Secrets

Of the

Giants
How to Double Your Returns Using Just 10% Of Your Portfolio

by Darrell Jobman

 1998 TradeWins Publishing Co. Reproduction or translation of any part of this work beyond that permitted by Section 107 or 108 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Requests for permission or further information should be addressed to the Permissions Department, TradeWins Publishing Co. ______________________________________________________ The past performance of any investment instrument is no guarantee of future results. And while futures and options trading can generate large profits quickly, trading these instruments can also involve significant financial risk. You should be aware of and carefully consider these risks before trading.

Chapter 1

Introduction
Everyone seems to know the U.S. stock market will, in the near future, do one or more of the following:

Go up forever Crash and burn Stay about where it is now

Of course, no one knows for sure whether any of these scenarios will ever happen. Looking back only to 1982 from today's perspective, the "forever upward" argument with a few bumps along the way looks pretty good. But going back through history, including the period since 1982, there have been episodes - October 1987 or October 1997, for example when you might have been convinced the negative scenario looked like a sure thing. The buy-and-hold case has been strong for so long that it feeds on itself by continuing to attract huge amounts of capital into stocks from mutual funds, 401k plans and individual investors. But even during this biggest and longest record-setting bull market in history, many investors - especially those with some experience with down markets are becoming cautious and nervous about the future of U.S. stock prices. These investors are asking a number of nagging "what if..." questions: What if the market drops? I don't want to see my money sucked away in a downdraft. But what if the market keeps going up? I don't want to miss out on the profits if the market keeps hitting new highs. Or, what should I do if the market stays about where it is, moving only sideways? If I can't make any money, should I be in the markets in the first place? See the dilemma? Wonder what you can do? There is a fairly simple solution. Ironically, however, the investment vehicles that can best help you achieve the highest overall returns no matter whether the stock market

goes up, down or sideways are also the vehicles many investors wrongly believe to be the most speculative, risky and dangerous. These investment tools are futures and options. They can help you: Increase your profits from stocks in a rising market Protect you from many of the risks in a falling stock market Squeeze out positive returns if the stock market stays flat for an extended period

The advantages offered by futures and options are so huge you simply can't afford to not consider becoming a trader rather than an investor and adding them to your investment portfolio. A trader has a little different outlook than an investor. First, the trader is concerned mostly about market direction: Which way are prices headed? Second, the trader is as likely to sell as buy. In contrast, the typical stock investor is only a buyer you may have more or less of your funds invested, depending on your market outlook, but you are always long. The investor's main concern is not whether to buy or sell but picking the "right" stock. Not everyone, of course, has the temperament to be a trader and, even if you do, you may have no desire to trade on the level of the high-profile traders mentioned in Chapter 2. You do not have to have a greedy, get-rich-quick mentality to use futures and options to your advantage. In fact, in some circumstances, you may find they are just a conservative addition to your portfolio. This book focuses on the stock-related futures and options contracts because those are the areas with which you probably are most familiar. First, we'll give you a few examples of why you might want to give futures and options a serious look. Then we'll compare futures and options with stocks, which contracts you might use and when you might use them. Finally, we'll show you how to tap the advantages of futures and options and provide you with a few strategies that could fit your particular investment situation. Once you see how futures and options can add flexibility and versatility to your investment portfolio in stock-related areas, you may want to expand into other financial and commodity contracts to incorporate them into a more diversified investment program. If so, there are plenty of books, videos and other educational materials available to help you.

Chapter 2

Secrets Of The "Giants" That Can Work For You

Using futures and options, you can become very rich, very quickly and with easily identifiable risk, from a rather modest investment. If you are like most traditional investors who have never looked beyond CDs or the stock market, that's a pretty strong statement and you are probably thinking, "Whoa! If it sounds too good to be true..." But keep reading! It IS possible to make big money quickly and to preserve the money you already have by incorporating futures and options into your investment thinking. That is because of the power of leverage, a major attraction of futures and options compared to most other investment vehicles. Used carefully, leverage is like using other people's money it is one of the secrets to wealth achieved by highly successful traders and professional money managers worldwide. For example: The Secret Of Richard Dennis, Who Turned $1,600 Into $200 Million, Then Retired At Age 39 Richard Dennis came into trading as a quiet, well-disciplined, organized person far from the typical flamboyant image often associated with trading. After borrowing $1,600 from his father to buy a seat on the MidAmerica Commodity Exchange, Dennis became a trading legend in the volatile 1970s he was so influential, it is said, he could affect the price of soybeans just by walking onto the trading floor. Moving from floor trader to upstairs trader to money manager, Dennis turned his initial $1,600 stake into a fortune estimated at $200 million before he "retired" from trading at age of 39 in August 1988. After a short absence, he resumed trading but has maintained a lower profile since his return. "Learning (trading) is a lot tougher than it looks," Dennis said in a Futures magazine interview. "All the rules sound simple, but doing it day-by-day is difficult. It takes "stick-to-it-ivness" to do it right. The secret to trading, I think, is what you do with the wrong positions, not with the right ones.

Aside from taking a few hundred dollars to millions of dollars, Dennis' main legacy for traders is his "turtles" experiment. Dennis contended that educated, intelligent people could be taught to trade successfully by following a set of rules and emphasizing money management and persistence. A partner, William Eckhardt, argued that trading was an innate skill some people have it, others don't.

George Soros Controls So Much Money, Hes Been Accused of Deciding the Economic Fate of Entire Nations!

In the mid-1980s they decided to put this issue to the test, and Dennis trained about 20 individuals in his strict trend-following, technical method. Dennis' view was vindicated: Many of his trainees or "turtles, as they became known were highly successful and became well-known traders in their own right. Today they manage millions of dollars, and some of them, such as Russell Sands, are passing along the turtle trading methodology to dozens of other traders. The Secret Of Paul Tudor Jones, Who Went From Cotton Trader To Manager Of One Of America's Hottest Funds Paul Tudor Jones was inspired by Dennis' example and became one of the most successful traders of the 1980s. Starting as a floor clerk at the New York Cotton Exchange, he became a successful broker, then a trader, and, finally, a widely known money manager with more than $300 million under his care. His funds recorded triple-digit returns year after year and became so popular that people demanded to get into them long after he stopped accepting new money. The Secret Of George Soros, Who Has So Much Money He's Been Accused Of Deciding The Economic Fate Of Nations! While you may not recognize the names of Dennis and Jones if you are new to futures trading, George Soros is certainly one of the better-known figures in the investment world today, notably for his impact on currencies (specifically, the British pound) a few years ago. Soros used the leverage of futures and options to build and maintain his famous

Quantum Fund, one of the earliest and most successful hedge funds in history. Quantum was essentially a mutual fund that employed leverage and various hedging techniques to deliver superior returns to shareholders. "We operate in many markets," Soros wrote in his book, The Alchemy of Finance, in explaining his investment strategy for the Quantum Fund, "and we generally invest our equity in stocks and use our leverage to speculate in commodities. Commodities in this context include stock index futures as well as bonds and currencies. Stocks are generally much less liquid than commodities. By investing less than our entire equity capital in relatively illiquid stocks, we avoid the danger of a catastrophic collapse in case of a margin call." Soros, of course, is one of the world's most astute (and wealthiest) investors. He obviously understands when and how to use leverage to his advantage while maintaining control of risk at the same time. That comes through clearly in his book's day-to-day notes during the "investment campaign" that built his funds into holdings so large that he could eventually help to shape economic and political history. The Secret Of Larry Williams, The "Million-Dollar-A-Year" King Larry Williams has been one of the most successful and best-known futures traders, analysts and writers in the United States in the last 25 years. In addition to developing Williams' %R and a number of other indicators and trading system concepts, Williams achieved trading legend status when he won the Robbins World Cup Trading Championship in 1987. Trading more aggressively than he would normally, Williams took his $10,000 starting account to more than $2 million before giving up some of his gains to finish with $1.1 million an astonishing performance no one else has ever come close to matching. When you attend one of Williams' seminars, you will hear him stress that there are two categories of Larry Williams made traders: winners and losers. You don't have to be a trading profit of $1 particularly brilliant or have an unbeatable system or million in one year, work hard at analyzing markets to be a successful then wrote a book trader, he will tell you. All you have to do is watch about it. Many were the winning group of traders and do what they do. And who are the winning traders? According to Williams, they are the companies that convert commodities into consumer products. Kellogg, Pillsbury, Hershey and other commodity-based companies didn't become huge by being wrong about the markets at least not very often. Because of their size and their requirements for huge amounts of physical commodities, they not only make the market, they are the market.

skeptical, so he put his reputation on the line in a 1-year public trading contest and turned $10,000 into a $1.1 million fortune!

How do you know what these major players are doing? Williams describes their actions in the marketplace as being like a herd of elephants walking on a muddy riverbank the tracks are pretty easy to follow. If you are picking a side to follow in the marketplace, the odds are with you if you stay on the side of the big boys, he stresses. Conclusion___________________________________________________________ There are literally hundreds of savvy investors who have made millions of dollars by including futures and options in their total investment portfolios. The traders mentioned in this chapter are only a few of them. You can find profiles of other successful traders in books such as Jack Schwager's two Market Wizards books or in Futures magazine. In addition to showing that it can be done that you can get rich as a trader these examples emphasize two other important points: 1. You can learn to trade successfully. Yes, it helps to have certain personal characteristics and, yes an element of timing, as well as market conditions, both contribute to trading success. But you can learn techniques and strategies that can lead to profitable trading, just as the traders mentioned here. 2. Trading success can be a means to accomplish what you believe is really important about life. Many traders are not motivated by just adding dollars to a trading account but by the cause they support. For example, Richard Dennis has been actively involved in political issues (liberal Democrat). Paul Tudor Jones has provided scholarships for students from an innercity school. Larry Williams includes treasure hunting and a search for the real Mt. Sinai among his interests. George Soros is helping to develop capitalism in eastern Europe, making such an impact that he's credited by some with aiding the fall of communism! What is your cause? Maybe you aren't thinking about setting up a foundation yet, but you no doubt have a dream. No matter what it is, following the model provided by these "super traders" can help you achieve it. Perhaps the next chapter will too...

Chapter 3

How Just 10% Of Your Portfolio Can Double Your Total Return
Millions of people in the United States have become involved in the stock market in one way or another in the last 10 years, whether it be individual stocks in a personal account or via a mutual fund. Millions more have experience in bonds. If you are reading this, it means you have some interest in investing, so you are probably one of these people. As a participant in these traditional investment areas, you may need to be convinced first that you should even read about anything new, especially futures and options. After all, you may not want to be the one at a cocktail party who gets those archedeyebrow looks when someone points at you and whispers, "He's a futures trader." Despite their growing use in the investment world, futures and options still carry a "gambling" stigma that often draws a scoff when mentioned in polite investment circles. But even as conservative an investor as Benjamin Graham, developer of the "value investing" strategies that inspired Warren Buffett and many others, could make room for these "speculative" instruments in an investment program. Writing in the final chapter of his well-known book, The Intelligent Investor, Graham states, "...a defensible investment operation could be set up by buying such intangible values as are represented by a group of 'common-stock option warrants' selling at historically low prices.

The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price. At the moment they have no exercisable value. Yet...there is a safety margin present. A sufficiently enterprising investor could...include an option-warrant...in his investments." (ed. note: the book was published in 1949 before today's option market had been invented) One of key reasons futures and options can skyrocket your overall returns is leverage. Simply put, futures and options contracts and exchange regulations are set up to let you buy more with less money. Typically, you'll need to invest only 5 to 10 percent of the face value on a futures contract; the percentage on an option varies, but is generally only a small fraction of the face value of the underlying instrument. This disparity between face value and "margin" (the amount you are required to pay) gives you an incredible amount of leverage. In turn, this leverage can have a powerful effect on your portfolio. Perhaps the best way to demonstrate this leveraging power is through a few highly simplified examples. Example A - Investing Only In DJIA Stocks_______________________________ Let's start with a model investment portfolio of $200,000 invested only in the 30 stocks in the Dow Jones Industrial Average (DJIA). The time frame we'll be looking at is the first half of 1997. This was a period that produced some of the strongest gains in modern history, as well as one of those 10% corrections that make investors nervous, so it's a good time frame for making a comparison. If our $200,000 model portfolio mimicked the DJIA exactly, you would have recorded profits of about $40,000 during the first half of the year a return of more than 20% in six months (see chart). You probably would be quite happy to settle for that in any year. Along the way, you saw your portfolio rise 10% to a peak in March (February if you use the Standard & Poor's 500 Index), then fall a little over 10% in a month's time to put you slightly into negative territory before advancing more than 22% from the April low. All in all, a great performance. Your pattern would have been similar if you had invested your money in a number of individual stocks or in some mutual funds. Of course, if you made your own selections, you might have done much better or much worse, depending on where you invested. For example, one of the fastest growing equity mutual funds in the first half of 1997,

the Vanguard Index Trust 500 Portfolio, was up 27% for the six-month period and has had annualized gains of about 15% for a number of years. Many other mutual funds, however, failed to match the performance of the DJIA or the S&P even in the 1997 bull move. Picking which type of fund to invest in can also be tricky, partly because different business "sectors" have differing growth rates, cycles and trends. Funds invested in real estate reported 35%-40% gains for the year ended March 31, 1997, for example, even though it was only a few short years ago when the real estate market nationwide was in dismal shape. During that same period, the Japanese economy was booming, which caused many investors to put money into international funds that were heavily invested in Japanese stocks. In the first part of 1997, however, Japan hasnt fared so well. Those same investors who bought into Japan just a few years ago would have suffered negative results. Gold-based funds have a similar history: While many were generating double-digit returns in the first six months of 1997, their long-term performance has been pretty dismal. The point is this: If you only invest in equity-based mutual funds, you'd have to be a very astute investor just to match the returns of the DJIA and the S&P Index. If you invest in individual stocks and anticipated the surge in the technology sector in 1997, on the other hand, you might have purchased shares in IBM or Microsoft. IBM started the year in the upper 70s, dropped about 17% to the spring low and then rebounded to 105 by the end of June, up about 35% for the year.

Microsoft had a similar pattern, but did not show a loss at the spring low. From that point, Microsoft rocketed up, hitting 150 in July 76% higher than it was at the start of the year. Those are great gains that would satisfy almost any investor. But what if the stock you chose was Eastman-Kodak? It started 1997 around 80 and followed the market up in February and down in the spring. But, instead of bouncing back as many other stocks did during the sharpest bull advance in history, EastmanKodak fell to about 65 by July, an 18% decline for the year. The bottom line? There is plenty of risk in both mutual funds and individual stocks. You need plenty of market savvy or luck to be invested in the right ones at the right time. There's another, simpler way to enjoy higher returns, however. Do what the world's richest investors do: Take a portion of your portfolio and invest it in futures and options. This will not only multiply your overall returns, but it will do so without adding undue risk. Example B The Powerful Effect Of Adding Futures To The Mix_____________ For the second part of this demonstration, let's say that you divided your $200,000 investment portfolio into two portions: $180,000 is invested in DJIA stocks as above to take advantage of the index basket concept without having to worry about selecting individual stocks The remaining $20,000 just 10% of the total portfolio is placed in S&P 500 Index futures. Using round numbers for our oversimplified illustration, the S&P Index went from about 760 at the start of the year to 830 at the peak Feb.19. Then it sank to 745 on April 14 before surging back up to the 900 level by the end of June. In each case, the percentage return was a point or two below the DJIA, as the blue chips attracted much of the investors' attention in 1997.

Applying the percentage changes in S&P Index points to the $20,000 invested in futures, you'll see some of the biggest positives and negatives of futures. At the first peak, the futures account nearly tripled to $55,000. Then, when the market fell 10%, the account dropped to $12,000, a decline of 37.5% from the beginning of the year, a rather discouraging outlook at that point. But from that low, the account multiplied more than six-fold by the end of June a 287.5% gain for the futures portion of the the portfolio.

10

Moving just 10% of the portfolio into futures rocketed overall returns from 20.7% to 47.4%

Moving just 10 percent of the portfolio into S&P Index futures helped the portfolio gain nearly $95,000 or 47.4% in six months more than double the dollar amount from the portfolio that contained only DJIA stocks!

This is one example of how the power of leverage from just 10% of your portfolio would have made a substantial difference in your total portfolio returns. Who wouldnt like to have those results?!
Table 2-1

Comparison of Model Portfolios With And Without 10% Invested In Futures

Total Portfolio Value At
Start Jan. 1 Feb./Mar. (Peak +10%) April low (-10.5%) June peak (+22.6%) % change for year to date

Dow Stocks Only $200,000 Dow stocks + 10% futures Stocks $220,000 $196,900
(-1.5% from start)

$241,399

+20.7%

$180,000

$198,000

$177,210
(-1.5% from start)

$217,259

+20.7%

Futures* $20,000 Total $200,000 $243,000

(+21.5% from start)

$12,500 $55,000
(-37.5% from start)

$77,500

+287.5%

$189,210
(-5.1% from start)

$294,759

+47.4%

*Futures values based on S&P 500 Index points, where the percentage changes were slightly lower than for the DJIA.

NOTE: There are several things about the returns shown in these tables that you should know: 1. These are simplified examples, based on percentage changes of indexes applied to the portfolio amount and do not include commissions, fees, slippage, or other variable costs. Therefore, the examples shown here may not represent actual net returns on investment.

2. While the initial $20,000 invested in futures would have been enough to cover the margin of one S&P futures contract, it may not have been advisable for an account that small to have been trading S&P 500 Index futures during the time period shown.

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However, nearly every investor can now include a stock index component in their portfolio with the new, smaller index contracts (see Appendix). 3. The return with using futures or options could have been even greater than shown because it is as easy to sell those instruments as it is to buy. If you were short during the April dip and then had the foresight to buy again at the bottom of the dip, your returns would have been somewhat greater. These returns do not reflect any short sales, but this is one of the flexibility features that can make futures and options so attractive to many stock investors. (See Chapter 7 for strategies.)

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Chapter 4

An Enlightened Comparison Between Stocks and Futures

The illustrations in Chapter 3 certainly make futures and options look like an attractive investment alternative for stock market investors. However, before going any further, we need to lay a little groundwork about what futures and options are and how they compare with traditional stock investments. Ask any active investor, you probably already know that futures and stocks have some things in common they both are traded on exchanges, have standardized contracts, can be analyzed technically or fundamentally, etc. However, there are some distinct differences that need to be emphasized so you can understand the role of each in a portfolio. First and foremost, one widely held misconception must be clarified: futures and options are not the equivalent of gambling. They are legitimate investment choices, and they can be used in a variety of ways to give you as little or as much risk as you want.

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Every investment area has its risk spectrum, even stocks, and it can vary widely within an area. The risk spectrum on blue-chip stocks, for example, is not the same as that of a penny stock. An investment in Coca-Cola or General Motors is not the same as putting your money into the latest hot, new initial public offering or into shares in some long-shot, high-flier company. If you invest in blue-chip stocks your aversion to risk may keep you away from many other stock possibilities. But even a blue-chip stock has its risk. If Microsoft is at 150 and loses 15 points in a day and it has happened that's a 10% decline in the value of the stock in one day. If you own 100 shares, that's a loss of $1,500, a sizeable blow for almost any pocketbook. And that's not even mentioning stocks hit by some traumatic event that causes mammoth one-day plunges. Of course, stocks like IBM or many others in the technology area also make large one-day gains. The risk/reward profile for stocks is like most other investments (see diagram): If prices go up, you win the higher, the better. If prices go down, you lose the lower, the more you lose if you even hang on to the stock. The same risk/reward profile applies to futures and options, but as you will see, you have many ways to modify this profile by including futures and options in your portfolio. One of the primary functions of the stock market is to transfer capital: Those who have capital are willing to invest it in those companies that need it to develop a business that can turn out products or services that they need to market at a profit. For your investment, you own a piece of that company and participate in its success when it distributes dividends or when the value of its stock appreciates. You are an owner of property with the right to vote on what happens to it. The irony of associating risk and gambling with futures is that one of the primary functions of the futures market is to transfer risk.

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Someone who has actual risk but does not want it a farmer with a field of wheat or a mining company with a copper pit, for example is willing to transfer its risk of doing business to someone willing to take on that risk with the prospect of profiting from favorable price changes. The exchanges serve as giant auction places to discover the price at which both parties are willing to transfer this risk. In this market, no property changes hands at the time of the transaction, only a legally binding commitment to fulfill the terms of a contract at a later date. The table on page 18 summarizes some of the main differences between stocks and futures. However, because the purposes of these two investment areas are so different and because they often use the same terms to mean different things, it is important to highlight several key features first before showing you why you might want to incorporate stock-related futures and options in your portfolio. Nature of the markets When the price of a stock increases, the total value of the company increases and every stock owner shares in that gain. Therefore, most stock market investors are all smiles when they hear about an up market. The futures market, on the other hand, is a zero-sum game that is, for every dollar someone wins, someone else loses a dollar with the amount taken in by brokers and exchanges, reducing the total pool of profits that goes to the winners. That's one reason it often is more difficult to make money in the futures market.

Time The buy-and-hold strategies that work in stocks do not work with futures or options because futures and options contracts have an expiration date. In many cases, the time period is less than a year and, often, only a few months. When you buy a stock, you can think about a long haul of months or years. When someone talks about a September Standard and Poor's 500 Index futures or options contract, it means that whatever you expect to happen in the market better happen by September because that contract will cease trading at that point. Because of this constant time pressure, involvement in futures or options is usually called "trading" whereas involvement in the stock market is "investing.

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Selling "short" Futures, and especially options, require knowledge of some concepts that are different from stock or other "traditional" investments. For many investors, one of the most difficult to comprehend is, "How can I sell something I dont own?" or "How can I buy the right to sell?" But, with futures, it is as easy to sell as to buy, and there is no difference in risk. With options, you have a few more wrinkles to consider, but selling or buying can be done just as easily. Margins There really should be different words for each market for this term. "Margin" in stocks is the down payment you make to buy shares; it must be at least 50% of the value of the stock. You owe the rest, and the entire price goes to the seller. "Margin" in futures is more like a security deposit or a bond or earnest money that is deposited with the broker, not the seller, to signify that you will perform your side of the contract. Typically the margin required to open a trade is slightly less than required to maintain a trade. In both cases, however, the margin may amount to no more than 2%-7% of the total value of the contract. Leverage Because the margin you put up for futures or options is so low relative to the value of the contract, your leverage is high. You control a contract valued at many thousands of dollars for only few thousand dollars in margin money. Consequently, a small change in price can cause a huge percentage change in your margin account. It is this feature of the futures and options trading that often produces the horror stories you hearbut it is this same feature that provides the opportunities you are seeking as an active investor. Perception There seems to be a vast gulf between the public perception of "legitimate" investments in stocks and bonds and the "gunslinger" image that many, including the mainstream media, have of futures and options, despite the flexibility that futures and options can bring to an investment portfolio. You may have been led to believe, "The more a market moves, the riskier it is." That may be true with some investments but, with the power of leverage provided by futures and options, you'll soon learn, "The more a market moves, the more opportunity it offers." So why havent you heard positive things about futures and options? First and foremost, most brokers are licensed to deal in stocks and mutual funds, not futures or options. There are different tests and different registrations required for brokers in each area, and the vast majority of brokers handle only stock investments because that's where most of the investment money is.

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If you go to the Merrill Lynch site on the Internet and click on the icon for "Investment Dictionary," you will find a list of investment terms and concepts, some of them a little complicated. But you won't find a listing for "futures" or "options." Obviously, that's by design because the company wants customers in investments perceived to be "safe" and traditional. If your broker can sell you stocks but can't do business with you in futures, guess what type of investment they are likely to stress? And guess what type of investment you are likely to hear horror stories about, even though some of the scandals get tagged with labels such as "derivatives" or "options" or "speculation" when they should be called "fraud" or "scam" or "scheme" because they have nothing to do with legitimate futures and option trading?

Stocks vs. futures

This table compares some of the main features of stocks and futures. Both have options, which have the characteristics of the underlying Instrument, so options are not included here. Stocks
Main Purpose Contract Contracts Available Life of contract Margin Short selling Main risk concern Trading limits Commissions
Capital formation Standardization Fixed for each stock

Futures
Price Discovery; risk transfer Standardization

Unlimited Limited to specific month; Indefinite in most cases sometimes very short-term Down payment; minimum 50% Performance bond/security deposit; of stock price Typically 2%-7% of contact value Possible but difficult; unlikely Yes, as easy as going long for individual investor Company viability, High leverage due to small margin performance; relative to contract value market risk Daily price limits, position limits Usually none but depends on for some contracts circumstances Per share Per contract

Source: Futures Industry Associates

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Chapter 5

10 Good Reasons To Invest In Futures And Options

The Previous chapters explained the characteristics of futures and options and some of the stock-related contract choices you have. Chapter 3 provided some illustrations of returns during the first half of 1997 and why you might get excited about including futures and options in your investment portfolio. But the flexibility provided by futures and options to achieve investment objectives goes well beyond that. We will save the specific strategies for using stock-related futures and options in various circumstances for the next two chapters, but there are at least 10 ways they can help you accomplish what you want with your stock investments.

1. Enhance stock market returns._____________________________

The illustration in Chapter 3 showed how using only a small portion of your investment funds to buy futures or options in a rising market could boost your leverage and kick up your portfolio's profits substantially. But that is only one way you can use futures or options to improve your investment results. Because it is as easy to sell as to buy in the futures and options market, you could also use these contracts to capitalize on a downturn in stock prices, or you could sell options in a stagnant market. You can also use options to help you acquire stocks at a price below what you see listed in the newspaper, giving you a lower base from which to make more money if they go up. The added benefit is that futures and options can do this while letting you select the level of risk you are willing to assume and reducing the total risk you would have from a straight stock purchase. In any kind of market condition, futures and options give you the possibility to increase your portfolio performance. See Chapter 7 for strategies.

2. Hedge or insurance protection._____________________________

Let's assume you are one of those wise investors who put your pension fund or IRA money into stocks or mutual funds over the last 15 years and watched your college fund or retirement nest egg grow into a sizeable sum.

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Based on what you have seen in the last few years, you think the stock market will continue to go up and preserve your hard-earned gains. But what if it doesnt? When you make a significant investment in a house or a car, one of the first things you do is find a way to protect against losing it in fact, your lender may require you to do so. But how about your investment funds? Futures and options can be used to set up a type of insurance policy against downside risk without forcing you to give up the potential for unlimited upside profits. You can even set up the amount of the "deductible" you want on this insurance.

3. Provide exposure to the whole market._______________________

Let's assume you have a substantial holding in one company or a small group of companies. Perhaps you think the move in those stocks has about played itself out or, for some reason, decide that you would rather be invested in the broader stock market. Your account may not be big enough to buy all the stocks in S&P 500 Index or some other broad-based index, but you can use futures and options to gain this exposure to either up or down moves in the stock market as a whole, depending on your analysis.

4.Provide exposure to a sector of the stock market.______________

Conversely, you may have a broad range of stocks and mutual funds but decide that the hot place to be is in technology stocks or maybe the bank stocks, at least temporarily. Or you may want to increase your holdings in one sector of the stock market at the expense of another, or you may simply want to focus all your investment money on one sector. You can trade the NASDAQ 100 Index or the Semiconductor Index or the Bank Index or one of the dozens of other narrowly focused index futures or options contracts to shape your market exposure to match your investing philosophy and strategy. You can accomplish some of these same objectives with mutual funds, but futures and options can yield a greater return more quickly and you dont have to rely on some money manager to include the right stocks in their sector fund.

5. Reduce analysis and guessing on stocks.______________________

In the previous two items, you knew how you wanted to adjust your exposure. But assume you dont know much about individual stocks except for that tip your brother-in-law gave you and decide to do some research.

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That means you have to study the earnings, p/e ratios, sales, management, etc. for hundreds of companies to find the single stock (or stocks) that look good to you. Then you have to be sure it's in a sector or portion of the market that's doing what you expect. Then you have to be right about the market as a whole; if the tide of the market isnt in your favor, your stock isnt likely to go very far against it, even if you've picked the best stock. Stock picking is not an easy thing to do. That's why mutual funds have become so popular. You can use futures and options in much the same way to position yourself in the market without having to analyze all those individual stocks.

6. Maintain a stock portfolio through difficult or uncertain periods.

Let's say you finally have done all your research and have put together the portfolio of stocks you really want to keep for the long term because you are convinced they will move higher. But the stock market hits a weak spell and is threatening to go lower still. Or the Federal Open Market Committee meets next week, and you are worried the Fed will take some action that could dampen the market as a whole, weighing on the price of your stocks even though their fundamentals seem to be solid. Or Congress appears to be intent on passing a "revenue enhancement" (tax increase) or some other bill that could send the whole stock market into a tailspin. You could sell off some of your stocks, but you dont want to break up your portfolio for what you expect to be a temporary blip or for something that may never happen. Instead of selling your stocks, you could keep your portfolio intact by using futures or options to capitalize on a temporary setback in the stock market or to protect yourself against a worst-case scenario. You might need this protective position for only a few days until the danger is past, but it could help you preserve your portfolio. The same tactic could apply to an individual stock. Instead of dumping it during a period of adversity or when you think a news event such as an earnings report might be negative, you could keep the stock for the long haul by using options for temporary protection.

7. Replace cash transactions._________________________________

Let's say your situation is the opposite of the examples above: You have no stock portfolio but, suddenly, you have come into a sum of moneyyour old company

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downsized and you received a lump-sum severance payment, youve gotten a bonus for signing with the New York Yankees, you received an inheritance, you won the lotteryor whatever. In any case, you have an amount of money you know you want to put into stocks but you dont know which ones. You expect the stock market will go up and you want the money working for you there rather than sitting in a money market account. As a temporary agreement for a future transaction, futures and options can be used to get you into the stock market quickly to gain the exposure you want as well as protect you once your portfolio is in place.

8. Reduce the net price of a stock._____________________________

Again, assume you have the funds to buy a stock but you want to buy it at "your" price. You can let the market come down to your price, but the chances are it may not and the opportunity to buy the stock gets away from you. A strategically placed options position can help you have your order in place to buy at a lower price while you take in profits if the stock doesnt get that low. This tactic reduces the net cost of the stock and lowers your break-even point. You can also use options to add value to the stock beyond its current price quote when you sell. Either way, you may be able to get a better deal on the price of stocks than with an outright stock purchase.

9. Transfer risk quickly.____________________________________

Regardless of what you want to accomplish, you can transfer your risk in seconds with a trade in the futures or options market. The key, of course, is liquidity. Not all stock-related futures and options contracts have a sufficient volume of trading activity to get you into or out of a position efficiently. However, contracts such as the S&P 500 Index or S&P 100 Index or many of the larger companies with options available on them have a volume of thousands of contracts every day so you should be able to execute a transaction about any time you want during the trading session and get a fill close to the current price you see listed. The major stock index futures and options markets can handle even huge orders quickly and efficiently so you can modify the risk/return of a whole portfolio with just one trade that takes only moments to complete.

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10. Cheaper transaction costs.________________________________

In addition to speed and efficiency, a futures or options transaction also costs much less to execute than a comparable stock market transaction. If you wanted to take an active role in setting up and unwinding a stock portfolio to deal with changing conditions, the commission costs would be prohibitive. Using futures or options to make these temporary adjustments in exposure will cost you less than $100 per contract (depending on your broker, type of account and the level of your activity). You get more bang for your buck not only from the leverage offered by futures and options but also from your brokerage commissions.

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Chapter 6

How To Become A Good (i.e. Profitable) Futures And Options Trader

Futures and options can add so much flexibility to an investment portfolio that it would take a much bigger book than this one to cover all of the possibilities. This introductory volume only touches on enough of the basics to show you how useful these contracts can be and to pique your interest to learn more about them from other sources. We need to preface a discussion about futures and options strategies by reemphasizing a few concepts and elaborating on some of the major terms you need to understand before moving on to the strategies. 1. With many investments, you have one essential decision: Will the price go up? If you think it will, you buy it now and sell it later for a profit. Most people buy stocks or houses that way. With futures and options you can sell as easily as you can buy if you think the price will go down, sell now and buy back later. You pocket the difference as your profit. That's not always an easy concept for everyone to grasp, because it just doesnt apply to any other investment vehicles they're familiar with. (You can't look around the neighborhood and sell houses that you dont own, for example, so how can you do so in the investment markets? It has to be wrong!) 2. Futures and options require a three-tier evaluation of the market: First, you have to form some opinion about the price outlook for the underlying instrument. Whether the underlying is an individual stock, a stock index or a futures contract, you need to make a judgment: Will it go up, down or sidewaysand how fast will it make its move? If you conclude you have no idea what might happen, even that uncertainty can be used to help you structure your investment plan. Second, you need to determine which trading instrument is right for you. Futures and options have different risk/return characteristics, and you need to know them well enough to see what fits your situation best and what amount of your portfolio you are willing to commit to them.

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Third, once you have selected the trading instrument with which you are comfortable, you need to evaluate time and price to decide which specific contract you should use to capitalize on your market opinion. You have lots of choices, depending on how strongly you feel about your market bias and the trade off you are willing to accept between risk and return. Note: You can be absolutely right about the direction of the market but still lose money in futures or options. Or, conversely, you can be absolutely wrong about the market and still make money if you construct your position properly. This third tier of evaluation the contract you choose can be critical to your success. 3. Time is a major factor in futures and options. Every futures or options contract is a temporary substitute for a later transaction, and every contract has a limited life. What you expect to happen to the underlying asset's price must happen within the duration of that contract's life or your market analysis means very little. That life may be only a few months, although it can be stretched to more than two years with longer-term options such as LEAPS (Long-Term Equity AnticiPation securities). This short-term lifetime feature means that, with futures and options, you have to develop the approach of a "trader" and not a buy-and-hold "investor." Generally, that means you also have to be prepared for a more active trading life than if you were buying stocks or mutual funds, although the time you spend on analysis may be less.

Futures concepts_______________________________________________________ The risk/return diagrams for futures are pretty straightforward. Like most investments, if you buy at Point A and the price subsequently goes up, you make a profit; if the price goes down from your entry at Point A, you lose money. Similarly, if you sell at Point A remember, that's as easy to do as buy in the futures market and the price goes down, you profit; if the price goes up, you lose. As we illustrated in earlier chapters, the leverage you get with futures can magnify the size of these changes in your account. If you are required to have $20,000 in margin to trade an S&P 500 Index futures contract and the market goes up or down 20 points, the $10,000 move is only about a 2% change in the value of the contract but it's a 50% return or a 50% drawdown for your account. That can be very good for youor very bad, depending on your position.

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The other notable thing about futures is the time element. If you are trading a March S&P 500 Index futures contract, that means it expires on the third Friday of March. At that point the contract is history, and all differences in positions between buyers and sellers are settled in cash there are no long-term considerations or buy-and-it-willeventually-go-up decisions here. The same is true for the other index contract "months" of June, September and December.

Options concepts_____________________________________________________ While both buyers and sellers have equal obligations in the futures market, only the seller has an obligation in the options market. The extent of this commitment depends on several important factors: Strike price (or exercise price) the price at which the underlying asset could be purchased or sold. If the S&P Index is at 920, you might have strike prices in 5-point increments ranging from 800 to 1,000 for example, 900, 905, 910, 915, 920, 925, 930, etc. At-the-money option the strike price is close to the value of the underlying asset in this case, the 920 strike price. In-the-money option (1) the strike price of a call option is below the value of the underlying asset with the underlying index at 920, a call with a strike price of 910 would be 10 points in the money. (2) the strike price of a put option is above the value of the underlying asset with the underlying asset at 920, a put with a strike price of 930 would be 10 points in the money. The amount that an option is in the money is called the options "intrinsic value." Out-of-the-money option (1) the strike price of a call option is above the value of the underlying asset with the underlying index at 920, a call with a strike price of 930 would be 10 points out of the money. (2) the strike price of a put option is below the value of the underlying asset with the underlying asset at 920, a put with a strike price of 910 would be 10 points out of the money. An out-of-the-money option has no "intrinsic value" but it does have "time value" that depends on the time remaining until the option expires. Premium or option price the amount you pay to buy an option or the amount you receive to sell an option is based on the sum of intrinsic value and time value. The more "in the money" or the longer the time period during which prices could change, the higher the price of the option.

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Volatility the fluctuation in price changes of the underlying asset. Price action may become volatile at times, and more time to expiration means more opportunity for wild price action to occur. Option premiums may inflate or deflate just because of volatility changes. Delta the price change of the option relative to the price change of the underlying instrument. An index futures contract has a delta of +100 if you are long or -100 if you are short. If the S&P 500 Index futures price moves up 10 points and the price of an options contract only moves up 5 points, it has a delta of +50. Every options contract has a delta to express its price change vs. the underlying instrument's price change. A major options strategy to control risk is to have a combination of options that produce a "delta neutral" market position. Picking your instrument______________________________________________ Whether you choose futures or options or some combination to help you structure your stock market portfolio will depend on how much risk you want to assume and how much return you are willing to give up to achieve a risk profile that is comfortable for you. You may choose some combination of trading instruments to modify your risk/reward exposure, but you begin with essentially three choices for either a bullish or bearish bias. Table 6-1

Your Investment Choices, If

You believe the You believe the market will go market will go up down Buy futures Sell futures or or stocks stocks Buy call options Sell put options Buy put options Sell call options Risk Unlimited Limited Unlimited Reward Unlimited Unlimited Limited

Looking at Table 6-1, you might come to a natural conclusion: Only buy options because they give you limited risk and unlimited profit potential. However, keep in mind that options pricing is like a huge actuarial study based on Black-Scholes and other mathematical models that calculate fair value based on time to expiration, strike price, volatility of underlying price movements and other factors.

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Option sellers tend to be commercial or professional traders who act like an insurance company granting a policy for a premium paymentand you dont see too many insurance companies willing to write policies at a loss. Options buyers do win when underlying price move is big enough, but the money in options trading is usually made on the writing or selling side. If you are convinced the price will go up________________________________ You could buy individual stocks or a broader group of stocks via a mutual fund or a relatively new long-term unit investment trust such as SPDRs (S&P Depository Receipts). Or you could put money into an index futures contract and tap into the power of leverage, which can produce much larger profits for every dollar committed. You can buy a call option on a stock, an index or an index futures contract. Buying a call gives you the right, but not the obligation, to be long at a specified price. Like the first choice, this offers you unlimited profit potential, but your risk is limited to the amount of premium you pay for the call. Or You can sell a put option on a stock index or an index or an index futures contract. Selling a put limits your profit potential to the amount of premium you receive and also gives you unlimited risk if the price of the underlying instrument plunges below your strike price. In many cases, you may sell a put not so much because you believe the price of the underlying is going up but because you believe the price will not go below a certain level.

If you are convinced the price will go down____________________________ You could buy a mutual fund that specializes in selling short, but because of 150% margin requirements and other factors, it is not likely you will want to be short stocks or SPDRs. You can sell an index futures contract as easily as you can buy one and, again, take advantage of the power of leverage to get more return for dollar committed. Your profit potential is unlimited but, remember, so is your risk. You can buy a put option on a stock or an index or an index futures contract. Buying a put gives you the right, but not the obligation, to sell at a specified price you buy the right to be short. If the underlying price plunges, you have unlimited profit potential, but your risk is limited to the amount of premium you pay for the put. Or

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You can sell a call option on a stock or an index or an index futures contract. Selling a call limits your profit potential to the amount of premium you receive and you also have unlimited risk if the price of the underlying instrument should surge beyond your strike price. In many cases, you may sell a call not so much because you believe the price is going down but because you believe the price will not go above a certain level.

If you are convinced the price will move sideways_______________________ Traditional thinking suggests that, if the price isnt going anywhere, there isn't much reason to buy or sell a stock or a stock index. As Will Rogers expressed the thought in the 1920s, "If a stock doesnt go up, dont buy it." That is true with futures as well as with stocks. However, you can use options to produce profits even in a stagnant market that remains flat for an extended period. If you can identify a price range, you can sell a call option at a strike price above the top of the range and sell a put option at a strike price below the bottom of the range and collect premiums from both sides as long as the price of the underlying asset remains within that range. Of course, there is always the possibility the price could break out of the range, exposing you to unlimited risk, but there are a variety of methods to use other options positions to mitigate that risk should you detect the start of any price move outside the range. Some traders limit their risk exposure by setting up a "delta neutral" position. For example, if they are long futures, which have a delta of +100, they could offset this exposure by selling the futures contract (-100 delta) to leave them with a delta of 0 because they have no position and no exposure. They can also offset the long futures position by buying two puts that have a delta of -50 each or by selling two calls that have a delta of -50 each. Deltas change constantly, depending on strike price, time to expiration and volatility. In fact, changes in volatility alone can be used to set up profitable options strategies. Professional traders buy low volatility (deflated premiums) and sell high volatility (inflated premiums) because they know the price of the option will adjust if a market heats up or cools down, even though the underlying asset price may not move all that much.

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Positioning for market conditions_____________________________________ Don Fishback, president of Fishback Management & Research and Fishback Financial Engineering and author of numerous resources on options trading, points out in his book, Options for Beginners (Not Dummies), "Over the past 10 years, the stock market has gone up or down more than 5% in a month only 15 times! In other words, if the S&P 500 Index was at 600 at the beginning of the month, in order for it to move up or down more than 5% in a month, it would have to be above 630 or below 570. Of the 120 months during the past 10 years, such a move out of that range occurred only 15 times! That's only 12.5% of the time. That means the S&P stayed within a 5% range 87.5% of the time!! That final figure is critical. Because it means that if we can find a strategy that makes money as long as the market stays within that range, we will automatically have a strategy that has, historically, made money 87.5% of the time! If you had an 87.5% success rate in your investments, think what that would do for your bottom line. Using options, Fishback created a methodology that uses volatility, basic statistical tools such as standard deviation, and probability theory to spot trading positions that win 90% of the time without guessing market direction. Of course, there is a little more to investing than that, and no one can guarantee 90% success. But, it is just one example of how options can be used to potentially improve a portfolios performance in any market condition. Larry McMillan, president of McMillan Analysis Corp., presents dozens of other strategies and real-life examples in his best-selling books on options. One topic he covers is "equivalent positions" two strategies having the same profit and loss potential. "Just because two strategies are equivalent doesnt mean they have the same rate of return," he explains in McMillan on Options. "For example, the cost of buying a call is far less than the cost of buying both 100 shares of stock and buying a put." Later, McMillan notes, "using options can actually make your use of capital more efficient than merely trading stock." Once you have looked through this book and seen how futures or options might be beneficial in your portfolio, you may want to explore one of the courses or books or videos on these subjects.

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Chapter 7

Practical Options Strategies

Options can be used in many different ways to tailor your investment program; we will look only at a few possibilities. The concepts apply to options on stock indexes, index futures or individual stocks, but you should understand them thoroughly and have all the risk/reward parameters outlined for you before you jump into any options position. Keep the following factors in mind as you go through the examples: Prices mentioned are for illustration purposes only and may not reflect reality in the marketplace. After the initial purchase, "stock price" indicates price at the time when the options expire. Be aware of liquidity: Some contracts may not have sufficient volume to get in or out of a position efficiently. Examples do not take into account such important items as interest you may earn on the cash in your account, dividends you earn from stocks you own and commissions.

Bullish call_________________________________________________________ Situation: Stock priced at $45, and your analysis suggests it could go up at least $5. You have $22,500 to invest and would like to buy 500 shares, but you are reluctant to put all your money into one stock. You can control 500 shares if you use options, however. Here's how your investments would compare with various prices at the time the options expire in a few months...

Buy 500 shares at 45

Stock price Value of stocks Change in value Return on investment

Buy five 45 calls at 4 each

Option price Value of options Change in value Return on investment

45 52 47 40 35

$22,500 $26,000 $23,500 $20,000 $17,500

Initial Purchase +$3,500 +15.6% +$1,000 +4.4% -$2,500 -11.1% $5,000 -22.2% 30

4 7 2 0 0

$2,000 $3,500 $1,000 $2,000 $2,000

Initial purchase +$1500 +75% -$1,000 -50% -$2,000 -100% -$2,000 -100%

Whatever investment vehicle you use, it obviously is always nice to be right about the direction of the market when you make your initial decision. When you bought options at 4, it means you assumed the price at expiration would be at least $45 (your strike price) plus $4 (the premium you paid for the right to be long at $45). Once the price is above the 49 break even point, your options make as many dollars as the stock purchase and a significantly higher percentage return. If the price at expiration is between 45 and 49, you lose some of your initial investment. If the price drops below 45, you lose all of your premium. But keep two things in mind: (1) The total premium ($2,000 here) is the most you can ever lose in this investment whereas you could lose much more in stocks if the price continues to decline further. (2) You still have $20,500 left that is not at risk and is earning interest, which would boost your return with options. You could use that to buy more shares at a lower price. Covered call_________________________________________________________ Situation: Same as above but you dont think the stock will move up $5 in the near future. You are interested in the stock as a longer-term hold, and you would like to receive the dividends. However, you also are concerned the stock price could work lower in the interim.

Sell five 45 calls at 4 each

Stock price 45 Below 45 Impact on investment Initial amount you receive from call sale = 5 * 4 * 100 = $2,000 You still own the stocks and keep the entire premium, which reduces your break-even price for the stock to 41; you could sell another call and repeat the process The stocks are "called away" from you at 45 but you get $22,500 for the stocks plus any options premium remaining if the stock is below 49; at 47 for the stock, for example: 4 (what you received initially) 2 (pay to buy back call) = 2 or $1,000 = 4.4% return

Above 45

This "covered call" strategy limits your upside potential but gives you down-side protection. If the price of the stock goes down, the premiums you received for the call lower your break-even point; if the price of the stock goes up, you have specified the profit you will receive but give up the right to gains beyond a certain point. In the meantime, you are collecting dividends while you own the stocks, which is not included in the return above.

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Cash-Secured Put____________________________________________________ Situation: Same as above except the stock price is wavering around 47 and you dont want to pay more than 45. You put in a limit order to buy 500 shares at 45. At the same time you sell five 45 put options at 2. This strategy helps you get your stocks at a price you set and lowers your break-even price. If the stock price makes a big decline, it won't you happy in either case, of course, but instead of your losses beginning at 45, they begin at 43 due to the premium you received from the put sale. You can also use a variety of combinations selling both calls and puts to refine the amount you pay for the stock or to alter your break-even point.
Stock price at expiration Stays above 45 Below 45 Action in options No stocks; keep premium. 2 * 5 * 100 = $1,000 The stocks are "put" to you at 45. Subtract the premium you receive and your net price is 43.

Action in stocks No purchase; limit order still open. You own 500 shares at 45, which is the price at which you wanted to own them all along.

Protective Put_________________________________________________________ Situation: Same as above but now you own the stock at 45. You want to hold the stock long-term, collect the dividends and keep open the possibility of unlimited gains. However, you are a little nervous about the market and don't want to see your stock price deteriorate to a level below what you paid for the shares. So you decide to buy some "insurance" in stocks, that means buying put options to protect stocks you have purchased without limiting your profit potential. Just as in the insurance world, the amount you pay for put options to cover you in case of loss depends on the size of the "deductible" you want. Buying the 45 puts cost a little more, but it gives you the right (but not the obligation) to sell your stocks at 45, the price you originally paid. The put at 40 costs less because your coverage starts at a lower level and you have more money at risk. Your choice of put depends on the risk you want to bear. As with other option strategies, there are a number of ways to use puts to ride the market up and protect profits while you maintain your hold on the stock.

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Stock cost Put options cost Total cost (Stocks + insurance) Amount at risk

No options 45 (500 shares = $22,500) 0 45 ($22,500) $22,500

Buy five 45 puts at 3 45 (500 shares = $22,500) 3 (3 * 5 * 100) =$1,500 48 ($24,000) 3 ($1,500)

Buy five 40 puts at 1 45 (500 shares = $22,500) 1 (1 * 5 * 100 = $500) 46 ($23,000) 6 (6 * 5 * 100 = $3,000)

LEAPS Enhancement___________________________________________________ Situation: You are a conservative person with an even more conservative spouse. You have accumulated $50,000 to invest. You have watched stocks go up and up over the years and have now concluded that maybe they'll continue to go up and you should have some of your money in stocks. But you're not sure. Your spouse is even less sure. You do agree you dont want to pick individual stocks but would like to invest in the market as a whole. One of the complaints about options is that they are too shortterm, often lasting only a few months at most. But a number of stocks and stock indexes also have *LEAPS Long-term Equity AnticiPation
Choices You finally convince your spouse to put a small portion of your assets in a stock market investment "but you better not lose it!" The amount, however, is hardly significant enough to make much money, even if you pick the right stocks or mutual fund. Invest $47,600 in 2-year S&P 100 Index at 92. T-notes at 5 % Buy two 2-year LEAPS* 95 calls at 12 = $2,400 T-note return: $5,298 If S&P 100 goes up 15% per year: 122 95 = 27 pts. 27 * 2 * 100 = $5,400 $5,400 - $2,400 = $3,000 Total earnings: $5,298 + $3,000 = $8,298 Return on $50,000 = 16.6% per year Worst case: $5,298 T-note return - $2,400 options cost = $2,898 = 5.8% Tradeoff: Smaller guaranteed return for opportunity to earn more than 5.5% if S&P 100 rises at least 8 % per year

Safe T-notes

Invest all $50,000 in 2-year T-notes at 5 %

Total T-note return: $5,500 Total earnings: $5,500 Return on $50,000 = 5.5% Gain locked in for two years but also eliminates possibility for larger gain

Securities that go out two years or more, even to the year 2000! Here's an example how you can use them. You can put most of your funds into your safe investment and use only a small fraction of your money to buy LEAPS that will enhance your total return as long as the

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stock market goes up a minimal amount the higher the stock market goes, the higher your total return. That gives you the opportunity to participate in a rising stock market at the same time your total risk is limited to the amount you paid for your LEAPS. Even if the stock market crashes, you are only out the LEAPS premium and you still have a guaranteed return (see table on previous page). LEAPS Protection____________________________________________________ Situation: You are the same conservative person with the even more conservative spouse as above. In this case, you have accumulated $50,000 in stocks already, but after watching stocks go up and up over the years, you have concluded the stock market could fall over the next two years. But you're not sure. And you know what your spouse will say if you lose any money.
Choices Do nothinglet The market do what it will All $50,000 at risk If S&P 500 drops 10% per year, $50,000 - $9,500 = $40,500 Sell all or part of your stocks (But what if the Market goes up?) Sell right, do all right; sell bad, be sad You finally convince your spouse you need to get some "insurance" on your stock market investment S&P 500 Index at 94 $50,000/($94 * 100) = 5 puts (rounded off) Buy five 2-year LEAPs* 90 puts at 7 = $3,500 If S&P 500 drops 10% per year, 94 -18 points = 76 90 - 76 = 14 points * 5 * 100 = $7,000 Earnings from five LEAPS = $7,000 - $3,000 cost = $3,500 Protected portfolio loss = $9,500 - $3,500 LEAPS Gain = $6,000 net loss still a loss but you have a cushion or floor for your portfolio if the S&P 500 Index falls more than about 6% per year If S&P 500 Index gains 10% per year, $50,000 + $5,000 + $5,000 = $60,500 - $3,500 cost of "insurance" = $57,000 = 14% return Your return is smaller because you have to pay for your "insurance" but you have the comfort of knowing it is there to protect you against catastrophe

Unprotected portfolio loss = $9,500

?? How good are you at timing?

If S&P 500 Index gains 10% per year instead, $50,000 + $5,000 + $5,000 = $60,500 = +21% return

You are out or partially out

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Appendix
Key Terms For Traders__________________________________________
Active investors must know a number of market terms and phrases. Here are a few key ones if you are involved in the futures or options markets. Bear, bearish trader who believes prices will move lower. Bull, bullish trader who believes prices will move higher. Call option that gives the buyer the right, but not the obligation, to purchase a specified underlying instrument at a specified "strike" price for a specified period of time. Contract (or delivery) month month in which a futures or options contract expires when the terms of the contract may be satisfied by making or taking delivery of the physical product or by cash settlement. Delta a measure of how much an option price (premium) changes relative to the price change of the underlying instrument. Fundamental analysis analysis of all factors that may move prices, such as supply/demand, production, earnings, sales, etc. Futures an exchange-traded standardized contract specifying time of delivery or settlement, quantity, quality and other terms of an agreement between buyer and seller. The only variable is price, which is "discovered" in "open outcry" auction trading on an exchange floor or on a bid-ask basis in electronic markets. Intrinsic value value of an option when the current price of the underlying instrument is above the strike price of a call option or below the strike price of a put option. The price (or premium) of an option is based on intrinsic value and time value. Margin (in securities) buyer's equity interest in a stock, with the unpaid balance owed to the seller in a specified period of time. Minimum set by Federal Reserve Board. Margin (in futures) earnest money or security deposit a customer places with a broker for each contract to show "good faith" to fulfill terms of the contract. Not a down payment. Minimum set by exchange and must be maintained as prices fluctuate.

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Option a contract that conveys to the buyer the right, but not the obligation, to buy or sell the specified underlying instrument at a specified price for a limited period of time. Only option sellers (also known as "writers") are obligated to perform if a contract is exercised. See "Call" and "Put". Put option that gives the buyer the right, but not the obligation, to sell a specified underlying instrument at a specified "strike" price for a specified period of time. Premium the price paid or received for an option. Stop an order to exit or enter a position at a specified price. A stop may be used to limit losses or take profits although there is no assurance the position will be taken at the specified price. Technical analysis analysis of price movement on charts. Strike (or exercise) price price at which an option can be exercised. A strike price can be "at-the-money" or very close to the price of the underlying instrument, "in-themoney" if it has intrinsic value or "out-of-the-money" if it has no intrinsic value (see "intrinsic value").

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