Option Investor
Educational Article

The Trading Wars

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by Mike Parnos

Trading With Attitude

Investing is a war. It's a war that is fought every day - and every day there are winners and losers.

If you're like most investors over the past two years, you probably feel like Davy Crockett at the Alamo - fighting off two thousand Mexicans with only Old Betsy and a Bowie Knife?

Walt Disney brought Davy Crockett back to life and painted him a hero, but that didn't make him any less dead. Why did he die? Because he fought the odds - and lost. All that's left of Davy Crockett is a coonskin hat and a tall tale.

When it comes to the stock market, I'd rather be a live coward, than a financially dead hero.

History provides many valuable lessons. There are many military events that accurately portray the right and wrong ways to approach the combat zone we know as the stock market.

For example, how did a seemingly disorganized band of patriots defeat the legions of highly trained troops of England's King George to ultimately win America's independence?

Appearances can be deceptive. The patriots weren't disorganized at all - just bad dressers. Their generals used unconventional tactics. They used the element of surprise. They hid until they had an advantage - then attacked, causing as much damage as possible, then retreating until the situation was right to mount another attack.

They were passionate, nimble, focused and had a strategy - aggressive when the situation called for it, but also patient. Waiting as long as necessary.

Patience is the greatest asset in the investment wars. If you don't have an advantage, you shouldn't be in the market.

The retail investor is the enemy. You don't have to destroy him - he'll ultimately destroy himself. He's emotional. He doesn't use money management skills. Never fear, there is a bottomless pit of retail investors who continue to take uncalculated risks or trust their money to King George type management firms with the belief that the sheer numbers of troops will ultimately win the war.

It doesn't work that way. Not anymore. The bull market has left only a mass of cow chips. Now you have to be very careful where you step.

What happens when you pick a direction? You can only make money ONE WAY -- if the stock goes in that specific direction.

Why not position yourself to make a little if the stock goes up, goes down or goes nowhere?

If the market is going nowhere, you can still make money by taking advantage of the traders who are betting on a particular market direction. Remember, the retail investor is WRONG most of the time!

Professional traders sit back, take the bets, and are RIGHT most of the time? There are trading tactics that allow you to benefit from this very scenario. Does your arsenal include these strategies?

Keep in mind, you don't have to bring home a whole scalp after every battle. If you can be satisfied with taking a "little off the top," you will be able to take fewer risks, keep your powder dry, and live to fight another day.

The war is ongoing - and so must be your focus. You may win a series of battles, but you can't afford to become overconfident.

Great tacticians will define, and accept, their risk before any battle. The same is true for the best money managers. There will always be casualties. You'll lose some battles. That's a given. A few sacrifices will have to be made. They will often take the form of insurance - money you spend on options to hedge your positions.

How many troops will you send into battle? How much money will you take to war? Until you have a plan, the safest place for your money is in the bank or a money market fund.

You can have the most sophisticated equipment (or weapons), but if you don't have a battle plan, you're going to lose the war.

The British troops are home recruiting more soldiers (investors) for the next war. They won't admit they lost the last war - or that their tactics were wrong. If they do, they won't get new recruits to sacrifice. Will they change their tactics? Unlikely. Will the results be different? Not if they're up against the same foe.

The investment battlefield is littered with millions of sacrificed investors who are lying there wounded, their financial lives slipping away, still hoping to be rescued by the British troops. They shouldn't hold their breath.

Have you won any battles lately? Or have you been one of the casualties?

It's not too late. You can still join the patriots and the fight to declare your financial independence. Guerilla money managers are recruiting. There's no dress code.

Why did the U.S. lose the Viet Nam war? Because guerilla tactics are almost impossible to defeat.

Remember, it was the shrewd Sitting Bull that lured General Custer to the massacre at Little Big Horn.

They call them "history lessons" because you're supposed to learn from them.

You can't teach an old bull new tricks. Unfortunately, there are a lot of bulls still out there - and ill prepared for battle.

You don't have to fight your war standing in a field of cow chips.

Strategy Du Jour

From the Couch Potato Trading Institute, here is a variation of a popular option strategy that will allow you to watch all 35 Law & Order reruns every week and make very respectable money at the same time.

The bulk of your effort will be expended finding a volatile stock that is vacillating in a nice wide trading range. That's what commercials are for.

Let's take a favorite of mine, QLGC. It closed at $39.80. This stock has been all over the map and, let's be realistic, who the heck knows where it's going to go? Not me. However, I'd feel pretty sure that, come August option expiration, it will be somewhere between $30 and $50.

We're going to construct what is known as an "Iron Condor." It may sound like a rejected special effect from a Star Wars movie, but it can be quite useful.

An Iron Condor is really pretty simple. It consists of establishing a bull put spread and a bear call spread on the same stock about a month out. In this case, they will be well out of the money. For this example we'll use a 10 contract position.

In establishing the bull put spread we'll buy the August $25.00 put at $.85 and selling the August $30 put for $1.65. We have just put $.80 ($800) in our pocket and have an exposure of $5.00 less the $.80 we took in.

Now we'll put on the bear call spread. Based on some significant resistance, it seems highly unlikely that QLGC will finish over $50. So we will buy the August $55 call for $.65 and sell the August $50 call for $1.20. We've just put another $.55 ($550) in our pocket and we have an exposure of $5.00 less the $.55 we took in.

We've taken in a total of $1,350 ($800 + $550). Our exposure is $3,650 ($5,000 less $1,350). QLGC can bounce around to its heart's content in the established 20-point range between $30 and $50 while we watch TV and get a peaceful night's sleep. The beauty of the Iron Condor is that, no matter how poor your stock selection may be, you can't be wrong in both directions.

In our example, your broker will require you to keep in your account as maintenance the $5000 for the bull put spread and the $5,000 for the bear call spread. Despite the fact that you can't be wrong in both directions, most brokerages don't have software that will recognize the position as a whole. Thus, in their eyes, each spread is dealt with independently. Hopefully, some programmer will have a vision and come up with a solution. But until then . . .

The return on your risk is 36.98% ($1,350 divided by $3,650) for about six weeks, which should leave you more than satisfied -- and you don't have to pick a direction. Ideally, all positions will expire worthless and the strategy will not require any closing commissions.

If the stock is acquired at some ridiculously high price or if the CEO gets caught with his hand in the till or his secretary, there is still a comfortable cushion. If the stock violates one of the short strikes, you simply buy the stock to cover the short call or short the stock to cover the short put. That's probably an over simplification, but it is a viable solution to a worse case scenario.

The whole point of the Iron Condor is to make a healthy return while you munch on Doritos and watch Jerry Orbach and Sam Waterson put the bad guys in jail.

Now, what did I do with that damn remote control . . . . .?

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