Surfing The Stock Market Waves
In a recent TradingMarkets chat room, one of my most frequently asked questions was, “What’s your favorite option strategy?” Aside from the obvious answer, “Whatever strategy that makes money,” I attempted to provide insight as to why one strategy would deserve favored status over another.
My conclusion will not surprise any of you who are experienced traders, as I’m sure you’ve offered the same advice that I routinely offer: There isn’t a single strategy that works in every market. So rather than trying to apply a given strategy to every market condition, you should instead match the appropriate strategy to what the market is throwing at you.
The best traders at my firm, or that I have had the pleasure of knowing — in pits in Chicago, Philadelphia, San Francisco, New York, or on trading desks around the world — all understand that the most money is made by going with the trend, not fighting it. Ultimately, we act like surfers, waiting for the wave and riding it as long as we can. Let the buying pressure, or selling forces, drive the markets. Read the tape, feel the lift, or slide and position yourself accordingly.
Since we’d been in a bear market (yes, no matter what the talking heads on CNBC say, WE HAVE BEEN IN A BEAR MARKET SINCE APRIL 2000!) I have concentrated on bearish strategies. These would include bear put spreads, short stock vs. long calls, and long gamma positions such as straddles, back spreads and butterflies. You have probably noticed that all of the aforementioned are spreads. I favor spread trading, especially for customers, as:
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The risks can be defined prior to entry
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The negative impact of time decay can be virtually eliminated
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Volatility contraction can be enormously reduced
Given that preface and our present market condition (writing on May 3, 2001), I must admit we’ve taken profits on the bulk of our short positions, and have been in long positions since the last vestiges of selling stock to raise money for tax season ended April 11. For that reason, I am going to profile my favorite strategy to take advantage of what today’s market has been giving us: the bull call spread.
For the purposes of this description, I will state that a bull call spread is the simultaneous purchase of an at-the-money call option(s) and the sale of a like number of out-the-money calls. Since we are short as many calls as we are buying, a volatility contraction should impact both long and short options, thus virtually eliminating the risk of premium contraction.
In plain English, if the perceived market risk (measured as volatility) should contract, the option you bought should shrink in a like amount to the option you sold. Likewise, the balance of long and short options should offset the time decay that would otherwise constantly be working against us. The downside of this strategy is that our upside potential is capped at the strike of our short call option(s). For my money, that’s little to give up for the positives, but you have to decide for yourself if you want options to be a casino, or a risk-limiting, “risk transference” device.
I love to use the bull call spread to let me ride the upside performance of a given stock or index with less risk. I saw great potential in (SEBL) at $24 (see my March 6 column) (BRCM) at $20 and yes, even (JDSU) the first time it hit $24. Rather than commit $20,000 or more to buy a 1000-share position in any of those stocks, I favored the bull call strategy. I could buy a $10 bull call spread, such as the SEBL May 25 – 35 spread for just 2 1/2, or $2,500 per 10-lot.
That’s about 1/10 the money we’d have had to put up to buy the stock. Here’s the real kicker: By defining our risk on entry, we can comfortably ride out the bumps and slumps of the market without getting that sick feeling in the pits of our stomachs, should the stock or index move against us.
Additionally, the risk vs. reward ratio really puts these spreads in a league of their own. Can you imagine how big the move would have to be in JDSU, or SEBL to triple your money if you bought 1000 shares of stock? Well, SEBL would only have to move from $24 to $35, a move of a mere 37% (which, by the way, SEBL did. See chart below) to expand our $2.50 investment to $10. That’s a return of 400%! SEBL would have had to explode from $24 to $98 to provide the stock investor with a matching return.
This isn’t done by magic. The reason option investors can benefit so handsomely is because they are not investing in a perpetual instrument, but a decaying asset. In other words, they have traded a specific period of time for the marvelous leverage of options. As long as the stock or index makes its move within my time frame, I can be a big winner. However, to present a balanced picture, I think it’s important to understand that should that stock or index not move within the expiration I picked, I could lose my entire investment.
Any frequent reader of my musings knows that I frequently buy bull call spreads that have some intrinsic (in-the-money) value. I’m not married to this practice, but I regularly buy the $1 or $2 in-the-money call against an out-the-money call, because the stock is just above the strike of that long call. For instance, BRCM might be trading for $31, so the 30 – 40 bull call spread I may be looking at will have an intrinsic value of $1, as my long 30 call is $1 in-the-money. I could have bought the 35 – 45 bull call spread, but unless the cost of the 35 – 45 is substantially cheaper and thus, offers a much greater risk/reward, I like owning a spread with some intrinsic (real) value.