GalaTime - Indian Capital Markets

http://www.galatime.com

2004-09-14T08:49:00.000-07:00

To make my blog more user-friendly and feature-rich, I have decided to move it to a new domain: http://www.galatime.com, hosted at TCH, and powered by Movable Type 3.1. I have imported all previous posts from BlogSpot, and added categories for easier navigation.

I plan to add more features over time, including:

Summary of my trading goals, methodology and money management
Table of current options portfolio
A list of potential trading candidates
Participation in mock trading (with a $100,000 portfolio) at Investopedia

Please share your comments and suggestions!

PS: Beginning Wednesday, Sept 15th, I'll automatically redirect this blog to the new domain @ galatime.com.

Taleb & Budwick on Options

2004-09-13T11:46:00.000-07:00

Continuing today's theme of interviews with traders, here's one that features Nicholas Taleb:

"Options seem to require a lot of complex mathematics, but in reality, we can figure them far more effectively with a diligent use of guts."
"Options have a tendency of sucking in very intelligent people and blowing them up. The smarter the person, the more spectacular the blowup."
"Trading is about dealing with randomness in an effective way. You have to be a hyper-realistic, no-nonsense type of person."

And another one (Parts 1, 2) with Philip Budwick:

"Options is to investing what chess is to checkers. It is the more refined and intelligent activity of the two."
"Losses are a part of trading. You cannot control whether or not you will lose money on a trade at times, but you can always control how much money you will lose."
"An adjustment to an existing option position should either lock in a profit, reduce your risk or hedge your position."
"Investing is to build wealth and unless you have a large source of capital, option trading is not solely to bring in income through credit strategies."
"Starting to trade options is like launching a new business and as is common with most start-ups, you lose money. "
"The art of investing comes down to managing risk and the most successful investors are not the best at picking stocks or strategies, but the best at managing risk."

ETF Option Strategies

2004-09-13T11:21:00.000-07:00

EliteTrader's forums regularly feature chats with fund managers, such as this June 2003 chat with Gene Weissman of E-Brokerage. Gene talks about the option strategies commonly used by hedge funds - specifically, he walks through a detailed calculation that shows how to hedge a given portfolio with index options/futures.

For ETF options, here are some excerpts from the transcript:

"Since Options will not move point for point with the future, we will have to figure out the Delta(the price change of the option compared to the underlying Future), using an option pricing model ."
"More complex options positions can be used that include a hedge-wrap Or Collar. The fund manger buys puts and funds the put purchase by the sale of calls. The fund manger could also sell index calls against his portfolio , for additional income and roll the postions each month .
"Option hedging strategies must be adjusted for market conditions and no one option strategy is suitable for all situations."
"Option hedging and adjusting is quite complex and you need specialized software like MicroHedge to ADJUST PROPERLY"
Recent hedging trends - "E-Mini's and SPY's especially are being used more & more"

FYI, here's a list of optionable ETFs from the AmEx.

Options: Speculation or Insurance?

2004-09-12T15:17:00.000-07:00

Options serve 2 primary purposes: Speculation & Hedging.

The more sophisticated, institutional investors write covered calls to increase returns from their (long-only) equity portfolios, and use naked puts to add stocks to build these portfolios at lower costs, while earning put premiums. They also purchase puts to protect (hedge) their portfolios against large drops in the market.

However, there are retail investors that buy calls/puts to speculate, with the intent of making high returns - albeit with very low probability. Such trades favor out-of-the-money options that have the potential of huge payoffs (similar to long-shot bets in horse racing).

A research paper published by the Financial Valuation and Risk Management program at the University of Zurich checks whether such investor strategies cause an over-valuation of puts (thus increasing hedging costs) and under-valuation of calls (thus reducing the returns for covered call strategies).

Some of their conclusions serve as useful guidelines for my strategy of selling naked equity puts and purchasing index/ETF puts as insurance:

S&P 500 Index Call Options: "if an investor wishes to buy call options, they should buy longer maturity in the money call options (thus gaining from the favorite bias) and sell shorter maturity out of the money call options (as there is less of a long shot bias for 1 month options compared to 3 month options)."

S&P 500 Index Put Options: "The deepest in the money puts pay on average the initial bet and losses increase as the puts are further out of the money.Investors should be indifferent between purchasing put options on stock indices at either 3 month or 1 month expirations."

The authors attribute these findings to a "long-shot bias" among option investors - particularly individual trades who tend to be buyers of options.

Portfolio Hedging Update

2004-09-10T14:00:00.000-07:00

The sharp rise in tech stocks over the past 2 days has allowed me to enter into my hedge trades (explained earlier) at significantly lower costs.

All 3 technology ETFs (IGN, SMH, SWH) jumped up by at least 5%, making the puts cheaper, and reducing my hedging costs by ~25%, as shown above.

I have yet to purchase the PPH put, since the pharma sector has not performed well recently, making the puts expensive - I would rather wait for an up-day for a better (cheaper) fill.

As of now, ~55% of my portfolio is hedged against large market drops, but NOT against a sharp drop in any of my individual stock holdings.

INTC Update

2004-09-10T13:59:00.000-07:00

Here's a SafeHaven article that notes "instead of trading at 11 times book and 12 times sales (as was the case in mid-2000) Intel currently trades at 3.2 times book and 3.8 times sales". The author argues that Intel has matured into a low-growth, cyclical stock (with reduction in ROE and profitability) and hence its stock must trade at lower P/E and P/FCF ratios.

My put order hasn't yet been filled (Intel Jan'05 $20 Put, Sell Limit = $1.75) since Intel recovered from the ~$19.8 level along with the Semis (and the Nasdaq, in general). The contract did hit $1.65, but fell short of my target of $1.75.

I intend to wait for a correction in the Nasdaq over the next few days (and a break in Intel to ~$19.5) for my order to get filled.

One Stop Shop . . .

2004-09-10T07:41:00.000-07:00

Option-Chart provides a graphing tool (similar to OptionStar's OSEZ tool) to analyze the risk/return profile of various option trades - however, this is a web-based Java tool, requiring no downloads.

But the more interesting part is their online (Java-driven) Option Calculator - it links to (20-min delayed) option quotes - thus avoiding the need to enter in option data. The tool can then be used for all sorts of calculations such as implied volatility, Black-Scholes value, risk/return graphs, etc. By linking to various sites such as BigCharts, iVolatility and Optionetics, this site serves as a "one stop shop" for option traders looking to screen for trading candidates - at no cost!!!

CBOE provides a free software called "The Options Toolbox" - this is a very good resources for beginners to understand option basics, and test their knowledge via the exercises in this tool. The Options Toolbox contains:

Equity and Index Option Strategy Selection
Option Fundamentals and Pricing
Simulated Position Analysis
CBOE Product Information and Reference Tools

Risk/Return Analysis

2004-09-10T06:37:00.000-07:00

As part of analyzing trade, we need to compute the risk/return profile of the particular option. This involves charting the expected profit (and loss) over a series of price points, as shown below.

Image: Courtesy of Optionetics.com
While I have been using Excel for analysis, I found a free, user-friendly tool from OptionStar, that lets you choose a particular option strategy, enter in the necessary parameters (option premium, strike price, expiration, etc.) and calculates the following:

Theoretical (Black-Scholes) value of the option
Table with expected profit/loss at expiration, over a price range
Corresponding profit/loss chart

The tool is in the form of an Excel file that needs to be downloaded and unzipped - it even includes an options tutorial, and provides the ability to create and test custom option strategies.

S&P 500 vs. Put-Call Ratio

2004-09-09T14:33:00.000-07:00

I wrote about the Put-Call ratio in an earlier post - how it is used as a measure of market sentiment and as a contrarian indicator.

To test this out, I downloaded the historical put-call ratio data (Jan '04 through Sept '04) from the 888-Options website, and tried to correlate the equity put-call ratio (and the index put-call ratio) with S&P 500 historical data from Yahoo. Simple correlation analysis gave the following results:

Correlation coefficient between the equity put-call ratio and S&P 500 = -0.58 (to put this in perspective, a coefficient of -1 indicates perfect inverse relation)
Correlation coefficient between the index put-call ratio and S&P 500 = 0.16 (Statistically insignificant)

In spite of some negative correlation, it is impossible to say that the PCR can be used to "predict" the S&P 500. Look at the chart below, which shows the 2 data series for the Jan-Sept '04 period.

The thick lines indicate a 10-day moving average of each series. Although we see some negative correlation between the two, it would be far-fetched to say that a high PCR always corresponds to a drop in the S&P 500, or that a high PCR always indicates a future rise in the S&P 500.

I think the PCR's utility is as a measure of market sentiment; this becomes evident if we re-plot the chart using a 50-day moving average, as shown below. We see the 50-dma for the PCR (thick blue line) steadily trending upwards - as investor pessimism increased since February on account of the Iraq war, election uncertainty, oil prices, anemic job market, and recent earning warnings.

The lack of conviction in the major market indices has led to an increase in the bearish sentiment in the market - and this is captured by the (moving-average) PCR.

Historical Options Data

2004-09-09T07:23:00.000-07:00

For those who wish to back-test their option strategies, I found a few sources of historical data -

1. DeltaNeutral
They provide end-of-day option quotes since Jan 2003, in DVD/CD formats, and here's how the pricing works - "The historical data DVD is available at a cost of $25 per quarter and then $8 per additional month. So January through December is $100. The monthly download service is $20 a month."

As noted above, traders can update their database every month via data downloads from their site - the $20/month charge seems reasonable, given that there are more than 2000 optionable stocks, and it would be highly time consuming to compile this data manually from CBOE, Yahoo, etc.

2. Stricknet
This is probably the cheapest source of historical data - $50 for data since Jan 2003 on all optionable stocks as well as ETFs. Data comes on CD, in Excel-compatible format. Again, they have a monthly data service at $20/month.

3 . CSI
CSI seems to offer historical data for index options and futures, but NOT equity options - "Options data is priced at $125.00 per year per index and/or future. 5 year minimum order applies per index or future."

4. Prophet
Prophet has equity options data since November 2000 and charges $495 for the CD - "Priced at just $495, this comprehensive data collection includes the open, high, low, close, volume, and open interest for all strikes and series. "

Prophet also offers data for index options and futures (since 1959).

OptionStrategist - Larry McMillan

2004-09-08T17:22:00.000-07:00

Some of you might be familiar with Larry McMillan's popular book on options - "Options As A Strategic Investment". He maintains a feature-rich site at OptionStrategist, that has several free resources including option calculators, tutorials, Q&As with Larry, etc.

What interested me was the daily Xtreme Report, which features over-valued and under-valued options - using the percentile ranking of the (20-day and 100-day) implied volatilities. The report also provides a list of options whose implied volatility is significantly above (or below) its average historical volatility.

Readers will note that this is very similar to the daily report published at VolatilityTrading.net, mentioned in a previous post here - the difference being that McMillan's site does not provide free archives of the daily reports.

Portfolio Hedging - Part 2

2004-09-08T12:23:00.000-07:00

Here's Part 2 of the portfolio hedging exercise I began earlier. I decided to use ETF options to hedge about 80% of my portfolio, shown here. Please refer to the table below as I walk through the hedging calculations:

To protect the "Capital @ Risk" against large drops in the market and/or stocks, we need to buy put options that match the capital in amount and expiration as closely as possible.

For example, the "Networking" category consists of CSCO and FDRY, with expirations in Dec '04 and Jan '05. The total capital is $2,550 and with the IGN ETF trading at ~26, we need to purchase 0.98 puts - calculated as 2,550 / (26 * 100). Obviously, we need to round this up to 1 Put contract.

Next, I chose the $25 strike price for this put - this will cost $140 in premium, but limit the worst-case loss on the ETF to 4% - calculated as (25-26)/25. Repeating this exercise for all the categories, we end up with $620 in hedging costs. This eats up ~30% of the premiums earned ($2,175) by selling naked puts.

Let's look at the protection gained via this hedging:

Assuming that the set of stocks in each category are perfectly correlated with the corresponding ETF, the purchase of these put options will limit losses to ~2% ($407/$18,365) since any further drop in the stock/market will make the ETF puts profitable and cancel out the losses in the stocks.

In reality, individual stocks are NOT perfectly correlated with the ETF. This is the only significant risk to this trading strategy - the possibility that an individual stock might drastically drop due to company-specific concerns such as earnings miss, lawsuits, management turnover, etc.

To manage this risk, one must

Limit trading to high-quality, larger-cap stocks
Monitor each stock regularly and closely - news, analyst downgrades, etc.
Limit losses on stocks that do drop by a large %

Option Screens

2004-09-08T11:17:00.000-07:00

Trotter Trading Systems publishes a daily list of options considered to be over (under) valued - based on implied volatilities that are significantly higher (lower) than historical means.
In fact, the site publishes several screens for option candidates, including those with:

Highest implied volatility (over-valued, expensive -> Sell)
Lowest implied volatility (under-valued, cheap -> Buy)
Highest (or lowest) ratio of implied-to-historical volatility
Highest (or lowest) % change in implied volatility
Highest (or lowest) ratio of daily option volume to average option volume
Highest (or lowest) ratio of Puts to Calls

They publish a daily report of these categories, and have freely available archives since January 2003. It would be instructive to check the effectiveness of such screens to uncover profitable trading candidates. For example, are stocks that appear in the "highest implied volatility" category good candidates for writing options?

Portfolio Hedging - Part 1

2004-09-07T14:10:00.000-07:00

Here's a view of my options portfolio, by expiration month:

Note that I have computed the "Capital @ Risk" column to determine the amount of hedging required. Here's a view of the portfolio by category:

By purchasing puts on 4 ETFs (Pharmaceutical - PPH, Semiconductor - SMH, Software - SWH and Networking - IGN), I can hedge more than 80% of my portfolio. Note that QQQ puts might work as an alternative to the combination of SMH/SWH/IGN puts.

By analyzing the statistical correlations between the portfolio and the index puts, we can identify the best hedging choice, and minimize the option premiums paid to insure against downside risks.

Investopedia

2004-09-07T07:47:00.000-07:00

There's an excellent set of option-related articles on Investopedia for novice as well as more experienced option traders.

One of them explains the use of LEAPs instead of stocks, for writing covered calls, and the type of market environment that suits this strategy - "Ideally, this strategy works in a mature bullish market, which is usually accompanied by low implied and statistical volatility. We want a low volatility environment because LEAPs have a high vega, which means they can increase in value when volatility increases, or fall in value if volatility declines, a point to which I will return below. " This strategy is especially beneficial for traders with limited capital, since LEAPS require a smaller capital outlay that the corresponding stock.

The website also offers a "free option selling package" - I have subscribed to it and will post an update after reviewing the information I receive.

SmartMoney Contrarian Screen

2004-09-06T15:29:00.000-07:00

SmartMoney regularly publishes a contrarian screen, featuring stocks that meet the following criteria:
· 13-week price change in lowest 10% of all stocks.
· Debt-to-capital ratio less than 0.5.
· Price/earnings-growth (PEG) ratio less than 1.0.
· Net margin positive.
· Annual sales greater than $200 million.
· Average daily trading volume at least 200,000 shares.
· Average analyst recommendation not Strong Buy or Buy.

Let's explore the use of their Sept 2 contrarian list to identify candidates for naked puts. I screened this list for stocks with market cap > $2B, P/E ratio below 30, and the availability of options - ending up with 5 trading candidates: CAH, CECO, FRX, NSM and SNPS. Here's a Yahoo Summary View of this mini-portfolio. A review of their 3mo/6mo/1yr/2yr technical charts indicates that most of these stocks are at multi-year lows, having broken through short and intermediate-term support levels.

I removed NSM from the list since my current portfolio has a significant % of semiconductor stocks, particularly if the INTC trade goes through. CECO was dropped due to potential legal issues facing the company - the impact of which is impossible to factor in my analysis.

Of the remaining 3 stocks, here's some favorable option trades:

Exp. Month	# Days to Exp.	Strike Price	Option Premium	Break-even Price	% Return*
SNPS Dec Put	104	$15.0	$1.1	$13.9	7%
FRX Jan '05 Put	135	$40.0	$2.4	$37.6	6%
CAH Jan '05 Put	135	$45.0	$3.0	$42.0	7%

* % Return requires the stock's price at expiration to be greater than the strike price.

Although SNPS offers the highest annualized return at 25%, I prefer FRX among the 3 candidates, for the following reasons:

SNPS: Weighed by class action lawsuits, lack of upside until Q3 2005, possible downturn in the semiconductor industry, competition from CDN, LAVA and MENT
CAH: Fundamentals not particularly better than competitors, low-margin business model, and SEC investigations. (Note: Motley Fool came out in favor of CAH on a valuation basis)

Specific to FRX:

I hold PFE and RDY puts, and FRX will diversify my risks within the healthcare set of stocks - although it does increase the % share of pharmaceuticals in my overall portfolio
FRX has been in a downtrend since March, but has fallen much further than its competitors. However, I expect the pharma industry to perform better after the elections - hence Jan '05 or later puts are preferable.
FRX has strong fundamentals w.r.t its competitors - including a PEG of 0.87 and operating margins as high as 35%
It's a contrarian bet after all!

Here's a Motley Fool article that supports the contrarian view based on valuation, but cautions about the biggest risk - "The debate about importing drugs from Canada (and the industry's high profit margins) has cast a pall over the drug manufacturers."

I'll track FRX (especially the short-term technical indicators) over the next few days to determine a suitable entry point for the trade.

Put Options by Jeff Cohen

2004-09-06T06:46:00.000-07:00

Over the weekend, I had the opportunity to read an excellent book, titled "Put Options", by Jeff Cohen. I'll try my best to capture the essentials of this invaluable resource for option sellers.

The basic premise of the book is a trading system (SafetyNet) that involves a combination of selling naked puts on large-cap, high-quality stocks, and buying index puts to hedge the downside risks. The strategy might seem simple at first glance, but the author takes pains to explain the logic behind this strategy, provides specific criteria for stock selection, and detailed back-testing results.

The book begins by debunking Wall Street sell-side propaganda - including CNBC analyst recommendations, earnings accounting, mutual funds, promoters of trading systems, etc. - followed by a detailed review of option basics.

For writing puts, the author makes the following suggestions:

Stick with large-cap (>$5B), high-quality companies - consider earnings growth, management team, employee quality, market leadership, cash flow, innovation while screening for candidates
Use technical analysis to determine key support levels for the stock
To enter the position - consider fundamental factors (PEG ratio, P/E ratio, intrinsic value), technical factors (support/resistance, % of 52-week high) and option premium
Diversify - Maintain upto 30 stocks in portfolio, with no more than 5% capital allocated to any single position
Sell longer-term puts to obtain larger premium (reduce break-even price) and provide more time for the stock to rise (thereby avoiding the need to close the position by being assigned the stock)
Sell slightly out-of-the-money puts to avoid being assigned the stock at expiration

To limit losses from large market/stock declines, the author makes the following recommendations w.r.t buying index puts:

Insure the principal, not the profits: buy out-of-the-money puts with strike price in the range of break-even price
Use statistical analysis to determine which index most closely matches the stock in terms of price movement
In case of a significant market correction, consider selling the index puts to lock in profits

Finally, the author proposes that one can modify the risk/reward profile of this strategy via the following factors:

Stock candidates (small/mid-cap for larger returns, with greater risk)
Leverage
strike prices & expiration dates
Degree of hedging
Degree of diversification

All in all, an excellent book for option sellers. The back-testing results not only support these strategies, but also provide insight on how one might build a back-testing methodology using historical options data.

How Low Can It Go?

2004-09-03T11:00:00.000-07:00

A naked put strategy on INTC, as described in my previous post, seems to violate several popular trading rules, such as :

Stay with the prevailing trend ("The Trend is your Friend")
Don't try to catch a falling knife
Don't try to predict the bottom

Bill Fleckenstein, who publishes the Contrarian Chronicles on MSN Money, has been bearish on Intel since October 2003. Several others, including the Kirk Report and Duru have predicted and/or justified Intel's downtrend. Looking at the semiconductor industry, things don't get much better. Analysts expect more companies to revise estimates downward for Q3 and Q4 '04, as evidenced by Altera, Cypress, IDT, and others.

The TraderWizard recently explained his bearish trade on Boeing via the purchase of put options. He faces a similar scenario, in that BA has been hitting 52-week highs despite being overvalued, and the trend remains upward.

Entering into trades against such headwinds requires firm conviction in one's analysis and trading strategies. Instead of hoping that the market will move in the desired direction, one must determine how to respond to different market scenarios. Perhaps my INTC trade will turn out to be a mistake - but as long as I take the opportunity to learn from it, it'll be worthwhile.

Of course, too many of such mistakes will wipe out one's capital. That's where money management and cutting losses come in. But let's leave that for another day!

INTC Trading Strategy

2004-09-03T07:09:00.000-07:00

Intel is holding at around $20, after its disappointing Q3 update. Let's look at alternative option strategies for INTC and expected returns:

Exp. Month	# Days to Exp.	Strike Price	Option Premium	Break-even Price	% Return*
Jan '05	140	$17.5	$0.75	$16.75	4%
		$20.0	$1.55	$18.45	8%
		$22.5	$3.0	$19.5	13%
Apr '05	230	$17.5	$1.1	$16.4	6%
		$20.0	$2.0	$18.0	10%
		$22.5	$3.5	$19.0	15%

* % Return requires INTC's market price at expiration to be equal to or greater than the option strike price.

Here's my criteria for picking the best option strategy, to suit my expectations:

Expected annualized return > 15%
Break-even price ~ $18 (Reasonable valuation assuming P/E of 16, and 2005 earnings of $1.1/share - even if analyst estimates get revised downward from $1.36/share)
Intel price expected to be ~20 in Q1 2005 (Intel's chart indicates reasonable price support at ~$20, and strong support at ~$15)

The Jan '05 puts meet these criteria; however, there is a possibility of a further drop in price, to the $15 support level - this would result in a 18% loss from the break-even price of $18.45, versus an expected 8% return over the same period.

Trading (and Exit) Strategy:

Sell Jan'05 $20.0 Puts with limit order of $1.75 (to improve expected return to 9% and break-even price to $18.25)
If INTC rises above $22.5, consider buying back these puts before expiration to lock in profits - this does require giving up some time premium
If INTC drops below $18, sell Jan/Apr '05 $17.5 Puts with target break-even of $16 - this would result in an average break-even price of $17 for the 2 trades combined

The key point here is - INTC is a good long-term buy in the $17-$18 range, and the use of naked puts is a low-risk strategy to add INTC to my portfolio.

Naked Puts on Intel . . .

2004-09-02T11:45:00.000-07:00

Intel's mid-quarter update this evening and Friday's jobs report, are anxiously awaited by most investors. To a large extent, they will determine the short-term direction of technology stocks, as well as the overall market.

Let's look at Intel as a candidate for writing naked puts. It has dropped from $34.6 to $21.5 year-to-date. It is a true "Dog of the Dow" since it ranks the very last among all 30 DJIA stocks, when listed by today's price as a % of the year-to-date high. The media has been getting quite bearish on Intel for a while, based on some compelling reasons:

Fundamentally, Intel faces slower growth, declining margins, increasing inventories, several product delays, poor back-to-school demand, competition from AMD - you name it!

Technically, the chart below shows both the 50-dma and 200-dma trending down, MACD < 0, and no clear signals from the RSI and stochastics.

If there's one company that can overcome these challenges, it's Intel. Consider this:

It is a technology monopoly, with a 16% share of the semiconductor industry
It has very high margins, considering the magnitude of its revenues ($32B+)
It holds $17B cash, very little debt, and generates ~$10B in annual cash flow
It is one of the very few companies that can profitably afford to build several next generation semiconductor manufacturing fabs
It is sole supplier of processors to Dell, which has a 2006 revenue goal of $60B

Here's a free Value Line (PDF!) report on Intel, that highlights its long-term prospects. Note that the Relative P/E Ratio as specified by ValueLine has now fallen below 1.0 for Intel.

This is an opportune time to go bullish on Intel, but with due caution to the short-term bearish trend. Since I don't have any edge in predicting the outcome of either Intel's Q3 update or the employment report, I intend to execute my trades later in the day on Friday.

A review of today's INTC option trades using CBOE brings to light the following:

Sept Calls were twice as heavily traded as Sept Puts, with the highest volume occurring at the $22.5 strike price
There was large trading volume on the Oct $20.0 Puts.
Volumes (and open interest) on Jan '05 Calls were significantly more than those on Jan '05 Puts; the $25.00 contract was the most active of all.

iVolatility provides data on implied and historical volatility for Intel - given the high liquidity on Intel options, there is no significant discrepancy between the calculated (theoretical) option premium and the actual bid/ask price.

I will finalize (and post) my trading strategy tomorrow, once the market has had time to absorb the critical news reports.

Buy or Sell?

2004-09-02T07:09:00.000-07:00

A common dilemma for novice option traders is whether to buy or sell options. My decision to write calls/puts was based on the observation that, for an option buyer to profit, all 3 of the following criteria must be met:

The underlying equity must change in the correct direction (increase/decrease for call/put buyers)
The underlying equity must change by an amount greater than the option premium
The underlying equity must change before the option expiration

However, an option seller will profit even if just one of these 3 criteria is not met. Thus, the odds are clearly in favor of the option seller.

Let's look at another article by John Summa - his analysis of historical options data indicates: "(1) on average, three out of every four options held to expiration end up worthless; (2) the share of puts and calls that expired worthless is influenced by the primary trend of the underlying; and (3) option sellers still come out ahead even when the seller is going against the trend." He also notes that in the case of put options, 82.6% expired worthless."

This does not imply that one should never purchase options. However, for a consistent stream of profits over a long period of time, it is better to write options and compound the returns on a frequent basis.

More on Volatility Indicators . . .

2004-09-02T07:03:00.000-07:00

I recommend TraderWizard's post on VIX and VXN - he explains in detail how one could have used the VIX and VXN to generate buy/sell signals for the DJIA over the past year. He also points to John Summa's article on Investopedia, for an in-depth discussion on implied volatility (IV) and statistical volatility (SV).

John (who runs OptionsNerd) suggests that option traders must make effective use of the discrepancy between theoretical and actual option premiums. For example, when IV>SV and both IV and SV are at historical highs for a particular stock, it's better to sell options to profit from the high premiums. This assumes that IV and SV will revert to mean levels, thereby reducing the option premium and allowing us to buy back the option at lower premiums. The decay of time value would further enchance the returns on this trade.

Put-Call Ratio (PCR)

2004-09-01T11:23:00.000-07:00

In addition to volatility indicators such as VIX, VXN and VXO, the Put-Call Ratio (PCR) is a popular indicator of market sentiment. Quotes for these are easily available via Yahoo Finance or the VTO Report.

The PCR is commonly used as a contrarian indicator. As Jim Graham explains, a high PCR reading indicates overly bearish market sentiment. If this occurs during a pullback in a rising market, it is a contrarian signal and indicates that the market is about to disappoint the crowd and turn bullish. However, a high PCR in a bear market is normal, since pessimism is to be expected among the crowd. Thus, using the PCR can be more of an art than science, and most traders use it only with a combination of other technical indicators.

Adam Hamilton explains the PCR in detail, again highlighting the difficulties is using the PCR to generate buy/sell signals. However, he captures the essence of the PCR as "a useful contrarian speculation tool because it provides a proxy for herd psychology, general speculator emotion at any given moment in time".

The same author published a more recent article (featured at the bearish portal SafeHaven) that looks at the abnormally high PCR levels in MAY '04. Historically, a spike in the PCR has preceded a financial crisis (think LTCM). However, no such event has occurred in the past few months. Which leads me to question - does the increasingly common use of the VIX and PCR make them less effective (contrary or otherwise) indicators?

Trends & Options . . .

2004-09-01T08:23:00.000-07:00

I have been reading about the remarkable successes of trend-followers such as Ed Seykota, Bill Dunn and others, featured in Michael Covel's book on Trend Following, and on Turtle Trader.

Is trend following in conflict with my strategy of writing options? A bit of research uncovered this (PDF!) article published in the Quantitative Finance journal, on the Institute of Physics website, of all places. The article demonstrates that those currencies (USD/JPY, EUR/JPY) that are profitable for trend-followers tend to be poor candidates for option writers, and conversely, those currencies (USD/AUD, USD/CAD) that generate consistent profits for option sellers have poor trending characteristics.

This graph plots the information ratio (which measures return per unit risk) for currencies - using either trend-following or option writing strategy. Currencies in the top-left circle tend to perform better as trend candidates, while those in the bottom-right circle are suited for writing options.

What if we hypothesize that some equities are better suited for option trading than others? Given the rather large universe of stocks, it might be better to test this on the Dow-30, S&P-100 or ETFs.

Please share your thoughts on this - including suggestions on building a system to categorize a set of stocks into option vs. trend candidates.

Option ABCs: Albatross, Butterfly & Condor

2004-08-31T13:39:00.000-07:00

For a concise view of various option strategies, look no further than Commodity World. The site also specifies the type of market environment that would suit each option strategy. The last table on the page includes names like "Long iron condor", "Short Put albatross", and "Short gut iron butterfly". I must confess that I don't know what these mean - but they sound pretty cool!

The site also features a set of common sense trading rules - most of which are relevant regardless of the type of financial markets we participate in.

With all the recent talk about low trading volumes, one of these rules jumped out at me: A market that is topping or bottoming out does not spend much time at the extremes, so there will be little volume at these points.

Or perhaps, like everybody else, I should just attribute it to summer doldrums!

Options on ETFs . . .

2004-08-31T11:21:00.000-07:00

Given the increasing popularity of ETFs, and the excellent reasons for trading them (as laid out in a series of posts by the TraderWizard), I am looking into trading options on ETFs.

CBOE offers options on a wide variety of ETFs, and I think this might be the best strategy for intermediate-term trading, aimed at profiting from sector rotations in the financial markets and macro-economic trends in the US and around the world.

Some examples:

A 5% run-up in the Inflation-indexed Bond ETF (TIP) from mid-June through mid-August '04
A 15% rise in the DJ Energy ETF (IYE) from April through August '04

The problem lies in the low daily volumes on the option contracts - but hopefully, there will be more traders who discover the benefits of ETF options and provide liquidity to these markets.

From Calls to Puts . . .

2004-08-31T09:40:00.000-07:00

I changed my screens to avoid small-cap and/or illiquid options, and decided to trade naked puts instead of covered calls. Although they are considered riskier, theoretically, naked puts have the same risk-return profile as covered calls. You do need to allocate sufficient capital to cover the puts at expiration (or margin calls) - but with covered calls, you have to use the same capital up-front to purchase the underlying equity.

Goldcorp (GG) puts served as my introduction to the gold markets, courtesy of the TraderWizard. Bill's posts on the gold markets educated and encouraged me to look into the gold mining stocks, and I chose GG puts based on their attractive risk/return profile.

Equity	Position	Buy @	Sell @	# Days	% Return
GG	Oct 12.5 Put	-	$1.7	80+	-
MSFT	Jan 27.5 Put	-	$1.75	60+	-
PFE	Jan 32.5 Put	-	$2.05	50+	-
RDY	Dec 17.5 Put	-	$2.5	40+	-
HPQ	Jan 20 Put	-	$2.0	20+	-

Blowing Up . . .

2004-08-31T09:02:00.000-07:00

One of my favorite option trading tales is that of Nicholas Taleb - of Fooled by Randomness fame. This 2002 article explains how Taleb seeks to profit from rare (black-swan) events, by purchasing out-of-the-money options and waiting patiently for a low probability, high impact event to bring in the profits.

An added bonus is Taleb's perspective on Victor Niederhoffer, whose books (Education of a Speculator, Practical Speculation) and comments are interesting reads, to say the least.

Time Will Tell . . .

2004-08-30T14:51:00.000-07:00

My current portfolio of covered calls is still biased towards mid-cap, tech equities. Obviously, these offer attractive returns on option contracts, but a single earnings miss will decimate profits. Only time will tell how profitable these trades will turn out to be - option trading requires a lot of patience!

A recurring theme in this blog (as the blog name and motto indicate) is Time. The decay in time value of an option fascinates me, since it indicates an inherent, favorable bias for the option writer - if only I can figure out how best to take advantage of this gift!

Equity	Position	Buy @	Sell @	# Days	% Return
ABAX	100 sh	$21.00	-	110+	-
	May 20 Call	$0.3	$2.2
	Aug 20 Call	$0.55	$1.9
	Nov 17.5 Call	-	$2.35
FDRY	100 sh	$14.34	-	120+	-
	Sep 12.5 Call	$0.05	$1.25
	Dec 10 Call	-	$1.1
FORM	100 sh	$18.96	-	130+	-
	Jul 20 Call	$0.5	$1.6
	Jan 17.5 Call	-	$1.95
CYD	100 sh	$17.7	-	120+	-
	Aug 17.5 Call	$0.0	$2.2
	Feb 12.5 Call	-	$1.75
CSCO	100 sh	$23.0	-	65+	-
	Oct 22.5 Call	$0.1	$1.75
	Jan 20 Call	-	$1.4
MVSN	100 sh	$24.9	-	65+	-
MVSN	Oct 25 Call	-	$2.25	65+	-
KSWS	100 sh	$20.15	-	65+	-
KSWS	Oct 20 Call	-	$1.6	65+	-
MACR	100 sh	$23.99	-	65+	-
MACR	Nov 20 Call	-	$2.35	65+	-

PS: I have removed the Commissions column since signing up with IB has minimized the vigorish that I have to pay out.

Systematic vs. Chaotic . . .

2004-08-30T13:34:00.000-07:00

Trading Markets (via Yahoo) has a timely article on using systems vs. discretion in trading. It reminded me of Jack Schwager's Market Wizards books, where a larger % of the featured traders used strict rules and back-tested systems, and stressed the need to wring emotions out of trading.

Some "old" advice might be of help:
"It is best to do things systematically, since we are only human, and disorder is our worst enemy."
-Hesiod (Greek didactic poet, ~800 BC)

A Tale of Two Covered Calls . . .

2004-08-30T11:57:00.000-07:00

I wrote LEXR and CLZR covered calls, just days before their Q1 earning calls. Both of them dropped from ~$18 to ~$10. No matter: I decided that I could recoup my losses over time by continuing to write covered calls, since there wasn't much more room for the prices to drop. Here's how things unfolded:

Equity	Position	Buy @	Sell @	# Days	Comm.	% Return
LEXR	100 sh	$17.19	$6.11	83	$16	-41.0%
	Jun 17.5 Call	$0.15	$1.55
	May 10 Call	$0.25	$1.25
	Sep 10 Call	$0.25	$1.4
	Dec 10 Call	$0.4	$1.0
CLZR	100 sh	$16.06	$10.0	132	$25	-10.5%
	Aug 15 Call	$0.4	$3.3
	Jun 10 Call	$0.0	$1.0
	Aug 10 Call	$0.0	$0.75

As you can see, LEXR continued to drop to $6, and I had to close my position with a 41% loss. Although I did manage to reduce losses on CLZR (from -21% to -10%), the correct strategy is to use stop-losses on the underlying equity, and if triggered, determine whether to continue being short the call or close the position altogether.

From 1999 to 2004 ...

2004-08-29T16:33:00.000-07:00

The 1999 bull market was my introduction to trading stocks and options. As you can guess, this resulted in a very lop-sided education. But in 2000, I did have the sense not to invest a large % of my net worth in the market and thus avoided a large drawdown. However, I took a break from trading until 2003, to focus on work, school (evening MBA) and a brand-new family. This helped me put aside a reasonable amount of trading capital, without neglecting my 401k or other savings.

Now I'm back, and far more serious about becoming a trader with the ultimate goal of "meals for a lifetime".

In March , I began using stock screens and IBD (Investors' Business Daily) as the primary source of ideas for options. I transitioned to PowerOptions in May - they offer an excellent service in screening options directly using all possible combinations of risk/return metrics, option greeks, fundamental metrics of the underlying equities, etc. Their strongest advantange is in letting you run screens for specific option trading strategies - e.g. covered calls, straddles, etc.

I changed from Scottrade to Interactive Brokers to minimize commissions, formed rules to avoid illiquid option contracts, and stuck to limit orders to get orders filled at my preferred price points.

Trade History (Q2 '04)

2004-08-27T14:10:00.000-07:00

It took only a few option trades (covered calls, in my case) to realize:

Commissions significantly lowered the returns on my trades
Returns were further reduced due to the large option spreads for small-cap companies, whose contracts had insufficient daily volumes and/or open interest
I was impulsive and didn't always use limit orders to get my order fills - not only did this result in a reduction in profits, but also highlighted the lack of discipline in my order execution

Equity	Position	Buy @	Sell @	# Days	Comm.	% Return
ATML	100 sh	$6.17	$4.75	118	$22	-15.0%
	Nov 7.5 Call	$0.0	$0.8
NTE	100 sh	$14.65	$21.20	52	$4	17.8%
	Sep 15 Call	$6.3	$2.4
CREE	100 sh	$20.86	$20.00	90	$22	7.3%
	June 20 Call	$0.0	$2.6
WFII	100 sh	$11.17	$9.76	98	$22	-8.4%
	May 15 Call	$0.0	$0.7
QGENF	100 sh	$12.19	$11.75	76	$22	7.3%
	May 12.5 Call	$2.4	$1.0
BLTI	100 sh	$15.14	$18.84	20	$41	3.9%
	June 15 Call	$2.4	$1.0
AMD	100 sh	$15.4	$17.33	26	$36	1.1%
	Apr 15 Call	$2.4	$1.0

First things first ...

2004-08-27T09:27:00.000-07:00

I'm going to spend the next few days creating links to my favorite blogs, options-related sites, and such. I'll also publish my trade history and current portfolio of options.

Why did I decide to blog?

2004-08-26T13:10:00.000-07:00

It's (supposed to be) fun!
Chronicle my experiences as a novice trader.
Collect bits of wisdom from my readers.
Work towards the goal of "meals for a lifetime", and ...
Have a Gala time along the way!