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 Fine-Tuned Science of Buying
a Dollar for 40-cents
A visitor to a small town noticed some activity on a street corner. Some loiterers outside a saloon were having some fun with the village idiot. A barfly held some money in each hand and said, "which would you like? The nice, shiny 50-cent piece or the dirty old dollar bill?"
The village idiot replied, "The shiny 50-cent piece." Everybody laughed as the loiterer handed him the coin. Another barfly stepped forth. Same question. Same answer. More laughter as the alleged, dunce got another half-dollar.
After watching this four times, the out-of-towner could stand it no longer. He walked up to the village idiot and said, "Don't you know that the dollar bill is worth twice as much as the 50-cent pieces?" "I know that." "Then why do you keep picking the coin?" "Because when I pick the dollar bill, they stop playing the game."
That street corner-sharp-in-disguise knew two things: (a) economics, and (b) psychology. Someone once said, "Mention economics and everybody is bored. Mention money and their eyes light up." Many a trader and gambler and man on the street are interested in money but not in economics, with the result that he has no money.
The easiest thing in the world: Inventing a game in which you always win. The hardest thing in the world: Getting other people to play it. You can create a form of wagering in which you always win, but you will make no money at it because you will be the only one at the gaming table. Both psychology and economics require that the other people who play must at least think that they have a chance of winning.
The seedy gambler sets out to "break the bank" and claims to have a system that "can't lose." Remember that a thousand dollars has to double only 10 times to become a million, another 10 times to become a billion, another 10 to become a trillion. If such a system existed, if there were a sure and quick and easy way to double again and again, what would happen? Mr. Gimme-Some-Chips with the rent past due would soon have all the money in the world, or at the very least, would bankrupt casino after casino and track after track.
Alas, this is an economic point, something not readily grasped by people whose fingers itch for money. There also exists a psychological point toward which many traders and gamblers have a mental blind spot. They think of the exchange or the track or the other participants as "my source of income" at least potentially. It simply does not occur to them, "Maybe I'm their source of income." Albert Pacelli in his book The Speculator's Edge quoted Warren Buffet: "If you're in a poker game for 30-minutes and you don't know who the patsy is, then you're the patsy."
In finance, so easily the hunter becomes the hunted and the cannibal notices that the main course on the menu resembles himself. Yet what a psychological aversion we all have to labeling ourselves "the patsy" or "the catch of the day."
The stock, futures & options exchanges, the casino & race track--the eye of the economist sees that there is not nearly enough money in all these places to make every participant a multi-millionaire. The total amount of capital ventured by everyone collectively may seem vast, but it is small compared to everyone's dreams of wealth totaled. The unwanted but inevitable outcome: Multitudes of disappointed people. Such a setup mass-produces also-rans, though nobody wants to be one.
Yet the eye of the economist also sees opportunities. After the races, thousands of discarded pari-mutuel tickets litter the grandstands. Torn by people who had wanted to stuff their pockets but who became "somebody else's source of income" without intending to be. Occasionally a hanger-around rummages through the tickets, hoping to find a winning one thrown away by mistake. The scotch & soda philosopher gazes at the litter and ponders all that money lost and gone. The economist/opportunist (not a bad combination) contemplates a way to be on the receiving end of those disappearing dollars.
A good receiving end? No easy find. In recent years, holders of casino stocks and race track stocks have had little to sing about while awaiting a repeat of Resorts International. Other forms of gambling beckon, but dice and roulette in your basement could make you an "income source" for a bail-bondsman. Selling junk bonds or IPO shares for a chain of empty restaurants requires an office with high overhead. Also, piles of negotiable paper sit unsold because many potential investors "stopped playing the game."
I have found that with option spreads, people do not stop playing the game: Daily action shunts put & call contracts on most optionable stocks. Except for a desk at home, my office is in my pockets. Bookmaking out of my hat could not be more compact or more mobile, and it is legal. I once closed out a spread position for a profit on my dentist's phone before going under the drill. Having overheard, he questioned me about investments while stuffing cotton in my mouth. I have since stopped giving dentist chair seminars.
Without a broker's license, I have sold more securities than some licensed brokers. While one broker I know hands out his card to people on a commuter train, my buyers purchase automatically via the options exchanges. I have never met them, which may be for the best because, alas, I have sold them so much worthless paper and pocketed their money. Like race track tickets, the items I sell could become worth something but usually do not.
Imagine that the month is February and you pay $5,000 for a deed which bears an expiration date--the third Friday of the upcoming June. You do not know what is under that topsoil; maybe oil or gold, maybe pebbles. In the months ahead, the deed may come to be worth more or less in resale value thin you paid for it, but after the expiration date it becomes penny scrap-paper. Also, bearing a definite expiration date, it tends to lose value steadily as time passes.
Let us imagine, however, that the very day you spend the $5,000, acquiring that deed entitles you to print another deed bearing a March expiration date and to sell it for $3,000. You can either put that $3,000 in your pocket or you can credit it toward your purchase of the June deed and then pay only $2,000 out of your own capital. The deed you sold expires on the third Friday of March, entitling you to print and sell another deed bearing an April expiration date for maybe more, maybe less cash than the March. Maybe more, maybe less because fluctuations affect both Junes and Aprils. April expires, sell May.
But take another look at that buy-the-June/sell-the-March deal. If you simply bought the June, it would eventually have to become worth more than $5,000 for you to make a profit. If, however, you also sold the March, you are ahead if the June is worth anything more than $2,000 after the March expires. Thus a "spread" is called that because your actual investment is the amount between the buy figure ($5,000) and the sell figure ($3,000), the aforementioned two grand.
The procedure is not risk-free because the June could drop in value to below $2,000 or even to zero. Yet funding an investment with 60% other people's money and only 40% your own is one hell of a head start, not even counting what you sell after March expires. Thus with spread strategies, put & call options are the race track tickets which, once you buy a batch, entitle you to print and sell more batches. The ones you bought could lose the race, but you can re-sell them before the final furlong, i.e., before the expiration date. The others you sell are bookmakers' revenues.
Value-oriented investment legend Benjamin Graham once said, "When you can buy a dollar for 40 cents, you don't have to worry about what the stock market is doing." The "dollars for 40 cents" were depressed stocks in solid companies, shares selling at market prices substantially below their estimated "true value." Something similar could be remarked about option spreads: The 10-dollar horse-racing ticket for four dollars. The 10-dollar ticket allowing you to now sell several two-dollar ones. If the ticket wins, fine. If not, well, you are part bookie working mostly with other people's money, and with the mathematical odds far more in your favor.
The phrase "money management" when applied to traders or speculators amounts to a euphemism for "risk management." Of course "money" sounds sweeter to the ear than "risk" just as a "market correction" sounds nicer than a "crash" and a "fiscal pause" better than a "depression." Cold comfort in bankruptcy court. Those pathetic booklets on how to win at gambling does contain at least one good piece of advice: No more than 5% of total in-pocket capital per dice-roll. Then, no matter how venomous the snake eyes, they cannot poison more than one 20th of one's bankroll.
One 10th of the capital per venture recurs as a viable loss limit or risk management limit for traders in margined stocks, futures, options; and better a still smaller slice of the bankroll than a larger. A good added ingredient is a certain mindset or mental approach which I utilize. One of the best books I ever read was Dale Carnegie's How to Stop Worrying and Start Living. I regret not recommending it in earlier writings because every trader should have a copy.
An early chapter in the book contains a three-part method for handling worry situations which applies excellently to finance and speculation.
1. Ask yourself, "What is the worst that could possibly?"
2. Prepare yourself to accept that a "worst."
3. Try to improve on or find ways to improve on the worst.
I do not want to be one of those trader/writers who tell about their wins, but never their losses. Gains from option spreads are the mother-lode of my income but a "failed expedition" will serve to illustrate the above. In November of 1996, common stock in Citicorp, the New York bank, hovered around 100 per share and slightly above, and seemed to be rising. I opened a "horizontal calendar" spread position in call options with a strike price of 110.
I bought 10 calls with a January 1997 expiration date for $4,190 including commission and simultaneously sold 10 calls with a December expiration for $2,324.92 including commission. The money from the sell was credited toward the buy, so that I had to "put up" only $1,865.08 of my own capital. A good mathematical rule: Let other people's money pay for more than half of what you buy, and the farther above the halfway mark the better.
Anyway, the underlying Citicorp stock lingered lethargically then ebbed a bit instead of rising further. On the third Friday and early Saturday of December, the "short-end" or obligation end of my spread disappeared when the December 110 calls reached expiration. Alas, the "long-end" January 110s were badly shrinking due to the stock's wane and the passage of time. To prevent further attrition, I sold the Januarys the following Monday for $714.97 including commissions--a net loss of $1,150.11.
A minus, yes, but an instructive one. Dale Carnegie's question "What is the worst that could possibly happen?" is an excellent one to ask before a financial venture. Stocks rarely drop to zero, but with "wasting assets" (expiration date securities) such as futures and options, and with margined shares, one can lose the entire amount ventured.
I could have lost the whole $1,865 invested in the spread but I salvaged $714.97--some "improvement on the worst" at least. Yet the larger amounts involved should not be ignored. Whoever paid $2,324.92 for the December calls lost it all. More significantly, anyone who paid $4,190 for January options as I did and sold when I did--but without spreading -- lost $3,470.03!
So why did I lose less than a third of that amount? Thanks to spreads and their magic ingredient (fanfare!) other folks' cash, I had bought a $4.19 horse-racing ticket for $1.86. That had to mean a smaller lose. Cashing in before the end of the expiration date race also helped.
Thus spread strategy contains helpful gadgetry for calculating the worst, improving upon the worst, counter-acting the worst. It boosts the likelihood of other people being your source of income instead of the other way around. You can stop playing the game at intervals, but the street corner loiterers keep shelling out the silver. It requires a bookmaker's knowledge of economics and a bookie's willingness to let economics work for you as it works against the gambler.
As mentioned earlier in this article, the psychology of trading carries no less importance than the economics of it. Would you expect "psychological insight" from a bubble gum comic? Bazooka Joe sees a tall, broad-shouldered, white-bearded man walking down the street. "Sam, you look so different!" Joe erupts. "I hardly recognize you! You're taller. You've gained weight. You're bald. You've grown a beard. Sam, I can hardly tell it's you!" The puzzled passer-by responds, "What are you talking about? My name's not Sam." "You've even changed your name!"
Such is the all-to-human tendency to believe what we want to believe. Despite available evidence. Even despite additional evidence ("My name's not Sam") piling up in front of us. Usually this is pretty harmless. The members of the Flat Earth Society do not sail off the edge and are not bankrupted by their beliefs. Sometimes the world is too unpunishing. Dr. Jonas Salk was Jewish, yet no one was ever denied Salk polio vaccine because he called somebody a "God-damn Jew."
Not so the financial markets. They habitually break the legs of the "I'm never wrong" types. There is a beautifully severe justice when a Ku Klux Klansman decides to take up trading in stocks or futures or options, accompanied by his chronic tendency to believe what he wants to believe. He finds himself tied to the plantation whipping post, financially-speaking, his back bare to the lash.
Unfortunately, the markets can also be merciless to nice people and will lop off pounds of flesh for innocent "Sam, I can hardly tell it's you!" kinds of errors. Citicorp stock has to rise heroically through the 110 mark. It cannot do otherwise! It will turn those December and January 110 call options into gold mines. If the shares tarry or wane as if to say, "My name's not Sam," that's just a trick to fool the ignorant, of course.
For the record, Citicorp's January 110s followed the Decembers in expiring worthless. The stock climbed subsequently. I was the buy & sell spread-strategy walking wounded-while the option-buyers or "long player" ended up as stretcher cases or graves details. The "Offer a dirty $1 bill on a street corner" types and the "That's Sam in disguise" types, both-over-pleased with their own calculations, beliefs, ways of thinking, got hit the hardest. Being a bookmaker is no iron-clad insurance policy against loss, but compared to the horseplayers it adds up to better economics and better psychology.
Within the realm of investor psychology, one pinnacle that looms large is intuition. Is it or is not, people ask, a valid financial tool? A broad term, intuition can be summed up in the statement, "I don't know how I know. I just know." This is as opposed to scientific or empirical thinking, for which there must be known and visible evidence. Like folk medicine, intuition comes in various types, some valid, some not.
Going to a theater to see a movie, I arrived a bit early and lingered in the lobby for a few minutes. A large, ornate staircase ascended from the lobby to the rest rooms and the balcony. A standing sign on the stair landing said the balcony was closed.
A young black couple entered the theater, he and she both about age 20. After handing over their tickets, they stopped at the refreshment stand, then began to ascend the stairs. An usher standing nearby said, "Excuse me. The balcony's closed." "Okay," the woman replied, Both descended. Then the gal asked, "How did you know we weren't going to the rest rooms?" The usher shrugged. "Just a hunch."
I had the same hunch. Not until a minute later did I realize what prompted it. Both carried refreshments. People generally avoid taking food to the bathroom. At it's most on-target, intuition at the conscious level is evidence at the unconscious level. Other varieties tend toward voodoo dream book nonsense.
What is said at every coffee table conversation? "I was thinking about my cousin Sidney, whom I hadn't seen in months. Right that minute, he showed up at my front door. It's ESP." No mention of 1,000 people thought of who did not surprisingly show up. TV and print announce some housewife's pre-monition that dramatically came true, no mention of hundreds of other prophecies that did not. When Jeanne Dixon passed away recently, nobody spoke of her predictions that World War Three would break out in 1958 or that Richard Nixon would be the Republican presidential candidate in 1964 with running-mate-Walter Reuther.
All right, so you will not venture a large chunk of capital based on what a palm-reader said at a party. But you might make a trade in stocks or options based on some financial data, an elevator conversation, and an "intuitive impression" that shares in Podunk, Inc. will rise. One should ask: Is that really an "intuitive impression" or a desire disguised as intuition? Desires abound in the market, and they appear both masked and unmasked. Is that a crystal ball inside you or a wishing well?
When you find yourself saying, "I don't know how I know. I just know," look below the surface mentally and subconsciously. You might find a voice singing "Wishing Will Make It So" or you might find solid evidence. You may have noticed a stock gradually rising over the weeks (a call spread opportunity) or gradually declining (a put spread opportunity) and stored the data mentally at an unconscious level. Remember, always, that gamblers "playing hunches" go broke with monotonous regularity, as do their counterparts on the exchanges. Intuition well-used can be accurate, but it makes a warning label of the ancient Greek maxim, "Know Thyself."
Art historian Richard Muther, Ph.D. did not intend his two volumes The History of Painting as a psychology dissertation. Yet his illuminations on the human psyche are awakening. In Volume 1, Muther wrote about Italian Renaissance artist Alessandro Botticelli, who created his finest paintings under the aegis of Florentine banker-prince Lorenzo de Medici (I1 Magnifico or The Magnificent). Excerpts follow:
"A new type of the Madonna, independently created by Botticelli, enters the domain of art. A curly-haired angel offer her grapes and ears of wheat, the symbol of the sacrifice . . . and the angels press forward bedecked with wreaths of roses, bearing vases, candles and lily stalks.
"He only needs to apply the brush, and we are transported into a wide and lofty cathedral where the odor of incense mounts to heaven and a thousand great white candles flicker. We see solemn processions with flower-decked baldachins marching across the floor strewn with roses, and hear the silvery voices of children singing the praises of the Infinite One." (Pages 175-6)
"Everybody knows that from these entrancing paintings is wafted a perfume of youth, purity and grace, identifying Botticelli himself with the springtime . . . In his Pallas the head of the goddess, with its soft full outlines and long wavy hair, is of such radiant beauty . . . that one thinks of the transcendental sweetness of Leonardo da Vinci."
In The Birth of Venus, Botticelli "develops the sentiment from the landscape, the wide and endless ocean, upon whose quietly rippling waves the Cyprian goddess is wafted like a fair dreamland picture. The ringing of bells, the song of voices, and the rustling of garments is in the air; a longing, dreamy feeling pervades the entire earth." (page 179)
"A midsummer night's dream has taken form in his Primavera, with its nymph-like graceful beings which seem like an anticipation of Bocklin. Botticelli was the first to see the elves dance. Slender dryads who housed in a thicket of the wood beside bubbling springs, have come to take part in the dance of spring.
"It is wonderful how in these paintings also he uses flowers to enhance the effect. Clive branches encircle Pallas and crown her head, and in The Birth of Venus, the mantle of the hour is decked with flowers of spring, and the wind god strews roses in the air. In the Primavera oranges and myrtles shimmer; golden fruits and white blossoms gleam from the dark foliage.
"Like the Sleeping Beauty of the fable, Primavera is envelope with wild roses; flowers of the meadow encompass her neck; blue cornflowers and white primroses are entwined in her fair hair . . . Botticelli appears as a perfectly charming mannerist in his treatment of draperies, these transparent veils and fluttering bands. None before him used such fine gauze draperies, clinging tightly to the limbs and clearly revealing the flower-like forms." (page 180)
Did you think that painting was strictly a visual art form? The sound of bells chiming, voices singing, waves splashing, garments rustling. The scent of perfumes and incense, flowers and blossoms. The taste of oranges and golden fruit. The feeling of sylvan breezes and ocean breezes, spring sunshine and leafy coolness, wispy fabric clinging to voluptuous limbs.
Some would say, "The paints are real but the rest is merely your imagination." Imagination, yes, but "merely?" Your imagination is a far-from-faint pipe organ to play upon. As for the key word here, Webster defines Evoke as " 1. to bring to mind or recollection; 2. to recreate imaginatively." Under synonyms for Educe, the dictionary says, "Evoke implies a strong stimulus that arouses an emotion or an interest or recalls an image or a memory." Even that power-definition understates it since we have seen from Florentine art that "evoking" can kindle all five senses as "a longing, dreamy feeling pervades the entire earth."
Intuition gone rampant and awry will see a vein of gold where only dirt exists, "evoking" a vision of wealth which reality will replace with a bankruptcy judge. Knowledgeable and fine-tuned, intuition often evokes quite accurately the topography of the unseen land beyond the hills, where ores and nuggets are not unlikely.
No one can always be right, but as a trader's knack and intelligence improve, his intuition and evocations probably will also. He will smell the blue cornflowers that the Italian Renaissance goddess of spring wears in her hair, but he will not see Fort Knox in huckstered shares or the Hope Diamond in hearsay over double-bourbon.
Recommended Readings: Options as a Strategic Investment by Lawrence G. McMillan; Option Strategies by Courtney D. Smith.