Trading

options frightens many investors because it is not as mainstream as buying individual stocks or investing in mutual funds. It's sometimes viewed as an esoteric science that can only be mastered by some sort of trading guru.


Paul G. Foster
Editorial Engineer,
1010WallStreet.com

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However, in small amounts, they can actually be a good tool for investors to use to complement or hedge their positions in equities and mutual funds, and activity in options can be a good predictor of what will happen in the equity markets.

Paul Foster, "editorial engineer" and options specialist at

1010WallStreet.com and former market maker for

Mercury Trading

, discusses how to trade options and what the options market is indicating about market levels now.

TSC: Many people are skeptical of the options market because the percentage of investors who lose money trading options is very high. What is the principal reason for that? Is it a case of investors being a little too overzealous in their pursuit of profits? Or is it more a case of investors not being educated enough?

Foster

: That's certainly one aspect of it but another is that the bid/ask spread has been historically too wide over the years, commission costs have been too high, there's been slippage in the execution, etc. Also, expectations are too high in the options market because people hear too many stories of people making 100% and 200% returns playing the options market, over a year. They feel they can accomplish those same returns. Playing the options market is for hedgers and people looking to take a small profit. People should not expect astronomical returns; instead they should look for a small profit. Investors get themselves into trouble when they set their sights too high.

TSC: What does recent activity in the options markets show about where the broader market is headed?

Foster

: Market-implied volatility has fallen over the last three weeks, indicating probable higher share prices. Volatility movements typically precede price movements. You saw higher volatility in January indicating probably more dramatic price weakness. You saw volatility starting to trend lower three or four weeks ago. You saw a basing of equity prices and now you've seen over the last week-and-a-half a surge in prices. So volatility movements precede price action on both indices and micro-stock issues. And those volatilities usually move up in front of an event, which sophisticated professionals know about.

TSC: You seem to focus on volatility quite a bit. For the individual investor, and more importantly, someone who is a novice when it comes to trading options, how should they read volatility gauges such as the Chicago Board Options Exchange Volatility Index (VIX)?

Foster

: I have money at the desk and a little bit of my own long-term money that I'm pretty conservative with. What you're trying to take advantage of with your long-term money are panic situations. So when you see high volatilities in individual stocks and you see their share price go down and continue to move down on astronomical panic and astronomical low valuation, that might be a time to put some of your capital to work, since you've got a couple of positives working for you. You've got the volatility indicating panic and you've got the share price at low valuation, meaning that there is someone out there that is selling these shares (or indices) on capital liquidation issues. That is what I look for in the long-term.

In the short term, when volatilities spike dramatically higher it is usually an indicator of forthcoming action such as bad earnings, management upheaval or takeovers. And you can structure your option spreads to sell that higher volatility and take advantage of that volatility going higher, or take advantage of that volatility trading way above its mean and selling it.

Last week, there was not much action heading into expiration due to higher share prices. Higher share prices cause the volatilities to go lower. A lot of these speculators that took positions a month ago were thinking the stocks were going to rebound and saying, "Let's go buy some calls," and they were buying those calls at too-high volatility levels. And then the volatilities collapsed and the share prices moved up, but not enough for them to make up for the losses they sustained on the premium or in the volatility collapse.

To tie it all in, people have lost a lot of money over the last three or four months. There was a lack of speculative capital or even hedging capital to play last week because people have been hurt so much. But that's kind of an issue where it was so slow that it indicates maybe that there really is a floor and what we're seeing is higher prices. And looking back on last week, it was a start of a rebound from a floor level.

TSC: Is it fair to say that trading puts is not something the novice investor should pursue? What are some of the mistakes investors make when trading options?

Foster

: Well, if they are buying the puts and they feel that the stock is going to move higher and it's a small part of their risk capital, that's fine. There are strategies out there that can reduce risk, but some of those strategies are never for-sure profit making ventures. You need the underlying stock to move your way, the volatility to move your way and the time decay to move your way.

Options trading is just another vehicle people can use when attempting to make money. But sometimes they are overly aggressive in their attitude of how to make money.

Trading options should be approached like any other type of investment. Watch the stock for three weeks, set your parameters and if you see an attractive entry point, take it. You have to premeditate the upward move and enter before the stock moves.

Don't enter into an

Ericsson

just because the stock has moved 40 cents today and 50 cents yesterday. Before you go visit your mother on Mother's Day, you don't show up on the doorstep and say, "Oh, I should have bought her flowers." Think it through two weeks in advance. The same goes for the equities market and the options market -- you need to plan ahead. Most people look at volatility and price swings on a one-day basis rather than looking at longer-term trends. Impulses are usually mistakes.

TSC: Cisco (CSCO) - Get Reportis typically the most actively traded equity option even on slow days. What does the recent aggressive activity in Cisco call options indicate about what lies ahead for the company and its stock?

Foster

: Part of the reason investors were buying Cisco calls two weeks ago was the prevailing confidence that the stock was ready for an uptrend. Those people buying the calls were paying possibly the high end of the volatility range, but they were committed to buying these calls because they were committed that the share price would head higher.

The call buyers were most likely large money management firm because the premiums were expensive. They knew they were going to be buying that stock in the future regardless of what the share price was doing. In essence they were front-running because they knew over the next couple of months they would be aggressive buyers of the stock. Fund managers recently

unloaded some of their stake in Cisco, particularly

Janus

. This means that the heavy sellers are out of the market. If the heavy sellers are out of the market, it creates an environment for the share price to head higher. In summary, these people were speculating there would be more buyers of the stock than sellers.

TSC: Can you provide some specific examples of how options activity indicates what is to come -- that is, what has yet to be reflected in the market? Either short-term or long-term?

Foster

:

Procter & Gamble

(PG) - Get Report

on Monday was down $2.25 to $65.25. Obviously the Street feels that Procter & Gamble overpaid for

Bristol Myers'

(BMY) - Get Report

Clairol

unit. They paid over $4.9 billion for it. So Procter & Gamble is down on the Street's perception that it overpaid for it.

On Monday, there was a lot of put activity in PG options. Last week, volatility for options expiring last Friday in Bristol Myers for at-the-money calls and puts was approximately 29. Today the June 65 puts were trading at around a 27 volatility. The July 65 puts are down to a volatility of about 27 as well.

This is an indication that there is more volume on the put side than the call side, meaning people are selling these puts with the assumption that the stock will probably end up going up in the next two months. On the put side, the volatilities are lower, indicating they're sellers, so that there's bullishness in that pricing. On the call side, the volatilities on the June 65 are also lower, down to a 27, indicating that there is a feeling of relief that the company did something.

So there's been some anxiety hanging over Procter & Gamble the past few weeks. Are they really going to pay $6 or $7 billion for Clairol? So the relief is that the company didn't overpay for it. Volatilities have come down over the last month because the Street has understood that PG or any other bidders weren't going to overpay for this thing because the word had leaked out.

There is more comfort than what the actual pricing of the stock reflects because there has been an analysis. So not only did the volatilities collapse yesterday but they have been trending lower over the last month on the leakage of the word that they're not going to pay an exorbitant amount for Clairol. They were going to make an in-control, logical quantitative bid. The options market was pricing in this Clairol deal before it ever happened.