How to Place an Option Order - The right way to give your broker a telephone order for stock or index options

Correct options order entry is a critical factor in getting good fills when trading options. Here I start a discussion of how to properly place your options trading order with your broker over the telephone. We start with the simplest order, the straight buy or sell. Future columns will focus on spread orders, changing orders and checking on orders.

Options Trading Topic: How To Place an Option Order

Dear Options Trading FAQ:

The reps at the brokerage firm I use never seem to understand what I want to do. I get nervous when they try to rush me and things get muddled. Any suggestions?

Dread the Call

Dear Don't Dread:

Your anxiety is a common one. Option trading beginners are nervous enough about the position they are about to enter - put them in a fast-paced, unfamiliar environment and often there is confusion.

Do try to be careful. Misspoken words during option order entry can lead to serious money errors. Buys may be executed instead of Sells, Puts instead of Calls, etc. Remember, your broker will do EXACTLY what you say (whether you really meant to or not). Also, harried representatives have been known to be short on patience with confused order placers. Chalk it up to the poor upbringing of the reps, perhaps, but most customers have encountered a certain degree of rudeness early in their trading careers.

There is a set sequence of wording that Wall Street professionals use among themselves to avoid errors. Options orders are always "read" in this fashion. Clerks are trained from day 1 to listen for and repeat for verification the orders in the same way. If you, the public customer, adopt the same lingo, you'll be way ahead of the game. In addition to preventing errors in your account, you will win the respect of your options broker as a savvy, street-wise trader.

Here is the "floor-ready" sequence of an options order:

After identifying yourself and declaring an intent to place an option order, clearly say the following:

For a one-sided order (simple buy or sell of a stock option):

"Buy 10 Calls XYZ February 50's at 1 1/2 to open, for the day"
Always start with whether it is a buy or sell. When you do so, the clerk will reach for the appropriate ticket.

Next comes the number of contracts. Remember, to determine the money amount of the trade, you multiply this number of contracts by 100 and then by the price of the option. In the above example, 10 x 100 x 1 1/2 = $1,500. Don't ever mention the equivalent number of underlying shares. One client of mine used to always order 1000 contracts when he really meant to buy 10 options (equivalent to 1000 shares of stock).

Thirdly, you name the stock. Call it by name first and then state the symbol if you know it. Be aware of similar sounding letters. B, T, D, E etc., can all sound alike in a noisy brokerage office. Over-The-Counter stocks can have really strange option symbols.

The month of expiration comes next. Again, be careful. September and December can sound alike. Floor lingo uses colorful nicknames to differentiate. The "Labor Day" 50s are Sept options while the "Christmas" 50s are the December series. But don't get carried away with trying to use the slang. Don't ever use it to show off to a clerk. Simply use it for accuracy (e.g. "the December as in Christmas 50s").

Then comes the strike price. Read it plainly and clearly. 15 and 50 sound alike as does 50 and 60.

Name the limit price or whether it is a market order. Qualify it if it is something other than a limit or market order. For example, 1 1/2 Stop. Pet peeve of many clerks: Don't say "or better" when entering a plain limit order. That is assumed in the definition of a limit order. "Or better" is a designation reserved for a specific instance where one names a price higher than the current market bid-ask as the top price to be paid.

For instance, an OEX call is 1 1/2 to 1 5/8 while you are watching the President on CNN. He hints at a budget resolution and you jump on the phone. You want to buy the calls but not with a market order. Instead, you give the floor some room with an "1 7/8 or better order". Clerks use this tag as a courtesy to each other to let them know they realize the current market is actually below the limit price. This saves them a confirming phone call.

Next is the position of the trade, that is, to Open or to Close. This is the least understood facet. It has nothing to do with the opening bell or closing bell. It tells the firm if you are establishing a new position (opening) or offsetting an existing one (closing). Don't just think that by saying "Buy", your firm knows you are opening a new position. Remember, options can be shorted. One can buy to open or to close. Likewise, one can sell to open or to close.

If your order has any restrictions, place them here at the end. Examples are All or None, Fill or Kill, Immediate or Cancel, Minimum of 15 (or whatever you want). Remember, restricted order have no standing. Unrestricted orders have execution priority.

Finally, state if the options order is a day order or Good Till Canceled. If you don't say, the broker will assume it to be a day order only, but the client should mention it as a courtesy.

Very Important: Your clerk will read the order back to you in the same way for verification. LISTEN CAREFULLY. If you don't catch an error at this point, they can stick you with the trade.

Proper option order entry can mean the difference between a successful execution and a missed fill or a poor price. Doing it the right way can save you precious seconds. Further, it will mean a better relationship with your broker. The representative will act differently when he sees a customer who knows what he is doing. The measure of respect given to someone who knows how to give an order properly is considerable. After all, you've just proven that you "speak" his language.



Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Index Options, Stock Options, Options Order

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Premium - Smart Money or Dumb?

Option Trading Topic: Option Premium: Smart Money or Dumb?

Dear Options Trading FAQ:

Help, I get confused when thinking about options trading! In some recent letters you say to look at the option premiums and go contrary to what is popular. Then, you go ahead and give other examples where you laud call option buying in certain stocks as "informed". Which is it, oh Option Guru?

For example, if the call options are priced higher than the put options, I myself would think it to be a bullish signal, but from your example :

>Here is an example from today (01/04/96):
>The SPX is 620. The Jan 610 put option is 1 5/8. The mirror-
>image call option, the Jan 630 is 1 7/8. The call here is
>actually priced higher than the put!! Quite bearish.

How is it *quite bearish*?? I would think since there are equal numbers of people thinking the equity price will go up or down, there is equal chance of it doing so, no?

Can't Get Contrary on Option Trading

Dear Can't Get Rich Trading Options If You Can't Get Contrary:

Let me start with the example you quoted. The analysis went in my mind as follows: "Ever since the Crash, the SPX Put option premiums have been highly valued (needed by institutional players as insurance). In a "normal" situation they will be bid higher than their respective calls. So I see that in this case where the calls are more expensive than the puts, something unusual is going on. In fact, my usual trigger level is when the calls and puts trade at the same price - here we have exceeded that. There is a bullish frenzy present that cannot last. The puts are undervalued and the calls overvalued. The imbalance in sentiment must swing back the other way - What would cause that? Why, a market downswing. So go bearish."

That turned out to be precisely right as market followers know. This thinking was predicated on the assumption that the SPX option players represented "dumb" money. That brings me to your initial question, How to recognize the option sentiment as right or wrong.

Traditionally, the bulk of option speculators are considered wrong-way thinkers. Many time-honored technical indicators are contrarily based on the action of option traders (Put/Call Ratio, Dollar-Weighted Put/Call, Premium Ratio, etc.). I would go along with that when it comes to large bodies of option speculators (i.e., index options as a whole, or total equity option put/call ratios).

When looked at in total, one should consider the sentiment revealed as possibly wrong-way. Mind you, the crowd is allowed to be absolutely right at times (as many "too-early bears" in this current market can attest to - that means you, Mr. Granville and Mr. Prechter!), but in the whole, it is not in the nature of any market to let the herd make unlimited tons of cash.

The work of Bernie Schaeffer, Larry McMillan, and others have shown, however, that in specific instances, "smart" (and I mean VERY SMART) money can be seen moving into certain options. Careful tracking of money flows and volume swells in equity options can tip one off to the placement of "smart" money. This "informed" option activity (in the absence of news) alerts the savvy option trader to upcoming news in the stock. Recent examples of this include the huge inflation of option premium in the Loral calls the night before the takeover announcement. That case was dramatic as the price of the options continued to RISE in the face of a downticking stock. Another example is the jump in the options of Roberts Pharmaceuticals. For days the call options acted unusually, then the stock jumped 4 points in a day. Subsequently, it was announced that there may be an important drug approval coming up.

Particulars aside, watching the action in specific equity options will forecast the crucial moves in the stock. Here we must consider unusual option activity (a jump in implied volatility, a huge premium in price over the theoretical value, a swell in put or call volume), in the absence of news, as an indication of what the insiders are doing. There is hardly ever any "big news event" in a stock that occurs in isolation. The option activity will tip you off first. There seem to be no secrets on Wall Street (Psst, Harriet, Now you know I'm not supposed to say anything, but your dad better buy some calls on my company by next Tuesday...)
Sometimes it is not at all easy to discern if option activity is "smart" and should be emulated, but the concept is valid. If you concentrate on stocks whose options suggest something is cooking, you start on a higher plane than the usual trader. Let the options work for you. Make sure you keep an ear open to what they are telling you.

More in future columns on advanced techniques on reading option premiums (divergences, non-confirmations, etc.)

PS. Often times, with "outrageous" premiums extant, the savvy option trader will play the stock itself rather than join the mania in the options. If you are wrong, there is a good chance for another go at it, unlike with the overpriced options where there is often no second chance.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Pricing, Options Strategy

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

More Pegging and Capping of Options

Options Trading Topic: More Pegging and Capping

Dear Options Trading FAQ:

Hi. I know an options research firm that often talks about out-of-the-money call option accumulation at certain strikes that can act as resistance for a stock. The theory behind that, I thought, is that the market makers who sold those calls will hedge by buying other calls and sell stock whenever the stock gets close to moving above the level with the high call accumulation to try to keep those calls out-of-the-money.

But then, I had a trader and a market maker call me and tell me that that is not usually the case and that the market maker doesn't even care where the stock is really. I'm very confused. What am I missing? Should I be a...

Conspiracy Theorist or Trusting Soul? An avid options trader.

Dear Always be Both as an Options Trader:

Ah, the ever-present whispers of stock manipulation. Traders with large option positions have great incentive to influence the price of the stock (especially at expiration). One of the most popular Options Trading FAQ columns dealt with the tendency for stocks to land exactly on their strikes on expiration day. If you would like a reprint of the "Coincidence or Conspiracy" Q&A from Oct 25, 1995, please e-mail me.

Some background: Trader Blair Hull (interviewed in The New Market Wizards by Schwager pg.385) says that there is a natural tendency for stocks to finish at the strike. He did some statistical work that was quoted in the WSJ. A stock is about twice as likely to finish within a 1/4 point of the strike price at an option expiration than might be expected.

Why is this? As mentioned, it was covered in my previous Q&A on option trading, but basically there is great incentive to do so. The particular option strategies require a close to the strike finish in order to maximize profit. This can be done through "natural" tendencies or by outright manipulation such as pegging or capping. In your example, selling shares of stock to purposely keep the stock below a certain strike is called capping. There are rules expressively forbidding this activity, so it can be a touchy subject.

To answer your question more directly, the option trader and market maker are right. This sort of case is rare. What happens most of the time is that the market makers set their hedges at the onset of the positions. That is, when they have to buy or sell to meet a public order, they lay off the risk on the spot. They would adjust their portfolio either in other options or in the stock itself (long or short). They will keep the hedge going as well as they can so that movement in the stock will not hurt them (delta neutral). The risk to them comes in the form of a large gap opening where they don't have a chance to adjust the hedge (out of kilter).

There have been (and always will be) cases where the market maker will try to peg or cap the stock at the expiry. Blair Hull laughs at a recollection: "When I was a trader on the PSE, two smaller mm's wanted to pin the price of a particular stock to the strike. They wanted to sell the stock on the expiration date and make sure that all the calls and puts went out worthless. They enlisted the aid of a large market maker in this scheme. The large market maker agreed to join their group and pin the stock. Instead, he took the opposite position and took them both out of the game."

This sort of stuff is unusual but the potential may exist when certain calls or puts accumulate. Maybe that is what your option research firm is talking about. It makes for an interesting report by the analyst, but I would side with the trader and the market maker on this. In fact, in most things, one should usually trust the guys and gals "downstairs" more than the fat cats "upstairs".

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Valuation, Options Pricing

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Put Call Ratio for Options Trading

Topic: The Put/Call Ratio

Folks: This letter addresses a fundamental subject in option analysis - sentiment readings. Please read it carefully and write me if you need help in understanding it. A good grasp of the Put/Call Ratio is very important to your trading.

Dear Options Trading FAQ:

I have an options trading query for you to consider. Let me introduce it by copying to you a portion of a recent news article by a Reuters reporter, Medora Lee who often writes about options trading. She is writing of Bernard Schaeffer's bearish outlook on the tech sector due to the high number of calls being chased:

>>>
Despite expected gains in broader U.S. stock indices and the Dow 30, Schaeffer warned that technology indices continued to look bearish. "I remain bearish on the semiconductor sector although bounces are certainly possible after the recent huge declines," Schaeffer said, adding, "both Applied Materials (AMAT) and Micron Technology (MU) continue to attract hordes of bottom-fishing call option speculators, and there is very muted put activity. This is classic bullish sentiment in a bear market that strongly suggests that the bottom is not at hand."
>>>

Now, it seems to me that this comment on call option activity is not very insightful. At some point the market *will* turn around and at that point those that have been fortunate enough to predict it and time it will be correct in their bottom-fishing call speculation.

I'm personally not big on trying to time the market since I don't think it can be done, but to claim the bottom fishers are wrong because they are a reverse or contrarian indicator also seems problematic. But maybe there are some things I don't know about using put/call ratios as technical indicators of market direction.

Can you enlighten? Thanks again for your continued commentary on options trading.

Options Trader Confused by the Put/Call

Dear Put/Call Ratio Doubter:

Ah, the famous Put/Call Ratio. This is that demon contrarian indicator that *puts* (ha, ha, -very punny!) options traders into a tizzy. Option traders just can't stand being used as a wrong way signal! For those of you who need a review, it is the number of put option contracts traded divided by the number of call option contracts. In the abovementioned example, Mr. Schaeffer's eye was caught by the very low put/call ratio in the tech sector (very few puts traded as compared to calls). He reads this in the usual contrarian fashion - that the option trades represent dumb money. That is, speculative funds that usually prove to be ill invested. Therefore, he is situating himself opposite the call buyers and maintaining his bearish stance on techs.

Yes, use of the Put/Call Ratio can be problematic in that one must always take into account what the general market atmosphere is. Note that Schaeffer places the call option buying into context by referencing the bearish tech environment. This is important in that the Put/Call Ratio figures can go to different levels in different market scenarios in order to trigger a signal.

Had the same call buying occurred in a rising or flat market for AMAT and MU, Schaeffer's signals may not have been triggered. Proper use of the Put/Call Ratio comes with experience in watching it and in understanding just when certain amounts of put or call volume is allowed to increase or decrease without tripping an alarm. For instance, if MU was going straight up (instead of declining), one must allow for increased call volume caused by that rise and not go short against the natural increase in call buying.

You mention that in some cases, the market will turn and prove the fortunate bottom-fishers right. Yes, but I think you will agree that those folks were mostly just lucky guessers. That money does happen to represent purely speculative money as opposed to really smart money. By and by, one must use the Put/Call Ratio as a contrary indicator. There are exceptional times when other rules apply (I'll cover that subject in an upcoming letter), but stick with the classic interpretation as a general rule.

Bottom line for options traders? I think Mr. Schaeffer's analysis is sound and was reported well by the news service. Whether he'll turn out to be right in his market judgment is another matter. Only time will tell.

Keep an eye out for advanced Put/Call Ration interpretation techniques in future letters.

Good Luck!

PS. I have been working on my own proprietary option sentiment survey which I'll unveil in the very near future. I'll be collecting market opinion surveys from the Options Trading FAQ readership and compiling the data for distribution to the major media channels. The standard Wall Street sentiment studies (AAII, Consensus, Market Vane, Investor's Intelligence, etc.) have been getting a bit stale in their polling methods. It's time for a little shakeup!

The Options Trading FAQ Sentiment Survey (TM) will be the first electronic weekly sentiment polling of a very interesting demographic group. The average Options Trader FAQ reader is a well educated, solidly financed, internet savvy, private investor intensely interested in advanced trading techniques. Such a group certainly deserves to be tracked. Using the technology of the Internet to do so will allow for accurate and timely data gathering. I am very excited about this venture and hope the readership will be kind enough to contribute to this leading edge research project. Warning! As with the other sentiment surveys, we may find ourselves also to be a reliable contrary indicator. In that case, we'll just always place our orders opposite to our market opinion. It's certainly been working for myself since I started reversing my orders !!

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Indicators, Options Put/Call Ratio

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use. Think about your options.

Trading Options at the Opening

Topic: Trading Options at the Opening

Dear Options Trading FAQ:

I've heard that an order has to be placed by a set time before the market opens to be entitled to the opening price of a particular option. Does it mean that if you put in an a market order before the market opens, you are guaranteed a fill at the opening price?

Isn't it risky to put in an market order before even knowing the bid and ask for that option? I've found that most options don't have a bid and ask price in the first 15 minutes after the stock markets have opened. Why?

What are the trading hours for options? While you're at it, maybe you can give me a tip or two on the different ways to place an order, like at market; at bid; at ask; or in between.

Early Bird Options Trader

Dear Early Bird Gets the Options Premium:

In order to get the printed opening price, your market order must be represented in the opening rotation. Get your order down to the floor at least 15 minutes before the market opening. In busy market times, they may start the rotation procedure even earlier than that. What exactly happens during the rotation?

The individual exchanges can send you specific information, but it usually goes something like this: Starting with certain months and strikes, each option series in sequence is "opened" and a bid-ask is determined. Pre-rotation orders are filled according to this price and further trading is not permitted until all series have gone through the rotation.

As you point out, options can take 10 - 15 minutes to get through with the rotation and start trading. Here are a few implications of the opening procedure:
Playing a news-induced, gap opening? Be careful of the delay in the option trading. By the time the options start, the stock may be correcting from its first thrust already.

Use the opening to get out of your position. Pent up demand for the option can mean good news for the seller. Often the high price of the day is set at the opening. Take advantage of the swell in liquidity to offset positions at the opening.

Does that mean that those playing the opening are always wrong? I wouldn't go that far, but with news related price pushes, they seem to pay too much on that first morning's opening. This is particularly true on Mondays.

As for how to place an order for the opening, that's quite tricky. You are looking to jump on an emerging trend, but don't want to overspend either. If you are reluctant to use a market order, try an "or better" order. Let's say you wake up to the following scenario tomorrow: The S&P December contract is up 1.95, the long Bond futures up 20 ticks, and the OTC tech stocks all indicating higher. The OEX call option you've been watching closed at 2. You don't know what to do.

The market is poised to go to new highs and this could be the impetus to a great one day upmove. On the other hand, the calls will be so rich that any stalling or an early pullback will mean a drubbing to the call holders. Compromise by giving an order to buy the calls at 2 1/2 or better. That way, you have in mind a top price you will pay, but will also be entitled to the opening price if it is lower.

As for the trading hours of options, the answer depends on if it is an equity option or an index option. Equities go until 4:10 New York time (10 minutes longer than common stock) while index options trade until 4:15 p.m.
I'll discuss getting the most out of different types of orders in an upcoming issue.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Pricing, Options Order, Market Opening

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use. Think about your options.

Stops on Options Orders

Options Trading Topic: No Stops on the SOX?(Semiconductor Index)

Dear Options Trading FAQ:

My broker wouldn't accept my stop order on the SOX. Says the specialist firm stopped taking them. Can this be true? No stops on these options?

Can't Stop Trading Options Now

Dear Options Stop Dropped:

Yes, as of last Thursday, Nov 16, the SOX specialist firm of Susquehanna Investment Group stopped dealing with stop orders on options. They applied for, and received, the ok from the officials at the Philadelphia exchange to cancel all existing option order stops and to refuse future stop orders until further notice.

Traditionally, stop orders on options are refused by the specialist in times of great volatility. In this case, it seems that recent price action by heavy-weights in the index such as Micron (MU), Texas Instruments (TXN), LSI Logic (LSI), and Applied Materials (AMAT) has caused the Semiconductor Index to swing wildly. It becomes just too risky for the specialist to try to fill the stops on his book.

Option floor sources say that such short term halts of accepting stops is not that uncommon, but is usually in effect for just a day or two. In this case, the feeling on the floor seems to indicate that this may become a lengthy affair.

It would be interesting to speak to the Susquehanna folks to see what the official party line is and when they expect to bring the stops back.

Oh, well. I guess you'll just have to stay glued to your own quote monitor all day long and watch for those options trades.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Employee Stock Options and Trading Strategy

Option Trading Topic: Employee Stock Options

Dear Options Trading FAQ:

I have a couple of questions on long-term options given as employee benefits. Particularly, 10-year options that are issued with a strike price that is equal to the current price.

How should they be valued? They can't be sold, so perhaps Black-Scholes isn't appropriate. What about looking at them as a 10-year, interest-free, tax-deferred loan that is invested in the stock?

If you are worried about a fall in the stock price (or non- movement in the next, say 1-2 years) after a big run-up, what should you do with these options? What about exercising them, putting the stock in a margin account, and then selling covered call options that are out of the money (or even in the money).

If you exercise the options and buy the stock, then you must hold for 1 year before you can sell (for capital gains purposes), or if you sell within 1 year, then it is taxed as ordinary income. Is there an options strategy (selling short against the box perhaps, although I don't exactly know what this is) that could allow you to take (or lock in) profit, without realizing the gain for a year?

Concerned About Dad's Stock Options

Dear Keeping an Eye on Dad's Dough:

This is a real sub-specialty that some brokers are experts in. If your dad wants professional advice, he should ask around his office to see who the others know and trust.

Basically, the question your dad needs to think about is: How long term a play do I want this to be? If he is a long term bull on his company's prospects (and why wouldn't he be?), he should consider just holding his options as they are. Why would he need to convert it to stock? Currently, he has a long-term bullish play at no capital requirement. Can't beat that.

If his take on the stock is grim, then he should not only cash in but brush off his resume too! As for cashing in, that is an area to get help in. Ask around. There are various ways to approach it depending on the tax consequences and such. Also, when the options come due, does he want to continue betting on the rise of the stock, cash it all in, or diversify his holdings? Lots of questions to think about.

There are many in the group who have stock options as a benefit (very common in high-tech companies). Maybe we'll get some input from them. Will pass on any info. Stay tuned, dear options trader.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Employee Stock Options, Options Valuation, Options Pricing

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Backwardation of Option Pricing

Options Trading Topic: Backwardation of Option Pricing

Dear Options Trading FAQ:

Perhaps you can explain two recent closing option prices that just don't seem to make sense to me. I noticed that the last transaction for SIII Dec. 20 call options was $1.00. The closing price on the same day for the Jan 20 calls was 7/16. Why in the world would there not be a greater premium on the farther out January call option?

Thought Time was Precious with Options

Dear Option Timer:

I think the key words in your question are: LAST TRANSACTION. In talking about options, we really must look at last bid/asks and not closing prices. In inactively traded options (i.e. options other than OEX and SPX) or strikes, there is often a drastic difference between the last transaction price and the current bid and ask.

In your particular example, I would guess that the January call options have not traded for a while. If you look at the closing bids, you'll see prices that make more sense.

There actually are instances where the option with a shorter time to expiration will trade for more than one with a longer contract life. Every once in a while, I'll see a question about this.

The last time it was brought up, it was seen in far-out-in-time, deep-in-the-money SPX options. How can this be? As you point out, shouldn't the extra time mean something? Well, this phenomenon (known colloquially as backwardation) has to do with the cost of carry of these pricey options. Certain strategies will call for purchase of nearer term options and this greater demand will actually leave a inversion in the normal relationship. An interesting oddity - maybe it can be exploited.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Pricing, Options Valuation

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use. Go options!

Swinging Option Spread Trading

Option traders: Welcome back from the Thanksgiving break, all you option traders. Hope all had a good time. Mine was wonderful, except for the food poisioning. Thanks Ma!

Options Trading Topic: Swinging Option Spread Trading

Dear Options Trading FAQ:

In the past year I've played many bull spreads, several times buying back the short options when the stock bottoms and reselling it when the stock is back up. I use bull spreads mainly to handle such unexpected drops such as the one that happened to MSFT, dropping from 100 to 81. I established the MSFT Jan 100, Jan 110 call debit spread when MSFT was around 96 (Buying the 100 Call options and Selling the 110 Call options for a net debit amount). When the stock dropped to 81, I bought back the Jan 110 to close the position. I then sold the Jan 110 back out to open when MSFT went back up to 100 and my exposure is now much less.

What do you think of this option strategy? Can I do this over and over? I know this only works for volatile stocks and also with low commissions.

Busy Option Spreader
Dear Maybe a Little too Busy with the option trading:

Just one question - when the short call falls in price so that you want to buy it back, doesn't the long side fall in value too? In your example, you bought to close the 110 call option when the stock hit 81. What was the value then of the 100 call that you were long? Not much, I would guess. The paper loss at that time must have been severe. It was a good play to close out the short side because the stock rebounded, putting good premium back into the long 100 call.

At this point many would have chosen to sell out the long side, flattening the position and salvaging the trade. That would be an example of a classic successful legging out of a troubled spread.

Here though you choose to re-spread the whole affair by selling the 110 call option again. I suppose it is because your original bullish outlook on the stock has been restored, but aren't you asking for a bit of trouble? In the time it took for all this to transpire, haven't you lost a bit of premium from your long call? Wouldn't a simple stop strategy have meant much less exposure from the start? If the stock had not come back, the spread would have been a complete loss.

It sounds like you're caught a little bit in the fact that you can make some short term money in the short side of the spread. Don't forget that in this and all spread strategies, you are "supposed to" lose money on one side. Don't fall into the trap of trying to make both sides profitable. It seems like you are cheering for the short side to come down so that you can buy it back to sell it again later. Well, don't wish for that because, theoretically, your debit spread in calls demands a swift, strong upmove.

I have a client who loves to try to make money on both sides of an option spread. An eternal optimist with his positions, he doesn't care which way he is spread, bullish or bearish. First he'll root for the net long side and then break the spread to cheer for the other side. Action is his game - he'll take it in whatever fashion it happens to appear in.

Let's try to be a little more controlled than he. I think you sense the concerns I've voiced, because you allude to needing low commissions and an active stock.

Just don't get carried away. If you want to play swings in the stock, use simpler strategies - buy plain calls for a rally and puts for a decline.
Often times the simplest things work the best.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Option Spreads, Options Strategy

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Margin Requirements for a Buy-Write

Options Trading Topic: Margin Requirements for a Buy-Write

Folks, Here is an exchange of letters with a reader which you may find interesting if you've done buy-writes. It illustrates the not-as-simple-as-it-seems nature of the buy-write margin calculation.

Dear Options Trading FAQ:

Here's another discount broker horror story you can add to your horror story "portfolio". I tried doing a buy-write today. I knew it was going to be difficult going in, but I didn't expect them to flub it THIS badly!

I was trying to buy 100 shares of MU at 50 1/2, and sell the Jan 1998 50 call at 18. The margin requirement for this is an incredibly low $725 (yes, I realize there could be a margin call if it goes down), due to very inflated premiums and the use of a 2-year LEAP. The buy-write gives me downside protection of 25%, to about 38, and the return on margin is 149% if called, and 163% if unchanged. I realize now that I would rather have sold the 55 calls which give me 5 more points to the upside for only 1 point less protection on the downside. Maybe this worked out for the good, since I will have to attempt the trade again tomorrow - read on...

Well, first the LEAP threw them. Even though I was very clear in saying "January, 1998 50 calls" AND gave them the symbol, they insisted on quoting me the January 1996 calls. I also had to explain several times what I was doing. They thought I wanted to buy both the stock and the options. I got switched over to another broker, who seemed to understand buy-writes. He gave me a new quote, and it looked like we were ready to roll. Until... "you will be bringing in a check for $3600, right?".

After several more minutes, I still hadn't gotten through to him. I had at least convinced him that the margin requirement couldn't POSSIBLY be higher than $2525, if I were simply buying the stock, and forget about selling the option! I wrangled him down to $1800, but that was it. I got his name, muttered "I'm going to hold you to this trade", and hung up.

Next, I placed a call to their margin clerk. I left him a voice mail, and didn't expect to hear from him till the next morning. Well, actually, I heard from him about 5 minutes later, as apparently he'd been brought the trade from order-taker #2. I was very polite and said that perhaps I'm wrong, let's just go through this step by step... We both quickly agreed that the broker had incorrectly used the effective price of the stock instead of the market value in calculating the margin requirement. Yes, it did cost me $33 a share, but it's WORTH $50! Doh!
By this time it was 1:02 (4:02 eastern). (I first called at 12:45). He asked me if I wanted him to "drop the ticket". I was skeptical of the time (glancing at my atomic clock - well, it's synched to my Internet provider, anyway...) but I said "yes". He seemed to think there was time. Of course, there actually was enough time, since I'd placed a market order, giving up any hope that they could successfully do a contingent order. They could have still sold the option - there were 8 minutes left - and they could have easily picked up the stock in the after-hours market.

When I called back to check on my order, there was again much confusion. I finally got a call back from the head trader who explained that it had been too late (OptionFool, you DO have a big clock where everyone can see it, right?) but that he could put it in "first thing in the morning". He also reiterated my suspicion that the order could have gone through anyway - "this could have just been a market order". Yep, it sure could have, since that's the way I placed it! Anyway, I decided to look at the numbers again in the morning and start all over. (Hopefully, head honcho will have a little talk with the troops in the meantime...)
How about that?

Know More Than They Do

Dear You Know More Than I Do Too!

Now I feel really stupid. Glancing at the figures in your "horror story", I don't see where some of the numbers mentioned come from. What is the 725, 3,600 and the 1,800? How do you figure the 725? Why wouldn't it be calculated like this?:
Buy the stock at 50 1/2 Sell option at 18 _________ net debit = 32 1/2 x 100sh = 3,250
At 50% initial margin, the cash req is 1,625

The concept is this: Buy the stock and offset the purchase requirement by bringing in usable cash from a covered option sale.

The Options Trading FAQ

Dear Option FAQ:

I’m disappointed in you! You're figuring it the same way my broker did. Guess brokers just think that way. :)

The margin guy at Jack White agreed with me. Now, if it turns out that I'm wrong (I will allow for the possibility, but remember, now you're fighting both me AND Larry McMillan...) then JW is *really* hosed-up, and I'd sure like to know so I can toss McMillan and find another bible.

I explain below where the $725 figure comes from. $1800 is, of course, how much the sale of the option brings in. I still can't figure where the $3600 came from. It's just a number the broker pulled out of thin air.

The net debit isn't the right calculation. Here's why. Let's do a question and answer:

Q. How much is the stock worth?
A. It's worth $5050.

Q. How much can you borrow against it?
A. $2525 - wait a minute - I see where this is going - you're trying to trick me!

Q. No, I'm not. :) How much cash do you have to put up to buy the stock?
A. $2525.

Q. Right. Now, I'm selling an option for $1800. What I get when I sell the option sure looks like cash! So, after crediting the $1800 - cash - I receive for the option, how much more margin do I owe?

A. $2525 - $1800 = $725 Damn! Don't ever let em' count their own change!
Q. You're still skeptical, I can tell. OK, tell you what: I'll just put up the full $2550 margin for the stock.

A. Now you're talking!
Q. Now, about that option premium... It brought in $1800. I've been eyeing that big-screen TV down at the Appliance Mart. Mind mailing me a check?

A. Wait a minute - you're going to send me $2550, and I'm going to send you $1800... Oh.... Doh!

At first glance, net debit appears to be the right basis for the margin calculation. But it's wrong. The reason it's wrong is that it values the stock (for loan purposes) at the effective cost, rather than the market value. Looking at it yet another way, using the net debit disallows part of the current market value of the stock - in fact, 2 times the option premium - from the loan value of the stock. What? Because I only paid $39 for it, it's only worth that? :) In the case of LEAPS, and in particular 2-year LEAPS on a highly volatile stock - 2X the option premium is a very significant percentage (more than half) of the price of the stock.

I believe that the sequence of calculations in McMillan is the correct one.
Actually, the requirement is 766.50. Here's the calculation. I made an excel spreadsheet with the calculations from McMillan (2'nd edition - pp 43-45). I've attached the output from the spreadsheet.

Margin interest rate 9.00 % Margin rate (regulation T) 50.00 %
STOCK PURCHASE stock price 50.75 shares purchased 100.00 commission 36.00 Annual dividend/share 0.20 Annual dividend 20.00
OPTION SALE option price 18.25 contracts sold 1.00 commission 36.00 strike price 50.00 Months to expiration 25.75
NET INVESTMENT REQUIRED stock cost 5,075.00 plus commissions 36.00 net stock cost 5,111.00 x margin rate 50.00 equity required 2,555.50 less premium received (1,825.00) plus option commission 36.00 net margin investment 766.50
DEBIT BALANCE Net stock cost 5,111.00 Less equity (2,537.50) Debit balance 2,573.50 At 50.00 % margin
RETURN IF EXERCISED Stock sales proceeds 5,000.00 Less stock commissions (36.00) Plus dividends 42.92 Less margin interest (546.00) Less debit balance (2,573.50) Less net margin investment (766.50) Net profit - margin 1,120.92 Return % 146.24 % Net yearly return 68.15 %
RETURN IF UNCHANGED Unchanged stock value 5,075.00 Plus dividends 42.92 Less margin interest (546.00) Less debit balance (2,573.50) Less net margin investment (766.50) Net profit - unchanged 1,231.92 Return 160.72 % Net yearly return - unchanged 74.90 %
BREAK-EVEN POINT Net margin investment 766.50 Plus debit balance 2,573.50 Less dividends (42.92) Plus margin interest charges 546.00 Total stock cost to expiration 3,843.08 / shares held 100.00 Break-even point 38.43 :
PERCENT DOWNSIDE PROTECTION Initial stock price 50.75 Less break-even point (38.43) Points of protection 12.32 % downside protection 24.27 %

How about that, Options Trading FAQ?

Love, Me and McMillan

Dear M&M:

I give up! I now dub thee Sir OPTION TRADER. - You can take over the column, I’m staying out on an extended Thanksgiving holiday! Actually, I spoke with my margin clerk, and this is what I learned (I think ):

There are two applicable calculations: 1) the fed call requirement and, 2) the house call calculation. The first is as you have calculated: 50 1/2 for the stock times 100 shares at 50% initial margin is $2525. Then subtract the full proceeds of the option sale (1800) Requirement is $725. So, on the day of the sale, you are correct, only the 725 is needed. Then, after that, (as you have alluded to earlier), the house calculation applies as follows: 30% of the stock (that is when they’ll issue a call), but using the exercise price instead of the current stock price if the option is in the money. This is known as Pegging the stock (to account for the terms of the outstanding contract).

Also, the clerk replied (rather haughtily, I thought) that, for protection, each firm can set their own requirements higher than the minimums set by the exchanges.
Good Work. Now I’ve learned something from this forum too! I’ve got a question for you. Looking to jump into this internet craze, I bought calls in... ;D

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order, Options Margin

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.