Terry Trasher's Trading Tutorial
Terry Trasher's Trading Tutorial - Terry interviews traders regarding their favorite strategy. Terry does his best to be objectionable, I mean objective to critique any strategy. Terry loves to take lots of risk and thinks risk adverse strategies are wimpy. He doesn't like to give his quest a break!!
TERRY: Today we are fortunate to have Jay Boring, oh sorry, Jay Barring who has a strategy in options that he calls a vertical credit spread. Jay has been trading options and designing conservative strategies for his clients at Barring & Associates for over 20 years.
TERRY: Jay, before you start, let me give you my reservations about options:
1. I understand that there are so many options available that very few of them have any liquidity. The slippage (the difference between estimated and actual transaction costs) will kill you.
2. If you know which direction a stock is headed why not just buy or sell the stock. With options you only get a percentage of the move.
3. With options don't you lose a little every day because of time decay?
4. I heard that it's suicide to use stops in options because the floor traders are always gunning for them.
5. How do you know whether an option is over- or under-priced?
6. When you determine that an option is overpriced, isn't it usually for a good reason. For example: a buyout?
7. Because options are cheap dollar-wise, isn't the commission cost as a percentage of the dollars involved pretty excessive?
JAY: Wow Terry, you've got some learning to do!
Let’s start with your last comment first. Years ago, commissions were a large part of the equation - but now they are almost insignificant, I pay $1 per option.
The time decay comment is very valid and that is why I sell options in my strategy. In that way time works for me not against me.
TERRY: But Jay, I thought you were conservative. If you sell an option, let’s say a call, isn't your risk unlimited?
JAY: Only if you are not “covered” by owning the underlying stock or owning another call to “cover” the short call. You see, in my strategy I sell expensive calls and cover with cheap calls -
TERRY: But Jay, how do you know when one is cheap and one is expensive?
JAY: I'm sorry Terry, but you misunderstand - I could care less whether a call is overpriced or underpriced based on some formula - What I mean is that I sell high priced calls and buy low priced calls to cover. In that way, I start out with a dollar credit in my account. Example:
with the stock at 65, I'll sell a 65 call for 4.5 and buy a 70 call for 2.25, that gives me $225 cash for each 100 shares. The margin is $500, but I already have $225, so $275 is needed for each 100 shares.
TERRY: Jay, there you go again, now your taking, not one, but two positions - now that would require liquidity, the slippage will murder you.
JAY: You don't understand. For example: If a stock is 50 with an option series that expires in about 5 weeks - I'll sell a 50 call and buy a 55 call with the order placed as a spread. In this example a 50 call would sell for 3.5, a 55 call could be bought for 1.25 - so the order is entered as a spread with a bid for a net credit of 2.25. If I get the trade... great, if not there's another train leaving every 15 minutes.
TERRY: But Jay, If you have bearish information on XYZ, why don't you just short the stock - that way you'll make a killing if it really tanks.
JAY: I might have bearish information but did I mention that EVEN IF I KNOW NOTHING THE ODDS ARE STILL IN MY FAVOR.
Lets do the math:
Stock Price: 50
Margin required for 100 shares short: $2500
Margin required for Credit Spread: 8 contracts: $2200
Position in 5 Weeks:
STOCK PRICE SHORT 100 SHARES SHORT 8 50's/Long 8 55's
40 +1000 +1800
45 +500 +1800
50 - 0 - +1800
51 -100 +1000
52 -200 +200
53 -300 -600
54 -400 -1400
55 -500 -2200
60 -1000 -2200
TERRY: Jay, this seems too complicated and boring to me - I just want to be long or short the stock or market since I usually know which way its going - Besides, you don't make enough for all that work.
JAY: Your right Terry, it's pretty boring - like watching paint dry (or time tick by) but I earn interest as the paint dries. Let me summarize:
1. Not very exciting, not very risky - its just about making money
2. No major prediction of the stock or market movement is necessary - a simple trend recognition, chart pattern. or oscillator will work to increase our already favorable odds.
3. Only three things can happen to the stock - it goes up, it goes down or it stays the same. In two of the three I make money - it can even go against me to 52 and I make money.
4. Commission/slippage is minimum because the trade is put on as a spread and more often than not the options just expire and no closing transaction is needed.
5. Time works for me not against me.
6. No stops are necessary since I know the worst case scenario in advance.
7. Since this strategy results in profits more often than not, it's safer to risk more of my capital on each trade.
8. There can be no surprises - if the stock gaps against me, it can go as far as it wants - my maximum loss is fixed and won't be exceeded. I can sleep more soundly.
9. Since this trade does not require constant monitoring instead of watching every tick, I am free to find other trades.
10. I want to mention again - EVEN IF I KNOW NOTHING THE ODDS ARE IN MY FAVOR.
TERRY: Thanks for your strategy, Jay. Your strategy actually sounds pretty good, for widows and orphans. I hope our audience is still awake - Sorry guys, for next month I'll try to get something a little more stimulating and risky like trading should be.
For more information on credit spreads contact jim@qtt.com
