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For now, here are some basic definitions of the option strategies covered in this bookIMPLIED VOLATILITY AND TRADE SELECTION When it comes to professionally trading options, there is no more important component than volatility. As discussed in earlier chapters, volatility will often dictate which strategy is best in any given situation. We have already explored what volatility is and the relationship between two types of volatility: implied and historical volatility. Now let us correlate the relative implied volatility levels to the inventory of available option strategies using a strategy matrix. It will provide some guidelines on how to best use this valuable strategy-driving indicator. Before presenting a comprehensive table of implied volatility levels and option strategies, lets review the definitions of each strategy. These definitions serve only to facilitate an understanding of the table so that you may refer to it when needed with clarity. Although most of the strategies have been covered in this book, the reader is encouraged to investigate additional educational resources that offer a more in-depth analysis on any or all of the strategies. You may want to find one or two that seem to make the most sense to you, and start paper trading them until you understand them thoroughly. For now, here are some basic definitions of the option strategies covered in this book: Call Gives the buyer the right, but not the obligation, to buy the underlying stock at a certain price on or before a specific date. The seller of a call option is obligated to deliver 100 shares of the underlying stock at a certain price on or before a specific date if the call is assigned. Put Gives the buyer the right, but not the obligation, to sell the underlying stock at a specific price on or before a specific date. The seller of a put option is obligated to buy a stock at a specific price if the put is assigned. Covered call Sell an out-of-the-money call option while simultaneously owning 100 shares of the underlying stock. Covered put Sell an out-of-the-money put option while simultaneously selling 100 shares of the underlying stock. Bull put spread Long the lower strike puts and short the higher strike puts with the same expiration date using the same number of contracts, all done for a net credit. Bull call spread Short the higher strike calls and long the lower strike calls with the same expiration date using the same number of contracts, all done for a net debit. Bear put spread Long the higher strike puts and short the lower strike puts with the same expiration date using the same number of contracts, all done for a net debit. Bear call spread Long the higher strike calls and short the lower strike calls with the same expiration date using the same number of contracts, all done for a net credit. Long straddle Long both an at-the-money call and an at-the-money put with the same number of contracts, identical strike price and expiration date. Long strangle Long both a higher strike OTM call and a lower strike OTM put with the same number of contracts and same expiration date. Call ratio backspread Short the lower strike calls that are at-themoney or in-the-money and simultaneously buy multiple higher strike calls with the same expiration date in a ratio less than .67. Put ratio backspread Short the higher strike puts that are at-themoney or in-the-money and simultaneously buy multiple lower strike puts with the same expiration date in a ratio less than .67. Call butterfly spread Sell two at-the-money middle strike calls and buy one call on each wing. The trade is a combination of a bull call spread and a bear call spread. Put butterfly spread Sell two at-the-money middle strike puts and buy one put on each wing. The trade is a combination of a bull put spread and a bear put spread. Long iron butterfly Long a lower strike out-of-the-money put; long a higher strike out-of-the-money call; short a middle strike at-themoney call; short a middle strike at-the-money put. Condor Long a lower strike option at support; sell a higher strike option, and an even higher strike option; and buy an even higher strike option at resistance (all calls or all puts). Call calendar spread Buy a long-term call and sell a short-term call against it for the same strike price and same number of contracts, using different expiration months. Put calendar spread Buy a long-term put and sell a short-term put against it for the same strike price and same number of contracts, using different expiration months. Diagonal spread Buy a long-term option and sell a short-term option with different strikes and as small a net debit as possible. Collar Purchase stock and sell a call against it usually for a year or longer. With the premium received for selling the call, buy a protective put. In order to determine which strategy is best in any given situation, it is useful to consider volatility. Recall that there are two types: 1. Historical volatility. Measures a stocks tendency for movement based on the stocks past price action during a specific time period. 2. Implied volatility. Approximates how much the marketplace thinks prices will move. It is derived from the option prices in the market and an option pricing model. Option strategists often use historical volatility as a guide, or a barometer, to determine if implied volatility is high or low. Table 19.1 shows the various strategies that can be used in high and low implied volatility situations. In this case, the implied volatility level column on the right-hand side of the table is referring to the relationship of the current implied volatility reading to the stocks historical volatility. If it is low, this suggests that implied volatility is less than statistical volatility. If it is high, this suggests that implied volatility is greater than historical volatility. Current Implied Volatility Level HighCurrent implied volatility is significantly above historical volatility. LowCurrent implied volatility is significantly below historical volatility. AverageCurrent implied volatility is at or near historical volatility. To use the strategy matrix effectively, the trader needs to select the directional bias of the stock, evaluate the implied volatility level, and then match this information up with the available strategies. For example, if I am bullish and the underlying stock has an average implied volatility level, then by using the selection matrix, I can select either a long call or a short put for my options strategy. On the other hand, if I am bearish and implied volatility is high, I might consider a bear call spread or a bear put spread. In conclusion, the table is a guide to help you understand your alternatives and subsequently determine which strategy works best in any implied volatility situation: high, average, or low. Use it not only as a quick reference chart convenient for choosing the appropriate strategy, but also to develop a fundamental appreciation for the role implied volatility plays in the selection process. SUCCESSFUL INVESTMENT MAXIMS FROM WALL STREET LEGENDS Lets take a look at the various investment principles, practices, and philosophies of some of the most successful equity investors on Wall Street. Most of these names you have certainly heard of; however, there are others who do not have quite as much notoriety. But as you will see, they all offer something valuable and different that can be applied to your own equity investing. The first legendary investor I am sure most of you have heard of is Warren Buffett. Buffett has a famous quote when describing his approach to the market: Rule number 1: Never lose money. Rule number 2: Never forget rule number 1. Buffett has often said when entering a stock trade that he is not attempting to make money but operates on the assumption that they could close the market the next day and not reopen it for five years. He asserts that he does not invest in stocks but rather in businesses and feels that one of the dumbest reasons to purchase a stock is because it is going up. Buffett feels that investors should draw a circle around the businesses they understand and then filter out those that fail to qualify on the basis of value, good management, and ability to endure hard times. This classic fundamentalist has another famous quote that drives home his philosophy: You should invest in a business that even a fool can run, because someday a fool will. Another Wall Street legend for whom even Warren Buffett has a lot of praise is Phillip Carret. Carret lived from 1896 to 1998. He founded one of the first mutual fund, the Pioneer fund, in 1928. Carret insisted an investor should never hold fewer than 10 different securities covering five different business sectors and at least once in six months should reappraise every security held. He maintained if one were to do it more frequently one would be more apt to sell it sooner than one should because many times it takes years for a stock price to reflect the value of the company. Carret always was aware of his surroundings when trying to uncover profitable opportunities. For example, when staying at a hotel in Boston he used Neutrogena soap and was so elated with the product that he purchased the stock. A few years later Johnson & Johnson bought Neutrogena and Carret made a fortune from his original investment. He also liked options and felt that an investor should set aside a small proportion of available funds for the purchase of long-term stock options of promising companies whenever available. Peter Lynch is also an investor who has had a fabulous career on Wall Street. One of his key rules is to absolutely understand the nature of the companies you own as well as the specific reasons for holding the equity. He maintains that if investors would put their stocks into categories they would have a better idea of what to expect from them. Even though Peter Lynch might visit more than 400 companies in a year, some of his best investments have come from using the companys product. For example, he purchased Taco Bell after trying and enjoying one of their burritos during his travels. Some of his other investment maxims include the observation that big companies have small moves and small companies have big moves. Also, he says its better to miss the first move in a stock and wait to see if a companys plans are actually working out. Mr. Lynch likes to invest in simple companies that appear dull and out of favor with Wall Street. He asserts that you should look for companies that consistently buy back their own shares and views insider buying as a positive sign, especially when several individuals are buying at once. As a true fundamentalist, he carefully considers the price-earnings ratio. It is his belief that if the stock is extremely overpriced, even if everything else goes right, you wont make any money. Another Wall Street wizard is Sir John Templeton, who is an expert at uncovering international investment opportunities. To illustrate, by the mid-1960s, Templeton and his famous Templeton Funds were invested in Japan, where stocks were trading at 4 times earnings whereas U.S. stocks were at 16. He believes that for all long-term investors, there is only one objective: maximum total return after taxes. Much of his investment philosophy is predicated on the belief that it is impossible to produce a superior performance unless you do something different from the majority. He goes on to explain that a time of extreme pessimism is a great buying opportunity, and a time of extreme optimism is the best time to sell. He is indeed a classic contrarian. The crux of his approach is that if you search for investments worldwide, you will find more deals and better bargains than by analyzing only one country. In addition, you gain the safety of diversification. One very colorful figure who had an exceptional career on Wall Street was Bernard Baruch, who lived from 1870 to 1965. In his investments he adopted a skeptical philosophy, always trying to separate facts from emotion. He insisted that to successfully speculate in the markets it must be a full-time job. Baruch viewed relying on inside information or hot stock tips as a very dangerous way to invest. Before purchasing any stock, Baruch would make sure he knew everything he could about the company: its competitors, its management, and its earnings growth potential. He never attempted to pick tops and bottoms and was always quick to take losses. In addition, Mr. Baruch tried to be in just a few investments at one time so the trades could be better managed. He would periodically analyze all of his investments to see if new developments had changed his original outlook. One of his key habits to which he attributed much of his success was that he constantly would analyze his losses to determine his mistakes. He would often get away from the hustle and bustle of Wall Street to perform this review. He always concluded this exercise with a self-examination of his trading decisions to better understand his own failings. Another impressive investment guru is John Bogle, who founded the Vanguard Group, a mutual funds company in 1974. The cornerstone of his investment approach is that investing is not complicated and can be done quite successfully by just employing a little common sense. He contends the investor can do very well by doing just a few things right and avoiding serious mistakes. He believes in taking reasonable risks to achieve higher long-term rates of return and that ones portfolio should be well diversified. This diversification maxim is why Bogle feels that mutual funds are so valuable. He contends that a set of diversified investments in stocks and bonds only has market risk versus the greater risk of being in just one or two stocks. Finally, he emphasizes thinking for the long term and that stocks may remain overvalued or undervalued for years, so staying the course is one of his key trading rules. He feels that patience and consistency are the most valuable assets an investor can possess. Henry Clews, a famous investor who lived from 1834 to 1923, was a very successful trader who practiced his craft in the very early days of Wall Street after coming to New York from England in 1850. Mr. Clews always felt investment experts should be sought out to manage portfolios, asserting that if one needed legal help one would see a lawyer and if one needed medical help one would not hesitate to see a doctor; thus if needing investment advice one should seek out a professional. Much of Mr. Clews advice centers on what types of people to avoid when seeking your investment fortune. Some of the characteristics he cites include individuals who unjustly accuse others of bad deeds, who never have a good word for anybody, who wont work for an honest living, or who run into debt with no apparent intention of repaying. He asserts that by prudently avoiding these types of people and selecting only associates without these characteristics your life and fortune will be a lot better off. I am sure most of you have heard of this next investment legend, Charles Schwab. He founded Charles Schwab & Company in 1974. After selling a controlling interest in the firm to BankAmerica in 1983, he bought it back in 1987 and took the company public that same year. Some of his investment wisdom for selecting stocks and mutual funds includes when reading financial papers to always pay attention to the advertisements as there might be an investing opportunity behind the ad. Mr. Schwab considers mutual funds to be the best investment for most people and claims index funds are a great way to invest for both the novice and the veteran investor. In addition, he feels that one should consider only no-load mutual funds with good performance records, not only for the current year but also over the life of the fund. Mr. Schwab strongly recommends that investors include an international component in their asset allocation plan. Another brilliant trader, Linda Bradford Raschke, currently the president of LBRGroup, began her professional trading career in 1981 as a market maker in equity options. After seven years on the trading floor, she left the exchange to expand her trading program in the futures markets. Linda Raschke has since been a principal trader for several hedge funds and runs commercial hedging programs in the metals markets. She has pioneered work on volatility-based trading indicators, which were incorporated into her daily trading programs and her overall approach to the markets. Linda Raschke is a very successful short-term trader who uses a swing trading methodology as the cornerstone of her success. Her approach is a combination of monitoring intraday news and economic reports along with pattern recognition on charts that signal potentially explosive moves. Linda use the Average Directional Index (ADX) as her core indicator to signal direction and examines market volatility to determine where best to apply her ADX tool. Traders who have employed these short-term tools have increased the profit probability of their positions dramatically. In fact, this is the main theme of Lindas trading philosophy. She requires that the probability of profit for any trade she considers placing is definitely in her corner before ever pulling the trigger. The effectiveness of this approach is obvious, given her long-term success in the business and that she was featured in Jack Schwagers book, The New Market Wizards (HarperBusiness, 1992). Linda Raschkes high-probability short-term trading strategies are worth learning for any trader wishing to profit from swings and volatility in the marketplace. As a technical trader, she has contributed a wealth of knowledge in this area and through her lectures and publications has helped many people become better market timers. I hope you have enjoyed this information about these Wall Street gurus. Even though they have different styles and have invested in different eras, each one has some very invaluable investment insights that can be integrated into your own approach to the markets. |
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