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Option Master Chapter 10
Download the Option Master Manual - PDF 187k

 

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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