THE NEW TRADING OF A LIVING- TRADING VEHICLES

THE NEW TRADING OF A LIVING



TRADING VEHICLES

All trading vehicles are divided into several classes. Their charts may look similar on a computer screen, but don’t let their looks deceive you. Each group has its pluses and minuses. They offer different profit opportunities and carry different risks. Choosing what to trade is among your most important market decisions. We’ll review the following major groups to help you make a conscious decision on which to focus:

  • Stocks
  • ETFs
  • Options
  • CFDs
  • Futures
  • Forex
Whichever group you select, make sure your trading vehicle meets two essential criteria: liquidity and volatility.

Liquidity refers to the average daily volume, compared with other vehicles in its group. The higher it is, the easier it’ll be for you to get in and out of your trades. You may build a profitable position in an illiquid stock, only to lose at the exit due to especially bad slippage.

When it began to sag, I decided to sell, and that’s when I discovered that its average daily volume was only 9,000 shares. There were so few people trading it that my own sales began to depress its price. Taking several days to trade out of my 6,000-share lot felt like taking a fat cow through a very narrow gate and leaving large strips of its hide on gate posts. Now I focus on U.S. stocks that trade over a million shares a day. That’s where I can slip in and out of my trades unnoticed and unmolested. With a large number of traders, there are plenty of orders to buy and sell, and my slippage, when it occurs, is small.

Volatility is the extent of average short-term movement of a trading vehicle. The higher the volatility of a trading instrument, the more opportunities it presents. Popular stocks tend to swing a lot. On the other hand, stocks of many utility companies that are quite liquid are very hard to trade because of low volatility—they tend to stay in narrow ranges.

There are several ways to measure volatility, but a good practical tool is “beta.” It compares any vehicle’s volatility to its benchmark, such as a broad index. If a stock’s beta is 1, it means that its volatility is equal to that of the S&P 500. A beta of 2 means that if the S&P rises 5%, the stock is likely to rally 10%, but it is also likely to drop 10% if the S&P falls by 5%. A beta of 0.5 means that the stock is likely to rise or fall by half of the percentage of the S&P. It would be better for a beginner to focus on low beta vehicles. You can find betas for most stocks on all key financial websites, starting with Yahoo Finance. Betas are like trail markers on ski slopes: green for beginners, blue for intermediate skiers, and black diamonds for experts.

Time Zones Globalization has lured many people to trade far away from home. I meet traders in Australia who trade U.S. stocks, and talk with traders in the United States who wrestle with European indexes. Still, you should think twice before trading far away from your own time zone. Your data screen is connected to the world, but your physical self is rooted in the area where you live. If you trade while sleepy, you put yourself at a disadvantage. If your head is on the pillow while your trade is open on the other side of the globe, you make it easier for your competitors to pick your pockets.

Some time zones are easier to trade than others. For example, it is comfortable to trade the U.S. markets from Western Europe, where the New York Stock Exchange opens at 3:30 pm and closes at 10 pm. It is very hard to trade U.S. markets from Asia, where the time difference is likely to be 12 hours. There are always exceptions to a rule, and you may enjoy trading at night—but if you feel tired and sleepy, don’t push yourself but find a local market.

Long or Short There’s more to trading than buying and waiting for prices to rise. Markets are two-way streets: they go down as well as up. Beginners only buy, but experienced traders are comfortable with selling short. 
In a nutshell, to make money shorting you identify a vehicle that you expect to drop, borrow it from your broker, and sell it.

After it declines, you buy it back at a cheaper price, return the borrowed shares to your broker, and get your deposit back. Your profit is the difference between the higher selling and lower buying prices. This is the same as in buying, only the process is reversed: sell first, buy later. Of course, shorting is too complex a topic to cover in two paragraphs : The New Sell & Sell Short: How to Take Profits, Cut Losses, and Benefit from Price Declines.

Stocks

A stock is a certificate of ownership of a business. If you buy 100 shares of a company that had issued 100 million shares, you’ll own one-millionth of that firm. If other people want to own that business, they’ll have to bid for your shares.

When masses of people start liking the prospects of a business, their orders for its shares will push up the stock price. If they don’t like the outlook of that business, they’ll start selling their shares, depressing prices. Public companies try to make their shares more attractive in order to push up share prices because it helps them raise more equity or issue debt. Top executives’ bonuses are often tied to stock prices.

Fundamental values, especially earnings, drive prices in the long run, but, as John Maynard Keynes, the famous economist and a canny stock picker once retorted— “In the long run we’re all dead.” Markets are full of cats and dogs, stocks of companies with feeble or nonexistent earnings that at some point fly through the roof, defying gravity. Stocks of new sexy industries can levitate on expectations of future earnings rather than any real profits. Stocks of solidly profitable, well-run companies may drift sideways or down if the crowd isn’t excited about their outlook.

Warren Buffett is fond of saying that buying a stock makes you a partner of a manic-depressive fellow he calls Mr. Market. Each day, Mr. Market runs up to you and offers to buy you out or sell his shares to you. Most of the time, you should ignore him because he’s crazy, but occasionally Mr. Market becomes so depressed that he offers you his shares for a song—and that’s when you should buy. At other times, he becomes so manic that he offers an insane price for your shares—and that’s when you should sell.

Buffett’s idea is brilliant in its simplicity, but hard to implement. Mr. Market’s mood is so contagious that it sweeps most of us off our feet. People want to sell when Mr. Market is depressed and buy when he is manic. To be a successful trader, you must stand apart from the crowd. You need to define objective criteria that will help you decide how high is too high and how low is too low. Buffett makes his decisions on the basis of fundamental analysis and a fantastic gut feel. Traders can use the tools of technical analysis described in this book.

What stocks will you trade? There are more than 20,000 of them in the United States, and even more abroad. Beginners tend to spread themselves too thin. Afraid to miss an opportunity, they buy scanning software. A person who doesn’t have a clear idea of how to trade a single stock will not be helped by tracking thousands. He’ll be much better off focusing on a handful of stocks and following them every day.

We’ll return to the question of stock selection in Part 10 “Practical Details.” In brief, it’s a good idea to limit your pool of trading candidates. That group can be small or large, depending on your skills and available time. A Greek friend of mine calls his watch list of 200 stocks his harem. He’s owned every one of them in the past; he reviews them on weekends, selecting fewer than ten that he may take for a spin in the coming week.

I have two “pools” in which I fish for trading ideas. On weekends, I run the 500 component stocks of the S&P 500 through my divergence scanner and zoom in on stocks flagged by that scan, selecting a handful that I’ll consider trading during the coming week. Second, I review Spike picks on weekends, figuring that among a dozen top traders submitting their favorite picks, there is bound to be at least one that I’ll want to piggyback. The number of stocks I closely monitor during the week is always in single digits. This is just my style; I have friends who monitor several dozen stocks at any given time. Only you can tell what number is right for you, but you should track only as many as you can focus on.

ETFs

An exchange-traded fund is an investment vehicle that trades like a stock. Different ETFs hold different types of assets, such as stocks, commodities, or bonds, and they usually trade close to their net asset values. There are ETFs designed to track indexes, sectors, countries, commodities, bonds, futures, and forex. The leveraged ETFs are designed to move double or triple the distance of the underlying index. There are also inverse ETFs and leveraged inverse ETFs that trade opposite to their underlying assets: when an index falls, its inverse ETF rises and vice versa. The number of ETFs has reached thousands in recent years.

With so many choices, what’s there not to like about ETFs? Actually, quite a lot. The industry keeps quiet about the fact that there are two ETF markets. The primary market is reserved for “authorized participants”—large broker-dealers who have agreements with the ETF distributors to buy or sell large blocks, consisting of tens of thousands of ETF shares. These middlemen buy at wholesale and then sell to you at retail. You, as a private trader, always sit in the back of the bus—in the secondary market.

An active trader friend who reviewed added: “I believe that ‘authorized participants’ can also obtain ETF shares to short in large lots. My broker always tells me there are none available, not even of broadly held ETFs, which I can’t imagine they don’t have lots of in inventory. When I ask them about this, they stonewall. I wonder how such a shorting transaction by an authorized participant is accounted for. I wonder if it somehow ends up as paired transactions. If so, the added selling pressure would be hidden from view.”

Administrative expenses incurred by ETFs dampen investors’ returns. According to a study by Morgan Stanley, ETFs missed their 2009 targets by an average of 1.25%, which was double the size of their “miss” in 2008. Those percentages are your “haircuts” for the privilege of trading ETFs rather than individual stocks. The more exotic the index tracked by an ETF, the greater your “haircut.”

Some ETFs lose value so fast that their issuers repeatedly perform reverse splits in order to raise prices back into double digits. With the passage of time, those ETFs sink back into single digits, and then their issuers perform another reverse split to make their ETFs appeal to new suckers.

A friend of mine lost over a million dollars last year: he anticipated a market decline and bought an ETF of a volatility index (volatility rises when markets fall). Sure enough, the market dropped 10% and volatility spiked—but his ETF went down instead of up.

Many ETFs “track” their underlying indexes in a shabby manner. After giving commodity ETFs a try, I wouldn’t touch them with a ten-foot pole, having experienced several days during which the underlying commodity went up, while my commodity ETFs went down. I stopped trading country ETFs after running into several situations in which a country index would rise to a new high, while my ETF would stay well below the breakout level.

The leveraged ETFs are more “futures-laden” than non-leveraged ETFs and have much greater rollover losses each month. The disadvantages that retail investors suffer are magnified in the leveraged ETFs. They may track their underlying vehicles more or less correctly during a single trading session, but deviate widely with the passage of time.

FIGURE  $VIX, the volatility index, and VXX, a volatility ETF, weekly. 

FIGURE  Natural Gas Spot and UNG, a natural gas ETF, monthly.


The only ETFs that trade more or less decently are broadly based ones, such as SPY and QQQ. Overall, ETFs attract many unsophisticated retail clients, but the pervasive haircuts and poor tracking of the underlying securities slant the field against them. Remember an important principle: TANSTAFL—“there ain’t no such thing as a free lunch.” When it comes to ETFs: buyer beware.

Options

An option is a derivative instrument—a bet that another security, such as a stock, an index, or a future will reach a certain price by a certain date. A call gives its holder a right, but not an obligation, to buy a certain quantity of a specified security at aspecified price at a specified time. It is a bet on a price increase. A put is a right, but not an obligation, to sell a certain quantity of a specified security at a specified price at a specified time.

It is a bet on a price drop. There are two parties in every options trade: a buyer and a seller, also called a writer. Buyers buy options, while writers create options and sell them to buyers. The key point to keep in mind is that option buyers as a group lose money over time, despite occasional lucky trades. At the other end of the table, options writers as a group make steady money despite occasional losses.

Writers create options out of thin air to meet demand from option buyers. One of my students, a market-maker on the floor of the American Stock Exchange, said to me: “Options are a hope business. You can buy hope or sell hope. I am a professional— I sell hope. I come to the floor in the morning and find what the public hopes for.

Then I price that hope and sell it to them.” Each option has an exercise price. If a stock fails to reach that price before the exercise date, the option expires worthless and the buyer loses what he paid, while the writer keeps his loot, whose polite name is premium.

  • An option is at-the-money when the current price of the underlying security equals the exercise price.
  • A call is out-of-the-money when the current price of the underlying security is below the exercise price. A put is out-of-the-money when the current price of the underlying is above the exercise price. The farther out-of-the-money, the cheaper the option.
  • A call is in-the-money when the current price of the underlying security is above the exercise price. A put is in-the-money when the current price of the underlying is below the exercise price.
An option can be at-the-money, out-of-the-money, or in-the-money at different times in its life, as the price of the underlying security fluctuates. The price of every option has two components—an intrinsic value and a time value.

  • An option’s intrinsic value rises above zero only when it’s in-the-money. If the exercise price of a call is $80 and the underlying security rises to $83, the intrinsic value of your call will be $3. If the security is at or below $80, the intrinsic value of that call is zero.
  • The other component of an option’s price is time value. If the stock trades at $74 and people pay $2 for an $80 call, the entire $2 represents time value. If the stock rises to $83, and the price of the call jumps to $4, $3 of that is intrinsic value ($83 – $80), while $1 is time value.

Option prices depend on several factors:

  • The farther out-of-the-money the exercise price, the cheaper the option—the underlying security must travel a longer distance to make the option worth anything before it expires.
  • The closer the expiration day, the cheaper the option—it has less time to fulfill the hope. The speed with which an option loses value is called “time decay,” which doesn’t occur in a straight line but becomes steeper as the expiration nears.
  • The less volatile the underlying security, the cheaper the option, because it has a smaller chance of making a large move.
  • Minor factors influencing option prices include the current level of interest rates and the dividend rate of the underlying stock.
Different factors that impact option pricing may clash and partly cancel each other out. For example, if a market drops sharply, reducing the value of calls, the increased volatility will lift option values, and the calls may lose less than expected. There are several mathematical models, such as Black-Scholes, widely described in options literature, that are used to determine what is called a fair value of any option.

Buying Options

The simplest and easiest approach to options is to buy them. That’s exactly what beginners do, and unless they learn quickly and change, their accounts are doomed. This is the standard line of brokerage house propaganda: “Options offer leverage—an ability to control large positions with a small outlay of cash. The entire risk of an option is limited to the price you pay for it.

Options allow traders to make money fast when they’re right, but if the market reverses, you can walk away and owe nothing!” They fail to mention that in order to profit from buying an option you must be right in three ways. You must choose the right stock, predict the extent of its move, and forecast how fast it’ll get there. If you’re wrong on even one of these three choices, you’ll lose money.

Ever tried tossing a ball through three rings at an amusement park? This triple complexity makes buying options a losing game. A stock, an index, or a future can do one of three things: rise, fall, or stay flat. When you buy a call, you can profit only if the market rises; you lose if it goes down or stays flat. You can lose even if it rises, but not fast enough. When you buy a put, you win only if the market falls fast enough. An option buyer makes money only if the market goes his way at a good enough speed, but loses if it moves his way slowly, stays flat, or goes against him.

An option buyer has one chance out of three to win—but the odds are two out of three in favor of an option writer. No wonder the pros write options. A pro sells a call, and if a stock drops, stays flat, or even rises slowly, that call will expire worthless, and he’ll keep the premium. He sells poor buyers hope—and as that hope turns out to be worthless, he keeps their money.

Options attract hordes of small traders who can’t afford to buy stocks. To get a bigger bang for their buck, they buy calls as if those were substitutes for stocks. This doesn’t work because options move differently from stocks. Gullible amateurs buy empty hopes, which the pros are delighted to sell to them.

Beginners, gamblers, and undercapitalized traders make up the majority of option buyers. Just think of all the money those hapless folks lose in their eagerness to get rich quick. Who gets all that money? Some of it goes for brokerage commissions, but the bulk flows into the pockets of option writers. Well-capitalized professionals write options rather than buy them. Option writing is a capital-intensive business:

you need hundreds of thousands of dollars at a minimum to do it right, and most successful writers operate with millions. Writing options is a serious game for knowledgeable, disciplined, and well-capitalized traders. If your account is too small for option writing, wait until it grows bigger.

Markets are like pumps that suck money out of pockets of the poorly informed majority and into the wallets of a savvy minority. Smart traders in any market look for situations in which the majority does something one way, while a small, moneyed minority does the opposite. Options are a great example of this rule.

Writing Options

There are two main types of option writing. Covered writers buy a stock and write options against it. Naked writers write calls and puts on stocks they don’t own.

Covered writers own underlying securities. For example, a fund may hold a large position in IBM stock and sell calls against it. If the stock doesn’t rise to the exercise price during the life of those calls, the options will expire worthless. The covered writer will add his premium to the fund and write a new call with a new expiration date. If IBM does rise to the exercise price and “gets called,” they’ll deliver their stock at its strike price, collect the money, and use the freed-up capital to buy another stock and write calls against it.

Large funds tend to use computerized models for buying stocks and writing covered calls. Covered writing is a mathematically demanding, capital-intensive business. Most serious players spread their costs, including staff and equipment, across a large capital base. A small trader doesn’t have much of an edge in this expensive enterprise. Covered writing was very profitable in the early years of exchange-traded options. By now the field is very crowded, and the returns have become thinner.

Naked writers sell options without owning their underlying securities; they back up their writes with cash in their accounts. A naked writer collects his premium when he opens a trade, but his risk is unlimited if that position goes against him. If you own a stock, sell a covered call, and that stock rises to its exercise price and gets called, you have something to deliver. If you sell a naked call and the stock rises to or above its exercise price, you’ll have to pay. Imagine selling calls on a stock that becomes a takeover play and opens $50 higher the next morning—you still have to deliver.

This combination of limited rewards with unlimited risks scares most traders away from naked writing—but as usual, there’s a gap between perception and reality. A far-out-of-the-money option with a short time to the expiration is very likely to expire worthless, meaning the writer will profit. The risk/reward ratio in naked writing is better than it looks, and there are techniques for reducing the impact of a rare adverse move.

Savvy naked writers tend to sell out-of-the-money calls and puts whose underlying stocks or futures are unlikely to reach their strike prices during the remaining life of an option. They sell not just hopes but distant hopes. Good writers track volatility to find how far a stock is likely to move and then sell options outside of that range. This game goes into high gear during the week or two prior to option expiration, when the floor mints money out of thin air, selling naked puts and calls that have almost no chance of reaching their exercise price.

Cautious writers close their positions without waiting for the expiration dates. If you write a call at 90 cents and it goes down to 10 cents, it makes sense to buy it back and unwind your position. You’ve already earned the bulk of potential profit, so why expose yourself to continued risk? It’s cheaper to pay another commission, book your profits, and look for another writing opportunity.

Becoming a naked writer requires iron discipline. The size of your writes and the number of positions must be strictly determined by your money management rules. If you sell a naked call and the stock rallies above its exercise price, it exposes you to the risk of ruin. You must decide in advance at what level you will cut and run, taking a relatively small loss. A naked seller cannot afford to sit and hope when a stock moves against him.

Writer’s Choice

Time is the enemy of options buyers. Every buyer has lived through this sad sequence: they buy a call, the stock rises, but their option fades to zero, and they lose money. Buyers lose when the underlying security takes longer than expected to get to the level at which they can collect on their bet. Most options become worthless by their expiration date.

What if we reverse this process and write rather than buy options? The first time you write an option, and do it correctly, you’ll experience the delicious sensation of time working in your favor. The option that you wrote loses some of its time value each day, making the premium you’ve collected safer. When the market goes nowhere, you still make money, as time value keeps evaporating, making it more likely that you’ll keep the premium.

If living well is the best revenge, then taking a factor that kills most options buyers—time—and making it work for you is a gratifying experience. Since each option represents a hope, it’s better to sell empty hopes which are unlikely to be fulfilled. Take three steps before writing a call or a put:

1. Analyze the security against which you want to write options.
Use Triple Screen to decide whether a stock, future, or an index is trending or non-trending. Use weekly and daily charts, trend-following indicators, and oscillators to identify trends, detect reversals, and set up price targets. Avoid writing when earnings are about to be announced—do not hold open positions during those potentially stormy days.

2. Select the type of option to write.
If your analysis is bearish, consider writing calls, but if bullish, consider writing puts. When the trend is up, sell the hope that it will turn down, and when it’s down, sell the hope it’ll turn up. Do not write options when markets are flat and premiums low—a breakout from a trading range can hurt you.

3. Estimate how far, with a generous safety margin, the stock would have to run in order to change its trend. Write an option beyond that level.
Write an option with a strike price the market is unlikely to reach before the option expiration. An objective tool that shows the degree of safety of your planned position is an indicator called Delta, which we’ll discuss below.

Time Decay Options lose value with each passing day, but their rate of decay isn’t steady. Options drop faster as the expiration date draws closer. Like a boulder rolling downhill, time decay becomes vertical at the final cliff. Time decay is bad for option buyers, but very good for option writers. You collect your premium the day you sell a call. The deeper it falls below the price at which you wrote it, the safer your premium. Time decay is a friend of the option writer but an enemy of the option buyer.

With that in mind, the sweet spot for an option writer is approximately two to three months from option expiration. That’s when time decay starts gathering speed. It accelerates in the last few weeks of the option’s life. When you write options close to the expiration, you benefit from faster time decay. You can get more money for options with longer lives, but don’t be greedy. The goal of a writer is not to make a killing on any single trade but to grind out steady income.

Delta is a tool that shows the probability of the underlying security reaching your option’s exercise price by its expiration date. It’s one of several options tools, collectively called the “Greeks”. You can find Delta for any stock, index, or ETF on many financial websites, especially those of brokerages that offer options services.

A cautious option writer should aim to sell calls or puts whose Delta isn’t much above 0.10, meaning there is only a 10% chance of the exercise price getting hit before the expiration date. Remember, as an option writer you don’t want the underlying security to reach that price: you want to sell empty hopes. If 10% risk seems high, keep in mind that Delta is derived without any reference to market analysis. If your decision is based on good technical analysis, your risk will be lower than what Delta indicates.

The temptation to sell naked options closer to the money and get fatter premiums is dangerous. The Delta is likely to be high, meaning that a slight counter-trend move can push your position underwater. If you’re going to write options, treat it like writing accident insurance policies. To make steady profits and sleep well at night, sell your auto insurance policies to ladies who only drive to supermarkets rather than to motorcycle daredevils.

Limiting Risk

A big options trader shared with me his technique of “slicing the bid-ask spread.” He puts in a low bid or a high ask and then starts giving up a penny at a time until somebody bites. For example, he recently saw an option he wanted to write. The bid was $1.18 and the ask $1.30, but he had no intention of selling at $1.18 and paying that huge spread. Instead, he put in his order to sell a large number of contracts at $1.29, a penny cheaper than the ask. 

No response. A few minutes later he lowered his ask to $1.28—and suddenly a buyer materialized, snapped up his contracts, and then the bid-ask spread went back to $1.18/$1.30. My client finds  there are large traders watching from the sidelines, not showing their hand, but willing to trade within the spread. He gets them to bite by giving up a penny at a time.

Option writers can get hurt in one of three ways. Some overtrade, creating positions that are too large for their accounts. Assuming too much risk makes them nervous and unable to hold positions through any wiggles. Option writers also get hurt when they fail to run fast enough when an option moves against them. Finally, option writers can get blown out if they don’t have a reserve against a major adverse move. The longer you trade, the greater the risk of a catastrophic event.

A writer can grow careless selling naked options and pocketing profits. A smug feeling of self-satisfaction can blind him to reality. You must protect all trades, including naked options. Several suggestions:

  • Set your profit-taking zone—consider buying back your naked options.
The option you write is a wasting asset. When the underlying security moves far from the exercise price but there is still time left to the expiration, the price of the option you sold may fall near its rock bottom and lose value in tiny dribs and drabs. The loser who bought that option still has a bit of a chance that the market may reverse in his favor. He continues to hold that option like a lottery ticket— and once in a rare while his ticket may win.

As a writer, why hold an open position that has already given you most of its potential profit? You have little to gain, while remaining exposed to risk. After the option you sold loses half of its value, consider buying it back to close your profitable trade. By the time an option loses 80% of its value, you should be out of that trade.

  • Use a mental stop-loss on the option you sold.
It is better to use mental stops here because many pros go fishing for stops of thinly traded options. Using mental stops requires iron discipline—another reason why option writing isn’t a beginners’ game.

Set your mental stops both on the underlying security and the option itself. For example, you may sell a naked April 80 call on a stock trading at 70 and place your mental stop at 75. Get out of your naked option position before it gets into the money. Also, set a stop on your option: if it doubles in price, buy it back to cut the loss. If you sold an option for $1.50, buy it back if it rises to $3. It may hurt, but it’ll be nowhere near the “unlimited loss” that makes people afraid to write options.

  • Open an insurance account.
You may write a put and the market crashes the next day, or you write a call and suddenly there is a takeover. You hope this never happens—but trade long enough and eventually everything will happen! That’s why you need insurance. Nobody will write it for you, so you’ll have to self-insure.

Open a money market account, and every time you close out a profitable naked writing position, throw 10 percent of your profit into that account. Do not use it for trading—let your insurance account grow with each new profit, ready to cover a catastrophic loss or to be taken out in cash when you stop writing options. In a recent consultation with a professional option writer, I recommended that he send 10% of his profit above a certain threshold to the bank that holds the mortgage on his country house, using that prepayment as his insurance fund.

Can Option Buying Be Intelligent?

Professionals may buy puts on a rare occasion when they expect a severe drop. When a long-term uptrend begins to turn, it can create massive turbulence near the top, similar to an ocean liner changing its course. When volatility goes through the roof, even well-heeled traders have trouble setting stops on shorts. Buying puts allows you to sidestep this problem.

Prices tend to fall twice as fast as they rise. Greed, the dominant emotion of uptrends, is a happy and lasting feeling. Fear, the dominant emotion of downtrends, is sharper and more violent. Professionals are more likely to buy puts because of shorter exposure to time decay. Uptrends are better traded with stocks or futures.

A trader who expects a downswing must decide what put to buy. The best choice is counterintuitive and quite different from what most people get.

  • Estimate how low you expect a stock to collapse. A put is worth buying only if you expect a crash.
  • Avoid puts with more than two months of life. Buying puts makes sense only when you expect a waterfall decline. If you anticipate a drawn-out downtrend, better sell short the underlying security.
  • Look for cheap puts whose price reflects no hope. Move your finger down the column: the lower the strike, the cheaper the put. At first, each time you drop to the next strike price, a put is 25% or even 35% cheaper than at the previous level. Eventually you come to the strike level at which you would save only a tiny fraction of a put’s price. This shows that all hope has been squeezed out of that put, and it is priced like a cheap lottery ticket. That’s the one you want!
Buying a very cheap, far-out-of-the-money put is counterintuitive. It is so far out of the money and has so little life left in it that it’s likely to expire worthless. You can’t place a stop on it, and if you’re wrong, the entire premium will go up in smoke. Why not buy a put closer to the money?

The only time to buy a put is when you’re shooting for an exceptional gain from a major reversal. In an ordinary downtrend it’s better to short stocks. With cheap far-out-of-the-money puts you aim for a tenfold gain or better. Returns like these allow you to be wrong on a string of such trades, yet come out ahead in the end. Catching one major reversal will make up for several losses and leave you very profitable.

Why don’t more people use this tactic? First, it requires a great deal of patience, as opportunities are very infrequent. The entertainment value is very low. Most people can’t stomach the idea of being wrong three, four, or five times in a row, even if they are likely to make money in the end. That’s why so few traders play this game.

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