered bid for St. Joe Minerals in 1981. Thefront end was for 60 percent at a price of 60. The back end was also scheduled to be a tender offer—at an unspecified price in the high 40s. As Irecall, the cash tender in the front end was to expire in early February, sowe were buying February puts to hedge the stock being purchased.For reasons that I never quite understood, the marketplace was offeringa virtually free arbitrage. With St. Joe trading at 53, the Feb 55 puts wereselling at about 9. These are rough numbers, as a lot of years have passedsince this arbitrage was executed; but they are indicative of what happened.Consider this trade:Buy 1,000 St. Joe at 53Buy 4 Feb 55 puts at 9
$53,000 debit3,600 debit
Sell 600 St. Joe at 60 via tenderSell 400 St. Joe at 55 via put exercise
36,000 credit22,000 credit
Net credit:
1,400 credit
As long as the front end of the deal went through, this was guaranteedmoney. Apparently, most institutional money managers and many otherarbitrageurs were skeptical about the back end of the deal and, thus, weren’twilling to pay too much for St. Joe—they kept the price around 53. The rel-
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ative newness of put options meant that they either didn’t realize puts wereavailable for trading, or they didn’t visualize being able to lock in the backend by buying the puts. In any case, we made a very nice profit.
You might think that situations like that would have disappearedas the years went by. To a certain extent, you would be right. However, these two-tier deals are rather rare; and whenever one appears,there seems to be opportunity for the buyer of stock who also hedgeshimself with puts. This was true as recently as the end of 1994, whenChiron was involved in one of these two-tier deals.This was the “deal” for Chiron (symbol, CHIR): a partial tender offer wasbeing made for 40 percent of the company at $117 per share. The remainder of the company was then to exist in the open market, trading as its ownstock once again. The partial tender was probably going to happen beforeJanuary option expiration, but there was a chance that a second request forinformation by the government could delay the payout until after Januaryexpiration.Here were the current prices at the beginning of December with CHIRat 75:Dec 70 call: 51⁄4Jan 70 call: 6April 70 call: 7
Dec 70 put: 1⁄4Jan 70 put: 71⁄2April 70 put: 18
Anyone with any understanding of option prices at all would have toknow that the Jan 70 and April 70 puts look very expensive—but why?The novice often views such puts as an attractive sale. Moreover, thenovice would probably not understand why Chiron was only trading at$75. Note that the calls are trading near parity, only reflecting enoughtime value premium to account for the time until the front-end tender actually occurred.Now, I didn’t have the wherewithal to analyze what the back-end stubwould be worth, but I didn’t need to. Apparently, analysts had looked atwhat the remaining company would contain and had decided that it wouldbe worth something in the low 50s. I knew this, even without talking to oneof these analysts. Why? Because we have to assume that the arbitrageursare not stupid and have priced the stock properly, where “properly” meansthat they could make about a three-point profit or so if the deal goes
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through and their analysis is correct. Since a Chiron shareholder would sell40 percent of his stock at 117, the total value of his stock would be: 0.40 ×$117 + 0.60 × stub = $78. With Chiron currently at 75, leaving a littleroom for arbitrage profit (78 – 75, or 3 points) on the total deal is aboutright for carrying costs, and so on. Solving this equation, we find that thestub is projected to be worth 52.Now, admittedly, there could be some conjecture over whether theback end (the part of Chiron that is going to trade after the partial-tenderoffer) is worth more or less than 52. However, given that the current priceof Chiron ($75) is “predicting,” arithmetically, a price of 52, the putoptions had to be priced as if Chiron were going to be there when the tender ended. Thus, if Chiron were 52, an April 70 put should be worth about18, which is exactly where it was trading. As in the two previous examples,the puts’ prices are only related to where Chiron would be trading after thetender; put holders or sellers would not participate in the partial tenderoffer at 117.Okay, so why were the Jan 70 puts only selling for 7? Weren’t they asteal? Actually, the Jan puts were a huge speculation, because it wasn’tknown whether they would be worth zero (if the tender were not completedbefore January expiration) or 18 (if the tender were finished before Januaryexpiration). Only people who had some specific feeling on the timing forthe deal should have traded the January puts.The strategy that we established was to buy Chiron stock at these levelsand to buy the April puts against the remaining 60 percent position. Forexample, buy 1,000 CHIR and buy 6 April 60 puts. Then, as long as thepartial tender at 117 takes place, the downside risk is limited by the presence of the long puts.If, for some reason, CHIR traded at a price higher than 52, then wemight be able to generate additional profits, for we would, in effect, own thestub and the April 60 puts—which is equivalent to owning an April 60 call.So if the stub really took off, we would own free calls.The risk, of course, is that something happens to “break” the deal, andthe partial tender never takes place. In that case, CHIR would collapse andlarge losses would occur on the 1,000 long shares of stock, despite thepresence of the six long puts.The way things worked out, that was an unnecessary worry. As the tender date approached (which turned out to be before January expiration),Chiron stock rose slightly to just over 80. This rise, however, reflected moreoptimistic estimates for the back end of the deal. In fact, the stub opened fortrading at 61 (much higher than the original estimate of 52) and eventuallytraded all the way up to 67. The “equivalent” calls that were bought for a
OPTION TRADING PHILOSOPHY
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fractional price, eventually became worth $7. Thus, the two-tier strategypaid off, just by observing what was happening in the arbitrage and by constructing the appropriate hedge using the puts.
Why didn’t everybody set up this hedge? I don’t really know.Although one logical reason is probably size. The positions held byaribtrageurs and money managers in Chiron were so huge that therejust weren’t enough puts available for purchase to hedge the positions. Thus, a smaller trader can sometimes have a safer trade thanthe “big boys.”
OPTION TRADING PHILOSOPHYIn this final section of the book, we discuss some of the aspects oftrading that are specific to options. These are not all-encompassing,nor do they guarantee a profit; but if you follow these guidelines, youwill have the best chance of being successful with your option trading. These guidelines are not the path to easy riches; but followingthem will generally keep you out of trouble, increase your efficiencyof capital, and hopefully improve your chances of making moneywith options. If you are an experienced option trader, you probablyfollow a lot of these guidelines subconsciously, not even bothering tothink about them. However, if you’re new to option trading, thenthese might prove to be things that you’d want to check as you establish a new position. Some of these have been mentioned in earliersections of the book, but they are important enough to stress again.Trade in accordance with your comfort level.There is a myriad of strategies that option traders can employ.Some will be more in line with your risk and reward levels than others.For example, some traders don’t like to buy options. In fairly stagnantmarkets, the daily wearing away of the option due to time decay ismore than they can handle. If this is the way that you feel, then youmay want to specialize in spread trading and volatility selling.On the other hand, if you are not comfortable selling nakedoptions, then don’t. Even though such strategies are nicely profitable
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for some traders, they should not be used if they cause you sleeplessnights or other consternation.A friend of mine was an option trader on the floor of the AMEX. As was thecustom in the mid-1980s, he was a rather large seller of naked options.However, somewhere along the way, he stopped selling options. I askedhim why, and he replied, “I was wishing my life away. I always wished it wasnext month so that the options would expire.”
My favorite story regarding an aversion to selling naked options,though, goes back to someone you would least expect—a very riskoriented individual, who was head of an arbitrage department.In the 1970s and 1980s, it was common for most of the equity risktaking ofa firm—even one as large as PaineWebber—to be done by one department.Thus, the department would trade risk arbitrage, convertible arbitrage,index arbitrage, reversal and conversion arbitrage and also would take a certain number of risk-oriented positions. These risk-oriented positions mightbe some outright long or short positions in stock, some option strategies,and so forth.A good friend of mine was trading convertible arbitrage and also settingup option strategies. The head of the department was a well-known arbitrageur who didn’t blink at positions of several hundred thousand shares ina risk arbitrage position. However, he didn’t really understand options toowell. So one day, in 1974, he asked my friend to explain his position in IBMoptions. Apparently the position had been marking to market at a smallloss, and the head of the department wanted to know why. The reason wasthat IBM had been rallying in October and November, coming out of itsoversold bottom of the 1973–1974 bear market.The position was a one-by-two ratio call spread—the specific details areforgotten, but it was on the order of being long 100 IBM Jan 240 calls andshort 200 Jan 270 calls. The spread had an upside break-even point ofabout 300. Thus, it was net naked short about 100 IBM calls, and IBM wastrading around 210 or 220.So the trader explained that the position was good for another 80points or so on the upside over the next three months, and that it couldmake about $300,000 if IBM got to 270 at expiration. However, the headof the department wanted to know what the result would be if IBM were at
OPTION TRADING PHILOSOPHY
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350. When told that this would be a loss of $500,000, he said “What if theArabs take over IBM at 350? We’re screwed. Take off the position.”
Now that’s paranoia. What were the odds of the Arabs (whowere extremely powerful with their OPEC cartel in those days) evenwanting a computer company? Probably something way less than0.1 percent. Still, it was too much risk for this otherwise heavy-risktaker. At the least, the department head, an experienced trader,knew what made him uncomfortable, and he didn’t want to pursuethat strategy any longer.Your comfort level extends beyond just deciding whether to tradeoptions strictly from the long side or the short side. It goes deeper—more toward your approach to the overall market. Some people prefer hedging, some prefer speculating. Hedgers generally limit theiroverall profit, but they also have less risk than speculators do. Ifhedged positions drive you crazy because you know you’ll have a losing side as well as a winning side, then perhaps you should tradeoptions more as a speculator, forming opinions and acting on themaccordingly.One friend of mine, back in the early 1970s, was trading the house accountfor one of the major grain companies. That is, he was risking their moneyin the futures market. After a successful career doing that, he decided thathe could do better as a floor trader, and he moved to Chicago and bought aseat on the Chicago Board of Trade (CBOT) to primarily trade corn.His first major position was a very large intramarket spread in corn,something like long May, short March, perhaps. He had always approachedthe market as a speculator, so this position was a little foreign to him; but hefelt that the safety of the spread was a good idea. It turned out to be a badidea. No matter which way the price of corn went—up, down, or sideways—the spread continued to go against him and cost him money. Eventually, the losses wiped out all the equity in his account.He later became one of the biggest and most successful corn speculators, but he never traded a hedged position again.
The important thing to realize is that it is much easier to makemoney if you are “in tune” with your strategies, whatever they may
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be. No one strategy is right for all traders, due to their individualrisk and reward characteristics and accompanying psychologicaldemands.Many traders don’t like speculating, preferring a more conservative tack. If that is your philosophy, that’s fine. You should look forhedged positions with a statistical edge and not attempt to day tradeor engage in other forms of short-term speculation.There’s an interesting footnote to the previous story about the grain trader.He did go broke from that corn spread but was able to borrow money andget started again. Eventually, after he had made his fortune, he told me thatthere’s a saying: “You’re never broke until you go broke twice.” What hemeant was that many successful traders went broke once but bounced backto make large profits. The first time was a learning experience.Now, I’m not sure that everyone needs to go broke before becomingsuccessful, but it happens to a lot of traders. Those who learn from their initial mistakes can recover to become successful traders.
Always use a model.We have, throughout the book, referred to the necessity ofemploying a model to evaluate options. The biggest mistake thatoption traders make is failing to check the fair value of the optionbefore it is bought or sold. It may seem like a nuisance— especially ifyou or your broker don’t have real-time evaluation capability—butthis is the basis of all option investments, whether they be strategic orspeculative. You need to know whether you’re getting a bargain orpaying too much for the option.Don’t always use options—the underlying may be better(if options are overpriced or markets are too wide).This statement is related to the previous tenet of using a model.Sometimes it’s better to trade the underlying stock or futures contractthan it is to trade the options, especially if you’re looking for a quicktrade. Over a short time period, an overpriced option may significantly underperform the movement by the underlying instrument.
OPTION TRADING PHILOSOPHY
613
There are other advantages to trading the underlying. For one thing,there is more liquidity, and markets are therefore tighter. Also, youcan more readily use stop orders (I don’t recommend using stoporders on options themselves). On the other hand, the advantages totrading options are leverage, limited dollar risk, and a possible theoretical advantage if the options are cheap.Avoid buying out-of-the-money options.In Chapter 4, we stressed the importance of buying in-the-moneyoptions as a substitute for the underlying stock. So this is a relatedstatement. In reality, there are some rare occasions on which youmight benefit from buying out-of-the-money options, but it wouldgenerally be to limit your risk to a fixed amount in a highly volatile situation. We discussed the Federal Paperboard (FBO) bull spread as anexample of that. Another example is Sybase.In Chapter 4, we related the story of how Sybase (SYBS) had heavy put volume, and then the stock collapsed when the company forecast poor earnings. This was an extremely volatile stock, so that even the in-the-moneyoptions had a good deal of time value premium. With the stock at 42 andthe negative rumors being very rampant, the following option prices existed(April was the near-term month) for SYBS: 42:April 50 put: 91⁄2April 45 put: 51⁄2April 40 put: 2April 35 put: none available for tradingThese all had ridiculously high implied volatilities, which would have collapsed had the negative rumor proved to be false. If there had been an April35 put listed, I would probably have bought a bear spread (buying the April40 or 45 put and selling the April 35). But, since there wasn’t, I was facedwith the choice of buying an expensive in-the-money put or buying the outof-the-money April 40 put. The April 40 was, of course, the most expensive in terms of implied volatility, but it also offered the least dollar risk.Therefore, I decided on the amount of money that I was willing to lose inthis issue and bought the April 40 puts. It was the only out-of-the-moneyoption that I bought all year.
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This example is atypical in that the in-the-money options were soexpensive. In that case, and that case only, would I consider buyingan out-of-the-money option.Don’t buy more time than you need.The longer-term options often appear, to the naked eye, to bebetter buys. For example, suppose XYZ is 50, the Jan 50 call costs2, and the April 50 call costs 23⁄4. You might feel that the April 50 isthe better buy, even if both have the same implied volatility (i.e., neither one is more expensive than the other). This could be a mistake,especially if you’re looking for a short-term trade. The excess timevalue premium that you pay for the April call and the resultant lowerdelta that it has both combine to limit the profits of the April 50 callvis-à-vis the Jan 50 call. On the other hand, if you’re looking for thestock or futures contract to move on fundamentals—perhaps betterearnings or a crop yield—then you need to buy more time becauseyou don’t know for sure when the improving fundamentals willreflect themselves in the price of the underlying.Know what strategies are equivalent and use the optimumone at all times.Equivalent strategies have the same profit potential. For example, owning a call is equivalent to owning both a put and the underlying instrument. However, be aware that the capital requirements oftwo equivalent strategies (and their concomitant rates of return) canvary widely. The purchase of the call will only cost a fraction of theamount needed to purchase the put and the underlying stock, forexample. However, the call purchase has a much larger probabilityof losing 100 percent of that investment.The option positions that are equivalent to long stock (or longfutures) and to short stock (or short futures) are perhaps the mostimportant ones.Buying a call and selling a put, both with the same terms (strikeprice and expiration date), produces a position that is equivalentto being long the underlying instrument. Similarly, buying a put andselling a call with the same terms is equivalent to being short theunderlying instrument. The next three guidelines deal with these
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equivalences. It was shown in Chapter 3 that the equivalent optionstrategy may be better than owning the underlying stock itself. Also,the equivalent option strategy is better than selling stock short and,of course, is the only way to completely short an index. Not onlythat, it doesn’t require a plus tick to establish the short position.Finally, the equivalent option strategy is mandatory knowledge forfutures traders, for it allows them to extricate themselves from a position that is locked limit against them.Trade all markets.There are strategic option opportunities in all markets—equities,indices, and futures. To ignore one or two of these just doesn’t makesense. The principles of option evaluation that are needed to construct a statistically attractive strategy apply equally well to all threemarkets. Furthermore, there are often intermarket hedges that areextremely reliable; but in order to take advantage of them, you haveto trade all of the markets.Have a little humility.The market has a way of exacting a toll on braggarts. WheneverI meet someone at a social function and he starts telling me about hiswinning trades, I know I’m not talking to a professional trader. Professional traders, if they want to tell you about their trading at all, willmore likely tell you about their losses (those are often better stories,anyway). Also, remember not to confuse brains with a bull market. That is, if you got lucky in a position because the market movedyour way, don’t feel that you are of superior intellect; you might getstung the next time.
The Biggest MistakeI’m often asked what is the biggest mistake that novice optiontraders make. There are a lot of good answers to this question: nottrading with volatility (or, alternatively stated, not using a model) is a
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good answer. So is failing to use good money management, both interms of stops as well as taking partial profits. But the one thatseems to me to be the most applicable is that most novice traders—and some not so novice ones, too—put too much hope in a position. They buy options that have too little time remaining and thatare too far out-of-the-money. They are too optimistic. So, use amodel, manage your positions well, and take a realistic view of theposition’s prospects.
SUMMARYThe information included in this chapter was less specific in naturethan the trading systems, strategies, and methods described in earlierchapters. However, since trading is more of an art than a science, thisinformation is extremely important. First, there were suggestions onbasic brokerage and data gathering. We also described techniques tohelp with money management. The historic examples illustrated someof the good points and bad points of speculation and option trading.Finally, we laid out some general guidelines on the philosophy oftrading.
Appendix A
Listed Indexand Sector OptionsThe following lists are index options and HOLDRS that tradeoptions. You should also be aware of the fact that there are a considerable number of other Exchange Traded Funds (ETFs) listed onthe Chicago Board Options Exchange (CBOE) and on the AmericanStock Exchange (AMEX). The best place to find a current list of thesewould be at the web sites of the exchanges themselves.Airline Index: $XALAsia 25 ADR Index: $EYRBiotech: $MVBBiotech: BTK (AMEX)Banking: BKX (PHLX)Mexico: MEX (CBOE)S&P 500: SPXTechnology: TXX (CBOE)Broker Dealer: XBDComputer & Technology: XCIConsumer Stock: CMRCyclical Stock: CYCCable Media (SIG): $SCQCommodity Related Stock Index: $CRXComposite: $GTCComputer Box Maker: $BMXDefense Index: $DFI or $DFXDeutsche Bank Energy: $DXEDisk Drive Index: $DDXDogs of the Dow: $MUTDow Jones 30 Industrials: $DJXDow Jones Transportation: $