exit strategy for a long call is to sell if the option loses half its value to the downside or when the option doubles in price to the upside. Of course, we can always set stops once our price target is achieved to let our profits run, but the last thing we want to do is see a profitable trade turn into a loser. This trade did indeed work out well, with LEH shares moving up fol- lowing this bullish sign. As originally expected, the stock went higher and our option was at a double on June 2 with the stock trading near $72.50. At this point, either the option could be closed or the trader could set a stop to make sure that if the stock were to move lower, the option would be sold before the profits were lost. Keep in mind that buying long calls is a great way to use leverage, but it is also a high-risk one. When the strate- gist identifies an explosive situation like in the Lehman Brothers example, he or she might want to consider other trades like bull call spreads, call ratio backspreads, or some of the other bullish strategies discussed in the earlier chapters of this book. CONCLUSION Not all traders use charts or computers. In fact, 20 years ago much of this information was either not available or extremely expensive. So, traders do not need to spend a lot of money on research and analytical tools. A 464 THE OPTIONS COURSE –300 –200 –100 0 100 200 Today: 150 days left 100 days left 50 days left Expiry: 0 days left ATM Implied Volatility 30 04/07 04/17 04/30 05/12 –400 Currently: 2003–05–20 7 – 30 day = unk 30 – 60 day = 27.19% 60 – 90 day = unk >90 day = 30.73% FIGURE 18.8 IV Chart for LEH Trade (Source: Optionetics Platinum © 2004) ccc_fontanills_ch18_453-465.qxd 12/17/04 4:44 PM Page 464 high-speed Internet connection, a brokerage firm that specializes in op- tions trading, and access to research can produce enough information to trade successfully. Hopefully, this chapter has helped to expand your knowledge regard- ing the tools that are available and how a trader uses information to cre- ate a trade. The example toward the end of the chapter explained how to find an explosive opportunity and how to analyze the situation to find the best options contract for the given strategy. Not all successful traders use the same approach. Through time, you will undoubtedly develop your own tools and methods for picking winning trades. Hopefully, the chap- ters in this book are helping you along the way. Tools of the Trade 465 ccc_fontanills_ch18_453-465.qxd 12/17/04 4:44 PM Page 465 CHAPTER 19 Final Summary T his book has reviewed a variety of strategies that can be applied in various markets. It has avoided trying to forecast market direction or analyzing charts with detailed market patterns, and has not refer- enced highly technical data or difficult-to-interpret fundamental informa- tion. Although these trading tools may have their place in your trading arsenal, they are exhaustively studied in many other publications. The pur- pose of this book is to focus on options trading strategies and to demon- strate how professionals trade without overanalyzing the markets. When traders get bogged down in trying to process too much information, the re- sult is what I often call “analysis paralysis.” I have tried to make the information contained in this book as straight- forward as possible. 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 explored in this book. 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 466 ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 466 mini-crash. It was not as severe as the 1987 crash when there was a 22 per- cent 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 fa- miliar with that market’s personality. When change occurs, this familiarity will enable you to profit the most from the change. Practice these strate- gies by paper trading your market until you get the hang of it. I recom- mend 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 experi- ence and you’ll learn what you need to master along the way. In addition, you need to determine what influences a specific mar- ket. 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 knowl- edge 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 Final Summary 467 ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 467 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. Garbagemen Good at Predicting Economy In December of 1994, the economists sent a questionnaire to four chairmen of multinational companies, former finance ministers from four countries, four Oxford University students, and four garbagemen. They were asked to predict average economic prospects including world economic growth, inflation, the price of oil, and the pound’s exchange rate against the dollar in the ten years following 1994. The economists said the garbagemen and company bosses tied for first with the predictions. The finance ministers came in last. So, let me get this straight. Politicians supposedly run entire coun- tries, 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 ex- perienced 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 signifi- cantly 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 cor- nerstones 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 disci- plined, system leads to profits in trading. On one hand, it means taking a 468 THE OPTIONS COURSE ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 468 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 moni- tor market events as they unfold. Discipline can sometimes have a negative sound, but the way to free- dom 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 environ- ment 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 invest- ment 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 strat- egy and each contract has its own advantages and drawbacks. Forecasting the price of the underlying equity is a prime motive be- hind 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 Final Summary 469 ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 469 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 prof- itable 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 op- tion expires, the option strategist still would not have achieved the in- tended 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 suffi- cient 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, differ- ent 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 enter- ing 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 impor- tant component than volatility. As discussed in earlier chapters, volatility 470 THE OPTIONS COURSE ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 470 will often dictate which strategy is best in any given situation. We have al- ready explored what volatility is and the relationship between two types of volatility: implied and historical volatility. Now let us correlate the rela- tive 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 strate- gies have been covered in this book, the reader is encouraged to investi- gate 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 un- derstand them thoroughly. For now, here are some basic definitions of the option strategies covered in this book: Call Gives the buyer the right, but not the obligation, to buy the un- derlying 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 un- derlying 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 simultane- ously owning 100 shares of the underlying stock. Covered put Sell an out-of-the-money put option while simultane- ously 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. Final Summary 471 ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 471 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, us- ing different expiration months. Diagonal spread Buy a long-term option and sell a short-term op- tion 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 pro- tective 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. 472 THE OPTIONS COURSE ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 472 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 barom- eter, 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 situa- tions. 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 sug- gests 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 di- rectional 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 alter- natives and subsequently determine which strategy works best in any im- plied 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, Final Summary 473 ccc_fontanills_ch19_466-484.qxd 12/17/04 4:44 PM Page 473 [...]... provides insightful articles and monthly columns to a variety of newspapers, magazines, and e-zines Now you can read them before they hit the newsstand! • Market Commentary: Get the lowdown on the mood of the marketplace three times a day with specific tips on stocks on the move and profitable market strategies from the Optionetics trading team  494 THE OPTIONS COURSE • Stock and Options Portfolios: A portfolio... earnings per share growth and stability and the EPS growth the last two quarters The resulting number is compared to other companies in the table and given a rank of 1 (lowest) to 99 (highest) Focus on companies with an EPS ranking of 95 or better when buying and 20 or lower when selling (i.e., buy stocks with the greatest strength and sell the weakest) It is a good idea to track the EPS rank of your stocks... 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 484 THE OPTIONS COURSE Furthermore, the trader... once the information is in the marketplace Stock Page Headings Many people look at these tiny numbers and become overwhelmed This section of the paper is easier to read once you know which information is important to focus on • 52 Weeks Hi/Lo: High and Low Prices for the Past 52 Weeks Important: This figure tells you the price change of a stock over the past year The difference between the high and low. .. 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,... features the following areas: • Stock and Option Quotes and Charts: Find delayed stock and option quotes and charts, most active gainers and losers lists, market analysis, index charts, research, bond quotes, and updates on all major markets Use the free Options Ranker to sort through the universe of options to find the cheapest and most expensive contracts • Educational Articles: The Optionetics trading. .. 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 Final Summary 481 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. .. shares and the stock trades five times that high (500,000), this information is useful If the stock has a high trading volume and is found on the Price Percentage Gainers and Losers list, then you have a confirmation signal that the stock is making a move When volume is decreasing or stable, the stock will likely go nowhere as interest in the stock is dwindling It is important to watch the volume of the. .. Bradford Raschke, currently the president of LBRGroup, began her professional trading career in 198 1 as a market 478 THE OPTIONS COURSE 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... to practice trading, using a fake account and real prices until you get comfortable with the strategies and their results Chicago Board Options Exchange www.cboe.com The Chicago Board Options Exchange (CBOE) has news, new option listings, and exchange information on equities, options, and LEAPS Specialization includes calls and puts on NYSE stocks, the S&P 500, U.S Treasury bonds, and other indexes . 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. 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. 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