Archive for September, 2009

Before you short the market with options…

Sunday, September 6th, 2009

After reading our previous article (Time to short stocks in the NYSE?), one of our readers asked us a very practical question on using options to successfully trade the market. For those who are thinking of making their wealth with options, please read and understand what we wrote to this reader:

But one thing you have to bear in mind: learning about the technical aspects of options (e.g. delta, gamma, theta, delta-neutral, options strategy) is the easy part. We have quite a few good book recommendations that can teach you the technical aspects of options very well. The difficult part is to be a good trader. Even if you are an options expert, you will still make plenty of losses if you are a bad trader. On the other hand, if you are a good trader, you can still make good money with the most basic options strategies.

Options is just a tool. A bad trader who uses a powerful tool will lose money regardless of how well he/she understand about the tool. A good trader, coupled with a strong basic understanding of the tool, can make good money.

Options trading is a very vast field of study (for example, the topic of volatility in itself can cover a thick volume). Therefore, this is something that we cannot cover in just one article. For this article, we will give a little preparatory background about options before going into something more practical. For those who are totally uninitiated to options, please read Introducing options as insurance and How not to use options first before continuing.

For budding options trader, the thing to remember about options is: statistically, around 80% of options expire worthless.

  • Therefore, buying options (whether call or put) is likely to result in loss.


  • But the other 20% of options (that are not worthless when they expire) have the potential to yield fantastic profits.

Therefore, buying options allows you to profit from Black Swans. If you have not already, please read Failure to understand Black Swan leads to fallacious thinking. Put it simply, even though you are more likely to lose money buying options, you will make lots of money should you win the unlikely-to-win (based on statistical probability) bets.

  • Conversely, if you write options, they are likely to result in profits.


  • But on the other 20% of options (that are not worthless when they expire) expose you to a contingent liability that can result in substantial loss.

Therefore, writing options makes you vulnerable to Black Swans. Put it simply, even though you are likely to make a nice income writing options, you are exposing yourselves to contingent liabilities that can result in substantial losses (if you are not hedged).

In options trading lingo, buying options gives you positive gamma while writing options gives you negative gamma. If you have no idea what “gamma” is, forget about it because it is a specialised jargon used in the options universe. If your options position have positive gamma, you will benefit in sudden increase in volatility. On the other hand, negative gamma positions will benefit from little volatility in the market.

When options traders construct an options position, they are using a combination of buying and writing options to adjust between the positive and negative gamma according to their tolerance for risk and their conviction of the market.

In the current market, if you believe that there’s a likelihood of sudden unexpected increase in volatility, your options position should have positive gamma (e.g. from simple buying of put options to the more complex put ratio backspread). Positions with negative gamma are vulnerable (e.g. writing put options in the belief that a nice gradual up-trend will continue) to sudden increase in volatility. To explain this in more detail, let us give you a few examples:

  1. If you buy out-of-money put options, you are likely to lose 100% of your money, based on statistical probability. But if the market suddenly crashes, you will make many times the return on your capital.
  2. If you write out-of-money call options, you are likely to make a little money most of the time. If the market crashes or rises a little, you will profit a little. But if the market rises significantly (e.g. a stock that receives a takeover bid), you will likely to suffer heavy losses.
  3. If you buy out-of-money call options, you will suffer limited loss should the market crashes. But if the market sky-rocket suddenly (e.g. if the Fed announces that they will drop freshly printed US$100 trillion from the sky via helicopters), you will make big money.
  4. If you write out-of-money put options, you will make a little money if the market rises or falls a little. But if the market crashes, you can lose a lot of money.

That’s all for today on options. If you do not understand what we are talking about, don’t worry. Options traders live in a different planet from the rest of the world.

One final note: in a recent interview, Marc Faber said that he believes that the market will make a big move in the next 10 to 14 days.

Time to short stocks in the NYSE?

Thursday, September 3rd, 2009

In our last article, we mentioned about that gold prices are in the cusps of renewed volatility. The question is, will the volatility break gold prices out to a new record high or will it break it down to a low?

Yesterday, gold price surged US$20 with high volume of trading. Gold prices had not jumped so much for quite a while already and in the minds of many trend following traders (in the context of gold prices forming a technical pennant) this is indeed a buy signal. In the days to come, if this upward momentum is sustained, this will attract the attention of the mainstream media.

But is this the time to short stocks? Let’s take a look at this Point-and-Figure indicator:

NYSE Bullish Percent Index

This indicator tells us the percentage of stocks in the NYSE that are currently under “Buy” signals. Unlike the other index (e.g. Dow Jones & S&P), this is a very ‘democratic’ indicator in the sense that each stock is given an equal share of one ‘vote.’ It is used as a contrarian indicator to tell us when the market is in extreme bullish position or not. As the chart shows, it is current down to 77.23%, from a high of 80%. As you can see from the chart, 80% is an unprecedented high since 2001. The market is at a very high risk territory for a reversal.

Currently, this Point-and-Figure indicator is not officially in trend reversal status yet. But it will be soon if more stocks comes under “Sell” signal.

Explosive gold price movement ahead. But up or down?

Tuesday, September 1st, 2009

In Marc Faber latest market commentary report, he highlighted the fact that gold prices had been range-bound since February this year. But as the months progresses, the price range gets narrower and narrower:

Gold prices trading range

In technical analysis, this type of price formation is called a “pennant.”. A pennant is like a spring coiled up, ready to jump at any moment. As the price range narrows, it can be interpreted to mean that buyers and sellers are getting more and more polarised and entrenched in their convictions regarding the next move for gold prices.

This means to price volatility for gold will be upon us soon. The question is, which way? Up or down? Marc Faber opined,

I lean toward the view that gold will break out on the upside. The only problem I have, however, is to reconcile my relatively positive view about the price of gold (and other precious metals) with a rebound in the US dollar and a correction in equities. Of course what could happen is first a rebound in the US dollar and a brief correction in gold and equity prices before these short term trends – driven by further monetary easing – reverse, and gold (as well as other commodities) and stocks move up again in tandem.

However, our view is that should the precious metal prices fall (in the context of correction in equity prices and rebound in the USD), the fall may be quite substantial (we could be wrong here). This is because others traders and speculators are also watching the pennant formation in gold prices and should the break-out prove to be on the downside, they’ll be likely to press the “sell” trigger.

Another possibility is that in the coming correction, gold prices and USD may go in the same upward direction. That happened before last year as US Treasuries and gold were rising simultaneously (in the context of capital flight towards safe havens after the collapse of Lehman Brothers).

Ladies and gentleman, what are your bets? Up or down? For options traders, they can bet on both by buying in-the-money call and put options.