to sell thestock (short exempt) and exercise your call. In this manner you achieve parity as the net price for your call. Suppose the following prices exist on expiration Friday of January expiration:XYZ: 23.50 bid, 23.60 offeredXYZ Jan 20 call: 3.40 bid, 3.70 offeredAt these prices, the market makers are setting the bid an eighth belowparity and are setting the offer 10 cents above parity. This is fairly typicalfor an in-the-money option at expiration.You own the Jan 20 calls, and you attempt to sell them at 3.50. However, the market makers don’t budge, and time is running short. You cansell the stock at 23.50 (where it is bid) and exercise your calls, thereby buying the stock at 20. In effect, you have sold your calls for 3.50.How much you have to pay out in commissions has a major effect on theoverall net money received from these trades. Suppose you are normallypaying $4 per option and 8 cents per share of stock as commission rates.Let’s compare the two choices that this trader has: (1) selling his callat 33⁄8, where it is bid, or (2) selling the stock and exercising the call, asjust detailed.(1) Net money from selling call at 3.40:Sell call at 3.40:$340.00 creditCommission:4.00_______________Net credit:$336.00 credit
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(2) Net money from selling stock and exercising:Sell stock at 23.50:$2,350 creditCommission on stock sale:8 debitExercise (buy stock at 20):2,000 debitCommission on stock purchase:8 debit_______________Net credit:$ 334 creditThe two methods produce virtually the same result, so you seem to bejust spinning your wheels to go through with the stock trades. The betterprice achieved is eaten up by the extra commissions.However, many brokers will discount stock commissions on tradesinvolving exercise or assignment. Suppose that you receive a 50 percentdiscount on exercises and assignment. Then your net credit from method 2would be $342 ($350 credit from the stock trades, less $8 in commissions).If that were the case, it would make sense to use method 2.
Another important feature to consider when selecting a brokerage firm is margin rates, especially for the treatment of nakedoptions. If you are a strategist, you almost certainly will be tradingnaked options at some time or another. It might arise from sellingnaked puts to simulate the covered writing strategy; it might comefrom ratio writes to take advantage of expensive volatility; or it mighteven evolve out of something simpler, such as selling out the longside of a bull spread that is out of the money and letting the short sideexpire worthless.Some option firms don’t allow naked option trading at all. Avoidthose firms, unless you never plan to do anything besides buy options.Other firms heartily discourage naked option trading by imposingonerous margin or equity requirements. It has been explained that theexchange sets minimum margin requirements for naked option selling. Select a broker who uses the same standards—exchange minimum margin requirements. This goes for futures and futures optiontraders as well. Use a brokerage firm that adheres to exchange minimum margin requirements. In fact, futures option traders shouldrequest SPAN margin, which is even more favorable than exchangeminimum. SPAN applies logical price projections, which include the
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use of volatility, to naked options to arrive at margin requirements.While I wouldn’t consider it absolutely mandatory for your broker toallow you to use SPAN requirements for your futures option positions,it would certainly be worth requesting.The final point I would like to make about selecting a broker is tofind one who trades all markets; specifically, this means index,equity, and futures. Later, we encourage you to trade all markets; butin order to do that, you have to have a broker (not necessarily thesame broker that executes your stock and stock option trades) whocan execute those trades. Even if you don’t plan to trade futuresoptions, for example, you will almost certainly have to if you aretrading Standard & Poor’s 100 Index (OEX) options. You mayrecall the story of the 1989 crash, where OEX options ceased totrade and the only thing that prevented disaster for those traderswho were naked OEX puts was to be able to sell Standard & Poor’s(S&P) 500 futures. We have also pointed out that it is sometimesmore efficient to trade S&P futures than OEX options if impliedvolatility is too high.
Data VendorsMany traders and investors are using their home computers to act asquote machines. There is a wide variety of products and services onthe market, and more are being introduced all the time. Thus, whilewe attempt to survey the landscape accurately at the present time,you must understand that technological advances might presentother opportunities in the future.When deciding to select a data vendor, you need to consider several things, including whether you need real-time or delayed prices,how you will physically receive the prices, and what type of softwareis able to work with the prices you’re receiving.
Costs. When buying stock or futures market data from a vendor,you have two costs to consider: (1) the service charge imposed bythe vendor and (2) the exchange fee imposed by the exchange thatoriginally disseminated the prices. In essence, the vendor buys the
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prices from the exchange and then resells them to its subscribers. Ifthe end user (you) is only interested in delayed quotes or end-of-dayclosing prices, then there is no exchange fee—only the vendor feeneed be paid.However, in a rather archaic setup, the exchange is entitled to collect exchange fees from every end user of its real-time prices. Therefore, if a trader needs real-time prices, he must pay the exchange fees,too. In the modern world of competitive (and decreasing) costs fordata of all sorts, it seems unreasonable that the exchanges can imposethese fees. However, at the present time they can, and they do. Theseexchange fees can be quite modest for individual investors; for example, the New York Stock Exchange (NYSE) only charges $4 permonth for their quotes, if they are disseminated to an individualinvestor. However, professional investors—and that is defined ratherbroadly by the exchanges to include everyone who is trading for anaccount other than his own—must pay considerably more. Moreover,the futures exchanges’ fees are quite a bit higher than most stockexchanges.If you are only interested in stock and option quotes, you can probably get them real-time for less than $100 per month. Delayed or closing quotes can be obtained for $20 a month or less. However, if youwant real-time quotes on all the stock, option, and futures exchanges,you are probably going to have to pay costs of $500 a month ormore—and that doesn’t include much in the way of analysis programs.
Data Connection. The next feature that must be considered ishow you are going to get the prices, physically. Most investors whoare interested in doing their own analysis pull the prices into theirown computer and then run various software programs (chartinganalysis programs, for example) on that data. However, it isnot absolutely necessary to have a computer and software in order tobe able to receive pricing data.If you only want to see quotes and you move around a lot, youcan get them on handheld devices—usually cell phones with textmessaging, personal digital assistants (PDAs), or pagers. Thesedevices also let you see news headlines in many cases. Data Broadcasting Corporation is reintroducing a more sophisticated handheld
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device, called a Quotrek—which was very popular at one time butwas then phased out.However, if you are going to perform any analysis, then you willneed to have a more sophisticated way of getting and handlingdata—using a computer. There are essentially three methods bywhich you can observe and analyze prices by computer: (1) you canuse your own computer to access another computer and observeanalyses on that computer; (2) you can use a terminal supplied by thedata vendor that performs specific tasks and connects to the data vendor’s main computer; or (3) again using your own computer, you candownload data and analyze it with your own software.In method one, the trader doesn’t have to actually subscribe toa data service, per se. The vendor whose computer he is accessingpays the exchange fees and charges the end user a unit charge foraccess to the main computer. This unit charge might be a flatmonthly fee, or it might be a fee based on the amount of time thatthe user is logged onto the main system. Examples of this type ofdata connection might include any number of Internet providers,where the trader can log into their web site and look at prices oranalyses. This is an increasingly popular way to access data and outputs, as the Internet has gained popularity and speed. The StrategyZone, at our corporation (www.optionstrategist.com), is one typicalexample of this sort of access, where you can view charts of put–callratios, charts of implied volatility, precanned reports showingexpected returns and probability analyses for major strategies; or adaily market commentary; or just look at lots of option and volatilitydata. If you want a more interactive experience, something likePowerAnalyzer can provide it. Prices generally vary, based on thedepth of the analysis provided.The second method of getting data is to install the vendor’s terminal at your home or business site. This can be a rather expensivemethod, but it has some advantages, especially for sophisticatedusers. Perhaps the best known of this type of data vendor isBloomberg. Bloomberg terminals can be found all over the world,mostly in professional trading rooms. A Bloomberg terminal isinstalled at your office and is connected to the main Bloomberg computers by a direct phone line. A direct phone line is one that is dedicated to a specific purpose, in this case, to linking the terminal with
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the main computer. A direct phone line can cost upward of $500per month, and the rental cost of a Bloomberg terminal is $1,500per month. In reality, a Bloomberg "terminal" today is really a Dellcomputer that you lease from Bloomberg with all the softwareinstalled on it.For this rather large cost, you receive a vast, startling array ofdata. There are voluminous quotes, not only on listed securities butalso on bonds and foreign stocks; and sophisticated analyses areavailable at the press of a key on the terminal. Option implied volatilities and historic volatilities on the underlying— graphed right on theprice graph of the underlying security—are readily available, forexample. Moreover, some of the most sophisticated research onWall Street can be read by Bloomberg users, although much of itrequires an additional fee for access. In addition, shopping can evenbe done on the Bloomberg terminal, although that is hardly a reasonto go this route—it’s just an added feature.The third method of receiving data is to have the data comedirectly into your own computer. This is what eSignal, Realtick, PCQuote, DTN Wallstreet, S&P Comstock, and others supply. WitheSignal, you can subscribe to real-time prices, 15-minute delayedprices, or just closing prices. Each one has different costs, with thereal-time data being the most expensive. All of these systems areweb-based at the present time, meaning that you install their software on your computer, and then you can access their data. Plus, allof these services offer some sort of charting, option montages, newsretrieval, and so forth. Some of these services are add-ons, for whichthere are extra charges. In all cases, your computer can act just like abroker’s quote machine. Of course, this ties up your computer whilethe software is running, so many investors actually buy a secondcomputer to act as a quote machine.There are at least four ways that data can physically be delivered to your home or office: (1) dial-up phone line, (2) high-speedInternet, (3) cable modem, and (4) satellite. Also, there are severalforms of high-speed Internet connection: T-1 line, DSL, and someareas in between. T-1 and DSL are phone lines, too, but they aremore expensive than a typical phone line. T-1 is the widest bandwidth and is the most expensive. The others are much less expensive and probably would serve most customers nearly as well.
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Remember, though, that if you are watching streaming quotes allday long and accessing the Internet for other uses, you are going toneed a relatively large band width to keep things flowing at a highrate. Satellite can be fairly expensive to have installed becausesomeone has to put the dish on your roof and get things started.Any of these can fail on you; but in my experience cable is probably the most reliable (mostly because everyone would be screamingmad if their TV wasn’t watchable for any length of time).Finally, it should be noted that you can buy data and process ityourself. Genesis Financial Data Systems (www.gfds.com) and TheBetter Software People (www.tbsp.com) are both good sources ofclosing price data, including bids and offers. Of course, then youwould have to write programs to analyze the data or hire a programmer to create those programs. Because of the programmingrequirements, this method is only applicable to a few traders; butsome do enjoy doing their own programming.
SoftwareAs mentioned earlier, when you have an online brokerage account,there is a software interface that allows you to view the data and toplace your orders. In some cases, the software interface is quite complete; but in others, you may want to buy or create some software forfurther analysis. One thing that an option trader should look for insuch software is a good option montage—the page that shows anumber of option contracts on the same underlying at once. This isnecessary for spread trading.With Realtick, for example, which is the interface for a numberof online brokerage firms, you have the ability to view a myriad oftechnical indicators, to draw charts, and to view one of the bestoption montages available (with Realtick TurboOptions). Whatmakes the TurboOptions montage very useful is that the optionmonths are easily viewable on the same screen so that you can lookat calendar or diagonal spreads very easily. However, if you want toview vertical spreads (in the same month), you can expand the montage to view a lot of different strikes all in one month. The montage
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is capable of displaying option theoretical value calculations based oneither the Black-Scholes or the Binomial models and can show the“Greeks” and implied volatility for each option. The charting software incorporates many of the most common technical indicators—moving averages, ADX, RSI, and so forth. Realtick interfaces directlywith order-entry software, so trading is simple, right from the optionmontage or from the stock’s market-maker screen.eSignal also provides a complete set of analysis software, including charting and news retrieval. It also links to some online brokeragefirms for direct execution. It, too, has an option montage with thecapability of displaying theoretical values and the Greeks. Anothercomplete package is offered by TradeStation, which has data, software, and brokerage all wrapped into the same software package.In fact, no matter which online broker you use, there is probablysome sort of interface software; but not all are sufficient for technicalor option analysis on their own.If you want more sophisticated analyses, you need to buy software. Most of the major software packages (for example, technicalanalysis charting programs, option analysis programs) work withdata supplied by the major data providers, such as eSignal or PCQuote.Buying your own data gives you a lot of flexibility; and if you arean accomplished programmer or want to hire one, this method givesyou access to the raw data, from which you can construct your ownanalyses. Even if you’re not a programmer, this may be the bestmethod because (1) you can keep your costs down by only subscribing to markets that you have an interest in, and (2) you only need tobuy software that performs the analyses that you will use.As an option trader, you will probably need to buy some optionanalysis software if you are bringing data into your own computer.There are several major option software packages available; you cannormally find them through advertisements in financial newspapersor magazines. Some of them include Option Vue (www.optionvue.com), Option Pro (www.optionpro.com), PowerAnalyzer (www.optionstrategist.com), and Power Options (www.poweropt.com). Inaddition, some of the more advanced, broader-based analytical tools,such as First Alert or AIQ, do option analysis as well. A more
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complete list of available software vendors is normally available fromthe data vendor.If you are going to buy option software, there are several qualitiesthat I would consider mandatory. First is that the software be able todisplay option prices in pages, along with theoretical values, delta,implied volatility, and so on. I mentioned earlier that I would want thedata vendor’s software to display option pages. However, if the software vendor’s program can display option pages, then you mightrelax the criterion for the data vendor. The option software shouldalso have a portfolio-management system built into it. This portfoliomanagement system should be able to do more than calculate profitsand losses. It should be able to calculate, for example, the positiondelta of any position or of your whole portfolio. Ideally, you wouldalso be able to calculate position vega, gamma, and so forth. In thisway, you can determine the exposure of your option portfolio to various market conditions.The specific model that the software uses is not important. Aswas explained in Chapter 6, there are several option models available, and they give very similar answers to theoretical value questions. Also, if the model does not specifically calculate futures optiontheoretical prices, that is not a problem as long as the softwareallows you to change the short-term interest rate (which almost allsoftware packages do). If you set the short-term interest rate in yourmodel to 0 percent, then you will get the correct theoretical valuefor nearly all futures options. The exception would be deeply in-themoney futures options, which would appear to be somewhat underpriced by our simplistic method. Be sure that the software allowsyou to change the interest rate if you are going to trade futuresoptions.The software should also be able to perform what-if analyses;that is, you construct a position that you are considering, and thesoftware can describe how that position will perform in the futureunder certain assumptions such as time passing and volatility changing. Preferably, it will graph this information. Option Vue is particularly good at this kind of analysis. In addition, Option Vue softwarecan perform expected return analysis, which makes it the Cadillac ofthe industry.
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Ideally, your software should be able to keep historical records ofvolatility and underlying prices. Historical records of option pricesare not mandatory, for they take up a lot of disk space and aren’treally necessary for further analysis. However, being able to trackhistorical volatility (which can be done via the historical prices of theunderlying security) and to track the past ranges of implied volatilityare necessary for many option trading strategies, particularly thosediscussed in Chapters 4, 5, and 6.Before leaving this section on software, it should be pointed outthat there are some low-level software programs that are “standalone.” They do not get their data from a real-time data feed. Ratheryou, the user, type data into a file, and the software analyzes thosedata. For many traders, this type of software is often sufficient, and itis always quite inexpensive (less than $100) because it doesn’t haveto link into a real-time data source. For example, to see the impliedvolatilities of a group of options, all you would have to do would be totype in the stock price, the expiration date, the strike prices, and thecurrent option prices (for this last item, you would need to have someway of quoting prices). The simple computer software program canthen display delta, gamma, implied volatility, and so on. Of course,with no historical record of volatility, you would have a hard timedeciding whether the options were expensive with respect to theirhistory; but you can see how they compare with each other at thecurrent time. Programs of this type are often called option calculators. These are three very useful and popular ones: Option Evaluatorby McMillan Analysis Corp. (www.optionstrategist.com), OptionsLaboratory by Mantic Software (www.manticsoft.com), and OptionMaster by Ken Trester at the Institute for Options Research(www.options-inc.com).In sum, there is no best data service and accompanying software.“Best” depends on what you perceive as your needs. If you are asmall investor who only wants to see end-of-day quotes, then something very simple will suffice. However, if you are a real-time trader,then you want a more sophisticated data service, although your software needs may not be complex. Finally, if you are planning on trading volatility in the option markets, then you are going to need moresophisticated software and probably real-time pricing as well.
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TRADING METHODOLOGYAND PHILOSOPHYThe preceding chapters have concentrated mostly on trading strategies and systems. Thus far in this chapter, we have looked at how toget yourself physically set up to trade. Those are both very importantparts of trading, but there is more to trading, much of which has todo with mental preparation and execution.
Managing Your MoneyOne of the most important aspects of trading is money management. We have presented several systems and strategies in this book,but it is up to the individual investor or money manager to decidehow much of his capital he is going to allocate to each position.However, money management encompasses much more than justdeciding how much to invest. It also has to do with taking losses sothat the investor can be “alive” to invest another day.Most people are familiar with a simple form of money management: dollar cost averaging. This simple strategy—buying the samedollar amount of stock at equally spaced intervals—is designed tohelp an investor avoid putting all of his money into a market at once,lest he should be buying at the top. It’s not a bad strategy, but it haslittle relevance to short- or intermediate-term trading—it is more of along-term, buy-and-hold strategy.Most traders approach short-term trading with a fixed amount ofmoney that they feel comfortable risking. Thus, they have a pool offunds, and that pool will either make it or break it; further moneyswill not be added if the trading is not working out. A professionaltrading firm approaches the matter differently. The professional trading firm will put a limit on the losses that it will allow from a strategy—if that limit is hit, trading will cease. This is a proper approach,and one that often distinguishes large professional trading firms fromindividual investors.Firms that are in the business of trading will often accept new ideas fromoutside traders or analysts. Traditionally, such firms have been the large bro-
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kerage firms; but in recent years they have cut back on their risk taking, sohedge funds have taken up the slack. It is sometimes possible for a traderwho has an original idea that is well documented to be profitable toapproach one of these firms and receive trading capital. Profits might besplit 50-50, perhaps, but the supplier of the capital has the right to terminate the trading if losses get too large. The firm might terminate trading iflosses reach 15 percent to 20 percent of original capital.In the late 1980s, one new strategy that was quite profitable was Japanese warrant trading. The Japanese stock market was soaring at that timetoward its all-time high of over ¥40,000. Many Japanese companies hadissued warrants. Warrants are much like options, except that warrants areissued by a company, and that company retains the proceeds from the initial warrant sale. Market professionals have always felt that hedged warranttrading was a viable strategy. The book Beat the Market, written by EdwardThorp and Sheen Kassouf in 1967, dealt solely with this strategy. In hedgedwarrant trading, you buy undervalued warrants and short the underlyingcommon in a proper ratio in order to create a delta neutral hedge. This ismuch like owning a cheap straddle in the option market. Profits can accrueif the underlying stock moves way up or down in price or if the warrantreturns to “fair value.”Thorp and Kassouf were only discussing trading in U.S. markets, andtheir warrant model in the book was a rather simplistic one; but the strategywas sound. Over the years, U.S. companies stopped issuing warrants, andthe strategy dried up. However, the same strategy appealed to many traderswhen the Japanese companies began issuing warrants.One fairly large and aggressive trading firm agreed to open a department to trade these warrants in a hedged manner, having been approachedby a trader who had outlined the benefits of the strategy and had documented its theoretical success. The way in which the trading evolved andthe trading firm managed its risk are the point of this story.The mechanics of operating the strategy with Japanese stocks introduced some different variables into the real-world equation: one was the difficulty and the high cost of borrowing the actual shares of Japanesecompanies (they needed to be borrowed so that they could be sold short asa hedge against the warrants); another was the currency risk for U.S.traders—the underlying market was trading in yen, while the warrants weretraded in dollars (the warrants were traded out of Hong Kong and London,so they were denominated in dollars).But an even more insidious problem was built into the pricing structure,and it was a difficult one to foresee. We have discussed the necessity ofmeasuring implied volatility in percentiles, by looking at where it has been
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trading. Most of Chapter 6 was devoted to trading volatility based on thisconcept. We saw, however, that sometimes volatility will break out of itsprevious range and cause losses for a volatility trading strategy.In effect, warrant hedging is a volatility trading strategy: you attempt tobuy the warrants when implied volatility is low and hedge them with stock.When the Japanese market was moving up strongly through the late 1980sand into the beginning of 1990, the range of implied volatilities was quiteuniform. However, when that market topped out and began to trade down,implied volatilities fell to levels unheard of then. In some cases, out-of-themoney warrants were dropping nearly as fast as the stock (in effect, thedelta of an out-of-the-money option was nearly 1.0!). Of course, this atypical action was caused by the decrease in volatility.In any event, the hedges that were established for the firm’s accountwere losing a great deal of money when this happened. When the lossesreached the previously agreed-upon amount, the traders were ordered toliquidate their positions in an orderly manner and close the accounts. Noexcuses or rationalizations, just no more trading.
This is a discipline that individual traders rarely impose uponthemselves. It is easy to make excuses, to reason that next time you’llbe more careful with volatility estimates, that you’ll be in more liquidissues, and so forth. However, the need to cut losses and terminate astrategy can be great, especially if it is a proven winner and you arelosing money trading it. You are probably doing something wrong—perhaps emotions are leading you to overrule your “system—andsometimes the only way to stop that wrongdoing is to stop tradingthat strategy.This is distinctly different from operating a strategy properly, butrunning into several incidences of poor luck that cause losses. For thefirm traders in the previous example, it wouldn’t be of much help—hitting the stop-loss point would cause them to lose their jobs in anycase. However, individual traders, no matter how wealthy, oftenwork with a fixed pool of capital for a strategy, capital that they arewilling to risk in order to determine if the strategy can be a successfulone. If they are willing to risk the entire pool of capital (which, weassume, is only a portion of their overall assets), then they would notwant to use the fixed-loss form of termination, as in the previousexample. Rather, they would use a form of investment that allows
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them to invest more heavily when they are winning and to reduce thesize of their trades when they are losing.This is an important concept that was first illustrated to me many years agoin a book I read that detailed the life of the famous gambler, Nick the Greek(not Jimmy the Greek). Nick was a well-known gambler who had manyinteresting stories and who mainly played casino games and bet sports. Nickbelieved in progressive betting, and so should you. In progressive betting,you increase your bets each time you win; but if you lose, you return to youroriginal bet size.One night when not much was happening in a particular Las Vegascasino, Nick was standing at a craps table when a Nebraska farm boyentered and bet $1 on the pass line. He won. He then bet $1 again andwon again. The farm boy ran off one of the most amazing streaks Nick hadever seen—he rolled 28 straight passes (even if you’re not a casino gambler,you should understand that winning 28 straight wagers on any casino gameis a pretty remarkable feat). Then he lost. The farm boy had netted out $27and he left.Nick, on the other hand, had started with a $10 bet and had won$40,000 by the time the farm boy was done with his remarkable streak.Nick did this with progressive betting. He increased his bet each time thathe won, eventually betting massive amounts—all of which was the house’smoney—near the end of the streak. If there hadn’t been a table limit, Nickmight have broken the house itself on a streak of that length.
The book never explained what progressive system Nick wasusing, but the common one is to increase your bet by 60 percentevery time, pocketing 40 percent of the winnings for yourself. If youare lucky enough to be involved in a streak of even eight or ninestraight wins, you’ll be very happy. At the end of eight wins, forexample, your next bet would be 1.68 times your initial bet, which isabout 43 times your initial bet. If you think it would be hard toremember how much to bet after each win, especially if the streakgets long, just bet the Fibonacci numbers: 5, 8, 13, 21, and so on.Each one is about 1.61 the previous one; but even easier, each oneis the sum of the previous two. So all you have to do, in order to calculate the next one, is remember the last two. That’s pretty easy todo, even in the heat of battle.
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The power of progressive betting is very strong. Of course, in acasino game, you are destined to be a loser if you play long enough,because the house has an advantage. However, if you just gambleoccasionally, it’s a lot more fun to use progressive betting becauseyou might hit a streak that is long enough to make you a winner forlife, considering that you are only visiting the casinos occasionally.Mathematicians have attempted to apply this same thinking tothe stock market and, specifically, to how much to invest in a trade.The main difference between the casino bets and the stock marketinvestments is that you normally have more than one stock marketinvestment going at a time. So instead of getting a series of sequential results, your results are mixed together. Also, it’s easy to knowwhen a casino game ends—the shooter passes or craps out, or thecard player wins or loses. But in the stock market, only you are incontrol of how each investment ends. If you are trading with a system, then that system might have specific entry and exit points, andthat would make things easier to evaluate in the context of themoney management system that we are going to discuss.Back in the early 1950s, a scientist at Bell Telephone Laboratories wasworking on a problem. He needed a formula to determine the optim