Q&A
Don Bright of Bright Trading
NEW TO OPTIONS
I am new to options, although I have been trading stocks for several years. Does the technical analysis I use in stocks also apply to options? Do I need to change anything (such as the parameters of MACD, RSI, and DMI) to adapt to the options market? Do you know of any website that provides charts of options? -- Richard Wilson, via e-mail
Trading options is a completely different animal. My brother Bob and I spent more than a decade on various option exchanges (CBOE, PSE, CME), and we were around during the glory years. I say "glory years" because we were able to gain a tremendous edge by using our theoretical models. These models are based on historical volatility of the underlying security and interest rates.
Be sure you understand the difference between the actual volatility of the stock and the implied volatility of the options. This is primary to trading. Many novice option traders think that just because a certain series of options are trading at a much higher volatility than the historical on the stock, they are overvalued. This can be a real trap.
You need to know the basics: deltas, gammas, betas, thetas, and so forth. You need to know the relationship between the puts and the calls of the same strike price. You need to know what the conversions (and reverse conversions, called reversals) are worth based on your cost of money and expected return. To explain: If you buy the stock, buy the put, and sell the call, you have purchased a conversion. If you do the math based on interest rate and days until expiration, you will find that most are trading at or near fair value. In this context, fair value refers to the expected return from interest on their money (floor traders often do the reversal side of these three-way transactions), and what you would expect to receive from a money market instrument.
If by trading you mean simple speculation of what the options are expected to do based on your expectation of the underlying stock movement, then you must consider only the risk-reward ratio using two or more standard deviations from historical volatility. (The limited risk that you hear about is the cost of the options you buy; all you can lose is 100% of the amount you spent. The higher risk is, of course, the amount you could lose with an extreme movement in the stock, when you sell or write the options.)
You can get information about trading options by going to www.cboe.com. As always, try to stay away from the "how to make money" books out there. Feel free to submit any follow-up questions to me. Good luck!
24-HOUR TRADING
Has anyone heard if there will be opening and closing prices when and if 24-hour trading takes place? If there aren't any opening and closing prices, won't technical traders be hurting? -- Jason Gaddis, via e-mail
It is my understanding that 24-hour trading will take place much like it does on the Globex, where they close for a short time prior to and after the primary market hours. I am not aware of any definitive answer at this time.
PROFESSIONAL OR RETAIL?
Your response to "Getting Started" in the February 2001 issue seemed quite arrogant and elitist when it came to your definition of a trader. It appears you believe that to be a trader, one must be a member of an exchange, a floor trader, or part of a firm like yours, Bright Trading. "These people are either exchange members or licensed professionals."
Does this mean that all the other professional, full-time traders are not real traders? What license are you referring to? Should I get one? I make approximately two trades per day. Does that mean I'm not a trader, just because I don't make 200 trades per day and trade from an office in my home instead of an office owned by you? I don't think so, but maybe I am missing your point. If so, please enlighten me.
I believe that a much better definition of a professional trader is someone who is consistently profitable. I like to think of myself as a professional trader for this reason. Sitting in one of your offices or on the floor or being licensed is no guarantee of that. But I've been wrong many times. No doubt you are much more experienced in this business than I am. I hope to learn something from your response. -- Ron Scott, via e-mail
Please be assured that I never intended to sound either elitist or arrogant. If I came across that way, I sincerely apologize. STOCKS & COMMODITIES is currently publishing my articles that explain the differences between professional trading and retail trading [Editor's note: the first article appeared in March 2001]. I try to make it clear that when I say professional, I do not mean versus amateur, but versus the retail customer of a brokerage firm.
I realize that many people do make a living trading as a customer, but in all honesty, the people who make the most are definitely licensed -- you can save thousands per month in fees. The licensing requirement came about a couple of years ago, and has proven to be a great thing for firms like ours. We no longer attract the "let's try stock trading for a while" (much like the "sell real estate on the weekends") type of individuals. I wish you continued success in your trading endeavors.
DERIVATIVES
Trading the Standard & Poor's 500 index has a few forms. You could trade the index tracking stock SPY, you could trade the S&P futures, or you could trade options on the S&P futures. What are the advantages and disadvantages to trading futures or options futures versus trading the underlying commodity? Do people trade futures just because they are more leveraged, and futures options to be even more leveraged? -- Michael McClellan, via e-mail
Good question! We have to first look at who is trading these various instruments. The S&P futures are traded on the floor of the Chicago Mercantile Exchange (CME), and they are a primary indicator of real-time, short-term market direction. Many institutions and large arbitrage houses use the futures to hedge against baskets of stocks. The two primary options are the options on the futures (CME) and the options on the spot (actual cash value of the index) traded on the Chicago Board Options Exchange (CBOE).
Options are often used like a form of insurance against a portfolio of stocks. If a firm owns $10 million of stocks, they may buy puts on the overall market as protection against a downward move while still keeping the dividends on the stocks they own. S&P depositary receipts (SPYS) are traded on the American Stock Exchange (AMEX) and are used by longer-term investors to closely track the overall market.
Speculators and traders who want to quickly get in and out of the market also use futures. This can be done either through a broker or electronically by trading the e-mini (also listed on the CME). The same basic option strategies can be applied to any group of S&P options (straddles, strangles, calendar spreads, money spreads, and so on), with similar risk-reward ratios. The leverage you refer to actually varies from firm to firm, and should be reviewed on an individual basis.
H.L. CAMP & CO.
Based on your column in the February issue, I contacted Hank Camp at H.L. Camp & Co. (www.programtrading.com) with questions about his research. His responses were less than informative, to say the least -- actually a little off-putting. Can you tell me anything about Camp's research, the results thereof, and where I might find information about him? -- Tom Adams, via e-mail
I cannot answer for Camp or his firm, although both are respected on Wall Street. As you probably know, I do not recommend individual companies or methodologies. I do, however, try to supply free informational websites for our readers. H.L. Camp & Co. does offer "pay" courses for their type of trading, and it may have been for this reason that they remain somewhat tight-lipped.
SHORT-TERM TRADING
This is a two-part question regarding a two-part answer you gave a reader in the February issue. First, I am a 22-year-old who became interested in trading about three years ago. I am currently position trading because I find it is the most efficient method for my amount of capital and time. Your statement that there are two types of people who should be in the market, traders (active professional daytraders by your definition) and investors, left me feeling a little discouraged. Is it unrealistic to focus on swing trading or position trading?
One of the reasons I choose position trading, as I said, is limited capital -- capital that gets eaten away by commission expenses (trade less, spend less). Even with a $9.99 commission, my position-sizing strategy keeps me out of a lot of trades. (I currently risk 3% or less on each trade, look for a risk-reward of at least 1:2.5, and then size my position accordingly.)
This leads me to the second part of my question. You mentioned that brokers who do not charge per ticket are a good idea for people trading in small lots. Where are these brokers? The only ones I could find have active trader requirements that would exclude non-daytraders. If you could name a couple, I'd appreciate it. -- John A. McGraw, via e-mail
I certainly do not want to discourage you from your current pursuits, as long as you understand the risks (it sounds as if you do). I do my best to shape my answers based on what I think the level of experience the person inquiring has. I am not always right, obviously. As I mentioned in a previous answer, a multiarticle series in S&C I have written addresses the differences between professional trading and retail trading.
Many people trade based on limited trading capital and lack of time due to other employment and/or education commitments. This is, of course, understandable, but does put them at a strategic disadvantage to those who are trading for a living on a trading floor. You seem to have found some success in short-term trading (I prefer that term rather than swing or position because it refers to both retail and professional traders).
There are risks far in excess of the risk-reward ratio that you mentioned when trading volatile small-cap stocks. You can get in (either buying or selling), but you cannot always get out at a fair price. Many times I have seen the best traders lose $10, $20, or $30 on a single trade when trying to sell an over-the-counter (OTC) stock (and even some big caps). Your other point about trade less, spend less is understandable, but in the case of professional traders, the exact opposite is true. Our traders who do the best trade the most. But again, our costs can be as low as one-half cent per share or even less, for volume traders.
Now to your second question. I don't usually recommend brokerages, but I think I can make one exception since you asked so directly. The only firm to which I have ever sent people (those who did not want to go through the licensing procedure and decided to keep trading as a customer) is Interactive Brokers (www.interactivebrokers.com). They are part of Timber Hill, a longtime and respected Chicago-based trading firm. I have zero connection with them, by the way. I believe that their fee is $0.01 per share with only a $1.00 minimum.
BASIC OPTIONS
I don't understand how the price of an underlying stock can go up and the price of the calls can go down. I thought that the calls are supposed to move up when the stock goes up, and puts move down. -- Michael McClellan
Let's discuss some option basics. Call options on an underlying stock have individual strike prices. This is the price at which you can exercise or purchase the stock. If you have purchased a $50 strike price option on a $45 stock, the stock would have to rise above $50 for the option to have any intrinsic value. If the stock went to $49.99 the day the option expired, then the option expires worthless. This is called time decay. Time decay is the friend of the seller, since each day that goes by, the erosion in the selling price of the option becomes larger. Time decay is the enemy of the buyer of the option for the same reason. Option buying is supposed to be of lower risk than selling options, but is generally less rewarding as well.
ERRATA: PROGRAMTRADING.COM
The website mentioned in the February Q&A (www.program-trading.com/buysell.htm) comes up as "under construction." Can you provide any more information? -- J.W. Galston, via e-mail
The site address contains a hyphen, which was used to join the two segments of the website's address across a line break. However, the hyphen is not part of the address. The correct address is https://www.programtrading.com/buysell.htm, which is the same address without the hyphen. We apologize for the inconvenience.
Don Bright is a principal with Bright Trading (www.stocktrading.com), a professional equity trading corporation with offices around the United States. E-mail your questions for Bright to Editor@traders.com, with the subject line directed to "Don Bright Question."
Excerpted from an article originally published in the April 2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2001, Technical Analysis, Inc.
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