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:
Treasure, Swamp Gas & Phone Monsters
A bit of Yiddish folklore from the Old World: A neighbor knocked on the door and asked to borrow a tin spoon. The next day he returned two tin spoons. "Why two?" the lender asked. "The one that you loaned me was pregnant and gave birth during the night. So I am returning both parent and offspring."
A madman or a fool, the lender thought. Nevertheless, he accepted both. The next day, the borrower showed up again and asked for the loan of two expensive silver candlesticks. The way this man's mind works, pondered the candlesticks' owner, tomorrow he will bring me four of these expensive silver pieces. So he gladly loaned them.
The next day, the borrower did not bring back the items, nor the next day or next. Angrily the owner went to his neighbor's house and demanded their return. "They died during the night," the borrower explained. "Ridiculous, fool! How is it possible for candlesticks to die?" "Simple," replied the borrower. "If you believed that spoons can birth and you accepted them, then it is also possible for candlesticks to die. May they rest undisturbed."
Another old story from the Philadelphia men's wear trade: A man enters a shop and asks to buy a suit. The haberdasher responds, "You shall have the finest custom-tailored suit. First we bring in an entourage and they take your measurements, then your measurements are flown to England. Then we phone Turkey and order them to shear fine fur from the Angora goats. The wool is flown to a French weaving mill where it is woven into the best mohair. Then the cloth is flown to England where it is custom-tailored into a masterpiece of a suit based on your measurements. Then that gem of a suit is flown here."
"But you don't understand!" the customer protests. "I need this suit by tomorrow evening."
The men's wear-dealer replies, "Don't worry. You'll get it."
An old Irish joke: At the end of the work-week, Clancy opens his pay envelope and finds it $10 short. He complains to the foreman who says, "Your pay envelope last week was $10 over, but you didn't complain about that." Clancy retorts, "Well, anybody can make one mistake, but two in a row is intolerable."
A slice of New England history: Author and philosopher Henry David Thoreau was also a surveyor. He would explain to a client about there being more than one method of surveying. Inevitably the first question was not, "Which is most accurate?" but "Which will get me the most land?"
Incident in a barber shop: Angelo put down his scissors for a moment and said, "Hey, Mike. Look at this thing I bought." He held up a hardback volume entitled Winning Big in the Casinos. The customer in the chair reacted, "Angelo, you know why the guy wrote that book? To get back the money he lost."
From the newspapers: Dear Abby in her advice column quoted some story or explanation she did not believe, then added her own remark, "If you can buy that, I have some swampland in Louisiana to sell you." She was deluged with letters from readers wanting to invest in the Louisiana swampland. Even though it existed only in her wisecrack.
The desire and effort to cadge profits may be less universal than breathing, but only slightly. With the variety of forms that these take come the variety of risks and unknown factors, and always there are risks and unknown factors. So if one's taxi is to stop at the bank and not the bankruptcy court, the questions must be addressed: Do you know the risks and unknown factors in your particular hunting copse? Can you spot and deal with them?
Everybody says yes, and yet! One need not know quantum physics and differential calculus to trade successfully. Yet one must grasp the intricacies relevant to the hunt. The fact that each speculator is in effect a one-person business carries a hazard: It is nice to be your own boss but dangerous to mark your own test papers and keep giving yourself a hundred. That is precisely what many traders do on the matter of "grasping the intricacies," of gauging the risks and unknowns.
Nobody thinks himself a moron or a borderline-incompetent, but the high casualty rate in the financial trenches casts ample doubt on all those "I can't lose!" self-evaluators. The roulette-player with the "can't miss" system never seems to ponder why the world does not swarm with people who got rich doing what "can't miss." He knows that a casino has millions of dollars in expenses and yet he feels certain that it will not come out of his pocket. Clancy could believe in a magic pay envelope that would add a sawbuck to his wage but not in accountants who would have to make things balance out. Many traders on the stock exchanges and futures exchanges and options exchanges similarly "believe in magic" and appear just plain blind to the realities of the accounting ledger.
Those farther up the mental ladder can also stumble. The Yiddishman was a thinker and had tin-spoon evidence to support his theory. Yet he trusted his valuables to a man whom he labeled either a madman or a fool (the possibility of "cunning swindler" apparently did not occur to him). He expected this odd-ball to deliver repeated profits of 800 overnight with the dependability of the Bank of England.
It is possible to profit off of a madman, but not as a steady income. A psychotic may think himself John D. Rockefeller and pay you a philanthropic donation, then think himself Jack the Ripper tomorrow. Then again, there may be a method to the supposed madness. A fox guards your tool shed without pay "just to be nice," then volunteers to guard your henhouse. Did you see the scam coming when the borrower sacrificed a tin spoon and then asked for a loan of expensive silver? Too many traders win some tin and then expect the market to pour silver into their laps, quickly and effortlessly and repeatedly -- yes, very repeatedly. There just ain't enough sterlingware for everybody who wants or expects this.
What was your take on the haberdashery store episode? It is the kind of gag in which much of the audience does not "get the joke" or "gets it" in a way entirely different from the next person. A person of theoretical or fanciful thought may assume that the joke takes place in a surrealistic world where super speed is a humorous hypothetical. Someone more alert to the seamy side of the real world would say, "The suit's coming off the rack. That men's wear merchant is palming off the hard-to-get-rid-of stuff from the back room." The latter would make a more capable trader.
Speculation -- anything involving financial risk -- is a poker game in which one of your opponents plays honestly, another plays honestly and smartly, another cheats and still another tries to pick your pocket. However, it works to your advantage that the rogue's repertoire is usually not lengthy. Did you ever read the "Business Opportunities" classified in any newspaper? So why does the seller want to get rid of the business if it is the Fort Knox that he alleges? "Selling due to illness" or "'Owner retiring" or "Partners disagree" or "Owner has other interests." As repetitious as "The dog at my homework."
Yet plenty of adults believe it as though it were the government's guarantee of bank interest and principle. To add a teardrop, the gullibility extends to stocks, futures and options. You can make steady profits if you are well-versed regarding both the natural hazards and the banditry. Counterfeit gilt-edge stock certificates sold door-to-door a century ago have disappeared but the de Mille-sized crowd scenes in the bankruptcy courts have not. According to the Wall Street Journal (8/8/98):
"Securities regulators from four states have acted to shut down what they called a nationwide network of "boiler room" sales offices promising investors big returns from the currency turmoil caused by the Asia crisis.
". . . Nine employees of Options Trading Group Inc. were arrested July 30 based on warrants issued in Idaho, where some of the steepest investor losses occurred, according to state regulators in Texas and Ohio.
"Options Trading and its employees stand accused of cheating roughly 1,000 investors out of many millions of dollars. State officials allege that the company used high-pressure sales techniques and high transaction fees to exploit headlines about currency turmoil in Asia, and convinced these investors that there was money to be made on futures options for Yen, Marks and Swiss francs."
Boiler rooms. High-pressure telephone sales. With many firms the patsy answering the phone is a retiree or other person on a limited income. How many even heard of futures or options before the hawker mentions them? How many of that small percentage have a relevant book or two on the shelf? Talk about infinitesimal numbers! Obligatorily under law they hear that risk exists and losses occur. But does anybody inform them that the financial survival rate is somewhere between gladiators and Alamo defenders? "I need those profits by early next month." "Don't worry. You'll get 'em."
As an option spread strategist, I suppose my laments could be compared to those of an undertaker trying to look sad at a spare-no-expense funeral. The "fat" that gets "burned off" in a spread is other people's hard-earned capital. The "armor" that gets "shot up" protecting my capital is other folks' money. A spreader's profits are those of a bookmaker, a bankruptcy lawyer, a coffin-maker. A boiler room huckster is a recruiter who says to Grandpa Gus, "Here's a submachine gun. Tomorrow's the battle. Win medals. That there is the trigger. It's real easy." Although I pocket a dead man's gold, I still prefer to keep grandpops and picnickers out of the Verdun trenches. A well-trained gun hand has a chance. A "Fortune awaits you!" phone-call-receiving Vanderbilt does not.
Let us not blame everything on the novice. Few activities other than trading are so crowded with financially-scarred veterans who get caught in the same ambushes again and again. One relative of mine -- now a retired professional musician--was wiped out completely three times in his life. The cause? Heavy use of margin in buying of stocks. Everybody knows on day one that margin can double the bad news as well as the good, but it took three massacres to make him "feel the significance" way down deep. Like speculators in many categories he lived on the hope of a turn-around until the pealing of the monetary funeral bells.
It happened to him with stock shares over a period of about two decades. The teardrops would have come in quicker succession had his "thing" been options or futures. In what other pastime does the dollar-amount of the bait so often exceed that of the trout? Even with anglers who have been at it for years. "Pastime"? An old adage states "When a habit starts to cost money, it is called a hobby." Is your trading a habit, a hobby, a gamble, a business?
Everybody likes to think of his speculations as a "business" because nobody likes to think of himself as a player of government-approved three shell games or an on-the-charts model plane flyer going over budget. At the fantasy-level, trading confuses too easily with the conquest of Everest, the capture of Geronimo, the discovery of the Star of India Sapphire. It needs more business kinship with a furniture dealer, a camera shop, an actual jewelry enterprise. If you know your small gems and carats and financial details, you may get a chance to bid on the Hope Diamond. If you expect to swell $1,000 into $1,000,000 rapidly via some marked-deck techniques applied to the Exchanges, such is the barstool angler at it for years; a string of emptied bank accounts.
Regarding the financial details: Let us assume that you have a 50-50-chance of doubling your money, whether poker or roulette, stocks or options or futures. This means you have one chance in four of doing it twice in a row, one chance in eight of three consecutive bull's eyes, one in 16 of four, and so on. $1,000 has to double only 10 times to become $1,000,000. So how come the world does not swarm with millionaires who began with a grand? The odds against 10 such hits in a row are one in 1,000. Half of those who began won once, half the winners got eliminated when they tried to repeat it, half the surviving quarter got chopped on the third attempt, and so it goes. Needed is more business, less repeat coin-toss, especially for those who expect to be at it for any length of time.
Regarding the mental approach: The basic purpose -- being in business for a profit -- is too easily consigned to a back burner if not the wastebasket in the thinking of many speculators. In recent issues of CTCN, J. L. from Wimauma wrote, "It ain't the money" and he stressed the feeling of "Accomplishment" with a capital "A" as "the source of all human pleasure." Although I read J. L. as avidly as theater-goers used to go see John Barrymore, on that particular point I wish to take a diametrically opposing stand. Traders should be "in it for the money."
Traders should be "in it for the money" because the most widespread alternative is so dangerous: Being in it for the entertainment -- the thrill, the suspense, the fascination. Those relishing fascination or thrill simply tolerate too greatly the holes that speculation shoots in their wallets, month after month and year after year. The example worth repeating: The horse-player who has been losing for years but who cherishes the excitement of post time. Had he banked those chunks of gambling money he could hire a limousine on the interest. But the gradual accumulation of interest does not electrify and jazz up his nervous system like the horses rounding the far turn. Myriads of his counterparts react likewise to the buzz of the Exchanges. This is business?
Years ago in pre-casino Atlantic City, my parents had as neighbors a retired cab driver and his wife. The fellow whom I shall call Sam was continually rah-rah about the stock market. If an acquaintance approached him on the street and asked him about stocks, Sam would pull papers from his shirt pocket and read off data. He reveled in armchair gabs about shares and their performances. Once as he talked in my parents' parlor about his buys and sells, my father asked him, "Sam, what's your over-all outcome been in recent years? With so many thousand here and so many there, what's the over-all tally? Gain or loss, a ballpark figure."
Sam replied, "Broke even." Breaking even is a kind of loss, my father thought, since certificates of deposit or a money market would have brought several percent gain. Another time, Sam's wife walked in from the kitchen where she had been chatting with my mother and said to him, "When I hear you talk about the market, it makes me sick!" Subsequently she said during a private conversation that, far from breaking even, he took beating after beating. Hearing him gab on about investments griped her because a hefty part of what he lost was her money.
Yet I had to admit that Sam was happy and entertained, as much as any sports fisherman rhapsodizing about sunrise over the lake or the large-mouth bass that put up a fight. The trouble is, securities investing costs far more than bait and tackle. Dictionaries define a "fish story" as "a lie or exaggerated tale." Claiming that he "broke even" may be the trader's perennial fish story. Sam and his wife would have suffered far less financially had his enthusiasm been about chess or backyard telescope astronomy or Indian arrowheads or Joe Miller's Jests or lighthouse lithographs or Damon Runyon Era sports legend. Speculation can be a sound business but use it as a win-the-prize funhouse and you can lose the United States Mint.
Again we arrive at the hazards of self-evaluation, the tendency to mark one's own test papers and declare oneself a Rhodes Scholar. Everybody says, "I'm a scientific trader but he's a crap-shooter. I'm the Andrew Mellon of my specialty but he's Charley Horseplayer." You mark more accurately if you remember the past. Keep in mind: If it were possible to make money consistently that way, somebody would have done it. People made money consistently mining for nuggets and sailing a Spanish galleon to the Spice Islands, wholesaling or retailing sporting goods or plumbing fixtures. But the slot machine or keno player or Exchange coin-tosser on a big budget?
A Grand Canyon of a gap lies between taking a profit and taking it consistently, and what winner does not cherish another go at it? You know the racial slur that means temporary prosperity accompanied by big spending. The terminology would be fairer if "nigger rich" were "honky in a horse-parlor rich" or "necktie whitey with a broker dares it all rich." Temporary prosperity. A 50-50 chance of gaining once, one chance in four of twice, one in eight of three times, with a Russian roulette exposure of capital on each venture and 15 of 16 chambers loaded on the fourth try. Would it be unfair to the red man to call this a tomahawks-&-scalps mathematical progression? "I broke even" conceals a multitude of tears.
This does not appear to register in the thinking of the trader who expects to multiply his capital again and again, and with seven-game series rapidity. Knowing that it has been tried plenty of times before, he does not pause to wonder why similar thoughts and attempts in the past did not spill forth plethoras of millionaires, why the files of high-turnover brokers are crammed with no-longer-actives instead of Andrew Carnegies.
Psychologically, we all have a certain satisfaction with and even a fondness for the way our minds work. When you are out driving, anybody who drives faster than you is a "speed demon" and anybody slower is "overly cautious." What is an over-sexed person? Anybody who wants it one time more than you do. What is a glutton? Anybody who wants another dinner helping after you feel full. Just about everybody admits he is less than perfect but that does not prevent just about everybody from using Nice Guy Me as a measuring stick for the world. Practically everybody from the real Einstein to his alleged "reincarnation" in the psychiatric hospital thinks
that way. Often this is harmless but in the realm of speculation, many shot-up bank accounts are what sledge-hammer the way to a trader's second thoughts about how his mind works.
Years ago, I made a beginner's luck bundle buying and selling call options during the boom in Atlantic City casino stocks. Calls with gambling shares underlying yielded profit upon profit. Trouble came when I tried to repeat my success with other underlying stocks. I thought that "playing long" or buying put & call options to re-sell would be my life's occupation. Fortunately, it took just a couple of quick gunshot wounds to make me realize that I was pursuing profits contra mathematical "odds against" that took no prisoners. I detoured into (a) "writing covered calls" or selling call options on good stocks that I owned, and (b) horizontal calendar spreads. Since then my trading life has been not one of pure gains but one of a bookmaker favored by the odds. That solid, practical "plus" showed itself plenty over the long haul.
The time of this writing -- September 1993-2014 -- stands as a gloomy one for Dow watchers and investors, with the stock market having lost most of its past year's record gains. My most recent option spread position closed with a minus, yet my crying towel remains dry thanks to the success of prior trades. Also the recent losing trade served to test a couple of strong points of my methodology and they tested well. Less philosophical than some, I prefer a profit rather than "a loss with lessons attached," but a minus that can instruct serves at least some purpose. I shall not tell that white lie worn to dingy gray about "breaking even."
The much-publicized Viagra potency drug had me looking at the Pfizer Company's shares and options. In early July, there was too much price gap between Pfizer's August and September options. My attention turned to another pharmaceutical company, Bergen Brunswig, which had a near-conservative P/E and received some publicity due to Cardinal Healthways' intention of buying it. The latter also placed some upward nudges on the stock price which fluctuated near 50. The August 55 call options and the September 55s gaped at only about 7/8 of a point from each other, 3½ to 43/8.
I entered an order with the broker to buy 10 September 55s and sell 10 August 55s at a 7/8 point difference or spread. Nothing done. The next day I phoned in the same order but with a full one-point difference. I bought 10 Septembers for $4,500 and sold 10 Augusts at $3,500, a spread of a point or $1,000 plus commissions out of my capital. One item that makes spreading perennially attractive is the sorcery of other people's money, with the August buyer paying 3½ times more than I, financing most of my Septembers, and the non-spreading September buyers paying 4½ times more than I for comparable options. Another item has to be other people absorbing most of the risk, a crucial sea wall in this case.
News that the federal courts might permit the Cardinal Healthways/Bergen Brunswig merger boosted the latter's stock to above 60 points, placing my short-end August options more than 5-points into the money, bad news for a short position. However, I anticipated that this was just a temporary spurt and such news could not come every day. The next day, the share price fell to the low 50s, putting my Augusts a few comfortable points out of the money.
In August the worst happened. A federal judge nixed the merger on anti-trust grounds. Bergen Brunswig shares fell to the low 40s and then the high 30s, shrinking the call options with 55 strike prices and shrinking the accompanying price gap between months. To make a weeks-long story short, I lost over half my $1,000-plus-commissions investment. Is there an instructional bright side? A couple. Those who paid $3,500 for the Augusts lost between $3,000 and $3,500 depending on whether they sold right after the court decision or waited until expiration hoping turn-around. The non-spreaders who paid $4,500 for the Septembers lost varying amounts over $3,500 depending on when after the judgment they sold. Thankfully the spreader -- the brigade in the middle -- suffers the lightest casualties while the long players on the left and right flanks catch the most gunfire.
A second bright side: This happened at a point in my evolution when I was demanding narrower and narrower opening spreads. I am, ashamed to admit that a couple of years ago I would have tolerated a two-point gap at the start, jeopardizing two grand plus commissions of my own capital instead of just one. Losing over half of $1,000 is certainly not as bad as losing over two-thirds of $1,500 or more than three-quarters of $2,000. Half-price at the entrance gate is half the battle. Less cargo on a ship reduces the risk, as does letting surrounding ships catch the torpedoes. You would like to see everybody reach prosperity port but everybody will not. Brokers' statistics say most of the fleet will sink.
Since I am not too philosophical about "bright sides" on losing trades, I would not mention a third such side unless it were really vital. An Iron-Clad Rule: Limit your loss or your exposure to loss. In my particular strategy this translates as: Risk one but do not risk a second until the first starts bearing fruit. In the previous issue of CTCN, I described a spread in call options of Mellon Bank. Once that moved into plus territory and a closing out of that position was in sight, then and only then did I launch the Bergen Brunswig position.
My plan was to consider launching another spread if and only if the Bergen Brunswig one moved solidly and markedly into plus territory. Twas not to be. That proved an effective warning sign. The sight of Bergen B taking on water signaled me not to send another ship into the channel. After I closed that one out, the end of that trading day found me with no other spread positions. As typhoon and tidal wave of the collapsing market raged upon the water, I had no crafts vulnerable. Brunswig proved a bad investment but a good warning light, especially for a one-at-a-time, limit-your-risk trader.
I recently began communicating by phone and Fax with people who write to me. The biggest difficulty I find is in persuading traders or soon-to-be ones to limit their risk or their exposure to loss. A happy medium is possible between the I-can-never-win pessimist and the boxer so optimistic he thinks his opponent will throw no punches. While too many speculators bunch up around the latter, good business locates itself attitudinally in between. A fine business rule: Hope for the best and prepare for the worst. An alert clothier buys wear popular with teenagers but limits his purchase because he knows the fad may die suddenly. Most of an option spreader's ships cross safely and deliver a profit but this one may sink or partially lose cargo.
Each trader likes to think himself the businessperson, the inner office that walks, and regard others as the chips-on-green-felt players. Everyone likes to think of his wallet as "the smart money" and others' as "the sucker money." Remember that smart cash is limit-the-risk cash. It could grow diamonds or it could vanish in the swamp gas. The check-writer needs to figure this and keep the amount as small as is practical.
A Wall Street Journal article (September 22, 1993-2014) bore the title 'In the Field of Investing, Self-Confidence Can Sometimes Come Back to Haunt You." Writer Jonathan Clemens quoted finance professor Steven Thorley of the Marriott School of Management at Brigham Young University in Utah: "A positive mental attitude, optimism and self-confidence are good attributes. But in the financial world, they just don't work. You're not interacting with people. You're interacting with prices. They don't care how you feel that day. In general, over-confidence is a negative." Such over-confidence could describe the player, whether sugarfoot or gladiatorial, who envisions dollar-multiplications and vast fortunes, soon too, ere the bonded bottle of shots needs replacing.
He is not ignorant of the 10-mile financial graveyard haunted by vast numbers of souls who used to hold similar visions. Still he anticipates that the next shovel-full of earth will uncover Captain Kidd's treasure. Viewing trading as a business means thinking in terms of a wholesale shipment of Samsonite luggage and not long-lost Spanish doubloons; rum & molasses merchanting rather than free-booting or treasure-hunting. Boy pirates of the Exchanges expect quick fortunes, get quick spankings.
One does not write about finance for any length of time without entering the sphere of psychology, of "why people do" this or that. In high school, I did amateur magic in the student variety show. During school hours, one or another fellow student would see me reading a non-curriculum booklet or catch a glimpse of one in my loose-leaf notebook--a "magician's methods' pamphlet or a "humor for stage" patter piece--and would insistently want to look at it. I learned something: After a minute and a half of riding a bus, standing in line, or sitting in a cafeteria or study hall, people crave entertainment. Anything that can amuse is psychological sparks & tinder, even trivially or momentarily.
On important matters, if trading or investing is the most interesting thing in people's lives, it often becomes a stage show and profits get secondary status. "Secondary" usually means tossed in the wastebasket. For example, everybody is against cheating, everybody from athletes to gamblers. Nobody writes a doctrine or makes a speech in favor of cheating. Yet many athletes and gamblers have an even stronger dislike of losing. They cheat because in their mental hierarchies, dislike for cheating ranks second to dislike for losing. Among mind priorities, with desires competing against each other and numerous aversions jockeying for first place, second place means out-of-the-money and off the edge of the earth.
When trading is the most interesting thing in a person's life, it strains under triple duty, serving as a liven-things-up variety show and a sports event that you root for from the stands and a novel with a Byzantine plot difficult to put down. Business and profits can become second stringers where only the first string gets on the playing field. Let "Ain't We Got Fun?" Sam in Atlantic City serve as an object lesson. It is the psychological lock on the strongbox that the trader have other interests, and not just mild ones.
Contrarily, I believe that those with at least some claim to being Renaissance Men and Women make the best traders as well as the best critics. Mention has already been made of using the stock market as a fascination-fixating, get-wrapped-up-in substitute for chess or sports fishing or astronomy et cetera. It would help if the active-as-a-checker-player investor were fascinated by a few other things. Also, the accomplished pianist who studies Egyptology could add a percent to his already fine grasp of intricacies. Judging from speculator loss reports, plenty of traders have far more need of that percent. To those who claim that Italian Renaissance art has no relevance to modern finance, I still insist that people who appreciate the brush-strokes and the use of light and color by Correggio or Giordano are less likely to handle trading like sports betting. Let the spill-over be off the canvas and not Rose Bowl point-spread sheet.