Showing posts with label options-trading-for-beginners. Show all posts
Showing posts with label options-trading-for-beginners. Show all posts

Long-Term Options- Introduction

Long-Term Options


Introduction

Instead, the purpose of this is to highlight the fact that option premiums in general do not reflect the expected long-term growth rate of the underlying equities and to explain an investment strategy that can be used to take maximum advantage of this phenomenon. As I mentioned before, my own interest in this subject stems from the fact that I could no longer contribute additional funds to my retirement plan. As a long-term investor in the market, I had assembled a stock portfolio over many years, and I simply did not wish to raise cash by selling any of my winners. My few losers and laggards had long since been disposed of and the proceeds used to buy more shares of my better-performing stocks. I'm not a short-term, in-and-out investor, but I wanted to keep buying.

Options seemed the way to go, but as with stocks, purchasing calls requires money. What's more, options can only be paid for in cash, so going on margin and borrowing the funds from my broker was out of the question. My next thought was, if I'm going to raise cash, why not sell covered calls on my portfolio? I tried this a few times and promptly had some of my stocks called away from me when their share prices sharply increased as a result of takeover rumors or positive earnings surprises. I wasn't too happy about having to buy back shares using the little cash I had remaining to cover the gap between the exercise price received and the higher repurchase price. So much for covered calls.

By process of elimination, the only strategy remaining was selling puts. This method, you will recall, generates up-front money through the premiums received. Option premiums must be paid on the next business day and are available for reinvestment even faster than proceeds from the sale of stock (which settle within three business days). And because these funds represent premiums paid, not dollars borrowed, they are yours to keep. However, as the fine print in most travel ads states, "certain restrictions apply." Premiums have to stay in your account in case they are needed later in the event of assignment. But because they are in your account, you can use them to acquire additional equities. 

The problem with this approach, I soon discovered, is that applying it to standard options does not bring in much money, especially in relation to the risk assumed in potentially having the underlying stock assigned to you. You can certainly sell a put whose exercise price is well below the current stock price, thereby minimizing the risk of assignment, but doing this brings in a very small premium. A larger premium can be generated by selling a put with an exercise price much closer to or just below the current price, but this can entail significant risk of assignment. Substantial premiums seen on out-of-the-money* puts typically indicate highly volatile stocks or instances where the market (probably correctly) anticipates a sharp drop in the value of the underlying equity—situations that had no appeal to me whatsoever.

And if all that isn't enough, there is also the fact that dealing in standard options, with their quickly changing market values, typically requires substantial, if not full-time, commitment to the task. Most option traders I've met have had little time for anything else during their working days and have often spent a good deal of their evenings and weekends conducting research into what trades to enter and when to cover and get out. This kind of nerve-wracking, nail-biting, glued-to-the-console environment is not what I wanted either. It then occurred to me that there was a solution to this dilemma.

There does exist a class of options whose premiums are relatively large, which bear less risk than standard options, and which, because the underlying equities are comparatively stable, do not have to be monitored with anywhere near the same intensity as standard options. What distinguishes this class of options is their long-term expiration date, which permits the market price of the underlying equity plenty of time to recover should the overall market, industry sector, or the company itself encounter a temporary downturn or adverse conditions. It occurred to me that by selling puts on stronger, well-endowed firms whose intermediate- and long-term prospects are above average, it might be possible to achieve high returns without incurring undue risk.

LEAPS

The class of options that fits this description was actually created by the Chicago Board Options Exchange in 1990. Because standard options expire at most eight months after their inception, the CBOE introduced a new product for investors wishing to hedge common stock positions over a much longer time horizon. These options, called LEAPS (Long-term Equity AnticiPation Securities), are long-term options on common stocks of companies that are listed on securities exchanges or that trade over the counter. LEAPS expire on the Saturday following the third Friday in the month of January approximately two and a half years from the date of the initial listing. 

They roll into and become standard options after the May, June, or July expiration date corresponding to the expiration cycle of the underlying security. In most other ways, LEAPS are identical to standard options. Strike price intervals for LEAPS follow the same rules as standard options (i.e., they are $2.50 when the stock price of the underlying equity is between $5 and $25, $5 when the stock price is between $25 and $200, and $10 when the stock price is over $200). As for standard options, strike prices for LEAPS are adjusted for splits, major stock dividends, recapitalizations, and spin-offs when and if they occur during the life of the option. 

Like standard options, equity LEAPS generally may be exercised on any business day before the expiration date. Margin requirements for LEAPS follow the same rules as standard options. Uncovered put or call writers must deposit 100 percent of the option proceeds plus 20 percent of the aggregate contract value (the current price of the underlying equity multiplied by $100) minus the amount, if any, by which the LEAP option is out of the money. The minimum margin is 100 percent of the option proceeds plus 10 percent of the aggregate contract value. 

LEAP Premiums

Option premiums in general vary directly with the remaining time to expiration. As a result of their longer lives, LEAPS have premiums that can be considerably greater than those of their standard option counterparts. Each entry in the table is the theoretical premium corresponding to the expiration time in months shown in column 1 and the stock volatility, ranging from a fairly low level of 0.15 to a fairly high level of 0.65. Intel's stock, for example, has a volatility of about 0.35, so when the stock price reaches $100, an at-the-money put option should command a premium of $829.60 ($8.296 × 100 shares) with six months to expiration and a premium of $1,313.40 ($13.314 × 100 shares) with 24 months to expiration.

That is, if the stock price and strike price are both $50, the corresponding per share premiums are exactly half the amounts shown. The first question people often ask is why the at-the-money call premiums are so much greater than the corresponding put premiums for the same time horizon and volatility level. Note, for example, that for a stock with a volatility of 0.35 and an expiration date 30 months away, the put premium is $14.035 per share versus $27.964 for the call premium. Is this difference due to general inflation and/or the expected growth rate in the underlying equity?

The answer is no. The reason the call premiums are greater is that option pricing models assume that stock prices are just as likely to increase by, say, 10 percent as they are to decrease by 10 percent on any given day. On a cumulative basis, there is therefore no limit to how high prices can go up over time, but there is a definite lower limit (zero) to how low prices can go. It is this possibility of unrestricted price movement upward versus restricted price movement downward that explains why calls are more expensive than puts.

Commissions

There is another major advantage associated with LEAPS. Because of the inherently greater premium levels involved, the brokerage commissions charged are going to be a smaller percentage of the proceeds received. At a full-service firm, the brokerage commission to buy or sell a single option might be $45. In percentage terms, this amount is almost 12 percent of the premium for the one-month Intel option, but just 3.2 percent of the premium for the 30-month LEAP option. Commission costs per contract rapidly decrease at a full-service firm if more than one contract is involved and might range from $25 to $35 each for three contracts down to just $15 to $20 each for ten contracts.

At a discount broker's, the commission might be $20 each, but it is typically subject to a minimum fee of $40 and a maximum fee of $70 on transactions involving one to ten contracts. For online, deep-discount, and option-specialized brokers, the commission might be $15 each but is typically subject to a minimum fee of $35 and a maximum fee of $60 on transactions of one to ten contracts.

Table  European-Style At-the-Money Put Premiums as a Function of Time and Volatility


Although there can be significant differences in total commission costs between full-service brokers and other firms, I prefer to work with options-knowledgeable people at a full-service firm. I can readily do this because I am not a short-term investor, and the relatively small number of trades I do per year does not result in significant commissions in terms of absolute dollars. This is particularly true when one remembers that in selling options that subsequently expire worthless, only one commission is involved, not two.

Table  European-Style At-the-Money Call Premiums as a Function of Time and Volatility



LEAPS Available

LEAPS are currently traded on over 300 widely followed equities (as well as on numerous industry sector, domestic, and international indices). Shows the name of the underlying security, its stock symbol, the standard option symbol, the exchange code(s) showing where the option is traded, the options cycle governing when the LEAP option rolls over into a standard option, and the option symbol for the LEAPS expiring in the years 2001 and 2002. Omitted from the table are issues for which no new LEAPS will be listed as a result of mergers and acquisitions that have taken place.

Exchange Codes.

LEAPS are traded on one or more of four major exchanges,* as indicated by the following symbols:

A American Stock Exchange
C Chicago Board Options Exchange
P Pacific Stock Exchange
X Philadelphia Stock Exchange

Expiration Cycles.

These are the January, February, and March cycles that control how and when each LEAP option rolls over into a standard option. It is important to note that the trading symbol for a LEAP option will change when it does roll over and become a standard option, and quote requests, statements, trades, close-outs and exercise instructions should reflect this. In Table, the numerical codes used for the expiration cycles are:

1 January Sequential
2 February Sequential
3 March Sequential

The expiration cycle of a given class of options also tells you the specific month that the corresponding LEAP is due to open for trading. For example, Intel is cycle 1, so the next set of Intel LEAPS is supposed to open right after the May expiration. Boeing is cycle 2, so the next set of Boeing LEAPS is supposed to open right after the June expiration. And Pfizer is cycle 3, so the next set of Pfizer LEAPS is supposed to open right after the July expiration.

LEAP Symbols.

To facilitate trading, LEAPS are symbolized by a four- to six-character trading symbol made up of a root symbol designating the underlying equity, a single character designating the expiration month, and a single letter designating the strike price involved. Because LEAPS expire only in January, the code letter for the expiration month is always A for calls and M for puts. The root symbols for the underlying equity began with the letter V for the January 1999 LEAPS and the letter L for the January 2000 LEAPS, and begin with the letter Z for the January 2001 LEAPS and the letter W for the January 2002 LEAPS. This V/L/Z/W sequence of initial letters is repeated every four years, so the letter V will likely be assigned as the starting letter for the year 2003 LEAPS.

As each LEAP option rolls over into a standard option approximately a half year prior to expiration, the root symbol portion of the trading code is changed to that of the standard option. Because of conflicts that frequently arise with existing trading symbols of stocks and standard options, there is often no consistency in the designations of LEAP root symbols. Note too that although the LEAP root symbols are three letters long, in some instances they consist of just two letters. A dash indicates that there was no LEAP option offered for that year on a particular security, often because of a pending merger or acquisition.

It is frequently the case that as a result of a wide fluctuation in stock price (as well as mergers, acquisitions, and stock splits), there is going to be more than one LEAP root symbol for a given stock and expiration year. For example, the January 2001 LEAPS for Yahoo have the root YZY for strikes between $22.5 and $35; ZYH for strikes $37.50 through $85; ZGH for strikes $90 through $135; ZYO for strikes $150 through $200; and ZYM for strikes between $210 and $250. The only sure way to determine the correct root symbol for a given LEAP option series is to consult an online table showing the specific LEAPS available, such as the one maintained by the Chicago Board Options Exchange. Or you can call the CBOE directly at 800-OPTIONS (678-4667).

Position Limits.

Not shown in Table because of rapidly changing conditions is the maximum number of open contracts that are permitted on any option class. As opposed to stocks, whose outstanding shares often number in the hundreds of millions, the maximum number of open option contracts (including LEAPS and standard options) permitted on the underlying equity is heavily limited. These limits are set in accordance with the number of outstanding shares and the trading volume of the underlying equity.

The larger, more frequently traded stocks are assigned initial position limits of 75,000 contracts, while less active issues are assigned initial position limits of either 60,000, 31,500, 22,500, or as few as 13,500 contracts for the smallest of traded issues. As a result of stock splits, mergers, acquisitions, and other factors, these limits are periodically adjusted. Position limits are imposed by the various options exchanges to prevent any person or entity from controlling the market on a given issue. Because every option contract has both a buyer and a seller, the open contract count is the sum of the number of opening calls bought and the number of opening puts sold, so as not to double count.

Using Options to Buy Stocks

There's no way around it, buying stocks takes money. But by now you've guessed where the money for buying stocks can come from: not out of your pocket but from the premiums accumulated from the sales of the LEAP puts. As described in the preface, the purpose of my selling LEAP puts was not just to enhance the cash flow and dividend yield of my stock portfolio. Rather, it was to furnish the funds with which to continue stock acquisition.

Table  LEAPS Available August 1999



Table  LEAPS Available August 1999


Table  LEAPS Available August 1999


 Table  LEAPS Available August 1999


Table  LEAPS Available August 1999 


Table  LEAPS Available August 1999



Table  LEAPS Available August 1999


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THE OPTIONS COURSE- Final Summary

THE OPTIONS COURSE



Final Summary

It has avoided trying to forecast market direction or analyzing charts with detailed market patterns, and has not referenced highly technical data or difficult-to-interpret fundamental information. Although these trading tools may have their place in your trading arsenal, they are exhaustively studied in many other publications. The purpose of this book is to focus on options trading strategies and to demonstrate how professionals trade without overanalyzing the markets. When traders get bogged down in trying to process too much information, the result is what I often call “analysis paralysis.”

Learning to trade can be quite difficult and perplexing. Each strategy has an infinite number of possibilities when applied to the markets. Each trade is unique, and your task as a trader is to learn from your achievements and your mistakes. There are no absolutes in trading. However, I do believe that you will be able to build a solid trading foundation based on the delta neutral strategies. This approach to trading comes from years of experience from my trading team and my own endeavors. To become successful, it’s up to you to take a systematic approach to becoming a confident market player.

However, you must be willing to spend the time and energy it takes to study the markets if you want to learn how to trade successfully. In late October of 1997, the Dow Jones Industrial Average dropped 554 points or 7 percent. By most people’s standards, this constitutes a mini-crash. It was not as severe as the 1987 crash when there was a 22 percent drop, but it definitely shook up the markets. Throughout the day of the mini-crash, I talked with a number of traders and investors to discuss our views on this market decline. At many brokerage firms, clients were being forced to meet margin calls as their positions declined. 

Eventually, there were more sell orders than the markets could bear and trading closed early at the New York Stock Exchange. Compared to the millions of individuals who lost a great deal of money, traders who were using the strategies included in this book fared much better. They knew how to hedge their positions and either made money or at least minimized the losses to their accounts. This approach to trading offers protection and enables players to keep playing the game. To get started, find one market you like and get to know it very well. Find out how many shares or contracts are traded. 

What is the tick value? What are the support and resistance levels? What are the strike prices of the available options? How many months of options should be analyzed? Is this a volatile market? Does it have high liquidity? Do you have enough capital to play this market?Once you determine the right market for you, focus your efforts on evaluating which strategies best take advantage of this market’s unique characteristics. This can be accomplished by paying close attention to market movement trends. For example, stock shares tend to go up in price over the long run. This means that in many cases I take a bullish bias over the long run in top stocks.

Since many futures markets go sideways, I like to apply the appropriate range-bound strategies. By concentrating your attention on one market, you will become familiar with that market’s personality. When change occurs, this familiarity will enable you to profit the most from the change. Practice these strategies by paper trading your market until you get the hang of it. I recommend three to six months of paper trading before investing a dime. For every great trade you missed, there will be mistakes that could have wiped out your whole account. Take small steps up the ladder of experience and you’ll learn what you need to master along the way.

In addition, you need to determine what influences a specific market. Markets have spheres of influences. You need to get to know what internal and external forces drive your chosen market. For example, the bond market affects the S&Ps. What affects Dell, Intel, Microsoft, gold, and silver? All of this research combines to increase your overall knowledge of trading, which will help to make you a more successful trader in the years to come. During one of my two-day Optionetics seminars, I kept saying that very few traders and investors really know what is going on in the markets. The very next day, as if by magic, the following article appeared in USA Today. I promptly revealed it to the students at my seminar.

So, let me get this straight. Politicians supposedly run entire countries, right? Then how come their own finance ministers cannot beat garbagemen at predicting economic prospects? This only emphasizes the point that the markets are great equalizers of education. It is irrelevant whether you have an MBA or a PhD or are a rocket scientist. High school dropouts can do just as well at trading, if not better, if they are disciplined and have the skills and knowledge to succeed. It is actually easier for me to train individuals with very little experience or none whatsoever than those who have years of experience. This is due to the fact that many experienced traders have developed bad habits that need to be broken.

Approximately 99 percent of the time that I trade delta neutral, I am able to manage my risk on entering the trade and monitor it each day as the market moves. Delta neutral trading is a scientific system that significantly reduces your stress level. It provides you with the means to limit your risk and make a consistent profit. It directs you to take advantage of market movement by making adjustments. By learning to trade using delta neutral strategies, traders have the opportunity to maximize profits by making consistent returns.

OPTIONS-TRADING DISCIPLINE

Proper money management and patience in options trading are the cornerstones to success. The key to this winning combination is discipline. Now, discipline is not something that we apply only during the hours of trading, opening it up like bottled water at the opening bell and storing it away at the closing. Discipline is a way of life, a method of thinking. It is, most of all, a serious approach. A consistent and methodical, or disciplined, system leads to profits in trading. On one hand, it means taking a quick, predefined loss because the first loss is always the best.

On the other hand, discipline gives you the impenetrable strength to keep holding on to an options position when success is at hand or passing on the trade or an adjustment when you don’t have a signal. It also entails doing all our preparatory work before market hours. It is getting ourselves ready and situated before the trade goes off so that, in a focused state, we can monitor market events as they unfold. Discipline can sometimes have a negative sound, but the way to freedom and prosperity is an organized, focused, and responsive process of trading. With that, and an arsenal of low-risk/high-profit options strategies, profits can indeed flow profusely. The consistent disciplined application of these strategies is essential to your success as a professional trader.

Finally, as option traders, in order to improve in the area of discipline, we must identify, change, or rid ourselves of anything in our mental environment that doesn’t contribute to the strictest execution of our well-planned trading approach. We need to stay focused on what we need to learn and do the work that is necessary. Your belief in what is possible will continue to evolve as a function of your propensity to adapt. On a cautionary note, avoid high commissions, brokers soliciting business, and software that promises or boasts impossible results. High turnaround fees can really eat into your profits. Remember, nothing beats your own ability to trade effectively. No one wants to take better care of your money than you do.

CHOOSING THE OPTIMUM OPTION STRATEGY

For the skilled investor, stock options can be a very powerful tool. Whether they are used alone or in combination with other options or stock, options offer the flexibility to address any number of unique investment goals and parameters. However, before the search for a suitable strategy can even begin, the investor needs a solid understanding of how option investments work. The options strategist is always faced with a variety of alternatives. To determine which one is best you must consider your investment goals, market outlook, and risk tolerance all of which are key in narrowing down the list of reasonable candidates.  The same goals and predictions can also limit the choice of suitable strike prices and expiration dates.

Each strategy and each contract has its own advantages and drawbacks. Forecasting the price of the underlying equity is a prime motive behind directional option strategies. Whether the goal is profit or protection, the market outlook certainly narrows the list of strategic alternatives. More often than not directional strategies require the investor to make at least three assessments about the future price of the stock. The first one is obviously direction itself. Based on our market analysis, we need to determine if we expect the price of the stock to rise, fall, or stay at the current level. The second judgment is about the size of the move. This will have a distinct bearing on the choice of strike prices.

For some option strategies, it is not enough to decide on a direction. The magnitude of the projected price move may determine which strike prices are suitable candidates. For instance, when analyzing a call option with an out-of-the-money strike price, you will need to determine how high would the underlying stock have to rise to make the position profitable as well as how realistic this move would be based on your research. The third decision concerns the time frame in which the stock price forecast must take place. Options have a limited time span. If both the projected direction and size of the move come true, but only after the option expires, the option strategist still would not have achieved the intended goal. 

That is why timing is just as crucial in strategy selection as it is for everyday life. So, option strategists who are making a directional call must be right on three levels; the stock price must move in the right direction, by a sufficient amount, and by the expiration date. If the trader is wrong about any of the three projections, it could have an adverse impact on the success of the strategy. For some strategies, it is enough for XYZ to reach a certain level at some point before expiration, but the exact timing is less important. The consequences for being a bit off the mark are much more serious in other cases. There are some that succeed only if the stock price behaves correctly for the duration of the contract. 

A clear idea about where the underlying equity is likely to move and when, should improve the option strategist’s chances of success with selecting and implementing an appropriate directional strategy. Finally, even when two traders’ forecasts are exactly the same, different goals may dictate two very different approaches. For example, is the trade intended primarily to generate income or is it to protect an existing position in the same stock? Or is it a way to set a price objective for entering or exiting a stock position? The answers to these kinds of questions will guide the trader in ruling in some strategies and ruling out others when attempting to select the optimum options strategy.

IMPLIED VOLATILITY AND TRADE SELECTION

When it comes to professionally trading options, there is no more important component than volatility. As discussed in earlier chapters, volatility will often dictate which strategy is best in any given situation. We have already explored what volatility is and the relationship between two types of volatility: implied and historical volatility. Now let us correlate the relative implied volatility levels to the inventory of available option strategies using a strategy matrix. It will provide some guidelines on how to best use this valuable strategy-driving indicator.

Before presenting a comprehensive table of implied volatility levels and option strategies, let’s review the definitions of each strategy. These definitions serve only to facilitate an understanding of the table so that you may refer to it when needed with clarity. Although most of the strategies have been covered in this book, the reader is encouraged to investigate additional educational resources that offer a more in-depth analysis on any or all of the strategies. You may want to find one or two that seem to make the most sense to you, and start paper trading them until you understand them thoroughly.

Call Gives the buyer the right, but not the obligation, to buy the underlying stock at a certain price on or before a specific date. The seller of a call option is obligated to deliver 100 shares of the underlying stock at a certain price on or before a specific date if the call is assigned. 

Put Gives the buyer the right, but not the obligation, to sell the underlying stock at a specific price on or before a specific date. The seller of a put option is obligated to buy a stock at a specific price if the put is assigned.

Covered call Sell an out-of-the-money call option while simultaneously owning 100 shares of the underlying stock.

Covered put Sell an out-of-the-money put option while simultaneously selling 100 shares of the underlying stock.

Bull put spread Long the lower strike puts and short the higher strike puts with the same expiration date using the same number of contracts, all done for a net credit.

Bull call spread Short the higher strike calls and long the lower strike calls with the same expiration date using the same number of contracts, all done for a net debit.

Bear put spread Long the higher strike puts and short the lower strike puts with the same expiration date using the same number of contracts, all done for a net debit.

Bear call spread Long the higher strike calls and short the lower strike calls with the same expiration date using the same number of contracts, all done for a net credit.

Long straddle Long both an at-the-money call and an at-the-money put with the same number of contracts, identical strike price and expiration date.

Long strangle Long both a higher strike OTM call and a lower strike OTM put with the same number of contracts and same expiration date.

Call ratio backspread Short the lower strike calls that are at-the-money or in-the-money and simultaneously buy multiple higher strike calls with the same expiration date in a ratio less than .67.

Put ratio backspread Short the higher strike puts that are at-the-money or in-the-money and simultaneously buy multiple lower strike puts with the same expiration date in a ratio less than .67.

Call butterfly spread Sell two at-the-money middle strike calls and buy one call on each wing. The trade is a combination of a bull call spread and a bear call spread.

Put butterfly spread Sell two at-the-money middle strike puts and buy one put on each wing. The trade is a combination of a bull put spread and a bear put spread.

Long iron butterfly Long a lower strike out-of-the-money put; long a higher strike out-of-the-money call; short a middle strike at-the-money call; short a middle strike at-the-money put.

Condor Long a lower strike option at support; sell a higher strike option, and an even higher strike option; and buy an even higher strike option at resistance (all calls or all puts).

Call calendar spread Buy a long-term call and sell a short-term call against it for the same strike price and same number of contracts, using different expiration months.

Put calendar spread Buy a long-term put and sell a short-term put against it for the same strike price and same number of contracts, using different expiration months.

Diagonal spread Buy a long-term option and sell a short-term option with different strikes and as small a net debit as possible.

Collar Purchase stock and sell a call against it usually for a year or longer. With the premium received for selling the call, buy a protective put.

In order to determine which strategy is best in any given situation, it is useful to consider volatility. Recall that there are two types:

1. Historical volatility. Measures a stock’s tendency for movement based on the stock’s past price action during a specific time period.

2. Implied volatility. Approximates how much the marketplace thinks prices will move. It is derived from the option prices in the market and an option pricing model.

Option strategists often use historical volatility as a guide, or a barometer, to determine if implied volatility is high or low. Table 19.1 shows the various strategies that can be used in high and low implied volatility situations. In this case, the implied volatility level column on the right-hand side of the table is referring to the relationship of the current implied volatility reading to the stock’s historical volatility. If it is low, this suggests that implied volatility is less than statistical volatility. If it is high, this suggests that implied volatility is greater than historical volatility.

Current Implied Volatility Level

• High—Current implied volatility is significantly above historical volatility.
• Low—Current implied volatility is significantly below historical volatility.
• Average—Current implied volatility is at or near historical volatility.

To use the strategy matrix effectively, the trader needs to select the directional bias of the stock, evaluate the implied volatility level, and then match this information up with the available strategies. For example, if I am bullish and the underlying stock has an average implied volatility level, then by using the selection matrix, I can select either a long call or a short put for my options strategy. On the other hand, if I am bearish and implied volatility is high, I might consider a bear call spread or a bear put spread.

In conclusion, the table is a guide to help you understand your alternatives and subsequently determine which strategy works best in any implied volatility situation: high, average, or low. Use it not only as a quick reference chart convenient for choosing the appropriate strategy, but also to develop a fundamental appreciation for the role implied volatility plays in the selection process.

SUCCESSFUL INVESTMENT MAXIMS FROM WALL STREET LEGENDS

Let’s take a look at the various investment principles, practices, and philosophies of some of the most successful equity investors on Wall Street. Most of these names you have certainly heard of; however, there are others who do not have quite as much notoriety. But as you will see, they all offer something valuable and different that can be applied to your own equity investing.

TABLE  Strategies for High, Low, and Average Implied Volatility Situations


Note: The following abbreviations are used in the table: ATM = At-the-money, ITM = In-the-money, OTM = Out-of-the-money.

The first legendary investor I am sure most of you have heard of is Warren Buffett. Buffett has a famous quote when describing his approach to the market: “Rule number 1: Never lose money. Rule number 2: Never forget rule number 1.” Buffett has often said when entering a stock trade that he is not attempting to make money but operates on the assumption that they could close the market the next day and not reopen it for five years. He asserts that he does not invest in stocks but rather in businesses and feels that one of the dumbest reasons to purchase a stock is because it is going up.

Buffett feels that investors should draw a circle around the businesses they understand and then filter out those that fail to qualify on the basis of value, good management, and ability to endure hard times. This classic fundamentalist has another famous quote that drives home his philosophy: “You should invest in a business that even a fool can run, because someday a fool will.” Another Wall Street legend for whom even Warren Buffett has a lot of praise is Phillip Carret. Carret lived from 1896 to 1998. He founded one of the first mutual fund, the Pioneer fund, in 1928. Carret insisted an investor should never hold fewer than 10 different securities covering five different business sectors and at least once in six months should reappraise every security held. 

He maintained if one were to do it more frequently one would be more apt to sell it sooner than one should because many times it takes years for a stock price to reflect the value of the company. Carret always was aware of his surroundings when trying to uncover profitable opportunities. For example, when staying at a hotel in Boston he used Neutrogena soap and was so elated with the product that he purchased the stock. A few years later Johnson & Johnson bought Neutrogena and Carret made a fortune from his original investment. He also liked options and felt that an investor should set aside a small proportion of available funds for the purchase of long-term stock options of promising companies whenever available.

Peter Lynch is also an investor who has had a fabulous career on Wall Street. One of his key rules is to absolutely understand the nature of the companies you own as well as the specific reasons for holding the equity. He maintains that if investors would put their stocks into categories they would have a better idea of what to expect from them. Even though Peter Lynch might visit more than 400 companies in a year, some of his best investments have come from using the company’s product. For example, he purchased Taco Bell after trying and enjoying one of their burritos during his travels. Some of his other investment maxims include the observation that big companies have small moves and small companies have big moves. 

Also, he says it’s better to miss the first move in a stock and wait to see if a company’s plans are actually working out. Mr. Lynch likes to invest in simple companies that appear dull and out of favor with Wall Street. He asserts that you should look for companies that consistently buy back their own shares and views insider buying as a positive sign, especially when several individuals are buying at once. As a true fundamentalist, he carefully considers the price-earnings ratio. It is his belief that if the stock is extremely overpriced, even if everything else goes right, you won’t make any money. Another Wall Street wizard is Sir John Templeton, who is an expert at uncovering international investment opportunities. 

To illustrate, by the mid-1960s, Templeton and his famous Templeton Funds were invested in Japan, where stocks were trading at 4 times earnings whereas U.S. stocks were at 16. He believes that for all long-term investors, there is only one objective: maximum total return after taxes. Much of his investment philosophy is predicated on the belief that it is impossible to produce a superior performance unless you do something different from the majority. He goes on to explain that a time of extreme pessimism is a great buying opportunity, and a time of extreme optimism is the best time to sell. He is indeed a classic contrarian. The crux of his approach is that if you search for investments worldwide, you will find more deals and better bargains than by analyzing only one country. 

In addition, you gain the safety of diversificationOne very colorful figure who had an exceptional career on Wall Street was Bernard Baruch, who lived from 1870 to 1965. In his investments he adopted a skeptical philosophy, always trying to separate facts from emotion. He insisted that to successfully speculate in the markets it must be a full-time job. Baruch viewed relying on inside information or hot stock tips as a very dangerous way to invest. Before purchasing any stock, Baruch would make sure he knew everything he could about the company: its competitors, its management, and its earnings growth potential. He never attempted to pick tops and bottoms and was always quick to take losses. In addition, Mr. Baruch tried to be in just a few investments at one time so the trades could be better managed. 

He would periodically analyze all of his investments to see if new developments had changed his original outlook. One of his key habits to which he attributed much of his success was that he constantly would analyze his losses to determine his mistakes. He would often get away from the hustle and bustle of Wall Street to perform this review. He always concluded this exercise with a self-examination of his trading decisions to better understand his own failings. Another impressive investment guru is John Bogle, who founded the Vanguard Group, a mutual funds company in 1974. The cornerstone of his investment approach is that investing is not complicated and can be done quite successfully by just employing a little common sense. 

He contends the investor can do very well by doing just a few things right and avoiding serious mistakes. He believes in taking reasonable risks to achieve higher long-term rates of return and that one’s portfolio should be well diversified. This diversification maxim is why Bogle feels that mutual funds are so valuable. He contends that a set of diversified investments in stocks and bonds only has market risk versus the greater risk of being in just one or two stocks. Finally, he emphasizes thinking for the long term and that stocks may remain overvalued or undervalued for years, so staying the course is one of his key trading rules. He feels that patience and consistency are the most valuable assets an investor can possess.

Henry Clews, a famous investor who lived from 1834 to 1923, was a very successful trader who practiced his craft in the very early days of Wall Street after coming to New York from England in 1850. Mr. Clews always felt investment experts should be sought out to manage portfolios, asserting that if one needed legal help one would see a lawyer and if one needed medical help one would not hesitate to see a doctor; thus if needing investment advice one should seek out a professional. Much of Mr. Clews’ advice centers on what types of people to avoid when seeking your investment fortune. Some of the characteristics he cites include individuals who unjustly accuse others of bad deeds, who never have a good word for anybody, who won’t work for an honest living, or who run into debt with no apparent intention of repaying. 

He asserts that by prudently avoiding these types of people and selecting only associates without these characteristics your life and fortune will be a lot better off. I am sure most of you have heard of this next investment legend, Charles Schwab. He founded Charles Schwab & Company in 1974. After selling a controlling interest in the firm to BankAmerica in 1983, he bought it back in 1987 and took the company public that same year. Some of his investment wisdom for selecting stocks and mutual funds includes when reading financial papers to always pay attention to the advertisements as there might be an investing opportunity behind the ad.

Mr. Schwab considers mutual funds to be the best investment for most people and claims index funds are a great way to invest for both the novice and the veteran investor. In addition, he feels that one should consider only no-load mutual funds with good performance records, not only for the current year but also over the life of the fund. Mr. Schwab strongly recommends that investors include an international component in their asset allocation plan. Another brilliant trader, Linda Bradford Raschke, currently the president of LBRGroup, began her professional trading career in 1981 as a market maker in equity options. After seven years on the trading floor, she left the exchange to expand her trading program in the futures markets. 

Linda Raschke has since been a principal trader for several hedge funds and runs commercial hedging programs in the metals markets. She has pioneered work on volatility-based trading indicators, which were incorporated into her daily trading programs and her overall approach to the markets. Linda Raschke is a very successful short-term trader who uses a swing trading methodology as the cornerstone of her success. Her approach is a combination of monitoring intraday news and economic reports along with pattern recognition on charts that signal potentially explosive moves. Linda use the Average Directional Index (ADX) as her core indicator to signal direction and examines market volatility to determine where best to apply her ADX tool.

Traders who have employed these short-term tools have increased the profit probability of their positions dramatically. In fact, this is the main theme of Linda’s trading philosophy. She requires that the probability of profit for any trade she considers placing is definitely in her corner before ever pulling the trigger. The effectiveness of this approach is obvious, given her long-term success in the business and that she was featured in Jack Schwager’s book, The New Market Wizards (HarperBusiness, 1992). Linda Raschke’s high-probability short-term trading strategies are worth learning for any trader wishing to profit from swings and volatility in the marketplace. 

As a technical trader, she has contributed a wealth of knowledge in this area and through her lectures and publications has helped many people become better market timers. I hope you have enjoyed this information about these Wall Street gurus. Even though they have different styles and have invested in different eras, each one has some very invaluable investment insights that can be integrated into your own approach to the markets.

TRADING PERFECTIONISM

In the trading arena, you will find endless sources of financial achievement and accolades, which often go hand-in-hand. In general, our culture respects achievement. Our daily lives are full of pressures to be better, faster, and more accurate. Of course the ultimate achievement would be to attain total perfection. The logical extension of better is best, and the ultimate best is perfect. Many times we carry this burden of impossible expectations into our trading, where it can be quite detrimental.

Knowing and understanding these self-imposed problems might not banish your temptation to seek unrealistic goals, but awareness of forces working on you can help you develop emotional discipline. For example, many people allow others to define their expectations and goals—the old “keeping up with the Joneses” syndrome. Many people often care way too much about what others think about their trading. Instead you should spend your time determining your own personal financial goals. Trading is challenging enough without loading it up with this type of emotional baggage.

Also, people have widely differing levels of comfort with uncertainty. Some people have no fear and will try just about anything. There are others for whom making decisions without 100 percent certainty is a nightmare. Trading decisions are made emotionally difficult because we:

• Are keenly aware of our chancy surroundings;
• Accurately predict that waiting will afford us some additional information;
• Our precision-dominated world makes us believe a perfect answer might actually exist.

So we recoil from decisions in the realization that our odds of less than ideal results are high. It seems we must always fight our aversion to uncertainty and get on with our investment lives as best we can.

Which brings us to envy. This major enemy is constantly poised to defeat our trading endeavors. We see the rich and famous and read of the fabulous successes of a very few traders, but we fail to focus on their status as exceptions to the norm. By allowing envy to define the exceptional performance of others as our own standard, we help to defeat ourselves. Such self-imposed frustration leaves us concentrating on the difficulty of our task rather on the task itself. For many traders, for whom no amount of gain is enough, greed is a success killer. Whether by long actual experience or merely by considering the odds, we know that we will not sell at the highest price. And yet we seem to always hold on for that last extra point. 

Are we greedy in our trading because we think that an even bigger gain will stroke our egos and pad our pockets even more? Do we hold on because this particular stock has treated us well and we are willing to stay in the trade rather than risk selecting another trade? Whatever the reasons for and operating dynamics of our greed, it will defeat us. Greed is merely another way of expressing a driving need for perfectionism. Ego is another key barrier to trading success. We seem to want to be right and be the best even if there are no other observers. Our egos feel better when we are right and worse when we are wrong. So, in thinking about buying, we become frozen into indecision by realizing we might make a mistake, which would in turn injure our egos. 

When looking at holding versus selling, we subconsciously provide our egos with more chances for stroking and forestall the known immediate pain of an ego injury by doing nothing. That way, our possibilities for further gain, for reducing or recovering a loss, and for avoiding the pain of not selling at the top are left open. Here we have perfectionism again making our ego feel good and urging us to do nothing. Knowing your ego’s tendency to get in the way, and observing in real time your own behaviors that indicate this is happening, can help you to come to terms with perfectionism. It is probably not to-tally curable, but can be managed by constant attention. There are some trading tips one can follow to minimize the occurrence of these self-imposed problems. 

Databases and experts are wonderful sources of financial information. However, the more sources you consult, the higher the likelihood that the information will conflict. Such conflicts will confuse you, allowing information overload to drive up your anxiety level. It is important for you to use as much information as you can easily handle. You need to develop a trading approach that feels comfortable and then stick to it. For example, if you are more attracted to value than growth investing then go for it. If fundamentals make more sense intuitively than technical analysis, so be it, and vice versa. Go with what you can reasonably handle and ignore the latest fundamental or technical tools that come out. As a trader, this will help you to stay focused, follow your plan, and concentrate on making consistent profits.

TRADING TIPS FOR SUCCESS

Becoming a trader who consistently wins in the options market requires three key elements:

1. A bargain-hunting instinct with the ability to identify undervalued and overvalued options.
2. A sound and well-designed game plan that provides consistent action over time and that prospers in all market conditions.
3. The discipline to follow the game plan.

In applying this formula for success in the options market, the first element is simple: You must always seek to buy underpriced options and sell overpriced options. Most option investors do not follow this basic rule of option investing. They spend far too much time studying the underlying stocks and following the market, and base their option purchases only on these factors, ignoring the price and implied volatility of the option. If you do not buy underpriced options or sell overpriced options, you are going to lose eventually. You must also create a good game plan. In the options market, the game plan is far more important than in other markets because things happen so quickly that you must be prepared before you play. 

Then, you have to follow your game plan. A good trading plan involves a gradual program for investing in the options market versus the elephant approach, where you take all of your money and invest it all at one time, all on one side of the market. In addition, your portfolio must be balanced, investing money in both puts and calls. As you become more familiar with the different trading tactics, you can further diversify among directional, sideways, and delta neutral strategies. Also, be sure to diversify among different sectors over time. Set aside a speculative fund for options, realizing you could lose everything because of the short-term expiring nature of these investment vehicles. Most importantly, this speculative cash must be money you can afford to lose. 

If you play in the options market with money you cannot afford to lose, your emotions are guaranteed to overwhelm you and you will be forced into bad trading decisions. Finally, the most important part of your game plan is not how many positions to take and when to take them, but once you are in a position— when do you take profits and when do you cut losses? Here you must clearly define when to take profits or cut losses before you place the trade, or your emotions will force you to do the wrong thing at the wrong time. Try to be consistent. Don’t keep changing the rules of your game plan in the middle of the strategy. The last ingredient to success is ironclad discipline. You may think that this step is the easiest one to implement, but discipline can be difficult to maintain, especially in the midst of the battle when you may be incurring losses and have to make some tough decisions. 

If you don’t have your trading plan written down on paper, and instead decide in your head what moves will be made at each point, your lack of discipline will catch up with you sooner or later. If you find yourself straying from your game plan, you are doomed, and you might as well liquidate all your positions and invest in some Treasury bills. Without discipline, you will simply never win the options game. Options traders lose when they follow the crowd because the crowd feeds on emotions. To profit consistently, you must stand alone and act rationally. In the options markets, this means buying underpriced options/selling overpriced options, and having a well-designed trading plan—one that shuns your emotions, forces you to be consistent, and keeps you with a balanced, diversified portfolio.

THE HEART OF MY TRADING APPROACH: OPTIONETICS

Over the years, I have taught my trading approach—which I call Optionetics—to thousands of people all over the world. The Optionetics philosophy of trading is not just valuable to beginners; long-time professionals benefit as well. Overlaying the Optionetics way of trading with any trading system that trades liquid markets can significantly enhance that system’s performance. The Optionetics methodology facilitates the implementation of a system’s money management rules using a trading technique worthy of application. To validate this assertion, I want to briefly review the Optionetics philosophy, trading system basics, and money management approaches and conclude with the beneficial impacts the Optionetics philosophy can have on a trader’s current trading system.

So just what do the Optionetics philosophies encompass? The absolute crux of this approach can be classified as a scientific method of analysis that utilizes options as tools to minimize risk exposure. Since risk is directly correlated to a trader’s number one nemesis—stress—it stands to reason that if you can get a good handle on risk, your ability to execute your trading plan will accelerate.The Optionetics approach to the markets predefines the risk and reward of each and every trade to determine its feasibility. Once the risk/reward ratio has been revealed and the maximum loss position is clearly defined, a natural calm comes over the trader that triggers a very pronounced stress level reduction. The results are much better decision making during the trade execution and management phase.

Another major benefit of trading the Optionetics way is that it surrounds your core trading or belief system with a flexible investment plan. This flexibility allows the traders to employ a variety of option strategies that best exploit the current market environment. For long-term survival in the trading business, the ability to change directions is absolutely essential. This attribute, which is at the heart of the Optionetics philosophy, turns the naturally dynamic trading environment of the markets into extremely profitable opportunities. Now let’s take a look at what constitutes a typical trading system. There are three building blocks in any system: market entry, exit with a profit, and exit with a loss. 

Identifying these and making decisions about them is a key element in a successful trading system. Before you trade, your system should tell you: Where should I get into the market? Where should I get out with a profit? And where should I get out with a loss? You need to know the answer to all three of these questions before you trade. If you know the answer to only one or two, you do not have a complete trading system. An effective trading system has to clearly delineate the market entry price, the exit with a loss price, and finally the exit with a profit price. Of course, with all sound trading system approaches, the trader must have some complementary money management rules that can be effectively applied. Money management takes the trader past the point of no return. 

For example, a trader who makes $100,000 over the next two years and then loses the $100,000 during the following two years has a return of zero dollars. Had the trader used proper money management, the $100,000 could have grown to $500,000 at the end of two years. Then, during a large losing period as much as $100,000 could have been protected. After the trader made it to $500,000, the account was in a position to withstand just about any size drawdown, as long as the trader continued to apply money management rules without going back down to zero. This is why money management is so important. There is no need for your account to reach the point of no return. Proper money management discounts all factors that cannot be mathematically proven. In addition, proper money management takes into account both risk and reward.

Now let’s examine how the Optionetics approach can enhance the implementation of both the trading system being employed as well as the accompanying money management rules that are to be applied. The use of puts and calls to hedge against long and short stock positions offers the following four benefits:

1. Greater protection than stop losses.
2. Protection of stock positions from major losses.
3. Elimination of the risk of receiving a margin call.
4. Low maintenance requirement, allowing you to lock in profits.

Given the fact that stop losses are essential components of a good money management system, the Optionetics approach provides a far superior method of protection through the utilization of options. For example, with the distinct possibility of a major gap down or up the traditional stop loss can encounter major slippage. Employing an option as your risk reduction strategy eliminates this negative slippage impact. 

Also, by clearly delineating the risk and reward picture of every trade, the Optionetics discipline automatically enforces the most important money management rules of them all. When a trading system generates the market entry, market exit with loss, and market exit with profit price levels the Optionetics methodology can really go to work. The approach allows you to apply the optimum options strategy based on the system’s forecasted price levels as well as the underlying option’s current and forecasted volatility. Furthermore, the trader can be as flexible as each trade demands. 

The Optionetics approach enables traders to make adjustments based on market flow, keep their positions intact by locking in profits, continue to minimize risk, and provide the staying power to see the trade to fruition versus being continually whipsawed in and out of the market. With so many benefits of applying the Optionetics trading philosophy, it behooves the trader to master these trading principles and use them faithfully in conjunction with one’s current trading system. The improvement—not only in the system’s profitability but also with better risk-to-reward profiles—makes it a very worthwhile endeavor indeed.

CONCLUSION

The markets by their very nature have multiple personalities. Perhaps the only way to beat them is to get to know their personalities and learn how best to use the right tools to help make winning decisions. In order to do well in this business, you need to cultivate patience, pursue knowledge, garner experience, and always persevere.By reading this, you are opening yourself to a veritable anthology of knowledge that has taken years to accumulate. Just remember, there are a million trades out there every day. It’s just you and your trading savvy against the world! The many tools and strategies are your biggest allies. The more you get to know them, the better equipped you’ll be to profit in the highly volatile markets of the twenty-first century. 

Perhaps we all have a fear of failure and the ever-pressing need to become successful. Accomplishing these very human goals usually takes a lifetime. Along the way, I have found it absolutely necessary to nourish my self-confidence by cultivating the disciplines that I seek to master. Trading is one of those disciplines. Getting good at it has entailed developing discriminatory good taste as well as impeccable timing when it comes to the buying and selling of options. And yes, timing really is everything in the markets. But getting good at timing is more than an art; it’s also a science—the science of Optionetics—and through it you can develop real trading savvy. All it takes is a lot of practice and a little courage.

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