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: Raw Wind, Cold Iron, Hard Bone
A money-printing machine in your closet would be great except that it will attract unwanted guests carrying badges and warrants. Imagine instead a machine enabling you to write paper securities and sell them for instant cash, with the law on your side.
With spread strategies, option contracts beget other option contracts that sell instantly. They are the gold ingots that alchemy-like create other gold ingots, not for the vault or for maybe-someday sales but for same-day money in your account.
Risks? Yes, but the begetting is also a fortification. A fall in silver would, hurt less if silver bars bore offspring.
Fabulous thought: If owning stocks and bonds gave you the right to print and sell more stocks and bonds while still holding the originals. But no, spreads are the domain of futures and options, including my specialty, equity or stock options.
A few years ago, I took out a short-term trial subscription to Value Line Options (1-800-634-3583) and gave special attention to the page "Recommended for Covered Call Writing." I bought 1,000 shares of a recommended $10-a-share mining stock for about $6,500 plus margin. Each 100 shares entitles a stockholder to write (issue and sell) one "Covered Call" option contract which in turn entitles the contract-buyer to purchase the stock at a given "striking price" if the shares rise above that price before the contract expires.
Each month, I sold 10 Calls with short-term expiration dates and a striking price of 10. Each time I would receive a premium of between $750 and $900. The stock fluctuated between nine and a fraction and 10 and a fraction. Month after month, the 10 Call % expired worthless and I would sell another batch with the next month's expiration date. One month the stock price rose slightly above 10; the contract holder exercised' the right to buy my 1,000 shares.
Then the stock dropped to nine and a fraction. I bought back the 1,000 shares at a slightly lower price and sold 10 more Calls. Glad that the premiums rolled in one month after another, I nevertheless wondered: Who bought these options again and again, getting nothing in return? I realized that I was in effect a legalized bookmaker. Those contracts expiring worthless were losers' horse-racing tickets.
I mentioned Value Line and the "Recommended" stocks for a reason. A writer of Covered Calls should never, repeat never, buy a stock for option-selling purposes unless he would also buy it for its own sake. Another item apropos at this point: The selling of options, whether by a stockholder or a spread strategist, is to no small extent a "fleecing of suckers." It is for you only if you can manage a cynical chuckle at the sight of a pad & pencil roulette-player.
It is estimated that over 90% of all out-of-the money Puts and Calls expire worthless. As a spread strategist and with limited capital, you can skim an amplitude of that lost money. You can "be the bank" out of your desk drawer. You can run a de facto gambling house from your den and "gain the house advantage."
Of course, a strongbox-in-the-closet tycoon must know pertinent script and scrollery. When I crossed the Euphrates from stocks-for-covering to Put & Call strategies, the following was and still is the cuneiform alphabet. Spreading can be done with either futures or options. You buy one batch of contracts and sell another either simultaneously or shortly thereafter.
With options, the two batches must be either both Puts or both Calls. Both must connect to the same underlying stock (equity options) or commodity (futures options). When the batch you buy costs more than the batch you sell, the money you receive from the latter pays for part or better yet most of the former, depending on prices. You pay the difference or the "debit," hence the term "debit spread."
Let us say that the options or futures you buy have expiration dates farther into the future than the ones you sell. This positioning goes by the moniker of "time spread" or "calendar spread." Many "debit spreads" are also "calendar spreads" because time value makes the farther-into-months-ahead contracts more expensive than comparable shorter-term or nearer-in-time ones.
Let us say that you buy 10 equity Call options with a June expiration date and a striking price of 40, and you sell 10 Calls with an April expiration and a 40 striking price. That is a "calendar spread" because of the different months and a "debit spread" because June 40's cost more than April 40's and your checkbook must fill the gap.
What else? The identical striking prices make the above example a "horizontal spread" also. On a price & time chart, the two 40's with different months would appear on the same level with a horizontal line passing through both, and May forming a gap between them. The bought June's constitute the "long end" of the spread and the sold April's the "short end."
Getting to the XYZ of it, the short-end 40's are Covered Calls, covered not by stocks or commodities but by the long-end contracts. If the underlying security were to rise substantially and the April's were exercised, the spread strategist could deliver and fill the order simply by exercising the June's he owns with the money that the April contract-holder just paid.
Alas, this would wipe out the debit money that the spread strategist paid and would also require him to pay commissions. Never, repeat never, let the short-end stay in-the-money beyond the trading day that it happens. I took several of my best profits by buying back and closing out the short-end, whether Puts or Calls, while holding onto the fast growing long-end as underlying security continued deeper into the money.
The above is one way to make a profit. The other, IF the underlying security avoids the strike price, is by time decay. The difference in price between the batch of contracts you bought and ones you sold widens or "spreads." The cash you invested in the gap broadens. Molten nuggets in the soil. Also, if the April's expire worthless in the example given, the holder of the June's can write (create and sell) Mays. The securities-printing machine in the closet.
This article does not cover credit spreads, vertical or diagonal spreads, or uncovered options because, to state it plainly, I don't do none of them. Those interested should consult books on the subject. In fact, anyone considering putting any money at all into stocks, options, futures or spread strategies should read profoundly. More on books later.
So that the preceding paragraphs not be construed as a sunshine & roses portrait of spread strategies and the surrounding financial milieu, let us now shine a flashlight into the Black Hole of Calcutta. If you buy shares in Ford or Chrysler, investor money forms some kind of link-up with car-buyer money. From the latter comes gross revenues, operating capital, and hopefully, earnings, dividends and upward pressure on share price.
If 1,000 people place $1,000 each in a 10-year, 10% corporate bond issue, that $1,000,000 total brings back $2,000,000 -- the original investment plus interest. If those same people gamble one grand each at a casino, the $1,000,000 brings back only about $850,000 -- the original stake minus the house's cut of the pot. This is what makes gambling a loser's game: Too little gravy in the pot with everybody wanting plenty.
In the early 1920's, Boston promoter Charles Ponzi sold promissory notes which guaranteed investors 50% return in 90-days. Ponzi claimed that he used the money to speculate in foreign currencies and International Currency Coupons, then shared the gains with note-holders. The first folks collected, then subsequent ones. Soon people flooded his offices.
When federal investigators cracked down, they found no currency or coupon speculations. Ponzi had paid the first wave of investors with money from the second wave, and the second wave with money from the third. The few who got in and out early made a profit, but the rest? Federal authorities imprisoned Ponzi and disbursed his seized holdings. Note -holders received only 28¢ on the dollar.
Some investors refused to surrender their notes to the halls of justice, believing that the "financial wizard" would eventually make good his word. Everybody else was more cynical. During my father's 1920's boyhood in the Italian neighborhood of South Philadelphia, one kid would say to another, "What are you trying to do? Pull a Ponzi?" The essence of the Ponzi Scheme: No profit dollars added to investor dollars; the mere shifting around of capital among the participants. Robbing Peter to pay Paul.
Futures and options are zero-sum games. Somebody must lose a dollar for each person who gains a dollar. No car-buyer money seeping through to shareholders. No bond interest or C. D. interest making sure that more money comes out than went in.
More like in a casino. Like in a Ponzi scheme. Nobody calls it robbery, but Peter has to lose a dollar for Paul to gain a dollar. Actually, these are worse than zero-sum games. The casino gets a cut of the pot by paying out less in wins than it takes in. Ponzi skimmed and pocketed more than a few note-holder dollars. Nowadays, brokerage commissions, brokerage house expenses, exchange and trading floor expenses; Peter always loses more than Paul gains.
Is it any wonder that in turning to options or futures, so many people expect Lady Bountiful and meet Lucrezia Borgia? Analysis by basic arithmetic reveals plenty of poison in the cup. Plenty of prime cattle in the royal pasture, but not nearly enough to fill the banquet tables of everyone expecting a fill.
Numbers. What a person overlooks even when they stand as a stone wall he crashes into. For centuries, men built wings and flapped them, trying to fly like a bird. Overlooked were the plain mathematics. A one-pound bird has a one-foot wingspan and flaps those wings 72 times a minute to stay aloft. As for the needed energy, the phrase "eat like a bird" is misleading. A person eats two to three percent of his bodyweight in food per day, a bird 50%!
Thus a 150-pound man would need a 150-foot wingspan, and would have to flap those wings 72 times a minute. Try flapping just your arms 72 times a minute. For the required energy he would need to eat 75 pounds of food per day. Such are the absurdities that man gets into when he builds wings, but ignores mathematics. But is there any more good sense among the huge numbers of futures traders and options traders who expect a worse-than-zero-sum game to drop a million quickly and easily into all their bank accounts?
At New York University, I took a calculus-heavy course in finance and did all right but found the knowledge of little practical use. Fundamental arithmetic lights up the realities just fine. I am involved in spreads because here the numbers are far more an ally instead of a big-guns enemy as with most trading.
Case in point: The Options page of the Wall Street Journal, 1/19/96, carried listings for the previous day's trading. The section called "Leaps --Long-Term Options" posts Puts & Calls with expiration dates one to two years in the future. The IBM Put with the 90 striking price and the expiration date of 1/97 last traded at 5-¾. The IBM 90 Put expiring one year later 1/1993-2014 last at 8-5/8.
Do you need a neon sign to see the significance? Compared to the 1/1997, the 1/1993-2014 contains 800 more time, but costs only 50% more! I cite this as an "eye exercise" because the trained eye of a spread strategist should notice such things. He routinely buys the bargain and sells the overpriced. I do not trade long-term (year or more) options right now, but I may in the future, using Harrison Roth's fine book LEAPS: Long-Term Equity AnticiPation Securities.
The point right now is that an intelligently-planned spread strategy is number-friendly, with mathematics working for it instead of against it. Ergo, the spreader's privilege to "be the bank" and "gain the house advantage" while other people gamble certainly counts. Also essential to the formula: Bulk quantities of other people's money. That stacks the mathematical deck in your favor profit-wise; also makes great tank armor during a worst case scenario.
After repeated profits from Put spreads on software and semiconductor stocks, I gave attention to Cisco Systems with common shares fluctuating in the high 60's on the downslope from 89 and a fraction. Put options with strikes of 65 stood too close to the stock price; a bothersome no-trend twitch could put them in the money.
The ones with a 60 striking price seemed better. This was early January and the out-of-the-money January options had shriveled to fractions due to time-decay. Cisco had no March options so February and April took center stage, with an already existing spread between them of about 1-¾. I phoned the broker. "A spread order," I said. "A buy and a sell going in together, each dependent on the other. Cisco option symbol CYQ. Buy 10 April 60 Puts to open a position. Sell 10 February 60 Puts to open. Debit 1-¾ points. Day order."
On a 10 and 10 order, the I-¾ point debit translated to $1,750 of my investment capital. But the order was not executed, so the next day I raised my ante an eighth. I phoned in an identical fugue but with a debit of 1-7/8 points. Order executed, I bought 10 April's at 4-3/8 ($4,375) and sold 10 February's at 2-½ ($2,500) paying a difference of just under $2,000 with commissions.
This two-masted schooner sails under 3-names --debit spread, calendar spread, horizontal spread. The money that built it came more from other people ($2,500) than myself ($2,000). A banker's maneuver, one could say, or a dealer's card advantage.
One strength of construction lay in the time-decay that accompanies calendar spreads. After the close of the buy/sell day (1/16), the February Puts had 23 trading days until expiration and the April's 69 days. Time for eye exercise and basic arithmetic. The April's were richer in time than the February by triple, but cost measurably less than twice as much. Buy the bargain, sell the overpriced.
The moving mechanics of time-decay deserve scrutiny. When the trading day after the transaction day ended, the February options lost 1/23 of their time but the April's only 1/69. And 10 trading days before the February expiration, the February contracts will lose 10% worth of time in one day and the April's less than 2% (one of 56 remaining days). Thus the short end (obligation) of the spread shrinks more and faster than the long end (ownership), expanding both the gap between the two sets of contracts and the money filling it in.
An option spread strategist should also be a chart-watcher because of that moving asteroid, the underlying security going up and down. I positioned a Put spread under Cisco shares because I anticipated their continued decline. If they fell through the 60 line I was prepared to buy back/close out the short-end options and hold the growing long-end.
Days later -- surprise -- the stock climbed from the high 60's to the mid-70's. Not what I wanted, but it did serve to test the armor-plating and shock-absorbers contained in spread strategies. Whoever bought April Puts identical to mine but without initiating a spread was down slightly more than half in the stock rise. Yet worse, whoever bought those February, I sold was out 75%! The figures: Feb.5/8--Apr. 2-1/8. A 1-½ point spread and a minus to me of 25%.
Flesh wounds around the bullet-proofing and I could have bled worse. Spreads are protected strategies, relatively, but never totally risk-free. No more than one-tenth of capital per venture stands as a locked-safe-embedded-in-concrete rule. As with buffalo-hunting, spread strategies can bring wagon-loads of meat thanks to an inexpensive box of bullets. Yet we must also endure like the buffalo hunter -- the raw wind, the cold iron, the hard bone.
Reading Recommendations: The phone number for L&S Trading given in the previous issue of CTCN is no longer valid due to Colorado's change of area code. Updated: 970-586-6262. Still gold-medal among their wares: The two books by W. D. Gann in one hardbound volume -- The Truth of the Stock Tape & The Wall Street Stock Selector.
Worthwhile option volumes at Barnes & Noble and Walden Books: Listed Stock Options by Carl F. Luft & Richard K. Sheiner, Option Strategies by Courtney Smith, How the Options Markets Work by Joseph A. Walker, Options--A Personal Seminar by Scott H. Fullman.