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Options Trading With Bill Wermine

Week
3	OUTLOOK 2001
2	HEDGE FOR PROTECTION
1	A TALE OF TWO OPTION TRADERS

A TALE OF TWO OPTION TRADERS
by William Wermine

Once upon a time there were 2 option traders. One consistently lost while the other made lots of money.

"Why are you so successful,?" asked the loser Mr Chasing Hope, to the winner Mr.

Bookmaker "Why do I lose almost every time?" Bookmaker explained, "to win in any game, you must know the rules, you must know what motivates the players and you must have an edge. I will teach you these simple things so you can be a winner."

IN THE OPTIONS GAME THERE ARE ONLY TWO BETS

"The option game consists of only 2 bets. One bet is a call while the other is a put. A player buys a call if he thinks the market is going up while he buys a put if he thinks the market is going down. The person who takes the other side of the bet is the seller of the option."

"Option sellers do business in the way of insurance companies. An insurance company charges a premium for fire insurance. The insurance company only pays if your house burns down. If it does not burn down the insurance company keeps the premium."

"You buy a call if you think the market is going up. If it stays the same or goes down the option seller keeps the premium."

"You buy a put if you think the market is going down. If it stays the same or goes up the option seller keeps the premium."

"In both examples your odds of winning are only one in three if you buy an option."

"It gets even worse for the buyer. Think of health insurance. If a person has cancer, smokes, drinks and works in a high risk job such as construction do you think the insurance company will charge him a low premium? Of course not, the premium will be very high to compensate for the added risk of illness accident or death. Even if this poor soul dies it is of no concern for the insurance company. The premiums collected from all high risk clients such as this man will more than compensate for any of these individuals dying. The same is true for markets. Call and put options for the Japanese Yen are very expensive. In fact the market can move in your favor and you may only break even or lose money. The reason is simple. The yen is highly volatile and the option seller must charge a high premium to protect himself against adverse price movement."

"When options are launched on the KLSE Futures, premiums will be high because the KLSE can at times be very volatile. You may be correct in market direction and still lose money."

"Observe the prices for December 2000 options. The 950 call is sold for 20 points or 2000 RM. That means that the price of the December Futures must go to 970 for the call buyer to break even. The 700 put is sold at 35 points or 3500 RM. That means that the December Future must fall to 665 for the put buyer to break even."

The call buyer would lose all his money if price closed at 950 on Dec 29 the expiration of the December futures contract.

These are theoretical premiums as options have not yet been launched on KLSE futures. Once they are launched premiums will probably be even higher.

"Are you beginning to understand? To make a profit, you must be correct in market direction and price has to make a major move in that direction No wonder 80% of option buyers lose money."

WHO ARE THE PLAYERS AND WHAT MOTIVATES THEM?

Bookmaker explained, "There are two groups of players in options. The buyers and the sellers. You, my friend Hope Chaser, are a buyer. That is why you lose consistently. You buy and you hope the market moves in your favor. You play options like a buyer of social welfare lottery tickets. You buy hope. Have you ever known anyone who consistently makes money buying lottery tickets? The only consistent winner is the underwriter. For every dollar taken in only 60% is paid out."

"The seller of options uses the same tactics as a lottery underwriter, insurance company or casino."

"These businesses assess risk, levy a premium, and get rich."

"Their edge can be your edge. You as an option seller will win 80% of the time."

TRADE WITH AN 80%+ CHANCE OF MAKING MONEY ON EVERY TRADE !

Bookmaker was always happy to share his knowledge. His mission in life was to earn consistent profits from the market and teach a few worthy souls his moneymaking strategy.

"Chasing Hope, why do you buy calls and puts when most of the time you lose?"

Hope answered "I buy them because I have hope to make huge profit with only small premium risk."

Bookmaker made his usual frank comment, "Most of the time you lose your premium don't you. Better you should sell hope than buy it?"

This leads to Bookmaker's Rule #1: NEVER BE A BUYER OF AN OPTION, BE A SELLER

because it is a proven, statistical fact that 80 % of options expire worthless. If you buy an option your chances of winning are only 20 %. If you are a seller of an option your odds of winning are 80 %.

"This sounds like a winner, how do I sell options and how do I protect myself should the market go against me? I am afraid to be a seller of options because the brochure from the KLOFE said that sellers of options have unlimited risk," asked Chasing Hope.

Bookmaker replied, "options are like anything for sale. Buyers and sellers come together in a marketplace and decide on a price. The process to be implemented in Malaysia is similar to buying a share or futures contract. Buyers and sellers are matched electronically. In US options markets buyers and sellers are matched using an open outcry system. Risk is managed by having a pre existing plan to cut losses should your position go against you. Here is a simple plan you can use."

(Chart of Soybeans with an option selling strategy.)

"This plan puts time on your side. An option seller put money into his pocket every day."

"If January soybeans settled between 550 and 475 by expiry. the seller would collect 22 cents for the 550 call and 10 cents for the 475 put. This would be a profit of 1600 US$ as each cent in grains = 50 US."

"To protect yourself from unlimited loss you would place a protective buy stop at 550 and a protective sell stop at 475. If the future price reached those levels you would immediately liquidate the entire position. You would take a loss on one option and a profit on the other option as well as a small profit on the futures. There is less than a 20% chance of this happening."

This was Bookmakers Rule #2: USE THE SAME WINNING PLAN AS CASINOS, PUT TIME ON YOUR SIDE.

The bookmaker explained: "casinos are in the hope and dream business. They sell the dream that you can make $2,000,000 RM by investing only one dollar in the one arm bandit. Have you ever seen anyone win a jackpot? Usually what happens, a player will start with a few hundred dollars and lose all. The player keeps pulling the handle hoping that the next pull will be a big jackpot. Time is the enemy of the player because the longer he plays the more money he loses The result is empty pockets. Time is on the side of the casino."

"In option trading, time is on the side of the option seller. Each day that passes the option becomes worth less."

"Here, my friend Hope, is an example of an option selling plan with Live Cattle. Live Cattle which is traded on the Chicago Mercantile Exchange is an excellent market for an option seller. Most of the time Live Cattle congests in a range. You may sell both puts and calls at the same time."

(Chart of Live Cattle with an option selling strategy)

"By selling the 70 call and 65 put you would take in a premium of 2.85. Since live cattle is 400 US$ for each cent that would mean you collect 1140US$ of premium."

"If price remained between 65 and 70 until expiry of the December contract, you would earn the entire premium."

"Do not forget to manage your risk. Remember what the KLOFFE brochure said. Sellers of options have unlimited risk."

"Place a futures buy stop at 70 and a futures sell stop at 65. If either one of these sell stops is hit liquidate your entire position. One option would be a loss, the other a profit and you would earn a small profit on your futures."

This is Bookmaker's most important rule, RULE #3: IF YOU SELL AN OPTION YOU MUST PLACE A PROTECTIVE BUY STOP IN THE FUTURES.

Bookmaker shared one of his war stories. "on 22 Sept 2000, the European Central Bank the US Federal Reserve, Bank of Japan and Bank of England intervened to boost the Euro currency. Within a few hours the Euro rose over 400 points or $5000 US per contract. The sellers of call options protected themselves with futures sell stops and managed to keep their losses small. This is one of the few times that an option buyer made money."

"Do you feel motivated to change your strategy,?" asked Bookmaker, "I certainly do, replied Chasing Hope, "in fact I am going to change my name to Steady Money."

Bookmaker smiled and remarked, "continue to learn and improve your self. Join the KLSE Library which is located in the Exchange Building behind Maybank headquarters. There are many excellent options books. The best is by David Caplan entitled TRADE LIKE A BOOKIE. You can also view Caplan's video tape on BOOKIE TRADING."

"If you wish to try this strategy there is only one licensed commodity broker in Malaysia authorized by the Malaysian Securities Commission to deal in US Futures/ Commodity options. The name is Phillip Futures Sdn Bhd. Spot commodity firms will never allow you to sell options just as Genting casino will never allow you to underwrite a blackjack or roulette game in their gambling hall. Phillip Futures is also licensed to deal in the KLSE Options contract upon launch.

Chasing Hope took Bookmakers' advice. He joined the KLSE Library, opened an account with a licensed broker and changed his name to Steady Money. He became a successful options trader. He now has his own bookie business and earns a nice living for his family.

Steady Money gave this advice, "to keep what you have, pass it on."

"Pardon me," as he spoke to the young trader next to him." Have you ever heard of the Bookmaker?"

We offer a variety of high quality futures brokerage services for your trading needs. We are licensed by the Malaysian Securities Commission to deal in KLOFFE/ COMMEX and US Markets. Services range from full service attention to self directed accounts. For information please call Qini Ren or William (Bill) Wermine 03 21666205/ 03 469 2681 or visit our website at www.tradethetruth.com.