Issue 62

OPTIONS SPREADS: The Rosetta Stone that Sheds Crocodile Tears
Greg Donio

Comedian Bill Dana doing the character Jose Jimenez said he used to own a ranch. It was called the Circle V Bar 20 Double Diamond Rocking Chair Half-Moon Tumbleweed Ranch. It was a big spread but it did not have many cattle because not many survived the branding.

I used to laugh at the vision of cowhands destroying steer after steer after steer without realizing this was not smart. Then I learned about the many thousands of bank accounts destroyed by the huge hot irons of the Fork-Belly Futures Ranch and the June-Expiration Options Ranch, to name a couple.

John Rothschild wrote that between 80 and 90 percent of all futures traders lose all their money. Other publishings pinpoint the 90. Also, various published sources say that over 90 percent of all out-of-the-money options expire worthless.

Am I a voice or doom? Not really. Just a jungle planter who knows snakes bite, who stays alive and in profits. Never out of my sight are the graves of others who tried to carve a fortune from the speculative jungle, the crocodile skin profiteers and the sell-fake-deeds-to-cannibals profiteers. I pocket an uncut diamond and avoid the quicksand. Widows weep for those who step carelessly.

During the Atlantic City casino stock boom of the late 1970s, I took hefty profits in Resorts International and Caesars' World common shares, also Bally call options. The head of the Philadelphia office of the discount brokerage chain remarked to me, Everybody would like to do what you just did, but if everybody could, a loaf of bread would cost a thousand dollars.

He was mixing college economics with investment reality. Why does the government not make everybody a millionaire simply by printing vast amounts of paper currency? Because the more dollars there are in circulation, the less each dollar is worth, so that hot dogs with sauerkraut would cost several hundred dollars each. This is the operator. Please deposit two thousand dollars for three minutes.

Same result if making a large fortune quickly were as easy as is thought by those who read the hack pages of the supermarket tabloids. Make $100,000 in Four Weeks! Or as easy as expected by the amateur optioneer who anticipates multiplying his cash repeatedly in time for the lawn party. If it were such a snap, the highways would be jammed bumper-to-bumper with chauffeured limousines.

In his 1923 book The Truth of the Stock Tape, W. D. Gann wrote, People expect more profits in speculation than in any other business. A man who would be satisfied with a return of 25 percent per year in a business is not satisfied if he doubles his capital every month in Wall Street. Many people are satisfied with four percent 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.

He was writing of the time when you could buy $10,000 in stock for $1,000 in cash and a $9,000 margin loan or brokers loan. A 10-percent rise in the shares doubled your money but a 10-percent drop drained every penny. Today the margin limit for stocks is 50 percent but the people who buy on a 10-point margin and always lose remain active in commodity futures. Options, whether on stocks or bonds or futures or currencies, provide another on-the-edge game.

Now as then, People expect more profits in speculation than in any other business. After scoring with Atlantic City casino shares and options, I did heavy reading on investments and speculations at the Mercantile Library on Chestnut Street in Philadelphia. A book on futures trading contained a core statement, A mild increase in the price of the underlying commodity multiplies your investment.

Someone with a ballpoint had done some crossing out and writing in so that the statement read, A mild decrease in the price of the underlying commodity wipes out your investment. One can imagine the financial agony that moved that writing hand. I read books on stock options because of a happy surprise with Bally casino call options. I had bought the calls, fully expecting to exercise them and buy the underlying shares IF those shares rose. Bally stock rose 40 percent but the options for which I had paid $ 2,000 climbed to $5,000 -- more than double.

To hell with exercising! I simply phoned the broker and re-sold the calls at a profit. I had purchased the options simply as a side door to additional casino stocks. By oh-so-sweet accident I discovered that options had a life of their own, and a vivacious life at that. Like futures, they could surpass the underlying by a golden mile percentage-wise.

Resorts International, Bally and other boardwalk roulettes subsequently plunged but by then I had pulled out and invested most of the profits in bank shares. I had anticipated that after the ribbon cutting near the slots, the party would not last. Alas, alas, I used part of the profits attempting to repeat the option success with puts and calls on stocks of other categories. There I was sprayed with gunfire from one of the sad 90s -- the fact that over 90 percent of all out-of-the-money options expire worthless because most shares do not move so spectacularly.

Thus did I learn of the giant branding iron at Rancho Optionero that turns dollars into cinders? The stock, options and futures markets are, among other things, firing squads that say to many traders, We must take you out and shoot you so there wont be too many millionaires. So a Virginia ham wont cost five grand. We are sorry and must shed crocodile tears.

Also at the Mercantile Library, I found a book on Option Spreads. I am sorry not to remember the author or exact title but it was the jungle diamond snatched from amid venomous vipers. The question is asked on many a barstool: Who gets all that money that's lost in the markets? At more specialized question: Who received the cash paid for all those put & call options that expire worthless on the third Friday of every month?

Much of it goes to stockholders who sell covered calls on shares they own. A fair amount goes to sellers of naked puts & calls. A part goes to spread strategists, the merchant caravan to which I belong. The latter are probably the least numerous among the three categories of traders. Yet that strategy earns high marks for both requiring a relatively small investment and (trumpet fanfare) reducing the risk.

Let us say that you buy 1,000 shares of an optionable stock. Each 100 shares you own gives you the right to sell one covered call option, so with 1,000 shares you may sell 10. On April 22, 2002, for example, Dell Computer trades for 27 a share. You may buy 1,000 shares for $27,000 cash or $13,500 at 50 percent margin. Let us say $15,000 for a bit of protection against margin calls. (Specifying a company name is not a recommendation.)

With options, one point means $100 or $1,000 if you are selling 10. The option columns for April 22 say that Dell calls with an expiration date of May and a strike-price of 30 trade for .2 or two-tenths of a point with a volume of 1,369 options sold. The .2 means you can sell one covered call for $20 or 10 for $200. The 30 strike-price means whoever buys one Option has the right to buy 100 shares of Dell common stock at 30 dollars a share before the expiration date--the third Friday of May.

Since Dell stock currently sells for 27, the May 30 calls are said to be out of the money but trade for cash because the shares may climb above that strike-price before expiration. The option columns in the same newspapers (Barrons, The Wall Street Journal, numerous dailies) say that June 30 (expiration month and strike-price) Dell calls sell for .55 ($55 for one or $550 for 10) with a volume of 296. August 30s weigh in at 1.15 ($115 or...$1,150) volume 366.

The November 30s at 2.15 translate $215 or $2,150, volume 13. January (2003) 30s at 2.6 are $260 or $2,600 and volume 25. If you paid $15,000 to buy Dell shares on margin, selling Junes for $550 with a two-month commitment or Augusts for $1,150 with a four-month commitment each annualizes to better than a 20 percent return. Selling the seven-month-ahead Novembers for $2,150 annualizes to just under 30 percent and nine-month-ahead Januarys ($2,600) about 35 percent. If the stock rises to above 30, the options will be exercised and you must sell at 30 for about a 10 percent gain on the shares -- another plus when handling out-of-the-money calls.

If the stock stays below 30, the options expire worthless and you may sell more carrying a later expiration date, and if those expire worthless, still more. If the stock declines in price, the sale of covered calls provides varying degrees of cushioning. For example, the sale of Novembers for over $2,000 offsets over a $2,000 loss in the shares. However, stock investors who sell covered calls or calls covered by shares they own are perennially warned: "NEVER buy a stock for option-selling purposes unless you would also buy it for its own sake."

The Reason: If the shares in a particular company are not a good investment in and of themselves, the nose-dive will hurt far worse than any option offset can heal. Such fundamental and technical factors carry significance for the spread strategist as well as the stock investor. The numbers in the preceding paragraphs are option spreaders figures as well as shareholders ones. Same data, different viewing angle.

The Key Fact: Owning options with expiration dates far in time gives the trader the right to create and sell options dated nearer in time. Possessing stocks, bonds or money does not allow you to print more stocks, bonds or money, but with puts and calls the rules change delightfully. Let us say you buy the 10 Dell call options with a January 2003 expiration date and a strike-price of 30, and you pay the already-mentioned price of $2,600. That gives you the right to sell 10 nearer-in-time June 30s for $550 and, after they expire, 10 July 30s. The Julys do not exist yet but will, starting late May. After the Julys expire, golden et ceteras shine August through December.

If the spread strategist wants a bigger moneybag now, he can buy Januarys for $2,600 and instantly sell Augusts for $1,150. Also, he need not wait until expiration on the third Friday of August to mine another vein. He can buy back and close out the Augusts at a reduced price after time-decay has eroded their value, such as in June or July, then sell a later expirer. Selling options that expire worthless and selling then buying back at a reduced price are both shorting for gain variations.

Although spreading is not risk-free, you may have noticed how numerical proportions change vastly to favor the spread strategist. $1,150 from the sale of Augusts is a far bigger return on an investment of $2,600 (purchasing the Januarys) than on an investment of $15,000 (Dell shares on margin) or $27,000 (stock bought for cash). Also, even though options have a risk factor (expiration) that shares do not have, far less cash is risked. Most importantly, when things do not happen as planned, when a stock descends instead of ascending or the reverse, the aforementioned cushioning or offsetting grows astonishingly.

To be specific, the $1,150 makes a far bigger shield when protecting $2,600 than when trying to protect $15,000 or $27,000. This does not even factor in the money from the sale of options expiring other months. When you gain a nickel and lose a dime, that nickel is far larger than when you gain a nickel and lose a dollar. A couple of pennies from another month and a couple more from still another -- What a Difference. So although option spreads involve risk, it helps mightily when your casino chips give birth to other chips and can do it again.

Financial calfing of this particular variety is known as a Horizontal Calendar Spread. In the Dell Computers example given, the spread was horizontal because the options bought and. those sold had the sane strike-prices (30) and calendar because of different expiration months (buy the far-in-time Januarys, sell the near-in-time Junes or Augusts). The options bought are called the long end of the spread and those sold the short end. Inevitably, selling short means profiting from other investors losses, with expiration dates as Boot Hill.

Sell the Junes. After they expire, sell the Julys. After they expire, sell the Augusts. Each sale is a purchase by some optioneer who wants the puts or the calls to swell in value, who gives it his hopes and a chunk of his bankroll. Among the sad 9Os, over 90 percent of those out-of-the-money Junes and Julys and Augusts become worthless paper. So what should you do? Sell plenty of paper that becomes worthless.

The spread strategists Rosetta Stone bears, among other engravings, a cryptic three-letter imprint: OPM. It comes from the dreamer who stands on a curbstone and envisions himself living in a penthouse. It comes from the barfly who thinks up a Heads I win, tails you lose gimmick. It comes from the tenant who has trouble paying the rent and buys a book like Break the Bank at the Casino. It comes from the cab driver and the inventory clerk who takes the Famous Writers correspondence course because they did well on that entrance test that nobody ever seems to fail. The et ceteras abound, from the horse-player to the secretary who writes chain letters and expects 10,000 one-dollar bills in her mail slot. OPM-Other Peoples Money.

People have always sought wealth on dead end streets and emptied their wallets along the way. Yesterdays Ponzi notes, deeds to Florida swamp, penny stocks sold door-to-door at a dollar-per-penny mark-up. Today's no money down real estate seminars taught by people who failed in real estate and make money from seminars. Today's financial newspapers reporting one after another high-toned investment program that turned out to be a Ponzi scheme.

In an old haunted house movie, the Bowery Boys buy sight-unseen a luxury mansion that turns out to be a refugee from the wreckers ball. Hope springs eternally and, with it, the hand reaching for the checkbook. When the Aprils expire, sell the Mays. When they expire, sell the Junes. Other Peoples Money and the monthly wreckers ball. He who gets the money lost weeps crocodile tears on profit dollars.

An old adage states, If you sit in a poker game for 20-minutes and you don't know who the patsy is, then you're the patsy. The trouble is, many people get duped because nobody likes to hang that label on himself. Similarly, everyone likes to think of his own capital as the smart money and other peoples as the sucker money. Thus many drained bank accounts never bore the sucker money ranch brand but should have.

Ere you title yourself Lord Goldleaf of the Sophisticated Bankroll, remember the barfly is not incapable of titling himself also. Practically all futures and options traders consider themselves smarter than the poker patsy and more practical than the curbstone dreamer. Yet that does not reduce the numbers of the sad 90s -- the percentages whose dollars get scorched in the branding. Granted, there is always risk and anybody can lose. Are there rules for not becoming the sheep fleeced and butchered?

I have found becoming an option spreader a fine way to start since that method gets much of the money other people lose. Hail to OPM! Also, there are no plaques engraved with maxims on my wall but I can envision several. Confucius said, When a learned man makes an error, he makes a learned error. Professionals can lose but they lose less cash less often than the jungle picnickers. Not risking too large a portion of your capital on any one-venture counts as one important rule.

Another is studying and becoming sophisticated within the specialty. In their book All About Options, Wasendorf & McCafferty wrote, 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 thee more complicated strategies that are more conservative by comparison.

Horizontal Calendar Spreads using out-of-the-money options would rank high among those strategies. As for the wrong reasons people who want to make a lot of money quickly without exerting much effort well, if they like the smell of horses their cash winds up in the bookmakers till. If they like the hum and color of the markets, it winds up in the option-sellers till, and the spreader sells as well as buys. Ergo, the smart money rests in the pocket of the well-read or well-studied trader.

What to read? Not and easy question. Since relatively few traders are spreaders, not a lot has been published on the subject. In his landmark book The New Options Advantage, David L. Caplan wrote, Two positions that have great benefits in many diverse situations, covered call writing and calendar spreads are often overlooked by most traders. The book does not atone much since its section Calendar Spread runs only two pages. The above-quoted Wasendorf & McCafferty book All About Options devotes only three pages.

On the plus side, George Angells book Sure Thing Options Trading carries good basics on option-spreading, as does his book Winning in the Futures Market on spreading with futures. Well-known are Lawrence G. McMillans books Options as a Strategic Investment and McMillan on Options. Special mention goes to LEAPS -- What They Are and How to Use Them for Profit and Protection by Harrison Roth. It focuses on long-term (8-months to 2-1/2-years ahead in time) options but also has much worthwhile to say about conventional shorter-term ones. Chapter 35 on Calendar Spreads deserves a trophy, with the 42-page Introduction plus Chapters 10 and 11 making good foundational reading.

Chapter 35 says, Our intention is to keep writing OTM out-of-the-money shorter-term calls and keep collecting those lovely premiums. This points to a keystone of truth: The spread strategist must also be a stock trend follower, positioning a spread with call options above a rising stock or with puts below a descending one. Those imaginary plaques on my wall include several four-word variations by W. D. Gann: Go with the Trend, Dont Buck the Trend and Trend Is Your Friend.

One statement that flies off the wall and hovers before my eyes more than rarely was written by Nick Darvas: There is no such thing as cant in the stock market. A stock can do anything. That advice saved me more than once from the It cant happen! quicksand. It can also protect a trader from risking too large a portion of capital on any one venture. This links up with Gann's warning: Never average a loss. This is one of worst mistakes a trader can make. Averaging means buying more shares or options in anticipation of rebound -- while the stock is trending the wrong way!

One make-believe plaque on my wall bears a carved-in-marble quotation of unknown origin: Go the extra mile. Its never crowded. Being better-read or better-studied than most traders is one way of going the extra mile and finding that the population dwindles along that stretch of road. Also, go back and look at those Volume figures month by month on the Dell out-of-the-money call options. Or look at today's (April 24) volume numbers on the strike-price 10 out-of-the-money calls of Sun Microsystems (shares selling for just under 9):

May. 1, volume 1,333; June. 3, vol. 858; July .5, vol. 1,013; Oct .9, vol. 409; Jan (1903) 1.25, vol. 150. This means you can buy 10 far-in-time Januarys for $1,250 and sell 10 near-in-time Junes for $300 or 10 Julys for $500. You can sell 10 Junes then 10 Julys when the Junes expire. Or buy back the Junes at a shrunk fraction a couple of weeks before expiration then sell Julys while they have more meat on them. If the stock has not risen, so the 10 strike-price is still out of the money, you can sell Augusts, then Septembers, etc. If you want plenty of offset armor you can sell Octobers in spring for $900 and get back almost three quarters on the day you buy the Januarys.

In the latter position, you can buy back the Octobers in a few months, after time-decay has ravaged and reduced them, then sell Novembers, then Decembers. If the stock rises above the strike-price of 10, placing the options in the money, you must at least close out the June or July or October short-end by buying it back. You can sell the long-end Januarys which will have risen in price. Or you can keep them and sell Augusts or Septembers with a strike-price of 15, i.e.. out-of-the-money.

If the Sun Microsystem stock in this example declines, the January calls for which you paid $1,250 would lessen in value. However, the Junes would offset $300 of this or the Julys $500 etc., with the sale of a subsequent month bringing more on the plus side. Why did I ask you to watch the volume figures? Notice that many people buy the near-in-time options and markedly fewer the far in times. The fars are the extra mile that is never crowded. From the spread strategists vantage point, the Bowery Boys and horseplayers buy the near in times.

Brief mention was made earlier of the naked option seller. He sells calls on stock he does not own or sells puts which obligate him to buy shares for more than their market value. Usually the options expire worthless and the cash he received for them is pure profit. But the occasionally makes this as dangerous as lions fangs. One commodities man sold $100,000 in out-of-the-money calls on futures. While he waited for 100 grand in profit when they turned worthless at expiration, the underlying futures rose dramatically. Buying back to pull out cost him $500,000. GO yee not naked.

With spreads, the long-end increases in value along with the short-end. Spreading is not risk-free but it is risk-reduced and a situation similar to the one above often generates a profit. Another there in spirit plaque on the wall courtesy of Gann: Handle speculation as a business, not as a gamble.

Gamble. Everybody knows about the horseplayer who has been losing for years but keeps betting. In simple arithmetic, he would have done far better putting that money in a bank over the years. Of course, it does not take much study of psychology to understand that a bankbook lacks the excitement of post time and the suspense of the horses rounding the far turn. He has many counterparts in stocks and futures and options. They keep losing but speculation electrifies and jazzes up their nervous systems. Like the wagerer who bets on the weather to make it interesting, this kind of interesting is pathological.

The problem can be pinpointed. Nothing thrills many people as much as trading. Rail tycoon and short-seller Daniel Drew in the late 1800s and speculator king Jesse Livermore in the early 1900s both amassed millions but both kept trading until they lost everything and died broke. Drew was piratical in his speculative methods but his brand of old time religion regarded as sinful the reading of novels and attendance at stage plays or operas. Jesse Livermore graduated to big brokerage houses but got his start in bucket shops next door to barbers who took bets. The crap shoots behind the ash cans never left his inner man.

In short, neither ever wore a diamond stickpin, in an opera box. Neither ever enjoyed the swell of a Rachmaninoff piano rhapsody or Chopin played in a candle-lit Paris salon. Nothing excited them except the doubling of dollars with the stakes large and suspense a a plenty. Thus they kept risk venturing even after bank interest would have kept them in penthouse and servants. Too many traders are like that today. Nothing fascinates them or makes it interesting except the markets when played like roulette wheels. Is this the hallmark of the successful trader or of handling it like a business?

The Wall Street mogul of the Gilded Age rode the horse-drawn hansom cab to the grand opera or the art museum or the archaeology exhibit. It would be nice to say he has latter-day counterparts but every time I pick up the Wall Street Journal I doubt it more. It has become a soapbox for big-name Conservatives, i.e., people who call themselves traditionalists when their knowledge of tradition goes as far back as Shirley Temple, Stardust and Mickey Mouse.

Former Judge Robert Pork, critic/author Michael Medved, Oklahoma Governor Frank Keating and one-time White House confidant John DiIulio have used the Journal pages to condemn today's movies and music for supposedly causing mountains of immorality and anti-social behavior in real life. All cheer-lead for a return to the sweet old times of Hays Office movie censorship and l930s radio song censorship and all seem to have blurred vision of any past prior to Walt Disney. It hurts my Italian pride that so many traditionalists think Titian and Tintoretto drove Prohibition rum trucks for Capone.

The saddest thing is that the Wall Street Journal does NOT receive cascades of mail stating that Mascagnis classic opera Cavalleria Rusticana has been performed countless thousands of times throughout the world without causing the seduction of a virgin, wife-stealing or fatal stabbing. That melodic adulteries and poisonings penned by Verdi and Puccini did not spill over into the behavior of opera-goers. Too few cultured voices in finance?

The Journal editors have NOT been deluged with bags of letters saying the nude pagan voluptuaries painted by the Venetian colorists have not as yet caused spectators to collapse into quivering blobs of lust. That undraped Salome carrying the severed head of John the Baptist has not provoked any schoolgirls at the art museum to strip naked and chop off heads. The old carriage-trade man of finance who lit his cigar from a gaslight and enjoyed art has left us but does he lack successors?

Have YOU written a letter to the Wall Street Journal? It is better for both your psyche and your finances if there are things that fascinate you or bind spells on you besides market fluctuations. A CD of music by Debussy can enrich twilight. So can a book on the archaeological discoveries of Lord Carnarvon or Sir Arthur Evans. The old-order tycoon who put aside his ticker tape to study Florentine brush-strokes and use of atmosphere had less inclination to use his portfolio as a crap game and more likelihood of profits. Today, the Wall Streeter or La Salle Streeter who makes side bets on ball games would be better off with a side copy of Giorgio Vasaris Lives of the Artists. Furthermore, the Wall Street Journal can use the cultural input.

In literature, the American novel The Pit by Frank Norris was published in 1903 and dealt with the Chicago grain market. At the Board of Trade Building, the description of the crowded visitors gallery overlooking the main floor contains both a cross-section and a lesson: There were men in top hats, and women in silks; rough fellows of the poorer streets, and gaudily dressed queens of obscure neighborhoods, while mixed with these one saw the faded and shabby wrecks that perennially drifted about the Board of Trade, the failures who sat on the chairs of the customers rooms day in and day out, reading old newspapers, smoking vile cigars.

Which wag do you not want to be? So one more imaginary plaque on the wall bears an illustration of a top hat and says, The smart money avoids old newspapers and vile cigars.


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