Overcoming the Fear Factor

The Daily Reckoning PRESENTS: It’s human nature to avoid or dismiss things that you don’t understand – tasks that you find daunting or subjects that you just can’t wrap your head around. Options trading, for example, made even our Maniac Trader’s knees knock together at one time…read on to see how he wrestled that fear and has since made options the most profitable part of his trading strategy…

OVERCOMING THE FEAR FACTOR

Early in my career there was one area of trading that I avoided like the plague – options, or options on futures, to be precise.  I thought they were too complicated, too expensive, too risky. It took me a long time to learn that all my fears were misguided. In fact, options have ended up being the most profitable part of my trading by far.

Now, I was no math maven in school. I’ve struggled since Mr. Richardson’s 6th grade math tests, especially the five-minute one. (I still wake up in a cold sweat over that one.) Let me tell you, his math tests kept me after school many a day and destroyed any interest in math that I may ever have had.  All through the rest of my academic life I always did exceptionally well in vocabulary, reading, and writing, but stunk at math in all forms except geometry, which my brain confused with drawing. Still, to this day, I’m a terrible mathematician and rely on all the modern-day conveniences, like accountants.

Anyway, if you spent a lot of time after school for math as well, then you may think you’re not able to trade options. Think again.

Some options books can be mind-boggling, with complicated mathematical equations and lots of detailed explanations that would mystify even Einstein, all to try and explain a simple concept.

We won’t go into great detail here; there are plenty of resources for that on the Internet or in your local bookstore. All you need to do is understand the basics of options and how they can immediately benefit your portfolio in ways you couldn’t imagine. Right about now you’re probably saying, “OK, how?”

? Options limit risk and give you unlimited profits.

? Options give you tons of leverage in an already highly leveraged market.

? Options can allow you to trade markets you may not otherwise be able to afford to trade due to extremely high margins (e.g., natural gas, gold, crude oil).

? Options limit risk and give you unlimited profits. Worth repeating this one.

Before you do anything, you simply must learn the basics of options, there are no two ways about that – even the Maniac Trader had to succumb at some point! Forget your fear – if this 6th grade math dropout can do it and be consistently successful, so can you.

So let’s begin.  A “call” option is what we buy when we think the market is going higher; a “put” option is what we buy when we think the market is headed lower. Either way, the goal is the same: to make money from the difference between the strike price of the option and the current market rate of the investment. Right now we’ll only discuss buying options.  Buying options, either puts or calls, involves limited risk and unlimited profit potential. You can sell options, also called “writing” options, but this carries with it limited profit potential and unlimited risk. Selling or shorting options is highly risky; if you’re new to trading and even if you’re not, many brokerage firms won’t even let you do it.  So let’s just focus on buying calls and puts.

When we buy a call or put we have to pay what is called “premium.” Premium is a fancy way of saying what you’re going to have to fork over for the option position. You can calculate what a fair premium should be in many ways, but at first it’s best to work with a broker who has experience in calculating what a fair value for the option is; get them to help you learn how to do it and don’t take no for an answer.

Most of the time you can find out where the option that you want to buy is trading just like you can get futures quotes-in the newspaper or on the Internet. If not, your broker can call the floor and get a fresh quote, much as they may do with spread orders. It’s a good idea anyway, because sometimes there are so many options they don’t all get updated and the price information on the screen may not be the most current. Always check first before trading.

Now I’ve gotten ahead of myself a bit.  Why exactly am I buying an option in the first place?  Why not just buy a cattle futures contract if I think it’s going higher? Great question. Answer: Two B-I-G advantages.

The first huge advantage is that when you buy options you’re not required to put up any margin.  Nope…zip, zero, nada.  In other words, for something like cattle futures you would need to put up around $945 per contract as a guarantee or margin, and that money would remain locked up for the length of the trade. If you were to buy a cattle option instead, you would not have to post the margin at all, and could use that $945 toward other trades or simply keep it liquid. This is one of the greatest attractions of trading options: not tying up capital with margins.

Second, options allow you to control a vast amount of a particular commodity at a ridiculously low price. Leverage again – we love leverage! As you know, futures allow you to do this, but to a much lesser extent. Also futures carry unlimited risk as I pointed out earlier, while the risk in options is limited to just the premium you pay, nothing more.  Now the trick is finding bargains in options and knowing what the risk/reward potential is. This is where many traders come unstuck.

Make no mistake, there are plenty of blunders people make when it comes to options, but a few really stand out and I’ll share them with you now.

First, chasing the market doesn’t pay. Never, never, never do this.  This holds true even more so for options than for futures.  Chasing after a trade in a market means you’ll end up paying too much or selling for too little. In options trading this can mean the difference between consistently making and losing money.  Remember, options have an intrinsic value when you purchase them and the time value is always whittling away.  The option is constantly depreciating, like some new car from hell. So avid overpaying for an option at all costs – it will be even harder to turn a profit when it comes time to close the position.

Time is on your side…don’t buy options with too little time value.  Time value is one of the most important things in options, and for that asset you have to pay more premium, but it can be worth it. The more time you have on your side the more chance your trade has of making money.  Buy too close in, say one or two months, and you may not have enough time until expiration for any real price movement. I don’t advise trading options with less than three months until expiration or more than 18 months.

Remember: “cheap” doesn’t always mean good. Also, stay away from way out-of-the-money strike prices. Way, way out-of-the-money strike prices for commodities may be cheaper but the old saying, “you get what you pay for” usually applies.  If the option is so far out-of-the- money, say in heating oil, that it will take an ice-age to get to that price level, then “cheap” is a relative term.  Try to buy a strike price that’s only slightly out-of-the-money unless you feel very strongly that the market is going to make a significant move in your favor; then you want to buy deep, way out-of-the-money options, as they’re called.

There are plenty more pitfalls. And as important as knowing what not to do is learning what you should do to get a decent entry point for an option, which I will discuss next time. Stay tuned…

Regards,

Kevin Kerr
for The Daily Reckoning
April 26, 2007

Editor’s Note: Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation’s top commodities gurus, Kevin’s expert opinions are routinely featured in the country’s premier media outlets.

The above was taken from Kevin’s newly-released book, A Maniac Commodity Trader’s Guide to Making a Fortune. In the book, Kevin dispels the common myths and misconceptions about these markets, offering an insider’s view of what he calls “the last bastion of pure capitalism on Earth.” Whether you’re a novice or an experienced trader, Kevin’s down-to-earth, clear-cut guidance will make you more savvy, more confident, and more able to jump right in and grab those profit opportunities that are waiting for you.

Two important milestones were reached yesterday.

The Dow climbed over 13,000 – a new world record, noticed by all.

Meanwhile, ignored by almost all, the dollar (USD) sank to its lowest level ever against the euro (EUR).

Of the two, the latter we consider more interesting. For the decline of the dollar – against euros, gold, and financial assets generally – undermines Americans’ wealth even as they see themselves living in the lap of prosperity. The decline of the dollar could also push forward the day on which the world’s big holders of the greenback look at their piles and begin to worry that they have a trillion or two too many. At that point (which we have been attending for so long we often forget what we are waiting for) you should see some real excitement in the world’s investment markets.

The most obvious consequences will be a further sell-off of the dollar, sparking an increase in U.S. dollar-yields. This, in turn, would disrupt millions of financial decisions, making lenders more wary and borrowers more prudent.

That there is still ample room for movement – towards wariness on the part of the former, and prudence on the part of the latter – is demonstrated in today’s International Herald Tribune. Yes, dear reader, the mainstream press is finally catching on to the imperial trend we spotted years ago – towards widespread, commonly accepted fraud. Today it is ‘fraud for housing.’

“Loans that require little or no documentation of income soared $276 billion, or 46 percent, of all subprime mortgages last year, from $30 billion in 2001,” says IHT. Now, these ‘liars’ loans’ are defaulting at eight times the rate of regular, fully documented prime mortgages.

According to the paper, many of the buyers didn’t even know they were lying about their income; the mortgage brokers lied on their behalf, inflating income figures in order to get the loans through the approval process.

“I saw account executives openly engage in conduct such as altering borrower’s W-2 forms or pay stubs, photocopying borrower signatures and copying them onto other, unsigned documents and similar conduct,” said a witness.

But the FBI is not on the case. The G-men aren’t interested in ‘fraud for housing.’ They’ve got bigger fish to fry – people who lie to get multiple mortgages with no intention of paying them back, known as ‘fraud for profit.’

And don’t expect the local DA or politicians to go after the small fish either. There’s nothing in it for them – no glory…no votes…no path to higher office.

Instead, they will move to ‘protect’ the hapless victims of mortgage fraud – in many cases, the very same people who lied to get loans. Every era produces its own special variety of fraud; and every great, shining fraud is followed by paler imitators. Typically, borrowers get themselves into trouble; and then the politicians thunder about ‘debt relief’ or a ‘moratorium’ on foreclosures.

From Grant’s Interest Rate Observer, we learn that in the midst of the Great Depression, many debt relief measures were passed. One of them was a clear interference with the right to contract, and was challenged in the U.S. Supreme Court. The Supremes affirmed the state’s power to meddle, saying it was justified by the economic emergency. But Justice George Sutherland, who was writing for the dissent (but who might have been writing for the Daily Reckoning), expressed the view shared by all economists who aren’t idiots – both of them.

“The present exigency is nothing new. From the beginning of our existence as a nation, periods of depression, of industrial failure, of financial distress, of unpaid and unpayable indebtedness, have alternated with years of plenty. The vital lesson that expenditure beyond income begets poverty, that public or private extravagance, financed by the promises to pay, either must end in complete or partial repudiation, or the promises be fulfilled by self-denial and painful effort, though constantly taught by bitter experience, seems never to be learned: and the attempt by legislative devices to shift the misfortune of the debtor to the shoulders of the creditor without coming into conflict with the contract impairment clause has been persistent and oft-repeated.”

But in the contest between the sanctity of contracts and debt relief, the forces are badly mismatched. For every creditor trying to get his money back, there must be thousands of debtors armed with voter registration cards, determined to stop him.

More news:

————–

Addison Wiggin, reporting from Baltimore, where spring has finally sprung…

“‘Our country has a fine future, economically,’ Warren Buffett recently told us in a rare interview. In 2003, Mr. Buffett penned a now infamous article for Fortune Magazine called Thriftville vs. Squanderville. The piece outlines the dangers inherent in the historic trade imbalance the US has with China. We’re animating the story for a documentary we’re filming on Americans and their love affair with debt. Buffet granted us an interview for the film. And, we have to say, we were surprised by some of his remarks.

“The Oracle is a productivity bull!”

To find out what else Mr. Buffett had to say – and for more insights into today’s markets, check out the inaugural issue of The 5 Min. Forecast

————-

And more views…

*** Something has been missing from our lives. Yes, it’s been weeks since we’ve had a good laugh. So, we turn to the editorial pages of the International Herald Tribune to find our favorite comic, Thomas L. Friedman, a man who wants to make a better world, in the worst possible way.

We used to enjoy reading his columns. You could always count on him to come up with such a damned fool idea, on any subject, that it would have been an embarrassment to a jackass. But what intrigued us was trying to figure out how the man thought – or if he thought at all. When we explore Friedman’s oeuvre we feel we are probing down clumsily, like a neurosurgeon with a kitchen knife, into the softest mush of the human brain. How does it work, we wonder?

Friedman is no idiot. He writes in complete sentences. Somehow he has gotten a gig not only as a columnist for America’s most prestigious newspaper, but as a semi-serious author, and celebrity speaker at business functions.

(His success has not made us jealous; it has only made us suspicious. We wonder what the rest of the world must be thinking if it can take Friedman’s ruminations seriously.)

It was Friedman, we recall, who pushed hard for the United States to invade Iraq, and who then described U.S. troops (the most lethal attack force the world had ever seen), as ‘nurturers’, and who, like midwives, were helping to deliver a baby democracy in the Mesopotamian desert. Then, when the war went bad, he blamed the Bush team, urging them to send yet more armed nurturers and spend even more money. It was he, too, who blamed terrorism on high oil prices; and he still urges the United States to ‘go green’ as a way to promote ‘reform’ in the Middle East.

The man has a plan for everything. That is what makes reading him so funny. He cannot seem to appreciate that the world is a product of many thousands of generations’ worth of evolutionary adjustments, compromises, and innovations that he could not possibly hope to know about…nor can he imagine that there is any situation – no matter how remote or complex – that his own little mind cannot improve.

Thus does he urge America’s voters to insist upon a “Green Election” in 2008. We won’t bother with the inane details (such as having a college student question the candidates because “young people will be the ones most affected by global warming”); What is appalling is the desperately shallow earnestness of it. Why would a college student have any more insight into global warming than anyone else? And why, if voters are so interested in global warming, don’t they ask the candidates themselves? How is it possible for an intelligent Homo Sapien to write such obvious hooey?

What we are beginning to suspect is that there is something wrong with the brain itself. In spite of all its pretensions to logical thought, the thing is barely functional. It will believe anything.

*** Ooh la la…now the old British rock band, the legendary Spinal Tap, has joined the fight against global warming. The group was initially known as The Originals, until it found out that another group had that name, whereupon it changed its own name to the New Originals. The band has just recorded a new song, says the TIMES of London; it is entitled “Warmer Than Hell.”

Spinal Tap was never a popular band. But it was on its way to mediocrity when its drummer, John “Stumpy” Pepys, was killed in a bizarre gardening accident. Nor is this the band’s first attempt at world improvement. The lead singer previously set up a charity called ‘On Your Toes,’ intended to help people with ‘high insteps.’

*** And this from Paris:

“Darling, I felt like telling you not to come home this week,” said Elizabeth by phone.

Marital tension? Connubial strife? Was our vacation really that bad?

“No…no…it’s just that the apartment is such a mess.”

“What? Didn’t the painters finish?” we asked.

“Finish? They didn’t even start. They must have walked out the door the minute we left for the airport. It is amazing; this country is supposed to have one of the highest unemployment rates in Europe, but it’s almost impossible to get anyone to do anything. We’re going to have to live for weeks more in this dust and mess. I don’t know if I can take it.”

We don’t mind the mess; but we’re not sure we can stand the expense. We saw nicer apartments in Buenos Aires selling for one-tenth the cost. In fact, we stayed in a splendid apartment, overlooking the broad avenue, on the 9th of July Avenue. That apartment is much nicer than our digs in Paris, and it would cost less to buy the place than it is costing to fix up our place in Paris.

Of course, we have no way of knowing, but we wouldn’t be surprised if prices between the two cities converge. Lower in Paris; higher in Buenos Aires.

“Maybe we should just move to Buenos Aires,” we ventured.

“Okay…now I really don’t want you to come home. It’s because of you, moving us around, that we’re in this mess.”