The Options & Spreads article that follows has been written by an expert who trades successfully for a living. He also offers a course on trading Options & Spreads. For more info on the course click here.
The following article is very educational, informative and well-written.
OPTIONS & SPREADS: the Business, the Profession, the Sucker-Trap
A cloudy afternoon in Manhattan. At Minerva's art studio the model Barbara arrives, a brown-haired Venus in blue jeans. She chats with us--artists, students, hobbyists such as myself--in a tiny accent that hints an Italian cathedral town. Then she doffs her clothing, strikes a pose, and becomes Aphrodite on the misty shores of Cyprus.
During a break, I stop trying to be the ink-sketch Botticelli momentarily while art studio owner Minerva Durham lets me use her business phone to call a broker's 1-800 line. I doubt if I would qualify as a Renaissance Man, but I try to give attention to both the fine arts and the gold florins.
"Your option spread order was executed," he says. "You sold 10 April 70 calls at 2-½ and bought 10 June 70 calls at four." He mentions the underlying stock, the option symbol, and the point-and-a-half debit that I required iron-clad when I phoned in the order earlier that day.
On the same day, I both bought and sold out-of-the-money call options on the same stock. The June's I bought being "richer in time" with more months until expiration than the April's I sold. Also more expensive due to time value. Buying $4,000 worth (four points times 10 calls) and selling $2,500 worth (2-½ points times 10). I paid only the point and a half debit or the $1,500 difference plus commissions.
This was a "horizontal spread" using call option contracts on the same stock at the same striking price (70), but different expiration dates, a couple of months apart. Whether or not I would enjoy a profit would not be known for at least two or three weeks. But the odds favored it by more than 90% because of that important "going in" bottom line: $2,500 of somebody else's money and only $1,500 of my own!
I live a do-what-I-want life, poring over musty volumes on the Kingdom of the Two Sicilys or the life of Verdi, then checking with the broker via the library phone booth. I take a college course in archaeology at the New School for Social Research and Finance & Investments at New York University.
After one class, NYU professor of finance and floor-trader Rich Bensignor remarked to me, "The way you make your living, you must spend your day glued to a computer screen." "Not really," I replied without elaborating. No need to mention the ink-sketch Dianas and exquisite brook-naiads from Deer Park or New Rochelle.
Almost as much as any Greek temple or Roman pantheon, the Mercantile library on Chestnut Street in Philadelphia stands brick-firm in my memory even though it was demolished years ago. In its business section, I first read about "spreads" and "spread strategies." I use them with stock options or equity options, but they can also be used with futures options and futures contracts themselves.
The substantial advantages of spread strategies include the following:
- The likelihood of a profit is over 90% as opposed to over 90% losses when options and futures are "played long."
- You "make out like a bookie" in that you use plenty of other peoples' money--amplitude that sweetens the pot.
- Other peoples' money cushions and shields your own investment capital when markets, portions of markets and individual stocks and futures contracts become tempest-tossed. Bob McGovern wrote in CTCN (2/95): "I don't have to figure how much my short October is making or losing, or calculate how much the long April contract is making or losing. All I have to check is the difference in price between the two contracts." Thus the spread strategist can be seen relaxing while financial cyclones wreck other traders' money and nerves.
- There are at least two ways to profit, one of them termed "time-decay." Being closer to the expiration date, what you sold (short-end) shrinks faster in value than what you bought. Your investment is in the gap between them, what McGovern called "the difference in price between the two contracts." The widening of that gap means your vein of gold becomes broader.
With time-decay, you use "the ravages of time" as a force to swell bank accounts.
The second way to gain is a switch to the long position. Let us say that an underlying stock or futures contract rises to the "striking price" level of your horizontal call option spread or descends to the level of your put spread. You buy back the short-end and let the long-end remain. According to trend theory, that underlying security has "broken through a barrier" and will probably continue in that direction. Such a continuation increases the long position's dollar-value.
Some spread strategists wait until the underlying security passes through the striking price and into the money before they buy back the short-end. I close out the short-end when the security "touches" the striking-price even though it is not yet "in the money." The continuation failed to occur only once and succeeded more times than I can count. Delaying the buy-back would have meant more cost and therefore less profit because the continuation--Bless it!--swells the short-end while beefing up and fattening the long.
Remember that American-style options can be exercised at any time, unlike the just-before-expiration European ones. Buy back, close out any in-the-money short positions fast! Also, when following trends, remember a statement by Nicholas Darvas: "There is no such thing as "can't" in the stock market. A stock can do anything!"
Due to space limitations, this article contains only bits and pieces of information on spread strategy. This form of trading offers plentiful profits with amazingly low risk, and the use of other people's money while they take the big risks. But read and learn you must, and in no small depth.
Several excellent books suitable for this purpose will be named shortly. Apply their instructions wisely and you will make a mental shrine of where you first read them, as I have with the Mercantile Library and earlier books on the subject.
One text earns mention right now--Wasendorf & McCafferty's All About Options, because on page 149 it contains the following combination checkered flag/warning flag: A negative personality rarely earns profits consistently. They are usually attracted to options for the wrong reasons--to make a lot of money fast without exerting much effort. Therefore, they don't spend the time required to learn some of the more complicated strategies that are more conservative by comparison.
Spreads stand prominently among the "more complicated strategies that are more conservative by comparison."
The minimum needed to become a trader in stocks, futures or options is low: A checkbook and enough mental competency to sign a few papers. Little more than the requirements for a racetrack sucker! People are "attracted to options for the wrong reasons--to make lots of money fast without exerting much effort. Therefore, they don't spend the time required to learn." Did you ever read a more concise description of an empty-pocketed horse-player?
It brings to mind a book not about investing: Magic in the Modern Manner by stage conjurer Cecil Lyle, in which he devoted a chapter to a stand-out card trick. He wrote, "Many will stop reading when I say you need four double-faced playing cards for this effect. Many others will continue reading, but will not bother to obtain the necessary items from a magic dealer. A few will take the trouble, and they will possess a gem of card magic."
What a lament! How fed up he must have been with would-be Houdinis who craved spotlight and applause, but got lost when it started requiring effort. Not restricted to conjuring, this ilk teems in the financial world, comprising the "sucker trade" at many an exchange and brokerage office. It's easier to write a check than to develop one's brain and know-how.
For those willing to devote professional-grade time and effort toward trading and options and strategies theme books possess locked vault value: Sure-Thing Options Trading makes the honor roll on both the basic and the sophisticated levels, authored by George Angell. Outstanding is the word for David L. Caplan's The New Options Advantage; it deals with futures options, but its techniques also apply excellently to equity ones.
All About Optionsby Russell R. Wasendorf & Thomas A. McCafferty has already been cited, but it deserves a second mention and a third. Allan S. Lyons' Winning in the Options Market and Harvey Conrad Friedentag's Investing Without Fear--Options, should both be required reading, gunpoint compulsory maybe. Too little has been written about the worthwhile long-term options, but thankfully there is the loaded-for-bear-and-bull LEAPS--Long-Term Equity AnticiPation Securities by Harrison Roth.
I have detoured around books that are calculus-heavy. Physicist-turned-Wall-Street-broker, Basil Venitis told his NYU finance class that information contained in obtuse mathematical formulae can be stated just as well in plain English.
Webster defines diligence as "persevering application; persistence; characterized by steady, earnest and energetic application and effort." The financial world is full of wrecks who do not fit this profile, who wrote a check and expected wealth to fall into their laps. It all comes down to this: Acting on your own, can you educate, train and discipline yourself as a West Point cadet or a medical student is educated, trained and disciplined?
Actually, you need not put in nearly as many hours as they do. But you must put in substantially more time, effort and perseverance than the "fast and easy money" crap-shooters, you must handle trading as a business or profession with the diligence due a business or profession.
Except for some dividends, nearly all my 1994 income was Form 1040 Schedule D--Capital Gains, thanks to covered calls and spread strategies. I have the time to peruse an archaeological text and to try creating a new Medici Venus on pearlcoat studio bond. Paradoxically, I have the time because I put in the time, and what Webster called "steady, earnest and energetic application and effort."
Technical analysis or chart analysis fits in well with spread strategies--the horizontal calls above the rising security, the horizontal puts below the falling one. Wall Street's and NYU's Rich Bensignor said of charting and trading, "Old support lines become new resistance lines and vice-versa. You will lose the bulk of the time unless you make it your passion or profession." The passion, the profession, the intricate know-how, sets apart the scientific trader from the racetrack sucker who uses a broker in place of a bookie.