The Newest Lesson on Options

Let’s return to basics.

We received a number of queries of late from folks new to the game of options, many of whom would like to partake of the wonderful profits we at Normandy have been blessed with achieving over the years.

It therefore behooves us to go over a few of the fundamentals of the game – good reminders, too, for those with substantially more options experience. One can never get enough of the basics.

We’ll start with this –

Your first concern as an investor in any asset class – stocks, bonds, commodities, options, etc. – is to be aware of the primary trend. The primary trend is the long term, multi-year direction of the market you’re trading, and by and large, it’s the side of the trade you want to be on at least three quarters of the time.

That said, let’s delve a little deeper.

We’ve posted a two year chart of weapons manufacturer General Dynamics (NYSE:GD) for illustrative purposes. Take a look –

NYSE-GD-CHART

The primary trend (in red) is one of three trends active in the market at any given time. The secondary, or intermediate-term trend (in blue), runs counter to the primary trend and lasts anywhere from a few weeks up to a few months or more. It’s also tradable, though it’s more challenging to do so successfully.

Finally, the short term trend, represented by all the squiggles and wriggles and jiggles that last anywhere from a few hours to a few days should, in our opinion, be ignored outright. Trading the short-term trend is very simply a sure-fire way to lose all your money. It’s the domain of day traders new and broke, the time horizon that’s well nigh IMPOSSIBLE to consistently make money at.

It looks like this –

DAILY RANDOM MODIFIERS

We should make clear that there’s one other trade that we’re scrupulous to avoid.

It’s an initiative that attempts to make money from a ‘counter-trend’ move within an exisiting intermediate trend.

Explanation:

Take a look, for instance, at the last intermediate trend on the GD chart above (in blue, far right). The overall move was (and still is) down. And once it’s been discerned that an intermediate trend lower is, in fact, in force, the safest way to play it is precisely in that direction – on the downside.

But you can also see that the move lower was punctuated by several sharp moves higher. These are called ‘counter-trend’ rallies, and they can make for good, quick money because they happen suddenly and are usually quite steep. But, alas, they’re also, in our experience, nearly impossible to play. And we have the losses scarred deeply enough in our trading book to knowhow true this is.

Want good advice? Avoid trading any ‘counter trend’ move during an intermediate trend.

What, then, are the absolute best trades to make?

We’re going to give two answers to this question – one short, one long.

The best trade is very simply the trade that doesn’t lose you money. It sounds pat, we know, but the truth about trading is that there’s so much that can go wrong, that if you manage to get out with the skin still on your back and your capital intact, you should thank your lucky stars.

That’s the short (but absolutely true) answer.

The longer one goes like this –

It’s always advantageous to attempt a long PUT trade on an intermediate move within a primary bull market.

Before we explain why, let’s go over that one more time –

  1. The security you want to identify is in a primary up-trend.

  2. It has peaked and is beginning an intermediate-term decline.

  3. As soon as you identify the turn, you purchase PUTs on that security.

Now the WHY?

Options are priced in such a way that when they’re least volatile they’re also at their cheapest. That generally occurs when a security is at or near an intermediate- or long-term top. Investors at that point are complacent, and their expectation of future gains serves to reduce implied volatility, a major input in the pricing of options.

Conversely, when a security has fallen dramatically and is in the course of bottoming, there usually exists an accompanying sense of dread and panic among investors that pushes implied volatility to extremes, and along with it, option prices.

It’s clearly to an options player’s benefit, therefore, to be a buyer in the first scenario (at tops), and a seller in the second (bottoms). The only trouble, of course, with selling options is that one opens oneself to unlimited losses, and because we’re addressing beginner options strategies here, we’d recommend against any option sale in the midst of a panic.

That leaves buying PUTs at tops.

The buyer of PUTs at an intermediate- or long-term top benefits both from the bargain price he pays for the product at the outset, and from the inflated price at which he sells during the panic bottom – if he can manage to hold on for that long.

Winnings in these sorts of scenarios are typically in the 1000’s of percents, and we count ourselves blessed for having scored a few in our lifetime.

Keep Your Eyes Open!

As we’re now in the midst of a primary bull market in stocks, the opportunity to cash in on such a move is ever-present. It requires some diligence, of course, but if after scouring the landscape you can determine a few candidates that appear genuinely to be in the midst of topping, consider it good practice to buy some cheaper, out-of-the-money PUTs on them all. It only takes one to score a whopper.

Remember – on a straight PUT purchase, you can’t lose more than you spend.

Sweet thing, that Pearl. Always flossing.

This Week’s Trade

We feel it safe to report that we’ve never in all our year’s done what we’re about to do today.

Today, we’re going to mimic exactly a trade that we set last week that looks even better now, as we go to press.

You’ll recall that last week we recommended a long Facebook (NYSE:FB) CALL and a short sale of a FB PUT – both November expiries.

As it turns out, Facebook backed off, then returned to roughly the same level it was when we set the trade. And we say the stock is now stronger for the pullback. Here’s how we’re going to profit from this…

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We therefore highly recommend you consider a second CALL purchase on FB using the November 85 Strike, now selling for $7.40. Sell the FB November 70 PUT for $2.76. Total debit on the trade (this week) is $4.64.

Last week it was $4.76.

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We therefore highly recommend you consider a second CALL purchase on FB using the November 85 Strike, now selling for $7.40. Sell the FB November 70 PUT for $2.76. Total debit on the trade (this week) is $4.64.

Last week it was $4.76.

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With kind regards,

Hugh L. O’Haynew, Normandy Research

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