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.
1
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




2
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.






3
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.
4




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.

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 J ones 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



George Soros
Controls So Much
Money, Hes Been
Accused of
Deciding the
Economic Fate of
Entire Nations!
5
Larry Williams made
a trading profit of $1
million in one year,
then wrote a book
about it. Many were
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!


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
traders: winners and losers. You don't have to be
particularly brilliant or have an unbeatable system or
work hard at analyzing markets to be a successful
trader, he will tell you. All you have to do is watch
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.
6

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 J ack 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 inner-
city 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...

7


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 arched-
eyebrow 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.



8



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 J ones 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 DJ IA 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,
9


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 DJ IA 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 J apanese economy was booming,
which caused many investors to put money into international funds that were heavily
invested in J apanese stocks. In the first part of 1997, however, J apan hasnt fared so
well. Those same investors who bought into J apan 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 J une, up about 35% for the year.
10

Microsoft had a similar pattern, but did not show a loss at the spring low. From that
point, Microsoft rocketed up, hitting 150 in J uly 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, Eastman-
Kodak fell to about 65 by J uly, 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 over-
simplified 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
DJ IA, 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 J une a 287.5% gain for the futures portion of the
the portfolio.

11
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

$220,000

$196,900
(-1.5% from
start)

$241,399

+20.7%
Dow stocks +
10% futures
Stocks

$180,000 $198,000


$177,210
(-1.5% from
start)

$217,259 +20.7%
Futures*
$20,000 $55,000
$12,500
(-37.5% from
start)

$77,500 +287.5%
Total
$200,000
$243,000
(+21.5% from start)
$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 DJ IA.


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.
12
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.)


13

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.


14


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.



15


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.
16

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.


17


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 Futures
Main Purpose Capital formation Price Discovery; risk transfer
Contract Standardization Standardization
Contracts Available Fixed for each stock Unlimited
Life of contract Indefinite in most cases
Limited to specific month;
sometimes very short-term
Margin
Down payment; minimum 50%
of stock price
Performance bond/security deposit;
Typically 2%-7% of contact value
Short selling
Possible but difficult; unlikely
for individual investor
Yes, as easy as going long

Main risk concern
Company viability,
performance;
market risk
High leverage due to small margin
relative to contract value
Trading limits
Usually none but depends on
circumstances
Daily price limits, position limits
for some contracts

Commissions Per share Per contract

Source: Futures Industry Associates
18

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.
19




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.
20


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
21

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.
22

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.
23

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 re-
emphasizing 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.
24

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.
25

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-will-
eventually-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.

26

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
market will go up
You believe the
market will go
down
Risk Reward
Buy futures
or stocks
Sell futures or
stocks
Unlimited Unlimited
Buy call options Buy put options Limited Unlimited
Sell put options Sell call options 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.
27

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

28


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.
29

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.

"J ust 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.
30

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 Buy five 45 calls at 4 each
Stock
price
Value
of stocks
Change
in value
Return on
investment
Option
price
Value
of options
Change
in value
Return on
investment
45 $22,500 Initial Purchase 4 $2,000 Initial purchase
52 $26,000 +$3,500 +15.6% 7 $3,500 +$1500 +75%
47 $23,500 +$1,000 +4.4% 2 $1,000 -$1,000 -50%
40 $20,000 -$2,500 -11.1% 0 $2,000 -$2,000 -100%
35 $17,500 $5,000 -22.2% 0 $2,000 -$2,000 -100%
31


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 Impact on investment
45
Initial amount you receive from call sale =5 * 4 * 100 =
$2,000
Below
45
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
Above
45
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

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.
32

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
Action in stocks
Action in options

Stays
above 45
No purchase; limit
order still open.
No stocks; keep premium.
2 * 5 * 100 =$1,000
Below 45
You own 500 shares at 45,
which is the price
at which you wanted
to own them all along.
The stocks are "put" to
you at 45. Subtract the
premium you receive and
your net price is 43.


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.

J ust 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.
33

No options Buy five 45 puts at 3 Buy five 40 puts at 1
Stock cost
45
(500 shares =$22,500)
45
(500 shares =$22,500)
45
(500 shares =$22,500)
Put options cost 0
3
(3 * 5 * 100) =$1,500
1
(1 * 5 * 100 =$500)
Total cost
(Stocks +
insurance)
45
($22,500)
48
($24,000)
46
($23,000)
Amount at risk $22,500
3
($1,500)
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 short-
term, often lasting only a few months at most. But a number of stocks and stock
indexes also have *LEAPS Long-term Equity AnticiPation

Choices
Safe T-notes
You finally convince your spouse to put a small port-
ion 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 all $50,000 in
2-year T-notes at 5 %
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
Total T-note return: $5,500
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: $5,500
Return on $50,000 =5.5%
Total earnings: $5,298 + $3,000 = $8,298
Return on $50,000 =16.6% per year
Gain locked in for two
years but also eliminates
possibility for larger gain
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

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
34
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
Sell all or part of
your stocks
(But what if the
Market goes up?)
You finally convince your spouse you need
to get some "insurance" on your stock
market investment
All $50,000
at risk
Sell right, do all
right; sell bad, be sad
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,
$50,000 - $9,500
=$40,500

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
Unprotected port-
folio loss =$9,500
?? How good
are you at timing?
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 instead,
$50,000 +$5,000
+$5,000 =
$60,500 =+21%
return
You are out or
partially out
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



35
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.
36

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-the-
money" if it has intrinsic value or "out-of-the-money" if it has no intrinsic value (see
"intrinsic value").