Mike

We’re not talking Bikinis, we mean highs and lows.  Not as in buy low-sell high, but as in trends and chart patterns.

A stock industry maxim reads, “The public is right in the middle, but wrong on the ends.”  Spelled out, many fortunes will be lost by buying when one should ultimately be selling, or by selling when one should buy.

Many analysts try to predict tops and bottoms with price targets.  Their predictions may pan out with amazing accuracy.  Some well-followed analysts’ predictions become self-fulfilling prophecies.

Have you ever bought a stock at the bottom?  Or better still, sold at the top?  How did you know at the time it was one of the extremes?  Luck or genius?  If someone bought at the bottom, then someone sold to them.  For every seller at the top, there was an unlucky buyer.  Have you ever been on the wrong side of a transaction at either end?  Misfortune or ignorance?

Buying near the bottom is easier than selling at the top.  An absolute bottom exists, zero.  The ultimate top is unknown.  Theoretically a stock could trade to infinity.  Although I’ve never seen infinity on a chart.

Honestly, you could sell at the top.  As an example; selling into a merger or takeover.  When a company tries to take over another company, they have to pay above the then current market price to motivate shareholders to approve the sale.  If they don’t offer enough, they don’t get the votes.  Typically, a buy out offer will be the highest price in a specific time period.  Creating a top.

Some people trade blindly, others with blinders on, still others just need a different pair of glasses.  If you look at things in a different light, you should become better traders.

An old adage claims, “He who defines the terms, wins the argument.”  So don’t send me an e-mail disagreeing.  Some of this will be completely new.

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No one can buy bottoms or sell tops.  Transactions require two parties, buyers and sellers.  There has to be someone on the other side of a trade.  Without a willing seller, a buyer keeps his money.  Without a buyer, no sale takes place.  Tops and bottoms have only one willing party.

Commonly known as the bottom, it should truly be known as the lowest price.  The highest price is not the top, but just the highest price.  Bottoms are lows that don’t go lower.  Tops are highs that don’t trade higher.  They can only be confirmed after the fact.  Not during or before, but after.

Prices decline because of concentrated selling with scattered buying.  Translated, more sellers than buyers.  Prices fall with lower sellers; a rush to the exit.  To fall further it needs a seller at a lower price.  If a seller at a lower price doesn’t exist, the decline will stop.  Even with ready and willing buyers, no transaction will take place without sellers. The absence of sellers indicates the bottom, a theoretical point just after the lowest price.

Until prices increase a bottom hasn’t been made, only a new low.  The price may stay flat, forming a solid bottom to rise from.  Only after the prices rise can one look back and see the bottom.  It must turn back upward.

Trying to buy a bottom is like “trying to catch a falling knife”.  More often than not, you’ll injure yourself.  Often a stock that you thought was trading near a bottom will fall even further.  Stocks bottom out when there is no one left to sell any lower.  You will be a better trader if you let the stock turn to the upside before buying.  Don’t get greedy.

The opposite extreme to the bottom is the top.  If prices decline because of selling pressure, then prices rise due to buying pressure.  Concentrated buying with scattered selling, more buyers than sellers.  A high is only a high until replaced with a new higher high.  A high becomes a top after it peaks and turns down.  A top is the absence of buyers.  No one to pay more.  Without buyers, sellers can not trade.

You may trade at the ultimate extremes in price, but you can not trade at the tops or bottoms.  There’s no one to take the opposite side.  If you traded at the extremes it’s not because of genius or stupidity, it’s because of luck.  Good or bad.  The good news is, you can create luck with knowledge and technical analysis.

All investments have risk.  Real estate, stocks, and mutual funds have risk, and of course options have risk.  But have you ever considered the risk of cash?  Not the risk of someone breaking into your house and stealing the money under your mattress, but the risk your money in the bank doesn’t retain buying power.

This week we’ll discuss option trading accounts and how brokerages look at them.  If you lack an option trading account, knowing almost everything about them won’t help you make any money.  This will not be a recommendation to any specific broker or brokerage.  Its an individual decision, like picking a favorite flavor of ice cream, my favorite flavor shouldn’t be yours, no matter how much I know about ice cream.

You shouldn’t chose a broker by low commission rates, but the trading authority they will allow.  If you have a more complicated or “more risky” strategy that consistently has made money in the past and your broker won’t let you trade it, you need a new broker.  In defense of the broker, if you’re consistently betting the milk money on “long shot losers”, he doesn’t need the risk of a lawsuit for allowing you to speculate away your grocery money.  Don’t laugh, brokers get sued all the time.  Good brokers don’t want the label of a churn and burner, using tactics making more commissions than profits.  Brokerage won’t allow everyone shovels to dig themselves holes they can’t get out.

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By reading these articles, many of you will know more about options than your broker.  If they won’t allow you to trade strategies they don’t understand, no matter how much you understand, consider changing.

Different brokerage firms might have different rules and requirements, but this is as close to industry standard as it gets.  There are five levels of option trading authority.  These levels are based on risk and complications.  Risk to you the trader, but more important the perceived risk to the broker.  Some strategies are complicated, both to the investor and the broker.

The five levels are:

Level One; selling covered calls.
Level Two; buying puts and calls.
Level Three; spreads.
Level Four; selling uncovered (naked) puts.
Level Five; selling uncovered (naked) calls.

Options are a contract between two parties.  The buyer has rights, the seller has obligations.  Call options give the buyer the right to buy a stock at a predetermined price (the strike price) within a predetermined time period (the expiration date).  The seller, also known as the writer, is obligated to deliver the stock if the buyer exercises his right.

Most investors should easily attain Level One trading authority. Considered so safe a strategy, the IRS allows it in IRA accounts.  When a investor owns stock, he may sell a call, giving the buyer the right to purchase the stock.  The brokerage liens the stock, they won’t allow you to dispose of it since it guarantees your ability to perform your part of the contract.  Think of it this way, the broker is covered.  The chain of events flows.  If the call buyer exercises his right, the broker doesn’t have to contact you.  The stock is sold automatically.  The broker takes it out of your account, and puts in money.  If the call buyer doesn’t exercise his rights before the call expires, the lien disappears.  You’re free to sell the stock, or another covered call.  Pretty safe, pretty simple.  Covered calls have two risks, both related to market fluctuations.  First, like owning stock, you run the risk of the stock price declining.  You also run the risk of not participating if the stock makes a major upward move.

Level Two is buying options.  The option purchaser pays the option premium hoping for a favorable move in the underlying stock.  The investor actually speculates the value of the option will rise.  It’s not a complicated scenario, try to buy low, sell high.  Buying options is less complex and less commission intensive than covered calls.  The pitfall requires risking entire amount ventured.  If an option runs out of time and has no intrinsic value then it’s worthless.  Zip, Zero!  Because of the possibility of total loss, not everyone will be allowed Level Two authority.  Not difficult to get, but with few exceptions not allowed in retirement accounts.  The determining factor generally is account size.  It’s the grocery money issue.

Levels Three through Five require a margin account.

Level Three:  spreads.  In my opinion, the least risky, but most complex of all transactions.  A brief explanation; a spread is a position with two or more components.  Simultaneously buying or selling two different options changes the risk/reward curve.  Spreads can have predetermined risk with predetermined reward, but done right, unlimited possibility!  My attempt, this week, is not to teach spreads, but to help you know about setting up your account.  I would encourage all option investors to have spread writing authorization.  Make it a goal.  If you don’t have it set up, find out what it takes for approval.  Be aware, many brokerages require one year prior account activity before okaying spreads.  If your broker demands more time than your account has been open don’t fret, you’ll be given the tools to profitable trade until such time.

Level Four, selling uncovered (naked) puts.  Think of it this way, the seller acts as the insurance company, the buyer is the policy holder, the put sold the policy, the strike price equals policy value, and the option premium collected the insurance premium.  The policy states that if on or before expiration the stock price is below the strike price, the policy holder may sell the stock at policy value, regardless the actual market value.  The put seller obligates himself to buy the stock no matter how low the price drops.

A funny thing about Level Four naked puts, without margin, the risks are identical to Level One covered calls.  Think about it, in both, if the stock price is above the strike price the option seller won’t own the stock.  If the stock price is below the strike price, the covered call writer keeps his stock; the naked put writer is obligated to buy the stock.  The reality is naked puts have lower margin requirements, and therefore higher leveraged potential returns.  Everybody knows with higher rewards, there must be higher risk.  I like naked put selling, but I feel the same high returns are available, with less danger with put spreads (Level Three).

Level Five, selling uncovered (naked) calls.  Only money guarantees your ability to deliver the stock, and it takes a lot!  Technically this strategy has unlimited risk.  The sky is the limit.  The seller is obligated to deliver stock he doesn’t own.  Unless you have a lot of experience and a ton of money, your broker won’t allow you to sell naked calls.  Don’t ask.  The bright side is, I only know one circumstance worth considering using Level Five authority.  If you have a calendar spread on expiration Friday, with the short option out of the money, consider selling the next month’s call without waiting until the following Monday.  You won’t lose two days of time decay nor have unknown market exposure.  You’re entering into a new spread without closing the old one.

Often out of the money options have too much value on the ask side on expiration day.  Market makers know most option traders can’t sell uncovered options, and to keep a spread hedged over the weekend following expiration Friday, option traders need to buy back their short position to close.  Hence, they overcharge for them.  Market makers are not stupid.

If you can’t understand this situation, don’t worry, you don’t want Level Five authority, nor will your broker approve.

The New York Stock Exchange (NYSE) matches buyers and sellers of stocks.  An auction system, high buy and low sell being matched by Specialists.  Trades taking place when the two agree on price, one coming to the other.

Market orders mean agreeing to the best price at that moment in time.  The moment in time the Specialist gets the order, not the moment in time it was placed.  Market orders are a truly scary thought.  I’ve heard countless stories dealing with market orders, all of them horror stories!

An orderly market requires a relatively equal number of buyers and sellers in a close proximity of price.  Trading halts when an order imbalance occurs.  The Specialist’s job entails filling market orders fairly.  They need time to determine the price for matching market buys with market sells.  In an effort to be fair, trading might also halt pending news.  Most major announcements come before or after the opening bell.

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The NASDAQ market works differently.  Unlike the NYSE’s trading floor, the NASDAQ trades stocks electronically.  And unlike the NYSE Specialist system, the NASDAQ uses Market Makers.  The Market Makers create a fair and orderly market by bidding and/or offering.  They try to buy stock at their bid or sell stock at their ask.  They try to make the Bid/Ask spread like the option Market Makers.  They are not required to be on the floor of an exchange.  With limitless location possibilities and only the volume and size of trades to deal with, most NASDAQ stocks have large numbers of Market Makers.  It takes commitment to be a NASDAQ Market Maker.  It’s not a part time job.  It also takes an inventory of stock to trade from.  This calls for large sums of money.

Option Market Makers are like a blend of the NYSE Specialist and the NASDAQ Market Maker.  Options trade on an actual exchange like the NYSE, but Market Makers offer liquidity with ready Bids and Asks.  The major difference lies in the number of possibilities.  You either buy stock or you sell it.  Option trades include both buying and selling, both puts and calls, with countless strike price choices.

Option Market Makers don’t start with a large inventory, they create the option contracts as buyers and sellers appear.  They would just as soon not ever own stock.  If they do, it means the buyers and sellers of options are not in equal proportion.  Their profit comes from buying at bid and selling at ask, called the Bid/Ask spread.  Option Market Makers buy and sell numerous option contracts, not always the same ones.  Through the use of Delta, Market Makers and option traders are able to remain basically market neutral or completely hedged.

Delta is a measurement of change in an option compared to the change in the underlying.  Delta is also the measurement of relativism between option contracts.  This relativism is what Market Makers use to hedge.  They try to remain at Zero.  Neutral.

To show how Market Makers trade Delta Neutral, let’s make some assumptions.  Let’s say an in the money (ITM) call has a Delta of .75, an at the money (ATM) call has a Delta of .50, and an out of the money (OTM) call a Delta of .25.  If a retail investor buys an ATM call from the Market Maker, the Market Maker is now short a Delta of 50.  Remember 100 shares per contract, means .50 x 100, so the decimal is dropped..  If someone then sells two OTM calls to the Market Maker, the Market Maker is then buying a total Delta of 50.  So selling -50 Deltas and buying +50 Deltas, equals zero Deltas.  Therefore the Market Maker is considered Delta Neutral.  A snapshot risk free trade.  Snapshot, meaning at the instant the trade takes place.  Technically, the risk is the Gamma, the change of Delta.

Puts are measured in negative Deltas.  This can be quite confusing.  Delta measures the change in the option verses the upward movement of the underlying.  So if your stock moves higher, the put would move lower.  Disturbing as it seems, two negatives make a positive.  If the stock price drops, with a negative Delta, the put option increases.

Selling a call option with a Delta of .50 and buying a put option with a Delta of -.50, the net effect is zero.  Buy 20 options with Delta of .75 sell 60 contracts with a Delta of .25, Neutral.  Long 20 contracts with a Delta of .75 = + 15000, selling 60 times .25 = -15000.  15000 minus 15000 equals nothing.  Hedged or Delta Neutral.

Some stocks went up.  (Hopefully yours.)  Some stocks traded lower.  Some stock prices stayed the same.  (A few flat lined dead on arrival, many roller coasted up and down back to the starting point.)

I was just recently in Las Vegas, for business of course.  I enjoy going by the gaming tables.  Market research, crowd psychology.  Seeing how people bet their cash.  Well chips anyway, if bettors had to use real money, they might recognize how much money they just lost.

Ever watch people learning to play craps?  They’ll use real money.  Haven’t they heard of paper trading?  Maybe because the pit boss and the other casino employees are always willing to help.  Lots of assistance available to make a bet.  No matter what color the chips.

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Gambling and specifically craps have much in common with options: complex risk reward curves.  Since the IRS doesn’t allow deducting crap table loses from your income taxes, why would anyone want to throw dice.  They can bet options, I mean trade options.

Many amateur options traders invest as if they were at a casino.  No regards for the odds, just mesmerized by the big potential payoff.

Anyone who has been around Wall Street any length of time knows there isn’t many “sure things.”  Truly, time’s passing is the only safe bet.

In this example we will trade based on Theta alone.  We will consider the other “Greeks” asleep.  In reality, they are NOT dormant.  The fact is, you could set your trades up to minimize their effects.  Remember it’s best not to awaken a sleeping giant if at all possible.

Our hypothetical example will be four At the Money (ATM) options on a single stock:

One month option = $ 1.00
Two month option = $ 1.41
Three month option = $ 1.73
Four month option = $ 2.00

With these hypothetical examples, let’s enter a simple time or calendar spread.  We will buy the four month option for $ 2.00 while simultaneously selling the one month option for $ 1.00.  Our net cost would be $ 1.00 ($ 2.00 less $ 1.00).  Again for demonstration purposes we will not take commissions nor the bid/ask spread into consideration. And also ignore strike prices as well.

If everything remained the same except for time’s passage, after one month the option we sold (short position) would be worthless to the buyer.  An At the Money (ATM) option has no value at expiration.  A $ 1.00 profit to us, offset by the $ .27 loss on our four month turned three month option, brings our position value to $ 1.73.

Anyone who can find situations where all the variables remain constant for one month deserves to make 73% on their money.

In our perfect example situation, we could now sell another one month option for another Dollar. After the second month, the option we originally bought would have lost half its time, but only $ .59 of its value.  Now priced at $ 1.41, the income would be equal to its original cost, $ 2.00.  Our cost would be zero.  Our profits infinite.

Closer to expiration, owning options costs more.  Inversely, selling options closer to expiration can pay more.

If the one month ATM option is $ 1.00, and the four month equals $ 2.00, then the nine month option would be priced at $ 3.00.  Continuing forward, the 16 month option’s price would be $ 4.00 and $ 5.00 would buy the 25 month option.

If we could sell one month of time for $ 1.00, we could pay for the 16 month option in four months.  Giving us a year of potential for free.

Please don’t base trades on any one option pricing component, while ignoring the others.  You’ve been given enough information to be dangerous.  If you trade with blinders on, you tend to get blind sided.

Knowledgeable traders earn the right to have less money at risk and greater potential for profits.  Knowledge comes with experience, and experience comes with time, regardless of real chips or paper trades.

Episode I.

Is there a Trekkie out there who can help me out?  I understand the Black-Scholes option pricing formula, but I just can’t comprehend Star Wars.

People with tents sleeping in line waiting to buy tickets to a movie.  Not just any movie, but a movie that’s playing everywhere.  Multiple theaters, gobs of seats, and plenty of screenings.

I have a few thoughts as to why anyone would go through all the trouble to be among Star War’s first viewers.

Crowd Mentality!  The media hypes the movie, and a feeding frenzy begins.

Bad Math Skills!  Until there’s a scarcity of theaters, there’s no scarcity of seats.  Each theater has hundreds of seats, one per person.  Don’t forget they empty the theater and show the movie again.  Over and over, infinitum.

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Bragging Rights!  Every time a day one viewer watches the video, he will remember he’s able to tell his grand kids he saw the movie on May 19th not May 20th.

Bad Business Skills!  Who is smarter?  The guy in a tent for a week, or his buddy who pays him $20 to buy an $8 movie ticket?

Too Much Free Time!  Hello, don’t people have anything better to do than wait days to buy a ticket to a movie?

Am I missing something?  I just don’t get it.  While you’re at it, explain to me how Episode One can come 20 years after the first movie.

I haven’t seen the movie yet, was it worth the hype?  Was the expectation greater than the event?

What does this have to do with option pricing?

I get e-mails from many mathematically challenged, crowd following option traders who don’t know the value of time and can’t brag about good trades.  Besides, even I have to jump on a bandwagon every once in a while.

Don’t forget the suspense.  Our last column ended in a cliff hanger.  Will the sequel be worth the hype?  Does understanding Implied Volatility and Vega help traders to win more often and lose less frequently?

Enough excitement, back to option pricing.

In mathematical equations you solve for the unknown.  Two plus two equals what number?  That’s too easy.  Let’s use multiplication instead of addition.  Two times two equals?  Still too simple, how about option pricing?  Without going into tremendous detail of option pricing formulas, here’s the gist.

The price of the stock compared with the strike price has a value.  The amount of time to expiration is easily calculated.  As are interest rates and dividends.  You take all these components plus the expected volatility, plug them into the pricing formula, and solve for the unknown; the option’s price.  Actually the option’s theoretical price.

While mathematical formulas determine theoretical value of options, market forces determine the price at which options trade.  The market consists of buyers and sellers.  Supply and demand.

More buyers equals higher prices.  You can’t pitch a tent to be one of the lucky, you need to write a check.  On the flip side of the coin, excessive sellers and/or insufficient buyers drive prices lower.

Market Makers estimate with formulas.  Charging according to whatever the traffic will bear.  If the market won’t support higher prices, it drops.

The Dark Side of the Force.

Back to our make believe world, where nothing changes unless we allow it.  Without any movement to the stock price, interest rate, dividend, and time to expiration; the price of an option can still vary.

The funny thing about all our previous make believe examples, this one might not be so made up.  In reality, an option’s price may fluctuate without any other circumstantial difference.  This situation can happen.

A rumor may spread about a take over possibility.  The interest rates and dividends could certainly remain the same before and after the rumor.  The stock price might not move.  In no time at all the price of the options could sky rocket.  The hype could end just as sudden and the stock price not falter, but the option price melts.  Could it be, the expectation was greater than the event?

What about earnings reports?  After the announcement, there is no guess work, no unknown, no expectation.  Option prices tend to drop, the sizzle is gone and all that is left is steak, or gristle.  Don’t fuel the fire by over paying for options.

Comparing Implied Volatility to Expected Volatility tells if an option is fairly valued.  If the Implied Volatility is less than Expected Volatility the option is said to be undervalued.  If Implied Volatility is greater than Expected Volatility the option is overvalued.

Vega measures option price changes based on volatility.  Although Vega is considered one of the “Greeks,” it’s not actually Greek.  It’s Spanish.  Or as most would say, A foreign language.

“May the Implied Volatility be with you.”

 

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