The Tycoon Report

The Most Profitable Way to Play Options - The Trend is Your Friend, But Cash is your Soul Mate.

I love options!

Have you ever loved something or someone who really hurt you, maybe nearly killed you in the past? Perhaps left you with scars, whether it be mentally or physically? I have. I was in an abusive relationship with option contracts.

At first "the call option" started off light. Just a couple of love taps. It was okay, I knew that it was just part of the relationship. I knew that there was a 485% profit light at the end of the tunnel. I'm telling you we had some great times, the call option and I. Then after making 90% here and 85% there, the call option would deliver a swift blow to the head in the form of 100% losses. Told me that I was stupid. Playing with those risky, out of the money calls that expired in 5 weeks. But the tech stocks were gunning higher and higher. I mean everyone else was doing it, right?

So I went back in and had a great time. I forgave the call option, and I booked some of the largest profits ever! My closest friends came to me in confidence and sat down with me. They put their hand on my shoulder and said "Look, Chris, you need to get out of this. "We are all very concerned about you. "You are too good for this." I swore that I would start hedging myself.

I promised myself that I would sit on some cash "just in case." But I thought about all of the good times that the call option and I had together. Ahh, the good times. Buy 'em at $1, sell 'em a week later at $6.90. The call option really knew how to treat a trader. Sure, I lost 80%-100% here and there, but I remember one time I made a $112,000 profit on $10,000. Those painful beatings I took were just part of how the call option showed its love for me.

I mean, it was really my fault for losing 100% on the occasional position. I, I ... I brought it on myself. I was greedy. The call option didn't mean it. Besides, the market was hitting new highs and the call option said "sorry" and promised it would never happen again. My friends always argued.

One friend even ran into the trader’s office and ripped the ticket in half one time and stomped on it repeatedly when I was getting killed on a position. My friend yelled, "You stay away from Chris! "One more 100% loss, and you'll have to answer to me!" And he looked at me and shook his head as he walked away fuming.

I guess that I had to hit bottom before realizing that I had to find something that would always treat me right, and was safe. I found cash. Or I started putting it on the side for a rainy day. I started taking a few bearish positions as well as bullish. I would only buy options that were deep in the money, and that expired in anywhere from 6 months to 2-3 years.

Today I counsel other traders in abusive relationships. I started The Trend Rider where together, we meet. So far we haven't closed out one losing trade. We have taken both bullish and bearish bets. Okay, I went off on a tangent. Ha-ha-ha.

But SERIOUSLY ... People! Very Very Important! You MUST be responsible here. The market has been rallying! Since September, my positions have returned an average of 26% in about 2 1/2 weeks. Don't get caught on what you may see as "easy street."

What do I mean? If you play options, you may have gotten greedy lately. It's okay; sometimes "greed is good" (as Gordon Gekko said). I can't stress enough to you the importance of keeping cash on the sidelines if you are playing the options market.

The amount of cash (protection/security) that you should have really depends on your options strategy. It is one thing if you are using highly sophisticated strategies where you are hedged.

If you are in a position where you can only lose a portion of your net position, by owning both puts and calls on a stock (aka a "straddle") then you would need less cash on the side than if you are unhedged because you own a put, or a call, by itself.

We know that this is a great way to realize 40% profits (on an option) if the underlying stock only moves by 10-15%. You can rack up some pretty healthy profits and even be up 400% within a year if you play your cards right. But you must remember that with bigger reward, comes bigger risk.

That is why if you are unhedged on your position, you should always have double the value of your unhedged options sitting in cash. In other words, if you have $100,000 in options, then you should have $100,000 in cash in case the market turns against you. Don't ever forget that in one day the entire market could make such a drastic move that your options could lose significant value.

One day, you could walk into work or you could be home brewing your morning coffee, and you will turn on your computer, or CNBC only to find that some frightening news has caused the major indices to come down from head to toes!

If you own call options, it could be bad unless you have a few put option positions out there that would turn a nice profit if something terrible happens. Eventually, in 2001, I started buying loads of puts on the NASDAQ, and for many of my clients, I was the only money manager who was making them big money.

Don't think that the market can't turn right around in a week and start breaking 12-month lows. It can. There could be some sort of crisis, or attack, or meltdown, or alien invasion. Something. Whatever the cause is, something will nail the stock market so hard that every single call option you own will be down 80%-100%.

So what do you do? Take both bullish and bearish positions, right? Not a bad idea. In fact, it's a great idea. By doing so you are guaranteed to lose! That's not a typo folks. You will win overall, as long as you guarantee yourself a few losers.

That doesn't mean that you should do things that you don't think will work. It just means that you should place some bets on some stocks that you think will trade higher by purchasing call options, and you should bet on some stocks to trade lower, by purchasing put options.

Now let's be honest with ourselves. If the markets are trending higher, the majority of our positions will be bullish. For some of you gunslinging cowboys/cowgirls, all of your positions will be bullish. If the market is breaking multi-year highs, and you are wise enough to have some bearish bets on the table, if a major catastrophe causes the market averages to tank, only those few (bearish) positions will do well as your calls will sharply decline in value.

Another thing: if the market tanks, like in October 1998, or after 9/11/2001, or October 1991 or 1988 (the list goes on,) that will be the time to grab your ... um ... guts, and buy the long term calls. These things don't happen often, but they do happen. If you bought the long term calls on any of those major market dips,you could have easily doubled, tripled or quadrupled your money in the subsequent six months.

Here is one reason why options are considered to be a sophisticated trading vehicle: It takes a certain rare discipline to go against human nature. That is why option trading is not for everyone. Most people have a hard time sitting on a large amount of cash.

Most people are too tempted to take that money and either spend it, or trade it. Sure, most people believe, and will tell you, that they are not one of those people. But they are. Believe me, I managed money for all sorts of people, both experienced institutional traders and individual investors. Not only that, but most people have a hard time buying something and sitting on it while it goes the wrong way. Those are the people who want to be right on every trade.

But you can't possibly, consistently, play both sides of the market (hedge your bets) and be right on every trade. You have got to be willing to accept some losers in your portfolio as protection. So the key here is to be sure that you are sitting on some cash for a rainy day. The one time that you decide to take everything and take a huge bet when you think "the coast is clear" will be the day that nothing works.

You can make a killing, and you can reduce your risk with options.

Just as long as you have discipline, and never stray away from that discipline.