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The Options & Spreads article that follows has been written by an expert who trades successfully for a living. He also offers a course on trading Options & Spreads. For more info on the course click here.

The following article is very educational, informative and well-written.


OPTIONS & SPREADS: Gaslights & Green Eyeshades

Centuries ago, map-makers had an unwritten rule: "Where you know nothing, place terrors." Thus the blank spots on maps became monsters' lairs, islands of giants, crevices 1,000 miles deep and the ocean boiling at the Equator.

During the Age of Exploration after Columbus, many explorers had an unconscious rule which, if made conscious and put in words, would have been something like, "Where you know nothing, place gold fields."

Both these viewpoints are exaggerated, but what makes them relevant to today? It would be no exaggeration to say that today's speculators are cartographers and explorers, that they face risks and the unknown, that their maps contain blank areas which their expeditions and imaginations must fill in, and that some will carry profits in the ship's hold while others will not survive. How are you filling in those unknowns?

Passbook savers view speculation as vampire land. Neophyte traders view it as the dump-wealth-in-your-lap land of El Dorado. Let us assume that you have had a fair piece of experience. You are familiar with the region's diamond mines and its lions and leopards. At times you have acquired gems and at times claw-marks. So what next?

All experienced traders are NOT created equally. Some make the same mistakes over and over, for years even. Others bring about "improvements" in their procedures which make as much difference as changing deck chairs on the Titanic. Famous last words: "I would not have suffered those losses in the past if I had the method I have now. I expect to make a fortune." Still others do things differently and really fare better than previously.

Good Truism: If you fire enough shots, you are sure to hit the target eventually. Bad Truism: If you take enough steps, you are sure to step on a land mine eventually. Bad Side of Good Truism: If you bet on all the horses, you spend more than you win. Good Side of Bad Truism: You lose less in the explosion if you limit your risk. The Thread That Connects All This: Be Stingy With Your Capital Dollar and Be Informed.

An acquaintance of mine, a futures & options broker who asked not to be named, saw a statement I made in print: "Those who have read books on options are invited to respond." He said, "You're crazy, to put it bluntly. If I only accepted clients who've plowed through McMillan and Angell and Caplan, I wouldn't be able to pay my office rent. Remember this and remember it good: A suitable client is anybody whose check-writing hand was not shot off in the war. Sure, it's sad that they lose, but they can see as well as anybody that the ocean doesn't swarm with yachts, I mean, yachts carrying suckers who wrote a check to a broker. But they still expect fabulous wealth, riches oozing out of the woodwork. You do spreads, huh? That says it all. You drain everybody else's bank account just like I do."

I have stated in previous articles that gains from option spreads resemble coffin-maker profits and a skim off the suckers at the gambling den. These words are written a few days after Thanksgiving, and I give thanks not only for profits but for ongoing profits. One CTCN subscriber, a New York medical doctor, wrote to me and asked about my five-year track record. I have been doing option spreads only since 1995, the same year I began writing regularly for CTCN. My transactions have been detailed down to the dollar in those articles, so I have been trading in a display window. Anyone curious about my track record may consult backissues. In dollars as well as instances, the gains have substantially outweighed the losses.

While my win record is not 100 percent, I can report consistent profits in a financial boxing ring where "consistent" is a word not often uttered. The good doctor's letter prompted me to take a look at my first CTCN article, in the issue dated October/November 1995. It opened with a trade I had done months earlier, buying 10 June call options with a strike price of 70 and selling 10 April calls with the same strike price--a horizontal calendar spread. In dollars I had bought $4,000 worth and sold $2,500 worth and paid the difference of $1,500 plus broker's commissions. In points, I had bought options worth 4 points each and sold options worth 2½ with a difference or "spread" of 1½ points.

Like the president of Prego Spaghetti Sauce, I like to think I got better as I got older. An option spread of 1½ points seemed just fine then. I have since evolved toward smaller or skinnier. A point or less than a point seem excellent, 1-1/8 and 1¼ good, 1-3/8 fair, 1½ half a warning flag. Something else did not change. The article contained three "substantial advantages of spread strategies" which still stand:

1. The likelihood of a profit is over 90 percent as opposed to over 90 percent losses when options and futures are "played long."

2. You "make out like a bookie" in that you use plenty of other people's money--amplitude that sweetens the pot.

3. Other people's money cushions and shields your own investment capital when markets, portions of markets and individual stocks and futures contracts become tempest-tossed.

The latter does not guarantee against a loss but it helps to make losses fewer/smaller. I recently came across corroborations of other items in that three-year-old article. That piece quoted Wasendorf & McCafferty's book All About Options: "A negative personality rarely earns profits consistently. They are usually attracted to options for the wrong reasons -- to make a lot of money fast without exerting much effort. Therefore, they don't spend the time required to learn some of the more complicated strategies that are more conservative by comparison."

By quoting magician/author Cecil Lyle, I compared above "wrong reason" traders to amateur magicians who consider adding a particular trick to their repertoires but lose interest if it requires more than casual preparation and effort. They want Houdini-like spotlights and applause but God forbid they should have to sweat a little. A recently-discovered old critique found likewise.

In 1944, critic Edmund Wilson wrote of a then-decades-old book on magic: "From the directions and diagrams of Hoffmann it was possible to learn the rudiments of sleight of hand and how to build your own apparatus; but magic has, it seems, fallen a victim to the same pressures that produce outlines of philosophy and digests of famous novels. A growth of interest in nonprofessional conjuring has been accompanied by an increasing reluctance to take any trouble about it, so that the amateur is likely to satisfy himself with devices that require no more skill to operate than the jokes on sale at novelty shops."

Like dice and trick decks, perhaps? The growth of "nonprofessional conjuring" has been paralleled by the growth of nonprofessional wrong-reason trading, each with aversion to "exerting much effort" and aversion to spending "the time required to learn some of the more complicated strategies." Gann's Maxim: "Handle speculation like a business, not like a gamble." As with many pieces of wisdom, no one speaks out in disagreement but multitudes of people violate it. Every speculator will say, "I'm not a gambler. I'm a businessman. Do you see a roulette wheel?" No, but the lack of effort and learning time gives such "business activity" an uncomfortable kinship to exploding cigars, wizard's powder, The Pharaoh's Lucky Number Dream Book, and How to Win at Poker by a man who died broke.

Handle it like a business? In the minds of many who take up trading, the fact that learning the arithmetic of dice-rolls is easier than learning a business keeps matters in the back aisle of the novelty shop. Even older than the above Edmund Wilson quotation is Philip L. Carret's book The Art of Speculation, first published in 1930. Carret wrote, "Speculation is no simple business. The amateur cannot take a few thousand dollars' capital, fifteen minutes a day of time, treat it as a sideline and be any more successful than he would be in any other business. Indeed, speculation requires broader knowledge, closer attention, sounder judgment than the average business."

Then as now, plenty of traders handled it with an unbusiness-like blend of on-the-side dilettantism and addiction. The author also said, "Familiar observation of the sources whence a stock broker's customers are drawn lends force to the indictment against the speculator. The lawyer whose partner neglects his practice to spend profitless hours pouring over the quotations in the morning paper and haunting his broker's boardroom is one strong critic of stock speculation.

"The business man who has seen a promising subordinate lose interest in his job as he caught the fever of the ticker is another. Then there are the well-known figures, whose origin no one seems to know, but whose authenticity no one questions, that 95 percent of traders in stocks lose money in the long run. These are readily available to the critics of stock speculation."

A defender of speculation, Carret viewed skeptically the "well-known figures." Today with futures and options, the "90% losers" figure persists despite the tendency of telephone hucksters to deny it like tobacco executives denying smokers' funerals. The fact remains that trading attracts the dabblers and the poorly-prepared and the hypnotically-induced like no other businesses. Did textile-wholesaling or toys or the granite monument business ever bind spells and lure people like yesterday's ticker-tape or today's tote board?

When advising traders or would-be traders, I am often the big turnoff, although that is not my intention. I turn off more than a few seekers-after-wealth when I advise them to read or study perhaps a quarter or a third as much as a jeweler reads the gemologist's manual, the dealer's guide, the basic principles of accounting, a couple of chapters on the history of gem-setting. Not seeking to bother their brains with complexities, they want fortunes fast and easy. Plenty of times I have quoted Philip Carret: "Speculation requires broader knowledge, closer attention, sounder judgment than the average business." Reactions-wise, that statement is a 12-word party-pooper.

Also I turn off plenty of traders or would-be traders when I talk about business-sized profits and not avalanches of wealth. 25 or 35 percent profit in three weeks or so? You gotta be kidding. They want astronomical multiplications of capital, and not slowly. If any clerk or secretary can make a vast fortune so quickly and easily, then why are there not a couple of million Lear jets each serving champagne to a clerk or secretary? Handling it like a business means dealing in realities. Finding Inca gold in three easy lessons is not reality, but many venturers expect something similar.

Did you know that "parquetry" meant an intricate floor design? Edith Wharton's novel The Age of Innocence portrayed Manhattan high society during the 1870s. Let us indulge in a divertimento that will turn out to have a bearing. Her novel sparkles with the following evening vignette:

"Mrs. Beaufort, then, had as usual appeared in her (opera) box just before the Jewel Song; and when, again as usual, she rose at the end of the third act, drew her opera cloak about her lovely shoulders, and disappeared, New York knew that meant that half an hour later the ball would begin.

"The Beaufort house was one that New Yorkers were proud to show to foreigners, especially on the night of the annual ball. The Beauforts had been among the first people in New York to own their own red velvet carpet and have it rolled down the steps by their own footmen, under their own awning, instead of hiring it with the supper and the ballroom chairs. They had also inaugurated the custom of letting the ladies take their cloaks off in the hall, instead of shuffling up to the hostess's bedroom and recurling their hair with the aid of the gas burner; Beaufort was understood to have said that he supposed all his wife's friends had maids who saw to it that they were properly coiffees when they left home.

"Then the house had been boldly planned with a ballroom, so that, instead of squeezing through a narrow passage to get to it (as at the Chiverses'), one marched solemnly down a vista of enfiladed drawing rooms (the sea-green, the crimson and the bouton d'or), seeing from afar the many-candled lusters reflected in the polished parquetry, and beyond that the depths of a conservatory where camellias and tree ferns arched their costly foliage over seats of black and gold bamboo.

"Archer was distinctly nervous. He had not gone back to his club after the Opera (as the young bloods usually did), but, the night being fine, had walked for some distance up Fifth Avenue before turning back in the direction of the Beaufort's house. He was definitely afraid that the Mingotts might be going too far; that, in fact, they might have Granny Mingott's orders to bring the Countess Olenska to the ball.

"Wandering on to the bouton d'or drawing room (where Beaufort had the audacity to hang "Love Victorious," the much-discussed nude of Bouguereau) Archer found Mrs. Welland and her daughter standing near the ballroom door. Couples were already gliding over the floor beyond: the light of the wax candles fell on revolving tulle skirts, on girlish heads wreathed with modest blossoms, on the dashing aigrettes and ornaments of the young married women's coiffures, and on the glitter of highly glazed shirt-fronts and fresh glace gloves."

You can read between the lines that the red carpet, diamond shirt-studs and mother-of-pearl hair ornaments were paid for by Vanderbilt rails & shipping, Astor furs, Morgan banking, varieties of interest and dividends, profit-taking on stocks, bonds, promissory notes and instruments resembling futures and options. I used to feel that people who ventured into investing and speculating too easily envisioned themselves beneath gaslight flames and gilded sconces. Now I wish more of them would think like that.

Several years ago, I knew a man who bought a block of penny stocks costing a few cents a share in a type of business about which he knew very little. He shrugged, "It's a risk, but I have to admit that owning 10,000 shares of anything sounds so good." I picked up on his line of reasoning instantly. Owning 10,000 shares of something made him feel like a tycoon, like he had "arrived." It made him feel on par with the mogul riding a hackney coach from Wall Street or the Gold Room or the Bankers' Club to the Beaufort mansion.

He did not say quite that much but I noticed that he had some scribbled notes that he took from his pocket to glance at. I glimpsed the ballpoint words "dress circle." Merriam-Webster defines "dress circle" as "the first or lowest curved tier of seats above the main floor in a theater or opera house." Clearly this man was thinking cognac and cravat. That seemed a thin basis for venturing a hefty chunk of change and still seems it. Yet in the years since then, I have come to respect that man more if only in contrast to other traders and investors whose thinking hints of novelty stores.

Yes, everything is relative. Back in the 1970s, I made a profit with mail-order on the side and so I wrote a monograph on how to start a one-person mail-order operation. I advertised it for sale in the "Money-Making Opportunities" section of one of the supermarket tabloids. It received a very poor response. No wonder. It was surrounded by ads that said, "Make Thousands of Dollars Each Week!" The couch potatoes and barstool ponderers did not want business-sized profits but mountains of money instantly. You may already be the new Rockefeller!

The tabloid-readers who answered those "Deed to Fort Knox" ads were not in the least made skeptical by the sight of every barfly and supermarket customer not hiring butler & maid with the thousands of dollars per week. When I began to do more advising on stocks and equity options recently, I encountered this type again with increasing frequency. The nice guy who knows beer can labels better than he knows financial intricacies wants to own his own diamond mine, and fast. He never notices that the many who drank beer before him never carry off vast fortunes with the ease he expects. "Speculation is no simple business" Phil Carret said. Yet it hypnotizes and lures people like car dealers' conventions or meat-packing or booksellers' guilds never do. And it disappoints more.

I find myself wishing that more traders would aspire to an opera box or a seat in the dress circle, or would admire the paintings in the drawing room. That would have to mean fewer "wrong reason" traders and fewer dabblers trying to trap crocodiles. Alas, speculation attracts increasing numbers of couch potatoes and barstoolers whose techniques are small improvement over the water-witch with the dowsing rod.

Many a broker does not discourage them because he must replace the find-water-with-a-stick people who left his office last month and cried all the way to the pawnshop. The Holy Grail is even worse than other questionable Holy Grails: It is rusty tin with "get rich quick" engraved on it. Anybody with an unparalyzed check-writing hand qualifies. You call this "handling it like a business" like you call an outhouse the Beaufort mansion.

One need not be a club man wearing a top hat, but more of them in the trading realm would mean fewer green eyeshades and chips-by-the-ashtray mindsets. More Pompeiian artifacts and fewer beer can collections would also count as a plus. There is nothing wrong with a song like "Louisiana Hayride" except when the person listening to it is a lottery-player who writes down license plates. Then he and thousands like him plunge into futures or options, which is to say, try to spear live sharks after reading both sides of the instruction sheet. A person who has been hypnotized by the Dance of the Vulcan Maidens in Verdi's opera Aida or has heard Shostakovich create a crimson twilight via music possesses a better chance of distinguishing the financial penicillin from the snake oil.

A long time ago I came across a riddle which sounded ridiculously simple but which fooled everybody. Gradually I realized it was a personality test in miniature. The riddle: Who's buried in Grant's Tomb? But wait. It's multiple choice. Is it (a) Grant, (b) Grant and his wife, or (c) nobody? Not as easy as you thought, huh? The correct answer which nobody gets right is (b) Grant and his wife. Those who say (a) tend to be routine people giving the routine answer. They may be inert matter managing to put one foot in front of the other or they may be diligent folks doing a full day's work for a full day's pay. But challenge and adventure are not their things. Financially they would tend to be passbook savers.

Those who say (c) are usually venturesome types intrigued by an "empty crypt" mystery. Curiosity, a thirst for challenge -- they have these. Financially, they include many speculators in stocks, futures and options. On the minus side, they give the wrong answer to the riddle and they count among the massacre-like losses in these financial fields. Also on the minus side, many in this category have a weakness for fascinating theories with thread-thin evidences like UFOs and the Bermuda Triangle.

The answer (b) has evidence and probability on its side: Husbands and wives are usually buried together. In addition to being correct, the person who gives this answer has a good claim to being evidence and probability oriented, scientific-minded and businesslike. Such a person tends to be skeptical toward flying saucer reports and "make a fortune overnight" pitches. He or she has the best probability of gaining business-sized profits. I toss in an extra merit badge if oils and frescoes have influenced how they see, like Archer Newland in The Age of Innocence: "Newland leaned back in his chair and smiled at her. She looked handsomer and more Diana-like than ever. The moist English air seemed to have deepened the bloom of her cheeks and softened slight hardness of her virginal features; or else it was simply the inner glow of happiness, shining through like a light under ice."

In the movie Harlow, Martin Balsam in the role of film studio head states a key business rule: "To know what to avoid as well as what to do." Skepticism toward "instant wealth" sales pitches stands essential because they multiply like roaches and, worse than that, they change their shapes to impede detection. Among the latest is "Become a Day-Trader!" proliferating in the "Help Wanted" ads and the "Business Opportunities" classifieds. "How Would You Like To GET RICH DAY-TRADING? Trade With Up To 800 Accuracy!" According to the Oct. 8, 1993-2014 edition of the Wall Street Journal, "State securities regulators have stepped up their scrutiny of daytrading, worrying that smaller, fly-by-night firms are luring too many novice investors into the business and creating unrealistic profit expectations, sometimes with advertisements promising quick riches."

According to a lawsuit filed in Texas, one couple lost nearly $50,000 of their savings as a result of the day-trading come-on. The suit alleges "highly leveraged" investing "incredibly churned, on margin" and "with tens of thousands of dollars in commissions and fees."

Perhaps inevitably, old scams have come in a tidal wave to a new medium -- computers and the World Wide Web. The Wall Street Journal for Oct. 29, 1993-2014 said that since cyberspace is pretty much unregulated and anonymous, "the Internet is a magnet for unscrupulous stock promoters in search of a fast way to reach millions of potential investors. Many violators are more traditional, penny-stock, boiler room operators who have traded cold calls for cyberspace," this according to SEC enforcement chief Richard Walker. In the same issue, the SEC chief of Internet enforcement John R. Stark stated, "All types of scams are finding their way to the Internet. You have Ponzi schemes, pyramid schemes, public offerings, oil and gas fraud, every kind of fraud."

Handling it like a business. Knowing what to avoid. Technology advances but suckers do not wise up. As in the old days of bucket shops and gold bricks, the dupes and patsies still think that a bountiful angel is dropping a Klondike deed in their laps. Venturesome types who believe that Grant's Tomb is empty also believe that Yukon gold flows through the Web. The spell of the tickertape machine has been replaced by the spell of the computer screen. As in the days of candlelight and Curb, an encore of the envisioned big bankroll, the busy check-writing hand, the cry of, "I got taken!" The more things change, the more the bunco squad has to work overtime.

I do not expect to see any cyber-suckers looking at Roman bronze in the Metropolitan Museum. CTCN subscriber Simon Wainer, one of the leading gemologists on Manhattan's Jewelers Row, showed me some silver settings based on centuries-old designs from Valencia and Florence. Although Mr. Wainer talked readily about computers, my instincts told me that his name will not appear on the growing list of traders and investors buying the Brooklyn Bridge over the Internet. This cannot be said for all the bar & grill Cornelius Vanderbilts who cannot recognize a Dry Gulch three-card monte game disguised in silicon.

In the Blondie & Dagwood comic strips, a neighbor's little boy Elmo tells Dagwood, "I've been thinking about what I want to be when I grow up. I decided I want to be very, very important." Then the kid adds, "The rest of the picture is still a little fuzzy." That could be the story for many speculators. They want to be very rich. Worse than a little fuzzy, the rest of the picture falls apart terribly as to details. To change one's thinking, to alter the way one's mind works, is a tall order. But with all those "Capture Fort Knox!" cavalry brigades of traders suffering 90% casualties, those in the saddle remain too tolerant of ride-off-a-cliff strategy. Are improvements possible?

We are stuck with the Over-All System. With so many people trying for vast fortunes, either most must get massacred financially or everybody makes millions and a basket of paper money buys a can of coffee. If everybody gets a raise, nobody gets a raise. Coffin-maker profits and bankruptcy lawyer profits--sad--but real world people do not live forever and everybody does not prosper. In the real world, the improvements must occur inside one person's skull. All humanity will not prosper but he might. Tet if he avoids driving off a pier, he will be an exception.

In Orson Welles' classic film Citizen Kane, newspaper publisher Charles Foster Kane represents low-grade, sensationalistic "yellow journalism." He hires or steals a group of reporters away from a higher-grade, respectable newspaper. Kane's unsentimental business manager remarks, "He'll have them changed to his kind of newspapermen in less than a week." The idealistic, optimistic drama critic responds, "Of course, there's always the chance they may change him without his knowing it."

It would be nice if all changes occurred in a favorable direction, good blood always altering bad blood instead of the reverse. Some art books turn male nudes into waist-up shots and female ones into facial close-ups. Evidently, the prudes influence the art works but not the other way around. I stated in a previous article that a businessman becomes a crap-shooter far more easily than the reverse. Yet to indulge in a bit of macabre symbolism, a person can switch from the empty crypt category to the two Grant corpses.

I advised a man on option spread strategy via Fax. Subsequently he told me, "I'm glad you steered me toward horizontal calendar spreads. When I only played options long, I succeeded but it was the hardest thing in the world to repeat that success. You can't call something a business unless you can make a profit repeatedly. I find that with spreading, it's not perfect but the odds are so much more with you than against you. With you instead of against you. I didn't think that was possible on a one-man basis."

Let us condense that into a Maxim: Aim for repeated profits instead of overnight riches.

Also let us conclude with another item from Edith Wharton's novel The Age of Innocence. Rumors circulated on Fifth Avenue that the owner of the Beaufort mansion was momentarily menaced by "unfortunate speculations" in railroads and "threat of insolvency," also extortion "by one of the most insatiable members of her profession." (This was 1870s New York, not 1990s Washington.) Chapter 27 begins:

"Wall Street, the next day, had more reassuring reports of Beaufort's situation. They were not definite, but they were hopeful. It was generally understood that he could call on powerful influences in case of emergency, and that he had done so with success; and that evening, when Mrs. Beaufort appeared at the Opera wearing her old smile and a new emerald necklace, society drew a breath of relief." Where you know nothing, Gilded Age jewels become good omens.


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