By Lee Lowell, Advisory Panelist, Mt. Vernon Research
Tuesday, December 27, 2005: Issue #270

If you own at least 100 shares of stock, and you’re not selling call options against it, then you are throwing away free money. How’s that?

Well, there are other traders out there who will give you money today for the right to take your stock away from you if it reaches a much higher price.

Selling covered calls is such a great strategy for padding your bank account that I still can’t believe there are investors who aren’t taking advantage of it. It’s one of the best ways to take in extra cash flow that you never thought you could have.

Here’s how it works…

Selling “Longshots” On Intel With Out-of-the-Money Calls

Let’s say you own 500 shares of Intel Corp (INTC) that you bought in 1997 for $25.50/share. How have you done?

Well, if you didn’t sell during the tech bubble in 2000, then you are breaking even as of today, with INTC trading for about $26/share. Bummer. All that time and you still haven’t made any money on it. You probably could’ve used that money to invest in something else, or at least buy yourself a nice gift after all that time. Who knew? Nobody knows how an investment will turn out over time.

What could you have done in the meantime? Sold covered call options against your shares. There are two great things about this strategy:

• It allows you to passively accumulate income over time by having someone else pay you money. You become the option seller. For every 100 shares of INTC you own, you can sell one option contract. In this case, you can sell five option contracts.
• It reduces your cost basis of the stock by the amount of the option you sold. If you sell enough covered calls over time, your cost basis could be zero! Let’s look at an example.

Below is an option chain for INTC with an April 2006 expiration date. The last price for INTC was $25.97 (upper right corner).

What we want to do is concentrate on selling out-of-the-money (OTM) call options. An OTM call option has a strike price that’s higher than the current price of the stock. In this example, we will focus on the $30 strike calls.

We see from the “Bid” column that the $30 calls are bidding at $.25. This means that for every $30 call we sell, we will take in $25 ($.25 x $100 multiplier). Since we own 500 shares, we can sell five option contracts and net a take-home pay of $125.

This strategy is great if we really like the stock and want to keep it in our portfolio. The only way we give up the stock is if it moves a good deal higher. Instead of waiting to see if INTC will ever go up in price, we are taking a proactive trading strategy and making some extra cash on the side.

What happens when we sell the $30 strike calls? It means that if INTC trades above $30 by April 2006 expiration, and stays above $30, we will be forced to sell our INTC shares to someone for $30/share. It’s called getting “assigned on our short options.” But is that a bad thing?

Well, considering that INTC hasn’t been above $30 in almost two years, and you don’t really want to give up your shares, I don’t think it’s a bad bet. Plus, the trade is only good until April 2006. If INTC doesn’t get above $30/share by April 2006 expiration, then the trade is over and we get to keep the $125 free and clear… and we also keep our long INTC stock. We can also repeat the trade for a different expiration month.

If you happen to get assigned on your call options and are forced to sell the stock, then so be it. You still came out ahead. Not only did you make $125 from the options, but you also have a gain on the stock from your original purchase price of $25.50. That’s a $2,250 gain.

Using The Force When Selling Covered Calls

Selling OTM covered calls forces you to take some profits along the way (assuming you are selling calls with strike prices above your initial stock buy price). Also, since we are selling the calls for $.25, it reduces our cost basis to $25.25. Do that enough times over the years and your cost basis could be zero!

Some investors will worry about causing a capital gains tax event if they are assigned and forced to sell their shares. That’s true. But in my opinion, it’s better to take a profit somewhere along the way.

Would you rather hold your stock just to avoid the IRS? Look at all the stocks that have imploded since the 2000 meltdown. I’m sure there are many folks kicking themselves for not selling at some point, either through a regular stock sale or by an option assignment.

In the case of our INTC example, if we had been selling covered calls all along, taking in $125 once every three months or so, we could have netted a nice sum while the stock lingered for seven years. It’s sort of like a consolation prize while you’re waiting. Everyone else who didn’t sell covered calls has nothing to show for it.

This strategy is a way to gain sideline income while you wait for an eventual sell price (you do have a sell point, don’t you?) Why not sell potentially worthless options, repeat the process many times during the year, lower your cost basis and enjoy the income?

Good trading,

Lee

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By Lee Lowell, Advisory Panelist, Mt. Vernon Research
Thursday, December 15, 2005: Issue #267

Much of my own option trading occurs from the short side. I’m not referring to a bearish directional outlook, but rather a trading strategy that involves the selling of options instead of buying them. This involves either selling “naked” options, or initiating option credit spreads.

You see, you don’t always have to be an options buyer, and you don’t have to own something first before you can sell it. The great thing about the financial markets is that you can sell first and buy second, instead of the long-standing philosophy of buy first, sell later.

The reason I like to sell options is because I believe that you gain more margin for error if you are incorrect in your market assessment. But you have to know how to sell them correctly. You can’t just sell any old option and think you’ll have a profitable trade. You have to take into consideration the following:

• The general direction of the market or stock you’re trading
• The strike price
• Time to expiration
• Volatility of the options

Many people trade options under the assumption that because they think they know where the stock is headed, they can buy cheap out-of-the-money (OTM) options with little time to expiration. This is the downfall of most option traders. How many of us are actually that good at predicting where and when a stock is going to move? I know I’m not, but many investors still trade options that way. You’re giving yourself such a small window to be correct in your assessment since there’s not much time left before the option expires.

Let’s look at why the short side can be more profitable than the long… and how to set up a put credit spread for a 75% chance of winning.

Three Out of Four Chances to Win With A Credit Spread

When you buy an OTM call or put, you only have one way to be profitable, and that’s if the stock moves far enough higher or lower to pass your break-even point in the time allotted. When you sell an out-of-the-money call or put, or an OTM credit spread, you actually have three ways to become profitable.

For example, if you sell an OTM put option or put credit spread, you will be profitable if the stock moves higher, stays flat, or moves slightly lower, but not lower than your break-even. If you sell an OTM call option or call credit spread, you will be profitable if the stock moves lower, stays flat, or moves slightly higher, but not higher than your break-even. The only way to lose is if the stock moves well past your break-even price.

So that’s three out of four scenarios, or a 75% chance of having a successful trade when selling options. When buying options, you really only have a one-in-four chance of winning, or 25%. I like the odds better when selling options – you can be incorrect in your market assessment to a degree, and still have a profitable trade.

Let’s take a real-life scenario and see how I would set up an option trade:

Here’s a six-month daily chart of March 2006 Sugar. We can easily see that sugar has been in an uptrend for quite some time, so why try to rock the boat and trade any other way? Let’s stick with the trend and look for a bullish trade.

Instead of buying call options and trying to predict what level sugar might go up to, we’re going to look at selling OTM put credit spreads instead. Selling put credit spreads is a bullish strategy that lets us take advantage of our directional bias, but also gives us room for error if sugar retraces to the downside somewhat.

How The Option Credit Spread Works

Ideally, we’d like to wait for sugar to pull back a little to one of our trendlines before initiating the trade, but I will show you the strategy so you understand how it works.

Since we believe sugar won’t retrace much lower than the $1,270 level, we’ll use that as our support area, and the place in which to pick the strike prices for the put spread. We’d like to sell the $1,250/$1,200 put spread (not a recommendation – educational purposes only!). Let’s check the option prices below.

We can sell the March 2006 $1,250/$1,200 put spread for 9 points. Here’s how it breaks down:

What we’re doing is selling the $1,250 put (for a credit of 21 points) and buying the $1,200 put (which costs us 12 points) as a single trade for a net credit of 9 points. If you look in the “Last” column, you’ll see the prices for each strike. Just take the difference between the two and you get your net price.

In the sugar market, each point is worth $11.50, so our initial credit is $103.50 (9 x $11.50) for each spread we sell.  Since we are bullish, we don’t want sugar to go lower than our break-even price of $1,241.

In order to figure the break-even, you take the upper strike in this case and subtract the net credit ($1,250 – 9 = $1,241). As long as sugar stays above $1,241, we will retain the net credit and have a profitable trade. Sugar can go higher, stay flat, or go lower, but not lower than $1,241 for us to win. Since sugar is currently at $1,381, we have much room for error and three out of four chances to win.

Based on our technical analysis, I think it’s easier to predict what level the market WON’T get to, rather than the level it MIGHT go to.

Good Trading,

Lee Lowell

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About a year and a half into my days as an options market maker on the floor of the New York Mercantile Exchange (NYMEX), I discovered the strategy of selling short-term, out-of-the-money options (OTM).

For anyone who’s not familiar with the term “out of the money,” these are put options with strike prices that are lower than the price of the underlying futures contract. Call options that are out of the money have strike prices that are higher than the price of the underlying futures contract.

Selling these options is a great way to generate some income by taking advantage of options that expire worthless – while someone else is taking on the risk. Let me explain…

How to Pocket Cash From Traders Losing Their Bets

From 1991 to 1998, the years I spent on the floor, crude oil energy futures stayed mostly in the range of $15-$25 per barrel. I noticed that many people would pay good money for options that were well above and well below the current price of the nearest futures contract.

If oil was at $20 per barrel, people would buy options on the $15 puts and/or the $30 calls, hoping the price of oil would get to one of those two levels by the time the options expired. What I noticed was that these options were expiring worthless most of the time, because of the large distance that the futures contract had to move for the option to become profitable, plus the fact that the options had such a short life span.

So, I decided to start selling these options, which allowed me to pocket the money from the buyers. All I had to do was wait for expiration to see these options expire worthless.

Over time, I realized that due to the increasing potential of unrest in the Middle East, and the effect that OPEC had on the price of oil, I knew that there could possibly be more violent movements to the upside than to the downside. At that time, I started restricting my out of the money option selling tactics to just the put options.

People were still paying high premiums for these, and I was willing to sell them. What I didn’t realize at the time was that not only was I taking in monthly premium income, but I was also setting myself up to possibly buy crude oil at unheard-of cheap prices.

In the early ’90s, I was selling put options with strike prices from $15 all the way down to $9. If I was ever assigned on my short put options (meaning that the buyer executes his right to sell crude oil futures to me), I would be buying crude oil at very cheap levels – not such a bad thing to do with a worldwide commodity in such high demand. Turns out, I was never assigned on any of my short options, and that was mostly due to the short life span and large distance of being out of the money.

A Reliable Income Strategy

Over the years, I became the market maker that most of the brokers would come to when their clients needed to buy some out of the money put options. Other traders would shy away from these selling tactics, claiming the “unlimited loss potential” of short options. They said I was crossing over to the “Dark Side.”

But for me, the strategy was sound:

• I was taking in good premium,
• I could possibly buy crude oil at unbelievably low levels,
• And I had risk-management plans in place.

The NYMEX futures contracts would trade electronically during the night after the open-outcry session closed, so if I had to protect myself, I could buy or sell futures contracts if need be.

After I left the NYMEX, I started a trading business from my own home office. I began trading stock options with the same methodology. I would sell put options below the market (out of the money) on stocks that I really wanted to own. This would allow me to collect the premium upfront, and potentially allow me to buy them at a great price.

When you are looking to buy a favorite stock at a cheaper level, selling put options is a viable strategy to potentially set a limit price while earning income in the meantime. The way I was using it on the NYMEX was mostly to collect the steady monthly premium income, but when applying it to the stock market, you are potentially setting yourself up to buy a great stock at a great price.

Good Trading,

Lee Lowell

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By Lee Lowell, Advisory Panelist
Tuesday, October 4, 2005: Issue #247

Before becoming an options market-maker on the NYMEX, I never anticipated the initial pain that my legs would feel after having stood in the same spot for five and a half hours a day. That’s what pit traders do. They stand in the pit all day long, giving bids and offers to brokers in hopes of doing a trade with them.

As part of my series of articles on the life of a market maker, this piece will focus on the actual mechanics of what happens when an option order hits the pit, how to read fair value sheets and how the market maker plays a role in the action. Remember, everything that I explain in this article relates to my experiences as it happened on the NYMEX.

The First & Fastest Market Maker To Check The “Sheets”

The opening bell would ring at the NYMEX at 9:45 a.m. EST and close at 3:10 p.m. EST (pre-9/11). Within those five and a half hours, it was every market maker’s job to be the first – and the fastest – to give a specific broker a bid and ask quote that they needed for their customer.

Let’s say, for example, the upstairs Merrill Lynch desk (customer) needed a bid/ask market for the October 2005 Crude Oil $66 call option. The Merrill Lynch broker in the pit would randomly shout out to no one in particular, “How’s the Oct. $66 call?” That’s the market maker’s cue to check the corresponding futures market price and then check their “sheets” to see what a fair bid/ask market would be to yell back to the broker (and yes, everyone really is yelling at each other).

The reason for checking the corresponding crude oil futures market price is that if the market maker actually does an option trade with the option broker, the market maker will then immediately place an offsetting delta-hedge trade in the futures market to eliminate any immediate directional risk. Market makers are not there to pick a direction; they are there to capture a non-directional edge on the trade. I’ll explain that in a bit.

So, before actually giving the option broker his bid/ask market, you would see the 20-some market makers in the pit all waving to their “point man” in the futures pit for a quote on the futures market. The point man would hand-signal back to the options market maker approximately where the futures prices are trading (the options pit and the futures pit are two separate pits that sit side by side). Once the option market maker has a decent idea of the futures price level, he can then give the broker an accurate quote after checking his “sheets.”

How to Read “Fair Value” Sheets… And Keep Brokers On Your Side

The graphic below is a very simplified version of what an option market maker’s “fair value sheets” would look like. The one below contains the “fair value” and “delta” calculations for various futures and option prices for crude oil options as of October 3, 2005, with a fictional expiration date of October 21, 2005.

Here’s how it works: Along the left-hand side are prices for the front-month crude oil futures market in 5-cent increments. In this example, we’re only seeing prices for the futures at $65.45, $65.50, and $65.55. A typical trader’s sheet would contain many dollars worth of prices, so you would literally see market makers coming into the pit with thick booklets of trading sheets, sometimes for more than one commodity. You should see what the floor of the exchange looks like at the end of the day. Actually, you wouldn’t be able to see the floor because every inch ends up covered with obsolete trading sheets.

The “P/C” column indicates whether you are looking at a put or call, and the “VOL” column represents the volatility level you are using to help price the options. The top row of the sheets shows the strike prices that are available to trade in that particular commodity. Here we see strike prices for crude oil options ranging from $62 to $67. The last pieces of the puzzle are the “Fair” and “Delta” Columns. These represent the fair market value for each put or call at the corresponding futures price along the left-hand side, and the delta column lets the trader know how many futures contracts are needed to offset any option trade to balance out the directional risk.

The broker was asking for a market on the $66 calls and we find out that the futures are trading at $65.50 at that moment in time. We check our sheets on the left-hand side for the “calls” at the 65.50 mark with a volatility of 38%, and then we move along the top until we intersect with the 66 strike of the “Fair” column. We see that the fair market value of the $66 calls at a corresponding futures price of $65.50 comes out to be $1.828.

Any attentive market maker in the options pit would now yell back to the broker, “$1.80 bid at $1.85.” This means that the market makers are willing to buy that option at a price of $1.80, or sell it at $1.85. At this point, we don’t know if the broker is a buyer or seller, so we always have to give both sides of the market (we don’t care if we buy it or sell it).

Now, if the broker decides to buy the option from us at our price of $1.85, we have to tell him how many option contracts we want to sell. To make it simple, the delta sheets are based on a trade of 100 contracts. If we are lucky enough to sell 100 contracts to the broker, we look at our sheets again and see that the delta is .46. In order to offset our initial directional risk, we would hand signal back to our point man to buy us 46 futures contracts. Since we are selling call options to the broker, our initial delta is short 46 potential futures contracts, therefore we need to buy 46 futures contracts to keep our delta at zero.

The Paycheck’s in the “Edge”

Delta tells us a few different things:

• It tells us how much an option price will move for a corresponding $1 move in the underlying security; and
• How many shares or contracts of the underlying security must be bought or sold to offset any directional risk from an options position.

As I mentioned earlier, the option market maker is looking for an edge, not a directional trade. If that $66 call is valued at approximately $1.83, and we get to sell it at $1.85, then that’s what we call getting an edge. Our best-case scenario is that someone wants to sell that option now, and we would be able to buy it back for $1.80. That’s how market makers try to make their money. They continuously try to buy for less than what their sheets are telling them, and to sell it for more than what their sheets are telling them.

Unfortunately, it’s not as easy as that, but that’s the main thrust of the market maker’s job. The whole process of getting the futures quote, checking the sheets, doing the trade, and doing the hedge all happen in a matter of seconds. It sounds like a long process, but it’s not. The faster you are, the more trades you do. Speed is key!

So, do that everyday for five and a half hours without sitting down and/or not taking a break for lunch, and you, too, might be saying, “Man, my legs are tired.”

Good trading,

Lee

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By Lee Lowell, Advisory Panelist
Tuesday, September 20, 2005: Issue #243

So you want to know what market maker survival is all about? What it’s like being a market maker? Well, you’ve come to right place… I spent many years as a market maker on the floor of the New York Mercantile Exchange (NYMEX).

And today, I’m going to give you the breakdown of how a market maker thinks, acts and operates when an option order hits the pit. On top of that, I’ll explain the fierce Darwinian struggle that takes place day in, day out at markets like the NYMEX.

This will give you a better understanding of who’s taking the other side of your trade, and why that person isn’t always trying to “take you.” You’ll also see who holds the advantage in getting your options orders filled.

Remember, these facts and stories only apply to my experience during my days on the NYMEX. Let’s get right to it…

How Market Makers Are Like Gladiators

First, we need to understand the makeup of the options pit and how market makers fit into that arena. Believe it or not, there is a sort of hierarchy, or caste system, that prevails in the options and futures pits.

The days of a newbie market maker are not all that much fun. You are essentially the low man on the totem pole in that ring. You need to prove yourself not only to the other market makers, but to the brokers as well.

An options or futures pit on an exchange floor is made up of three or four concentric circles, with a raised rim or step along the outer edge of each circle. Each circle is elevated higher and wider than the next so there are people standing on higher or lower steps in relation to their front-side or backside neighbor.

Just think of a sports stadium without the seats, where everyone has to stand instead of sit.

These steps form the pit hierarchy. The brokers are the ones who get to be on the highest step. This is because they need to be near their phones, which are installed in small wooden booths that align the outer edge of the top step. The brokers are the ones who have all the orders. They get their orders from either retail customers (you and me), or from their in-house traders who take positions for the firm (Goldman Sachs, Merrill Lynch, Citibank, etc.), or from other big institutional firms.

Stay Close to the Brokers

Make no mistake, you want to be in good with the brokers, and you want to be as close to them as physically possible. A market maker is only as good as the amount of orders he/she can get involved with. If you’re a market maker and you don’t make any trades, how are you going to make any money?

To make sure they do, here are two of their missions:

• Just try to survive.
• Eventually move yourself up in the pit to be as accessible to the brokers as possible.

Sounds easy, but it’s not. You have to contend with other market makers who have been standing in the same spot for years, and they’re certainly not going to let some green rookie take their place.

Why You Want Your Broker to Be Big and Loud

I remember the first two words I heard the very first day I stepped into the pit as a market maker, “fresh meat.” That’s right, market makers and brokers will prey on the new guy as a sort of initiation. It happened to me, and will most likely happen to every other new guy as well.

Most of the new market makers will start on the lowest step, which is the farthest place from the brokers, or they just try to squeeze into a space wherever they can. Being timid or shy at this point is not a good thing. You need to assert yourself as quickly as possible.

I think the exchanges are one of the last places in the work field where being physically big and loud has a huge advantage for you. That is what gets you noticed. That’s why sometimes you’ll see many former ball players getting jobs as brokers or other types of floor traders.

How Market Makers Survive

Nevertheless, all new market makers will be feeding off the scraps of orders that were not taken by all the bigger, faster, louder and more senior traders in the ring. You take what you can get at first and work your way from there. It’s tough being at the bottom, but if you’re good, you can move up quickly.

So there’s the true insider view of the options markets and how the market makers survive. As you can see, they’re just guys trying to make a living. And if you have a good one working for you, he can help you make a good deal of money, as well.

In the next installment of this semi-regular series on market makers, I’ll explain exactly how an option order gets filled from start to finish, and how the market maker fits into that equation.

Until then…

Good trading,

Lee

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