Chapter 12

Options

When I first entered the investment business, the Chicago Board of Options Exchange (CBOE) did not exist. Options were underwritten by brokers and were traded over the counter. Since that time, however, much literature has been written regarding the topic of options. Unfortunately, most information concentrates on procedure and valuation studies. Although some attention is devoted to methods that evaluate market sentiment and that indicate market direction, the extent of this information is woefully incomplete. All the observations I have made originate from personal experiences acquired as a result of numerous forays in the options markets and are not found in textbooks. As I have stated repeatedly throughout this book, “sweating out” personal trades seems to make a trader more alert to potential pitfalls; it also contributes to indelibly fixating on his memory various strategies and opportunities. I will describe my techniques and rules, and, I hope, impart some wisdom that will reduce the likelihood of your trading failure. These techniques have application to both equity and futures options.

Rather than recite numerous incidents and episodes that affected my options trading life, I will share with you the lessons learned. They were acquired as a result of being taught by the “ultimate market teacher”—trading losses. Psychologists have said that many traders possess an unconscious desire to lose in their investments. I am not one of those individuals. I have looked on trading losses, however, as the tuition cost required to be educated in successful market trading. This may sound trite, but I learned from experience. Had someone else offered this information to me years ago, I would have applied it and would have avoided frustration and heavy market losses. Although I was hungry and my appetite for information was voracious, nothing existed to satisfy it.

It has often been said that the only winner in the options game is the writer. Studies have shown that over 80 percent of option traders lose money. When the listed option markets opened, lack of sophistication characterized both the writers and the buyers of the options. The learning curve for the buyers, however, was longer than that for the writers, because little literature was devoted to their plight of trading failure. More than likely, this was a result of the fact that whereas the writers—sellers—were predominantly institutions and floor traders, the buyers were small investors who were naive and did not possess the information and resources the writers did to eliminate these inadequacies.

Emotions and expectations play an important role in options pricing. Strip away these human feelings and the game of options trading becomes much simpler. Many models, developed to ascertain fair values, have been employed by writers for some time and, by using both computers and mechanized strategies, the emotional component has been effectively eliminated and replaced with discipline. My goal was to develop a suitable set of rules for the buyer. Through experience, I accomplished this goal and created a list that is readily accessible anytime I venture into this risky market. Foremost on my mind is the fact that I must control my emotions and must ignore the emotionalism of all my market counterparts who are buying at the same time. My experience suggests that observation of the following rules offers a chance that a trade can turn into a profitable experience. Specifically, I adhere to the following:

1. Only purchase a call option when the overall market is down in price versus the previous day's close;
2. Only purchase a call option when the underlying industry group is down in price versus the previous day's close;
3. Only purchase a call option when the call is down in price versus the previous day's close.

These rules have served me well and, with the exception of replacing the requirement of a down close versus the previous day's close with an up close versus the previous day's close, the rules for purchasing put options have been defined as well. Options trading is difficult enough without allowing your emotions to interfere as well. Together with the simple mathematical comparisons and models presented below, this list should get you on the road to success.

For years, traders have used a simple options ratio to identify sentiment extremes that coincided with price turning points in the underlying securities. Although practitioners have exacted some degree of success in forecasting price reversals, the results are spotty. Simply, what they do is divide overall put volume by overall call volume. My research suggests that approach is deficient for a number of reasons:

1. The assumption is made that for each expiration date and price, there are puts and calls listed;
2. No dollar-weighted adjustment whatsoever is made to the volume statistics;
3. No consideration is given to the interplay of option volume and open interest.

These are critical items that must be addressed to properly assess market sentiment.

Initially, when options were listed on the exchanges, they were limited to calls. Slowly, puts were introduced, but had a trader calculated just the basic put–call ratio, it would certainly have distorted and skewed the results in favor of call volume.

It makes sense that not only is the number of options traded important but so also is the price of these calls and puts. Why should the impact of options priced at one-eighth of a dollar be the same as those priced at five dollars? Consequently, I devised my own ratio of calls to puts by multiplying the volume by the dollar value of each option. I called this ratio the TD Dollar-Weighted Option Ratio. The same band of overbought/oversold that is applied to the conventional approach can be used. However, the results should be more indicative of true sentiment.

Another ingredient in the option equation is often overlooked: the interplay between option volume and open interest. Every time an option is written, open interest expands. By invoking a methodology that incorporates option volume as a percentage of its open interest and in turn dollar-weighting these numbers, another important ratio is created that has predictive value. To get an appreciation for the relationship between volume and open interest, just examine what occurs when the volume in a particular futures market—not options—on a particular day exceeds the open interest on that same day. In essence, what has transpired is that the ownership in that market has been turned over and, consequently, its personality and price characteristics are prone to change. On another level, a similar situation occurs with options.

My personal experience in trading options revealed a situation that is not obvious until one is confronted with its consequences. Specifically, just prior to the market's close on a Friday, I purchased some call options. No news announcements were released prior to the following Monday's reopening. In fact, the underlying security opened much higher. To my dismay, the option's price opened lower than Friday's close and my purchase price. To no avail, I attempted to resolve this perceived dislocation with logic. I consulted with an options expert, and he explained that most option models are updated over the weekend. Typically, the time premium is recalculated at that time. Subsequent to this episode, I concluded that it was prudent to initiate a position on a Monday rather than late on a Friday unless I anticipated that an important event would occur over the weekend and could significantly offset the time premium erosion. This is particularly applicable to options expiring within a month's time.

I have provided you with some of the methods I use to evaluate the sentiment associated with various options markets. Not only can you use these models to evaluate the relative attractiveness of option opportunities, but you can translate this information into opinions regarding the underlying securities. I would hope that you can apply these indicators, as well as the rules for entry, to your advantage by becoming an offensive options trader capable of seizing opportunities as they arise, rather than being defensively disposed struggling to preserve capital.