The World of Options

There are infinite ways that options can be utilized in your investment portfolio. Whether you are an individual writing covered calls on 200 shares of IBM, a hedge fund manager with billions in assets that need to be protected against volatility or “tail risk,” or anywhere in between, there is a place for options in your account, period.

To get the most from the options markets, it is best to fully understand the underlying securities from which they are valued and then take on the options themselves. The trends, abnormalities, and patterns that emerge in the options markets get their cues from their underlying security. Because of this, you must never look at an option (strategy) in a vacuum.

When I was trading on the floor, I tended to end my trading day delta-neutral—or not having a “directional bet”—going into the next morning. Market makers, like I was, have to deal with a constant flow of orders without preparation. By ending delta-neutral the previous day, I could reset and remain flexible in my strategy.

Option traders tend to have an “if, then” attitude because of our ability to be elastic with our hypothesis and adjust positions as events, news, and data change. This mind-set is usually in stark contrast to a regular stock trader, who needs to be more rigid in predictions and theses. I certainly prefer the flexibility options offer, because I still have yet to meet a person who knows exactly where a stock is going, not to mention that I always like contingency plans. As an option trader you always have the choice of getting or giving odds depending on the situation.

KEY POINT:

Options traders can use certain strategies to take a neutral position in a stock or can employ protective tactics to increase their probability of becoming profitable, even on the fly.

As a professional with a trained eye I can look at an option chain on just about any security and surmise a general hypothesis about the condition of the stock; but I am learning more and more that it’s actually easier—and more profitable in the long run—to make sense of the nuances of the underlying detail first and use the options markets as your microscope and scalpel as opposed to your looking glass.

But we all get that wild streak from time to time. I remember looking at Apple’s upside call skew in early 2011 (see Exhibit 1.1) and thinking that it might be a good idea to sell some out-of-the-money call spreads because they were so expensive. Little did I know that they had planned a conference call to announce a special dividend and the stock started screaming higher (those calls were pricey for a reason), putting me in an uncomfortable spot; always take time to do your homework!

Exhibit 1.1

Have a Checklist

I believe that the most effective method of trading starts with a checklist or filter of sorts that gets you to a specific quantitative, objective target on which you can add your subjective twist. Start from the outside (macro) and work inward (details of a stock’s fundamentals and technicals).

Optimally, your checklist should consist of fundamental, technical, and statistical parameters that narrow your potential candidates to a manageable field. Bloomberg’s OSRCH screen is a quick and dirty way to cut through some of the basic fundamental, technical, and statistical noise that exists. Once the noise is out of the way, you can more effectively review only the top contenders without wasting too much time on research and missing your timing.

There are many ways of finding candidates. Running scans and filters at different times will help you to screen for stocks that meet certain criteria. Another method I favor is to form a thesis around a general social, technological, political, or global trend and find the stocks that stand to benefit (or falter) from it. Form a timeline and potential path in your head of how you think these events will unfold and then overlay an option strategy on top of that thesis.

In addition to all this, when you are forming a forward thesis, consider the effects of news, earnings, macroeconomic climate, seasonal effects, and even political developments. I can’t stress this enough! The emotional waves of the masses often override corporate fundamentals and technical formations at least in the short term. Don’t get stuck with blinders on in your own bullish or bearish mind. It’s the worst place to be.

In the longer term, earnings strength and a viable, thriving business structure with a popular good or service is what I believe motivates the markets. Most analysts, especially those using the Discounted Cash Flow (DCF) methodology and the like, agree.

The core of the options universe revolves around volatility and time. Many of the strategies, techniques, and methods I cover in this book are related to volatility/time in some form or fashion. You must understand both the volatility of the stock and the volatility of the option or spread that you are trading. An intimate knowledge of volatility in the underlying asset and subsequent manifestation in the derivative is essential to generating consistent profits and becoming a professional trader.

Smart Investor Tip!

The checklist is a major step in preventing mistakes and overlooking key information. It also helps with trade consistency and keeps scatterbrains like me focused.

We explore volatility in detail in Chapter 7 and reference it throughout this book. You also see the Bloomberg screens used to analyze it. At the end of the day, everything comes back to volatility; make its comprehension your number one priority. Just when you think you get it, you are just getting started.

The volatility conundrum haunts every good option trader. It is a question that cannot be solved, at least not fully. But you can make “realistic assumptions” about it and often that is good enough.

If you get what I am saying then you probably have some experience under your belt; if you do not, then you have a long journey ahead of you—take it slow.

Exhibit 1.2 shows the growth of puts and calls separately over the last 20 years (calls in yellow).

Options traders are growing in record numbers. Their cumulative experience and growing selection of strategies continue to increase liquidity and flexibility in the option markets, which is beneficial for all of us. See Exhibit 1.3 for totals in annual options volume. It is also the reason why indicators such as the Chicago Board Options Exchange (CBOE) put-call ratio are becoming antiquated and obsolete. I discuss this later.

Don’t be a sucker—learn as much as you can before taking big risks in the option markets.

Exhibit 1.2

The Basics

Thales of Miletus used options to lock in a low and set price for olive presses ahead of Greek harvests back in 600 BC. In the 1600s, the Dojima Rice exchange, which started on the front lawn of Yodoya Keian, arguably became the world’s first futures exchange.

Even though options in some form or fashion have been around for thousands of years, the modern standardized world of options came about in 1973 when the Chicago Board of Trade (CBOT) gave birth to the CBOE. The CBOE became home to the first equity and index exchange in the United States.

Exhibit 1.3

This was about the time the Black-Scholes model was created as a means of calculating options prices using standardized, measurable, objective integers as opposed to random price quotes that often favored the dealer, not the customer.

Prior to that, the option market was fragmented and if you wanted to buy or sell an option, you went directly to a dealer as opposed to everyone meeting on the exchange to create the most efficient price. Because of this fragmentation, there were major price discrepancies.

You see, without a standard formula there was no accurate way to price an option anyway. It was simply a random price driven market, with little rationale as to the correct price to buy or sell.

When you think about it, the underlying asset has its own set of random forces pushing and pulling on the price. Quantifying and finding a price to buy or sell an asset is hard enough. For a derivative to have no structure, you simply end up magnifying variables and making things more complicated and random.

KEY POINT:

The underlying securities themselves can also be flawed; think back to the Credit Default Swap (CDS) or Mortgage Backed Securities (MBS) vehicles.

Dealers (called Bucket Shops) would publish static quotes with not only wide bid-ask spreads, but prices that sometimes made no sense compared with today’s pricing systems and models. This is where volatility and time come into play, but back then it didn’t matter because not many people understood this. These shops operated more like horse tracks than financial firms. The dealers had a good idea about what the options were really worth and would “handicap” the prices (odds) many times in their favor. Sure people won some money from time to time, but the dealers were in control.

Jesse Livermore (Reminiscences of a Stock Operator, 1923) made a killing with options because he had the uncommon knowledge about how to derive their value. Perhaps he had a knack for knowing which way the market was moving, too, because the Bucket Shops banned him when he won so...