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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: The Pyramid And The Palace

In The Sketch Book published in 1820, Washington Irving wrote of his visit to London's centuries-old Westminster Abbey: "I entered from the inner court of Westminster School, through a long, low, vaulted passage that had an almost subterranean look, being dimly lighted in one part by circular perforations in the massive walls.

"Through this dark avenue I had a distant view of the cloisters, with the figure of an old verger, in his black gown, moving along their shadowy vaults, and seeming like a specter from one of the neighboring tombs." The approach to the abbey through these gloomy monastic remains prepares the mind for its solemn contemplation. "The sharp touches of the chisel are gone from the rich tracery of the arches; the roses which adorn the keystones have lost their leafy beauty; everything bears the marks of the gradual dilapidation's of time, which yet has something touching and pleasing in its very decay." (From the essay Westminster Abbey)

I too have seen dilapidation and decay but could not call them either touching or pleasing. Not in London but Atlantic City. Certainly, the casinos have crystal chandeliers and thick carpets and art deco and huge windows showing night descending upon the ocean, but Pacific Avenue runs the length of the elongated city, one block from beach and boardwalk, passing the street entrances of most of the hotel/casinos. In great profusion, shops along the avenue exhibit three-feet-high yellow signs bearing big red letters, "Cash For Gold." Their loose definition of "gold" includes jewels, watches, cameras and numerous other valuables.

Standing at one point along Pacific Avenue, and glancing a couple of blocks in either direction, I could see seven of those red & yellow signs without walking a step. One little shop was the ultimate multi-purpose outfit: Cash For Gold, Western Union, Checks-Cashed, Chelsea Bail Bonds.

That storefront is practically a curbside sermon for financial traders. Count yourself some kind of a success if you do not pawn anything, stay out of trouble with the law, do not wire family or relatives for desperation-money, and you cash your checks at a respectable bank.

The short walk in Atlantic City from ritziness to decay contains other lessons for traders, including my fellow option specialists and spread specialists. The most popular types of gaming at the casinos has come to be the slot machines. They easily outdraw all others. The developmental years of the Jersey shore gambling houses saw repeated increases in both the number of slots and the amounts of floor space allotted them.

It "just so happens" that of all forms of casino gaming, the one-armed bandit requires the least knowledge or intelligence. Just drop in the coin and pull the lever. People baffled by dice, roulette, blackjack or baccarat swarm in vast numbers to the slots. Isn't it sad how humans keep falling into pyramid hierarchies, with the least brainy forming the biggest layer at the bottom?

I have written in the past and quoted other financial writers about the "sucker trade" in securities investing and speculating. Many people want big money in a hurry, too impatient to await profits from 10-year bonds or slow-growth stocks, quarterly dividends or semi-annual interest. That is not necessarily fatal. However, many of them are also impatient to learn about stocks or futures or options in any real depth. People who pore over the engineering textbooks or the restaurant management manuals are too profit-grabbing anxious to be bothered studying investments or strategies. Anxious to plunge.

Spend months studying options? Hell, no. They want to multiply their money again and again during those months. Otherwise they might as well settle for a passbook. Such an attitude is fatal. Like casino lover-pullers who feed a machine mathematically rigged against them, they routinely transform their bank balances into other people's grosses and profits. No matter what education availability, warning labels or legislation, the pyramid's bottom layer will always be its biggest layer.

This carries not one but two extremely important messages for the intelligent trader. One is to stay the hell off that bottom layer. That is not as easy as it sounds. When just about anybody speaks of "the average person" he means someone else. "I'm better than average because I know what's what." When he speaks of "the sucker trade" he emphatically means someone else. Consequently, bottom layers are full of people who think they are farther up the incline.

Every art contest or song-writing contest brings an avalanche of dross from people who think themselves gifted. The man who thinks he is Napoleon judges himself an expert in military science. Thus they do not award Rhodes Scholarships to people who mark their own test papers. Of course, you should have confidence and should believe in yourself. But self-evaluation can be more tricky in the financial realm than elsewhere, and more dangerous.

The sharpshooter either hits the target or fails. The trader often adds a dose of "I'm a nice guy" or "I deserve rewards" to his self-scoring. The armchair explorer who thinks he knows how to deal with cannibals or wild elephants is at least protected by the lack of these in Appleton, WI. The stock, futures and options markets routinely devour self-proclaimed financial geniuses.

You can be a smart and capable trader with something less than an Olympic athlete's preparation, also something less than a cattle breeder's or diamond merchant's time and effort. But your study and preparation, time and effort, must be professional grade. Also, judge yourself with the clear-eyed objectivity that goes into judging a gemstone or a prize Hereford. The "sucker trade" and the base of the pyramid teem with Self-evaluators who casually gave themselves the medal.

I know a phoning bill collector who occasionally gets told by one or another delinquent debtor, "If it weren't for me, you wouldn't have a job." So those deadbeats bottom-fished for a reason to praise themselves. If they took up trading, they would declare themselves financial geniuses Monday and be bankrupt by Thursday. To stay above this level, remember the advice of the Executive Speechwriter Newsletter: "Go the extra mile. It's never crowded." Unlike the territory of the one-armed bandit.

In stating that a pyramid's bottom layer is always its biggest, I added that this carried two key messages for the smart trader. What is the Second? You will enjoy a hefty financial plus if you are on the receiving side of the cash quantities that the base layer routinely spills forth. The gambling house always wins via dollar slots and other games. The pawnbroker always wins when wagers hock valuables at a fraction of their worth. How can you gain continually? There are bottom layers at securities exchanges and in casinos.

Washington Irving wrote that his mind prepared "for its solemn contemplation" where "a coat of hoary moss - obscured the death's heads and other funereal emblems" at Westminster Abbey. Occasionally I feel solemn among the ghosts and headstones of options that expired worthless--after fattening my bank account. Just as deadbeats tell bill collectors, "If it weren't for me, you wouldn't have a job," losers in options trading could say to me, "If it weren't for us, you wouldn't have those profits," such is the cashing-in-at-the-morgue aspect of spread strategies.

Let us get a more positive handle on it. Petroleum tycoon J. Paul Getty said he had three rules for success: (1) Begin work early in the morning; (2) work until late at night and; (3) find oil. You may regard that startling third as the Star of India sapphire and consider the other two dispensable. Anyway, my variation on those three rules does not leave much of the original.

As mentioned, the multitudes of losers in the options game include many who failed to devote the time and effort to in-depth study and preparation; who wanted better than diamond dealer profits without at least studying a few crystals or learning some business intricacies? Time and effort, yes. Yet here I am pounding my home typewriter at noon and planning an afternoon stroll in the park under blue April skies.

I did not and do not duplicate J. Paul Getty's 14-hour work days. Nor do I laze like the horse-player who dreams of fabulous wealth. In reading the stack of books, past and present, and in handling transactions through the discount broker, and in doing ballpoint calculations with blank paper and the financial page, I put in the time and effort necessary for the business of options. Do things right and you will have leisure time.

Long hours of hard work are often necessary but are no-guarantee of fortune. Spend 12-hours a day writing an Elizabethan-style verse-play in iambic pentameter for Broadway. See if the backers or the ticket-buyers pour forth the cash. Good business is less a matter of clock-time than of gearing oneself to the financial realities of the marketplace: What will people pay money for? Thus Getty's Third Rule--"Find oil"--can be taken symbolically as, "Have something to sell."

The word "proletariat" literally means "those having no property except their sons." In actual usage, of course, it means those having nothing to sell except their labor. The industrialist has manufactured goods to sell. The farmer, crops. The shop-owner, retail wares. The broker, stocks, bonds, futures, options. Thanks to spread strategies, options are among the few items in the strongbox that can spin off near-duplicates of themselves.

I favor option spreads because of this generating power in the "something to sell" department. Can a barrel of Getty oil create or beget another barrel of oil? If you buy an antique car, you may be able to resell it later for a nice profit. But can it spin off another antique car that you can sell on the day of your original purchase? Likewise a parcel of land, Swiss francs, gold Krugerrands--No can do.

In launching an option spread-known in brokerage terminology as "opening a position"-- I have a flagship rule: Do not go into business unless somebody else pays for more than half. Soon after the start of March 1997, I noticed something interesting about the NASD stock Vivus (stock symbol VVUS; option symbol VVQ). Although the near-in-the-money options for March expired in less than three weeks, their price was more than half that of the equivalent April's.

In opening a spread with call options, I look for a stock that is trending upwards with strong earnings and a good price/earnings ratio. With put options, the stock should be trending downward and the lousier the earnings the better. According to Barron's and the Wall Street Journal, Vivus hovered in the high 50's and low 60's from a 52-week high of 811/4 with no earnings for the previous 52-weeks and no price/earnings ratio. Stock-holder hell is put option heaven.

The gap between Vivus March 55 and April 55 puts was about a point and a half with the March trading for a little more than that. I phoned the discount broker and said I wanted to open a spread position, Vivus put options. Buy 10 with an expiration date of April and a strike price of 55. Sell 10 with an expiration date of March and a 55 strike price. With a point and a half debit. Therefore, the amount at which I would buy was open, as was the amount at which I would sell, but the differ-between them was fixed at a point and a half.

What I phoned in was a "day order" as opposed to a "good till canceled" one. Near the end of that March 5 trading day I called in and received the results. Bought 10 Vivus April 55 puts for 3-1/4 points. Sold 10 Vivus March 55 Puts for 1-3/4 points. Notice the difference or "spread" between them: The "point and a half debit" fixed when the order was entered. In dollars and cents, I bought 10 option contracts for $3,250 and sold 10 for $1,750, paying only the point and a half "spread" or $1,500 difference plus commissions.

Paying for the April 55s I bought: $1,750 from the sale of the Marches and $1,500 (plus commissions) of my own capital: More than half somebody else's money! Call it lift-the-phone capitalization. Call it a silent partner. Call it sucker money from the slot machines. What is it not? No beating the backwoods for customers. No advertising for clients or business partners or financial backers. No Initial Public Offering shares lying unsold in the desk drawer. Owning options gives you the right to create and sell options. The biggest molten gold nuggets ever to come out of the dirt could not claim as much. No 14-carat spreads.

When the 1965 New York World's Fair was in the planning stage, many feared that pickpockets would swarm to the fair ground. Instead, the fair had very little trouble with pickpockets. Police figured out why. Pickpockets would not pay the two-dollar admission fee. Too big an investment! However, one can be "stingy with capital" lawfully and smartly, like the spread strategist who routinely pays less than half the total.

With spreading, profit is usually made via time-decay. On my Vivus venture, for example, at the end of the first full trading day after the day I opened the position, the March options lost one 12th of their time value (one slice off the 12 trading days until expiration) while the April's lost only one 32nd of time value thanks to the expiration 32 trading days later. The point and a half gap or spread between the market prices of the March and April options grew to a fraction over two in a few days.

The performance was cut short when the market value of Vivus shares descended below the 55 strike price of the puts. I had to pull out to prevent an exercise of the March 55s, the "short end" or obligation end of the spread. Since in-the-money options are "assigned overnight," there would have been no problem if Vivus shares had temporarily fallen below 55 then climbed to "at or above" that figure before the end of the trading day. But as the March 13 trading day neared its close, the stock was bedding down below that line.

I phoned the broker and said, "I want to close out the position at the market." I never say "at the market" when opening a position. As already indicated, I give a specific debit amount or what-I'll-pay amount or in-the-gap amount. The way option prices fluctuate, saying "at the market" when you apply to open a position could result in your spending or investing 50 percent or more than you intended, e.g., two and a quarter or more instead of a point and a half, stacking the numerical deck against a profit. When closing out a position, however, "at the market" is fine for a quick bail-out. I netted $784.71 after commissions, just over 50% profit in six trading days.

Mention deserves to be made of the availability of both puts and calls, enabling the option trader to play a stock's rise or fall with equal ease. It has always been possible to profit from the decline of share prices by selling short. Yet this has perennial disadvantages, both financial and psychological. For the long-player of stocks, the potential loss is limited since share prices cannot fall below zero, but for the short-seller no barrier exists on the upside. With Vivus I could have lost the optioned $1,500, but no more than that. The play-the-downside ghosts still wail in vast numbers over Resorts International's shooting star, also called the short-seller Alamo.

The psychological drawback may be viewed either seriously or lightheartedly, with me preferring the latter. Short-selling has long been regarded as the investment ghetto, if not the villainous cabal, the 5 percent who bet on stocks to go down while everybody else roots for them to rise. One investment book contains a chapter entitled, "It's Not Immoral To Sell Short." The author actually felt it necessary to explain that the practice is not exactly like mugging a grandmother.

A smattering of the stigma has spilled into put option trading, less than a lot but more than zero. In a July share-slide I took profit on an IBM put spread just before the stock rebounded. (I had relaxed my rule against spreading puts under a company strong in earnings and fundamentals. The result was a profitable close shave.) A young woman stockbroker said to me only half teasingly, "You played IBM to go down? You had better pull down your shade before you break out the champagne and celebrate."

I have amply used both calls and puts, with both delivering mostly profits but the latter delivering the irony. Around New Year 1996, the commentator on the financial cable channel lamented that 1995 had been a dismal year for investors. I had done well thanks to put spreads under Latin American shares and other stocks. Ah, the forbidden zest of hearing a joyful song in your head while they play mournful music.

In recent weeks, a female financial analyst on TV practically wept over NASD tech stocks. My Ascend Communications put strategy could have dried a few tears. In trading and finance, every sorrow is a joy to somebody else, and vice versa. The pursuit of joy includes switching sides occasionally. When a stock price decays and the right options are there to meet it, I can understand Washington Irving writing about "something pleasant and touching in its very decay."

Why are we treading the worn stones beneath the chiseled traceries of Westminster Abbey? Because I still insist on traders and investors being Renaissance men and women. You have a better chance of staying out of those Cash For Gold shops if your heart strolls the colonnades and courtyards of Europe in the 1500s. Notwithstanding his fondness for British places including abbeys, novelist Henry James (1843-1916) made 14 trips to Italy during his lifetime and made some noteworthy observations.

What he saw included Venice of the late 1800's as described by John Addington Symonds in Sketches and Studies in Italy and Greece: "We carry away with us the memory of sunsets emblazoned in gold and crimson upon cloud and water; of violet domes and bell-towers etched against the orange of a western sky; of moonlight slivering breeze-rippled breadths of liquid blue; of distant islands shimmering in sun-lighten haze; of music and black gliding boats; of labyrinthine darkness made for mysteries of love and crime; of statue-fretted palace fronts; of brazen clangour and a moving crowd; of pictures by earth's proudest painters cased in gold on walls of council chambers where Venice sat enthroned a queen."

Yea, Venice has always brought out authors' penchants for descriptive writing. With artists, a key vision of more than one was to personify the city as an enthroned sea-queen receiving offerings of pearls from Neptune and the Tritons. Tintoretto and Veronese both painted huge ceiling art on this theme surrounded by gold ovals in the Ducal Palace. In Italian Hours, Henry James wrote of the Ducal Palace, "The reflected sunshine plays up through the great windows from the glittering lagoon and shimmers and twinkles over gilded walls and ceilings. All the history of Venice, all its splendid stately past, glows around you in a strong sea-light.

"Every artist here is magnificent, but the great Veronese is the most magnificent of all. He swims before you in a silver cloud; he thrones in an eternal morning. The deep blue sky burns behind him, streaked across with milky bars; the white colonnades sustain the richest canopies, under which the first gentlemen and ladies of the world both render homage and receive it. Their glorious garments rustle in the air of the sea and their sun-lighted faces are the very complexion of Venice . . . "Veronese revels in the gold-framed ovals of the ceilings, multiplies himself there with the fluttering movement of an embroidered banner that tosses itself into the blue . . . The mixture of flowers and gems and brocade, of blooming flesh and shining sea and waving groves, of youth, health, movement, desire--all this is the brightest vision that ever descended upon the soul of a painter."

Florentine Renaissance artists were stand-outs in form, Venetians in color. Influencing the latter, earlier Byzantine art and Gothic art counts as two factors, a third the visual splendor of the city and surroundings, celebrated by Symonds as "that melodrama of flame and gold and rose and orange and azure, which the skies and lagoons of Venice yield almost daily to the eyes."

Yet rich colors and shimmering sea-light could sometimes be omitted. In the Church of San Giorgia Maggiore, Tintoretto painted a dusky "Last Supper" which John Ruskin described "We are reminded that the subject is a sacred one, not only by the strong light shining from the head of Christ, but because the smoke of the lamp which hangs over the table turns, as it rises, into a multitude of angels, all painted in gray, the color of the smoke; and so writhed and twisted together that the eye hardly at first distinguishes them from the vapor out of which they are formed.

"The picture has been grievously injured, but still shows the miracle of skill in the expression of candlelight mixed with twilight; variously reflected rays, and halftones of the dimly lighted chamber, mingled with the beams of the lantern and those from the head of Christ, flashing upon the metal and glass upon the table, and under it along the floor, and dying away into the recesses of the room." (From The Stones of Venice)

The eye that can appreciate such detail is markedly less likely to overlook the details inherent in stocks, futures, or options. Henry James wrote of Venetian "masters, who form part of your life while you are there, who illuminate your view of the universe." Your view of the universe includes investments and speculations. These are tough enough without the disadvantage of Norman Arial as "illumination," a light at the pyramid base!

So when you send a wire, do not wire for emergency money but for Venetian lace, glassware or gems. Also, if you should need a pawnbroker or a bail bondsman, be sure to find one capable of discussing paintings of "violet domes and bell-towers etched against the orange of a western sky" and "blooming flesh and shining sea and waving groves."


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