Option FAQ, Part 2: Hedge it to Me!

Last week, I began this Option FAQ with a basic introduction to options. In part 2, I will delve more into more advanced hedging functions.

The first hedging function I discussed last week was to put a floor on stock value by buying a put option. Now let's consider the reverse, selling a put.

Selling a put means you are providing someone the option to have their stock purchased from them, by you. This is the opposite of buying a put, and is similar to shorting any given stock (including requiring margin). What does this look like?

This chart is the mirror image from the basic introduction image. Blue represents the stock price, while the red line represents a Jan '08 Put Option @ $700 that you have sold while you hold Google stock.

As the graph shows, by selling a put option, you have created a ceiling for your portfolio.

Now lets talk about call options.

Call options provide the ability to buy an underlying equity. If you buy a call, you are purchasing the right to buy an equity at the specified price. If you sell a call, you are selling the right to buy from you an equity at a specific price. So what do calls and stock look like for your portfolio? I'm going to teach you to work it out for your self with fancy term called "Financial Engineering".

Technically, this is the design of various financial products that decrease external risk, and help you get a financial instrument with the exact risk you are looking for. As applied to options, this is like putting puzzles together.

Let me decompose those portfolio value charts that I have made, and provide you with what each option type actually looks like:


Now you've seen me combine stocks with the put options for portfolio value, so I will walk you through a combo stock + sell call. Remember a stock follows a diagonal line. So let's put these two lines onto one graph.

(Due to spacing issues, the graph I'm referring to may be lower on the page) The blue line is Google stock, the red line is the option, and the purple line represents the combination of the two. As you can see, prior to hitting the strike price, a combination portfolio has more value than the stock, primarily because of the money received for the sell of the option.

Past the strike price point ($700), the portfolio value flattens, while the components head in different directions.

This is the basis of a hedge. You want two instruments that move in exact opposite directions.

Now go out there and play with each of the four option possibilities, and we'll discuss the tried and true options combinations.

Market down, portfolio up

Now most who read that headline would think, "oh, you were shorting the market", but no. I was actually long all day today. How then could I make money today?

Well one, I followed my own rules yesterday and sold half of my positions for a nice gain. This morning, as the market reacted to Merrill and Amazon's announcements, I realized it would be a big up and down sort of day.

I kept track of the market as it dipped, and around 11am, the market seem to bottom, so I bought in. I bought both the Nasdaq Qs as well as Amazon stop, for basically the same reason. Technology stock I thought were being hit by a combination of profit-taking from the day before and a general feeling market sluggishness. I thought that the market was over reacting.

After lunch, I patiently watched the market fluctuate a little before inching its way up. I was happy to see the Nasdaq end up even and Amazon make some of its 17% decrease back.

What do I expect tomorrow? A lot of bargain buyers will be coming in to scoop up the cheap stuff, and the market so do well.

Sigh of Relief

As Apple announced their ridiculous amazing earnings (news here), and Microsoft poised to report their earnings on Thursday, the NASDAQ made the turn for the better as I had hoped (predicted?). The fed comments today also helped, implying that a rate cut will definitely be used if market conditions worsen.

Overall, my position is still down about 5% from where it was last Thursday, but after hours trading suggest my options so all be in the black by the time the market opens tomorrow.

Market Outlook for the Week

Well, all the interesting earnings reports are behind us. The markets really took a beating late last week, as companies across the board reported earnings below or only meeting expectations, which the street hated (the only bright spot being Google).

For me, it was a great time to buy more Nasdaq (QQQQ) calls options on the cheap. Right now, I have amassed the largest position I have ever taken in one equity, about 25% of my total funds. It is a massive bet, but I am betting that the market well view the market this week with new eyes, see plenty of buying opportunities, and price in a rate cut coming after all this negative economic news.

What do I need? I need the Nasdaq to go up about 5% from where it closed on Friday, and my options will do very well.

Go Nasdaq!

Total's trades net me $400+

As a short-term trader, one of the things I love are news events that are guaranteed to move the market in some fashion. Events such as those allow me to bet one or the other, and the leverage of options really allow me to profit off of those quick moves.

Today is a good example. I knew early today that the minutes of last month's Federal Reserve would move the markets. Traders and analysts would be scrutinizing every word to see if another cut was on the horizon.

Feeling optimistic, I bought 30 October 53 QQQQ (Nasdaq-100 Index) Calls and 15 November 54 QQQQ Calls, as well as 10 October 158 SPY (S&P 500 Index) Calls. Around mid-day, the calls were about even, but the market had been fluctuating up and down for a while.

Right around 1:30PM, 30 minutes before the minutes were to be released, volume picked up, and the price started to trend upward. After the news was announced, that all the Fed governors were unanimous on the rate cut decision, the Nasdaq actually went negative while the S&P continued upward.

I wasn't phased. It always takes a bit of time for the market to digest Fed news.

By about 3:30, the frenzy started, and both Nasdaq and S&P ended up, pushing my Qs and SPYs to, so far, a $414 gain. I expect another good day tomorrow, but I will sell off some to decrease downside risk. By Thursday, I plan to dump it all.

Options Trading, Part II

The key to any kind of trading is thinking of every trade as a negotiation. When two sides sit down across from each, rather you are the buyer or the seller, both have weaknesses and strengths. Both have reasons they want to participate in the trade, and if you want to make abnormal profits, you need to know why you are capable of making those profits.

Quickly though, let me first explain what abnormal profits are. Abnormal profits are as it the term suggest, profits that are unusual. For example, if you suddenly find gold, you would profit off selling them. But no one will pay you more than the market price for it. That is a normal profit. An abnormal product would be say, gold is going for $100, and normally is costs you $80 to dig up gold, but all of a sudden, you discover a cheap process that finds you gold for $50 and you still sell it for $100.

Abnormal profits occur from having a comparative advantage. If you don't have an advantage, you aren't going to make abnormal profits.

So why do you care to make abnormal profits? Because with the increased riskiness of options, and the sheer amount of extra work you need to put into it, what's the point of getting a 15% return at year end when you could have just bought say the Nasdaq index and just let it sit there for a year for the same return?

I will continue posting for the rest of the week my views on Options Trading. But if you want to profit from what I post, you first have to ask yourself, what comparative advantage do you have over other traders?

Maybe you are smarter, or have a keen analytical sense, or perhaps Greenspan is your next door neighbor. Any of those are fine, but you have to know your advantage so that you can tailor your strategies around it.

[Update] I wanted to add as an incentive to consider your comparative advantage, the difference between me knowing what it was and just playing the market. Last year, I obtained a 10% return over 6 months following classic investing strategies, while this year I have so far obtained a 21% return in the last 2 months (I only started trading again in the last two months).

Options Trading, Part I

Recently, a reader asked a question about how to trade options. I thought about this question, and I realized I needed to explain a lot of background before we can get into the nitty gritty.

First, I do assume you understand what a stock is and the various drivers of stock price.

Second, I assume you have the understanding that investing is inherent risky and options even more so.

Third, I assume you have some fundamental math skills and can use Excel.

Now, rather than explaining what a basic option is, I will link to the Wikipedia article that already explains it pretty well. You only need to read the intro, section 1 and section 6 of the article. The rest is either useless or will be explained by me.

-10% to +12% gains in 3 days (that story is in the 3rd paragraph)

There has been a whirlwind of interesting events that have transpired in the last week. Some I can't talk about until I know for sure. But in terms of my finances, and mainly my trading, I can.

Finance-wise, I have been managing to stay within my budget. This has been helped by a combination of seeing the parents more during meal times, and just general life busy-ness preventing me from spending much money. One large upside though was a visit to the casino, which netted me about $400 in extra spending money.

On the trading side, I had been down about 10% on this past Monday. I had hoped for a 25bps decrease in the Fed Fund rate to help out my portfolio, and when a 50bps cut was announced, by portfolio roared back. I started unwinding my portfolio Tuesday, and by yesterday, I was completely out of all my long positions by around 11:30am. Selling had netted be a positive 12% gain on my total investment.

Not bad. And what a relief.

But then I started to think. I knew that the rally had really been artificial, because after all, what does a 50bps rate cut mean? Realistically, nothing much different from 25. Around noon I started buying short positions, and the market started to dip. By the end of the day, by short positions were ahead by about 5%.

The market continued its down slide today, and my shorts are looking better and better. My play here is to sell around the end of the day tomorrow, and then go long again, since I think by Friday, the market well have corrected itself past the Fed cut's temporary boost.

First Trade

Today was the first day I could trade so I tried something small to test out the platform. As I have often promoted, I bought Cisco today. But rather than the usual stock buying, I purchases two call options for Cisco ending September '07 at a strike price of $32.50 for $0.45 each.

Options contracts are sold usually in multiples of 100, so buying two contracts really means I purchases 200, or $90 worth. A call option purchase makes money if the underlying stock rises above the strike price by the ending, or expiration, date. In between, the price of the contracts can rise as the underlying stock closes in on the strike price. Also, there is inherent time value of money depending on how far away the expiration date is.

I will talk more about this later, but for now, my roommate is wielding my very nice cutlery in her first attempt to make a fruit bowl out of a watermelon, and I need to make sure she doesn't lose a limb.