Stock Options Blog

PROFITING WITH LONG OPTIONS

It’s a known statistic in the options markets that the writers end up banking money 9 out of 10 times simply because the erosion of time is in their favor. This can lead the buyers (holders) to leave the table with less than they came in with, and the fallacy that “it’s a scam”. “Long options” (buyer/holder side) are therefore thought to be the “losing camp”, while “short options” (seller/writer side) are seen as the “winning camp”.

I believe I have formulated a “long options” strategy which suggests otherwise, however, and which leads to far greater returns than possible with the writing of options. The reason I’ve stayed in the “losing camp” with the “longs” all this time is because of several factors ranging from my risk tolerance (I cannot stand the thought of being exercised or the stock moving heavily in the opposite direction merely on an unexpected press release), and the fact that my broker only allows the opening of long options positions… A reason I’ve hated my broker previously. After formulating this strategy though, I’ve come to the conclusion that I now prefer STAYING in the “losing camp” because it’s only a “losing camp” if you don’t employ the right technique.

The Method:
The main jist of this strategy is that it’s basically a form of day trading of exchange traded options rather than stocks.

1. Buy long calls or puts only… No straddles, strangles, spreads, or naked writes. Covered call writing is okay, but that’s a (income) strategy of it’s own and doesn’t generate the triple-digit types of returns this strategy does.

2. Enter the position (opening contract) fairly close to expiration (with about 2 weeks remaining till expiration).

3. Analyze the stock and it’s near term prospects thoroughly prior to opening your position, and determine the likely direction and price range of where it will PROBABLY trade the NEXT TRADING DAY. The key word here is “probably” as you have to think in probabilities in order to plan for the likely and even unlikely scenarios the stock may undergo in such a short timeframe. Therefore, you’ll have to set price targets you believe have VERY HIGH odds of being hit in this very short time frame. The easy part here comes from realizing that in such small and non-volatile time spans only a very limited number of highly probable scenarios, and an even lesser number of unlikely scenarios is possible (as compared with an earnings release, for example) so you won’t have to lose sleep over it too much. On another positive note I will admit I’ve managed to get two winners in a row so far while losing some money on the third. Though a 67% success rate is nothing to sneeze at in such a risky transaction, I do believe that over time, with intense focus, one can achieve an even higher success rate than this (though 100% is obviously unrealistic). So a really focused individual might get 10 winners in a row and lose some on the his 11th trade.

4. The daily options volume on the underlying stock should be liquid enough so as to allow you to bail quickly when your profit target is hit. Opening an options position on a large cap stock (> $5 billion market cap) is probably the right course of action here because options volume and “open interest” on such stocks is usually large.

5. The open position must last no longer than 1-3 days, after which the position must be closed as the premiums will begin to erode quickly as expiration nears. At this point if your trade is slightly unprofitable (or breakeven in the best) then you should consider closing out the contract.

6. The underlying stock’s near term expected (implied) volatility must be low to medium (in the low end of it’s recent trading history) so that 1-3 days of being in the position would not shrink the premiums you paid because the IV eroded unexpected. Again, having an options position on a large cap stock is useful here because such companies are inherently less volatile than smaller (growth) companies.

7. The stock’s price itself must be at a short term bottom or peak, and within a trading range.

8. Buy only at-the-money or in-the-money options (avoid out-of-the-money, deep-out-of-the-money, and deep-in-the-money options).

9. Do not open a position during an earnings cycle, or other major event like an analyst day, product launch, analyst downgrade/upgrade, or pre-scheduled conference call. It is fine, however, to enter a position well in advance, or after such an event as long as you are sure you will have closed out the position shortly prior to the commencement of such an event. Such events cause the market’s expectation of near term volatility on the underlying stock to increase significantly. Thus, for opening a position you would be overpaying for the premiums. This would, however, be a desirable time to close out previously open positions.

10. Carefully select stocks that require a VERY SMALL move in your expected direction – like 1.5% - for a large move to occur in your options – like 100% profit. Such a stock could vary in price range from the double digits to triple digits (single digit stocks will probably not work well for this strategy, and penny stocks don’t have options traded on them). Selecting such stocks will also prevent you from incurring consecutive losing trades as you might be lucky to bail at break-even or even a profit less than you expected… If you aim for 100% you might do 10% if things go only partly the way your analysis suggested as such large cap stocks usually have low enough implied volatility that premiums erode less drastically than with a stock like Google – which at the date of this writing has a whopping $115 billion market cap, mind you. So it’s clear to see that sometimes mega large cap stocks make for a poor candidate for this strategy.

11. Reinvest ALL proceeds into the next trade (after commissions and monthly expenses) so the effect of compounding begins to leverage your portfolio.

12. Do NOT become greedy, depressed, or impatient and think of abandoning this strategy when you see other options moving up 5000% in less than a day hoping for a similar return. While it may be possible to achieve 5000% on a single options play the odds of you finding one (like MAYBE Google – when it crashes, for example, lol) and then actually profiting from it are very small, involve great risk, and too much patience in searching for and subsequently analyzing the underlying company. This strategy, on the other hand, will make you rich over time. And anyway, the feeling of having 5 big winners in a row is much more gratifying than the feeling that comes with having 1 super big winner, as having 1 super big winner will lead you to doubt your future abilities and lead you to assume “it was luck that did it”.

13. Set goals and follow them through. For example, if you know you can only reasonably manage to do 1 winning trade in a month (i.e., 1 trade every options expiration) then don’t overdo it because first of all that in itself is a marvelous feat. And secondly, you are not here to “prove yourself” to the markets, to your broker, your friends, or even to satisfy your own ego. You’re here to make money. So stay realistic with your goals, but more importantly make sure you HAVE goals and the aptitude to FOLLOW THROUGH on them!

14. This brings us to a closely related point: Don’t become overconfident in your ability to make successful trades that you begin doing stupid things! 5 winning trades in a row… NOT GOOD ENOUGH! Keep raising the bar, and DON’T become complacent! If you become satisfied then you get stuck in the comfort zone from which you will never venture out. And if you become overconfident - thinking the markets are a slam dunk - then your emotions will have taken control of your rational mind, and rationality is a mindset needed for long term success in the markets. While trading on emotions is NOT what makes this, or any other strategy successful!

15. Acknowledge IN ADVANCE that there will be times where this strategy will NOT BE APPLICABLE because the right stock at the right price and the option to go with it will simply not be there. DON’T FRET! And DON’T deviate from this strategy! Otherwise you’ll have your first losing trade wiping out most if not all your gains after a VERY HARD series of winning trades (because you’re reinvesting everything over and over), and that sucks! So if after 5 HARD trades you have $50,000 and on the 6th trade you lose 90% of it because you wanted to “try something new”… Let’s not go there. DON’T “try something new”. Instead stick with what you KNOW WORKS… And this strategy WORKS!

What do you think I can do to improve my skills, both in options and stocks? What did you do exactly?

The short answer is KNOWLEDGE. We live in the "information age" and what you know is MORE IMPORTANT than WHO YOU KNOW. Therefore, find out (read, read, READ) how OTHER PEOPLE got successful at what you're trying to do and apply the same principles and you'll more than likely get the same results.

It's easy to say, "buy low and sell high" but hard to apply it. So patient is another thing... A characteristic that options don't normally have (unless you're investing in LEAPS, which are options with long term expiration dates like 2-3 years out).

So get learning. And NEVER invest unless you know what you're doing.

That's the main reason I had to dropout of university because I realized that I couldn't be a part time investor and a student at the same time... Yes, I spend hours everyday on the net (but I workout too... benching around 200 lbs now =)

Okay, for OPTIONS:

I've looked at the equity options market for over a year now and have come to TWO major conclusions:

1] The options WRITERS have a HUGE advantage over the option BUYERS... Time. And this causes 80%-90% of all written options to expire worthless. Most options players would agree. The trouble with writing options is that unless you're a hedge fund (who commonly network with OTHER hedge funds to carry out their mind boggling schemes) you'll have a hard time writing naked options. If you're approved for an options writing by your broker (I suggest you apply for an account with Ameritrade) they'll probablly only allow you to write covered calls (for starters) and then a few months later (after you've kept you account in good standing for a few months) they'll probablly approve you for writing "spreads". The SPREADS, my friend, are the best thing ever. However, the downside to options writing is that you'll never make the type of returns that options buyers (infrequently) make.

2] The second thing I've learned is what has really impacted my investment style... I read a statistic a long time ago (I think when I was 14) that 9 out of 10 business fail within the first 5 years and of those that survive 9 out of 10 of them fail in the 10 years following that. So it got me thinking, "hey, if the business world is packed full of clunckers then why not go against the crowd and bet the opposite direction.?" Hence, I am more BEARISH than BULLISH (9-to-1). And I use options leverage to allow the statisic to work itself out in my portfolio ;)

However, as you now know, options are HIGH RISK, but the true risk is only in what you DONT know. The bears on this board aren't saying "strong sell" for nothing you know - i.e., after careful research we (and most of us have been posting her since M. Diddy went to prison) conclude that this is an overbloated pig destined to fall.

There's this neat audiobook titled "Getting Started In Options" by Michael C. Thomsett available at Amazon.com, your local library, and that sh*t internet company Audible(dot)com (ticker: ADBL) ... Yes, I made a very nice return on the Audible puts back in February (check the old message posts) - around the same time I bought puts in MSO (the first time).

Next you need to learn the Black-Scholes options pricing model... Don't worry, you don't need to know the equation, but you need to be able to figure out the fair value of an option using it (the allows you to know if an option is undervalued or overvalued too). There's this cool software program (free) available at CBOE(dot)com... W~W.cboe.C~M/LearnCenter/Software.aspx

(change the "~" to "w" and "O" respectively).

That software will do all the calculations for you and you can find out the volatility as calculated by the CBOE in the DATA>HISTORICAL STOCK VOLATILITIES section of the website. Personally, I compare THEIR calculated volatilites with the market's "implied volatility" to see if theres a major difference. If not, I just stick with the implied volatility.

Btw, those daily options trading video clips you see on CBOE by Dr. J are really helpful at times. The man knows what he's talking about, and has been helpful in my investment endevours in the past, so keep up with him whenever you can.

STOCKS:

Now, to improve your stock selection you really need to think like the OWNER of a company - i.e., you need to think LONG TERM. For this, again, you need to digest a TON of INFO. Read and listen to books and audio programs (especially in your car).

I suggest you read the following books (all of them have audiobook versions on CD too):

"Buffettology"
"The New Buffettology"
"One Up On Wall Street" (first investing program I ever heard, love it!)
"Common Stocks and Uncommon Profits"
"Rich Dad's Prophecy"
"Rich Dad Poor Dad"
"Learn To Earn"
"Beating The Street"
"The Next Great Bubble Boom: 2005-2009"
"Security Analysis"
"The Intelligent Investor"
"The Warren Buffett Way"
"The Warrent Buffett Way - Second Edition"
"Buffett: The Making Of An American Capitalist"
"Warren Buffett Talks Business" (Video)
"Brian Tracy: 21 Success Secrets of Self-Made Millionaires" (This is an EXCELLENT program... Can't be stressed enough!)
"Brian Tracy: The Psychology of Achievement"
"Rich Dad's 'Who Took My Money'"

There's tons more programs, but get started here.


Next, try and keep up with the news on a daily basis. For example, if you're an oil investor/speculator in the commodities market on the NYMEX then you have to know if there's another hurricane around the corner, like Rita unfortunately. So you have to stay with the news to know what's happening otherwise the market will know more than you and your chances of beating it drop.

Again, the lesson here is KNOWLEDGE.

Second question: Is losing money in the beginning, starting out, typical? Did you lose money when you first started?

You BET! In fact, I've been in DEEP WATERS before. Believe you me, I started off by investing CASH ADVANCES on my credit cards which have a steep interest rate, but I figured that I could make a killing and the interest rates wouldn't be a problem because I'll keep making the minimum payments... Didn't work out that way, but thank God I learned soon enough and made back enough money to pay the credit card companies (p.s., MasterCard is going public and it is unbelievable that they have LESS revenues than GOOGLE!)

So, do your BEST NOT to use your credit cards unless you're sure you'll be able to pay them off if your strategy in the market fails.

With stocks I didn't lose all that much. In fact, at the end of 2003 I was sitting at roughly a 25% gain on my stocks. Then in February 2004 I made the dive into the options market. The first move I ever made was buy calls on a sh*t stock called PortalPlayer (PLAY) which sells SoCs to AAPL for their iPod - waiting to buy puts on it again during xmas ;) And I lost the entire premium on it because I had timed it wrong. I bought calls which were too close to expiration.

The message here is that DO NOT buy near expiration options unless you can live with losing 100% of the premium you paid. Because your timing could be off and it's really hard to time the market. Look back at the dotcom days in the late 90's... Analysts were pessimistic about stocks in 1996-97 after the huge rally had already begun citing that valuations had gotten ahead of themselves and the NASDAQ was destined to fall. It went up to like 5300 in the following 2 years at which point these same analysts had changed their perspectives completely and became bullish instead.

Warren Buffett sold out a very large chunk of Berkshire's holdings during this time, and surely enough the market tanked.

Buffett says, "its very easy to know WHAT will happen in the markets, but almost impossible to know WHEN it will happen".

Therefore, market-timing works sometimes and sometimes it doesn't.

Like with MSO, none of us bears can be certain that this pos will tank. After all, it rebounded from $20 to $34 in the past few weeks. But with stocks it becomes easier because no one can ever force you to sell (you can't be exercied) and there's no expiration.

Third Question: What do you think of day trading, as opposed to other kinds of trading? Swing trading? Options trading?

I am a believer of the so-called notorious art of "day trading"... With a twist... I don't believe in day trading to be what the media says it to be. Some of the Fools at The Motley Fool, for example, say that day trading is buying a stock at 9:30 AM and selling it for a tiny profit at 11 AM and repeating the process over an over the entire year. Now, what I know is that with investing it's VERY HARD to be right 365 times in a row. Therefore, I believe the correct form of "day trading" would be to buy or short a stock or options with the intent to sell or cover within a period of a few weeks to months.

Swing trading... I've honestly been trying to figure this one out for a few months now and all I can see is that it's a trading strategy based on chart patterns... Of which I am not a fan. Only 5% of your strategy should be based on charts in my opinion because 95% of the financial world is full of "fundamentalists"... Have you ever seen a Goldman Sachs analyst say, "we believe MSO is a pos, but the technicals suggest it should hit $50 next week"? Obviously not.

Options trading... I L-O-V-E OPTIONS!!! =] (Can't ya tell? ;) I'm actually looking to move into the futures market on the NYMEX and then trading currencies on the ForEx when my portfolio has a value in excess of $1.5 million ... Hopefully by the end of 2007.

Fourth Question: How did you get started doing this? At what point were you able to say, "Now, I can make money consistently doing this. I don't need a normal job?

My family ALWAYS...ALWAYS had money problems, since as far back as I can remember. Parents were ALWAYS fighting over money. So it really hit me when I was 17 that I have to make a lot of money. And now I'm seeing that there's FAMILIES of 4 in other parts of the world who could LIVE OFF the price of an iPod for an ENTIRE YEAR! So I really want to get helping too.

The point where I was able to say to myself, "[n]ow, I can make money consistently doing this. I don't need a normal job" was actually never. Not even now. It's true that I don't work a job, but there's never any guarantees. All I do is hope and pray because the Lord can taketh as easy as He giveth. But I am much more confident now than I was when I first started off in the markets 2 years ago. So never think that you've become "unstoppable". I guess you can figure on 2 years (less the time you've already been involved in the markets) as well to feel the same amount of confidence, but never grow complacent or the market will eat you alive.


Which brings me to my last and MOST IMPORTANT POINT... God.

Now, if you're an atheist, believe you me, you should NOT be in the markets to begin with. I mean, if you believe, for example, that the universe began as the result of mere CHANCE (i.e., that the universe had no creator) and that we are on the earth to just do absolutely nothing, but eat, sleep, make money, and party then how do you justify making money in the markets? The chances of the universe forming on its own are LESSER than winning a lottery tickect everyday of your life till you're dead. Btw, ever wonder where you go when you're dead? What does that tell you? You don't just "rot and decompose" like some people believe.

I've been learning about the "terrorist religion" - Islam - for about 2 years now and it has CHANGED me BIG TIME. (Right around since when I got started in the markets.) The west has a completely screwd idea of what Islam really is. Islam isN'T some dude named Osama who carries out deadly plots from a cave in the east, lol!

TRUST ME, God can do ANYTHING. People say that they'll never be brought back to life and that there's no "judgment day"... But it's only HARD to do something the first time. He exercises UNIVERSAL power EVERY SINGLE DAY. Nothing is hard for Him.

If you separate religion from your life then it is STILL very possible that you'll succeed in the markets because God says in the Qu'ran that he give the unbelievers ease in this world since they're going to hell afterwards anyway. And if you don't steal and don't swear and all the other bad stuff but yet you don't believe in God or Judgement Day then you'll STILL take up a MAJOR a*s-whooping in hell.

But you can't stop by just saying, "sure I believe in God". I mean even Warren Buffett and Bill Gates believe in God, but you have to WORSHIP Him. He says in the Qu'ran, "I only created man jinn to worship Me".

Checkout this Billionaire dude. He's religious...

www.usatoday.com/money/companies/management/2005-09-18-advice-monaghan_x.htm

Here are two links that will help clarify all the BS you hear about Islam on CNN:

www.HarunYahya.com --> this is an EXCELLENT site full of multimedia about Islam

http://www.ArbitragePlayer.com --> This is my OWN site =]