Options for Rookies

Posting Live Trades. Why I Cannot do that.

I would find your posts more credible if you would transition from the hypothetical to your real-time actual trades and your active management of those actual trades.

Jeff

***

Hi Jeff,

Credible?  Are you telling me that you don't believe these are my honest opinions?

Here's why I don't believe it's a good idea to give specific trades in a 'regular' blog post.

1) I don't like to recommend specific trades to readers.  The trade would be perfectly sound for me and my comfort zone.  It would suit my trading goals and risk/reward tolerance.  But it would not be suitable for many traders.

2) The truth is that when someone who writes as a professional in a specific field does something, it's very likely that others will do the same.  And that's okay with me - if it truly represents a reasonable action for the person who copies the pro.

I just know - from past experience - that some follow blindly, believing that if a pro is making the trade it must be a winner.  I have enough losing trades that I do not want to encourage (despite all the disclaimers) anyone to follow me. 

3) I believe in guiding you and others to learn to think and make trades for yourselves.  That's why The Rookie's Guide to Options describes, in detail, how to open and manage positions and why I spend a lot of blog time describing how to adjust positions.

I am an educator, not a trading coach, and not a market guru.  I have no special insight on when to make trades.  I must depend on risk management skills to earn money.

4) For me, there's another problem.  I do not manage trades individually.  I manage a portfolio containing a bunch (perhaps a dozen) different positions.  Most of the time, I can afford to delay making an adjustment because I have a position (portfolio insurance) that is prospering when another gets into trouble.  Those can offset each other - to a point.  I do adjust, but later than I would adjust if trading this position individually.

Because of that, I would not be giving the best advice on how to manage a trade.  And I certainly do not want to to that.

Nor can I afford to take the time to set up a specific trade in a separate account when the sole purpose for doing that is to share my adjustment ideas in real time.

To do that, I would have to run a premium service and charge a monthly fee.  Obviously that service would include much more than sharing my trades, but I have no idea if anyone would pay a modest fee for that service.

If you look through the archives, I did just what you suggested last year.  But it took a lot of time and sometimes I missed an adjustment point because I was busy with something else.  That was unfair to anyone who followed the trade and wanted timely 'advice.'

5) And there's one more point.  I am not licensed to provide specific trading advice, and again - despite disclaimers, I know that some people would follow the trade.

I just cannot accommodate this request on this blog.  I hope you can understand.

I do post some of my trades on twitter, so if you follow me there you will get to see some trades that are posted as soon as possible after they are made.  There was a bullish adjustment made today at the market lows.  Lucky timing on my part.

469

Examining Adjustment Alternatives

When it's time to adjust a position, most of the time, it's easiest to exit the trade and find another.  At other times there are multiple - and all satisfactory - choices.  Let's consider one example.

The market has been marching higher in recent times, so iron condor traders may be facing a difficult time with their call positions.  In today's example, I'm looking at a portfolio that has two trades:

Position one:  An iron condor that is in trouble.  In fact, many traders would have closed this position long ago.  But a good number would still be holding because the short call is still out of the money.

Index is currently priced at 850, after a nice rally

Bought 10 (not recently): Oct 720/730P; 860/870C  iron condors

Collected $325

Position two:  A pre-adjustment, bullish spread with a naked long call, bought earlier

Bought 2 Oct 850 calls;  sold 8 Oct 880/890 call spreads. 

Paid $1,000 total debit for this trade.

Net credit: $2,250 (10 x 325 - 1,000)

Where do things stand:

a) The October put spread was covered by paying $0.20.  Cost $200

b) The 860/870 call spread is in dangerous territory and your action may depend on how much time remains before expiration; your market outlook (if you have one); your comfort zone; the size of your portfolio (is this a large or small position for you?), etc.  There is no 'one-size fits all' solution.

c) The 850; 880/890 (1 x 4 x 4) spread looks great.  This position never loses more than the original cash debit (if all options expire worthless), and has unlimited upside profit potential - above 890.

With your long call being ITM by 10 points and the OTM still away, this is a profitable position (at least right now).

What now?

You have two basic choices.  Manage these positions separately, or combine them and use the total Greeks to help manage risk.

There's no set of rules for anyone, but I prefer to combine the trades and make a single position.

Viable ideas

1) Cover the 10-lot of call spreads that remain from the iron condor.  To pay for those spreads, sell your two long 850 calls.

The advantage of this trade is that: Your 'naked' call spread position has been moved from 860/870 to 880/890 and the number of short spreads is now only 8, rather than 10.

You used your 2-lot of long calls to good advantage.  You sold them to pay for the losing side of the iron condor trade.  There should still be some cash left over, after these closing transactions.

If you want to refine this position further, you can close the 8-lot 880/890 call spread to exit the trade; sell an 8-lot put spread against the calls to create a new iron condor; hold the call spread, knowing that you may be forced to close it at a higher price later.

2) This is an example of rolling down the position.

a) Cover the 10-lot of 860/870 spreads and roll down by selling 10-lots of the 880/890 spread.  Your position is now short 18 of these call spreads.

b) Roll down the 850 calls

If it's more important to you to bring in some cash to offset the roll, then sell the 850/870 call spread 2 times.

If it's more important to have a less risky position, then sell your 2-lot of 850s and buy 3,4, or 5 of the 870 calls.

Rolling both positions down is likely to cost cash out of pocket, making it more difficult to end up with a profit by the time expiration arrives, but I prefer to ignore that.  If your position makes you uncomfortable and you must make a change (or exit), then that takes priority over taking extra risk in an attempt to salvage a profit.

c) It's always reasonable to reduce the position and you can do that here by cutting each position in half.

468

Guest Contributor at Bargaineering

Today I'm a guest contributor at Jim Wang's very popular and well written personal finance blog, Bargaineering.  Jim's work has been cited in the NY Times and Business Week.

The vast majority of passive investors are just that - passive.  The idea of combining option strategies with a passive investing approach may seem to be a contradiction in terms, but I believe the idea has merit.

All investors can benefit by owning stock market investments that are protected against large losses.  In other words - investments that are insured.  Collars are appropriate for passive as well as active investors.

467

Q & A. Hedging the sale of naked puts

Mark,

I follow your blog, having read your "hedge fund" book about a year ago ... which was my introduction to options.  A very understandable book, BTW.  Since then I've used covered calls pretty well ... making a few of the classic mistakes along the way.

Just read your entry about "beating the market".  I am looking at doing a "hedged put-writing strategy", which I've read about in another book (Put Options by Jeffrey Cohen). 

The idea is that you write puts on individual stocks, then hedge by buying OTM puts on one or more of the indexes.  I don't think I've seen you mention that strategy.  Is that an approach that you approve of?

The idea is that you sell the puts on the individual stocks -- stocks that you've done some research on.  He has some guidelines for picking those.  He recommends selling longer term options to generate a decent premium.

And then buying the index puts as the hedge, because the implied volatility is lower on the index, your "insurance" is cheaper.

If all (or a large proportion) of your stock picks happened to decline more than the index, you'd lose.  That seems to be one of the drawbacks.

Brian

***

Hello Brian,

I don't like that specific approach.  In fact, I'd prefer to do just the opposite of what you are suggesting.

In practice, indexes are less volatile than individual stocks (some stocks move up, others down, negating part of the volatility).  Thus, selling naked options or spreads on an index is less likely to result in a loss than selling options on individual stocks.  In return for that reduced volatility, you collect a lower option premium.

By buying puts or calls on individual stocks, you are hoping for a major news announcement and thus a big change in the price of the stock.  I've never tried this, but it's a strategy that has supporters.  Cohen is suggesting you do just the opposite.  This is a personal situation for me, and many investors/traders disagree:  I do not like to try to pick stocks that will out- or under-perform the market.  By doing 'some research' your strategy requires just that.  Thus, it's not for me.  But is it for you?  that's your decision.

Is the purpose of this strategy to sell puts in stocks you are willing to own?  Is it based on the premise that you have the ability to pick winning stocks?  To balance the risk of market movement in the wrong direction (down in your scenario), or of exploding implied volatility on puts you sold, the idea is to buy index options to hedge  those risks.The idea is to prosper by having your stocks outperform the market.I

If that's the rationale behind this strategy - and I don't know what Cohen is thinking here - I don't like it.  First I believe the vast majority of traders are unable to outperform the market.  Yes, day traders play for short-term swings, and many appear to make good money, but investors have longer holding periods.   If you know you can pick winners, from a proven track record, then this method is appealing.  But it's not for the majority.

Second, the margin requirement for these positions is much higher than when you hedge your trade with options on the same underlying.

Third, I don't like the correlation risk.  Sure, you sell puts in stocks you like, but as I mentioned, they are not going higher just because you like them (for most traders).

This method works when your stocks don't collapse.  It doesn't cost when nothing moves and all options expire worthless.  There is one problem if you choose volatile stocks - you may pay too much for your long options.  Obviously this can be balanced by selling the same dollars worth of index options as you pay for your options - but be certain to use a risk graph so you do not oversell index options and incur a loss on a big move.

This is a trading idea for which some practice is required.  You must learn how to determine how far OTM the index options should be and how many to sell.  This sounds right for a short research study - paper trading. 

Correlation Risk

Getting back to the correlation risk mentioned earlier.  I know it's much safer to hedge the specific puts you sell, rather than taking the generic stance of buying index options.  If you sell a bunch of AAPL 180 puts, wouldn't you feel more comfortable owning APPL 175 puts than some NDX puts?  I would.

466

Rookie's Guide to Options is #1 Options Book at Amazon.com

It's exciting to be at the top of the list.  Thanks to all who helped make this possible. 

To celebrate, there will be a special promotion for the month of October, 2009.  Stay tuned.

Monday September 28, 2009, 9:46 CT

465

Interview with Adam Warner of The Daily Options Report

Today it's my privilege to conduct an interview with Adam Warner (agwarner on Twitter).  Adam writes the highly acclaimed and popular blog, The Daily Options Report.

He co-wrote the options column on Street Insight from spring 2003 to spring 2005, and is currently Options Editor at Minyanville.com. 

When not writing, Adam is a proprietary option trader with Addormar Co, Inc.  He graduated John Hopkins University with a degree in Economics. 

Adam's blog is both educational and fun to read.

***

I see that you have a lot of fun with your blog, Daily Options Report, including posts on sports, bikinis, and making fun of Lenny Dykstra.  I like that.  What made you include material of that sort?  How does your wife feel about the photos?

The Dykstra photo's? Not a big fan, too much chaw.

The bikini's? That's probably what you mean.  She tolerates it I guess. I try to not cross any lines. I honestly don't remember why I started doing it, but at some point I noticed that if I popped on a chart I could literally hear the tumbleweed blowing, then if I popped on Melissa Theriau I'd get 20 comments.

Then unfortunately I discovered there's a brand of bikini named "ViX", and they run ads without quite attractive models......

Back to Lenny. When I started writing him up, he was taken somewhat seriously in the biz. He had recommendations on TheStreet, was on Fox's "Bulls and Bears" et. al. But I could see in about 3 paragraph's that it was utter nonsense. So it just started with pointing out the flaws in his early Deep Call illogic. Ironically, his actual stock picks were not bad, though we later found out he was just cribbing picks from Rick Suttmeier and then paper-buying Deep Calls. And then doubling down if it went against him....and doubling again...and....you get the picture. His representations became increasingly fraudulent, so I suppose it's no surprise that his representations about everything else way beyond options proved fraudulent as well.

It may have begun as fun, but the anti-Lenny campaign was a true public service.

I know you were a market maker on the Amex.  How long were you there and how did you get started?  Is this experience in any way related to what you studied in school?

I started as an MM on the AMEX in February of 1988, so managed to miss the crash. Probably a fortunate thing because my first lessons were on the wisdom of options selling, lol. In August '99, the exchanges started to dually list everything and poof, there went our spreads [NOTE: The bid/ask spreads narrowed, due to competition]. But it was still the bubble, so it was still a viable biz for a little while longer. But with tight spreads I just didn't see the advantage staying in a trading crowd and taking the other side of order flow. But on the other hand, I really loved the floor. But finally gave in to reality and left in October 2001 and have traded off-floor ever since.

I was an economics major at THE Johns Hopkins University. So just kind of tangentially related to what I studied.

You post several times per day and are active on Twitter.  Do you have enough time to do justice to your trading?  Do you watch the markets all day?

I've kind of grappled with that. I'm a little ADD-ish, and literally can't stare at a trading screen for long stretches of time. So I probably don't do justice to my trading.

The writing kind of goes in spurts, and often off hours, so sometimes I'll have a bunch of ideas after the close or early evening and then just pop it out the next day, so maybe I don't write as much during hours as it appears. The twitter I kind of like as a pseudo floor experience. Some value-added and some-nonsense of course, but sitting at home for work all day, it's a bit of a lifeline sometimes. I thought twitter was kind of pointless at first, now I wouldn't want to be without it during the work day.

I see that your first book is about to be published by McGraw Hill and is titled: Options Volatility Trading: Strategies for Profiting from Market Swings. That must feel good.  Congratulations.

From Minyanville: "Options Volatility Trading educates novice to intermediate investors on the nuances of the volatility index (VIX), the psychology behind it, and the best strategies to employ during dramatic market shifts. It provides a solid grounding in historical volatility patterns, distortions created by market noise, and how to use tools other than VIX."

Do you have any pre-publication tidbits to share with the readers of Options for Rookies? 

Well, as a measure of how great I find your site, I've done this for 21+ years now and I still learn things reading info for "Rookies". My book is a bit of compliment to the material you cover. It's maybe "Options for Intermediates". I assume a basic knowledge of options and options Greeks (although I do have a chapter on Greeks). Much is similar to your material though, I discuss position management, different strategies, et. al. A rather unpublicized area imho was the natural ebbs and flows of the expiration cycle. So perhaps of interest are a few chapters on timing certain types of options trades within the expiration cycle.

What gave you the idea to begin writing a blog, and when was that?

It was really just a whim. I was writing for StreetInsight (which I believe now is called Real Money Silver). I enjoyed it and liked all the people there, but it was a bit of an expensive service and I kind of felt like I was writing in a vacuum. It was 2005 I believe and blogs were just getting popular, so I figured I'd give it a try. I emailed the random few I knew read me over on SI, and my actual "break" came with a link from Charles Kirk (The Kirk Report) who at the time was THE name in biz blogs. Still is probably. We've had contact over the years and I'd also add he's about as nice as they get. [MW: I confirm that The Kirk Report is a well-done, influential blog]

Do you have a favorite option strategy that you consider to be your 'bread and butter.' or do you stay flexible and trade based on market conditions?

I try to stay flexible. In general I prefer selling options to buying, but reading you and Condor Options and others, I tend to spread them and keep the risk contained that way. I may end up with an Iron Condor, but I often leg it by selling the put spread first and then sometimes leaving it at just that, or sometimes legging a call spread short later.

There's much more to talk about, but that's more than enough for today.  Thanks Adam.

464

How I Beat The Market And Bought A Candy Bar With My Profits; a Guest Post

Today, I'm pleased to present a guest post written by an excellent writer whose blog discusses a myriad of interesting topics.  I'm a loyal reader.

About the Author: Josh Hanagarne writes World’s Strongest Librarian, a blog with advice about living with Tourette’s Syndrome, book recommendations, buying pants when you’re 6’8”, kettlebells, old-time strongman training, and much more. Please subscribe to Josh’s RSS Updates to stay in touch. John resides in Australia.

***

A Librarian’s Perspective on Analysis Paralysis, or: How I Beat The Market And Bought A Candy Bar With My Profits

I got bitten by the stock bug a couple of years ago after reading one of Jim Cramer’s books. It came across the desk at the library and I just wanted to know what the bald guy on the cover was screaming about. At the time, I didn’t know about the show, which was for the best.

I got excited while reading the book.  The thought of making money in the market sounded really, really nice. So, as any respectable librarian would, I started doing some research. You don’t do things without educating yourself, right? I wanted to make an informed decision before I started throwing what little money I had into the whirlwind.

So I began educating myself.

A Common Character Trait

I know a lot of writers, bloggers, powerlifters, bodybuilders, and professional strongmen. These groups all share a common characteristic—successful members of these clubs attract hordes of newcomers who blaze with enthusiasm before they realize how hard and thankless the work can be.

The books and gurus pump them up, they vow to knuckle down and get after it, and they do…for a while at least.

When the initial passion subsides, many of these people convince themselves that what is required is further study. Unfortunately, it is easy to convince yourself that reading about writing is actually writing.That reading other blogs is “research” for your own blogging. That reading a book about isometrics is making you stronger.

The “Preliminary”Reading List

Here was my reading list before I convinced myself I was “ready” to jump into stocks:

Mad Money

The Little Book That Beats the Market

Against The Gods

A Random Walk Down Wall Street

The Only Investment Guide You’ll Ever Need

After that last one, I thought: okay, I’ve got to be ready.  So I got an account on Sharebuilder and Scottrade.

Then, instead of investing, I read:

Hundreds of Articles on Morningstar

Lots of charts on the library’s expensive Value Line database

Tons of archived articles on Investor’s Business Daily

Something else Jim Cramer wrote

A few thing by the Motley Fool guys

The Five Rules For Successful Stock Investing

One Up On Wall Street

The Intelligent Investor

Rule #1: The Successful Strategy For Successful Investing in Only 15 Minutes A Day

And then, I was ready.  Sort of.

I closed my eyes, spun in a circle, gritted my teeth, and bought three shares of Research In Motion just like everyone else was doing. 

It did really well for a while, but eventually I sold it in time to make about $5.00.  Thrilled by my cunning, I went and bought a King Sized Twix and savored it to death. 

What I Learned

After talking with friends and family members who are more involved in the market than I am, I learned that they either:

Invest in unsexy stocks that grow over time or chase things that are sexy at the moment.  A lot of people tend to do that all at once, which I learned can create its own problems.

Regardless, it was the people who acted who had something to show for it, whether it was a financial profit or just a hard lesson learned.

Even calling me a beginner is generous.  But my limited experience has convinced me that like anything else, investing can be over-analyzed.  There can only be so much hand wringing before you admit you’re just stalling, even when the stakes are high.  If an ER heart surgeon debates for too long, the results will not be good for anyone involved.

The risk of losing money terrifies me, but reading about investing without really committing around to it felt like a waste of time.  That’s on me. 

But it was better for me—better emotionally, mentally, and fiscally-- to waste my time than to potentially waste my money.  That’s why I’ll never have a mansion.  That’s why I’ll always be a beginner.  Because when something is uncomfortable to me, analyzing it is easier than doing it.

Study gets you just so far, and then you’ve got to choose.  The choice will be different for anyone, because we all think in very different ways.  The pendulum of common sense and reason swings far indeed.

But man that candy was good.

463

VIX Graph. September 25, 2009

The CBOE volatility index,VIX, still appears to be range-bound.  The big questions for premium sellers is how long will that last and how dangerous is it to be selling premium now?

I'm a seller.  With insurance.

462

Q & A. Trading options: Is it worth the effort?

Mark,

I wonder how many others have similar thoughts. 

As I've spent the many years trying to pick the stocks (I'm part of the 70% 'they' say who don't even beat the market), I settled on the indexes because if I have N stocks I'm considering, chances are, and I've proven it, that I'll pick the one(s) that under-perform slightly to significantly.  Or, as has happened often, I picked a good one, but it hit a protective stop, which became the near-term low. 

By doing indexes, the risk is spread and odds are better to gain (theoretically).  You have to have such a watchful eye on what's happening, anyway, and you can only make it green if you happen to be on the right side of the trend.

Don,

You have concluded that passive investing beats active investing, a conclusion reached by many.  Professional advisors and planners, along with financial bloggers are pretty much in agreement that the vast majority of investors cannot beat the market by picking stocks.

Short-term traders, especially system traders disagree and feel they do beat the market.  But they are not investors.

Not everyone sees that he/she cannot out-perform the averages and many will never cease trying.  Be thankful you reached this first stage.

So far, in my elementary learning of options, it seems that you have to be on the right side of the trend to consistently make money.  On a simple example, buy stock, immediately write a covered call and buy a put.  If you do it right away, chances are your return is near zero due to costs.  But, if you buy the stock and it goes up, using the collar gives you a locked in protection.  But, if you're locking it in, why not just sell the stock in the first place and avoid the hassle?

When opening a collar position, you allow for a small loss and some profit potential.  You do not 'lock it in.'  Yes, you must be on the right side to profit.  Collars are insurance to limit losses.  But you don't profit when the stock or index falls and you own a collar position.

To profit from a market decline, you must be short, not long.

In a fantasy world, you'd easily be able to find situations that allow you to apply a strategy, knowing you have a locked in 6%/month, say, and not have to spend so much time on research, stealing it from family and life in general.  Sure, everything takes work, and maybe there's not an easier way, but by trying to learn more about options strategies (which inherently offer protection and reduce risk), will that knowledge/understanding of them prove useful or just a further stealer of our limited time with no real added benefit?  If there's no real added benefit, then it continues to become fulfilling of Nicolas Darvas' book title: "Wall Street: The Other Las Vegas" and you're lucky if your capital appreciates.

OK Don, now we're into the big stuff.

1) 6% per month is more than fantasyland. In the real world that is a 100% annualized return.

2) Options don't provide 'a benefit' just because you use options as an investment tool.  Options do one thing very well - and that's to allow you to measure and control the risk of any investment. 

'Options' don't make money.  The option strategy you choose doesn't make money for you.

You earn money by doing a good job of risk management.  The Greeks allow the quantification of risk. Once you understand how much risk there is in your position, you can modify it (or not).  If you control risk well, you will never take a big loss and you should prosper as time passes.

The strategy is merely choosing the specific options to buy and sell.  We all have strategies that suit us because they fit right into our comfort zones.  But, it's not the strategy per se that makes money.  It' how well you manage the position.

Thus, if you do no work and expect that merely using options will save the day, then yes, it will be a time stealer.  If you are diligent, truly understand what you are trading and what must happen for you to achieve a profit from a trade, and understand what can go wrong (and how much you can lose) - then - and only then will using options prove to be a benefit. 

Or you can ignore all that and just hope to be lucky. That seems foolish, doesn't it?

 

Regards,

Don

461

Q & A. Pricing options below intrinsic value

Hi Mark,

I always appreciate your simple and clear explanations on OPTION trading.

Please help me out in this question:

CME-Price on 4 Sep 09 = $270.00

CME Price Today =  $310.        A Gain of $40.00.

OPTION" JAN 190 call:

Price on 4 Sep = $77.90

Price Today =    $122.00          A Gain of $45.00

As Per IVOLATITLITY.COM,  DELTA=.97;  VEGA=.14;  IV=54%

Please explain the OPTION price move. I expected the ITM OPTION to move $39.00, not $45.

I am just wondering what role did the other two GREEKS played in this OPTION . I have not yet invested but am interested in buying may be TWO contracts.

Thanks

NG

***

Hi NG. 

It's nice to hear from you again.  But, today, I'm taking a harsh tone with you.

I believe I am very patient and take the time to help each individual solve his/her problems.  But today's question really bothers me on so many levels.

1) Why would you want to trade these options?  Did you just fixate on the Jan 190s and that's the end of the story?  The bid/ask spread is more than $3 wide as I write this, and you will not get filled at a good price.  When trading deep ITM options, there is little incentive for the market makers to care about your 2-lot and even less incentive for them to give you a fair price. 

2) Did you even look at the Jan 200 calls?  Or the 210s or the 220s?  If not, why not?   Each of these is a also deep ITM call, and if it suits your objectives to trade these options, the least I can do is offer guidance.

Each of those other calls is a better option to buy than your 190s - according to the current bid/ask prices.  Would you rather pay 122 for the 190 calls, or 112 for the 200 calls or 102 for the 210 calls?

It's foolish to pay $122 for the 190 calls when you can buy the $200 calls for $112.  And it's even less intelligent not to buy the 210 calls, if they are available at $102.  Do you recognize why that's true?

When you buy an option that is deeper ITM than another option, you must NEVER pay as much as the full difference between the strike prices for the higher priced option compared with the lower priced option.  Never.  Why?  When expiration arrives, the 190 call is going to be worth $10 more than the 200 call.  [I'll assume you understand why that is true and move on].  You cannot afford to pay that extra $10 now.  For two solid reasons: 

a) Paying that $1,000 means paying interest on that $1,000.  You pay interest and have absolutely nothing to gain. Nothing  Paying $12,200 for the 190 call instead of $11,200 for the 200 call would be doing exactly that.  But you do have something to lose:

b) If the stock tumbles and falls below the strike price, then your call expires worthless and you lose an additional $1,000 by buying the more costly call.  You lose that $1,000 (ok, I admit it's unlikely - about a 3% chance) for NO reason. You can never gain and may lose up to $1,000 extra.  Why would you do that?  [The 97 delta says there's a 97% chance the option will be ITM when expiration arrives, and a 3% chance it will be OTM]

The very fact that you are looking to buy the 190 calls tells me that you do not understand options well enough to be trading them.  But please do not let me stand in the way.  If you want to own 200 delta worth of CME, then do it.  But if you plan to use options, you must understand why the 190 call is a very poor choice.

Also:

You want to look at live option data, when determining the price of an option.

I am nitpicking here, but neither iVolatility nor your broker can give you the 'price' of an option.  It can show you the bid and show you the offer, but that's all.  The best 'price' to use is the mid-point between the bid and offer, NEVER NEVER NEVER use the 'last' as any indication of current price.  Especially with an option that is deep ITM.  It probably trades very infrequently and the 'last' price may be weeks old.

The option did not move  $44 (not $45) when the stock moved $39.  The prices you are using for the option are bad prices.  Not accurate.

With the stock trading at 270, this call option was in the money by 80 points, and it's INTRINSIC VALUE was $80. 

That means this option is worth $80 at the very minimum - and is worth more because a call owner only has to pay $8,000 to control 100 shares of stock and the stockholder has to pay $27,000 to buy 100 shares.  That $19,000 difference can be invested to earn interest and that interest adds to the value of the call option.  That's why the call is worth more than the $80.

The bid may have been $77.90 but no one who has the slightest understanding of how options work would consider selling at that price.  Never.  That's why it's a bad price.  Nor should you be using a price that is under parity as the current price of the option.

And in your question, you use a price quote that is 2 points over parity.  With stock at $310, the option has an intrinsic value of $120.  No one should pay $122.  It may have traded at $122 but it would be a bad idea to pay that price when the stock is $310.  It's not the price you should use to evaluate current the price of the option.

Once again, dealing with options such as these, always use the average of the bid and ask as a reasonable ESTIMATE of the option price.  I don't know where your broker got their 'price' but it's not the price you want to consider.

None of the other Greeks come into play with this option, except in a very minor way.

What really bothers me is:  How can you NOT know that $77.90 was $2.10 under parity and thus an unrealistic price?

For some people, options are easy to understand.  For others, a greater effort is required.  But to consider using options, and real money, when you do not understand that options are not priced below intrinsic value, and recognize that you never want to use less than the intrinsic value for the price of a call option, is a bad idea. You MUST grasp the concept that this option was worth more than 80 and selling it at any lower price is equivalent to throwing money into the trash can. 

NG, I don't want to take it out on you personally, but if you fail to understand this very basic concept, what does that say about me as a teacher?  I am very upset.

***

As I was ready to publish, I heard from NG again:

Mark,

Thanks for your explanation (reply to a comment). I can only tell you what I found.

TD Waterhouse data for OPTIONS are my only source OPTION data. TD Waterhouse says the THOMPSON REUTER is the data source. I have noticed that some of the OTM- DELTA values vary by a large amount between what TDW says and what IVOLATILITY.COM says.

For example CME - OCT 360 C -DELTA values are as follows

TDW=.28; IVOLATILITY.COM=.09

I asked my broker about this discrepancy and they said that they cannot comment on IVOLATILITY.COM. They feel that TDW values are correct. The front line guy said that these values are calculated by complex formula and has no idea why these two sources differ so much.

I am trying to learn from experts like you how best to adjust the RISK/ REWARD in CALL buy ,when I feel that stock may go up. I am looking forward to your in depth discussion of effect of IV and VEGA in option pricing.

At the moment I just look at DELTA and IV to determine how much ITM CALL option to buy. I learned that from you a while back, but still not quite sure how to use IV in my BUY decision.

I remember you said earlier that HIGH IV is a risky situation and OTM CALL or PUT can misbehave i.e. go opposite to stock price movement. I am trying to use ITM option strategy. I will look forward to your sage advice in RISK /REWARD of ITM CALL/PUT buying.

Thanks again.

NG

***

1) I appreciate that the only data you have is 'what you found.'  But that does not mean you must accept it blindly.  That $77.90 price was under parity by more than $2 and you must recognize when the data you see is incorrect.

I'm not telling you that when at option is priced at $1.50 you should be able to see that it should be $1.70 instead.  But this is a deep ITM option and you cannot just accept any price that's given to you when it is likely that the price quoted is 'last.'

2) There is something very wrong when you see delta of .28 and .09 for the same option.  Here's what you have to do.  [I really don't want to take the time to do it for you].  Use a calculator, such as this one.  Plug in the variables, including the volatility estimate and look at the option's theoretical value.  Determine which volatility gives a better estimate of the real market price) - and I do not mean your broker's price.  I mean the bid/ask midpoint).

3) People who buy call options do not hedge the position - most of the time.  Buying a call spread is one way to hedge, but nothing in your prior comments suggested that you were looking to hedge delta.  If you want to learn more about credit spreads, there are sources, including The Rookie's Guide to Options.  I cannot give an entire lesson to answer your question.

You want to buy deep ITM options.  To me, that's almost the same as buying stock.

4) IV and vega affects on option pricing are separate discussions in their own right.  You 'use IV' in your decision of which call to buy when an IV change makes a significant difference in the theoretical price of an option.  But, you are dealing with very deep ITM options.  They trade very near parity, and that means no time premium in the option.  The effect of vega shows up in the time premium and this option has none.  Thus, there is virtually ZERO effect of IV on the price of the option you want to trade.  Again, I ask, if you learned from me, why don't you know that?  I do not understand how that's possible.

You do not need an expert to teach this to you.  No time premium in the price of an option means the amount of time remaining is unimportant.  It means IV is unimportant.  You MUST learn that the price of an option = intrinsic value + time value.  If you don't get that, you will never understand how options work.

5) You have drawn another erroneous conclusion.  If I suggested NOT buying OTM options - especially when IV is high, that DOES NOT suggest you should buy ITM options instead.

The opposite of NOT buying OTM, is buying OTM.  It is NOT buying ITM.  I never suggested that you buy deep ITM options.

Here's my sage advice regarding buying options that are 120 points in the money: DON'T DO IT.

I hope I did not offend you but your questions hurt me to the core.  I am very upset.

460

The Banks Retreat

Two of the biggies, Bank of America and Chase have surrendered.  OK, that's a bit of an exaggeration.

In response to negative publicity from all over the internet and TV, these banks have modified their - still outrageous - overdraft fees.

Stories abound, but here's one from Florida.

I wish I could take a bit of credit for this result, but my contribution was less than insignificant.

459

Can You Beat the Market? Part V. Collars Outperform Buy and Hold

Parts: one, two, three, four

University of Massachusetts Professor Schneeweis and doctoral student Szado conducted a study, sponsored in part by the Options Industry Council (OIC).  The results are first being announced today, 9/23/2009, in a paper entitled: "Loosening Your Collar: Alternative Implementations of QQQ Collars."

Using 10 years of data, the study compared the performance of QQQQ, the PowerShares exchange traded fund when collared and when unhedged (owning QQQQ only, with no options).  As with the CBOE S&P 500 CLL 95-100 Collar Index, this study involved the purchase of 6-month puts and the consecutive sale of one-month call options. This time both the puts and calls were 2% OTM when traded.

[NOTE:  If the same nomenclature were used for this collar as for the CBOE collar, it would be called the OIC PowerShares 100, 98-102 Collar Index].

The study included two different collars: passive (with a set of fixed rules) and active (the rules vary according to changing economic conditions).

The study shows that the collared QQQQ portfolio significantly outperformed a portfolio that simply owned QQQQ from April 1999 through May 2009.  And if that's not enough of an eye-opener, risk was reduced by 65% over the 122 month study.

These results are spectacular, especially when compared with the performance of the CLL 95-110 Collar Index.  I'll comment on that later, but for now, let's concentrate on the findings.

***

Author's Conclusions: 

The 6-month put purchase is better than buying either one- or 3-month puts.

Active collar more effective than passive.  But, this is not the place to be concerned with the active collar.  The original paper can be accessed for that information.  UPDATED:  link to that paper.

The authors state that the collar was less effective during the steady up years of 2002 to 2007.  That's as expected.

My comments:

The graph says it all.  The QQQQ got hammered during the bursting of the technology bubble, and that's understandable because QQQQ consists of the 100 largest capitalized, non-financial stocks that trade in the NASDAQ market.  That means this ETF was loaded with technology stocks.

But, something bothers me - and I'm publishing this post before discovering the answer.  Collars are slightly bullish strategies. If you recall from previous discussions, a collar is equivalent to selling a put spread.  These positions are protected against large losses, but how did the collared QQQQ increase in value as the underlying asset was plunging in 2001? 

Is it possible that the premium collected by selling the call was so much higher than the premium paid for the put that it offset losses in the decline of the ETF?  That's just doesn't sound reasonable.  When markets are falling, IV is high, but is skewed so that lower strike prices (the puts bought) is higher than that of higher strike prices (the calls sold).

The only way I can see the collars increasing in value occurs if the strategy is not a true collar but includes more than one put per 100 shares of QQQQ.  Yet, the collar in this paper is defined as one put and one call per each 100 share.  I'll go through the details when available, and report back.  But right now, I find these results very unusual.

Addendum @ 6 minutes later.  Apparently when puts were significantly ITM, there was no longer any downside risk.  Thus, the sale of 2% OTM call options resulted in a profit month after month, as the calls expired worthless in a declining market.  These feels 'wrong' to me.  It's essentially selling (almost) naked calls.  Who would do that in the real world?

***

These results are very unexpected.  The normal expectation for collars is that they will do an excellent job and protect your portfolio when the market declines.  But, to gain the benefits of that downside protection, the collar owner must accept a limit on upside profits.

And that's the problem.  During the  years of this study, the market was down.  The annualized return for QQQQ over the 122 months of this study is -3.57%, and that's a significant decline.  In other words, there was no upside to sacrifice.  But there was plenty of downside - specifically the bursting of the technology bubble in 2000 - 2001 and the 2008- early 2009 bear market.  Under these conditions, collars always perform well.

Don't misunderstand.  As someone who believes strongly that millions of individual investors should seriously consider using collars on all, or part, of their holdings, I like the results of this study.  But I have no plans to use it out of context.  I want to see how this strategy worked from 1995 through 1998 and May 2009 through the present time.  I want to see the data for this strategy at its worst, not only at its best.  Then we would all be able to see just how well collars perform when compared with buy and hold.  I know this study was performed in academia, and that the numbers can be trusted, but I wonder whether the time period chosen was cherry-picked to produce these outstanding results.  More data please.

From the performance of the CLL 95-110 Collar index (see part IV), we can see severe underperformance for the collar strategy in the most bullish years.  Yet, collars were very valuable during bear markets.  Overall, the performance of this specific collar was disappointing. 

But, in defense of collars, the CBOE produced a collar index that is not as valuable as they might have chosen.  Writing call options that are 10% OTM may be suitable to the bullish investor, but to someone who wants to use collars for both capital gains and protection, I believe the more useful Index is the 95-100 CLL Index, which includes the sale of ATM calls.  I urge the CBOE to publish the CBOE S&P 500 95-100 collar index, which would allow a direct comparison with its BXM (Buy-Write Index).  

There is a lot of data, but it's costly and time consuming to put it all together.  And there are so many possible collars that it's difficult to know which to produce.  But I would love to see the CBOE continue to produce indexes that pull all the data together.  And I'm encouraged that the OIC took part in this study, and I encourage them to support additional studies.

Bottom Line: This paper is very welcome and shows that collars are not always too expensive to pay for themselves and are capable of producing market out-performing returns.  I just wish we had more data.

458

Can You Beat the Market? Searching for Answers. Part IV Collars

Parts I, II, III

The results are in for the buy-write indexes, but they are far from definitive.   Writing covered call options on a basket of stocks that mimic broad-based indexes is a reasonable play.  But I cannot conclude that it's a strategy that always makes extra money.

What is true, is that covered call writing:

Reduces portfolio volatility (good)

Enhances profits for a portfolio of large cap stocks (good)

Provides mixed results for more volatile stocks, such as those in the NDX and RUT (not as good)

Under-performs during strong bull markets and out-performs otherwise (as expected)

***

Personal note and a chance to vent: I have a bias towards the adoption of collars by a large segment of the world's investors.  I want to see studies that demonstrate that collars are a viable investment strategy, and not too costly.

Most investors use the buy and hold strategy because they don't know any better, take the advice of professional advisors who are more concerned with their own commissions and fees than with the best interests of the client, or just follow advice they read in the newspapers or find on many financial blogs. 

I'm not saying that buy and hold is a always a poor idea.  I have no problem with it when it's the investor's own decision.  Not when it's based on listening to someone who has a vested interest (annual fees) in telling you to hold stocks forever and continue to buy more.  None of these investors is Warren Buffett and it's not a good idea to attempt to do what he does.

Proof that investors make poor investment decisions is the trillions of dollars invested in traditional mutual funds.  These are funds which cannot perform as well as the market averages, but which are not bashful about collecting management fees for that under-performance. 

Many such funds even charge a sales load (I shudder at the thought of people wasting money on extra commissions) to be allowed to buy funds that, on average, under-perform index funds.  It's a shame that so many investors never learned how to invest. 

Avoiding mutual funds should be the number one lesson.  OK, end of rant.

***

It's appropriate to look at collars in our search for methods that beat the market.  The collar is a covered call, but it also includes the purchase of a put option.  Those puts are costly, and comparing portfolio performance for a collared portfolio against the same portfolio (unhedged, or buy and hold) should give investors an idea of just how much it costs to protect a portfolio against losses.

As we have seen with covered calls, the unhedged index is going to out-perform substantially during bullish markets.  In fact, collars should do less well than covered calls because cash is spent on the puts.  But, during bear markets, those puts are extremely valuable and the results are going to depend upon how much money the puts save when they are needed compared with how much they lose when they expire worthless.

Data on collars has been scarce.  But the CBOE recently (one year ago) published the CBOE S&P 500 95-110 Collar Index.  I've described that index previously, and more details are available at the CBOE site.

As the 'name' of the collar indicates, the puts are 5% OTM (95% of the index price) and the calls are 10% OTM (110% of the index price).

As previously discussed, this collar does not scream 'use me, use me.'  It provides excellent protection when needed, but is costly most of the time.  This can be seen in the data:

The results here are spectacular.  At the market peaks in 2000 and 2007, the collar index (CLL) lagged dramatically.  It's doubtful that anyone who adopted the collar strategy would be very tolerant of his/her portfolio performance.  Yes, at the market bottoms in 2002 and 2009, the unhedged portfolios declined by enough to 'catch up to' their collared counterparts.

The single collar index for which we have data tells us that collars work extraordinarily well when needed.  But something less spectacular is probably needed to attract a large number of individual investors. 

I'm waiting and hoping the CBOE will make the data available in the form of the 95-100 CLL Index. 

[ADDENDUM: Why? It allows direct comparison with BXM, the covered call index that writes ATM calls, and not 10% OTM calls.]

***

At 11:30 today (CT), data from a new study will be available.  This data shows that a collar strategy can provide returns that make collars a viable investment alternative.  I'll publish another post with further details at 11:32.

457

Options trading: Questions welcome

I received the following message via e-mail and reproduced an abbreviated version here:

Hi Mark,

In your part 2 article of "Can You Beat the Market?", you stated the exact reason I started learning about options recently: "...I'm looking for an investment strategy that increases my earnings at the same time that it reduces risk".  I'm not shying away from them, but want to learn, as by my initial learnings they can help reduce the risk and generate extra income/reduce cost basis. 

Over the years, I've started dealing more w/ ETFs because of my frustration of owning stocks that tanked or whipsawed through stop losses and then took off right afterward.  The ETFs are generally less volatile and since it's hard enough to pick the individual stocks that will outperform, I've settled on these for significantly lower risk on a downside gap vs stocks (stocks can gap 20-50% or so, but not the SPY or QQQQ).  I'm looking forward to your next articles as, yes, covered calls generates income and lowers the stock cost basis.  Those alone don't offer the downside protection that puts would provide...  I don't know if there's a way to combine all these or how to time the strategies, but that's what I'm trying to learn

I've been reading "Sure Thing Options Trading" by Angell to learn some basics.  If you have any common-sense advice from here, I'd appreciate your tutelage.  Should I just watch for more articles by you on this topic?
 
As I have further questions going forward, do you mind answering them?  I wouldn't overdo the privilege.
 
Regards,

Don

***

Hello Don,

1) I am unfamiliar with Angell's book. Take a look at a sampler version of my recent book by clicking here.

2) Yes, options were designed to reduce risk.  When used that way, most of the time the probability of earning a profit is increased - but those profits are limited.

3) Using ETFs or indexes is an excellent method for diversifying your stock holdings.  As you state, one of the benefits is the extreme unlikelihood of a large gap opening.  Such a gap is not impossible, but it's far less likely to occur than with individual stocks.  That's one good method for reducing risk.

4) I always say there is no 'best' strategy, but for what you are looking to do: protect assets from losses, increase profitability, and find a way to combine the good parts of various option techniques, I believe the collar fits the bill.

I've discussed the collar several times in the past, and will no doubt do so again.  Click here for a detailed example of a collar trade.

5) When I continue the series on 'beating the market: searching for answers,' the collar is the next strategy to be discussed.  One of the complaints that most people have about the collar is that it's costly - and using that strategy makes it almost impossible to beat the market. 

I'll take an up-to-the-minute look at collars and how difficult it is to make money using them.

6) Don - please send questions (and suggested topics for a blog post) and I'll do my best to provide a good answer.  It's not a problem.  That same request goes out to all readers of this blog.  If you have a question that's just too personal to post, send it by e-mail.

456

Can You Beat the Market? Searching for Answers. Part III; the Graphs

Parts one and two

The data is available for download at the CBOE.  But I've saved you the trouble and show the data in graphical format.  The performance of each of the three buy-write indexes is compared with a simple buy and hold for the same index.

When you look at the graphs, it's important to know that the time periods differ widely.  BXM was constructed earlier than the others, and although it may be possible to collect and use data from earlier times, it has not be done (BXM is available back to 6/30/1986).

BXM:  The CBOE S&P 500 BuyWrite Index

These two indexes have been averaging similar results most of the time.  During the very strong, bubble-building years of the late 1990s, buy and hold, as represented by the Standard & Poors Total Return Index (SPTR) performed much better than a portfolio that held the same stocks, but against which covered calls were written.

And that makes sense.  Writing covered calls limits potential profits.  That's the price that must be paid during raging bull markets.  But such markets are not common and writing covered calls outperforms sufficiently to make up for those very bullish years - for this portfolio - an investment in the 500 largest companies listed for trading.

When the bubble-bursting market decline began, BXM, the Buy-Write Index outperformed and made up for those under-performing years.  During the recent rally (since March 2009), the unhedged portfolio has once again done better, and SPTR  has almost caught up with BXM.

The bottom line for investors is that during the 21 years of available data, those who wrote ATM covered calls fared at least as well as those who owned a diversified portfolio of large cap stocks.

Question: Is this result good enough to claim that covered call writing provides  'enhanced returns'?  Probably not in dollar terms.  But what is true is that BXM provided a less volatile, smoother ride for those who adopted this strategy.  Reduced volatility is very desirable, and although most unsophisticated investors prefer to see extra profits, the idea of owning a portfolio that provides less volatile returns ranks near the top of the list of 'good attributes' for an investment portfolio. 

Please note: It's not a good idea to replicate the BXM strategy by owning all stocks in an index and writing index calls.  It's simpler to buy ETFs that mimic the performance of the specific index that interests you, and write covered calls on that.  The proper ETF for mimicking the BXM strategy is SPY.  You can use QQQQ as a substitute for NDX and IWM to represent RUT. For large cap stocks,

BXM performs well.  How about buy-writes for other indexes?

***

BXN:  The CBOE NASDAQ-100 BuyWrite Index

This graph illustrates what can happen when the market rises so rapidly that covered call writers are left far behind.  In 1999 the performance of NDX (NASDAQ 100 Index) is so much better than that of BXN (CBOE NASDAQ 100 BuyWrite Index), that I truly find it difficult to believe.  During 1999, NDX more than doubled from 454 to 917.  During the same year, BXN was up by 43%, but that outstanding return was dwarfed by the bullish performance of NDX.  Those who rode the rally unhedged collected big time.  On this graph, that 43% return for BXN looks unimpressive. 

As we now understand, that huge rally was based on nothing more than hope, and those Internet companies were not worth the prices at which they were trading.

By year end 2002, the excessive gains of NDX were wiped out by the market decline and the two indexes were trading near the same levels (NDX was still higher).  If the bulls never exited or hedged their positions, as most didn't, the out-performance soon disappeared.  

This demonstrates that a volatile index, such as NDX can perform much better during rallies, but also much worse during declines.  In simper terms - it's a very volatile index and writing covered calls reduces that volatility, but at the expense of smaller profits.  At least that's the story over the limited lifetime of the available data. 

Bullish investors may not be well served by any strategy that limits profits.  But, not every bullish investor is aggressive, and deciding whether to hedge (reduce the risk of owning) a portfolio is one of your major decisions.

***

BXR: The CBOE Russell 2000 BuyWrite Index

Over the 9 short years for which data is available, there is little to recommend either strategy - although buy-writing has the edge.  The interesting data is missing - and that's the bubble years from 1998 through 2000.  It's very likely RUT outperformed it's buy-write index during those years.

***

I'm attempting to draw valid conclusions from the data, but we must remember that data covering 10 to 21 years is not likely to tell the whole story.  We have seen some strong markets and some weak markets, and that tends to make the data more reliable.

Your task is to gather information that allows you make a decision on how to invest/trade.  Investors want to build a portfolio that suits their needs.  Reducing risk should be (ok, that's my opinion, not a fact) near the top of those needs.

Writing covered calls is a worthwhile strategy.  It provides the comfort of a less volatile portfolio, and depending on the type of stocks owned (large cap vs smaller, highly volatile companies) can even provide better returns.  Reduced volatility with good returns is a big plus.

But, covered call writing is a bullish strategy and does not fare well in bear markets.  It's much better than buy and hold.  But what about the conservative investor who prefers much more protection against large losses?  After a short break, we'll continue with a discussion of collars.

455

VIX Graph. September 18, 2009

Volatility is simply absent from the market.  Complacency reigns as the bears complain about all the terrible economic numbers.

VIX has been going nowhere for awhile.

454

Can You Beat the Market? Searching for Answers. Part II

See Part I.

I know that being able to find individual stocks that out-perform the market averages is a skill I lack.  I have not made the attempt in years.  If you have that skill, more power to you.

The question is:  can using risk-reducing option strategies enhance returns?  I'm looking for an investment strategy that increases my earnings at the same time that is reduces risk.  Isn't that what every investor wants to find?  Apparently not. 

Despite the evidence that using options gives investors (and traders) a better chance to beat the market - and with less risk - many shy away from options.  In fact, my quest (part I) to pique the interest of personal financial bloggers has not borne fruit. 

I'm not interested in only teaching investors who have an interest in options how to take advantage of this excellent risk-reducing tool, but what I'd love to accomplish is finding a way to get the average investor - who has never heard anything positive about stock options - to adopt option strategies as a method of guaranteeing that his/her retirement portfolio can survive any market crisis.  The strategy discussed today is not that effective and can offer no such guarantees.  Later in this series, such a strategy will be covered. 

The idea of buying options doesn't work for me, and I discourage that strategy whenever possible.  But for anyone who buys stock, or takes a passive investing approach and owns shares of broad-based ETFs (exchange traded funds), there is more than one option strategy that should be considered.

Covered Call Writing

Today the discussion is on covered call writing, which involves owning 100 shares of stock and selling someone else the right to buy your stock at a specified price for a limited period of time.  When you do that, you are selling (writing) a call option, for which you are paid a cash premium that is yours to keep - regardless of whether the option owner eventually buys your stock.

I consider this strategy to be one of the three basic conservative option strategies because it is among the easiest methods for an option rookie to use and understand.  

The purpose of this series is to compare the relative performance of various strategies, and data must be available.  Fortunately the Chicago Board Options Exchange (CBOE) has published indexes that measure exactly the performance of the investing methods we want to compare.  These are the Buy-Write (a term synonymous with covered call writing) Indexes. 

The first of these to be published was BXM, based on the S&P 500 Index.  Today, there is also BXN, an index based on buy-writing the NASDAQ 100 (NDX), and BXR, based on writing covered calls on the Russell 2000 (RUT) index.

The methodology for each of these indexes is the same, and can be found at the CBOE site.  The methodology involves:

Own a basket of stocks equivalent to owning the index.

On expiration Friday, approximately one hour after the market opens for trading, sell one call option that is out of the money, but as near the current index price as possible.  The call sold expires in one month and is held through expiration, when the process is repeated.  There are no adjustments.

Now that we know about these indexes, how did each of them perform, compared with their individual benchmark indexes?  This is a direct comparison between a covered call writing strategy vs. buy and hold for three different portfolios.

to be continued...

453

Revenge on the Banks: We can do it America.

Anyone angry with the banks?  Especially the big banks who helped cause the economic meltdown of 2008-2009?  I know I'm very angry. 

The bankers took enormous risk, they lost, and we paid the bills.  And they are back at the same old game, earning (Goldman, Morgan) billions for their risk-taking, senior employees.

Then there's the new credit card laws.  Because of the delay in the starting date for the new laws, the bankers changed their credit card policies and circumvented the new laws.

These people care nothing for their customers.  They are leeches on society.  They take from the poor - deliberately, actively - and give to the rich (themselves).

The latest brouhaha involves those overdraft fees for debit cards.  In case you haven't heard about this, the bank - as a courtesy to you - allows you to overdraw your account, with no warning, and hits you with a fee, typically $35 for going ten cents over your limit. 

Sure customers should know their balances, but this is deliberate, and it's big business for the banks.   And most banks do not allow you to opt out.  That means you must accept this overdraft 'protection.'  And even worse, many times customers have this 'protection' without being aware of it.

It's time to get even.  Tell these banks that we are 'mad as hell and not going to take it anymore.'

Here's how to do it.  A fantastic idea. Small claims court,  HT to Felix Salmon for bringing it to my attention.  Original poster is Karney Hatch.

452

Can You Beat the Market? Searching for Answers. Part I

Investors want to 'beat the market,' and continue the the search for alpha (a coefficient which measures risk-adjusted performance, based on the specific security and not the entire market). 

Professional mutual fund and hedge fund managers are paid big bucks to find alpha, and deliver enhanced performance to their investors.  Most are unable to beat the market on a consistent basis, and the search for alpha remains elusive.

There are those who believe actively trading in an effort to find that alpha is misguided and it's better to invest passively (thereby saving a bunch of money in trading costs and management salaries and bonuses) by owning share of index funds or ETFs.  Those funds charge very low management fees.

It's not my purpose to continue the debate over passive vs. active money management, but along the way I will mention some studies that have been made. 

Are there other ways to enhance market performance?  Can we use option based methods to produce the equivalent of alpha? That's the basis for this series of posts.

***

In late August 2009, one blogger (potato) wrote that "MW has been popping up in the comments sections of a lot of blogs recently touting an options collar strategy."  I wouldn't mention this if I weren't that 'MW.'

It's true.  I've been entering into discussions, where I feel it's appropriate, suggesting that personal finance bloggers give more support to the idea of using collars as a conservative investment strategy.

Here's the background:  Most PF bloggers take the position that active investing is inferior to passive investing.  The data supports their stance.  In other words, most mutual funds cannot match the performance of the appropriate benchmark (S&P 500 Index is the most commonly used benchmark). 

Why can't those funds, operated and managed by professional money managers beat the market?  The bottom line is that they can, on average, match the market.  But, it's been shown that the costs associated with active trading plus the management fees are high enough to convert the average fund from a market matcher to an under-performer.

Sadly most of the investing public is unaware of such studies.  In addition, there are many salesmen (earning hefty commissions) for those actively managed mutual funds.  Thus, most individual investors have no reasonable method for learning about the benefits of buying shares of index funds instead of actively managed funds.  The information is widely available, but most people trust their brokers and advisors, ignoring that free information.

Studies have also shown that individual investors have a higher opinion of their performance than that performance deserves.  Along the same lines, those who believe they are doing well tend to trade more frequently.  Additional data shows that those who trade the most, underperformed the most.

Thus, not only is passive investing more likely to produce a better result for professionals, but the same is true for individuals.  Less frequent trading of stocks yields better results.

The bottom line is that personal finance bloggers, who tend to be conservative and frugal, favor passive investing.

With that in mind, I entered the conversation on several blogs, suggesting that owning option collars (buy stock, buy puts, sell calls) represents a conservative strategy that is guaranteed to minimize losses.  The trade-off is that profits are also limited and that's a big turn-off for investors who believe it's easy to out-perform the markets.

Thus, one of my responsibilities when promoting the use of collars is being able to demonstrate that they produce reasonable returns and are not cost prohibitive. That is now possible.

Our path will include covered call writing as a method for enhancing stock market returns.  It may not strictly count as 'alpha,' but the cash earned is just as spendable.

to be continued...

451

Mary Travers

I lost part of my youth today

 

450

The Blogosphere. Finding the Truth

I find surfing the Internet to be an emotional experience.  I enter investing forums, looking to continue earlier conversations or to find a rookie's question to answer.  Every once in awhile  I come across angry people who post insulting replies to beginners who are eager to learn.  Why would anyone do that?  Someone comes for help and these angry souls bash them for not knowing the answers to simple questions.  I find that to be very upsetting.

Happily, the majority of posters are helpful.

Currently someone is nastily criticizing me for teaching people to understand how options work, when he believes I should be teaching them to trade and make money.  He has no clue that by understanding, the trader is well placed to earn that money on his/her own.

As part of my surfing, I visit many blogs.  The blogosphere is becoming more relevant in our lives, because there are fantastic bloggers who provide outstanding opinion and analysis.  Left wing, right wing, moderate - take your pick and you can find someone who has the ability to discuss politics in a rational manner - without anger or name-calling.  Of course, there are also the angry, mean-spirited bloggers.  I don't know what purpose they serve, other than to increase their own visibility.

As the newspaper business is sadly fading, there is an ever-increasing need for news sources and commentary.  Bloggers are filling the void.  The quality of those blogs ranges from outstanding to pathetic. 

Many are blogs written with good intentions, but filled with misleading information.  And that's as true in the investment arena as anywhere else.

Among my pet peeves are blogs that sell trading systems. Some make reasonable claims and some even provide documented (independent audit) of results.  But, most make absurd  claims, seeking to be paid large fees by the ignorant.  And, as P.T. Barnum said: "There's a fool born every minute." 

Via e-mail, I've been in touch with someone who is literally down to his last few thousand dollars and has reached retirement age.  He currently spends his cash on lessons and trading systems, looking, in vain, for a magic way to provide for his retirement.  It's too late.  He cannot be saved.  It hurts that this man is throwing away his little remaining reserves on an impossible dream.

I see too many bloggers telling readers that (for a fee) they can learn to have an 85% or 90% success rate with an income generating strategy.  And if that's not enough, the claim is that it's easy to generate 10% per month, on a consistent basis.  Of course these are not among the audited sites and the careless reader sends in the money and finds that the story is nothing more than selling far OTM put and call spreads - the iron condor strategy. 

It is not possible to earn 10% per month with an 85% success rate.  It's all a pack of lies.  What I, and other reputable bloggers are trying to do is educate, entertain, and spread information that should be helpful to readers.  Our intention is to help you avoid big mistakes, take a reasonable path when trading, and come out ahead of the game.

Can you imagine that someone who can earn 10% month after month would tell anyone the secret?  Earning 10% per month multiplies your investment by a factor of 10 in just two years.  $1,000 becomes one million in just 6 years (and one month), and one billion in 12 years (+ two months).  Who would sell that information?  No one.  But the gullible buy it.

Here, at Options for Rookies, my objective is to show you how to use a fantastic risk reducing investment tool, the option.  And the rest is up to you.  I'll continue to discuss trading ideas, strategies and reply to questions.  

449

Current Implied Volatility: Attractive to Buy or Sell?

Iron condor (and other premium-selling) option traders appreciate when conditions provide an added likelihood of earning a profit.

Such conditions are: high implied volatility and low realized volatility.  The former translates into higher premiums for the option spreads that we sell and the latter translates into a reduced probability of having the market make a major move. However, we are still subject to suffering through a relentless, non-volatile, one-way stock market.

Jared, of CondorOptions, offers hope that we are indeed in such an environment.  His (excellent) work includes publication of a weekly 'volatility tracker.'  His current stance:

"Where technical analysis might regard a VIX at 24 as somehow cheap – especially in relation to its levels one year ago – any casual market observer knows that, if anything, implied volatility in equities remains on the high side. We simply aren’t seeing 1.5% daily moves in the S&P 500, and until we do, traders should expect options to remain overpriced."

Option premium may not appear to be elevated, but compared with how volatile the markets have been, premium sellers are getting good value for the risks taken.

With the September cycle coming to a close, those who have positions loaded up with front-month options will no doubt choose new positions that expire in October.  But I prefer option positions that expire later.  I'm going to go with November this time.  It's a tough choice. 

Per Jared's observations, it's likely the options are 'overvalued' from the standpoint that the final realized volatility is likely to be less than the options are predicting (implied volatility).  But the absolute value of that IV is not high enough to make selling longer-term options attractive.  Thus, as long as IV remains near these levels, 2-month options are more attractive for my comfort zone.

When you open new positions, be certain you are comfortable with the risk and reward potential.  Jared's data bodes well, but things can change suddenly.

448

Are the Details Important?

I'm one of those people who pays attention to details. It makes my life more complicated, but at least when I communicate, I am doing the best I can to enable the other person to understand what I am saying or writing. [A previous poll shows that readers of this blog prefer extra details in the commentary]

I find it difficult to place myself in the position of someone to whom the details don't matter.  Conversations with friends who use a word that can have several different - all logical - meanings is stressful for me.  I don't 'get' their meaning and when I request clarification they look at me as if I were from another planet because I did not understand what they said.

Does anyone else have that problem?

The reason I mention this is because I want to review some books on options trading for this blog.  But I've encountered a problem.

What am I supposed to say when the author makes a mistake?  I'm referring to a serious mistake where the writer is presenting something untrue as fact.  But - should anyone give it a second thought if that error is inconsequential?  If no reader will lose money or mismanage a position because of that 'fact,' does that make the error of no importance?  Is it right to recommend a book that contains several such errors?  Is it fair to condemn the entire book due to a few, unimportant mistakes?  A quandary.

One best-selling book states that expiration occurs on "the 3rd Saturday of the month."  This error has been repeated through several editions.  Many people refer to the 3rd Friday as expiration day.    But, technically, expiration is Saturday morning, following the 3rd Friday.

For detail-oriented people, this is a significant difference.  Sure expiration is the 3rd Saturday most of the time - but not when the date is Saturday, the 15th.  When that happens, expiration occurs one week later.  To the casual reader - one who doesn't care about the details - this statement does no harm.  But, if it's possible that a trader who accepts the author's 'fact' may make a bad trading decision believing that expiration is Saturday, the 15th when it's really the 22nd, can the error be ignored?  How important is this error when reviewing the entire book?

What happens if there are many such careless errors?  I have seen such a book.  It's the same best-seller as mentioned above.  The mistakes continue edition after edition.  How can anyone write a negative review for a book that has been so widely accepted?

But other books also contain errors of fact.  If I had not written any books, I'd point out any errors that I find.  But as an author, if I write a negative review, it may appear as if I were promoting my book by being negative on the competition.  And even worse: what happens if I write negative reviews based on such errors and then someone finds mistakes of fact in one of my books?  That would be embarrassing.

If I were not so focused on the details I'd be able to ignore errors that are harmless.

447

Too Many Option Positions?

Hi Mark, another question.

Do you have a recommended number of options you should hold at any one time? I'm finding this will take some work to do it right, and holding too many at once might get out of hand. Thus I was wondering if your experience would suggest a recommended number of different options to be holding and working on at any one time? A recent stock seminar I took recommended to invest in 6-10 stocks at any one time, not sure how that translated into # of options at any one time.

Thanks for your time!

Jimmy J

***

Hi Jimmy,

Trading stocks takes less time than trading options (unless you are a day trader).  By that I mean you won't be making decisions every day or every week.  You buy the stock for a reason, do your research on a continuous basis, and eventually dump the loser or take your profits on the winners.  But less time is involved than with option positions.

Why? Option positions have risk that can be quantified and controlled.  That's advantageous, but it also requires you to take the time to think about those risks.  Most of the time, they will be within your comfort zone and there's nothing about which to be concerned.  Look at the Greeks (supplied by your broker - or at least, they should be) and consider if risk is in line or not.  this takes more time than a stock position.

Options are also time sensitive.  The positions only are alive for a relatively short period of time, and you must make decisions on buying more, closing, or most commonly - holding.  You do that on a regular basis.

I suggest you begin with no more than three different positions - especially if you are talking about positions on three different underlying assets.  And two is plenty for many rookies.  If you are concerned about being under-diversified, I can understand that.  Your choice becomes: a) trade more positions than you can comfortably handle (bad idea); b) use index options (or ETF options) to diversify.

Here's why I believe in limiting the number of positions:  If your positions can lose money on a big market move (iron condor, credit spreads, covered calls etc), then such a move will require you to take action on each position.  Each takes time and you will feel rushed to make decisions.  You could easily be losing money on other positions as you decide what to do to adjust one position.  That's unwanted pressure.  Minimize that by trading fewer underlying assets.  (I trade only one underlying, RUT).  Risk management is essential to long-term success, so don't deny yourself the time to do it correctly.

But if you buy options (a tough way to make money), then there is no pressure to act in a hurry when the market moves.  You may even have good profits to lock in.  If that is your strategy then you can easily handle more than the three I mentioned above.

How harried, or comfortable, you feel will tell you the right answer.  But, build slowly so you don't go past your ability to handle the portfolio in a crisis.

446

VIX Graph September 11, 2009

VIX holding steady.  Nothing exiting happening yet.

445

Avoid Costly Mistakes When Trading Options

Option traders are prone to making errors - especially when encountering a puzzling situation for the first time.   From time to time, I'll post a discussion on how to avoid some of those mistakes.  NOTE:  I'm not referring to a trading mistake where you decide to buy some calls and ignore them until they expire worthless.  I'm referring to avoidable monetary losses.

Don't sell options under parity

That's pretty straightforward advice, but sometimes it seems to be unavoidable.  When an option is in the money, and especially when it's deep in the money, the bid price is often substantially lower than the option's true worth.  If you try to sell the call option at its intrinsic value, it's possible no one will buy it.  That's feels unfair to me, but you cannot force anyone to pay a fair price for your options.

Example, using call options

You own XYZ Oct 80 calls and the current stock price is 87.

The intrinsic value of this call option is $700.  The option is in the money by 7 points and the very least that this option is worth (depending on time remaining and the implied volatility of these options, it may be worth more than the intrinsic value) equals that 7 points, or $700.  For anyone who must see a formula, then:

Call intrinsic value = stock price minus strike price 

Put intrinsic value =  strike price minus stock price

Many times the market for such an option is: 6.80 bid, 7.20 ask. If you own these calls and want to sell, please, do not sell below intrinsic value.  That would be throwing away money.

You have two reasonable alternatives.  First, try to sell the call with a limit price equal to the options intrinsic value ($7 in this example).  If it does not sell quickly, wait until the stock is 87 bid.  Then cancel the sell order, exercise your call option (hopefully your broker allows you to do that online), and immediately sell your long stock at $87.

By taking that approach, you save some money by collecting the full intrinsic value of the option, and you don't have to settle for less.  One caveat:  If your broker charges a fee to exercise an option, please take into consideration that extra fee.  It may be better to sell option at $6.95.  Yes that's selling $5 under parity, but if you save a $10 fee, it's a better deal for you.

For readers who know that I believe an investor should almost never exercise a call option, this is one of the two exceptions.  When you would be forced to sell the option under parity (at less than its intrinsic value), exercise and sell stock, allowing you to collect the equivalent of parity for the option.

444

Q & A. Covered Calls or Collars When Already Retired

Mark,

Would you consider a Put Credit Spread to also be an approach for Retirement Investment money during actual retirement? I get that impression from "Rookie's Guide to Options". If I understand correctly from your book, a put credit spread is equivalent to a collar but wondering if it is a good place for retirement investing or are actual covered calls a better method?

Thanks
Greg

***

Hello Greg,

1) Yes, the put credit spread is equivalent to the collar when you use the same strike prices and expiration dates.

2) Yes, to me it's an appropriate strategy for any conservative investor.  The real danger from these spreads is the feeling of overconfidence that may encourage you to trade too much size.  When you own 500 shares, then obviously doing 5 collars is appropriate.  But when the put credit spread involves a small amount of cash per spread, it gets tempting to trade 10, 20, or more credit spreads.  If you have the discipline to trade only the same number of credit spreads as you would collars - then this strategy is appropriate.

Being retired, preservation of capital is important. A collar is far less bullish than owning stock outright or writing covered calls.  But, even collars can lose money during bear markets.  That's why it's important to pay attention to which put strike prices you use for the spread.

Buy the same put when using the credit spread strategy as you would have bought for the collar.

Similarly, the put sold should correspond (same strike, expiration) to the call you would have written, if you were trading a true (rather than synthetic) collar. 

Risk management is the name of the game for someone in your situation.  Of course, I believe skilled risk management is essential for every trader.

3) My usual caveat applies.  I don't believe any specific strategy is 'better' than any other.  There are always trade-offs.  What I want to do is to be certain you see the advantages and disadvantages of each.  Then you can choose which method is 'better' for you, your financial goals, and current bankroll.  For example, a very wealthy person is more concerned with preservation of capital than additional income (Income is important, but secondary). 

4) The covered call strategy allows you to earn greater profits when compared with the collar.  That's a plus for covered calls.

But the collar is a covered call with the purchase of an extra put.  That put makes a big dent in your profit potential.  But, it does guarantee the safety of your investment because losses are very limited.  And you can establish the maximum possible loss by adjusting the strike price of the put that you buy.  Is that a plus for collars?  It depends on how you value profit potential vs. insurance protection.

So, the question to ask is:  do you want that protection?  Do you need that protection?  Would you rather try to earn extra profits, knowing it comes with more risk?

I have no idea if the markets will crash, continue to rally, or do neither.  You can take a chance that all will be well and adopt more bullish strategies.  I'm more cautious and prefer to avoid large losses.

And you can compromise.  You can sell covered calls on your holdings and buy fewer puts.  You don't have to be all collars or all covered calls. 

If you do not already own the shares, then I do prefer selling a put spread to trading the collar.  But if you already own shares, you can combine strategies.  The final test for you is going to be your comfort zone.  Don't gamble.  These trading methods make money over the long-term if managed well, but a market debacle can be very costly. 

443

Puts are Calls. Calls are Puts.

One of the fun aspects of writing a blog and communicating with investors is the opportunity to answer questions.  Some questions are very sophisticated, while others are basic.  It's those basic questions that require the most attention because the questioner is likely to be a rookie who is caught in a situation he/she does not understand.  If that rookie cannot be guided through this difficult spot, it's possible that he/she may throw up hands in disgust and abandon options.

That's the reason I pay special attention to questions to which the answer may seem obvious.  It's not obvious to the person who poses the question.

I recently found this question at EliteTrader, an online forum.

"When call IV (implied volatility) drops does that mean options traders are getting bearish on the stock?"

What I don't know is what situation made the poster ask this question.  But that's no reason not to provide a useful reply.

Answer: No.  Implied volatility, by itself, is not an indicator of market sentiment.  NOTE:  It does not matter whether call IV declines or put IV declines.  As soon as one declines, the other follows suit.  That's the result of arbitrage strategies (reversal/conversion).  If call prices decline, those arbitrageurs will buy calls , short stock, and then drive down the price of puts by selling them.

When implied volatility declines for the options of a specific stock or index, it can suggest one of a few alternatives, but market direction is not one of them:

a) Buying interest has declined.  That means fewer traders want to buy the options, and there is no force driving option prices (and implied volatility) higher.

b) Selling interest has increased.  The quickest way to drive down option prices is for sellers to appear on the scene.  That does not mean call sellers or put sellers.  In fact, it makes no difference which options are sold.  If there is selling pressure on the options, prices decline.

You may ask how can it not make any difference whether traders are selling puts or calls.  The answer is that to the professionals who provide liquidity - from the market makers to the off-the-floor traders sitting behind computer screens, an option is an option and it makes no difference whether it's a put or a call. 

Why?  If a trader buys calls, he/she has two choices:  Keep the calls, or turn them into synthetic puts by selling 100 shares of stock for each call purchased.  Thus, in this case, a call is readily converted into a put.  That's another way to state that calls are puts.

If the trader buys puts, the purchase of 100 shares per put changes those puts into synthetic calls.  Thus, puts are calls.

As a result, declining call IV produces the same result as declining put IV and as mentioned above, if the IV of the puts does not drop automatically (after call prices decline), arbs will appear on the scene to remedy any imbalance.

c) If IV is elevated because of a pending news announcement [That news has a good chance of causing the stock price to gap, and that possibility makes options worth more money, and IV rises], once the news is released and a major move is no longer in the future (it has already occurred after the news was released), there is no longer any reason to bid option prices higher.  Thus IV falls (for both puts and calls).  Again, it has nothing to do with market direction.

442

Trading Options in Your Retirement Account

I know we have readers from around the world, but the majority (based on a poll) reside in the United States.  The purpose of today's discussion is be certain that investors understand that most brokers allow you to use a retirement account (IRA or Roth IRA) to trade options.  I don't know the laws in other countries, but my advice is the same:

If you have a retirement account, and if you adopt conservative strategies, consider using that account for option positions that are less risky than owning a portfolio of stocks or mutual funds.

Special note:  This is a retirement account.  It is not a trading account; nor it is a gambling account.  Slow and steady growth should be your goal.  If you own mutual funds, especially those that under-perform the markets and charge high management fees, consider dumping those funds and reduce risk by writing covered calls on SPY (or other ETF).

Some brokers limit your choice of strategies, others give you a free hand.  In theory they limit strategies for inexperienced investors to protect those investors.  In reality, brokers that limit the methods you can use don't really understand that they are forcing you to adopt higher risk strategies.  Such brokers should be avoided.

Choosing a broker

Brokers offer different levels of service.  If you require hand-holding and constant advice, choose a broker who charges more, but who provides extra services.

If you trade online, you can use a broker with low commissions, or a very user-friendly trading platform.  Perhaps outstanding analytical software would be helpful to you.  Or you may decide to choose a broker with excellent educational materials.

It's important to use a broker who routes your orders to the proper exchange so you can get the best price for your trades. 

Here are three highly rated brokers.  If you are looking to open (or move) an account, this is a good place to begin.

TradeKing:

Many good features: Good education program and trading platform. Low commissions: $4.95 per trade plus 0.65 per contract.  Plus, I'm part of their educational program.

OptionsHouse:

Flat rate is good for investors who enter large orders.

OptionsXpress:

Higher fees, but outstanding software for managing portfolio.

441

Labor Day and the Markets are Closed

Enjoy the day off.

440

VIX Graph. September 4, 2009

VIX has been holding steady recently, with an occasion blip upwards. Now that summer is almost over, it will be interesting to see what lies ahead. We all remember the extreme volatility of 2008.

439

Q & A. Lightning Round

What is the difference between nonstandard and standard options?

GW

A non-standard option is one that exists after a corporate action - usually a merger, takeover, spin-off.

The old options must be adjusted to reflect the changes, and that means contract becomes non-standard to reflect the conditions of the 'action.'  Anyone who exercises a non-standard call option receives (upon paying the original strike price) the same 'package' that the holder of 100 shares was entitled to receive because of the action. 

[And a put seller has the right to sell the same package, and collect the original strike price]

Example: If a stock (XXX) spins off a subsidiary (SUB) such that all XXX shareholders are entitled to receive 0.05 shares of the new company for each one share owned, then the existing call options are adjusted to reflect that spin-off. Upon exercise of the old (now, the non-standard) option, the exerciser buys or sells 100 shares of XXX PLUS 5 shares of SUB at the original contract strike price.

New, standard options are issued (often one day later). These are 'normal' options and the deliverable is 100 shares of XXX and none of the subsidiary.

***

I am new to options trading and have a question on the fundamental difference between buying a put and selling a call. As I understand it, they are both bearish. Why would you sell a call vs. buy a put? Is it simply because when you sell an option you get upfront money?

Thanks,
AP

The difference is huge. When you buy an option, you have rights. When you sell an option, you accept obligations. That's why option sellers are paid - to accept those obligations.

On an elementary basis, they are similar in that each represents a short position on the stock. Yes, each is a play that the stock will move lower. But that's where the similarity ends.

When you sell a call option, you collect the premium (cash) up front. That's good. But if the stock heads higher, your losses are potentially unlimited. When, for example, you sell someone the right to buy stock @ $40 per share, the stock may move to 50 or 60 or 200. At some point you will be forced to either buy back that option or sell 100 shares at $40 per share.  Thus, you may have a gigantic loss.

When you buy a put option, you pay cash.  But in return for that cash, you have the right to force someone to buy stock and pay the strike price per share. If the stock tumbles, you can make a lot of money.  If the stock rallies, you lose no more than the cost of the option.

Many times, the option buyer doesn't see the stock move as expected and the cash paid to buy the option is lost. That's why buying options is so difficult. To profit, you must pick the correct direction for the stock. Not only that, but the stock price change must occur fairly quickly - before the option expires - and the move must be large enough to offset the price paid for the option. All in all, buying options is a difficult undertaking.

As an aside, selling a call option when naked - that means you do not already own enough stock to deliver when the call option is exercised by its owner - is not allowed by many brokerage firms. They consider that strategy far too risky for option traders. Especially rookies. I agree with that policy.

***

If you put on a credit spread, eg. buy an ABC July $570 call for $1.60, and sell an ABC July $560 call for $2.63, and both expire worthless, how do you calculate your return in percentage terms (what number goes into the denominator)?

Thanks.....Deb

As you know your return on investment depends on the amount invested.  When trading credit spreads, there is no 'investment' per se. But, you have money at risk - and that amount is your investment because for most traders, that is the margin requirement (when using Reg T margin rules).

Thus, return = profit / money at risk.

In your example, return = $103 / $897

You sold a 10-point spread, and the maximum value that spread can reach is 10 points, or $1,000. You collected $103 for the spread - making your maximum loss (and margin requirement) $897.

To provide a more accurate number, include commissions in the calculation. Thus the numerator is $103, less commissions. You can ignore the cost of closing the spread right now, but be aware of the commissions involved because you may want to exit the trade early, and much of that $103 can disappear if your commissions are too high.

438

Q & A My Personal Risk Management

Hi Mark,

Would you consider a post/ overview/ narrative on specific delta, gamma, theta and vega numbers/ thoughts you personally consider while managing your RUT portfolio?

REALLY enjoy your blog!

Dave

***

I cannot comply with your specific request because different situations require different solutions.  But I made a trade yesterday - reported on twitter:

"Locked in a gain; kept insurance, by adjusting: SOLD RUT SEP 570P that I BOT earlier and replaced them with RUT Sep 550P. +$10.30 per spread"

This is an appropriate time to discuss the rationale for the trade.  If it proves useful, I will do it whenever I have something interesting to report.

Part of my RUT September position: 

RUT is currently 557

Short:  RUT Sep 530/540 Put spreads

Long:  A few RUT Sep 570 puts as insurance

My thoughts and trade rationale:

"I'm holding onto my September iron condor positions right now.  I've already covered a few of the far OTM call spreads at 10 cents per spread and am not yet ready to cover any more spreads (RUT Sep 610/620 C) - at current prices.

The 530/540 put spreads are not that far OTM and may soon present a problem, but overall my portfolio is well protected, there is no reason to consider making a risk-reducing adjustment, and I don't want to pay the current price (> $2.00) to cover this spread.

The Sep 570 puts provide adequate protection right now.  In addition, I own other puts that provide additional insurance, but that's not relevant to the trade under discussion.

One of the difficulties when buying insurance is that the trades are made at a debit, and if all positions expire worthless, the month will be profitable, but the cost of insurance reduces those profits.  For some traders, the idea of paying cash for insurance is abhorrent because their entire philosophy is based on selling - not buying - premium.  With that in mind, I believe it's prudent to look for opportunities to recover some, or all of the cost of insurance - as long as portfolio protection is not forfeited.

My favored method for accomplishing that goal is to roll down the options held for protection - and to collect a decent lump of cash.  Thus, I entered an order to sell the Sep 570 puts and to buy an equal number of 550 puts.  I might have chosen to buy the 560 puts, but I prefer to collect additional cash. 

For this trade, I'm ignoring all the Greeks.  This trade is obviously going to make my position longer (selling negative delta), but because I still own excellent protection and because I want to take some cash off the table, I feel that it is more important to satisfy those criteria than to be concerned with a small number of deltas. The overall portfolio does not have downside risk.

I sold the RUT Sep 550/570 put spread and collected $10.30 per spread.  Is that a good trade?  That's not the question.  This trade accomplished something good for the portfolio - and that makes it 'good' by my definition:

a) I have $1,030 cash per spread

b) I still own protection against a disaster in the form of puts with a higher strike price than my short puts.  To me, that's important.

c) This trade is equivalent to gamma scalping where a trader buys dips and sells rallies. [Using this method, I recently sold the RUT Sep 580/600 call spread at $10.20]

So what's the downside?  What was lost?  Answer:  If the market tumbles, this spread could be worth $2,000 and I sold it for half that amount.  In other words, in a disaster - where protection is needed - I've given up an additional $970 payout from my insurance policy, per spread.  But, to me, it's not the $970 that I need.  Owning extra puts is what is needed for insurance.  I'm perfectly willing (for the right price) to trade in my 570 puts for 550 puts.

What's next:

I must still watch this position because it may require an adjustment.  If the market moves much lower, I will do something with the 530/540 put spreads.  At the same time, I'll sell out my insurance (the 550 puts).  Right now, I'm holding, looking for additional profit opportunities."

437

CBOE Collar Index Revisited

Six weeks ago, I discussed the CBOE Collar Index.  There are many possible indexes that the CBOE could have chosen to create.  They made a reasonable choice: the CBOE S&P 500 95-110 Collar Index.

That index creates a collar by buying a put that has a strike price nearest to being 95% of the value of the index, (or 5% out of the money) and selling a call option that is 110% the value of the index (or 10% OTM).  This works for many investors because they prefer writing OTM calls on a stock portfolio.

I was hoping to see the CBOE S&P 500 95-100 Collar Index (the call written is ATM) to allow a direct comparison with the BXM, the CBOE Buy-Write Index.  I've been posting comments on a bunch of personal finance blogs whenever I felt that such a comment was appropriate.  Those comments recommend adopting the collar strategy, instead of relying on asset allocation methods to protect portfolio value.

Alas, the 95-110 collar is costly, and significantly under-performs both the S&P 500 and BXM - most of the time.  When the markets fall however, the Collar Index (CLL) performs very well.  Convincing passive investors to consider learning to use collars is not an easy task in itself, but it would be easier if the CBOE's chosen collar index performed better.  Hence my desire to see the CLL index based on collecting the additional option premium available by selling ATM calls, rather than 10% OTM calls.

I'm hoping the CBOE will eventually publish the 95-100 Collar Index.  It would provide valuable information by telling investors the cost of protecting a BXM portfolio with 5% OTM puts.

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Q & A. Insurance, Risk, and Uncomplicated Positions

Hello Mark and thanks for your excellent blog! I have been considering your thoughts on trading 2nd and 3rd month Iron Condors and did a successful test last month, closing out the position 1 month early. I have been trading front month RUT iron condors for an average credit of 1.00, however I tend to leg into my trades. For example, I will first sell the call spread as the market is rising for around 0.50 (based on some technical analysis) and then wait for an opportunity to sell the put spread for again around 0.50, or vice versa. On some months I do not open up both sides of the iron condor because I don't like the risk of one particular side and can't get enough of a credit that would give me sufficient "breathing room" in the trade.

I had a question about your method of buying insurance. You tend to look for higher credits in your condors and then buy extra insurance. Would this not be similar to just opening up a wider iron condor for a smaller credit? It would seem to make things less complicated and have less commissions as well. I tend to think of these extra puts/call as complicating the overall portfolio, especially in relation to your recent posts on when you would then exit these positions (i.e. would you exit your long puts at the same time you adjust your put spread early?) I find the idea of opening up longer dated iron condors intriguing but the concept of purchasing extra insurance seems to really complicate the portfolio for me.

Tom

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Tom,

NOTE: Overall 'risk' is a combination of how much you can lose and the probability of losing it. Thus, 'reduced risk' can occasionally be a confusing term.  In today's context, I'm referring to 'dollars that can be lost' rather than the 'chances of losing those dollars.'

1) Any trading ideas I offer are meant to be something for readers to consider. I would never tell you that you must (or even 'should') adopt them.

What I am trying to do with this blog is to explain how options work and how the average investor can use them. Obviously some readers are far more experienced than others and already have ideas of their own. That's good. If those readers think about what I have to say, they may accept those ideas, or discard them. That's an educational process because it gets those readers to consider alternatives and make a choice.

For the rookie, such as yourself, I'm offering ideas that you may want to consider. But, if you are making your first few trades, we can agree that you should take it slowly and not do anything that feels complicated.

2) If it makes you uncomfortable, or if you don't fully understand, please don't use such ideas. Not until you understand them well enough to decide if they seem right for you and your trading style, philosophy, and bankroll.

3) There is nothing wrong with legging into trades, if you believe you have the market timing skills to do that profitably. Just remember when you sell inexpensive spreads, it takes a decent-sized move for the spread to widen by ten cents. That makes it tough to get your price, even after the market moves your way.

4) Regarding selling wider spreads: NO. That INCREASES risk (larger possible loss) with little extra to gain. That is not a good idea, and is NOT anything similar to owning insurance. The whole idea behind any type of insurance is to reduce the amount than may be lost.

Wider iron condors have a larger credit, not a smaller credit. Thus I ask: Did you mean: open a wider iron condor that is FARTHER out of the money?

If that is what you mean, that reduces 'risk' from the perspective of: 'it reduces the probability of losing money on the trade.'

When I refer to 'reducing risk' I don't mean it that way. I use that phrase to mean: 'less money can be lost' on the trade.

5) Yes. If I am adjusting a losing put spread, I would sell out all, or part of my extra puts. I would buy new insurance puts that are appropriate for any new put spread that I sold.

But, if I buy in a put spread early because it became very cheap, I'd still be tempted to hang onto my insurance. It truly depends on how much I can get when selling those extras. If it's very few dollars, I do not sell. Black swan events do happen. I may not want to bet on them, but if I already own a cheap option, there is no point in giving it away.

6) Commissions are not to be ignored.  But in today's world you can find a broker who charges less than $1.00 per option contract, with no additional 'per ticket' cost.  If you find commissions are hindering your ability to trade (and I get it, because I used to feel that way before the deep discounters arrived on the scene), you have the option to change brokers.  It's very difficult to avoid a trade just because the commissions are excessive.  If you feel that way occasionally, you must think about a new broker.  You don't have to change, but it is worth considering.

I hope this was helpful. Trading in an uncomplicated fashion is NECESSARY in order for you to remain within your comfort zone.

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