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 Neglected Klondike
Everybody wants to be wealthy. Economists tell us, alas, that if everyone were a millionaire, a loaf of bread would cost a thousand dollars. So what if there were a sure, quick and easy way of tripling your money? Everyone would use it again and again. We would all eat sirloins costing two or three grand per pound.
Many investors and traders overlook this hard economic fact as blithely as do horse-players and casino customers. Thus innumerable venturers in stocks, futures and options end in bankruptcy court, sitting next to an "I had a system" roulette-player. What could they have done differently? How about letting others pay for most of the chips?
With both option spreads and futures spreads, you buy one batch of contracts and sell another batch usually on the same day. The money from what you sell pays for most of what you buy, with you paying the difference or the "debit." That meaty buffalo herd--other people's money--beefs up your ability to make full and replenishable profits.
How much is an ample profit? No easy answer; wealth-seekers argue over this frequently, with opinions hemispheres apart. Let say that a gambler goes to a racetrack or casino with $100 and emerges with that plus $10. Disappointing. Barely pays for parking. He hoped to parlay it up to $500 or $1,000.
Hold on, Charlie. A 10% percent gain in one day annualizes to 3,650%. A federal bond or a certificate paying that much would be astronomically fantastic, an ecstasy of wealth if an agony of inflation. Yet the small-time gambler is disappointed. On the pittance end of the spectrum, a retiree tolerates one or 2% per year from a "blue chip" in his portfolio. "A good company! Well-established."
In the throes of speculation fever, many futures traders and options traders resemble the gambler in their notions of what to expect and what to call disappointing. They feel devastated if the complex, surprise-a-minute market does not function in their hands like an easy-to-operate money-printing machine. If the market dished out fortunes as easily as they wish or anticipate, it would make everyone a millionaire. It is a zero-sum game, not a money-printing game.
A zero-sum game means that someone must lose a dollar for each person who gains a dollar. This conflicts with the vision many have of a bountiful cash-crop, although plenty of bushels can be gained. W. D. Gann once wrote, "People expect more profits in speculation than in any other business. A man who would be satisfied with a return of 25% per year in a business is not satisfied if he doubles his capital every month in Wall Street."
Many people are satisfied with 4% in a savings bank, but when they come to Wall Street and put up $1,000 they expect to make $1,000 in two or three weeks. They are the people who buy on a 10-point margin and always lose. Do not expect the impossible in speculative markets.
You may think an average of ½-point a day, or 3 points a week, is too small a profit to bother with. Yet, in 52-weeks it would amount to 156 points. Make speculation a business, not a gamble. Go into it to stay, not to gamble all on a few trades, lose and quit. Be patient. If you can double $1,000 the first year and keep doubling it for 10-years, you would have over a million dollars.
I dislike gambling because it goes beyond mere risk or unknown factors. Racetracks and casinos are systematized against, mathematically rigged against the wagerer. Yet a glance at the track can instruct. There are professional handicappers who bet the races and win with fair consistency, but that is because they approach it differently from the masses of horseplayers.
Professional handicappers avoid any race in which the horses are too evenly matched or there are too many unknown factors. So they bet only about one race in 10, which requires more self-restraint than most horseplayers possess. For avid gamblers cannot scratch only one bad itch out of 10. Also, pros settle for about a 20% over-all profit. This requires less greed than grips the wagerers who craves to double their bankrolls quickly or better yet turn $100 into $500.
The parallel to the pari-mutual junkie can be found in the financial speculator. He itches to trade too often, over trades, craves astronomical profits, takes licking after licking, and writes one check after another to replenish his depleted brokerage account. With unbusiness-like Land of Oz logic, he expects a zero-sum game to disgorge easy wealth into his pockets. He overlooks the fact that with a more scientific map-reading and a better-engineered dig, he really could tap the mother-lode.
Gann wrote, "Make speculation a business, not a gamble." The spread strategist in either options or futures is, in effect, a combination racehorse-buyer and bookmaker. While purchasing the thoroughbred, he pays for most of it with bets that he took, i.e., other people's money. If the horse subsequently loses a quarter or a third of its market value, the trader nevertheless resells at a profit because his bankroll paid for less than half of it. Better still if, so to speak, the pony increases in value.
According to an old saying among racehorse-owners, "Nobody ever committed suicide while he had a good two-year-old in the barn." Also, the phrase "making out like a bookie" emblemizes prosperity. With spread strategy, the long-end of the spread is your thoroughbred in the stable and the short-end your lawful betting parlor. Not no-risk, but low-risk thanks to the admixture of horse-player bank notes to the greenbacks in your treasury. Not risk-free. Limit: A 10th of capital per venture.
Precisely how does one go about setting up the horse barn and the betting bank? I begin by getting a "fix" or a bearing on a category of underlying securities--in my case, an industry group of stocks and individual shares--that is gradually trending either upward or downward. After reading W. D. Gann's two books bound in one volume "The Truth of the Stock Tape" & "The Wall Street Stock Selector," I saw shares bounce between floors of support and ceilings of resistance practically in my sleep, and could notice them pulling toward the floor or the ceiling they would crash through.
The two-in-one Gann volume is available by phone and credit card from L & S Trading 303-586-6262 or from Lambert-Gann Publishing 509-843-1094. You may get results just as good from other technical-analysis systems such as classical Charles Dow Theory, Elliott Waves, Wyckoff point & figure, Darvas pyramids of boxes or Japanese candlesticks. These are not gospel, but can serve amply as a nautical almanac when you steer a financial ship through the winds and currents of trends. Gann's axiom: "Discover the trend and go with it."
Investment fundamentalists denounce the above technical-analysis systems as phrenology charts on the walls of fortune-telling dens. A citizen-of-the-world eclectic, I slip across schismic boundaries and look at the fundamentals. What if a stock trends upward and has a strong P/E and increased earnings? That can be my whig/tory or Sioux/Cheyenne signal to position a horizontal spread of call options a few points above the share price. Conversely, a floorward trend and Delmonico-to-hash financial figures code a put spread below share price.
For long players of options or futures, the trend of the underlying security or commodity must continue in its direction to produce a profit. For spread strategists, it helps but is not essential thanks to the two ace cards of time-decay and somebody else's cash. Several weeks ago, for example, I took to noticing that the gala party enjoyed by semiconductor and software was past midnight and starting to wane. Cirrus Logic common stock fluctuated in the mid-40s on the downslope from a high of 61. P/E of 30--the hungry side of the late-teens median.
So spoke both technical and fundamentals. I scrutinized Cirrus Put options with striking prices of 40. This was late October, just about. The 40 Puts with November expiration dates seemed runty in value, already shrunk by time-decay. Not a lot for the selling end or horse parlor end of a spread. Happily, the December and January 40s both still bulged with bankrolls.
I phoned the lower Manhattan office of York Securities, my discount broker. Discounted commissions mean much with spreads, a buy and a sell going in, likewise going out. In options, beginning an investment is called "opening a position" and pulling out "closing a position." "I want to open a position in Put options," I said. "This is a spread, a buy order and a sell order going in together, each dependent on the other. The stock is Cirrus Logic, stock symbol CRUS, option symbol CUQ.
"I want to buy 10 contracts, January 40 Puts to open, and I want to sell 10 contracts, December 40 Puts to open. With a one-point debit." The debit meant the price I was obligated to pay out of my personal investment capital. One point equals $100 for each set of a contract bought and one sold. On my 10 and 10 orders, it meant $1,000. The amounts for which I would buy the January and sell the December were open-ended, but my one-point debit order riveted the difference between those amounts to one grand or less, not counting commissions.
Order executed, I sold the 10 December at 1-7/8 and bought the 10 January at 2-7/8; the latter cost just under $3,000 and the former pulled just under $2,000 into my brokerage account-other people's cash, the swag, the horse-player loot. That paid for most of the January and my capital--my end of the ante-paid the remainder. The December I sold represented the "short end" of the spread, the January I owned, the "long end."
Long means owning something, short means owing or being obligated. Both mean letting time pass. In about a week and a half, time-decay slightly reduced the values of both the December and January, but more and faster the December because of their nearer expiration date. The one-point spread or $1,000 gap between the two batches of contracts grew to 1.5 points or $1,500. Thus the phrase "the ravages of time" falls like a sweet utterance or holy benediction on the ears of the spread strategist.
The wider the gap or spread between what you own and what you owe, the broader and more diamonded the sash. I waited for additional time-decay. Then the might-or-might-not-happen part of the plan occurred. The underlying security, Cirrus shares, kept trending downward. It briefly hit 39-7/8, "nicking" the in-the-money territory of the 40 Puts, before spending time at 40 & a fraction /41 & a fraction. Good news the trending, but the nick of the striking price sent a fast-action danger signal.
A spread trader should never let the short end be in-the money, however briefly, beyond the trading day that it happens. Options move into-the-money during the trading day, but are "assigned overnight." That is, execution orders get matched up with in-the-money contracts after the close of trading. An exercise of the short end wipes out the spread investment; add the commission cost of stock-buying and selling to fill the exercise order. But you are safe until the closing bell.
An execution order can stand and detonate overnight, even if options move out of the money the same trading day they move in. So I spent $2,050 buying back the December 40 Puts, closing out the short-end on the same day the shares touched 39-7/8. This turned my $1,000 venture into a $3,000 one, but I held onto the long-end January 40s because of favorable trending.
Days passed. The stock touched 39-7/8 again and rose as high as a particle over 42. I stood ready to resell the December 40 Puts if the shares found a floor above the striking price. Ready to re-open my betting windows and turn the $3,000 investment into a $1,300 or $1,500 one, plus wagerers' chips. If the stock waned, I would play the long Puts.
November 7th. I phoned about an hour after the start of trading and thought the broker was mistaken when he said, "Cirrus Logic 30-¼." I took a breath to tell him he had the wrong stock when he added, "Down 10-3/8 from yesterday." Half reeling, I asked about CUQ January 40 Puts. Market value of the 10 long contracts $10,250. Bellissimo! Buongiornata!
November 7th--14 business days after the opening of positions. So what did I do right? Reading extensively on options and other investments certainly mattered. Blending technicals and fundamentals while the zealots of each declared the other a false science. Watching for trends with telescope, nautical almanac and sextant. Like the professional handicapper, passing up at least 9 out of 10 chances to bet. Like the economist, knowing the rarity of money machines and cash cows in the real world, and thus being more alert to a true one. Like the spread strategist, detecting opportunities that others ignore.
I call spread strategies with options and futures "The Neglected Klondike." Vast cliques of financial people pass them up, and for reasons as different from each other as the cliques. The blue chippers lump them in with all option and futures activities as seedy, murderous gambles. Contrarily, the hot-blooded, fast-buck speculators crave astronomical profits quickly and so shrug off a spread's not-infrequent 30 or even 50% weekly gains. Nearly everybody mines elsewhere.
Additions to recommended readings: "Getting Started in Options" by Michael C. Thomsett - Jon Schiller's "The Insider's Automatic Options Strategy" - Robert T. Daigler's "Advanced Options Trading" - Richard M. Bookstaber's "Option Pricing and Investment Strategies."
Let us close with a statement from W. D. Gann's "The Wall Street Stock Selector" - "The lone hunter or fisherman is the man who bags the game. . . . The big men are just as often wrong as the little fellow, but most of them are smart enough to change quickly when they find they are wrong and do not hold on and hope, as the public does." The lone hunter or fisherman or spread strategist who tracks not the masses, but the trend and the opportunity.