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Imagine if owning diamonds enabled you to create and sell more of those gems. Imagine if owning paper money enabled you to print and spend more dollars without going to prison. Imagine if owning common stock gave you the power to issue and sell additional shares. In other words, suppose you could have your cake and sell it too, then materialize and sell more a little later, and sell more still later without touching the original, then finally sell the original cake at your leisure. Would you call that a great business, a great bakery to own?
The business is not risk-free but a jewelry store or a food store that could do that would have a wonderful advantage. It would also be a fine risk-reducer in a high- hazard financial realm. A phrase heavily used earlier in this piece was "other people's money." It is the selling end of the enterprise that pulls that in. Shops do that, of course, but they must pay wholesalers. Being able to materialize jewels, cakes or options out of the mist would sure cut out most of the overhead, but it is only with the latter item that this can be done.
Let us look at the stock options page of the Wall Street Journal for August 4, 2000. Verio stock shares trade at 52-3/8. (Nasdaq symbol VRIO. This stock is mentioned here only as an example, not a recommendation.) A Horizontal Calendar Spreader looks only at "out of the money" options, which would include Verio call options with strike-prices above 52-3/8. Among calls with a strike-price of 55, those expiring in August (third Friday of that month) traded at 2¼ on August 4, those expiring in September traded at 3-5/8 on that same day, those in November at 4 and February at 4¼.
I routinely buy and sell options in groups of 10. Let us say that you bought 10 call options with a strike-price of 55 and the February expiration. Trading at 4¼ means one sells for $425 and 10 for $4,250. Owning one such option means that if the price of Verio stock rises to, say, 60 or 70 or higher, you are entitled to buy 100 shares at the strike-price of 55 between now and the third Friday in February. In actual practice, however, you would not need to buy the stock because, if the price of the underlying shares were to rise markedly, the resale value of the call options would swell to much more than $425 for one or $4,250 for 10.
Most options are never exercised, i.e. their share-buying call power never utilized or share-selling power never utilized if they are puts instead of calls. Options that increase markedly in value are resold at a profit without being exercised and, sadly, most puts and calls do not increase in value and are a loss to their holders.
Over 90 percent of all "out of the money" options expire worthless. As with futures, most who trade in them do not intend to exercise and, also as with futures, the scalped cavalry rate pushes 90 percent, i.e., graves on boot hill.
So how can options be termed a "business" with smoke signals like that? Remembers those 10 Februarys you bought on August 4th? They give you the right to create and sell 10 Augusts and, after they expire, 10 Septembers and, after they expire, 10 Octobers etc. Let us portray that in dollars.
Assume you paid $4,250 plus brokerage commissions to purchase the 10 Februarys. Instantly this allows you to create and sell either 10 Augusts for $2,250 or 10 Septembers for $3,625.
As mentioned, you can sell 10 Augusts and then sell 10 Septembers after the Augusts expire. Remember, however, that all options lose value with the passing of time. By late August, "time decay" will burn one amount or another off the Septembers' $3,625.
A pronounced drop in the value of the underlying stock could shrink part or most of the $4,250 off Februarys. Also, they will lose value with the passing of time but, at this point in time, more slowly than the Aug or Sept Options.
The fact that spreading is in essence a risk-reducer means, in this example, you should choose the Sept instead of the Aug for the first sale. The larger the proportion of Other People's Money in the mixture, the lower the risk. If you invest $4,250 in Februarys and sell Septembers for $3,625, you are actually risking only the difference or the "spread" between those two figures, plus brokerage commissions.
At this time, October options in that particular stock do not exist yet but will in the weeks ahead. The spread strategist holding the Februarys may sell Octobers after the Septembers expire, then Novembers after the Octobers expire. However, the "unknown factor" that must be allowed for is the price fluctuation of the underlying shares. A declining stock price could shrink every thing, which is why the trader should include as much of other people's money in the mixture as possible. A rise in the shares above the strike-price requires an early pull-out since a spreader is a seller of "out of the money" options and should not stand pat with unexpired "in the moneys." I tolerate "in the moneys" over night at most and often for less than a full trading day.
At the time of this writing, February is six months away and the "sold" options in the example much nearer. In other instances where the buy side and the sell side of the spread are just one month apart, my formula stated in previous articles remains ironclad: A sell side of 3 points or higher and a gap or spread between the buy and the sell of less than 1½ points. For example, selling out-of-the-money Octobers at 3¼ and buying Novembers with the same underlying stock and the same strike-price for 4-5/8. The 3¼ sell fits the "3 or more" criteria and the 1-3/8 spread or difference is less than a point and a half.
In spreads with which the buy end and the sell end are several months apart, I am a little more flexible but still insist on mostly other people's money entering the total via the sell end (mostly, that is, compared to the price you pay on the buy end) and by "mostly" I do not mean "only slightly more." In the Verios call option example just given, the Augusts at 2¼ points barely qualify as mostly, a thin sliver over half of the Februarys at 4¼. The Septembers at 3-5/8 constitute a far better "mostly."
I write as an active trader, not as a pure theoretician or a swimming instructor who never gets wet or a huckster of alleged "winning strategies" who keeps his own money off the speculative battlefield. Always some readers are shocked when an active trader who writes admits to having had a losing trade. Some think there exists an unwritten law that writer/speculators tell of their gains but never their losses. Not so.
My plunge struck dry rock recently instead of oil and the disappointment, though small-scale, is instructive. When Legato Systems shares were around the 20 mark this past April, I tried an experiment with fractional options. The strike-price of 50 was far above the stock price. I bought 10 Legato call options with a strike-price of 50 and an expiration date of June for half a point and sold 10 May 50s for a quarter of a point. The $250 from the sale of the Mays paid for half of the $500 that buying the Junes cost me. I paid the difference of $250 plus brokerage commissions. This Horizontal Calendar Spread was Horizontal because both sets of options had the same strike-price of 50 and Calendar because of the different months, May and June.
It was a total loss albeit a small total. The experiment taught me to be sure the value of the options on the sell side was multiple points, not a fraction of one point. It also taught me to keep my experiments small. Multiple points on the sell end of the spread mean more of that crucial ingredient -- other folks' cash. Make it a helluva lot more than a quarter of a point. On August 4 Compaq Computer stock sold for 28?. Among its out-of-the-money call options, Augusts with a strike-price of 30 traded at a half of a point, Septembers 30s at 1-5/16, October 30s at 2-1/16 and January 30s at 3½. Januarys may make a good buy but for the sell end of a spread, have an autumnal heart and do not look earlier than October. Harvest Sam's, Bill's and Edna's cash.
After the October expires, the trader owning the January can sell November and then December. However, he need not wait until the third Friday of October. The value of October will shrink substantially in late September. At around that time the trader could buy back the Octobers at a shriveled price and sell the meaty Novembers. If he waits longer than that, the Novembers shrink. Compaq call options are mentioned here as an example rather than put options because the underlying shares are gradual trending upward.
It is advisable that an option spreader also be a stock trend-follower. A call option spread belongs above rising shares and a put option spread below declining ones. The fact that a stock can turn around and keep going is why spread strategies are not risk-free and why other people should provide as large a portion of the capital as possible. Also, spreading means selling puts or calls to hopeful people, about 90 percent of whom will end up disappointed and with depleted checkbooks.
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