Options haven't worked lately. Oh sure, the guy who bought
putsmade out like a bandit. If you owned
calls, you brought home thebacon, no matter how much premium you paid.
(TSC's options guy covers this stuff incredibly well. But so does thegovernment. If you bought a ton of Union Camp calls before that takeoverbid, you have already heard from the Feds. These out-of-the-money buysused to be commonplace when corporate raiders ruled the landscape,because they could never keep their mouths' shut. But the people at IP did this right. No one speculated in Union Camp before this one.)
But as a strategy to exploit moves, options, ever since the turn in themarket, have been too expensive to use as a proxy for common stock or as insurance against market woes.
(I use options two ways, as a way to play theupside (calls) and a way to play the downside (puts.) If a stock is at$90, I might buy a call struck at $80 to play the upside, or a putstruck at $100 to play the downside. Those would be proxies for common.Advantage: one for one play on the up or downside. Disadvantage: gun toyour head at the end of expiration, forcing you to roll the dice again.I also use it as upside or downside insurance. Let's say GeneralElectric is at $88, I might want to buy the December 90 calls for upsideprotection, or the December 85 puts for downside protection.)
For example, last week
Salomon Smith Barney
put out some ground-breakingwork on the power of expiration, basically outlining that expiration weekgenerated an average
gain of 2.13% vs. no gains for all of the otherweeks. In other words, this week and the 11 others like it in 1998 puton all the gains that the SPX saw this year.
(Thiswork proved prescient. After a horrible Monday, the market really tookoff, with much of it expiration related, particularly in the biggestS&P names like
That got me thinking, hmmm, maybe there were some out-of-the-money calls onsome likely movers in the S&P that could go to being in-the-monies if theweek took off, as this research shows it might. But after hitting up the out-of-the-money calls for every single likely target, I saw nothing that couldbe regarded as an odds-on spec.
(What is an odds-on spec? Let's say General Electric (which I am long) wasat 88 Friday and the December 90 calls were at 3/8ths of a dollar. Thatwould be a pretty good shot: lose three-eighths to make maybe a buck or two(on an upside explosion).
(This sentenceis why I picked this piece to rewrite. This was an honest- to- goodnessexample of something that occurred. GE was at $88 on Monday and the $90calls, which expired Friday, were at a buck and change. It turns outthey were a great, albeit expensive, bet. The darn stock blew throughthe strike after a fabulous analyst meeting and a bullish statementabout the future. This stock rolled over the shorts -- many of them arestill betting that GE is like some sort of stupid Long TermCapital; Wrong! -- and that call that I priced out at $1.25 went to $5 inthree days!! That would have been a monster hit. In other words thecalls telegraphed the move perfectly. They were rich for a reason; theywere worth it.)
Every call was too pumped to generate a solidreturn without a lot of risk if the strategy backfired. Even thein-the-monies, with one week to go, were expensive, priced as much as adollar over the common for calls that were four, five, six and seven bucks.
(Even the deep calls, the proxies for common, were trading asmuch as a dollar more than the common. In other words, with one week togo you should have been able to buy these deeps even with the common.But you could not do so.)
The news wasn't any better in put land. If you believed
was going toblow up, you might have been tempted to buy the December 65 puts. But theywere selling so "rich" that you made almost nothing when Coke lowered theboom.
(This would have been a mistake to buy. Butyou would have more than made up for it had you done the GE calls. TheCoke puts went out worthless and hedged against nothing. So yourinsurance policy would have to be renewed.)
Options professionals, and those who sell options, always like to speak interms of volatility. That's fine if you are at business school,and good if you are a
Long Term Capital
-ite. I speak in terms of odds,because odds are what happens in the real world. Options are like bets atthe track. There are times when the long shots reward and there are timeswhen they're so expensive that if they pay off they don'tgenerate a solid enough return to justify the total wipeout of yourinvestment.
. (Here is my predilectionfor reality over science. So many blowhards in our business think theyare smarter than the market. I am sure some clown with a model was outthere shorting the GE calls because they were so rich. He got taken tothe cleaner if he was naked short, and he lost his precious GE stock ifhe sold calls against it. He would then say "well that call wasexpensive and worth selling," and justify a stupid trade. I don't carewhat is rich and what isn't if I have a view. Had I done more work on GEand not been scared about impeachment, Iraq and all of the othernegatives, I would have bought these "expensive" calls and made afortune.)
Right now the long shots are crummy bets. That's why I have beenconfining my fund, and my articles, to common stock and leaving the optionsto the vol players who don't make you any money but generate some seriouscommissions. I recall the days when I used to be a salesperson andwas told to get a lot of people to make sucker bets because the vols wereso cheap!!
(Options are a dangerous gameand I frown on most people using them as a tool because they needconstant monitoring and you can lose your shirt. I think there are a lotof bad option players out there. That said, if you scroll through myarchives I think I can give you a pretty good sense about how I use themas insurance and proxies.)