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Chubby Vol and Smelly Cats



Edging through a relatively quiet morning and, while it's slow, I wanted to touch on the subject of option trading. Typically, when I mention "defined risk" vehicles, I'm referring to "calls" and "puts." For trading neophytes, call options give you the right (but not the obligation) to purchase the underlying stock (or index) at a particular price (the "strike") at any point up to the time they "expire." Conversely, put options give you the right (but not the obligation) to sell the underlying stock (or index) at a particular price (the "strike') at any point until expiration.

Now, as a trader that "grew up" on a derivative desk, I have always had an affinity for these vehicles-both as a "speculative" tool and as a hedging vehicle. I've always believed that, when used properly, options add tremendous value to the trading process. There are many times that I will look to capture the upside (downside) of a stock (index) and want to define my exposure while limiting my loss potential. Often times, that can be achieved through the use of paper (read: options).

The caveat, and there are many, is that most "non-professionals" are at a natural disadvantage as they don't fully understand the pricing mechanism involved in the option market. For instance, during periods of high angst (such as now), option premiums are quite "fat," reflecting the demand skew as traders "reach" for protection (or to define their risk profile). The irony, of course, is that during the times that defined risk is most desired, option premiums make this vehicle the most unattractive. You can monitor the aggregate option premium levels through such tools as the VIX (OEX volatility), the VXN (NASDAQ vol) and the QQV (QQQ vol).

It's impossible to cover the entire derivative spectrum in one column, but suffice to say that option premiums are at levels that are historically unattractive. The professional traders out there often look to "sell premium" during times like this, but let me be very clear: Do NOT try this at home. The risk profile associated with "negative gamma" (short premium) gets you "longer" as the market drops and "shorter" as the market rallies. If you don't understand what I'm saying, don't worry...but also don't trade options.

On a housekeeping note, please know that we're in the process of switching the trading journal to "black letters on a white background" and making the font size larger. We haven't forgotten about this, it's just taking a bit of time to get the changes in motion. Also, after a fierce battle, it seems that the people have spoken and the "starting five" top bands of all time are (in no particular order): The Beatles, The Rolling Stones, Led Zeppelin, The Grateful Dead and the WHO. Much to my chagrin, U2 was pushed out and joins the Eagles and Pink Floyd in the bullpen. Drat!

Tossing my other hat on and focusing on the open. Keep an eye on the banks, on S&P 775 (downside support) and S&P 800-810 (upside resistance). Also, in an effort to shake up the collective mojo, please join me in kicking off your shoes and trading barefoot today. Toes everywhere!

See you after the opening.


No positions in stocks mentioned

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