RE: an explanation about options
The following was written when options were just about to be
released on GMGC (General Magic).
At that time GMGC was trading at 14
and my portfolio had a liquidation value $436,000.
I owned SAP, and other stocks, but my principle investment was
36,000 shares of GMGC which I had accumulated between 1 7/8 and 14.
I was out of control and heavily margined.
I was arrogant and not very well diversified.
GMGC is now trading at 7 and I have lost my entire portfolio
in 3 horrific days of a 50% plunge.
Read my recent GMGC posts if you want to get a feeling for what it was like.
I was forced out of my SAP position at 58 and change (a mercy killing).
BTW: If the arrogance inherent in this article reminds anyone of themselves,
PLEASE EMAIL ME ASAP.
I will gladly help anyone analyse their current position.
I want everyone to avoid what I went through.
I don't know how to create the link to this article,
so I copied it here for convenience.
<<
To: John Long (2351 )________________Saturday, Jun 20 1998 4:19AM ET
From: Ray Rueb_________________________________Reply #2359 of 3319
RE: a little essay and examples on options
This may be a little long, putting into words things that I have learned from 22 years of options trading.
First, some definitions:
Stock trading (either long or short) might be speculation or investment.
For most people, it is investment.
If you get upset when the Dow goes down, you're a speculator.
If the Dow going down excites you because you see it as an
opportunity to accumulate more stock, you are an investor.
Margin trading is using your stocks as collateral on a loan
and using the money to buy more stock.
Current margin requirements for GMGC allow you to purchase $2000 of
stock using only $1000 of your money.
Covered option trading is very conservative and less risky than
long stock trading. Few individuals do covered option trading.
Option spreads are the practice of simultaneously buying and selling option contracts of differing strike prices and looking for
changes in the price spread between the two instruments.
I find making money in spreads to be difficult.
I usually use them to limit my risk when I'm trying to make money
from a short position.
I usually make money when the stock makes a big move out of
the spread range, and I lose money when the stock price stays
within the spread.
Uncovered option trading is pure speculation or gambling.
Buying call options is roughly equivalent to buying the stock.
Buying put options is roughly equivalent to shorting a stock.
Buying options limits your monetary risk but exposes you to a
greater percentage probability that you will lose all your money.
I live in Chicago and I know many options traders.
All have made and lost large amounts of money.
Only one individual I know stopped trading and still had more
money than he started with.
I frequently trade uncovered options.
When GMGC options become available,
I expect to do a lot of uncovered buying.
I am a stock speculator.
I always buy on margin when possible.
I frequently day trade stocks (buy and sell in a very short timeframe), especially GMGC, and I have shorted stocks on occasion.
I buy and sell options with frightening regularity.
I lost $6,000 in 3 days back in April when I got into a bad spread
position involving Best Buy (BBY).
I have purchased 53,000 shares of a stock selling for 3 cents,
and I currently own shares of SAPHY which sell for $225 per share.
My mother calls my investment style dangerous.
I call my investment style EXTREMELY dangerous, and a lot of fun.
I regularly receive margin calls (threats from my broker to
sell out my position if I don't come up with more money).
I never come up with more money,
and I've never been forcibly sold out.
In February, I opened my Ameritrade account with $20,000.
It currently has a liquidation value of $136,000.
This increase is due entirely to my trading in GMGC.
The current value masks the fact that I recently lost
$60,000 in 10 days from some bad trades while I was in England.
I also have more than one account, and I trade for my mother,
father, and my 2 daughters.
The accounts I directly control, currently hold a total of 42,000
shares of GMGC, and all are currently maxed out on margin.
If GMGC were to drop 6 points, all accounts would become worthless.
In my experience, buying call options is absolutely great as
long as the underlying stock is rapidly rising.
This is why I'm so excited about options becoming available on GMGC.
Also in my experience, buying call options is a great way to lose
all your money very rapidly.
Today I had 60 SEG Jun 25 call options expire worthless.
I paid over $16,000 for that position 4 weeks ago when SEG was $27.
Options involve the concept of "premium".
I believe there are 2 types of premiums...
a premium for time and a premium for position.
TIME PREMIUM: Options involve time periods.
The difference in price between the July call and the
Oct call is the time premium for the extra 3 months.
POSITION PREMIUM: Options are thinly traded instruments.
GMGC stock frequently trades 1 million or more shares in a day.
This makes GMGC stock very liquid;
it is easy to get into and out of a position and a ready "market"
exists in which to buy and sell the stock and the difference
between the bid and the ask is usually very small.
Therefore the stock involves a very small position premium.
Options are very thinly traded.
An active option may involve only 1000 contracts being traded per day.
Many options won't trade at all in a given day.
This is what's called thinly traded.
There is a large difference between the option's value and
the price you'll pay to get into the position.
This is how options traders with CBOE seats make their money
(its called scalping); they sell at the ask and buy at the bid.
You will buy at the ask and sell at the bid;
you pay a premium to get into your position,
seat holders make money in order to insure there's a market.
If you don't like paying position premiums, DON'T TRADE OPTIONS.
Here are some potential GMGC scenarios:
On Jun 24, GMGC stock sells for $15.00
Jul 15 calls sell for $1.00 (value 0, position premium $1.00)
Jul 12.5 calls sell for $3.00 (value $2.50, position premium $.50)
Jul 10 calls sell for $5.25 (value $5.00, position premium $.25)
Oct 15 calls sell for $3.00 (value 0, pos prem $1.00, time prem $2.00)
Oct 12.5 calls sell for $4.50 (value $2.50, pos prem $.50, time prem $1.50)
Oct 10 calls sell for $6.25 (value $5.00, pos prem $.25, time prem $1.00)
I define the value as the current price minus the strike price.
I define the premium as the price you pay minus the value.
So, to control 1000 shares of GMGC the positions cost the following (without commission):
stock: $15,000
margin $7,000
Jul 15 calls $1,000
Jul 12.5 calls $3,000
Jul 10 calls $5,250
Oct 15 calls $3,000
Oct 12.5 calls $4,500
Oct 10 calls $6,250
Now lets say GMGC announces 4 really neat things at the
annual meeting and the stock spikes at $20 for the close
on the next day.
The selling price for each of your positions should increase by 5,000.
However, options don't work that way.
The large position premiums which existed when you purchased
(and were larger when the strike price is close the actual price),
have disappeared because you've moved away from your strike
prices and you are now selling at the BID.
So the actual prices you receive for you positions might be:
stock: $20,000
margin $20,000
Jul 15 calls $5,125 (almost the same price as the July 10's were)
Jul 12.5 calls $7,625
Jul 10 calls $10,125
Oct 15 calls $6,125
Oct 12.5 calls $8,625
Oct 10 calls $10,625
So the actual profit for each position is:
stock: $5,000
margin $5,000
Jul 15 calls $4,125
Jul 12.5 calls $4,625
Jul 10 calls $4,875
Oct 15 calls $3,125
Oct 12.5 calls $4,125
Oct 10 calls $4,375
So the percent increase for each position is:
stock: 33.33%
margin 71.43%
Jul 15 calls 412.50%
Jul 12.5 calls 154.17%
Jul 10 calls 92.86%
Oct 15 calls 104.17%
Oct 12.5 calls 91.66%
Oct 10 calls 70.00%
SOME IMPORTANT NOTES:
1) this is a very rosey picture, however one I believe will come true.
2) if the price had gone to 10 instead of 20,
the losses are equally magnified by options.
3) long, deep in the money calls (Oct 10 calls) at current stock
price levels involve the same profit picture as the margin.
However, they limit the downside risk since their price would
inflate and accumulate position premium in a downward move.
4) Ameritrade would charge me $20 total buy and sell commission for
the stock or margin positions,
but $160 total buy and sell for the option positions.
I'll be buying the near term $15 or $17.5 calls on June 24th.
I'm hoping to control about 60,000 shares by end of day Thursday.
Does this make things any clearer?
It's the best I could do at 3am
Happy trading, good luck to all longs.
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