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Sometimes Greed is Good - But Not with Options!

By Chris Rowe November 9, 2006 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

I love options!  
 
Have you ever loved something or someone who really hurt you, maybe nearly killed you in the past?  Perhaps left you with scars, whether it be mentally or physically?  I have.  
 
It seems like it was a lifetime ago when I was in an abusive relationship with out-of-the-money/short-term option contracts.  
 
At first "the call option" started off light.   Just a couple of love taps.  
 
It was okay, I knew that it was just part of the relationship.  I knew that there was a 485% profit light at the end of the tunnel.  
 
I'm telling you we had some great times, the call option and I.  Then after making 90% here and 85% there, the call option would deliver a swift blow to the head in the form of 100% losses.  
 
Told me that I was stupid.  Said that I wasn’t good enough to make an informed decision on my own using stock, and that in-the-money-options were a waste of time.
 
My friends told me that playing with those risky, out-of-the-money-calls that expired in three weeks was dangerous and that I would only get myself into trouble.  
But the tech stocks were gunning higher and higher.  I mean everyone else was doing it, right?   

So I went back in and had a great time again and again.  I’ll tell ya, it was such a rush; living on the edge, knowing that at any moment I could lose it all, or make 2,000%!
 
Sure I took a beating every now and then.  But I forgave the call option, and I booked some of the largest profits ever!   

My father told me “all those damn short-term calls are the same!  They’re all losers!  Why don’t you be more like your brother?  He has a nice, balanced portfolio of mutual funds.  He never gets into trouble!”  I just dismissed what he had said since I knew he would never understand.
 
Then my closest friends came to me in confidence and sat down with me. 
 
They put their hand on my shoulder and said "Look, Chris, you need to get out of this. We are all very concerned about you.  You are too good for this."  
 
I swore that I would start hedging myself.  I promised myself that I would sit on some cash "just in case." But I thought about all of the good times that the out-of-the-money call option and I had together.  I was nothing without it.
 
Ahh, the good times.  
 
Buy 'em at $1, sell 'em a week later at $9.90.  The call option really knew how to treat a trader.  

Sure, I lost 80%-100% here and there, but I remember one  time I made a $112,000 profit on $10,000. Those painful beatings I took were just part of how the short-term call option showed its love for me.  
 
What the hell is the matter with you bro?  You're too good for that" my brother said. 

I said "You don't understand.  I mean, it was really my fault for getting cracked in the head and losing 100% on the occasional position."
 
"I, I ... I brought it on myself.  I was greedy.  He didn’t mean it.  He’s just under a lot of pressure from the market correction.  It’ll pass.  Besides, the market was starting to move higher again." 

The call option said "sorry" and promised it would never happen  again. 
 
My friends always argued.  
 
My friend even ran into the trader’s office one day when I was taking a beating on another position and getting ready to start buying more short-term out of the money calls.  My friend and ripped the ticket in half and stomped on it repeatedly.  My friend yelled, "You stay away from Chris!  One more beating of a 100% loss, and you'll have to answer to me!"  
 
And he looked at me and shook his head as he stormed away fuming.  
 
I guess that I had to hit bottom before realizing that I had to find something that would always treat me right and was safe.  
 
I found cash.  I started putting it on the side for a rainy day.  
 
I started taking a few bearish positions as well as bullish positions in case I was wrong about the direction of the market.  
 
I would only buy options that were deep in the money and that expired in anywhere from 6 months to 2-3 years.  
 
Today, I counsel other traders in abusive relationships.  
 
I started The Trend Rider where together, we meet.  
 
Although we have our ups and our downs, since we started 12 months ago, so far we’ve only closed out three losing trades out of 37.  
 
We have taken both bullish and bearish bets. 
 
Okay, I went off on a tangent.  Ha-ha-ha.  
 
But SERIOUSLY ... People!  
 
Very, very important!   You MUST be responsible here.  Don't get caught on what you may see as "easy street."   What do I mean?  
 
If you play options, you may have gotten greedy lately.   It's okay; sometimes "greed is good" (as Gordon Gekko said).  
 
I can't stress enough to you the importance of keeping cash on the sidelines if you are playing the options market.  The amount of cash (protection/security) that you should have really depends on your options strategy.  
 
It is one thing if you are using highly sophisticated strategies where you are hedged. If you are in a position where you can only lose a portion of your net position, by owning both puts and calls on a stock (aka a "straddle") then you would need less cash on the side than if you are un-hedged because you own a put, or a call, by itself.  
 
We know that this is a great way to realize 40% profits (on an option) if the underlying stock only moves by 10-15%.  You can rack up some pretty healthy profits and even be up 400% within a year if you play your cards right.  
 
But you must remember that with bigger reward comes bigger risk.  That is why if you are un-hedged on your position, you should always have at least double the value of your un-hedged options sitting in cash.  This way, if the market swings way too far in the wrong direction, you will be able to buy the bargains.  In other words, if you have $100,000 in options, then you should have at least $100,000 in cash in case the market turns against you.  
 
Don't ever forget that in one day the entire market could make such a drastic move that your options could lose significant value.  
 
One day, you could walk into work or you could be  home brewing your morning coffee, and you will turn  on your computer, or CNBC only to find that some frightening news has caused the major indices to  come down from head to toes!  
 
If you own call options, it could be bad unless you have a few put option positions out there that would turn a nice profit if something terrible happens.  
 
Eventually, in 2001, I started buying loads of puts on the NASDAQ, and for many of my clients, I was the only money manager who was making them big money.  Don't think that the market can't turn right around in a week and start breaking 12-month lows. While I don’t think it will happen, it can.  
 
There could be some sort of crisis, or attack, or meltdown, or alien invasion. Something.  

Whatever the cause is, something will nail the stock market so hard that every single call option you own will be down 80%-100%.  So what do you do?  
 
Take both bullish and bearish positions, right?  Not a bad idea.  In fact, it's a great idea.  
 
By doing so, you are guaranteed to lose!  That's not a typo folks. You will win overall, as long as you guarantee yourself a few losers. That doesn't mean that you should do things that you don't think will work.  
 
It just means that you should place some bets on some stocks that you think will trade higher by purchasing call options, and you should bet on some stocks to trade lower, by purchasing put options.  
 
Now let's be honest with ourselves.  If the markets are trending higher, the majority of our positions will be bullish.  For some of you gun-slinging cowboys/cowgirls, all of your positions will be bullish.  
 
If the market is breaking multi-year highs, and you are wise enough to have some bearish bets on the  table, if a major catastrophe causes the market  averages to tank, only those few (bearish) positions  will do well as your calls will sharply decline in value.  
 
Another thing: if the market tanks, like in October  1998, or after 9/11/2001, or October 1991 or 1988  (the list goes on,) that will be the time to grab your ... um ... guts, and buy the long term calls.  These things don't happen often, but they do happen.  
 
If you bought the long term calls on any of those major market dips, you could have easily doubled, tripled or even made 10 or 20 times your money in the subsequent 6-12 months.  

Here is one reason why options are considered to be a sophisticated trading vehicle: It takes a certain rare discipline to go against human nature.  That is why option trading is not for everyone.  Most people have a hard time sitting on a large amount of cash.  Most people are too tempted to take that money and either spend it, or trade it.  
 
Sure, most people believe, and will tell you, that they are not one of those people. But they are.  Believe me, I managed money for all sorts of people,  both experienced institutional traders and individual  investors.  
 
Not only that, but most people have a hard time buying something and sitting on it while it goes the wrong way.  Those are the people who want to be right on every trade.  But you can't possibly, consistently, play both sides of the market (hedge your bets) and be right on every trade.  
 
You have got to be willing to accept some losers in your portfolio as protection.  
 
So the key here is to be sure that you are sitting on some cash for a rainy day.  The one time that you decide to take everything and take a huge bet when you think "the coast is clear” will be the day that nothing works.  (Take it from me, because it’s happened to me, and I’ve seen it happen several times to Wall Street traders who were much savvier, more experienced and smarter than I in the past.)
 
You can make a killing, and you can reduce your risk with options, just as long as you have discipline, and never stray away from that discipline.  

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