"Option Strategist - Updater Newsletter 7/18/00" by Lawrence McMillan...
>>> Up To The Minute Market Commentary From Lawrence McMillan
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SOME WORRISOME SIGNS
If you're looking for a reliable gauge of market sentiment, the option market is a good place to turn. As a majority, option traders are usually wrong about the broad market at major turning points. So, what are these "wrong-way" traders doing and saying now?
First, let's look at their activity as evidenced in the broad market put-call ratios. This is the ratio of put volume divided by call volume, where that option volume is that traded on a broad market index or an a large segment of individual stocks' options aggregated together. The major broad market put-call ratios that we follow include: the equity-only (all stock options), the breakdown of stock options into those stocks listed on the NYSE and those listed on the NASD, the $OEX (also known as the S&P 100 Index), the S&P 500 futures options, the NASDAQ-100 ($NDX), and the QQQ (the NASDAQ "tracking stock" that trades on the AMEX).
In some cases it is also beneficial to follow the dollar weighted put call ratio on the same markets. Regardless of which of these put- call ratio one uses, they currently are pretty much all telling the same story:
Nearly all of these put-call ratios are on sell signals now indicating that a large number of option traders have been buying call options in relation to the number of put options that were trading. When all the option traders are bullish, it's time for a savvy investor to think about taking some defensive action.
Another caution signal flashing from the option market is the overall level of option prices. When option prices get "too cheap", that means that option traders are complacent. Technically, the term for the level of option prices is "implied volatility", and you can get a quick look at it by viewing a chart of the CBOE's
Volatility Index ($VIX), which can be quoted just like any other stock or index. If it gets below 20, that would be a warning that the market is ready to explode in one direction or the other (currently, it has been hovering in the 21-22 area).
Again, history has shown that when the majority of option traders are complacent, it's a good idea to be on your toes, for a big market move is usually on the horizon. In the past, it hasn't always been easy to tell whether such a move will to the upside or the downside so smart traders often buy both puts and calls (straddles) in that case. However, since the above indicators are tilting towards
the bearish side, that might give a better-than-even chance that any explosion will be on the downside again as it was in the late summer and fall of each of the last two years.
By the way, the market peaked in July in both 1998 and 1999 and given the state of these various option indicators it looks like it may do the same thing again this year.
Options Trading Strategy
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If this market is going to turn down, it may be time to think about buying some protection for your stocks. The "easiest" way to do this is with index options
because just one option order takes care of your whole portfolio, assuming that your portfolio more or less "tracks" the index underlying the options you buy.
Unfortunately, when one actually takes a look at the prices of the index options involved, he generally figures they're too expensive.
So, he forsakes the protection -- sometimes ruing it when the market collapses as it did in the last summers of the past two years. There is a slight alteration to the protective strategy that might work well for some: Buy a put bear spread instead of just buying outright puts. That reduces the cost of your protection.
Less, your stock would still be exposed below the lower strike of the put bull spread -- should prices fall that far.
However many institutional money managers use this strategy, figuring they're run that risk of the most serious decline in order to have more reasonably priced
protection in case of a more moderate (and probably more likely) decline.
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Q&A with MAC
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The following Q&A is an example questions answered by Mr. McMillan on our site.
Q: Please explain the principle of investing a fixed dollar amount in each option trade for the ostensible purpose of maximizing profits.
A: Well, I'm not sure who's principle that would be. But here's how I approach it. I RISK 3% of my account on any one trade. So, let's say you're looking at buy a call that costs 10 points. Furthermore, suppose there's $50,000 in your trading account. 3% of $50,000 is $1,500. How many options should you buy?
We can't tell yet, because we haven't quantified the RISK of the trade. If I'm going to hold the option all the way to expiration, by risk is the entire purchase or $1000 per contract. In that case, I would only buy 1.5 contracts (actually, just one, rounding down). However, suppose that I am using technical analysis, and I will bail out of these options if the stock breaks support about 5 points below current levels. Using a model, I might be able to determine that if the stock fell 5 points, the option would only drop about 3. Then my risk would be $300 per contract. In that case I could buy 5 contracts ($1500, which is 3% of
my trading account = risk, divided by $300 risk per option).
Investing in this manner while allow you to increase your "bets" when you're doing well -- when your account size is increasing. Meanwhile, when you hit a drawdown and your account size dwindles somewhat, this method will also make you reduce the size of your trades.
So, that's how I'd maximize profits.
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