Options Trading: The Hidden Reality

423 Pages·2005·4.43 MB·english

by  Charles M. Cottle

OPTIONS TRADING:

THE HIDDEN REALITY

RI$K DOCTOR GUIDE
TO POSITION ADJUSTMENT AND HEDGING

Charles M. Cottle

● OPTIONS: PERCEPTION AND DECEPTION
and
● COULDA WOULDA SHOULDA
revised and expanded

www.RiskDoctor.com

www.RiskIllustrated.com

Chicago
© Charles M. Cottle, 1996-2006

All rights reserved. No part of this publication may be printed,
reproduced, stored in a retrieval system, or transmitted, emailed,
uploaded in any form or by any means, electronic, mechanical
photocopying, recording, or otherwise, without the prior written
permission of the publisher.

This publication is designed to provide accurate and authoritative
information in regard to the subject matter covered. It is sold
with the understanding that neither the author or the publisher is
engaged in rendering legal, accounting, or other professional
service. If legal advice or other expert assistance is required, the
services of a competent professional person should be sought.

From a Declaration of Principles jointly adopted by a
Committee of the American Bar Association and a Committee of
Publishers.

Published by RiskDoctor, Inc.

Library of Congress Cataloging-in-Publication Data
Cottle, Charles M.
Adapted from:
Options: Perception and Deception
Position Dissection, Risk Analysis and Defensive Trading Strategies /
Charles M. Cottle
p. cm.
ISBN 1-55738-907-1 ©1996
1. Options (Finance) 2. Risk Management 1. Title
HG6024.A3C68 1996
332.63’228__dc20 96-11870
and
Coulda Woulda Shoulda ©2001

Printed in the United States of America

ISBN 0-9778691-72

First Edition: January 2006
To Sarah, JoJo, Austin and Mom

Thanks again to Scott Snyder, Shelly Brown, Brian Schaer for the
OptionVantage Software Graphics, Allan Wolff, Adam Frank,
Tharma Rajenthiran, Ravindra Ramlakhan, Victor Brancale,
Rudi Prenzlin, Roger Kilgore, PJ Scardino, Morgan Parker,
Carl Knox and Sarah Williams the angel
who revived the Appendix and Chapter 10.

Extra Special thanks to Yehudah Grundman of
The Kabbalah Centre International,
for his support and guidance.
Options Trading: The Hidden Reality v

P R A I S E
"Having attended many options seminars I can honestly say that The
Ri$k Doctor Webinars have been revolutionary to my options education.
Unlike many other so called "options gurus" you do not try to attract
people by promising them astronomical returns in fact you almost say the
opposite...which is that if I am not prepared to put in the work to educate
myself about the pitfalls in options trading it can be a very expensive
mistake and I should better forget about trading options altogether. This
was the first time I had heard anyone say this to me.
The bottom line is that as an ex-market maker and trader you have
practiced what you preach......unlike many people out there who have
never traded but are more than happy to sell people courses on how to
trade. .The way you examine, dissect and manage your risk in your trades
has given my trading a significant edge. The weekly Webinars provide a
great interactive platform to discuss and review new and old trades
directly with you every week! I only wish I had found out about you
sooner. In the past I have paid a lot more money to learn a lot less than
what you have taught me.”
THANK YOU!
Tharma London, England

“When I think back to my first discussion with Charles in 2001, I like to
think that I had "Bambi Legs" as an options trader. I had worked as a
clerk on an options floor, attended the expensive seminars, and had a
decent grasp of the fundamentals. I had also gone nowhere in 2 years of
trading my account and was getting frustrated. What followed for the
next several years was a robust education in defining my trading self.
From understanding the synthetic relationships inherent in options
positions, to managing myself as a trader, Charles was critical in my
development. The biggest takeaway for me to this day lies in the fact
that Charles was the first teacher or coach who didn't set me up for
failure by giving me unrealistic profit expectations. New traders need to
define themselves, their risk tolerance, and what strategies mesh with
those characteristics. If you've got baseless profit expectations, you'll
never find these critical attributes. Charles always had me think about
my positions and adjustments constantly in the present by asking: "If I
had no position on right now, what would I want."
Having a professional in my corner like Charles gave me the
confidence to truly discover my trading personality and potential. I don't
think I'd be trading for a hedge fund had I not worked with Charles.
Don't find yourself asking Coulda Woulda Shoulda!”

Justin California
©1996-2006 Charles M. Cottle [email protected]
vi Praise

“My goal this past year was to master and gain a deeper understanding of
options. I am a practicing physician and a trader. It was a stroke of luck
to come across the Ri$k Doctor, Charles Cottle, a true genius of options.
RD’s approach to options brings to mind a series of analogies and
similarities to the field of medicine as follows.
As a medical doctor uses the CAT Scan or MRI to view potential
human disease at the tissue or submicroscopic level, the Risk Doctor’s
laser-like perception sees below the surface of an option strategy and
reveals its true nature.
“Primum non nocere” (first do no harm) is one of the most
important dictums taught about patient management. Similarly, in his
Webinars, the Ri$k Doctor teaches traders to first see and limit downside
risks, while developing profitable option strategies, with and without an
underlying stock or contract. He does this by teaching his followers to
“card up” simple and complex options positions and then to use a variety
of synthetic tools to see the true nature and position risks before entering
a trade. Floor traders, whom RD has also instructed, sometimes use
these very same valuable tools.
Lastly, as a surgeon shows how to handle complications, so the RD
teaches how to adjust to changing conditions in the real market on an
ongoing basis.
In the ongoing RD3 Webinar series, the Ri$k Doctor teaches by
example, following the market real-time on a day-by-day basis and then
posting his adjustments for each strategy as the market moves. He
ultimately throws his followers into the fray and challenges each of them
to construct an option strategy and make adjustments on their own that
are appropriate for the perpetually changing market. In this unique
scenario, his students have the opportunity of experiencing an almost
real-live market trading experience, of putting their egos and emotions on
the line, and then of learning from mistakes and oversights without
risking hard-earned money. It’s as real as can be!
For those who are serious about perfecting their option trading
skills, RD’s Webinar series is like an exciting roller-coaster ride through
the ups and downs of the options markets. I do not know of any other
place that offers such a unique market ride.
It is a sensational training experience!”

Murph, MD New Jersey

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Options Trading: The Hidden Reality vii

P R E F A C E
WHY ANOTHER OPTIONS BOOK?
Dear Fellow Trader / Investor / Hedger,

I wrote this book so that you will come to understand that options are
either for you or they are not. For those beginners who understand basic
options material, this is a good starting point. For those readers who are
having problems trading options, this book will help you to determine
where the problems lie, and whether you may be successful with options,
or whether you should stay away from them.
My mom, dad and most of my relatives don’t trade options because
options are not for them. I have a cousin who trades options. He came
to work for me when he left college. I am going to teach you the same
way that I taught him. By learning how to avoid the pot holes and
surviving long enough to put together a personal game plan, he has gone
on to be one of the most exceptional options traders that the industry has
ever known. Experience in the markets will teach you more than I will,
just as it taught my cousin and thousands of other people who I have
shared this content with over the last 25 years. It starts here and it can
end here too, without losing a nickel because you will be able to answer
the question, “Are options for me?”
There is a lot of material in this book from my first book,
“Options: Perception and Deception” (OPD), which was geared towards
professional Market Makers who provide liquidity to the markets by
bidding and offering every strike and month. My second book, “Coulda
Woulda Shoulda” (CWS) kept a lot of OPD, but added content necessary
for retail investors because it was given to clients of an electronic
brokerage firm which I co-founded. “Options Trading: The Hidden
Reality” merges the information in each of those books, because retail
type traders, are now hungry for Market Maker techniques, and are much
more sophisticated than industry leaders (exchanges and brokerage
houses) give them credit for.
Most of the people reading this book know something about puts
and calls. To be able to trade puts and calls profitably, one needs a full
grasp of the concepts. The market takes no prisoners. It simply deletes
those who do not have enough knowledge and/or are hesitant to make
decisions.
You may be wondering how this book is different from other
books on options trading. The essence of my educational work is to
demonstrate where investors contradict themselves. People who do not
yet fully understand options do this a great deal. On the one hand they
are intrigued by a strategy, but on the other when they are shown its
©1996-2006 Charles M. Cottle [email protected]
viii Preface

synthetic alternative (which is the exact same thing), they are not
interested at all. The synthetic equivalent seems to be totally different.
Here is one of my favorite questions:

Exercise: What amount of money is the most that one can lose
with the following position?

QQQQ is trading at 37.30,
The 36 call is going for 1.70 and
The 39 put is going for 1.90.

A trader buys ten of each. Obviously, this is a good position if
there is a large move in either direction but what is the worst-case
scenario? Owning ten calls at 1.70 and ten puts at 1.90 is 3.60 ten times
making a total investment of $3600 (10 x (1.70 + 1.90) x 100 shares).
Most people, given 60 seconds to solve this problem, figure the
answer to be $3600, the limited risk amount invested. This is incorrect.
The answer is only $600 (10 x .60) x 100 shares. The proof and full
explanation is in Chapter 1, following Exhibit 1–10.
After learning market maker methods of trading, and grasping the
concepts (confusing at first, but it gets easier with practice), it will be
possible to answer this question in less than 5 seconds. Such clarity can
make a huge difference in one’s trading.
Today’s free resources available on the Internet aid retail
customers in competing with professional traders. Therefore, methods to
monitor and control convoluted positions, with dozens of strikes, have
been removed from this version, since retail investors have little need for
such measures. That is not to say that I have decided what the reader
should and should not know. I have selected topics that help to clarify
concepts that have made a difference in the careers of many professional
traders. I share my blunders, I think, even more than my triumphs. Most
books, I would imagine, talk about all the great ways to make money but
a lot of things have to go right in order for that to happen. This book is
more about what can happen and is different because it provides realistic
examples about what goes through the mind of the individual that has the
trade on. It relates how the market’s emotive powers influence what the
trader perceives to be opportunities, based on the pricing available at any
given time over the life of the position carried. All sorts of alternative
ways to achieve objectives are explored in order to help round out the
reader’s understanding and find ways to get out of or massage a position.
Unique illustrations help to sort out the confusing information that
accompanies an options position.
The reader should have the following prerequisite knowledge: the
understanding of basic option strategies, i.e. what a call is, what a put is,
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Options Trading: The Hidden Reality ix

the definitions of in-, at- and out-of-the-money options, along with strike,
premium, time value, volatility, exercise, assignment, expiration,
intrinsic and extrinsic value and other common options terms.
Familiarity with some of the common strategies will also be useful, like a
bull and bear spread, butterfly, strangle, straddle, back spread and ratio
spread. Most of this information is readily available, but some is better
than others.
A lot of people say that options trading is akin to gambling. (There
is even options trading at spread betting firms in England.) I would have
to agree up to a point. There is, of course, no house stacking the odds
against anybody although the human condition is an obstacle in itself. A
trader should get to know his or her trading self long before charging full
speed ahead. Options trading is not like the normal process of investing,
although it is done in an investment account and with all sorts of
investment information available to help in the decision making process.
This fact in itself gives a trader better odds than any casino.
Undoubtedly, people can make large amounts of money by
buying cheap out-of-the-money calls while enjoying limited risk. That is
true but they will probably lose their wagers most of the time just
because odds are against the options going in-the-money most of the
time. Options are a wasting asset and will expire in a relatively short
period of time. There are better ways to play the options game. A little
amount of education can go a long way in ensuring long term
profitability and help to avoid becoming a statistic.
My grandfather used to buy stocks and put the certificates in a safe
for thirty years and then see how they were doing. Those were
investments. The same can be done with options but only for days,
weeks or months, but it is usually wiser to keep abreast of the position
and be prepared for a trade adjustment.
Traditionally bear markets have been bad for the brokerage
business, to say the least, but options can be a trader’s best friend in a
bear market and when the world gets on board with what these products
can do, look out!
As the NASD1 says, “Options are not suitable for everyone”. I
agree, but not enough people who they are suitable for are using them
yet. I believe that options are for almost all stockholders. Why?
Because a long stock position acts almost exactly the same as a long call
and a short put at the same strike. Keeping this in mind, and the fact that
markets decline on occasion, people should be thinking what could be
done about the short put aspect of their long stock positions. They could

1 NASD
National Association of Securities Dealers
©1996-2006 Charles M. Cottle [email protected]
x Preface

cover (buy back) that put until things calm down, or perhaps buy a
different put above or below it, or two for each one. The same people
should always be considering position protection in addition to
enhancement, because even without a bear market stocks can plummet.
In short, I recommend that options be used to provide protection,
and for those with a taste for gambling, a limited amount of risk can be
taken with carefully defined parameters, providing that the investor fully
understands his potential loss.

Highlights of what “The Hidden Reality” has that CWS did not have includes:
Chapter 1 – More clarification and Color Illustrations
Chapter 3 – 2D and 3D Graphs of the Greeks from OPD
Chapter 4 – Graphic Illustrations for Gamma Scalping
Chapter 5 – Graphs of the Greeks for Verticals and More on Legging Spreads
Chapter 6 – 2D and 3D Graphs of the Greeks for Butterflies, Butterfly
Dissection, Skip-Strike-Flies
Chapter 7 – Graphics and Dissection of Diagonals, Double Diagonals, Straddle
Strangle Swaps and Double Calendars
Chapter 9 – Hybrid Hedge (Adapted from Slingshot Article)
Chapter 10 – OPD’s Skew Library Chapter
Appendix for Chapter 2’s Option Metamorphosis showing all dissections.

TODAY’S OPTION TRADING LANDSCAPE
Oh, you are still reading? You are determined, and that is a good sign.
Please be prepared to work hard, be patient and make sure that you
understand options to the fullest extent possible. If you are not prepared
to make this commitment, then stay away from options. You may be
lucky for a while, but not long term. Why? because there is a lot of hype
out there. Your email inbox is probably full of it -- How you can make
unbelievable returns. Guess what? It is unbelievable because it is not
true. The best options traders make about 100% a year consistently.
That is about 6% per month after commissions. A realistic goal should
be about 2-3% per month. By learning the Market Maker Paradigm, as
taught in this book and in my live interactive webinars (web based
seminars), you will be able to scrutinize what is right and wrong about all
those advisory recommendations.
Option trading is on its way to becoming a household word. The
players that are still around have learned from the school of hard knocks
that mistakes can be avoided if they trade with tried and true rules. Most
of the two-dozen ‘textbook’ option plays and strategies are totally
inappropriate for most people, and even the remaining few investors who
have used them. There are, however, a handful of strategies that are
suitable for even the most sophisticated options strategist.
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