Today’s Trading Lesson From TradingMarkets

“I’m sending out an S.O.S., sending out an S.O.S…”
courtesy of “The Police” and a message that I think as traders we have all
encountered at one time or another when it seems that nothing works, no matter
how hard we try. What if I were to tell you that I had discovered the proverbial
genie in the bottle for trading success? Now that
would be an attention grabber. If I said that the genie was utilizing equity or
index options as part of your trading strategy, hopefully you wouldn’t already
be asking for wish number two.

The real genie of
course is within each one of us, our acceptance of ourselves, our beliefs, our
strengths and weakness, and finding an appropriate course of action to help us
execute our trading methodology successfully within the marketplace. For each of
us, there is a path to follow and profit from, if we trust ourselves. My belief
is that trading options, whether on equities or indices, represents an integral
part in being able to stay on that path and not lose my footing, as the markets
try to trip me up on my daily journey.

My first column will
cover a lot of ground, not exactly a People magazine piece, if you know
what I mean. Starting with my personal background, my hope is to give you a good
understanding of who I am, where I’m coming from, and how this ultimately
evolved into position trading options off floor. My intention is to equip you
with the information necessary to make your own choice as to whether options
trading has a place in your trading methodology. Finally, the emphasis will be
directed at a particular options strategy, the Vertical
Spread. We’ll break it down, dissect it, and go through a couple of
real-life examples, in order to gain an appreciation for this, the first of
several “Simple Option
Strategies” I will be covering.

As an Options Market
Maker on the floors of the American and Pacific Exchanges from 1992 thru 1999,
the edge that I focused on was trading around fair value. The concept of fair
value is based on the volatility level that options are currently trading at in
the marketplace. This is called the implied volatility of an option. My trading
was concentrated on buying on the bid and selling on the offer of the Equity
options that I made markets in. This process enables the market maker to buy
“cheap” options, and sell “overpriced” options on a relative basis. As a
professional market maker, one also uses historic volatility levels as a gauge
to which direction implied volatilities might trend over time.

As volatility levels
have a tendency to revert to their historic mean, professional options traders
need to be aware of this pricing influence, and position themselves accordingly.
To sum up, the role of the Options Market Maker is much like that of the Stock
Specialist (see
prior article) in the functions that they perform. Their function allows
them to accumulate inventory, this includes both long and short positions at
advantageous prices during the course of their activities. Combine this with a
very favorable margin rate treatment, and a large capital account to withstand
the “bumps in the road” during this process, and ultimately the unwinding of
positions takes place at profitable levels.

In 1999, after seven
years of floor trading, I left in pursuit of greener pastures as new listings
rules drastically affected the market making business. The multiple listings of
equity options meant that products that once had been exclusively traded were
now in competition with the other exchanges for order flow. For the market maker
that meant increasingly tight bid/ask spreads, and hence less edge when trading
around fair value.

In deciding to trade
off floor, my initial efforts were on intraday “hyperactive” stock scalping.
This style of trading was very attractive coming from a position trading
background, as it presented an opportunity to trade with a clean slate each
morning, and no overnight surprises. With this type of trading, two minutes
could be considered a long-term hold as dimes and quarters were the initial
profit objectives, and scratching out or sacrificing nickels were the risk
levels for exiting losing trades.

After a
year-and-a-half of frustration with this style of trading, and coinciding with
another significant shift within the options industry, my days of scalping were
over. The shift that happened was the electronic access to equity options
markets perpetuated by the I.S.E., a fully electronic exchange for options
trading which forced the existing trading floors to adjust their execution
practices as well. Couple this with the tighter spreads already apparent in most
larger cap issues, and I felt the conditions were finally in place for
successful off floor options trading.

Transitioning my
option trading from a market maker perspective to that of an active short-term
trader has meant focusing on options in a new capacity. Expectations for quick
scalping opportunities around the bid and offer, as well as handling order flow
in the form of position management were no longer a part of the picture. The
edge that active options traders have from off floor is the ability to design
effective positions based on technical analysis, and maintain those positions as
long as their money management dictates. Some of the techniques that I utilize
are based off of market making strategies, but quite often it’s the simple
options strategies that are best suited to successful trading.

The Vertical Spread (or Verticals, as
they’re sometimes referred to) are a limited risk strategy consisting of one
long contract (purchased), and one contract short (sold). Verticals consist of
either all puts, or all calls, and can be designed with various degrees of
bullishness or bearishness by using in the money, at the money, or out of the
money options. For more information on the mechanics of this and many other
strategies, Tony Saliba’s site is an
excellent source of education.

The beauty that I
find in Verticals (or “Pocket Protectors” as I’ve christened them) is more than
the two contracts executed. One is the fact that it reduces the cost of the
initial debit (call bull and put bear verticals) by being able to sell a
contract at levels where I believe there to be support or resistance. As a
technician, this is an important characteristic in that the Vertical forces one
to “artificially” take profits in an area that I would normally be scaling out
of either part or all of the stock position as part of my money management.

It’s important to
note that because verticals initially cap off the effective profit potential of
the directional bet, emphasis should be placed on spreads that reduce the debit
cost by an amount which makes the vertical attractive, relative to an outright
purchase of a contract. Usually these opportunities are found in the more
volatile issues as the out of money options are priced on a volatility skew
relative to the at the moneys. This means that the implied volatilities of the
“wing” strikes trade on a higher absolute volatility.

As a guideline to
this caveat I like to search for opportunities where technically I’m seeing some
support or resistance in the direction of the trade and then finding a vertical
that will reduce my debit exposure by at least 25% to 35%. Personally, I don’t
consider selling options less than .30 cents as attractive propositions for
incorporating a vertical as I find the risk / reward generally not sufficient to
warrant such a position. Verticals can also be maneuvered easily into an
outright long contract position if the technical picture is turning more bullish
or bearish, thereby not necessarily capping profits prematurely.

“Pocket Protectors”
also work well when the underlying volatility might prevent you from entering a
trade because of that all-too-common human condition: fear. For instance,
technically you know a trade exists, but pulling the trigger with a stock
position just seems too risky in today’s markets. Personally, I find
position-trading stock in this type of environment very unnerving. Many times
when I have tried to execute with a stock position, I find myself getting
whipsawed between stop losses and reentries according to my money management
principles, and then missing the move when it finally happens.

I find that using
Verticals, which offer good risk-to-reward characteristics, leverage, and
limited risk, easier to swallow when I’m wrong. Just as important though,
Verticals allow me to participate in profitable situations that due to
volatility would otherwise not be a reality. Money management rules should still
apply to options, just as one does with trading stock, but because of the
smaller initial debit, looser technical stops are a potential weapon that might
just let you make a killing instead of being killed in the process.

Now let’s go through
a recent trade setup from start to finish.

On May 8,
Dynegy (DYN)
gapped down to new multi-year lows. The stock also exhibited a nice downtrend
line, which is shown in the chart above. Knowing that the stock could be
construed as technically oversold and prone to some upside volatility without
breaching the downtrend line, a Vertical spread presented a nice opportunity in
lieu of a stock strategy.

As the stock was
consolidating around the $10 level, off the lows by .35 cents the 7.5-10
Vertical put spread (BEAR) was offered for .85 cents (the actual strategy that I
ended up executing was this spread, coupled with a Bull Put spread known as a
Put Butterfly, which was effectively legged into during the next couple of
sessions). For .85 cents this spread represented a solid risk-to-reward
situation in light of the volatility in the underlying. If the stock reversed
for a contra move through the downtrend line, definitely a possibility in an
oversold volatile stock, then the spread would have been removed for a loss of
approx. .40 to .45 cents (rough guesstimate based on experience).

If the technical
assessment proved correct, and ultimately DYN proceeded to trade lower, one
could realize up to 1.65 in profits. So, the initial risk-to-reward scenario was
roughly 4 to 1. In a stock that I would otherwise consider off limits due to the
volatility, this Vertical presented a nice opportunity to participate with
excellent risk to reward characteristics. Indeed, the stock did exhibit a contra
move the next day.

On a percentage
basis, this move was definitely enough to get knocked out of the trade if
trading stock, but wasn’t powerful enough to break the downtrend, which was my
stop loss using the Vertical spread. Secondly, during this time DYN was
experiencing incredible intra day moves relative to the price of the stock. This
made re entry at good prices all the more difficult for even the most aggressive
traders, and another positive factor for deciding on the Vertical. Enough said,
the ensuing price action speaks for itself, and the Vertical realized its
maximum profit potential of 1.65 ( 2.5 point spread – .85 initial debit ).

Now let’s check out
an extreme example of how a Vertical strategy can definitely be called a “Pocket
Protector.” I wasn’t personally involved in the stock when the move happened but
had been monitoring the action for a potential setup.

On Feb 5, the day
before the wide-range bar down (hmmm…which one could that be?),
Overture Services (OVER)
had tested successfully a 38% Fibonacci retracement level (sorry about not
showing these levels, software limitations) as well as holding above a pivot
high from November. Overture Services had also been one of the darlings of the
IBD community up to this point. If between
the technical and fundamental picture one had decided to “go long” OVER at this
time (I was almost there myself), the “Pocket Protector” could have potentially
protected you in more ways than you could imagine.

The next day, on
pending news of an important contract renewal agreement, OVER crashed. The price
action was such that a well-placed stop loss below the market could have
produced much larger losses than anticipated. The stock was literally moving in
dollar price increments down, on huge volume. Regardless of strategy, stock, or
Vertically spread, this was not a good day to be long.

Here’s the irony
though, and this is not meant to detract from sound money management principles:
A Vertical call spread, had you been long one, would have been close to
impossible to exit during this malaise. Your only solace would be that your
losses were most likely smaller than if using stock during this debacle, and
that you were now the proud owner of a “rip up” spread.

As I stated earlier,
this is an extreme example, but sometimes “It ain’t OVER, till it’s OVER.” Five
days later the holder of the “rip up” was actually “in the money,” while the
original holder of stock was “OVER and OUT.”