is the greatest fool of all who buys at the peak.
This strategy can’t be guaranteed, of course. But it has shownabout a 16 percent annual return if the market does what it hashistorically. And, we believe it carries must less risk than just buy-ing the S&P or the Vanguard 500 (which is a fund variation ofthe SPY).
We also believe that the SPY has greater benefits to the retailinvestor than just buying a mutual fund. For one thing, there is thequestion of fees when it comes to a mutual fund. Second, to get in orout of a mutual fund—even if you wire-transfer the money—youcan’t move the money in or out in a day. Let’s say there is a marketcalamity in the morning, and the S&P index is down 2 percent in thefirst hour. If you wanted to invest—seeing this as a time to buy—bysending money to a mutual fund, you won’t be able to get in untilthe next day when most of the opportunity is gone. But with theSPY, if you choose to buy, you’re in today!
Additionally, since spiders are not corporate equities, there isno downtick rule. You don’t have to wait until an uptick to short aspider, or another index such as the QQQ or the Dow 30 industrials.(To short a stock, you have to wait for an uptick in the marketprice.) From a hedging standpoint, this is fantastic, because if themarket was in a freefall you could still hedge part of your exposure,while the person trying to short IBM, Hewlett-Packard or any otherstock needs to wait for an uptick in order to sell the stock short.Spiders are also a very liquid market, trading some 6 million sharesa day. For investors big and small, liquidity is your friend. It assuresyou that, when you need to make a trade, chances are there will besupply to meet your demand, and vice versa.
When you look at index options, it’s interesting to see theapproach of most big, successful firms. What many have done isto create a single portfolio, or global position for the firm. Thatplaying the broad market 123
portfolio or “book” reflects the sum total of all the trades andspeculations and hedges that the firm takes on. That enables themto get a fix on their overall market exposure. They may be buyingoption premium in the S&P 500, and selling premium in the Nas-daq 100 as a hedge.
For example, one index arbitrage firm that I know, employsseven in-house traders that may account for nearly 15 percent ofthe volume in the SPX (the S&P index options at the CBOE). Simul-taneously, in the OEX, they have another six traders who accountfor just under 12 percent of the average daily volume. Similarly, inthe Dow 30, two traders account for 30 percent of daily volume.Computer networks link the trades done by one group to the offset-ting trades done by another.
So when a large buy order comes into, say, the Dow JonesIndex Options pit, those traders don’t just look at where they canhedge in that market. Their computers help them determine thebest hedge, whether it’s to sell something in the S&P 500 (SPX), gointo the OEX, or go to the Nasdaq. A computer can do that calcula-tion in a microsecond and alerts the traders in that pit to make theoffsetting trade.
When they buy SPX, they’ll mainly sell the Nasdaq 100 orthe Dow 30, or S&P futures, or Nasdaq futures, or futures optionsagainst it, capturing the divergence between the markets. Ripplesgo through the market in seconds—not hours or even minutes. Inother words, one large trade affects all three major indexes withinseconds as the computer starts the hedging process, which is car-ried out by the firm’s minions.
Now, let’s take a look at this strategy in light of the zero-sumtheory, which states that for every winner that has to be a loser.That doesn’t work in options. For one thing, a professional traderhas the use of margin that the customer doesn’t. With my specialistmargin, I can trade a huge position for a fraction of the upfrontcost. Moreover, it’s possible (remember the cash-covered put sell-ing in Chapter 5) for us to either make money or lose money, de-pending upon the individual option that we trade.
An increasingly competitive and ultra-sophisticated market-place is index arbitrage. This, by no means, is a strategy for retailinvestors. In fact, most of the firms engaged in this strategy haveboth a multimillion-dollar capitalization and direct computer links124 how I trade options
to each of the U.S. options exchanges and futures exchanges. Butit’s interesting to look at the way these firms play arbitrage in theindex futures and options markets.
A basic arbitrage trade would be to take the S&P 500 and de-termine what the fair value is for S&P 500 future, using a formulathat any options trader would understand. You take the value of theS&P and assume that if it were deposited in a risk-free account for90 days, how much interest would it earn. That would give you anindication of the risk-free rate of return. (You could also use U.S.Treasury bilis to approximate that rate.) That rate of return is thenapplied to the value of the S&P over 90 days, which is the length ofone futures contract, and then divided by 360 or
S&P value x Interest rate x 90 days360
The result is a dollar value, which then must be adjusted forthe dividends that are paid on the actual stocks in the S&P 500basket. (The dividend equivalent amount is added to the contractif you’re long, and subtracted if you're short.) The dividend equiv-alency is published every day, including on the Standard & Poor'sWeb site. The bottom line of all the calculations is fair value, orthe difference that a futures contract should have versus thecash market.
As people became more sophisticated, they began to take an-other factor into account in their fair value calculations—slippage.Slippage is best and most easily described as the difference be-tween the price you see on the quote screen and the price at whichyour order is executed. Particularly if you’re executing a big orderoff the trading floor, you may not be able to buy, for example, 500options contracts at the price you see displayed at the moment youplace an order. Rather, it’s likely that you’re going to buy a littlehigher than you anticipated and sell a little lower.
Traders who use sophisticated computerized trading programswould often factor in slippage of one-half point. (So if fair value wasdeemed to be $3, they’d add on another $0.50, meaning the differ-ence between futures and cash would have to be more than $3.50before they’d consider making a program trade.)
Once fair value was determined, traders would look for opportu-nities to trade the imbalance between the cash and futures markets,playing the broad market 125
which is commonly known as arbitrage. When a disparity exists,the goal is to buy one market and sell another, and then exit the po-sition when the correlation comes back in line. So if you determinedthat the fair value of S&P futures ought to be $3 ($3.50 accountingfor slippage), and instead they were trading at $5 over the cashmarket, as an arbitrageur you would sell the S&P futures $5 overfair value and buy the underlying securities. The selling pressurewould start to bring the futures market back in line, while buyingthe cash would raise the value of that market. When the gap be-tween the two came back to $3.50 or so, you’d see the buy programcome to a screaming halt. When the futures drifted lower than fairvalue, you would seek to reverse out of the trade by buying back’your short futures and selling out the underlying stocks.
But what happens if the future market is undervalued com-pared with cash, say, trading at a $5 discount? Ideally, you’d wantto buy the undervalued futures and sell underlying securities. Butyou need to have the ammunition to make that trade in the formof stock on hand. Because of the downtick rule (you can’t short astock on a downtick, but must wait for an uptick), you can’t shorta stock you don’t already own. But if you own the physical stock,you can sell it at any time. Assuming you're long stock, you canbuy the futures and sell your shares until the market returns toequilibrium.
It should also be noted that there are curbs or limits thatwere enacted voluntarily at the Nasdaq, New York Stock Exchange,and the Chicago Mercantile Exchange, where S&P futures trade.The purpose of these curbs, which were put on the market follow-ing the crash of 1987, is to act as a brake to slow down rapid mar-ket movement.
The kind of arbitrage trade I just described was far more com-mon in the late 1980s and the early 1990s than today. For one thing,with the increase in participants, the markets are more efficientand discrepancies are far more rare. Rather, today very sophisti-cated arbitrageurs do cross-index arbitrage, taking advantage ofwhat they determine to be discrepancies in the value of one index—such as the Dow Jones—and another—such as the S&P 500. Or,they may make arbitrage plays in a sector index, for example Inter-net stocks, versus the Nasdaq.
But this is a game for professionals. The capitalization it takesand the margin requirements of this kind of trade would be extreme126 how I trade options
for a retail investor, who couldn’t simply buy the Nasdaq and shortan index as a hedge. Rather each component trade would be con-sidered a separate transaction, meaning you'd be naked long theNasdaq and naked short the index. As a professional trader, how-ever, I am allowed to consolidate all these trades into one hedgedtransaction, thanks to margin relief from the participating ex-changes.
While that’s an obvious advantage for the professional trader,the retail customer also benefits. When the professional arbi-trageurs play the spreads between the markets, they help to bringthe price relationships back in line. If it weren’t for these arbi-trageurs, then the one-way stampede by retail customers (whotend to want to buy and sell the same things at the same time)would create imbalance in the markets, which would trade at ex-treme discounts or premiums to each other. The more efficient themarket, the less time the futures stay out of line versus fair value.
Just because retail traders shouldn’t do arbitrage, it doesn’tmean they are shut out from complex index trades. Rather, there isan opportunity for a sophisticated retail trader to hedge usingindex options. Let’s say you’re long a portfolio of stocks and you de-cide to lock in some gains by selling options against your position.In this case, say you had Microsoft, Intel, and IBM in your portfolio,and to lock in profits in these equities you wrote options—or soldcalls—against them. You have hedged yourself somewhat againstan adverse move in the individual stocks. But you still have expo-sure to a major market correction.
One way to protect yourself from this kind of move might be tobuy puts or put spreads in S&P 500 options, which closely tracksMicrosoft, Intel, and IBM. Let’s say you held 1,000 shares each ofthe three stocks. To lock in profits, you sold at-the-money calls (a10-contract position for each security) in each stock. You sold 10IBM $115 calls for $5 a share, 10 Microsoft $100 calls for $6, and 10Intel calls for $5.50. And you'd reap $5,000 in IBM call premiums,$6,000 in Microsoft call premiums, and $5,500 in Intel call premi-ums for a total of $16,500. While that looks like a hefty premiumsum at first glance, remember you have $320,000 in total market ex-posure through our stock ownership. Obviously $16,500 is only asmall percentage of that.
To protect against a sharp market decline, you might buy putspreads in S&P index options—say, an out-of-the-money put spreadplaying the broad market 127
in S&Ps, which might cost a total of $4,000. With the S&P at 1440,you would buy the 1430 puts for $7 a share and sell the 1410 putsfor $3, for a net cost of $4 a share or a total position cost of $4,000.
Combined with the proceeds from the sale of the in-the-moneycalls, our net profit thus far is $12,500.
Putting this all together, if the market had a 10 percent correc-tion, the S&P would decline 140 points, and our put spread that wepaid $4 a share for would now be worth $20 a share, for an overallprofit of $16 a share or $16,000. But we have a total of about $30,000to offset if Microsoft, Intel, or IBM decline 10 percent a piece, eachlosing around $10 a share. With the $12,5C0 in net options profitsfrom the hedge, we've basically neutralized this loss. We have a netprofit on our hedge position of $28,500, and a loss in our stocks of$30,000, for a net loss of $1,500. For a hedge, that’s not bad.
Keep in mind that the person who owned the stocks outrightlost $30,000, or 10 percent of the portfolio’s value. By taking insome options premium on the stocks that you own and investingsome of the proceeds in index options, you provided yourself withsome substantial protection against an adverse move.
Let’s recap that hedge trade: You own 1,000 shares each ofMicrosoft, Intel, and IBM for $320,000 stock portfolio value. You areseeking to guard against a 10 percent correction, or a loss of$32,000 in stock value. To lock in profits, sell at-the-money calls ineach security as follows:
Microsoft $100 calls for $6 a share in premiumIntel $100 calls for $5.50 a share
IBM $115 calls for $5 a share in premiumTotal premium received: $16,500
Buy 1430 S&P Index puts for $7 a share
Sell 1410 S&P Index puts for $3
Total net cost $4,000
Market declines 10 percent. S&P put spread increases from $4 ashare to $20 a share for a profit of $16 a share, or $16,000. Com-bined with $12,500 in premiums received (profit on equity call op-tions minus $4,000 in net S&P put costs), total profit on hedge is$28,500. The loss on your equity portfolio is $30,000.128 how I trade options
Large investors routinely use index options to hedge overallportfolio risk. These investors include family trusts, professionalmoney managers, and large customers with multimillion-dollarportfolio exposure. But smaller accounts are also recognizing thevalue of hedging their holdings.
Maybe you have $50,000 in Vanguard or some other indexfund. A 10 percent correction could hurt you just as badly, propor-tionately speaking, as the guys with the multimillion-dollar port-folios. To hedge your position, you might use the same strategy
- that I just described here, locking in profits on your portfolio byprotecting yourself from an adverse, downward move.
Beyond the protection offered by index options as hedges,frequently there are attractive opportunities to speculate usingthese types of instruments. One reason is that it’s often easier topick a trend—upward or downward or even a sideways holdingpattern—in an index such as Nasdaq versus picking a trend in anindividual stock.
Right now you think Nasdaq is probably going to stay “up.”But what about Cisco? You say you like this stock for the long term,but you’re not sure if it’s going up or down in the meantime. Like Isaid, picking trends in individual stocks can be very tricky. Whenyou do have strong feelings and convictions about a stock, that’sthe time to invest that individual equity option, rather than theindex. For the rest of the time, you might consider focusing on theindexes because with one transaction you can get exposure to abroad range of stocks. As money flows into and out of the market(and these stocks), the indexes will move up or down.
Here’s how an index trade for a retail investor might look. Re-member, a stock index settles for cash. If you buy an OEX call op-tion and exercise it, you'll receive the difference in the index valuein cash; you won’t receive any shares of stock comprising the index.
So let’s say you buy OEX $750 calls for $6 a share. If the OEXfails to rise, you lose your premium—but that’s all you lose. Nowlet’s say, the OEX runs up to $870 a share. If it were expiration, youwould receive $20 cash per share ($2,000 per option) into youraccount. Your net profit would then be $14 a share, taking into ac-count the $6 a share you paid for the option. If you decided to takea profit, perhaps because the index value ran up farther and fasterthan you expected, and you wanted to take a profit, you could exer-cise your $650 call and cash out for that same $20 gross profit, $14playing the broad market 129
net. But remember, you can’t exercise early with most indexes,only the OEX or the SOX. Most of the rest, like the SPX, must beheld until expiration.
For beginners, one of the best things about index products isthat they offer an extremely liquid market. Despite all the hooplaover the Internet stocks, many of these have less-than-desirable liq-uidity in their options. But the indexes are always quite liquid be-cause there are so many firms doing cross-market arbitrage, asdescribed earlier. But which index to look at and possibly invest in?
I think it’s best to look at what else is in your portfolio, par-ticularly any stock holdings that you might have. One importantthing to consider when you invest in a stock is its beta. (Beta in-formation can be obtained in a variety of sources, including Mul-tex and Hoovers online.) A beta is a measurement of how muchthat stock moves relative to an index, usually the S&P 500. So if abeta is relatively high, that means the stock is comparativelymore volatile than the S&P; if the beta is low, the stock is lessvolatile than the S&P. So, for example, if you saw that a stock hada beta of 3, you would expect it to move 3 points for every 1-pointthat the S&P moved. That 3-beta stock would probably be a tech-nology stock and a Nasdaq issue. A stock with a beta of 1 wouldmove lockstep with the S&P, and would generally be a listed stocksuch as IBM or GM.
If you have a portfolio of stocks with large betas (meaningstocks that are more volatile than the S&P), you’re going to needprotection offered by the QQQ index or the Nasdaq 100, rather thanthe OEX or the SPX. Why? Because the large betas indicate thatyour portfolio tracks the more aggressive indexes such as thosedominated by technology stocks.
As a retail investor, most likely you’re trading the indexesbecause you think you need the protection for your overall port-folio (hedging your holdings in a comparable index), or becauseyou believe an index is likely to move in your direction and you aremore comfortable picking overall market direction than that of anindividual stock. As discussed previously, there are times whenan index is more likely to make a big move. One time is whenvolatility is low (as measured by the VIX) and the world is lookingoverconfident.
When it comes to investing in the indexes, you’re not going tobe limited to just one or two choices—the OEX, the SPX, or the130 how I trade options
QQQ, for example. There are dozens of indexes on everything frombiotech to utilities to durable goods to Internet stocks. (Of course,some will have more liquidity than others, and some will fade fromsight.) In addition, Standard & Poor’s, Dow Jones, Goldman Sachs,Morgan Stanley, Salomon Smith Barney, and other large financial in-stitutions create proprietary indexes for their customers. Still, veryfew of these indexes have garnered a large enough following to be asuccessfully listed product.
Generally speaking, the most successful indexes among thenewest listings have been the more volatile ones, including Inter-net, e-commerce, and biotech (which is seeing a resurgence due tohuman genome mapping). Those three indexes also are increasingin popularity. Plus, being in a volatile index, they can avoid the“right church, wrong pew” syndrome. They’re playing in the wholesector, instead of just one stock out of the whole sector, whichcould potentially be the one that underperforms all the rest!
You can’t discuss indexes without looking at the Nasdaq, andits volatile, skyrocketing performance in 1999 and early 2000. inearly March 2000, the Nasdaq Composite broke 5,000. Likethe 10,000-level in the Dow Jones Industrial Average, the Nasdaq5,000 was a psychological level that had transfixed the marketplace. At the same time, amid great debate about the Old Economyversus the New Economy (see Chapter 10), the Dow Jones Indus-trial Average was selling lower (although it experienced severalvolatile up and down days), while the Nasdaq’s general directionwas ever-higher.
On Friday, March 3, 2000, the Dow rose 300 points, largely on aU.S. Employment Report that showed 43,000 new jobs had been cre-ated—far less than the 300,000 new jobs that Wall Street had ex-pected. The huge decrease in the number of new jobs createdquelled inflation fears in the marketplace and, with that, a belief thatthe Federal Reserve would be less likely to raise interest rates fur-ther to cool down the economy that was growing too rapidly. Thatled to euphoric buying in the stock market, which was particularly /evidenced in the Dow, which had been beaten up so badly. The Dowwas trading around 9700, down from its previous 11,800 high.
On the following Monday and Tuesday, March 6 and 7, we had abig “cooling off” in the market amid some intense volatility. TheNasdaq Composite traded above 5000 points for the first time inhistory on March 7, then sold off 100 points within an hour. Thenplaying the broad market 131
on Wednesday, the Nasdaq was back above 5000, and it closedabove that level on Thursday, March 9.
The Dow, meanwhile, traded back above 10,000, and then soldback to 9700 on Tuesday, March 7. It finished the week around 9800,some 500 points below the previous weeks’ high.
During this time, my firm, Mercury Trading, was playing theNasdaq stocks and the indexes. Among the individual equities wewere trading was CMGI Inc., which, as of early March 2000, had a52-week range of 33% to 163 4 a share! As I mentioned previously,one of the most volatile times for a stock is just prior to earnings.CMGI was no exception. The stock was trading at about $145 ashare prior to its earnings announcement, and its volatility had in-creased from about the mid-80s to about 110 percent to 120 per-cent. The higher the volatility, the wider the stock’s anticipatedprice range. As a result of that volatility pump, CMGI options thatshould have been trading at $5 a share, were trading around $8.
Based on the opportunity we saw, here’s the option play wemade: We bought CMGI shares and LEAP call options that were one-or two-years out. Then we sold calls in March and April with strikeprices around $150, $155, and $160. Even if the buyer exercisedthese calls, the worse that could happen, we knew, was that we'dhave stock taken away from us at $150, $155, or $160 a share and weowned the underlying stock and LEAP options against those shorts.At the same time, we were collecting premiums on options thatwere higher than normal.
CMGI's earnings were relatively good, and the stock did tradeup about $5. But the next day, the ‘stock opened a little lower,around $148 a share. We sold out of our stock position, nettingabout $3 a share. Call options we had sold, collecting premiums of$8, $9, and $13 a share, were down to around $5, $7, and $10, addingto our profits—and reducing the risk that the call options would beexercised by the buyers.
At the same time, we were looking at opportunities in the in-dexes. For the week ended March 3, the Dow had rallied more than5 percent. We considered the rise in the market to be a knee-jerkrally that could quickly reverse. So we looked for put spreads toplay in the S&Ps, OEX, and Dow Jones because we believed therewas a good chance of profit-taking affecting these market indices.
Let’s say OEX was trading around $850 a share. We bought the$830 puts and sold the $815 puts, locking in a 15-point spread and132 how I trade options
paying about $4.50 a share ($450 per option). With the market cor-rection, OEX fell to $810 a share. We sold out of our put spread fora nice profit.
Such index trades allow you to play the direction of thebroader market such as when you believe a rally is likely becauseit’s oversold, or you’re looking for a correction after a strong rally.In other words, the indexes are a great way to play the extremes—whether the market is basking in the euphoria or in the midst ofwhite-knuckle panic.chapter 7
when to dowhat—and why!
Once you've got the basic mechanics of the strategies, the issuethen becomes, when—and how—do you employ them. The strategyyou pick reflects your market opinion. For example, let’s take thesimplest case—a Bull Spread. If you opt for this strategy, it’s be-cause you have a bullish bias. You’re buying calls because youbelieve a particular stock or index is going higher.
But there is another reason to employ a bullish spread: Itsmoothes out the volatility, particularly when a stock has been bidstrongly higher. Ideally, you buy the lower volatility option (whichcarries a lower premium) and sell the higher volatility one (whichhas a higher premium). When you have a bullish bias, however, it’simportant to realize that you are not the only one who is bullish inthe marketplace. And with a prevailing bullish opinion, you couldend up buying an option with high volatility and, as a result, an un-usually high premium. Cisco, Qualcomm, and Intel are all greatstocks that have had a wonderful performance for much of the1990s and through the first quarter of 2000. If you are bullish onthose stocks, chances are the volatility will reflect the demand forthose call options, especially ahead of industry events such asComdex or companies’ quarterly earnings reports. With all the peo-ple betting on the upside of those stocks, if you’re trying to buy acall option, chances are you aren’t alone, and the excess demand134 how I trade options
has already pumped up volatility above the normal range. In otherwords, you’re buying expensive options that reflect the market’shigher expectations for the company.
If you were bullish on any of those three stocks and blindlywent out and bought at-the-money or slightly out-of-the-moneycalls, chances are you would have to pay up because of the highvolatility. This is especially true ahead of earnings or stock splitswhen people want to speculate wildly that earnings will be muchbetter than Wall Street expects, or that the stock will rise becauseof the pending split. As a result, going ahead and wildly buying calloptions may be the wrong thing to do. Why? Because you could endup buying options with a high price that reflects the high volatility.An alternative would be to consider buying a bull call spread, whichwill help you to neutralize volatility and time decay.
Let’s say Cisco is trading for $77 a share. You buy the $80 callthree months out and sell the $90 cail three months out, thus creat-ing a bull call spread. What we've also done is neutralize the vola-tility, because we’ve sold one option for every option that we’vepurchased. Thus, if the volatility suddenly drops in Cisco—becausethe stock price is going down or the Street’s perception of growthdiminishes—the call options that you’ve purchased are going tolose money as the volatility is reduced. Similarly, the out-of-the-money calls that you've sold are going to decline in value, lesseningthe impact of volatility to your overall position.
For instance, let’s say you bought the July $80 call for 7% andsold the July 90 for 4%, for a net cost of $3.50 a share ($350 perspread). At the same time, you’ve locked in a $10 spread. The profitpotential is $6.50 while the most you could lose is $3.50. That’snearly a two-to-one ratio of the potential reward versus the risk,which is ideal (Figure 7.1).
Bull Call Spread
Bought Cisco July $80 call, paid 7% a shareSold Cisco July $90 call, collecting 4%Net cost of $10 spread, 3%
Now, let’s assume the volatility declined from 46 percent to 40percent because of a drop in demand for options. As a result, the$80 calls would experience a drop in premium from 7% to 65 whilewhen to do what—and why! = 135
 
Figure 7.1 long 1 July 80 call, short 1 July 90 call
 
 
Profit / Loss (Y} and CSCO Common Price (X) Risk Graph
 
   
 
 
Source: Created by StockmarketWorkshop.com.
the premium on the July $90 calls dropped from 4% to 3%. You'velost 1% on the calls that you bought, while the calls you sold lost%—which you keep. The net position is now worth $3.25, down$0.25 from $3.50. But if you had just bought the calls—withoutdoing a bull call spread—you would have faced a decline of morethan $1 a share on the volatility contraction. If you did the spread10 times, you'd be risking a grand total of $3,500. Rather, somebodywho just bought the call 10 times is risking $7,500.
