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Also at the Mercantile Library, I found a book on Option Spreads. I am sorry not to remember the author or exact title but it was the jungle diamond snatched from amid venomous vipers. The question is asked on many a barstool: “Who gets all that money that’s lost in the markets?” At more specialized question: Who received the cash paid for all those put & call options that expire worthless on the third Friday of every month?
Much of it goes to stockholders who sell covered calls on shares they own. A fair amount goes to sellers of naked puts & calls. A part goes to “spread” strategists, the merchant caravan to which I belong. The latter are probably the least numerous among the three categories of traders. Yet that strategy earns high marks for both requiring a relatively small investment and (trumpet fanfare) reducing the risk.
Let us say that you buy 1,000 shares of an optionable stock. Each 100 shares you own gives you the right to sell one “covered call” option, so with 1,000 shares you may sell 10. On April 22, 2002, for example, Dell Computer trades for 27 a share. You may buy 1,000 shares for $27,000 cash or $13,500 at 50 percent margin. Let us say $15,000 for a bit of protection against margin calls. (Specifying a company name is not a recommendation.)
With options, one point means $100 or $1,000 if you are selling 10. The option columns for April 22 say that Dell calls with an expiration date of May and a strike-price of 30 trade for .2 or two-tenths of a point with a volume of 1,369 options sold. The .2 means you can sell one “covered call” for $20 or 10 for $200. The 30 strike-price means whoever buys one Option has the right to buy 100 shares of Dell common stock at 30 dollars a share before the expiration date--the third Friday of May.
Since Dell stock currently sells for 27, the May 30 calls are said to be “out of the money” but trade for cash because the shares may climb above that strike-price before expiration. The option columns in the same newspapers (Barron’s, The Wall Street Journal, numerous dailies) say that June 30 (expiration month and strike-price) Dell calls sell for .55 ($55 for one or $550 for 10) with a volume of 296. August 30s weigh in at 1.15 ($115 or...$1,150) volume 366.
The November 30s at 2.15 translate $215 or $2,150, volume 13. January (2003) 30s at 2.6 are $260 or $2,600 and volume 25. If you paid $15,000 to buy Dell shares on margin, selling Junes for $550 with a two-month commitment or Augusts for $1,150 with a four-month commitment each annualizes to better than a 20 percent return. Selling the seven-month-ahead Novembers for $2,150 annualizes to just under 30 percent and nine-month-ahead Januarys ($2,600) about 35 percent. If the stock rises to above 30, the options will be exercised and you must sell at 30 for about a 10 percent gain on the shares--another plus when handling out-of-the-money calls.
If the stock stays below 30, the options expire worthless and you may sell more carrying a later expiration date, and if those expire worthless, still more. If the stock declines in price, the sale of covered calls provides varying degrees of cushioning. For example, the sale of Novembers for over $2,000 offsets over a $2,000 loss in the shares. However, stock investors who sell “covered calls” or calls covered by shares they own are perennially warned: NEVER buy a stock for option-selling purposes unless you would also buy it for its own sake.
The Reason: If the shares in a particular company are not a good investment in and of themselves, the nosedive will hurt far worse than any option offset can heal. Such fundamental and technical factors carry significance for the spread strategist as well as the stock investor. The numbers in the preceding paragraphs are option spreader’s figures as well as shareholder’s ones. Same data, different viewing angle.
The Key Fact: Owning options with expiration dates far in time gives the trader the right to create and sell options dated nearer in time. Possessing stocks, bonds or money does not allow you to print more stocks, bonds or money, but with puts and calls the rules change delightfully. Let us say you buy the 10 Dell call options with a January 2003 expiration date and a strike-price of 30, and you pay the already-mentioned price of $2,600. That gives you the right to sell 10 nearer-in-time June 30s for $550 and, after they expire, 10 July 30s. The Julys do not exist yet but will, starting late May. After the Julys expire, golden et ceteras shine August through December.
If the spread strategist wants a bigger moneybag now, he can buy Januarys for $2,600 and instantly sell Augusts for $1,150. Also, he need not wait until expiration on the third Friday of August to mine another vein. He can buy back and close out the Augusts at a reduced price after time-decay has eroded their value, such as in June or July, then sell a later expirer. Selling options that expire worthless and selling then buying back at a reduced price are both “shorting for gain” variations.
Although spreading is not risk-free, you may have noticed how numerical proportions change vastly to favor the spread strategist. $1,150 from the sale of Augusts is a far bigger return on an investment of $2,600 (purchasing the Januarys) than on an investment of $15,000 (Dell shares on margin) or $27,000 (stock bought for cash). Also, even though options have a risk factor (expiration) that shares do not have, far less cash is risked. Most importantly, when things do not happen as planned, when a stock descends instead of ascending or the reverse, the aforementioned cushioning or offsetting grows astonishingly.
To be specific, the $1,150 makes a far bigger “shield” when protecting $2,600 than when trying to protect $15,000 or $27,000. This does not even factor in the money from the sale of options expiring other months. When you gain a nickel and lose a dime, that nickel is far larger than when you gain a nickel and lose a dollar. A couple of pennies from another month and a couple more from still another--What a Difference. So although option spreads involve risk, it helps mightily when your casino chips give birth to other chips and can do it again.
Financial calfing of this particular variety is known as a Horizontal Calendar Spread. In the Dell Computers example given, the spread was horizontal because the options bought and those sold had the same strike-prices (30) and calendar because of different expiration months (buy the far-in-time Januarys, sell the near-in-time Junes or Augusts). The options bought are called the “long end” of the spread and those sold the “short end.” Inevitably, “selling short” means profiting from other investors’ losses, with expiration dates as Boot Hill.
Sell the Junes. After they expire, sell the Julys. After they expire, sell the Augusts. Each sale is a purchase by some optioneer who wants the puts or the calls to swell in value, who gives it his hopes and a chunk of his bankroll. Among the “sad 9Os,” over 90 percent of those out-of-the-money Jutes and Julys and Augusts become worthless paper. So what should you do? Sell plenty of paper that becomes worthless.
I have found becoming an option spreader a fine way to start since that method gets much of the money other people lose. Hail to OPM! Also, there are no plaques engraved with maxims on my wall but I can envision several. Confucius said, “When a learned man makes an error, he makes a learned error.” Professionals can lose but they lose less cash less often than the jungle picnickers. Not risking too large a portion of your capital on any one-venture counts as one important rule.
Another is studying and becoming sophisticated within the specialty. In their book All About Options, Wasendorf & McCafferty wrote, “A negative personality rarely earns profits consistently. They are usually attracted to options for the wrong reasons -- to make a lot of money fast without exerting much effort. Therefore, they don’t spend the time required to learn some of the more complicated strategies that are more conservative by comparison.”
Horizontal Calendar Spreads using out-of-the-money options would rank high among those strategies. As for the “wrong reasons” people who want “to make a lot of money quickly without exerting much effort” well, if they like the smell of horses their cash winds up in the bookmaker’s till. If they like the hum and color of the markets, it winds up in the option-seller’s till, and the spreader sells as well as buys. Ergo, the “smart money” rests in the pocket of the well-read or well-studied trader.
What to read? Not and easy question. Since relatively few traders are spreaders, not a lot has been published on the subject. In his landmark book The New Options Advantage, David L. Caplan wrote, “Two positions that have great benefits in many diverse situations, ‘covered call writing’ and ‘calendar spreads’ are often overlooked by most traders.” The book does not atone much since its section “Calendar Spread” runs only two pages. The above-quoted Wasendorf & McCafferty book All About Options devotes only three pages.
On the plus side, George Angell’s book Sure Thing Options Trading carries good basics on option-spreading, as does his book Winning in the Futures Market on spreading with futures. Well-known are Lawrence G. McMillan’s books Options as a Strategic Investment and McMillan on Options. Special mention goes to LEAPS -- What They Are and How to Use Them for Profit and Protection by Harrison Roth. It focuses on long-term (eight months to two and a half years ahead in time) options but also has much worthwhile to say about conventional shorter-term ones. Chapter 35 on Calendar Spreads deserves a trophy, with the 42-page Introduction plus Chapters 10 and 11 making good foundational reading.
Chapter 35 says, “Our intention is to keep writing OTM ‘out-of-the-money’ shorter-term calls and keep collecting those lovely premiums.” Th |
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