The trading bug bit me. That was a lesson! -2
I wanted to short the Dow Jones Industrial Average (DJIA).
It was 1990, the DJIA had failed to break 3,000. (That seems so long ago.) I had a feeling that I could make some money on the downside. Doing it taught me some important life and trading lessons.
Shorting the stock market, historically, was neither an easy nor cheap task. To short the stock market you need to borrow stocks on margin. This means opening a well-funded margin account. It provides the money used to guarantee the stocks and is the source of funds used to cover losses if the market moves against you and stock prices rise. Under this scenario, I’d have to set up sell positions in each of the DJIA’s 30 stocks. That’s a lot of shares and a big chunk of cash.
In the 1990s, there was an easier and less costly way to do this. Buy put options on a stock index, or sell the futures.
As I mentioned in a previous post, ethically, and as a condition of my employment at Futures World News, I could not trade in the markets or even exchanges that I covered. Trading futures or options on futures was a no no.. Trading stock index options on the Chicago Board Options Exchange (CBOE) could be sketchy, too, given that stock index (Standard & Poor’s 500) futures and options were traded on the Chicago Mercantile exchange. I didn’t feel precluded from trading options on individual equities.
Buying a put option on an individual stock traded on the CBOE was an easy and cheap way to short the market. Quick refresher: a put option is the right but not the obligation to sell a stock at a fixed price at a specific time.
The Strategy
An option is similar to a term insurance policy. It has a time-to-expiration. The cost is called a premium. It has more variables than that but this is sufficient detail for this story.
A call is the right, but not the obligation to buy a specific stock, at a specific time (the expiration), at a specific price (the strike price). Buying a call is a bullish move. It profits as the price of the underlying stock rises.
The call’s counterpart is the put. A put is the option (the right) to sell a specific stock, at a specific time, at a specific price. Buying a put is a bearish move. It profits as prices drop.
Options are listed every quarter and are priced in $5 increments, called strike prices. The strike that corresponds to the current price of the underlying stock is called the at-the-money strike price. Calls with strike prices below the at-the-money strike are called “in-the-money”. They are have higher values. The reason is because: if you exercise the call you get to buy the stock at a price lower than the market. There’s a certain guaranteed profit in the trade.
Calls with strike prices above the at-the-money strike are considered out of the money. These options are priced lower because there is no guarantee of profit.
On the put side, strike prices below the current market price are considered out-of-the-money and strike prices above the market price are considered in-the-money. The more in-the-money a strike price is, the more expensive the option is. The more out-of-the-money a strike price is, the cheaper it is. (Still with me?) However if the put option’s strike price falls (moves into out-of-the-money territory), the option price rises.
My idea was to purchase cheap out-of-the-money put options on an equity that would be a good proxy for the Dow Jones Industrial Average. I’d hope the market went my way and make some dough. I didn’t plan to hold the options to expiration. They were to be held long enough to catch some of the market’s downward move. My proxy stock was Motorola.
My hunch was being realized. It was time to pull the trigger. The recollection of the details of the trades, 30-years later, are fuzzy. I don’t remember all of the strike prices or option prices exactly. This story is less about the exact magnitude of losses or gains and more about the lessons learned or not. The prices are estimates.
I contacted my broker at Dean Witter (remember that company?) and opened an options trading account. Setting up an options trading account was more complicated than I had imagined. There were a lot of fine-print disclosures to read and many signatures required.
I outlined my strategy to the broker. He suggested Motorola might be a good DJIA proxy. Meanwhile, I started studying the indexes’ price behavior. My daily trading floor reporting rounds included regular stops at the charting machines on the trading floor and in the exchange library to print out price charts. I chatted with traders about my hunch and showed them the charts, asking their advice.
The Trade
I bought one out-of-the-money put on Motorola for about $450 and waited.
I got lucky. Within a few days the DJIA gapped lower. I did some of my trading during the market trading sessions in the blue circle area (see chart above).
When a market gaps lower it means that there’s a segment of prices not traded between the previous day’s low and the subsequent day’s high. To illustrate: suppose the price of apples trades from $1.11/apple to $1.15/apple on Monday. On Tuesday, the price of apples falls and the day’s prices range from $1.02/apple to $1.07/apple. Between the two market sessions the market did not trade the prices between the Tuesday high of $1.07 and Monday low of $1.11. That’s the price gap. The trend chart above unfortunately does not show the gap. It’s there, trust me. (The blue circle in the above chart captures the gap.
This was a better-than-hoped-for result. As the DJIA fell, so did the price of Motorola shares. My out-of-the-money put option was more valuable. In the blink of an eye, my $450 option was worth $1,200. I was in fat city.
Time to take some money off the table. I sold the put, closing out the position. I started thinking about what to do with my new-found riches. There was no practicality. Save the money, pffft!! Maybe I’d buy a bike.
A couple of days later, the broker asked, “Want to do that again?”
“Heck yeah!!”
It was so easy to make $750. Doing it again should be a cinch. I didn’t realize it but I was succumbing to one of the two leading emotions that drive traders: fear and greed.
I used the same strategy. This time, I laid $650 on Delta Airlines out-of-the-money puts.
During the Motorola trade, I was calm, cool and collected. This time the market didn’t go down. I was a wreck. I checked the quote machines all the time. My $650 shrank to $300. My greed had been replaced with fear.
What just happened? I was learning trading lessons the best way to do it, by making mistakes and experiencing failure.
The market went against me, that I couldn’t control. Additionally, I was buying options on a transportation stock, not an industrial. Transportation stocks behave differently. My greed blinded me to the fact that I bought an option on the wrong stock.
I took a few days to lick my wounds. I was still in the black but by less. Probably wasn’t going to get a bike.
I still had optimism. It was time to get back on the horse.
This time, I still wanted to bet on the DJIA. Despite appearances as a movie and theme park company, Disney was an industrial. Again, I bought puts for $600.
It was another nervous trade. I hovered over the chart machines like a helicopter parent. That didn’t help the performance. The market rose, Disney’s price rallied and my put options lost value. I sold at another loss. I hadn’t well-researched that trade either. Ugh!
I was caught in trading fever. The question was how far would I go. My broker tried to be helpful, offering another trade. He was the dealer selling the addict, me, more junk.
I gave Motorola puts another chance. This time, I invested roughly $300. The nervousness was gone. I was relaxed. When the market fell (hurrah!!) I held on and sold for a profit.
After four trades, I was back where I started. I had one big winner. Two losers and a final trade that brought me back to break even. I was done.
On reflection my education was thorough, short and cheap.
The big lesson I took away was that it was important to research the market, know what I was doing and why. I had spent several weeks researching the first trade. Admittedly I caught a lucky break with the trading gap. But, I think the market was headed lower anyway.
The second trade revealed my greed. I didn’t research the trade and I traded an amount outside my comfort level. That’s when the fear took over. It took two trades (Delta and Disney) to realize that. I was calm committing $500 or less.
By the last trade, I had gone back to looking at the market price charts and was prepared to buy Motorola puts. I also traded an amount in my comfort zone. That was a winner.
The trading took a lot of time and emotional commitment. Enough was enough. I took away two more lessons:
It helps to have a grubstake large enough to weather market swings. You don’t want to get forced out of the market on a head fake. Ultimately, I was willing to lose my entire $500 grubstake, But, when I started with a big winner, I lost my perspective and got greedy.
I was trading against professionals, sharks. These are people who spend a lot of time every day thinking about, studying the market and trading. As a market reporter, I did two of the three, but not with a profit motive. I didn’t trade. I might beat them once or twice, but not regularly. To these sharks, I was a minnow.
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This blog is about more than my experiences. It is intended to be a collective experience of working on the commodity markets physical trading floor. If you or someone you know has a story please let me know I’d like to include it in this ongoing chronicle. I can be reached at linton122@gmail.com
© Clifton Linton 2024