Tag Archives | option strategies

## Ratio spreads. Part I

There are several commonly used option strategies that never get mentioned at Options for Rookies.  I have my reasons for ignoring those strategies.  However, because this is an options education blog, it's worthwhile to describe some of these methods, explain the pros and cons of using them, and each reader can judge whether such strategies are appropriate.

One such strategy is the ratio spread.  It is sometimes referred to as a 'front spread' because it is the direct opposite of a back spread.

Ratio Spread

This term can have a broad or more narrow definition.  It's the narrow definition that is used most frequently:

Broad definition: A ratio spread is any option strategy in which the trader sells more options than he/she buys.

The more limiting definition includes: Similar to a vertical spread, all options are on the same underlying stock or index and have the same expiration date.  Only the strike price differs.  The options sold always have a smaller delta than the options bought.

Many times the ratio spread is initiated as a delta neutral position.  However, when you are trading with a market bias, you may prefer to select specific options and a specific ratio to suit your market expectations (more on that tomorrow).  Let's look at examples.

Note:  The following are randomly chosen spreads and are not recommendations.  I will not be trading any of these examples for my own account.

Example.  Ratio call spread

Buy 1 AAPL Jan 330 Call
Sell 2 AAPL Jan 350 Calls

This is referred to as a "1 X 2 call spread,"  with 'X' being used to represent the word 'by.'

As I write this (Nov 18, after the market close), AAPL is 308.43 and the estimated execution prices for this trade are \$6.60 and \$2.70.  The trader pays \$6.60 for the call purchased and collects \$2.70 for each call (\$5.40 total) sold.  Thus, the cost to buy this position is \$1.20.  As with any other options trade, that \$1.20 is per share and the true cost is \$120.

The total description of this trade is: "The trader bought the Jan APPL 330/350 1 x 2 call ratio spread at a net debit of \$1.20"

IMPORTANT NOTE: If you describe this trade verbally, especially when entering the order through your broker, you MUST use the lowest common denominator for the ratio.

In other words, if you enter this trade 20 x 40, the terminology is: "Buy 20 1 x 2 spreads at a net debit of one dollar and twenty cents for each 1 by 2."   Never, tell the broker that this is a total debit of \$2,400 (\$120 * 20).

Example.  Ratio put spread

Buy 2 AAPL Jan 270 Puts @ \$7.10
Sell 3 AAPL Jan 260 Puts @ \$5.20

This is a "Jan AAPL 270/260 2 by 3 put ratio spread at a net credit of \$1.40"
This position is initiated with the trader collecting a cash credit of \$140.

What's the Problem?

There is nothing truly 'wrong with spreads of this type, and experienced traders use them as part of their trading arsenal.  The main reason that I don't discuss ratio spreads is because they are positions in which you would be 'net short' options.  These are referred to as 'naked' shorts.

Many brokerage firms do not allow any of their customers to own positions with naked call options.  Others allow experienced traders to sell naked puts and calls.  Thus, some of you would be limited in your ability to trade this type of position, depending on the whim of your broker.

Risk Management.  That's the problem.  The major focus of this blog is to help rookie option traders learn to trade options successfully.  To do that, it's very important to recognize, and control, risk – in the form of 'how much money can I lose on this trade in the worst case scenario?'  Naked short positions make it impossible to gauge a worst case (for calls) and it bcomes difficult to keep a handle on current risk.

When short naked options, the loss is theoretically unlimited for calls and the value of the strike price (x 100) for puts.  In reality those extremes do not occur.  Yet, gigantic losses are possible.  That's why I never suggest that rookie option traders ever hold positions that are naked short any call options.  I make one exception for holding naked put options: If you want to accumulate stock positions for your portfolio, one acceptable method for attempting to do that is to sell naked put options.

The combination of

• Horrific results are unlikely but possible
• In general, brokers do not allow inexperienced traders to sell naked options
• I believe that it takes a good deal of experience before considering selling naked options
• I never sell them myself (simply because margin requirements are too high)

puts me on record for not recommending these trades to my audience of rookie traders.  Many experienced traders can handle  these spreads because they have seen what the market can do.  I assume that any trader who has been in the game long enough to have gained significant experience, survived because he/she already understands the importance of manageing risk. [That's my way of saying that traders who ignore risk will not survive very long]

Broken Wing Butterfly (BWB)

One other possibility for limiting risk and making the ratio spread a viable alternative is to buy one extra call or put option for each option sold.  In other words, there are no longer any naked shorts.  That option

• Is farther OTM than the short options
• Provides ultimate protection by
• Limiting losses
• Reducing margin requirments
• Creating a position that all brokers will accept

This new position is known as a butterfly spread – if the options owned are equally distant from the options sold:

Butterfly example:

Buy one AAPL Jan 330 call
Sell two AAPL Jan 350 calls
Buy one AAPL Jan 370 call

In most scenarios, the option bought is farther OTM and the distances are unequal. That new position is called a broken wing butterfly and is the position typically adopted by more conservative traders who want to trade ratio spreads.

Broken Wing Butterfly (BWB) Example:

Buy one AAPL 380 (or higher strike) call – instead of buying the Jan 370 call.

I'll have more to say about BWBs later in this series.

Next time I'll discuss the risk profile for ratio spreads and how your market outlook plays a role in choosing strike prices when trading ratio spreads.

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## Warning: The Hype Artists Want your Money

I made a Google search for recent mentions of  'option strategies' and found some amazing offers. They are so obviously untrue to anyone who knows anything about trading.  However I wonder how effective they are in trapping those who are looking into learning about options for the first time.

Regular readers of this blog don't require the warnings I offer below, but for true rookies,  this message is important.

• Please be aware that there is no free money
• There is no instant gratification in the options world
• There is much to learn and you can learn it.  But not in one short lesson
• Options reduce investment risk, when used intelligently
• Options for Rookies is here to help with your options education

Sampling of what Google uncovered

1)  " Perfect for novice investors…new 90-minute course shows you how to accomplish every investor's goal — how to earn consistent and reliable income from the stock market.

Starting with basics, you'll get a comprehensive plan for investing with options, including: · Explosive growth strategies: buying call and put options;  Income strategies: covered calls, credit spreads, calendar spreads, selling puts;  Hedging strategies: puts for insurance, collars for income and protection… you can earn consistent profits with strategies that can be applied to any investing lifestyle and regardless of flat or down markets. Don't wait for the market to move, start making money right now!"

All of that in just 90 minutes.  I had no idea option trading was so simple.  And this deal was offered at a discount! [MDW]

2) Learn The Secrets Of Professional Stock Option Strategies That Create A Consistent Stream Of Cash Into Your Bank Account.  Generate Cash In Just Minutes A Day.

It's even simpler than I thought.  Just 'minutes a day.' Who can resist?

And the money goes directly into my bank account.  That's wondeful because I won't need a broker or pay any commissions.  Gee whiz! These guys are offering the Holy Grail of investing.[MDW]

3) While surfing, this popup appeared:

Learn how I make 5%-10% returns every month.  Get a FREE copy of …

Every Month.  I like that part. No one should ever have a losing month! [MDW]

4) There's an easier way to make money trading options.  Binary Options are a pure and simple way to trade based on your opinion of where a market is headed over a certain period of time. They are contracts that, at expiration, pay out a predetermined, fixed amount… or nothing at all.

What they fail to mention is that the payoffs are far less than they should be.  It's the same as making a 50/50 wager with a bookmaker and collecting \$50 when you win and paying \$100 when you lose. [MDW]

***

Similar examples can be found all over the Internet.  The phrase 'caveat emptor' (let the buyer beware) is especially appropriate for options information.  You can find much excellent, accurate information.  This post represents a warning that there are plenty of people who are not bashful about asking for your money, and telling huge lies to get you to send that money.  Please be careful out there.

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## Attacking Advice from an Options Guru

Options for Rookies New Home Page

Bernie Schaeffer, from Schaeffer's Investment Research, long-time options analyst and trader offers his comments on why an investor should be trading options in today's market.

After reading the piece (quoted below), I tried to communicate with him via his website. I wrote that I was going to offer contrary opinions and asked if he wanted to discuss the issues.  I received no response.

I've inserted my comments amidst his advice.  In my opinion, the suggestions offered represent the worst possible advice one can offer to an options trader.  Especially when it's intended for a general audience.

In my opinion, it imposes the wrong mindset (making profits is easy, picking market direction is easy, trading options is a simple game), giving those who follow the guru little chance of learning to use options profitably.

Yes, that's a very strong statement.  I believe options education must include information that gives the reader a reasonable chance to earn money.  But no one hands that cash to you.  It requires discipline, practice, and understanding what you are doing when making a trade.

When you teach a beginner to buy options and predict direction, you set him/her on a path of financial ruin.  The shameful part is that there's no warning of how difficult it is to earn money via this strategy.  All our guru talks about is high leverage and the possibility of making big profits. There's no mention of the odds of succeeding.

When we consider that traders who follow these suggestions probably lack much (if any) experience managing risk, it's a recipe for disaster  The only redeeming virtue in this article is the recommendation to use only a modest portion your trading account.

I have no idea of why Schaeffer's Investment Research believes that most traders can successfully predict market direction when the evidence is clear that professional money managers cannot do it (most mutual funds underperform their benchmark indexes).  If this advice is not intended for the masses, but is specifically for people with a proven track record of beating the market, then I can forgive the advice.  But when it is general advice offered to the masses, I must fight back.  I know his readership is at least 10 (if not 50) times larger than mine, but I'm not willing to let his advice go without making an attempt to salvage the situation.

The article:

"The stock market gets no respect these days.

On July 27, an article entitled "Ten Stock Market Myths That Just Won't Die" was featured in The Wall Street Journal.
It attempted to debunk just about every reason your broker has ever
given you for investing in stocks – from "investing in the stock market
lets you participate in the growth of the economy," to "the market is
really cheap right now," to "stocks outperform over the long term."
Overall, it adopted a very cynical, negative view of the market."

As well it should be.  Too many brokers and other financial professionals are out to earn commissions, not to serve customers.  Warnings are necessary.

"If this article, which ends with the comment "In the long run, we are
all dead," is your idea of helpful investment advice, then please read
no further. But at the same time, if you're expecting me to try to
"debunk the debunker" by giving you 10 reasons to be bullish on the
market, then I have a surprise for you. While I do feel that the
unprecedented rush to the exits by individual investors and the
extremely negative press that has dogged this market since early 2009
will ultimately prove to be very effective contrarian indicators, I
understand the frustrations investors feel with the post-"flash crash"
market in all its high-volatility, directionless glory.

Instead, my message to you is about avoiding these stock market
frustrations and actually setting yourself up to make some money. I'm
sure you understand this will not happen by you sitting in cash vehicles
that guarantee you safety but pay you no return. You are being
"rewarded" for the risk you are taking, and that reward is zero. But at
the same time I'm not suggesting that your only alternative is putting
your money in the market. What I'm in fact suggesting is that you commit
a relatively modest portion of your capital to STRATEGIES designed to
EXTRACT MONEY from the market, regardless of direction, or even if there
is NO direction. And the only investment vehicle that can accomplish
this for you is options."

Committing only a modest amount of money makes sense.  I can agree with that.

Adopting strategies that are designed to extract money from the market also makes sense.  However, isn't that the purpose of every strategy?

The difficult part is knowing which strategies to adopt and when to use them.

"So in the format of the aforementioned Wall Street Journal
article, but with the goal of providing you with actionable information
designed to grow your portfolio, allow me to list for you 10 reasons why
you should be trading options right here and now.

• The calls in your options portfolio will allow you to
achieve big leveraged gains if the market catches most investors by
surprise and rallies through year-end"

That's true.  But the bigger truth is that you can readily lose 100% of the capital
invested.  Bernie, I admire the fact that you caution investors to use
only a 'modest portion' of their portfolio for these plays, but they are still high risk plays that require accurate market prognostication.

"The puts in your options portfolio will protect you against
"flash crashes" and other disruptive market events and even allow you to
profit in these situations."

This is also true.  Are you suggesting that buying both puts and calls gives your investor a good strategy for extracting money from the stock market?  I believe it's far more likely to extract money from his/her investment account.

As the 'flash crash' made obvious, it's not easy to get orders entered, and even more difficult to get them filled, during such an event.

My conclusion is that another flash crash is unlikely, and preparing for it is a waste of time and money.  Preparing for a true market debacle is another story, and being certain your portfolio is not decimated when that happens – makes sense.

• "You can still benefit from the unlimited profit potential of option buying yet limit your loss from any trade to 20-30%."

Limit losses?  Are you suggesting that option buyers unload their positions when losses reach that 20 to 30% limit?  That hardly gives them a chance to profit if that 'big rally' doesn't begin pretty soon. Limiting losses is a fundamental aspect when trading, but not for the scenario you described.  You want them to be involved if there is a rally through the end of the year, but you don't want them to own positions when losses exceed a designated limit.  Those are conflicting goals.

• "You can profit from market volatility regardless of the direction of the price movement."

You can lose from market stagnation, or reduced volatility – regardless of direction.

• "You can profit from buying calls on stocks that outperform,
and at the same time buying puts on stocks that underperform their
industry peers. That's the easy part."

We all know how easy it is to pick which stocks will outperform.  The proof is in the fact that each of your clients has already achieved multi-millionaire status and is heading towards the billionaire level.

And your newsletter must be at least 95% accurate when picking direction.  It's a cinch to do this. Just look at all the mutual funds – who pay big salaries for management personnel, and their track records.

Hmmm…I must be missing something here.  Those managers tend to underperform.  But that's okay, I'm sure your customers are much better at picking direction than all those pros.

• "You can achieve huge leveraged gains by buying options during
expiration week, when premiums are extremely low. And now, with the new
Weekly Options, there is an expiration week every week."

Wow.  Yes indeed.  Good thing you are so good at picking direction because the nay-sayers would tell you that's it's a great opportunity to lose 100% of your money in a hurry.

Did you know that the 'extremely low' option prices are accompanied by exceptionally rapid time decay?  I suspect you did know this, but chose not to mention it.

Buying Weeklys?  Leveraged profits are nice.  What about 100% losses?  Or do you stop yourself out of these trades after 2 days?

• "You can profit from the strong tendency of the market to
trade in well-defined ranges most of the time with a carefully selected
option premium selling program."

Well, which is it?  Are we to buy or sell these options?  You must tell us now, before we actually go out and make the trades suggested earlier.

Or is this this another example of making option trades when we know how each stock is going to perform?

• "You can profit from the huge volatility around events like quarterly earnings reports."

And do we do that by buying or selling the 'huge volatility' displayed prior to a news announcement?

• "You can profit by buying call options on stocks that are in
long-term uptrends, at much lower dollar risk than buying the stock."

Agree.  I hope you are referring to ITM options, and not suggesting that traders buy OTM, or even ATM options.  I assume that your readers are good at judging which stocks are in firm uptrends.

• "You can profit in all market environments by trading multiple
option strategies on highly liquid exchange-traded funds on
broad-market indexes, like the QQQQ."

Okay, but you wanted investors to buy calls on the good stocks and puts on the decliners.  How does trading an ETF allow for that?  Now they must predict market direction for the whole market, rather than for individual stocks.  So, does that mean all the advice given above is no longer valid?

• "In the long run we may all be dead, but we can make the most of the
short run by looking to the options market for our trading
opportunities."

Yes Bernie, all those opportunities are present.  But how do your readers know when to buy (or sell) puts or calls?  You neglect that one little detail.  Or are they supposed to buy your costly newsletters to get the answers?

In my opinion, options are designed to reduce risk.  Neither buying options nor selling naked options is the investing method that gives trades the best chance of success.  A jackpot possibility – yes, it provides that.  But that's no different from gambling and I'm disappointed that you shared these inconsistent thoughts with the world.

• "A good place for you to start might be our Options Center,
where every trading day we slice and dice what's happening in the
options market and its implications and where you can also find a wealth
of options-based tools and filters and explanations of various options
strategies."

I truthfully don't know how good this information is.  But, it may probably worth a look.

Bottom line: This is the type of guru advice offered to the average options trader.  This is the type of advice that gives options and options trading a bad name.  If you want to gamble, follow the advice offered by our guru.  If you want to use options with the chances of making a profit on your side, then understand how options work, make good trades, and carefully manage risk.

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## Stock Options: White Hats or Black?

Remember early TV days when the 'good guys' wore white hats and the 'bad guys' wore black?  It was easy to tell them apart.  Today, the white hats of the investment world are seen as wearing black hats by far too many.  Options.  Those are the good guys.

This post was first published at The Options Zone.

The word
‘options’ evokes a negative emotional response from people who never use them,
don’t understand how they work, and who prefer to remain in the dark.  Many investors truly believe that options are
risky investment tools, used only by high-rollers.  Thus, they make no effort to see ‘what all the
fuss is about.’  Surely they know that
huge numbers (several billion per year) of options trade, but they have no
curiosity.  Why?   I’d guess that an uneducated broker once
told them that options are ‘dangerous’ and are too complicated for the
individual investor to understand.  The
truth is that those stockbrokers were unwilling to learn, and provided a
disservice to their clients.

Today, the
world is more efficient, with useful information (along with misinformation and
hype, so please be careful) all over the Internet.  Options Zone is a safe place to learn about
options, and that’s the reason I accepted an invitation to participate.

Those of
us who understand how options work reap the benefits.  Those who prefer ignorance, must trade with
much more risk than necessary.  For most
investors, bull markets provide profits and bear markets bring the realization
that investing is not a gimmie.
Options are unique.

The
first obvious difference between options and other investments is their limited
lifetime.  However, the most important
feature of options – the one that makes it an indispensable investment tool –
is that options allow an investor/trader to measure and manage risk.

• If you choose not to be hurt during a bear
market, you can own insurance against large losses
• If you prefer to use leverage, you can attempt
to turn a small investment into many times that amount.  This is the ‘gambling’ aspect of options
that I don’t recommend – but it’s your money and you make the decisions
• You can own an option position that benefits
when specific stocks, or indexes, trade in a narrow range.  Or you can own a different position that
earns money when a specific stock moves much higher or lower
• Whatever your outlook for the market – bullish,
bearish, neutral – there is a hedged options trade that earns a profit if
your outlook becomes reality.  NOTE:  This sentence is not what the hypesters say.  Their line is 'you an make money in any market.'  Sure, but you have to be correct in your forecast.  You cannot take a bullish stance and expect to profit when the market crashes
• The bottom line is that each of these objectives
can be attained with limited risk.  There’s
no need to invest large sums to buy stock.
Options can be used to meet the needs of anyone who trades stock,
commodities etc.

When you
own options, the passage of time is your enemy.
But you can earn a profit when your prediction comes true.  By hedging the trade and accepting a limit on
profits, ‘time’ risk can be cut considerably.
When selling options, you earn profits as time passes.  However, other risk factors make this idea
too risky for most investors. Again, by hedging and accepting a smaller limit
on possible profits, that risk can be cut dramatically.

My
purpose today is not to compare the advantages or disadvantages of adopting
various option strategies.  Instead it’s
to point out that you can measure, and reduce, the risk of investing.  That’s why options are special and worth the
time to understand how they work.

More
experienced option traders know better than to try to make money by constantly
buying or selling options and predicting how the market will move.  They understand how difficult it is for the
vast majority to have an inkling of what’s coming next in the stock markets of
the world.

These
investors trade spreads, or reduced-risk, hedged positions.  I’ve discussed the best features of
some basic spreads and explained how to benefit by adopting them (see 'categories' in the right-hand column).

Today,
the idea is to help option rookies understand that options are used to hedge
trades – on a continuing basis – to reduce risk.  Note: options are not perfect.  If you want the combination of zero risk and guaranteed
profits, you are living on the wrong planet.

One
example is the popular strategy: covered call writing.  Investors earn profits when the underlying
stock moves higher, holds steady, or declines by a small amount.  It’s very popular among new option traders,
but serious, experienced investors also use this method.  In fact, there are mutual funds dedicated to
writing covered calls.  The point to be
made is that this method comes with risk.
If the market tumbles, covered call writers perform better than those
who simply buy and hold the same stocks.
But, by using options judiciously, risk can be reduced even
further.  By varying the specific options
traded, the covered call writer can enhance the upside or gain additional
protection against a downside move.
Options are versatile investment tools.

Option
strategies can be used to reduce risk and enhance the probability of earning a
profit.  The profits may be limited, but
the combination of more winning trades and smaller losses is appealing.  Only options can do that for an individual investor.

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Are you a fan of Options for Rookies?  Have you benefited by reading
this blog?  Are you one of the many readers who has sent congratulations
and thank you messages for proving valuable content?

I thank you for the kind words of encouragement.

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## Expiring Monthly: Gifts for Subscribers

As you know I'm working with four other option bloggers to publish Expiring Monthly: The Option Traders Journal.  Our plan is to bring you the finest collection of option related content each month  The premiere issue is ready for publication one week from today: March 22, 2010.

To celebrate the launch, and to encourage those of you who are undecided about subscribing (\$99/year) to make a final decision, we are offering gifts to randomly selected new subscribers.

To be eligible for the random draw, subscribe this week, Monday Mar 15, through Monday March 22, 2010.

We are not ignoring current subscribers.  We have a group of prizes set aside for you.  There's no need to take any action.  You are entered into the random drawing.

***

Among the offerings:

Autographed (Adam Warner) copy: Options Volatility Trading: Strategies for Profiting from Market Swings

Autographed (Mark Wolfinger) copy: The Rookie's Guide to Options: The Beginner's Handbook of Trading Equity Options

Mentoring session with Mark Sebastian

The Option Trader Handbook: Strategies and Trade Adjustments  2nd ed; George Jabbour and Phil Budwick

2 weeks subscription to the Condor Options newsletter (Jared Woodard)

My new eBook: Lessons of a Lifetime

Understanding Options
by Michael Sincere

Autographed (Mark Wolfinger) copy: Create Your Own Hedge Fund: Increase Profits and Reduce Risks with ETFs and Options

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One week from today, is the launch of Expiring Monthly
It's the electronic options magazine that's all options all the time.
Lovingly created by five options bloggers (disclosure: that includes
me), a one year subscription is \$99.  That's twelve monthly issues. Subscribe this week and you'll be entered into the random draw for gifts.

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