of the XLF collar. Ideally, shares will move toward, but not rise above, $23. A move above thestrike price of the short call will lead to assignment, leaving the strategistholding nothing but a deep out-of-the-money put. Losses will occur if XLFdrops below the breakeven, which is computed as the price of the stockminus the net credit, or $21.25 a share ($22 – $0.75). However, the putprotects the position from large losses. If the fund drops below $20 pershare, the strategist can exercise the put and sell all 1,000 shares for $20apiece. Therefore, the maximum possible loss is the price of the stockminus the net credit, minus the strike price of the put option, or $1,250:[($22.00 – 0.75) – 20] × 10 × 100.While a collar can be tailored to make money when shares movehigher, it is normally used for protection. It does not require a lot of attention. If the ETF shoots higher, shares will probably be called when thetime premium has fallen to a quarter of a point or less.Therefore, if the price of the exchange-traded fund has risen abovethe strike price of the call and the strategist does not want to lose theshares, it is better to close the short call by buying it back. If not, the callwill be assigned and the trader will make a profit equal to the differencebetween the exercise price and the original purchase price of the shares,minus any debits (or plus any credits).The put will protect the shares if the price of the fund falls. If the price
FIGURE 7.8 XLF June Collar Spread Risk Graph (Source: www.Optionetics.comPlatinum)
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drops sharply, the strategist will want to buy back the short call and thenexercise the put. If the short call is not closed and the put is exercised, thestrategist will be naked a short call. Although it will be deep out-of-themoney, it will still expose the trader to risk. Therefore, it is better to buyback the short call and close out the entire position. If the shares stay inbetween the two strike prices, the trader can roll the position out usinglonger-term options, or do nothing and let both options expire worthless.Delta and CollarsCollars are often created to proﬁt from a move higher in the price of theunderlying asset. When using the strategy, delta can once again be veryhelpful. Understanding delta can help the strategist understand why thecollar changes in value for each change in the price of the stock. For example, if a collar is created with 100 shares, selling a call with a delta of0.50 and buying a put with a delta of –0.35, the overall delta will be 0.15.Therefore, the trade will gain 0.15 cents for each 1 point advance in thestock. It will lose 0.15 cents for each point drop in the stock. So, it has abullish bias, which many traders seek when creating collars.Position
Delta
Long 100 shares of XYZLong 1 XYZ putShort 1 XYZ call
+1.00–.35–.50
Total Position Delta
+0.15
Importantly, deltas are always changing, and as they change, the strategist can make adjustments to the collar to keep a bullish bias. The adjustment can involve buying or selling puts, calls, or shares.
DIAGONAL SPREADSThe diagonal spread is similar to the call and put calendar spreads discussed earlier. It can be created with either puts or calls. Similar to thecalendar, the diagonal spread is often used to take advantage of time decay. In addition, it is an appropriate strategy when the investor expects asideways or modest move in the price of the underlying asset. The spreadcan be applied to stocks, indexes, or exchange-traded funds.To create a diagonal spread, the strategist buys a longer-term optionand sells a shorter-term option with a different strike price. Recall thatthe calendar spread uses the same strike prices. The expectation is thatthe stock will move toward, but not exceed, the strike price of the short
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option. As a result, the short option will expire worthless while the longerterm option retains most of its value and perhaps even appreciates. An example of a diagonal spread would be to sell an at-the-money call and buyan out-of-the-money call with a more distant expiration date.For the diagonal spread case study, let’s consider the Select SectorEnergy Fund (XLE) trading near $51.25 in early December. The strategistexpects the energy sector to stay in a range before exploding higher in thesecond half of next year. Therefore, 10 long June 55 calls are purchasedfor a debit of $2.50 per contract. To help finance the cost of these calls, thestrategist sells 10 January 52 calls for $1.50.The cost of the trade is $1,000 and is equal to the premium of thelong call minus the premium of the short call, multiplied by the numberof contracts and the multiplier [($2.50 – 1.50) × 10 × 100]. The net debitis also the maximum risk associated with this trade. Profits arise if theshares move higher. The maximum profit occurs when the short optionexpires and XLE is equal to $52 per share. At that point, the long call hasretained most of its value, but the short calls expire worthless. Thestrategist can then close the position entirely, sell more short-term calls,or simply hold the long calls in anticipation of the move higher in the energy sector.The risk curve of the diagonal spread, shown in Figure 7.9, is similarto the calendar spread. In both cases, the strategist wants the share priceto move higher, but not rise above the strike price of the short calls. A
FIGURE 7.9 XLE June/January Diagonal Spread Risk Graph (Source: www.Optionetics.com Platinum)
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move lower will result in losses because all of the call options will losevalue. If all of the options expire worthless, then the strategist loses theinitial net debit paid for establishing the trade.As noted with the calendar spreads, the breakevens for diagonals aredifficult to know ahead of time. The risk to the diagonal spread is easy tocompute in advance because it is limited to the net debit paid. The maximum reward is unlimited after the short-term option expires because thelong call can continue to appreciate in value. However, the breakevenpoint is more difficult to pin down. Often, traders will first look at thebreakeven price when the short-term option expires, but at that point thelonger-term option will probably still have value. In addition, the value ofthat long option will be difficult to predict ahead of time due to changes inimplied volatility (discussed later) and the impact of time decay.In sum, it is difficult to know exactly what the breakeven stock pricewill be for the diagonal or calendar spread because we are dealing withoptions with different expiration dates. In these situations, the best approach is to use options-trading software to get a general idea of thebreakeven levels. Then you can plan your exit strategies accordingly.
CONCLUSIONOption strategies provide the trader with a very valuable and powerfultool, no matter whether they are used alone or combined with other options or equities. This type of flexibility allows the trader to accommodate any of a number of unique goal and risk parameters. Before traderseven begin their search for the best option strategy, they must first havea basic understanding of just how option investments work in realworld trades.Options traders are typically presented with a multitude of differentchoices. To select the most appropriate strategy for the situation, theymust first consider their trading goals, market outlook, and risk toleranceto be able to narrow down the best candidates suited for them. Keep inmind that each strategy has its own advantages and disadvantages. It is vital for each trader to define his or her own risk tolerance as this makes iteasier to choose the best strike prices and expiration dates.If directional option strategies are preferred, it is essential that thetrader be able to effectively forecast the price of the underlying asset.Also, if these types of strategies are for profit or protection, the actualmarket outlook will certainly limit the list of strategic choices. Typically,directional strategies require the investor to make at least three assessments about the future price of the underlying security.
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First, of course, is direction itself, which is based on market analysisand allows the trader to determine whether the price of the underlying ismore likely to increase, decrease, or stay at the current level. Second, thetrader must form an opinion about the size of the move, which will surelyimpact the selection of strike prices. For some option strategies it is notenough to decide on a particular direction; rather, it is the magnitude ofthe projected price move that will determine which strike prices makeworthy candidates.The third decision involves the time frame in which the stock priceforecast needs to take place. Options are a decaying asset and have a limited time span. This means that if both the projected direction and the sizeof the move do take place, but only after the option expires, the optionstrader still would not have achieved the intended objective. That is whytiming is so crucial in options strategy selection, especially if the tradepossesses a directional bias. The bottom line is that if the options trader ismaking a directional forecast, s/he has to be correct in three areas; the underlying must move in the right direction by a sufficient magnitude as wellas prior to the expiration date.Some strategies are successful only if the underlying asset behavescorrectly for the duration of the contract. It is very important for thetrader to have a clear idea about where the underlying is likely to moveand when. This will definitely improve the option strategist’s chances ofsuccess with selecting and implementing the appropriate strategies.Understanding complex and advanced strategies can take some time,but it pays off in the long run. It not only helps in finding opportunities indifferent types of market environments, but it also can help the strategistadjust positions to limit risks and increase potential rewards. For example, the reader should now understand how a collar can offer low-costprotection for a position in an exchange-traded fund.Meanwhile, straddles and strangles can be used when the strategistexpects an explosive move higher or lower in the index or sector. Theshort strangle is sometimes used in the index market because it can generate a lot of premium. However, the risks are high when selling naked options. As a result, when looking for ways to earn premium, strategistsshould consider butterflies, collars, and diagonal spreads. All of thesestrategies can be created whether the strategist has a bullish, bearish, orneutral bias on the stock market as a whole, or on a specific sector.
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A
t this point, the reader has been introduced to the basics of indexes,options, and strategies. Now let’s take a closer look at the financialmarkets and what makes them move. What factors cause prices tochange in the financial markets? What makes an index move higher orlower? Why does the market trade quietly at times? Why is it sometimesvolatile? The answers to these questions may be subjective at best, but arestill well worth exploring.The stock market moves because of news. If there was no new information, prices would never change. The arrival of new information causesinvestors to react—to buy and to sell. In addition, the type of informationthat moves the market as a whole or a sector is generally different fromthe type of information that causes movement in shares of one company.For instance, a bad earnings report can cause a stock to plunge 50 percentin one day, but it is unlikely to sink the entire market. So what types of information and indicators do index traders want to consider when lookingfor profits? Let’s find out.
EFFICIENT MARKET THEORYAccording to one school of thought, it isn’t possible to successfully tradethe market because the arrival of new information is very quickly incorporated into asset prices. Only new information can move stock prices; sincethe future is completely unpredictable, it follows that stock prices are133
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erratic or random. The efficient markets hypothesis is at odds with the ideathat superior stock selection or market timing can yield above-averageprofits. The so-called efficient market theory (EMT) was popularized inthe book Random Walk Down Wall Street by Burton Malkiel (New York:W. W. Norton, 1973). On page 24, he explains:A random walk is one in which future steps or directions cannot bepredicted on the basis of past actions. When the term is applied tothe stock market, it means that short-run changes cannot be predicted. . . . Taken to its logical extreme, it means that a blindfoldedmonkey throwing darts at a newspaper’s financial pages could selecta portfolio that would do just as well as one carefully selected by theexperts.The type of information and the manner and timing in which it entersthe market are some of the reasons that stock prices are unpredictable.Each day, billions of shares of stock trade hands on the various exchanges. The buying and selling reflects the expectations of millions of intelligent human beings who have access to different information, somebullish and some bearish. It may reflect specific news or conclusions thatare drawn from piecing together various bits of information (i.e., the “mosaic theory”).If a company reports disappointing earnings results, investors willprobably sell the stock, causing the price to decline. Bears will continueto sell shares until the price of the stock is adjusted downward and it becomes attractive to potential buyers. If it falls too far, buyers will step inuntil the stock prices move higher. This type of decision making and adjustment goes on daily with millions of well-informed, rational, and intelligent investors doing the buying and selling.Each day, prices are adjusted using all of the readily available information (and in some cases, unknown or “inside” information) until theprices reflect all that is known and available to the investing public. Thisprocess is at the heart of the efficient market theory. Accordingly, themovement in stocks is essentially random because the only informationthat is not reflected in current prices is the unknown, or the future. Efficient market theorists are sometimes called random walkers.While random walk theory seems logical and has its many advocateswithin the academic community, it is not difficult to find flaws with theidea. For example, some investors have demonstrated, through the years,that it is possible to outperform the majority of investors with carefulstudy and research. Famed investors Peter Lynch and Warren Buffettcome to mind.In the book The New Finance: The Case Against Efficient Markets
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(Englewood Cliffs, NJ: Prentice Hall, 1995), Robert Haugen provides evidence that markets are overreactive and inefficient. His findings are basedon the fact that various market anomalies exist and lead to superior performance from certain kinds of stocks. For example, the price-to-earnings(P/E) ratio effect shows that, in the long run, stocks with lower price-toearnings ratios outperform those with high P/E ratios. (We discuss the P/Eeffect and some of these market anomalies in Chapter 10.) These anomalies suggest that it is possible to beat the market over time.The point for now is simply that, since there are investors who haveperformed better than the rest over the long run and because variousanomalies exist, the efficient market and the random walk theories do notseem to hold. The market is not efficient, and when developing a tradingplan it is important to understand that financial markets can be driven bythe emotions of fear and greed.But, to the index options trader, does it really matter whether stockprices are random or not? While EMT does hold important implicationsfor investors in the stock market, it is not necessarily at odds with the options strategist. The predictability (or unpredictability) of the financialmarkets does not necessarily matter when using strategies that try toprofit from time decay or changes in volatility (discussed in Chapter 12).In addition, the straddle strategy—which involves the purchase of anATM put and a call on the same stock—can yield profits regardless ofwhether the stock moves higher or lower. There is no need to guess there.Similarly, certain strategies such as strangles, backspreads, and butterfliesmay yield profits even without accurate market predictions. Therefore,the random walk theory is not necessarily at odds with options trading,and savvy option strategists can generate profits even given an assumption that the markets are efficient.
PASSIVE INVESTINGDespite its flaws, EMT has had an important impact on the stock marketthroughout the years. Its popularity gave rise to an index strategy knownas passive investing. To be specific, in 1976, a mutual fund company by thename of Vanguard created the Vanguard 500 fund (VFINX). It was the firstof its kind. Basically, the Vanguard 500 is a fund designed to track the performance of the S&P 500. It is a big pool of money that invests in the samestocks as the index. The fund then issues shares to investors. This type offund is sometimes called an open end fund because investors can buyshares or cash out directly from the mutual fund company. When an investor wants to buy shares, new shares are issued.
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The Vanguard 500 was not the first open end fund, but it was the firstone designed to track an index. It differed from other mutual funds because there was no portfolio manager actively researching stocks andmaking buying decisions at the helm. The underlying theory behind thecreation of the fund was the EMT; since the market is efficient, why try tobeat it? Instead investors should try to mimic the market. Since the S&P500 Index is considered a proxy for the stock market, investors shouldbuy and hold those 500 companies. The Vanguard 500 mutual fund provided the opportunity to do so.The Vanguard index fund has outperformed most professionally managed funds since its inception. As a result, this fund has become quite popular—in fact, it has assets in excess of $100 billion and is one of thelargest mutual funds in existence. Since Vanguard developed the S&P 500index fund in the mid-1970s, a number of others were created to emulatethe performance of other indexes.With index funds, there is no portfolio manager making decisions regarding which stocks to buy and sell. As a result, there is no need to payfees to a high-priced portfolio manager. This makes the Vanguard S&P 500index fund a relatively low-cost way of participating in the rise of the S&P500. For investors, the index fund offers two important advantages overactively managed funds. First, most actively traded funds fail to beat themarket. Therefore, the index fund, which tracks the market, beats mostother funds. Second, the costs are less. The lower expenses will also enhance returns.Index funds like the Vanguard 500 are known as passive investments because an individual or portfolio manager does not activelymanage it or make buying and selling decisions. If the market is efficient, it’s impossible to beat it. Therefore, the investor is better off simply buying and holding stocks that track the market. Passive investinginvolves no decision making. It seeks only to match the performance ofthe market.
ACTIVE INVESTINGObviously, we don’t believe that it is impossible to beat the market andeven if we did, we wouldn’t buy shares of the Vanguard 500 or any othermutual fund for our active portfolio. Instead, we trade exchange-tradedfunds like the S&P 500 Depositary Receipts (SPY), or SPDRs. The SPY,you will recall from Chapter 2, is a fund that also holds the S&P 500Index stocks.
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Exchange-traded funds such as the SPDRs hold several advantagesover mutual funds. For one, the annual expenses are generally less,which is an obvious trading advantage over the long term. In addition,ETFs have an important tax advantage as well. When an index mutualfund sells a large position in a stock, the capital gain is passed on to theshareholders and a tax liability is incurred. This is not true of exchangetraded funds.One advantage for the shorter term is that ETFs trade throughout theday like stocks and can be bought and sold through any brokerage firm.Mutual fund shares are issued through a mutual fund company and canonly be purchased at the daily closing price; it isn’t possible to buy or sellshares throughout the trading day. At the same time, traders can use limitand stop-loss orders when dealing with ETFs, just as with stocks. Finally,ETFs can be sold short in a down market. Mutual funds cannot beshorted, period.
Open End Funds versus Exchange-Traded FundsExchange-traded funds are different from mutual funds in several important ways. Here are a few points to remember:• Shares of ETFs trade on the stock exchanges. Shares of mutual fundsare purchased through the fund company.• Exchange-traded funds are quoted throughout the day. Mutual fundshares are quoted only once daily.• Investors pay brokerage commissions for trading ETFs. There are nocommissions paid for buying and selling index funds.• Options trade on ETFs. Mutual funds do not have listed options.• It is possible to sell short and use stop-loss orders with ETFs, which isnot possible to do with index funds.
Obviously, our approach to the market is not passive at all. It’s veryactive and therefore buying a mutual fund is not a strategy we teach fortraders. Since there are no options listed on mutual funds, they simplywon’t work for many of the techniques we use. Our goal is to generateprofits in a variety of market environments and not simply buy and holdshares for the long haul.To put it bluntly, we are not just looking to beat the market; we wantto trounce it by posting above-average returns year after year. Consider
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the simple fact that there are years when the market goes down and postsa negative return. As we saw in early chapters, we have strategies forbearish markets. So if the S&P 500 Index has an off year, which it oftendoes, the passive investor will lose money. We won’t.
FEAR AND GREEDOur approach to the market is active rather than passive for another important reason: We don’t believe in the EMT. There is an entire schoolof thought known as behavioral finance that makes a strong caseagainst the tenets of the theory. According to behavioral finance, themarket might be efficient in the long run, but emotions can push theprice of an investment or market to extremes. The two key emotionsare fear and greed.Fear and greed have a strong influence on financial markets, and thereare numerous examples of these two emotions at work. Books have beenwritten about financial manias. For example, The Crowd by Gustave LeBon (1897; reprint edition, New York: Dover Publications 2002) and Extraordinary Popular Delusions and the Madness of Crowds by CharlesMackay (1841; reprint edition, New York, Three Rivers Press, 1995) detailhow and why various speculative manias occurred through the years. Attimes, the forces of emotion work in subtle ways and on a small scale. Forexample, the forces of greed or fear can sometimes overrun shares of justone company. Figure 8.1 shows the rise and fall Cisco Systems (CSCO) inthe years 1997 to 2001. At its peak, Cisco was worth almost a half trilliondollars! That represents $4,000 per every household in America or $75 forevery human being on the planet.Other times, fear and greed can affect a specific sector of the market.At the time that Cisco shares hit their peak, Internet stocks were caught ina buying frenzy. Figure 8.2 shows the rise and fall of TheStreet.com Internet Index ($DOT) following the early 2000 debacle. Many companies inthe index lost more than 90 percent of their values in the years followingthe plunge in the internet sector. As with Cisco, greed pushed prices toohigh and then fear drove prices back down.The entire global equity market can be overcome by fear or greed.During these times, the mass of investors get taken in by an emotion,which triggers a flurry of buying or selling across international equitymarkets. For example, during the global financial crisis of 1998 the termcontagion became popular. Contagion refers to a global sell-off in financial markets. When this happens, investors are reacting out of fear and
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FIGURE 8.1 Rise and Fall of Cisco Systems (Source: www.ProﬁtSource.com)
FIGURE 8.2 TheStreet.com Internet Index Debacle (Source: www.ProﬁtSource.com)
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FIGURE 8.3 AMEX Japan Index, S&P 500 Index, and Eurotop 100 during GlobalFinancial Crisis (Source: www.ProﬁtSource.com)
not rationality, which can open the door for profits when the excessivepessimism is corrected (see Figure 8.3).In sum, while scholars are fond of the efficient market theory, history shows that investors do not always react in a rational manner andtherefore stock prices do not necessarily reflect all available information. Instead, investors or the “crowd” tend to overshoot at times. Savvytraders who can identify these opportunities can generate profits usingindex strategies. In Chapter 10, we discuss sentiment analysis andprovide some tools that traders can use to identify episodes of extremefear and emotion.
EARNINGSObviously, fear and greed are not the only factors that drive stock prices.Fundamentals and valuations will have a more lasting effect. In the stockmarket, the earnings outlook is the single most important fundamentalfactor to consider when trying to anticipate trends. As a company increases profits, its share price becomes more attractive. Over time, asprofits increase, successful companies distribute part of their profits totheir shareholders in the form of dividends.
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For example, consider Microsoft (MSFT). The software giant paidout a special $3.00 dividend in 2004. This one-time dividend represents areturn of profits to shareholders. That return of profits was three timesgreater than the price of the stock 15 years earlier. So an investor whohad bought shares in 1990 would have tripled their money with that dividend alone!As companies increase their profits and pay dividends, the shareprices become more interesting to investors and prices tend to riseas the outlook for future earnings improves. When aggregate earningsare growing at a fast pace, the stock market tends to perform well.When earnings are expected to decelerate or decline, stock prices willstall or move lower. A recession represents an extreme period for suchdeceleration.
Tools for Evaluating Earnings for an IndexIn addition to the earnings growth rates for the market, various valuationratios can be used to gauge the relative value of an index. For example,the price-to-earnings (P/E) ratio can help determine whether the market isattractive for trades to the upside. In general, the strategist will want tosee higher levels of earnings growth when P/E ratios are relatively high.Table 8.1 provides a few other tools for evaluating the relative value of theDow and the S&P 500 Index.
How do we measure earnings growth? The most common measureis year-over-year earnings growth on a quarterly basis. For instance, thetotal earnings for the first quarter of one year will be compared to thenext quarter. It is important to note that investors are generally moreconcerned with future earnings growth. Therefore, earnings expectations with respect to future quarters is often more important than present earnings.Table 8.2 shows the expected earnings growth rate for three S&P indexes for the first three quarters of 2004, projected in March 2004. TheS&P 500 Index ($SPX) was expected to show solid earnings growth duringthe next three quarters. Those expectations helped to drive stocks higherin the months prior to these actual earnings reports. From September2003 to March 2004, the S&P 500 Index rose 15 percent. The Small Cap 600($SML), which was expected to show even better growth, rallied 22 percent during that same time frame.
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TABLE 8.1 Relative Value of the Dow and S&P 500 IndexNow
One Week Ago
One Year Ago
10,778.58
10,877.51
10,543.22
P/E ratio
18.96
19.01
17.54
Earnings yield (%)
5.28
5.26
5.70
568.59
572.32
601.02
Dow Jones Industrial Average
Earnings ($)Dividend yield (%)Dividends ($)
2.29
2.27
2.26
246.78
246.54
237.85
Market to book
3.21
3.24
3.61
Book value ($)
3,359.70
3,359.70
2,918.09
S&P 500 Index
1,259.37
1,265.08
1,188.00
P/E ratio
18.86
18.95
20.57
Earnings yield (%)
5.30
5.28
4.86
Earnings ($)
66.76
66.76
57.75
Dividend yield (%)
1.82
1.81
1.72
Dividends ($)
22.92
22.90
20.43
Market to book
3.04
3