OPTIONS &
SPREADS
No plaque hangs on my wall, but an imaginary one
dangles before my eyes occasionally and bears words
by Nicholas Darvas: "There is no such thing as
'can't' in the stock market. A stock can do anything."
Nick Darvas and I (if I may presume to list myself
beside one so famous) survived longer financially
than that general did physically, because we read
more accurately the schooner barometer and coastal
beacons of risk. No risk means the soldier stays off
the battlefield and the mariner remains on dry land.
But then, no gold medal and no cash for cargo.
you can think of risk as a dragon, but you must understand
the hidden meanings of that creature. "Dragon"
derives from a Greek word meaning "acting"
or "seeing;" a loose but accurate translation
would be "guarding." Thus the dragon in
Greek mythology was a reptilian watchdog always guarding
something: The temple entrance, the princess, the
urn of gold. Wherever you find precious things you
will find dragons of risk. Yet they can be defeated
and/or they can work for you.
Risks may be big or small and -- more to the point
of this article -- handled foolishly or wisely. You
can, with relevant skill and caution, realistically
train a cheetah to chase down game and provide meat
for your table. Or you can put your right arm in the
lion's mouth and get nicknamed Lefty. Alas, we are
human. How easily we give ourselves a hundred when
marking our own test papers. How easily we assume
that our actions are the "wise" ones and
other people's the "foolish."
Thankfully, there is a middle ground risk-wise, a
Golden Mean between inflation-corroded money in a
stock and a go-for-broke crap-shoot. The significance
of risk for traders rests on two foundation stones:
First, stocks, futures and options are all "ain't
nothing guaranteed" types of paper. Second, the
ranks of traders teem with amateur chemists handling
explosives.
W. D. Gann said, "Handle speculation like a
business, not like a gamble." Yet did you ever
hear of a broker turning down a potential client because
the latter's approach was "not business-like
enough" or "not expert enough" or "not
scientific-minded enough?" While most are not
villainous, brokers find themselves in a sink-or-swim
position of having to sign-up fresh capital, like
military recruiters with their glamour and rewards
enlistment pitches have to sign-up quotas of warm
bodies.
Interpret "new clients" as "replacements."
Various estimates say that 9 out of 10 commodity traders
see their dollars turn into cavalrymen at Little Big
Horn. An estimate of less than 90% losers is an exception.
In his book A Fool and His Money, John Rothchild wrote
of "recent progress in eliminating the fraud
and abuses suffered by the average speculator in commodities.
Personally, it was hard to believe that anybody lost
sleep over the cheating in an industry where 80 to
90% of the participants lost all their money anyway."
Also, over 90% of all out-of-the-money options expire
worthless. Personally, did my option-investing capital
perish like Custer amid the Black Hills? Am I the
amateur chemist handling explosives, with hard-sell
commission-desperate brokers supplying the nitros
and potassium?
Spread strategies using options are not a philosopher's
stone or a perpetual motion machine in my basement
laboratory. They are nonetheless the home silversmithing
that shines appreciably. Less complex than calculus
and less tomorrow-land than computer stochastics,
still they stand out for enabling me to "handle
trading like a business, not a gamble."
A hallmark of the business-not-a-gamble approach
is the reducing and limiting of risk. You must take
chances, but you must limit your exposure. The story
is told of a preacher delivering a sermon. Suddenly
a nude woman ran into the church and streaked across
the altar. The reverend declared, "Anyone who
gazes upon her will be struck blind!"
In the congregation happened to be a successful investor/speculator.
He covered one eye with his hand and said, "I'll
risk an eye."
Like a pro he reduced the risk. Limited his exposure
or vulnerability. The First Commandment of Risk Management
stands rock-solid: No more than one-tenth of venture-capital
per venture. Option spreads are hazard-reduced, not
hazardless. A clothier does not put all money and
all inventory into a clothing line that could go out
of style next week. Just a limited amount of capital
and inventory. The difference between business and
crap-shoot.
Also, if you do option spreads, half your business
is that of a seller or dealer in risks, a legalized
bookmaker. Risk is a dragon that can menace a person
or stand guard for him. It is a cheetah that can claw
a hunter or pile up antelope meat at his command.
The cautionless dabbler and the too-impatient-to-read-the-jungle-map
type should stay away, but the person with reasonable
smartness and effort can have these fire-eyed quadrupeds
in his employ.
Another device helpful, but not idiot-proof is time.
Ben Franklin wrote, "Do you love life? Then do
not squander time, for that is the stuff that life
is made of." However, the lyrics of the 1940s
song "Speak Low" say, "Time is so old
and love so brief. Love is pure gold and time a thief."
With the type of option strategy known as time spread
or calendar spread, time guards your long-end holdings
while it steals and destroys the short-end IOUs you
sold for cash. You keep the cash.
Then you sell more IOUs on which you do not pay.
While this happens on the short-end of the spread,
the fattening of your holdings on the long-end is
a variable, happening not always but often. I have
been able to make it happen more often than not, ending
the game early with more greens in the pot.
As explained in a previous article, I begin by finding
an optionable stock that is trending. If upward, then
I position a horizontal spread of call options above
the share price. If downward, then a horizontal put
spread below. The strike price of the options should
be close enough to the share price for the puts or
calls to have meat on them, but not so close that
a slight fluctuation of the stock would place them
"in the money."
In my recent venture, I noticed IBM slipping slowly
from its 128 and a fraction high of some months ago.
The New York Times financial section declared it a
"bargain stock" but I interpreted its moves
as rear guard actions or fire-and-fall-back maneuvers
on the charts. Regarding fundamentals, company executives
announced that future earnings may be lackluster for
a time.
With share price hovering over 100 in early July
96, I obtained the following option figures from the
discount broker: July 95 (strike price) puts -- bid
9/16 ask 5/8; August 95 puts - bid 2-¼ ask
2-3/8; October 95 puts - bid 3-7/8 ask 4; January
(1997) 95 puts - bid 5-½ ask 5-5/8.
Usually, the long and short ends of my horizontal
calendar spreads are just a couple of months apart
(e.g.,. sell February/buy April or sell February/buy
May) but this time I looked farther into the future
because I wanted to try something special: A calendar
spread as a stock substitute. Explanation -- A stockholder
selling covered calls waits until expiration then
sells the next month, then the next and so on. Similarly,
a spread strategist can sell a whole line-up of short-end
options one batch per month if the long-end options
are well into the future.
So I bought 10 IBM puts -- strike price 95 -- expiring
in January 1997 and sold 10 July 95 puts expiring
two weeks from date of sale. Counting commissions,
I paid $5,660 for the Januarys and received $652.47
for the Julys. With the opening of a spread position,
the buy and the sell orders can be given to the broker
together with each dependent on the other, the price
difference between them or "debit" stated
by the investor as part of the order. In this instance,
however, it was more straight forward to handle the
two ends separately, buying the Januarys at the ask
price then selling the Julys at the market.
Let us detour for a moment and take another look
at that earlier paragraph that starts "With share
price hovering." Please note the numbers therein.
August 95 puts 2-¼ to 2-3/8. January 95 puts
5-½ to 5-5/8. From the vantage point of July
1996, January 1997 options are five or six times richer
in time value than Augusts. But do they cost five
or six times more?
No, they only cost not much above double. This alone
is a sword-against-penknife advantage for the time
spreader. For roots of causality look at the following
volume figures from the options page of the Wall Street
Journal 7/19/96: Sun Microsystems August 50 puts:
1095 contracts sold; January (1997) 50 puts: 48 contracts
sold. Microsoft August 115 puts: 406 contracts sold;
January (1997) 115 puts: 27 contracts sold. Compaq
August 45 puts: 1066 contracts sold; January (1997)
45 puts: 65 contracts sold.
You can see that option contracts nearer in time
to expiration do trade on far heavier volume than
those with expirations several months distant. In
finance, the busiest bridges are the most expensive,
good news when you receive the tolls. All those bids
and buys of near-term contracts inflate the prices.
Good news when you sell them.
In his book The New Options Advantage, David L. Caplan
wrote of the one-sixth-the-time-but-half-the-price
type disparity: "This often happens in volatile
markets as there is an increased demand for these
'more active' options for speculation and hedging.
Often, we find that the deferred month options are
'forgotten' and trading at volatility levels of 50%
or more lower than the active front month contract."
The paltry number of purchases keeps the "forgotten"
options at bargain-price levels, rich in time though
they are. This enables the calendar spreader to buy
the bargain while selling the over-priced to the anxious
crowd who makes it over-priced. He purchases the far-term
forgotten land and does a near-term land office business.
Anyway, back to my spread strategy with IBM puts.
I bought the Januarys and sold the Julys even though
the value of the latter was ravaged by time because
these would expire in just a couple of weeks and free
me from the obligation. My eye was on the plump and
active August 95s, then trading between $2,250 and
$2,375 for 10 contracts. Crediting what I received
for the Julys toward what I paid for the Januarys,
my "debit" or the amount I invested totaled
$5,007.53.
My plan, if IBM shares stayed around 100, was to
profit from time-decay, selling near-term options
and then, after they expired, selling the following
month and later the next. If the stock continued lower,
I would buy back the near-term options, closing out
the short-end of the spread, but keeping the richer-in-time-value
options of the long-end.
In anticipation of the latter eventuality, I had
positioned a horizontal put spread like a net under
a declining stock. A rising stock would have invited
a call spread overhead. Well, IBM did continue downward,
slightly crossing the 95 strike price line. We now
arrive at the questions of if and when to buy back
and close out the short-end. Readers of my past writings
will note this item as something new in my trader's
toolbox.
In an earlier time, the slightest toe-extension of
short-end puts or calls into the money would have
signaled me to buy back and close out. Ideally (if
this is not too severe a contortion of that word)
a spread strategist is not only a bookie, but a bookie
who never pays off on a bet. He writes and sells IOUs
which evaporate uncollected. Ergo, it is life's-blood
essential that he avoid an exercise of what he sold.
IBM ebbed to 94-1/8 or 7/8 of a point into the money
on the 95 strike prices of my short-end Julys. Was
exercise inevitable? Quite likely? Tom Curran, head
of York Securities in Manhattan, explained to me months
earlier, "Nobody is going to exercise an option
he holds if he can get more money simply by selling
the option." In my recent example, the put-holder
could gain 7/8 of one point by exercising it, i.e.,
selling the stock at 7/8 of one point above the market
price. However, that option sold on the exchanges
that day for a fraction over two points. All good
sense says do sell, don't exercise.
Another relevancy is that in-the-money options are
"as-signed overnight." In other words, exercise
orders are matched up with in-the-money puts and calls
after the close of the trading day. The New York Stock
Exchange ends trading at 4:00 p.m. Option transactions
continue for an additional 15 to 20 minutes. Then
option-holders who had exercised their puts and calls
during the day trigger overnight assignments, turning
many contracts into spent cartridges. So focus on
trading day's close.
In my case, IBM shares hit a low for the day of 94-1/8,
but ended the trading day at 95 and a fraction; puts
with a 95 strike price were out of the money in time
to avoid moonlight match-up. The following day, however,
I phoned the broker for quotes at 3:43 PM, 17 minutes
before the close of stock trading. IBM at 94-¾,
also its low for the day. Back in forbidden territory!
I told the broker, "I want to buy back 10 IBM
July 95 puts at the market to close the position."
The stock ended the day at 94-7/8 with 95 strikes
vulnerable to the nocturnal shotgun marriage. Glad
my short-end was gone.
Buying back the July puts, inflated by the decline
of the stock, cost me $2,000 plus discount commission.
This made my $5,007.53 investment in the long January
95s a de facto just-over $7,000 one. I had no complaint
because IBM's downward trend also beefed up the Januarys.
The 10 were worth $7,500 and climbing. The next business
day, just five trading days before expiration, I sold
10 July puts-strike price 90 this time - for $652.47.
This marked a change in strategy from a horizontal
calendar spread (different months, same strike prices)
to a diagonal calendar spread (different months, different
strike prices). Imagine a diagonal line descending
from the 95 level to the 90. This is a form of "covered
writing" in that the options you own cover or
secure the ones you create and sell. Within the boundaries
of covered writing, you can sell call options of the
same strike price as the ones you own or higher. With
puts, of the same strike price or lower. Thus I own
95s and sold 90s.
Shortly afternoon one or two trading days later,
IBM fell to 89-¾, placing the July 90s a quarter
of a point into the money. However, the shares climbed
in the afternoon and closed a few points higher. No
danger of an exercise. The down fluctuation temporarily
swelled the Januarys.
Special attention should go to closing prices for
a couple of reasons, overnight assigning being just
one. According to a piece of Investor's Business Daily,
a stock that closes at or near its high for the day
will probably go higher early in the next trading
day. Conversely, a stock that closes at or near its
low will probably sink lower. The theory holds that
various temporary forces that influence a share's
behavior have spent themselves before the market's
final hour and especially the closing half-hour. The
stock is said to move with a truer, less-impeded momentum
that carries over into the next day. This finding
has proven an excellent guide to tracking IBM's motions
these past few days before July expiration.
There is also the theory espoused by several financial
writers that the trading day is comprised of two distinct
time-sections. The morning hours tend to be dominated
by amateurs, including many working people who phone
buy and sell orders to the broker before going to
their jobs. The afternoon hours form the pro traders'
half of the inning and give them solidifying trends
to ride.
Although skeptical of all theories, I must admit
that the stock market made more sense to me when I
stopped expecting the first and second halves of the
trading day to resemble each other. Thus I routinely
watched IBM shares zig in the morning, zag in the
afternoon; they forgot their recent past during the
final hour or half-hour and began rehearsal for tomorrow.
I write this during the weekend after the third-Friday/Saturday-of-July
option expirations. The July 90 puts I sold expired
worthless. The $652.47 premium I received for them:
Pure gravy because time-decay or time-is-a-thief destroyed
the IOUs I sold, burned the bets I booked.
On Friday, IBM stock chipped below 64 during the
last hour of trading, with a low of 63-5/8 and a close
of 63-¾. The "forgotten options"
I bought, the January 95 puts I longed at a cost of
$7,042.53, weighed in at the closing bell at 8-¼
bid 8-¾ ask. Rendered concretely with dollar
signs on 10 contracts: $8,250 to $8,750. Time-wise
this comprises my trader's diary 7/9 to 7/19.
What about this coming Monday? The shares closed
snake-belly near their low on Friday and so should
continue lower early the next trading day. More panned
gold for a put-holder, thanks to what classical Dow
chartists call: lower tops and lower bottoms"
and the Ellioteers term "the a-b-c- downslope."
Yet let us not forget Darvas' words: "There is
no such thing as 'can't' in the stock market. A stock
can do anything." Add to this my own hair shirt
aphorism: "Anything is possible and I could be
mistaken."
Monday and thereafter, selling the Januarys at a
profit stands as a possibility. More so if a further
wane of the stock boosts their poundage. Or I could
hold them and create another diagonal spread by selling
10 August 90 puts which ended the day at 2-¾
($2,750 minus commission). However, with the stock
in the low 90s, a 90 strike price is too near to in-the-money.
A steeper diagonal, perhaps, with August 85 puts?
Tis a 1-3/8 point ($1,375 minus commission) opportunity,
with more downward space for the shares to sink to.
Or maybe no short end for now if the stock slides
markedly.
Capable decision-making. Essential for taking a scientific
approach and handling trading like a business, not
a gamble. The notion of a scientific approach and
a business-like approach contains several layers of
meaning. First off, it means expertise. A person can
be an expert at insurance, car dealership or restauranting,
but no one would take an "expert" dice-shooter
to mean anything but somebody who has lost a lot over
long time periods.
A person can be an expert at trading stocks or futures
or options, but too often the self-credentialed "financial
wizard" is a thinly-disguised roulette-player
who wagers until he runs out of capital. Just as it
is too easy to give yourself a hundred when you mark
your own test papers, so it is too easy to assume
that your capital is the "smart money" and
somebody else's the "mishandled funds."
Also, sadly, trading attracts impatient incompetents
like wholesaling, realty, haberdashery, undertaking
and office training school seldom do. It's a magnet!
The cheetahs and dragons of risk can produce for
you the heap of meat and the tureen of gold but they
are not lap-dogs and require an expert handler. You
can be an expert but be doubly cautions about judging
yourself one. Money can be made in a basement laboratory,
but too many self-proclaimed Edison's end up broke,
their self-evaluations more robust than their performances.
Another vital layer: Being dispassionate, objective,
detached. Inevitably, business and gambling and trading
all strain the nerves and fire the emotions sometimes.
Nevertheless, the wholesaler assembling a plan and
making a routine phone call provides a better model
for the trader than does the horse-player sweating
and pacing at post-time. An emotional roller coaster
is unscientific and unbusiness-like.
One final one: Do not invest huge amounts of self-esteem
in your projects. The gambler congratulates himself
as the smart boy when he expects to win then brands
himself the fool when he loses. Likewise, many a trader
ordains himself the financial genius then declares
himself an incompetent and a hopeless case. "Gee,
I didn't think myself stupid, but now I'm not so sure."
Engrave this axiom on an imaginary plaque: "When
trading, leave your ego out of it."
