Option Investor
Updates

THE BID/ASK SPREAD -- EXPOSED -- PART I

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In the trading wars, early on we learned that it was going to be us against the market makers. In every trade we make, we have to deal with a bid/ask spread -- and it's the market maker that calls the shots, sort of.

Because we have a plethora of new subscribers, we're going to devote some space over the next few weeks to reviewing the negotiation process that we use in determining the premium we ask for when placing our trades.

This is a complicated subject. It's an important trading skill, so we take a good few hours to go over it at our CPTI seminars. Putting it in columns is going to be a challenge. For veteran CPTI students and seminar attendees, this will likely be a bit of a review. But it's like chicken soup -- it can't hurt.

The posted bid/ask spread is like the invoice on the window of a car in the showroom. For some car dealers, the invoice is a starting point for negotiations. Other dealers adopt a "take it, or leave it" attitude. The same holds true in options trading. Some market makers display a reasonable degree of flexibility while others are just plain anal.

The Bid/Ask Spread
This calls for a quick review of the components of the bid/ask spread. When you look at an option chain you're likely to see the following:

Bid: $3.20 Ask: $3.80

This simply means the market makers are "bidding" $3.20 for the option. That's how much they're willing to pay you for it should you want to sell it. They are "asking" $3.80 for the same options. That's how much they want you to pay if you are purchasing the same option if you are looking to buy it. (Reminder: options trading above $3.00 are traded in $.10 increments. Options below $3.00 are traded in $.05 increments.)

When you see the quote on the option chain, the "bid" price represents the highest bidder (to buy) and the "ask" price represents the lowest offer (to sell). The market maker pays his 970 phone call bills with the difference between the bid price ($3.20) and the ask price ($3.80). The question arises, do we want to pay for his dalliances AND put his kids through college? Hell, no. We may have been born at night, but not LAST night.

The "Show or Fill" Rule
Not wanting to pay retail (the $3.80 posted "ask" price) for the option, we can submit a limit order to buy the option at $3.60. Enter the "show or fill" rule. That simply means that the market maker must either fill your order at $3.60 or change his bid/ask spread to reflect your order. Should he not fill your order, his new bid/ask spread would be:

Bid: $3.60 Ask: $3.80.

You are now posted as the highest bidder. With your $3.60 being represented (instead of the market maker's $3.20), it provides other owners of this option an opportunity to sell their options at this higher price ($3.60).

Prior to the "show or fill" rule, the market maker was not required to show your price. He could leave the quote unchanged, and your order unfilled.

Why Should You Be Filled?
Depending on the exchange, when a market maker posts a bid or ask price, the exchanges (at least the major ones) require that the newly posted price (in our case - $3.60) be good for at least the number of contracts that the bidder is trying to buy.

Say you placed an order to buy 10 contracts. Does the market maker want to sell you that option for $3.60? Another "hell no." But, if he posts that $3.60 on the bid, he is risking having to sell your 10 (but only 10) contracts to an option seller at $3.60, rather than at the $3.20 in the original bid/ask quote. He doesn't want to do that. So, what are his alternatives?

Again, the market maker only has to sell the 10 contracts to an option seller at $3.60. Then, the bid would revert back to the original $3.20. If the option seller has an order to sell 20 contracts, the market maker is only required to sell the 10. The remaining 10 contracts would likely go unfilled -- unless, of course, market conditions change.

It is often in the market maker's best interest to fill your order for ten contracts at $3.60 just to get you out of his hair. Sometimes it pays to be a nuisance, but you have to be a nuisance with some class. Also, remember, that in life you're not going to get anything unless you ask for it. The skill comes in just "how" you ask for it.

Don't Get Greedy
As in most areas of life, especially trading, pigs tend to get slaughtered. So, if you're a piggy that goes to the options market, you might end up as a ham sandwich. In our example, when you place your order, don't put your limit order in at $3.40. That would be an insult and people who are insulted will go out of their way to make sure you don't get what you want. We don't want to piss off the market makers (too much). We just don't want to pay retail.

Imagine you're selling your house and you're asking $150,000. Then someone comes along and offers you $100,000. In addition to thinking "GFY," you vow that this would be the last person in the world you would sell your house to. Market makers are human, too (I think). They may be our adversaries, but they have to live too. They're entitled to make a profit (within reason, of course).

Strange, But True
On occasion, and this has happened to me, you'll notice an "ask" price that looks like a hell-of-a-deal. You put in your order at the seemingly low ask price and you get a report back that you were filled on one out of 10 contracts. Meanwhile, the bid/ask spread has returned to reality -- with the ask price now nowhere near where you sold the one contract.

Unless the market moves dramatically in your direction, you're going to be sitting there with one filled contract and an open order to sell nine other contracts. You've used up a full commission to sell the one contract and, if you change your limit order, you're going to incur another commission charge.

How do you avoid this? Your online trading platform (if you have a good broker) should be able to tell you the size (the number of contracts) at that price that is waiting to be filled. If it matches your order, great! If not, you can make a decision whether or not you want to proceed. But, at least you'll have the information and can make an informed decision.

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GOOGLE IS TOAST!!! Only 60 points to go! :-)

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JUNE CPTI POSITIONS
CPTI June Position #2 - SPX Iron Condor - 1196.02
Our favorite index just keeps on giving. We'll keep on taking.

We sold 15 June SPX 1110 puts and bought 15 June SPX 1100 puts for a credit of $.70 ($1,050). Then we sold 15 June SPX 1225 calls and bought 15 June SPX 1235 calls for a credit of about $.70 ($1,050). Our net credit and profit potential is $140 ($2,100). Maximum profit range of 1110 to 1225. Maintenance is $15,000.

CPTI June Position #1 - CME Iron Condor - $246.19
We sold 15 June CME $170 puts and bought 15 June CME $160 puts for a credit of $.60 ($900). Then we sold 15 June CME $230 calls and bought 15 June CME $240 calls for a credit of about $.50 ($750). Our new bull put spread is $185/$175. Our new net credit is now $1.35 ($2,025). New maximum profit range of $185 to $230. Maintenance is still $15,000. Position closed for $3,225 loss.

CPTI June Position - GOOG Iron Condor - $280.66 (Formerly May Position)
We sold 12 GOOG May 160 puts and bought 12 GOOG May 150 puts. We also sold 12 GOOG May 220 calls and bought 12 GOOG May 230 calls. Our total net credit and profit potential is $1.40 ($1,680). Our maximum profit range is $160 to $220. Maintenance is $12,000.

We bought back the May bear call spread and rolled out to the June $220/$230 bear call spread. We also bought back the May $160 put for a nickel. Our new credit and profit potential is now $2,260.

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ONGOING STRATEGIES
ZERO-PLUS Strategy -
In my Feb. 8, 2004 column, I outlined a strategy based on an initial investment of $100,000. $74,000 was spent on zero coupon bonds maturing in about seven years at a value of $100,000. The principal $100,000 investment is guaranteed. We're trading the remaining $26,000 to generate a "risk free" return on the original investment.

This year, we're going to use the entire $26,000 of extra cash as maintenance for some Iron Condors. That should enable us to generate substantially more profit on this "no risk" strategy.

In May, we placed an SPX Iron Condor with a total net credit was 2,000. It expired worthless. Our new cash position is: $29,500 + $2,000 (May Profit) = $31,500

New Zero Plus Position: Coming Soon

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QQQ ITM Strangle - $38.10
We own 10 January 2007 $42 puts and 10 January 2007 $32 calls at a total cost of $14,600. Only $4,600 is at risk as the other $10,000 of intrinsic value will always be there. We then sold the March $36 puts and $38 calls, taking in a total of $1.10 ($1,100). If all goes well, the QQQQs will close somewhere between $36 and $38. We will then sell the April near term options, etc. etc. The objective is to sell premium every month for the next 22 months. When all is said and done, we should be able to show a very nice profit.

We rolled out our short May options to June (see details above) and took in a net of $800. Our new total of income generated is $3,850 ($3,050 + $800). We are short the June $37 calls and $36 puts.

We purchased back our June $36 puts for a nickel. We're waiting for a pullback and see what opportunities may present themselves to sell another short position.

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JULY POSITIONS
CPTI JULY Position #1 - RUT Iron Condor - 620.30
Today, we sold 12 RUT July 580 puts and bought 12 RUT July 570 puts for a credit of about $.80 ($960). Then we sold 12 RUT July 670 calls and bought 12 RUT July 680 calls for a credit of about $.50 ($600).

Total appx. credit and profit potential of $1.30 ($1,560). The maximum profit range is 580 to 670. Maintenance requirement: $12,000. Remember to adjust the number of contracts to the size of your trading accounts.

This position was suggested on Thursday, June 2 with the RUT trading near 620.

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CPTI SUMMER SEMINAR DATE: JULY 16 & 17 -- PHILADELPHIA, PA

WE'VE HAD 29 OUT OF 30 PROFITABLE MONTHS -- WITH NO END IN SIGHT!

WANT TO ACHIEVE SUCCESS WITHOUT STRESS WITH CPTI WEALTH-BUILDING TECHNIQUES? OF COURSE YOU DO!!

Spots are still left for my July Philadelphia CPTI seminar. They probably won't last long, so be proactive! That means GOYA. Contact me at mparnos@optioninvestor.com and I'll reserve a spot for you. He who hesitates may be SOL.

The dates and locations are:
July 16/17 - Philadelphia, PA

Send me an email at mparnos@optioninvestor.com and I'll forward you all the details. Don't be left out! The spots are filling up fast. It'll be a weekend you'll never forget! SERIOUS OPTION TRADERS ONLY! Directional trader converts welcome! The price is right and it will be an experience you'll never forget.

You should really try and make one of these seminars, if you can. With what you learn, you'll see a substantial increase in your trading results. If you've already signed up, I'll see you there. If you haven't signed up, what are you waiting for?

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HAPPY TRADING!
Remember the CPTI credo: May our remote batteries and self-discipline last forever, but mierde happens. Be prepared! In trading, as in life, it's not the cards we're dealt. It's how we play them.

Mike Parnos, Your Options Therapist and CPTI Master Strategist

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Couch Potato Trading Institute Disclaimer
All results reported in this section are hypothetical. While the numbers represented here may have been achieved or beaten by our readers, we make no representation that any individual investor achieved these exact results. The tracking for the plays listed in this section uses closing prices for the day the newsletter is published and it is not meant to imply that any reader actually received those prices or participated in these recommendations (even though many do). The portfolio represented here is hypothetical and for investment education purposes only. It is only an illustration of what type of gains a knowledgeable trader might receive utilizing these strategies. If you don't get close to these results, guess what? It isn't the fault of the strategies.

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