elling for tax losses. As the year came to a close, we established anApril call spread to own them on the cheap if the stock had a re-bound. That worked two years ago in Apple and Oracle, which wereboth under $20 a share at the time. Apple went from about $16 ashare to $150 in two years. Oracle, which was once $18, traded upto around $90.
In these instances, it all came down to having a plan and thediscipline to carry it out. Further, if you are going to trade options,even as a retail investor using spreads, you must be able to dealwith risk. With options, the best way to control risk is to buy op-tions, because you then control your future. The option buyer canonly lose the premium paid. Or, you use a spread, which also limitsthe risk potential.
Another key consideration for any trader or speculator is cap-ital preservation. When you trade options, there will be times whenthe market goes against you. As a professional trader, for example,there are times when | sell an option and the market moves in thebuyer’s favor. Then the buyer exercises the option—somethingthat I don’t want to happen—and I have to either buy stock or de-liver it. In fact, there can be times when, in a bad month, and usingour massive leverage, a professional trader might lose hundredsof thousands of dollars. The saving grace in all this is discipline. Ifyou can devise a plan, reassess it when necessary to enhanceprofits or cut losses, then you have a better chance of preservingyour capital.88 how I trade options
The problem is too many people make it appear that trading iseasy. It’s as simple as booting up the computer, picking up thephone, and throwing a dart at the stock tables. The truth is, youcan lose money when you buy or sell a stock because the marketcan—and will—move against you at times. If you don’t know whyyou are buying the latest dot.com, you might very well buy at thetop, only to watch a fast and precipitous decline. When the musicstops in Wall Street’s version of musical chairs, things can get uglyin a hurry.
So before you trade anything, you want to practice, or papertrade. That means instead of executing the trades, you write downon paper what you would have done. You keep track of the buys andsells just as if they were real trades. You devise a plan and stickwith it even though you are not executing any trades, because thisdress rehearsal for the market is critical. The results of this Papertrading will help you determine how well you pick stocks, and yoursimulated performance for choosing the entry and exit levels.
This then becomes like a journal, a recording of all your trades.All of your trades—both the winners and the losers—should bestudied. In fact, how you handle losses is very important. Becausewhen your money is really on the line, you must keep your disciplineor else the losses will mount—and your capital will erode.
Remember, a really good trader is probably right 60 percent ofthe time. With that kind of a track record, what makes a trader suc-cessful is the ability to cut losses short and let the profits run. Ifyou have half-point winners and two-point losers, you won't stay inthe game for very long. In other words, you can’t gobble losses andnibble for winners.
Regardless of the strategy that you use, the name of this gameis discipline. It’s the only way you’ll be able to devise and stick toyour plan—and preserve your capital to keep playing.chapter 5
from the short side
The spread strategies we’ve discussed thus far focus on the longside of the market. But it’s also possible to use spreads to play theshort side when you're bearish on a stock, betting that the marketwill decline, or simply to protect your holdings, whether they areindividual stocks or mutual funds. The next strategy we'll discussis the put spread.
Let’s say you've selected a stock after doing your homework,and you decide that the odds of the stock trading lower are greaterthan the odds of it trading higher. One way to play your hunchwould be to buy a put spread. When buying a put spread, I lockboth the maximum loss and the profit potential. For example, on a10-point put spread, the most I can lose is the amount I paid for theput spread, but the profit potential, just as in the bull call spread, isthe amount I paid subtracted from the strike price differential. Forinstance, if I paid $2.75 a share for a 10-point put spread, my maxi-mum profit would be $10 minus $2.75, or $7.25 per spread. Ideally, Iwant to have at least a 2-to-1 ratio. That means for the times thatI'm right, I’m going to be rewarded at least twice as much as theamount I'll lose when I’m wrong. Adhering to this kind of ratio isthe essence of risk control and money management.
Here’s an example of how a put spread works: Let’s say eBayis trading at $150 a share. I decide to buy the $150 put and sell the$140 put, for a $10 spread. If I pay $9 for the $150 put and sellthe $140 put for $6.50, I'll pay a net of $2.50 for a 10-point spread.90 = how I trade options
For one contract (equivalent to 100 shares), you would pay $250 perspread, which is also the maximum loss, and stand to reap a maxi-mum profit of $750 per spread (Figure 5.1).
Now, even if eBay went to $200 a share—the exact opposite ofwhat I wanted to happen—I would still lose only $250. Overall, I’mrisking $250 to make $750 per spread—a three-to-one reward/riskratio, which I consider to be great odds in my favor. And, I’m con-trolling the downside of what is otherwise a very volatile stock,which could be hard to borrow if I wanted to short it (as outlined inChapter 3). At the same time, I would be in a position to profit hand-somely if the stock trades the way I think it would and declinesin price.
Put SpreadeBay trading at $150 a shareBuy $150 put and pay $9 premiumSell $140 put and collect $6.50 premium
Maximum loss: $2.50 a shareMaximum profit: $7.50 a share
Figure 5.1 long 1 Oct 150 put, short 1 Oct 140 put
 
 
Profit / Loss (Y) and EBAY Common Price (X) Risk Graph
 
 
Source: Created by StockmarketWorkshop.com.from the short side 91
If eBay declines in price to $140 a share, profit on the $150 putis $10 a share, minus the $9 premium, for a net profit of $1.00 ashare, or $100. However, since the $140 put expires worthless, |keep the $6.50 a share premium, for a total profit on the trade of$7.50 a share ($1.00 plus $6.50), or $750 per spread.
If eBay declines to $130 a share, I make a $20 profit on the $150put, minus the $9 premium for a net profit of $11 a share. The $140put I sold is exercised, requiring me to buy stock for $140 when thestock is trading $130. I lose $10 a share, which is partially offset bythe $6.50 a share premium I collected, for a net loss on that trade of$3.50. My overall profit on such a spread trade is $7.50 ($11 minus$3.50), or $750 per spread.
If eBay rises to $160 a share, the $150 put I bought expiresworthless and I lose the $9 premium. The $140 put I sold also ex-pires worthless and I keep the $6.50 a share premium, for a totalnet loss of $2.50 a share, or $250 per spread.
For more sophisticated investors, there is another strategythat involves selling puts as a partial surrogate for owning thestock. Let’s say you like Xerox, which has sold off rather sharplyover the past few months, declining from $60 a share to around $25.As a result, you consider the options to be very undervalued, as thecollapse pumped up volatility in both call and put options. One wayto invest would be to buy the shares outright at today’s price andwait for them to appreciate in value. Or you could sell the at-the-money puts that are a few months out and collect a premium of,say, $3 a share.
The buyer of those puts could be someone who wants to lockin downside price protection by buying put options. For example,the buyer could purchase April $25 put options, which wouldprotect his or her investment if the stock declines below $25 ashare.
You, on the other hand, are bullish on the stock. You believethere is little chance, if any, that Xerox will trade below $25 a share.By selling the $25 puts, you get to keep the $3 premium if the stockbehaves as you anticipate and trades at least at or above $25 ashare. Interestingly, in this scenario both you, as the seller of theput, and the buyer, looking for downside protection, are both bull-ish on the stock. The stock buyer probably has a long-term bullishbias for XRX, while the put seller is simply thinking the stock isoversold and the options overpriced.92 how I trade options
A variation on this theme is cash-secured put selling. This is animmensely popular strategy that allows you to be the “house” orthe “insurance company” to take on someone else’s risk—for a pay-ment reward, of course. The obvious benefit is that you get to col-lect the premium, just as a life insurance company or the casinodoes. And, especially in volatile times, you’re rewarded very hand-somely for taking on that risk. But you are taking on risk.
In the 20 years that I’ve been trading, I'd say that cash-securedput selling is a strategy that works wonderfully 90 percent of thetime—that’s as long as you have the cash and haven’t leveragedyourself too much for the 10 percent of the time that it doesn’twork—such as those infamous “downturns” in the stock marketthat we saw in 1987, 1989, 1991, 1998, and in early 2000.
Cash-secured puts work very well, although many investorsdon’t understand this strategy. Those who do, however, often put itto good use. Consider my friend, whom we’ll call Frank, a very suc-cessful entrepreneur. After his introductions to options, he startedbuying seats at the Chicago Board Options Exchange and leasingthem out. There are a limited number of seats and they lease justlike an apartment on a monthly basis. And, unlike an apartment,there is no need to paint them and you never get a call in the middleof the night that the pipes are broken. Returns on Exchange seatsaverage about 18 percent, which is certainly an attractive return.
My friend Frank then graduated from just owning seats to fig-uring out some other way to make money with options. That’s whenhe became familiar with selling cash-secured puts. He sells puts onstocks that he loves, the ones he really thinks have upside poten-tial. When he’s right, he collects the premium. And for the few timeshe’s wrong, he’s got the cash in his brokerage account to buy thestock that’s “put” to him at an unfavorable price.
Here’s an example of a typical “Frank trade.” Let’s say he’sbullish on Intel (INTC), believing that the world’s largest chip-maker is going to grow by 20 percent, come hell or high water. Heknows the stock will have its share of ups and downs, but overall,this is a stock he wants to own. Now, let’s assume that Intel is trad-ing at $100, and the $95 puts that are two months out (which isthe right to sell the stock at $95 a share) are trading for a $3.50 ashare premium.
Frank would put up the cash at the brokerage firm to coverthe stock, and sell these $95 puts, which are out of the money at thefrom the short side 93
moment. (Remember that by selling these puts, Frank would be ob-ligated to buy Intel at $95 or lower if the buyer exercised that right.In return for selling these puts, Frank collects $3.50 a share.)
Intel trading at $100 a share.Sell $95 put (two months out). Collect $3.50 a share premium.
Keep $9,150 per contract (100 shares) in brokerage account tosecure puts in case the puts get exercised and he isforced to buy the stock.
In this instance, Frank is really bullish on Intel; he thinks thisstock is heading higher. You, as the buyer of these puts, are alsobullish on the stock. But you also want a little insurance to helpyou sleep at night, which is why you buy the puts. You alreadyown Intel shares, 100 of them, now trading at $100 a share. Youwant to protect the value of your $10,000 investment, so you'rewilling to pay $3.50 a share—or 3.5 percent—to protect a $100 ashare asset.
If you're correct and the stock price does rise, you will lose the$3.50 a share premium you paid for the puts. But you may very wellmake up for that loss—and then some—with the increase in thevalue of the shares that you hold. In the meantime, if you have$10,000 in Intel stock, you’re happy that increased to $110 a sharefrom $100. But with that kind of investment, you may very wellwant to “insure” it by buying puts that, as with insurance on yourhome or car, you really hope you never have to use. Frank, the putseller, meanwhile, is rewarded for providing the downside insur-ance by being able to keep the $3.50 a share premium.
Now, what happens if Intel shares do go down to say, $91.50?With a $95 put option you paid $3.50 a share for, you put the stockto him at $95, but the put protection cost you $3.50 a share. But ifFrank loves Intel at $100 a share—and is willing to own it at thatprice—how much more will he love it at $91.50 a share! He’s notupset about taking the stock at that price and holding onto it until,as he expects, it increases in value. With the cash in his brokerageaccount (remember these are cash-secured puts) he can purchasethe shares when the put is exercised. The proceeds of that stocksale, meanwhile, help to offset the losses on the value of the Intelshares held by you, the put buyer.94 how I trade options
For each time Frank did this trade, however, he would have tohave $9,150 in his account to cover the 100 shares (at $91.50 ashare) that could be “put” to him should the option be exercised.Assuming he does this trade 10 times, that amount increases to$91,500. The cash that secures the put can be in the form of a de-posit at the brokerage firm, on which he can get interest. Or it canbe in the form of a Treasury bill or a money-market fund, as longas it’s a cash-secured holding that can be liquidated at a mo-ment’s notice.
Overall, from Frank’s perspective, he’s earning interest on thecash or cash-equivalent investment that secures the puts. And he’scollecting $3.50 a share in premium for the puts he sells. If he’s ableto do that six times a year, that’s $21 a share in premiums—or$21,000—plus interest on $91,500, which at 5 percent wouldamount to $4,000-plus. In total, Frank is making about $25,000 forsix trades on a $91,000 investment, which is a pretty good rate ofreturn for being the “house.”
There’s another reason why speculators like Frank love cash-secured put selling. Frank has owned an insurance company or twoin his time. He knows that the actuarial tables used to predict oc-currences (deaths in the case of life insurance) make similar as-sumptions as the option pricing models but with one rather glaringdifference: Stocks rarely die! Oh sure, there have been a few, butoverall, the occurrence that is final for the premium seller at thelife insurance company, isn’t nearly so final for the put optionseller. In fact, a cash-secured put seller like Frank will tell you thatstocks have many more lives than any cat!
The risk, which I must stress, is that this strategy is not justabout collecting premiums to protect other people’s stock holdingsfrom downside risk—risk that you and the put buyer don’t expectto materialize. You have to know that there will be times when youend up buying a lot of stock, potentially at very unfavorable prices.
It doesn’t feel very good when the market makes a 10 percentor 20 percent correction and you know that you have $1 millionworth of stock tumbling into your account because put buyers areexercising these options. And these situations do occur, such asduring the crash of 1987, 1989, 1991, 1998, early 2000... and thenext time the market “corrects.”
Many of you probably remember when Russia defaulted in1998 on its domestic debt on the heels of economic crises in Asiafrom the short side 95
and in some Latin American countries. I remember being in Pariswith my wife, Brigid, in October 1998 when the market was down400 points. There I was on vacation, and | had all these obligationsout there in the form of puts that I had sold. Like other cash-secured put sellers, I had been riding along for months, collectingpremiums every month. Suddenly, the stocks everybody had tohave went from “must haves” to “don’t wants.” At times like this,the market doesn’t look so good, but that’s exactly the time you arebuying big chunks of stocks.
The impact on you when that happens depends largely on howgreedy you’ve been. Sometimes, instead of selling puts that are 5 to10 percent out of the money—and collecting relatively small premi-ums—you start selling puts with strike prices that are a lot closerin and collecting larger premiums. The problem is, there is a fargreater probability that these close-in puts will be exercised if themarket makes a “dip,” than the farther-out puts that won’t be exer-cised except in the case of an all-out correction.
Just like the Bear Call Spread (discussed in Chapter 4), youhave a limited amount you're going to win when you're right, amuch greater percentage you're going to lose when you're wrong.
As a professional trader with leverage in my favor, I can exe-cute trades that could, potentially, expose me to risk that wouldmake most retail investors very nervous and probably sick to theirstomachs, especially in 1998, or early 2000. I trade some majornames among the tech stocks—Micron Technology, Sun Microsys-tems, Intel, Cisco, Microsoft, Oracle. And I've had puts on many ofthese stocks in spreads that have gone against me. As a result, I’veprobably had to buy $60 million worth of stock, due to the com-pounding effect of the professional leverage (sometimes as high as100-to-1) that I can use, which is both a blessing and a curse.
In times of notable downturns such as in 1987, 1989, 1991,1998, and early 2000, that leverage is a curse, and I’ve had stock putto me that far exceeds the cash value of my trading account. At anygiven time, my firm is carrying $150 million to $250 million worthof stock on the books. So you can see the impact if, in a two-dayperiod, all of a sudden you end up with $60 million to $70 millionworth of stock in your account in a falling market.
Luckily, we’re able to limit our exposure on such adversemoves, sometimes through the use of stock index puts, other timesby ownership of way out-of-the-money “disaster puts.” So if I have a96 how I trade options
losing position in Sun Microsystems, Microsoft, Oracle, or Intel, I’llown Nasdaq Index options (NDX). If I end up having a lot of stockput to me at an unfavorable price, I'll make up at least some of themoney in my index positions. And, as my friend Frank and I know,stocks don’t just “die.”
Cash-covered put spreads are a wonderful way to play themarket from the bullish side, and you collect a premium for yourefforts. It’s like you're playing the “house” in Vegas, taking on therisk that someone else wants to offset, which is why they are ap-pealing to so many knowledgeable investors.
In early 2000, I was asked to speak to an investment clubwhose members included several engineers and doctors who hadamassed a multimillion-dollar account, which they had increasedwith cash-secured put selling. This strategy paid off handsomely,reaping a 42 percent return in the fourth quarter of 1999 alone.Anyone who remembers the December 1999 run in the Nasdaq andthe Dow could see how they could post those returns by sellingputs on the Nasdaq “names” among the tech stocks that tended tohave a lot of volatility. Remember IBM may have 30 percent volatil-ity, whereas eBay, Yahoo, and so forth may have volatility in the100 percent range. When you sell an out-of-the-money IBM put, youmay collect $2 a share. But when you sell an out-of-the-moneyYahoo put, you may collect $20 a share. (Of course, the reason thatpremium is so high is there is a greater chance, with Yahoo’svolatility, of a strike price being hit.) But when the market goes upand you've sold a Yahoo put, it’s a very good day.
There are other put spreads that investors can use, such asselling a put spread. In this strategy, as in cash-secured put selling,we profit from the upside movement of the stock. (Since we are sell-ing the put, our expectation is that the stock will not decline invalue enough to hit the strike price.)
Again, let’s assume that Intel is priced at $100 a share. To dothis spread, we sell the $95 put—granting the buyer the right toput stock to us at $95 a share—and collect a $3.50 premium. Thenwe buy the $85 put for $1. In this example, we have sold a $10-pointput spread for $2.50 (Figure 5.2).
If Intel is at $95 a share or higher at expiration, we keep the$2.50 per spread ($250). But if Intel is lower than $92.50 a share (the$95 strike price minus the $2.50 per spread credit), we're goingto own stock at that price or we're going to have to trade out of thatfrom the short side 97
 
Figure 5.2 long 1 Aug 85 put, short 1 Aug 95 put
 
 
Profit / Loss (Y) and INTC Common Price {X) Risk Graph
 
 
 
Source: Created by StockmarketWorkshop.com.
position. The advantage of this trade, however, is that you onlyhave to invest $750 to make a one-contract trade—the differencebetween the $10-point spread and the $2.50 per spread you col-lected. Making this kind of trade for $750 is a far more economicalstrategy than cash-secured put selling, which requires you to havea large account—often in the hundreds of thousands of dollars—atyour brokerage firm.
The drawback, however, is that the risk/reward ratio is out ofbalance. Your potential on this trade is $2.50 a share, or $250 perspread, but if you lose, at least your loss is capped at $7.50 a share,or $750. That means you risk $750 to make $250. On the otherhand, $750 is not a large upfront investment to make, especiallycompared with cash-secured put selling, which required $9,150per contract.
Intel at $100 a share
Sell $95 put and collect $3.50 premium
Buy $85 put for $1
Net profit on $10 spread would be $250 per contractLoss capped at maximum of $750 per contract98 how I trade options
When you compare the $750 per contract the put spread sellerhas to put up versus the $9,150 the naked put seller has to have inhis or her account, it’s easy to see why put spread sales are popu-lar with people who have less capital—or less risk tolerance—thanthose who do other forms of spread trades.
In options, spreads come in many varieties and in many forms,playing both the long and the short side. And they sometimes comeunder some very unusual names. (We all know about Bulls andBears. But what about Butterflies and Condors?)
An iron butterfly is more than just a reference to the 1960sheavy rock group. An iron butterfly is a spread that allows you toprofit from options on stocks or indexes that are trading in a range.When you buy a stock outright, you’re speculating that the pricewill increase. If that stock stays in a range—trading a little higherand then a little lower and then a little higher again—it’s tough tomake a profit. But with specialized spreads such as the iron butter-fly, you improve your chances greatly of making a profit, especiallyif that stock continues to trade in a range.
Say, for example, that I believe that during the month of April,which as we all know is the height of tax season, investors have sig-nificantly less capital to invest because they had to send money toUncle Sam. Even if you file for an extension, you still owe Uncle Samthe cash on April 15. With less cash on hand, there is less cash toinvest in the market, which then tends to stagnate in April. As a re-sult, April is a time when the market normally trends in a narrowband, instead of rocketing up and down as it does in December andJanuary (when it typically rallies) and October (when it usuallysells off because of lingering fears of the crashes of 1929 and 1987).
In other words, times of the year that a given stock or indexare likely to stagnate are perfect for doing iron butterfly spreads.
An iron butterfly is the simultaneous sale of a call spread andput spread, which result in a hedged short premium position thatreaches its maximum profit potential if the equity or index stays inyour predicted range. Let’s use the S&P 500 Index as an example.Butterfly spreads are quite popular with index option trades.They'll see that among the S&P 500, 20 stocks are up, 20 stocks aredown, and 440 are just about unchanged. That means the S&P indexis going to trade in a band. Plus, the diversification within thatindex, across a spectrum of industries, tends to work in favor of thepremium seller during times of low volatility.from the short side 99
Let’s say the S&P 500 Index is trading at 1450. I believe it willtrade between 1430 and 1470—up and down 20 points from whereit is currently. I could sell the 1470 call for $8.00 and buy the 1480call for $6.00 to protect it. In effect, I've sold a 10-point call spread(the differential between the strike prices) for a net of $200 percontract.
For the downside end of the range, I sell the 1430 put for $7.00,and I buy the 1420 put for $5.00. I’ve sold a 10-point put spread,again for $2.00. With these two spread trades, | have bracketedthe market just above and just below where I think it will trade, andI've collected a net of $4 in premiums. The most I could lose on thisbutterfly spread is the difference between the net of $4 in premi-ums received and the $10 spread value, or $600 per contract (Fig-ure 5.3).
Now, assume that the S&P fails to stay in my projected rangeand instead drops to 1400. The 1420 put that I bought is now worth$20. The 1430 put that I sold is now worth $30 to the buyer. My ex-posure on that trade is that I owe $10 per contract. But that’s offset
 
Figure 5.3 long 1 Aug 1480 call, short 1 Aug 1470 call; long 1 Aug 1420put, short 1 Aug 1430 put
 
 
Profit / Loss (Y) and SPX Index Price (X) Risk Graph
 
   
 
—1400 4410 1420 1430 1440 1450 1460 1470 9480 4490 4500
 
 
Source; Created by StockmarketWorkshop.com.100 how I trade options
by the $4 in premiums that I collected, so my loss on that trade iscut to $6 per option.
Conversely, let’s say the S&P rockets out of the range to theupside, reaching 1500. The 1470 that I sold is worth $30 and the1480 that I bought is worth $20, leaving me with a net exposure of$10. But taking into account the $4 in premiums that I collected, mynet loss on that trade is $6 a share.
But if the market stays in the range that I projected—in this in-stance between 1470 and 1430—then all the puts and calls expireworthless, and I’m able to keep my $4 in premiums. The maximumloss of $6 and potential profit of $4 is just under a 1:1 risk/rewardratio. While that’s short of my optimal ratio of 2:1, it is not asskewed toward a higher loss than some other spread trades.
One reminder: S&P index options are European-style options,which means they are only exercisable at expiration, which makesthem very popular.
S&P Index at 1450
Range projected to be 1430 to 1470
Sell 1470 call for $8.00 a share
Buy 1480 call for $6.00 a share
Sell 1430 put for $7.00 a share
Buy 1420 put for $5.00 a share
Net premiums collected: $4
Maximum loss is $6.00 a share ($10 spread value minus $4 inpremiums collected)
Maximum profit is $4.00 in premiums collected
For stock options, which