TimingCube - Option holders versus option writers - option writers,option holders,short selling,margin trading ,options investing,buy to open,sell to open

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Signal Update

Current Signal Performance as of

Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500
		QQQQ

Cumulative Returns since First TimingCube Live Signal () as of

Index	Long Only	Long Only with Margin	Long & Short	Long & Short with Margin	Buy & Hold
Nasdaq 100
Russell 2000
S&P 500
QQQQ

Note: QQQQ returns are included for continuity sake.

Market Update

Market action this week was very similar to what we experienced the previous week. After falling on Wednesday following a less-than-inspiring earnings report from Cisco, major indices recovered to finish the week on a strong note. Of particular importance is the fact that the SOX Semiconductor index has broken out to the upside and cleared both its 50-day and 200-day simple moving averages (SMA). This is significant because more often than not, the SOX leads the Nasdaq Composite and the overall market. Positive action for this index is therefore good news. Both the Dow and the S&P 500 finished the week at their highest close of the year and have therefore recovered all of their January losses. The S&P 500 gained 0.30% on the week, while the Nasdaq 100 and the Russell 2000 finished with mild losses of 0.26% and 0.29%, respectively.

There is no change as far as our Model is concerned and our Buy signal consequently remains active.

Trend Timing School

Option holders versus option writers

The primary intent with our series of articles on options trading is to introduce our subscribers to an alternative way to implement all four of the TimingCube strategies in retirement accounts, and overcome the fact that short selling and margin trading are not allowed in such accounts. Probably the hardest part in explaining - or understanding - options trading is to grasp the roles of the protagonists in the respective option transactions. The fact that there are two types of sale transactions, and that sometimes the option writer is also called the option seller, only adds to the confusion.

In the two types of transactions described in last week's "Implementing the TimingCube strategies with options" article, buying calls or puts and subsequently selling those same calls or puts, we are always the option holder. All four strategies can be executed without ever having to write an option. With options, as with all investment activities, there are opening transactions that are used to establish a new position, and closing transactions to liquidate existing positions.

Opening transactions:

Buy to open: the purchase transaction by which an option holder establishes a position
Sell to open: the sale transaction by which an option writer establishes a position

Closing transactions:

Sell to close: the transaction in which the option holder makes an offsetting sale of the identical option he purchased before
Buy to close: the transaction in which the option writer makes an offsetting purchase of the identical option he wrote (sold) before

Another way to put it is that closing transactions cancel out an investor's previous position as the holder or writer of that option. Note that closing transactions must happen prior to the option expiration.

In options vernacular, the option holder is also said to be long the option, and the writer is said to be short the option.

We intentionally skipped the option exercising process entirely because it is not part of the required strategies. Conversely, we do not expound further about writing options since such transactions are not required for our basic strategies, and as such are beyond the scope of this article. Some option writing transactions can be highly risky, and may not be authorized in qualified retirement accounts (e.g. writing naked calls).

There are no IRS or SEC regulations prohibiting buying calls and puts in qualified retirement accounts, but your broker may not allow it, or may not authorize it in your account. You need to verify with them directly, and if they do not let you trade in options you might want to check with the many brokers that do, e.g. Ameritrade, BrownCo, Fidelity and Schwab.

FAQ of the Week

Question: How does the performance of options compare with ETFs?

Generally speaking, options are leveraged derivative securities which can significantly outperform the underlying ETF/index/stock. The beauty of options trading is that it effectively lets us control the underlying for a fraction of the cost, which creates leverage without the use of margin. Referring back to the "Comparing equity and option investing" example we used last week, we see that one option contract, which controls 100 shares of QQQQ , costs us between 10% and 15% of what it would cost to buy the corresponding shares.

With the technique we describe and the type of options we recommend, an option is a good proxy for the underlying because the option premium (price) varies approximately one to one in dollar terms with the underlying shares. Ignoring the relatively small fluctuations in time value, when QQQQ goes up by $1, the call option also goes up by $1 (the put option drops by $1). Looking at it in percentage terms however, the ratio is closer to 10 to 1 because we invested a much smaller amount to buy the options. This 10 to 1 return ratio applied to 10% to 15% of our portfolio results in performance that is comparable with that achieved when investing the entire portfolio directly in QQQQ shares. Note that the 10 to 1 percentage gain ratio in this example applies for options where the time value is small compared to the intrinsic value, which generally is the case for the shorter expiration dates and deeper in-the-money options.

We would be careless not to stress once more that the option strategies we describe have an acceptable risk level only because they invest only about 10% to 15% of our portfolio, with the balance (85% to 90%) safely stashed away in cash or interest bearing vehicles. Unlike an equivalent equity position which exposes our entire account, the option position presents a hard limit as to how much we can lose regardless of what happens in the markets, and that is the amount we paid for the options, or 10% to 15% of the account.

Warm wishes and until next week.

The TimingCube Staff