hard-dollar prepayment penalties as a matter of ordinarybusiness, but no more. With the deregulation of interest rates and the fullerdisclosure of lending practices beginning in the late 1970s, lenders cannotthese days freely pick our pockets just because we wish to reduce our levelof debt. Instead, they fold the cost of the prepayment option into the interest rate of the loan. So, what does this option cost? The practical way to discover its cost would be to approach two lenders and ask one for a standardloan, however defined and of a specific term, which we can prepay whenand as we wish, and ask the second for an identical loan that we specificallycannot prepay. It would be very instructive to learn how much the secondlender would discount the interest rate on his loan.Loans are just one way in which you deal in options. Very possibly, especially during the recent bull market in stocks, your company might havegranted options to you on its own shares, many times with an exercise pricebelow (or way below) the current market price of the shares. These are calloptions by definition, of course. You have the right but no obligation at all topurchase your company’s shares, under stipulated conditions, and prior toa certain date. The cost of these options to you is the expenditure of yourtime working for the company. Obviously, you will make your own decisionas to whether this is a fair and worthwhile expenditure, and whether theseoptions, in combination with your wages and any available non-wage benefits, represent good value regarding your time and effort. Regardless of thedecision you ultimately make, though, you are dealing in options.Do you use retail stores’ coupons? You deal in a type of call option ifyou do. A store will sell you merchandise X at a reduced price Y on or before a particular date if you hand in the coupon when you buy X. Thesecoupons are partial call options having the wonderful immediate price ofzero. If you’ve a coupon in hand, you have the right, but no obligation whatever, to buy that merchandise at that store at the named price or with thenamed discount, on or before the named date. Your actual cost of this option is the incremental time and expense of going to the store that honorsthe coupon, which may well be zero if you had intended to go to that storeanyway. The retailer or the manufacturer of the underlying product is writing this type of option in the hope that you’ll purchase other products whileyou’re in the store.You don’t deal in options, eh? Pardon me, but that’s simply a false belief, if you still hold on to it at this point. These are but a few examples. Themore interesting question is, since you already deal in options, why not usethem to your advantage in your trading? Lenders do quite nicely by writinga prepayment option into your loan and charging a higher rate of interest.Companies retain good employees by writing nominally cheap calls on theirshares, which the employees, presumably, will exercise for a profit at some
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point in the future as the company prospers. Groceries and retailers generally, and lots of manufacturers, do very well by writing discounting calls,coupons, or special offers, against your purchase of the products they sell,as an inducement for you to purchase more of them.Isn’t there something rather curious here? In each of these everydaycases, someone writes an option in order to achieve or help achieve a profitor business or marketing goal. These option writers gain by your acceptanceand use of the options they write, even if you are (sorry, “have previouslybeen”) unaware of their existence, true? Is there some reason that you andI and the trader down the street should decline to use a similar tactic ofwriting options in our markets when and as we find this tactic to be advantageous to us? The only rationale that I can see for not applying various formsof this tactic to our trading is a combination of (many) traders’ unfamiliarity with options trading and the presence of yet another myth.
Unlimited Risk, My Foot—An Amazing MythOne of the most pernicious myths ever propagated by ersatz experts, and,oddly, by not a few thoroughly real experts too, has to do with one specifictactic that we might employ in using options in our trading. This is the mythof “unlimited risk” when a trader writes an option without also having anoffsetting position in the underlying asset. This tactic is usually called writinga “naked” option, and this myth is incredibly pervasive. Some of the world’sfinest writers on the subject of options, Larry McMillan and Sheldon Natenberg among them, use the phrases “unlimited risk” or “unlimited loss” whendiscussing naked option writing in their books. This viewpoint just bogglesthe mind. Let’s take a very stern and objective look at this myth, with theclear intention of putting a case of dynamite and a fast fuse right smackunderneath it.Pick a market, any market, stocks or futures or, for all it matters,nineteenth-century bowling balls (although we should suspect that the liquidity in this last market is a trifle too low for us to trade successfully, andoption trading in this market is likely extremely thin). Take two positions inthis market that will profit if this market moves up (or down, we can just aseasily construct an example for the other direction). Let’s say that today isJuly 7, and we buy December Chicago wheat at tonight’s price of $3.333⁄4per bushel for one position, and write a December wheat 330-strike put for17 3⁄4 cents for the other one, temporarily pocketing the option premium. Ifthe price of December wheat goes up between now and November 22 whenthe option expires, we will profit on both positions. If the price in November is within a few cents either side of tonight’s price, we’ll profit by writing the option and will make or lose a few cents on the purchase of the
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futures contract. Obviously, our trading risk shows up when the wheat market goes down.Fine. Suppose July wheat goes to $2.00 between now and November 22.If we take no action in either position, we’ll lose 1333⁄4 cents on the future,plus contest risk. Now, the put option will be in the money (ITM), by 130cents and will be priced almost exactly at that number, call it 1301⁄2, showing a loss of 112 3⁄4 cents (1301⁄2 – 17 3⁄4), plus contest risk. My, my . . . how odd.The dollar loss in the option position is less than that in the futures position.Looks like the option trade, in terms of pure dollar loss, is slightly less risky.“Wait just a dang minute,” I hear you shouting. “I’m not gonna stay longDecember wheat all the way down to $2.00! You think I’m nuts? I’ll have astop-loss order in there right away, and if it goes down 20 cents [or whatever amount you choose to risk], I’m out.” Sure you will, you’re not crazy. Iwill, too. So will Tom Clancy, Derek Jeter, the President, and GeneralGeorge S. Patton, Jr. . . . and he’s been dead for 58 years.And—guess what—so too will the trader who wrote the put option. Theassorted commentaries concerning the so-called unlimited risk involved inwriting naked options all appear to assume that a trader, just because heuses this tactic, has an extra strand of the stupids embedded in his DNA.Does an option writer spontaneously fall into a coma or something when aposition goes against him? What nonsense! Just as those who trade in theunderlying asset, the option writer will take some appropriate action tolimit his loss, unless he happens to be a certifiable idiot. While there is noformal stop-loss order available to option traders, you, I, or anyone will liquidate the option trade (or possibly defend it, as we’ll discuss in Chapter 7)at or near a pre-determined loss point, just as the asset trader would.When we write a naked option, we accept a known maximum potentialprofit and an indeterminate loss if the market moves against us, but the horrific prospect of unlimited risk is simply false to fact. The risk in writingnaked options is the change in the ratio of potential profit to potential loss,compared to the potential profit/loss ratio when we either trade assets orpurchase options, considered over all the prices to which the underlyingmarket might move until the option expires. Sound familiar? It should.This so-called unlimited risk turns out to be nothing other than our oldacquaintance, expectation. If our expectation in writing an option, eithernaked or covered by an offsetting position, is positive, we’ll consider undertaking the trade. If not, we’ll find something else to do. If our expectation is initially positive, but begins moving toward negative territory duringthe term of the trade as the market moves hither and thither, we’ll either liquidate the position or take defensive countermeasures, certainly before theexpectation of our trade actually becomes negative.This mythical and widely vaunted notion of unlimited risk turns out tobe just a variation on the logical fallacy of assuming one’s own conclusion,
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to wit, that the potential loss is unlimited because an option writer won’ttake action to limit his loss, but an asset trader will. Please excuse me for amoment while I light this little fuse. There we go. . . . hisssssssssssssssssss.. . . BOOM!
Fanatics Are, Well, FanaticsThe preceding commentary, sadly, does not (and I’ve had this discussionmany times) deter the true unlimited risk fanatic at all. He, she, or it will ask,rather stridently as a rule, “What about the December S&P Index futures onOctober 19, 1987?” “What about December Japanese yen on October 6,1998?” or “What about April 2000 platinum on April 20, 2000, or July 1973corn on July 17, 1973?” These dates saw some of the largest one-day movesin futures markets in modern history.Yawn. Oops, pardon me. Dealing with fanatics is a little tiresome. Assuming only that our hypothetical option-writing trader has even a little discipline, avoids writing options in markets having excessive native event risk(palladium, to name just one), and hasn’t recently been lobotomized, none ofthese exceptional moves were, would have been, or could have been morethan a minor problem. Only one of these extreme price moves, the Japaneseyen debacle, held any more risk for a naked option writer than for an assettrader. The risk to an option writer in two of these cases was exactly zero. Norisk existed, no matter how much the underlying market might have moved.In the remaining case, a naked option write would never have been undertaken in the first place by any marginally rational retail trader, and surely notby you or me. Let’s break these four examples down, right now.July 1973 corn? On July 17, 1973, the market went up fully $1.30 perbushel during the trading session, the largest single percentage intradaymove I’ve ever been able to find in modern futures markets. This date wasthe last trading day for the contract, and this was one heck of a move, about60% of the corn contract’s value the night before. There’s just one smallproblem here for our unlimited risk fanatic. Options on futures were illegalin 1973. There were no such things. There was no unlimited risk becausethere were no options. Scratch one example.Please allow me a small digression here. There’s one point to make abouttrading late-in-the-life futures contracts, options aside. Any trader who holdsa long futures position into the contract’s notice period (wherein the tradermay be assigned delivery of the goods described in the contract) and is notprepared to accept that delivery needs to reexamine his dangerously flawedideas about risk, reward, and expectation. In the plainest possible English,don’t even think of staying in a long position into the notice period, no matter your position or market view, unless you’re prepared to settle the contract via delivery and a subsequent redelivery.
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The experienced futures trader may say, “Big deal, I get delivery. So, I redeliver, what’s the problem?” While it’s true enough that redelivery is generally a straightforward process, and your brokerage has surely handled manythousands of such transactions, the fact of the matter is that it’s expensive.How does a minimum cost of $600 per contract in live cattle sound to you?Other markets are less confiscatory in terms of their delivery/redeliverycosts, to be sure, but in every market you will be voluntarily increasing yourtrading costs, your contest risk. This isn’t penny-wise and pound-foolish; thisis plain old pound-stupid. Don’t do it. By hook or crook, exit any long positionyou hold before the notice-of-delivery period begins.The opposite case, holding a short position into the notice period, may ormay not pose a related problem. Delivery is not an issue here—you, as theshort-seller, are the party who decides whether or not to make delivery, andyou and I most certainly won’t be doing that—but the approach of expirationof the contract is of serious concern occasionally. Suppose the shorts in amarket have difficulty acquiring the goods to deliver, or the goods are in thewrong place (for example, San Diego instead of New York in the case of unleaded gasoline, and a swap can’t be arranged for some reason).The shorts, in this situation, may get hammered by a short squeeze. Thelongs, the owners of the futures contracts the shorts have sold, can demandvery nearly any price for the contracts that they want, and the short-seller willhave to pay it in order to clear off the short position. July 1973 corn was aclassic example of this situation, with some shorts having to pay upwards of$6,000 extra per contract just to get out of the position. You and I can’t standthe gaff in this game, and the lesson here is completely clear. Don’t stay shortwhen there are only a few days left in a delivery-settled market (this is lessrisky if we’re discussing a cash-settled market such as lean hogs, but it is stillan undesirable tactic). Enough digression; let’s return to blowing up themythos surrounding unlimited risk in naked option writing.What of our second example, the April 2000 platinum market? It ran upa tidy 41.59% on April 20, 2000. Sorry, Mr. Fanatic, but this alleged examplewas just a variation on the July 1973 corn theme, a classic short squeeze onthe contract’s last day of trading. Now, options did exist on the April 2000platinum contract, but, terminally fatal for your argument, they had expiredfully a month before the squeeze materialized. Whether platinum optiontraders had profited or lost when the April 2000 options expired, thesetraders certainly weren’t put at risk by the last-day shenanigans in that market. They weren’t even in the market at that time. Scratch two.Black Monday? The date of the downfall of portfolio insurance and the23% drop in the Dow Jones Industrial Average? If you had written naked putoptions on S&P futures sometime before that date, you have my sympathy,but wait just a minute here. You had all the previous week to remove yourposition, and you must have been quite mad if you wrote or sat with naked
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short puts during that previous week, too, because the various indexes hadmoved straight south throughout. Is this 20-20 hindsight? Not a chance.Kid yourself if you wish, but don’t kid me. The three trading days priorto Black Monday had already constituted one of the most severe short-termmarket drops in history. Who wanted to write or hold short the index putoptions during that week? Only bottom-fishers. Greedy bottom-fishers. Formerly solvent bottom-fishers. Taking or holding such a position, indeed anyposition, under the circumstances in force at that time and in that market,was nothing other than gambling at its utter worst. An old Chinese proverbapplies fully here, and traders should always keep it in mind: when elephants fight, hope for the shade. Frankly, I’d say, run for the shade.If you believe that event risk when trading stocks is disproportionatelylarge compared to event risk in other markets (and I hope by now that youdo), then why in the world would you as a disciplined trader consider writing naked index put options, then, now, or at any time? The historical returnon your capital when writing these options, then as now, is rarely better thanmediocre when compared to employing the same tactic in many other markets. I’ve asked this question of a number of traders, and usually the answeris something like “Well, indexes are less volatile than individual stocks,they rarely have large gaps in prices, so it’s safer to write options on indexesthan on individual stocks.” Sigh. The continuous market fallacy rides again,and again, and again.Aarrghh! True, America’s stock markets rarely crash, but when they docrash, they crash more viciously than many other broad markets do becauseof the asymmetry between buying and selling short that we examined earlier. This asymmetry creates an ongoing and variable amount of pent-up desire to sell that cannot find expression in the normal market mechanism.Call it a selling panic waiting to happen. Furthermore, the histories of allstock market crashes that I can find are identical in one respect at least: thebear eats everything at the picnic, indexes included, and well before thedessert course, too. This notion of the relative safety of indexes during acrash is the merest moonshine, and it’s 200-proof corn squeezins’, too; it’sdownright deadly.What rational trader, particularly a retail trader, wants to attempt to earnsome very ordinary return on capital by accepting such a risk? Who, barringa very greedy, almost lunatic, trader would even consider jumping into a potential market crash situation and write puts? I don’t care if these marketcrashes only occur as often as the Arizona Cardinals win the NFL championship (they’re considerably more frequent, of course), this risk/reward situation is ridiculous. Do as you like, certainly, but this trader, your humbleauthor, absolutely never writes, nor ever has written even once, naked putoptions against stock indexes. If we don’t play a particular game, our risk inthe game is zero. Scratch three.
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The marvelous run-up of the Japanese yen against the dollar on October 6, 1998, in overnight forex trading, and in the Globex futures traded onthe Chicago Mercantile Exchange’s IMM, may appear to be a conclusivecase against naked option writing and for unlimited risk, but it isn’t. Fromthe Asian currency meltdown of 1997, the Russian default in August 1998,and the so-called contagion that hit a bunch of Latin American currenciesthroughout the same time frame, the currency markets were pretty wellscrewed up. This wasn’t any secret to anyone. Even those persons who claimto have learned how to trade cattle futures by reading The Wall Street Journal probably (no guarantees from me) had this one figured out. Nobodyknew what the blazes would happen with a number of nations’ currencies,and everyone was running scared.I won’t waste my time and yours weeping for the demise of a gold, orany other, standard, but the plain fact is that every national currency todayis money only by fiat and at the point of a gun. Stripped of lofty-soundingfrippery, currency trading was then, in 1998, and is still today a gigantic andcomplex variant of the card game we used to play as children, “pass thetrash,” sometimes called “screw your buddy,” which is an accurate if mildlycynical description of currency policies among nations.No longer is any nation’s currency, to quote one classical definition, “ameasure of value and a storehouse of wealth.” These days, currencies areonly units of account, economic constructs to facilitate commerce, andlevers to be used as convenient against one or another of a nation’s tradingpartners. All right, fine. If governments want to trade paper, traders will accommodate them. And, when government financial authorities, figurativelyspeaking I presume, start snorting PCP and smoking crack, as when theBank of England attempted to maintain a fiction about the pound’s value inSeptember 1992, traders will tear them to pieces. But, we’re discussing theastounding yen move in October 1998, so let’s return to that.As it happened, I had had an attack of the stupids and was short a fewcontracts of 1998 IMM December Japanese yen futures at the close of theday session on October 6, 1998. The position was mildly profitable at thatpoint. I’d thought about writing a few put options to protect the position,but I hadn’t (and I certainly should have, too, from the essential standpointof reducing risk in a wildly volatile market). Early in the Globex overnightfutures session, yen exploded just upward against the dollar. The sequenceof action was amazing. Up and up yen moved, stopped for a cup of coffee,and then moved up some more. No one seemed to know what was happening except that a number of large market participants were unwinding thefamous “carry trade,” the arbitrage between Japanese and other nations’ interest rates, which unwinding required the purchase of yen and the sale ofother currencies. LTCM was rumored to be involved, and at that time, whenmany traders were at least vaguely aware that its collapse was imminent,
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even the mention of that name being active in a market was enough to shiveranyone’s timbers.The only thing I was absolutely certain of during that night was that Ididn’t have the faintest idea of what was going on, and I got the heck outof Dodge City. Not very gracefully, either, because I cleverly (cough,choke) managed to sit still too long and turn the existing profit into a loss.About 3 A.M. local time, disgusted with myself for having been slow to exitthe trade, I bought a single contract of December yen (another very stupiddecision, considering the risk—never trade when you’re tired), entered astop limit order 110 pips below the market, and went to bed. The nextmorning, I learned that yen had continued zooming higher and that my earlier loss had mostly been recouped. Huzzah! . . . mutter, grumble. I sold backthe 1-lot and that was the end of that trade. Lots of aggravation, due to agood deal of incaution on my part. Not a penny of profit—and I didn’t deserve any, either, having been some combination of stubborn and stupidalong the way.Now, suppose instead of being short yen futures, a trader had beenshort an equivalent number of naked calls. Options trading on IMM/CMEcurrency futures is non-existent during the overnight Globex market, sowhat could an option writer do to protect himself, to limit or rid himself ofrisk? He might buy some quantity of the futures, sit still until the day session opens, and then liquidate the entire trade or adjust it further so that theexpectation of the trade is again to his liking. He might execute an EFP, anexchange for physicals, which, depending on the terms of the EFP, mightserve as well or better in the cause of risk reduction, but which would typically involve extra costs and wider bid-ask spreads. He might go to the interbank foreign exchange market to hedge his risk, but in doing so mightand very likely would create other different risks, and would absolutelyincur extra trading costs. He might try to purchase calls, similar to those hehad previously sold, during the Irish session on the FINEX exchange, butusually the bid-ask spread is very wide in that market, and on that particular night the spread must have been nearly unbelievable.Of these tactics, the first usually involves the lowest cost and is definitely simpler than the others, and probably would have been the bestavailable way to proceed. This tactic reduces the remaining overnight riskto that of the occurrence of a sharp reversal, a whipsaw, and in wild markets such as yen was that night, a whipsaw was a distinct possibility. We’dalways prefer to avoid such a risk, of course, but first things first—whenwe’re under the gun in an existing position, we must deal with the risk athand before worrying much about risks in the future.Even supposing a trader had been short naked calls on yen on that explosive night, where’s the unlimited risk? All trades except certain arbitragesinvolve some risk, but is a risk unlimited simply because a trader employs
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one tactic instead of another? Sell that stuff to the financial press if you will,but don’t try to sell it to anyone who can add. The ultimate point here isthat, as long as some countermeasure is available, whether to exit a trade,hedge it, or employ some other tactic, the risk in any position can be limitedor eliminated, assuming only that the trader is alert to the risk. In this ferocious yen move, the naked call writer did indeed have more risk than thetrader who was short the futures, said extra risk being more contest risk andthe added potential risk of a whipsaw when defending the position overnight,but unlimited risk? What arrant rubbish! Scratch four.The next time an unlimited risk fanatic crosses your path, don’t wasteyour time trying to persuade him, her, or it of the error of its ways. After all,the fanatic just might be the person to whom you and I may be selling options in our next trade, and we can both use the money, I’m sure. Let the fanatics savor their own delusions undisturbed.
Stocks Good, Futures Bad—Shades of“Animal Farm”Shortages of various goods occur occasionally, but there is not now nor everwill be any shortage of myths and moonshine about markets. Here’s another common one. How many times have you heard someone pontificateabout markets, something along these lines: “The stock markets createwealth. When you buy shares, you assist a company in raising investmentcapital that the company will use to build plants, employ people, or makebetter products, and profit thereby. Mathematically, stock trading is apositive-sum game, but futures markets are a zero-sum game that onlytransfers capital from one person to another.” If you’ve traded in marketsfor any length of time, I’d be willing to wager hard cash that you’ve heard orread these or some highly similar sentiments. If you have, memorialize theoccasion on which you did, for you’ve actually run across a truly worldclass moron. These are scarcer than you might think, if we exclude politicians from consideration.Remarkably goofy statements like this are factually incorrect in all particulars but one. Stock and bond markets are absolutely mechanisms forraising capital, but you and I, and that famously cited pair, Mr. Smith of Portland, Maine, and Mr. Jones of Portland, Oregon, never have contributedmore than the tiniest pittance toward this process. Why? Companies raisefunds only through the issuance of new shares or new bonds. For our part,unless we happen to purchase shares during an IPO or a treasury offering,the company itself will never see a penny of our capital, and the same is truewhen we deal in bonds. The rest of the time, these shares and bonds are exchanged among specialists, market makers, traders, investors, investment
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bankers, and mutual funds. The company in whose shares or bonds we tradeis simply not in this loop, as regards raising new funds after the initial issuance of the instruments in question.More laughably yet, our pontificator or anyone who utters a sentimentlike this one either never took or flatly failed his university courses in gametheory. Trading in any market is always negative-sum, in and of itself, because some fraction of capital is removed from the game with every singletrade we make, unless we can somehow trade completely cost-free. In apositive-sum game, some external source would be continuously injectingcapital into the game, by definition, and in a zero-sum game no capital wouldever enter or exit the game, by definition. Pontificators who utter nonsenselike this deserve nothing more than a polite invitation to have anotherdrink.Next, the stock markets create no wealth whatever. Wealth is createdby the application of capital, effort, and management skill to a business enterprise over time. Prices of shares reflect this process in theory, but theyneither initiate nor maintain it, and this actuality is all the difference. Finally, of course, the purpose of a futures market is not to create wealth, butto allow for the transference of risk from the producers and users of various goods and financial instruments to traders who will accept that risk inan attempt to make a profit. Our pontificator might as well whine about thePresident not being a competent left tackle. That’s not his job, just as creating wealth is not and never has been the task of the futures markets.You may very reasonably wonder why I would even bother becomingannoyed with phantasmagoric statements like the one at the beginning ofthis section and with the people who make them. What effect can such silliness have upon our trading results? That’s an easy one. The first part of theanswer is, “None, unless we let it.” The problem is that you and I may hearor read such a statement, or any comparable potful of drivel, uttered bysomeone who has a large reputation as an expert in investing or markets ortrading. We all are subject from time to time to being beguiled by the pronouncements of people whom we may perceive to be experts, and we mayoccasionally forget to analyze their statements objectively.The second part of the answer is, whether our pontificator intends to ornot, he is engaging in psychological warfare against us. Our pontificator obviously favors dealing in stocks over dealing in other markets. That’s fine,and more power to him in his view, but instead of offering coherent reasonswhy trading in stocks is more advantageous to us, he merely recites erroneous platitudes and disparages other markets that he dislikes, expressinghis view by mumbling pseudo-academic twaddle. Statements such as hisare attempts to introduce doubt, or even some weird sort of guilt, into ourminds regarding the relative risk advantage that we careful traders enjoy intrading in markets other than the pontificator’s favorite. Our pontificator is
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the personification of information or knowledge risk, and we must utterlyostracize him and his ilk at all times. We’d do much better listening to Typhoid Mary discussing modern hygiene.
Profit Depends on Minds, Not MarketsTrading is about making a profit, in the best case by applying a disciplinedmethod and an organized set of strategies over time. The markets in whichwe traders may deal are irrelevant to the activity of trading, except regarding the relative level of advantage we may obtain by dealing in one marketand shunning another. I’d be perfectly happy to trade tiger shrimp, tigerlilies, Bengal tigers, or Kellogg’s Frosted Flakes if I thought I understoodhow to profit by doing so.Consider. If you and I would restrict our trading horizons by heeding theviews of every purported expert to come down the pike, we’d very quicklyfind ourselves not trading at all! It’s a lock cinch to locate an expert who dislikes any given broad market, any specific market within that broad market,or any given trading strategy we might employ. All other considerationsaside, we should elect to trade in any market in which we can demonstrateto our own satisfaction that we can generate an advantage, and we shoulduse whatever strategies will facilitate our claiming that advantage. Devil takethe ersatz experts, the moonshiners, and the mythologists.No part of this chapter is about bashing any other trader or any particular methodology. If a trader is successful in applying his methods, I cheer,whether I understand the methodology or not. I like winners. In his bookPit Bull (HarperBusiness, 1998), Marty Schwartz explained his methods ina general fashion, and his methods assuredly work for him. The