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 Diagram & Jungle Map
During the American Civil War, a Union general and his retinue scouted a field for signs of enemy activity. A subordinate officer spotted some Confederates in the distance. The general said, "Don't worry. They couldn't hit an elephant from that.
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."