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Software for Pricing Options
by Kenneth R. Trester
and Robert P. Swanson
Chapter 10 - Buying Options for High and Consistent Profits
Plan Before You Play
High and consistent profits can only come from buying options
if you follow a disciplined and systematic approach. An option
investor who plunges into the market with no plan of attack is
doomed. In fact, if investors get lucky when they first venture
into the options market and make a big profit, they are almost
sure to give that profit back and more. The beginner who has a
winner in the options market tends to become overconfident,
believes that he will profit with every option that he buys, and
therefore bets far too much money on his next option positions --
and then probably loses all of it. If you need immediate
gratification and are not able to handle losses gracefully and
rationally, then option buying is not your game.
If you hold options until expiration, you will only profit
approximately 33% of the time on average. Therefore, even if you
do everything right, you could have a long losing streak. The
successful option buyer will have a lot of small losses, but a
few big winners to offset those losses. To cushion and handle
those losses, you will need a well defined game plan that
provides for a sufficient and continuing supply of speculative
capital that you can comfortably afford to lose, so that you can
get through some of the losing streaks you are sure to encounter.
Your game plan should specify how much money you will invest
in each position to ensure that you don't go overboard on any one
option position. This plan should also force you to diversify
into several option positions over time. In other words, don't
bet all your money on one horse nor all your money on one race.
There are extended periods of several months where the markets
may be quiet, and that can spell disaster for almost all option
buyers. At these times, a good portion of your speculative
capital should be set aside. A well designed game plan, then,
gives you the discipline and patience you need in order to
generate consistent profits over time.
The 10% Solution
When designing your game plan, we suggest you use a portion of
the interest and dividends that you generate from some of your
investment capital to provide the funds for your option buying
program. For example, if you have $50,000 in T-bills, bonds, and
other securities -- at present rates of return -- you will earn
about $5,000 a year from that portfolio. These earnings could be
your "option buying pool," and if you lose this $5,000,
you still have your original investment untouched and intact.
Do not use the $5,000 for option buying if you live off that
money or if you can't afford to lose the money. Furthermore, ask
yourself honestly, "Would I sleep comfortably at night if I
lost the whole $5,000 in the options market?" If the answer
is no, then that money should not be used for option buying.
The fact that the 10% solution replenishes your option buying
fund each year with additional interest earnings should give you
enough of a cushion to handle a series of losses and still be in
the game when that big winner comes along. One warning here:
never touch your principle or savings when you buy options unless
the options are used for insurance or for hedging.
Selecting the Best Option Buy Candidates
Once you have designed a well defined game plan, we come to
the most difficult task -- picking good option candidates. I
suggest two possible approaches to this task.
One approach is to identify the best underlying stocks or
futures first. Once you have pinpointed stocks or an index that
look like they are ready to move soon, then you should evaluate
the underlying options and identify the best priced options. Here
selectivity and patience should prevail.
If you cannot identify an underlying option that is
underpriced, or at the very least, fairly priced (to measure the
fair price, refer to the tables in The Option Player's
Advanced Guidebook, or use OPTION MASTER®), wait and
look for better opportunities. If you pay too much for an option,
you have stacked the odds against yourself. Even if you are right
about the underlying stocks or futures, the reward will not be
commensurate with the risk.
Options Before the Underlying Stock or Futures
The second approach to identify prime option buy candidates is
the one that we follow. We first scan most of the options that
are trading and identify those that are most underpriced
according to our pricing models. Once we have pinpointed the most
underpriced options available, we then look closely at the
underlying stock, index or futures. Next we select options with
underlying stocks with the best short-term technical potential to
make the proper price move. Here, whenever you buy options, price
is the key. If you can't get your price plus or minus an
eighth, wait and/or look for new option candidates.
The Best Priced Options
When we are trying to find the best priced options, we attempt
to identify two types of options:
1. Super cheap options (usually priced below $100
for stocks, $400 for futures) that are within striking
distance of the exercise price.
2. Slightly in-the-money options (or at-the-money
options) priced at less than 2 1/2 ($250) where the option
price will move almost point for point with the underlying
stock price.
Super Cheap Options
We love super cheap options because if the stock or futures
does not make the right move, all we lose is the small price we
paid for the option; and if the underlying stock or futures price
makes the right move, a gigantic profit can be generated.
For example, in the February, 1984 issue of The Trester Complete Option Report, we identified the Aetna Life (AET)
April 40 call priced at only 1/8 ($12.50) when the stock price
was 36 5/8, only 3 3/8 points from the strike price. Even if AET
did not rise in price, all we could have lost is $12.50 per
option. In our January issue, we identified a Phillips Petroleum
(P) May 40 call at 3/8 when the underlying stock was at 34 1/2,
only 5 1/2 points from the strike price. Phillips has since moved
to over $42 a share and the May 40 call option price rose to over
2 ($200). Of course, with such low-priced options, your chances
of profiting are reduced. They usually only pay off 20-30% of the
time if you hold them until expiration.
Also, time is an important factor. Make sure the option
has enough time before expiration to allow the underlying stock
or futures price to move through the strike price.
Slightly In-The-Money Options
Slightly in-the-money options or at-the-money options, when
they are priced right, have the advantage of moving almost point
for point with the underlying stock or futures price. Therefore,
a small move in the stock price can generate nice profits from
the option purchase. Limiting the option price to 2 1/2 limits
your losses just in case you are wrong about the stock's future
price movements, and yet still allows the option price to closely
follow the stock price.
For example, in our January issue, the W R Grace Feb 45 call
was identified at a price of 1 1/8 when W R Grace (GRA) was
priced at 45 1/4. This option expired without value, but if GRA
had risen to 50, the option would have increased by 4 points. W R
Grace was priced at 38 7/8 at the expiration of the call option
in February, but all you would have lost was the 1 1/8 points,
not the 6 1/8 points lost in the underlying stock.
Identifying options that are super cheap and
close-to-the-money or slightly-in-the-money at a low price is a
difficult task, and at times you may need to compromise. But the
option should still be underpriced based on the tables in my
books or a similar pricing model (the OPTION MASTER®).
Secrets of the Professional Trader
Once you have purchased an option, what do you do next?
Remember, if you hold options until expiration, you only profit
on average one third of the time. So, action should be taken
before expiration. A suggested strategy is to follow the familiar
adage, "cut your losses and let your profits run." Easy
to say, but hard to follow! But a highly successful commodity
trader that I know of follows these words of wisdom to the
letter. He has many small losses and a few big winners, and he
never stays in a position more than a few days if it has not
generated a profit.
When to Cut Losses
Whenever you are uncomfortable in an option position, you
should get out. However, if you are too skittish, you will
overreact and move in and out of your option positions far too
often and commissions will eat you alive. Therefore, we suggest
the 50% rule. If an option drops 50% in price, get out. Another
way to cut your losses is to buy cheap options. If you buy an
option at 1/2, that is all you can lose.
When the market makes a major trend change, or the underlying
stock makes a major change in its trend, all bets are off. Then
you should immediately sell most of the appropriate puts or
calls, but make sure you don't overreact to the situation -- make
sure the major trend has changed.
Let Your Profits Run
When you buy options, cutting losses is not a major problem
because if you don't cut your losses, your options will expire,
forcing you to take your losses. Taking profits is a different
story. Profits with options are created quickly and,
unfortunately, disappear quickly. That is why we suggest a
targeted sell price. Such a predetermined price to capture
profits takes advantage of intraday moves in options, and allows
a more hands-off approach to options trading.
But such a strategy limits your profits and does not allow
your profits to run -- an important ingredient of successful
trading. Therefore, we recommend a "round robin"
approach to taking profits.
The "Round Robin" Approach
The "round robin" method of taking profits is to set
a predetermined target sell price for only a portion of your
position. Let profits on the rest of the position ride. For
example, if you bought 10 Phillips Pet May 35 calls at 3/8, you
could take profits on only five of the calls if the calls reached
a price of 1 1/4, but you would let the other five options ride
hoping for higher profits.
When you have a good profit in an option position, be ready to
get out at any moment. For example, if the stock stops moving in
the right direction or the market begins to change trend, take
your profits and run. Never be afraid to take a profit and then
never look back and regret taking a profit too early. When you
have a nice profit, you cannot afford to let your profits slip
away. So, at the very least, use the "round robin"
approach or roll over to some cheaper positions, and capture some
of your profits.
In conclusion, the road to high and consistent profits through
option buying requires a good game plan, the selectivity to pick
only the lowest priced options, discipline to cut your losses and
maximize your gains, and the patience to wait for the best plays
and the big winners. Finally, be prepared to gracefully handle
losses along the way.
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