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October 13, 2006

Options: A Three Dimensional Chess Game
by Mack Frankfurter

"Could we look into the head of a Chess player, we should see there a whole world of feelings, images, ideas, emotion and passion." -- Alfred Binet (French Physiologist, 1857-1911)

One of my favorite pastimes is playing chess, which unfortunately I have not had the time to indulge as of late. To experience the full brunt and emotional psychology of the game try a five minute speed match against a chess hustler in Washington Square Park NYC, a mecca in the chess world. Some of those guys are FIDE rated 2200+ and you will likely walk away feeling beat-up.

Don't believe me? Bobby Fischer, the only US-born chess player ever to win the World Chess Championship, once said "Chess is like war on a board. The object is to crush the opponent's mind." Even more revealing is what he said during a Dick Cavett interview, "I like the moment when I break a man's ego."

For the uninitiated the inner nature of this multidimensional game is nicely explained by David Norwood in his book Chess and Education:

"It is often supposed that, apart from their 'extraordinary powers of memory,' expert players have phenomenal powers of calculation. The beginner believes that experts can calculate dozens of moves ahead and he will lose to them only because he cannot calculate ahead so far. Yet this is utter nonsense. From my own experience I can say that grandmasters do not do an inordinate amount of calculating. Tests, notably de Groot's experiments, support me in this claim. If anything, grandmasters often consider fewer alternatives; they tend not to look at as many possible moves as weaker players do. And so, perversely, chess skill often seems to reflect the ability to avoid calculations. It is, in truth, not clear that chess is a game of calculation. Of course there are times when intense calculation is called for, and often the master is better at dealing with these situations than the amateur. No wonder, he has had more practice than the amateur, but all the same his innate calculating ability need not be any greater. Most of the time it is something quite different that is required, something akin to 'understanding' or 'insight.'"

Interestingly, the analytical yet intuitive nature of chess and trading is very similar, and many great traders happen to also be fanatical chess players. In fact, the introspective process is so alike that Norwood's description could have been written about trading.

The psychological aspect of trading is something that serious investors should spend time studying. Generally, investors have three choices when trading an asset directly:

(1) stay out of the market
(2) buy and "go long"
(3) sell and "go short"

Once either "long" or "short" the next decision becomes whether to stay in the position or get out; technically this is known as "liquidating the long" or "covering the short."

The confluence of investor agendas results in historical market prices which can be tracked by charts. Anyone who has looked at charts can easily recognize markets that trend up or down versus markets that move sideways within a range. Charts are great tools, but don't forget they look backwards. As the regulators want to remind everyone "past performance is not necessarily indicative of future results."

From an emotional perspective such tactical investment alternatives, seemingly simple trading decisions, present an array of contexts. Remaining un-invested is neutral, but psychologically the trader is thinking in terms of greed or fear: "Should I stay out or get in? Is the reward worth the risk? What if I buy it here and it goes lower? What if I wait before buying and then it goes higher?"

Common sense wisdom says "buy low, sell high," but how many investors feel more comfortable "buying high, selling higher?" Unfortunately, most of the time we end up buying high and selling low, emotionally trapped by the "come back to breakeven before selling" curse. Chartists call this "resistance" because investors sell at these levels, while "support" levels are created when there no more sellers -- investors are willing to hold until a better price.

Purchasing an asset is usually the easy part; alas most investors don't think about an exit strategy. The "trend is your friend until the trend ends," but how far should you let a stock "run" before you sell it? How would you feel if you sold it but then it goes up further? What if it was higher, but now lower... Would you wait until it goes back up? What if it doesn't go back up? What if it goes lower still? At what point would you feel forced to sell?

This psychology underpins every day decisions/actions of markets participants. As you can see, there are many emotional dimensions to just buying and selling an asset. Quite a few books analyze the phenomena such as the 1841 classic "Extraordinary Popular Delusions and the Madness of Crowds" by Charles MacKay. Successful investors learn to discipline their emotions and act contrarian to natural tendencies. And when a trader has the sophistication to "go short" their thought process doubles.

Thomas Huxley, known as "Darwin's Bulldog" (1825-1895), once quipped that "The chessboard is the world, the pieces are the phenomena of the universe, the rules of the game are what we call the laws of nature, and the player on the other side is hidden from us." The same idea could easily be applied to trading: the market is the world, assets are the phenomena of the universe, the rules of trading are what we call the laws of nature, and the players' agenda on the other side is hidden from us. It is this multiplicity of agendas that influence the direction of the markets.

Yet when all is said and done, for most investors the choice is simple: stay out of the market, go long at a certain price, go short at a certain price, or get out at a certain price (liquidate the long or cover the short). As with chess there is vast complexity behind such decisions, but in the final analysis the rules to game are simple.

Not so with derivative trading! If directly trading an asset is like playing chess, then to quote Davide Accomazzo, Head of Trading for Cervino Capital Management LLC, "option trading is a three dimensional chess game."

An option is a contract whereby one party (the holder or buyer) has the right, but not the obligation, to exercise the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer pays a premium for such right.

Because options are indirectly related to the underlying asset and have many more components for an investor to consider, the result is an unlimited variety of ways to structure trading strategies as compared to just buying or selling the asset.

• First, options are a wasting asset and therefore have a time component. If an option is not "in-the-money" at expiration, they're worthless.

• Second, part of their value is determined by the relationship of the underlying asset's price versus the option's "strike price." The degree of correlation between the pricing of the asset and option is a function of the distance between the asset price and strike price.

• Third and fourth, there are multiple options representing different strikes prices -- this is called an "option series"; further, there are multiple expiration dates for each option series.

• Fifth, their price, while related to the underlying asset's price, is also tangentially influence by the underlying asset's volatility.

• Sixth, double up all of the points above as there are two basic types of options: "calls" which give the holder the right to purchase the asset at a certain price, and "puts" which give the holder the right to sell the asset at a certain price.

• Seventh, double up everything again because option traders can either be purchasers of options or sellers ("writers") of options.

So how do all this option background work together in forming three dimensional trading strategies?

Suppose the S&P 500 is trading in a narrow sideways range and volatility is extremely low. Bullish and bearish sentiment is equal and you think that the market is going to breakout either to the upside or downside -- but your not sure which way.

If you were trading the Spyder (ETF contract that is linked to the S&P 500 index) you could either go long and hope the market goes up, go short and hope the market goes down, or stay out of the market all together. Limiting yourself to three choices could be frustrating.

But with options you could purchase both a call and a put at the same time. Since your cost is limited to the premium of the option you have limited downside either way if the market rallies or crashes. But if the market does breakout to the upside or downside you will be positioned to take advantage of that move. The key is that you don't have to be right on the direction -- your betting both ways at once.

Now buying options can be expensive, so how do you pay for the right to be a holder?

Let's say that in the above scenario you think the market is going to go up or down, not in the next month, but maybe three months from now. You could "write" options (both calls and puts) with a nearer expiration date to help pay the cost for purchasing options (both calls and puts) with a later expiration date.

With this situation you've got four different positions operating at the same time on the same underlying S&P 500 index. Each of these positions will increase and decrease in value differently depending on the price action of the underlying S&P 500 index.

The above two option strategies are just a small sampling of the position combinations that can be created with options, thereby expanding a trader's tactical repertoire exponentially.

But take note, because of the volatile nature of markets, the purchase and granting of options may involve a high degree of risk. Option transactions are not suitable for many members of the public. Such transactions should be entered into only by persons who understand the nature and extent of their rights and obligations, and of the risks involved in option transactions. Education is paramount!

As you can imagine the variety of trading strategies that options offer are limitless and multidimensional. It is that variety of trading possibilities that has attracted many investors to get involved with option trading. Some of us happen to like to play chess too.

Michael "Mack" Frankfurter
Managing Director, Operations
Cervino Capital Management LLC

Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made, if any, will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. This material does not constitute a solicitation to invest in any program offered by any commodity trading advisor mentioned in the article including any program of Cervino Capital Management LLC which may only be made upon receipt of its Disclosure Document. Past performance is not necessarily indicative of future results. Investment involves risk. Investing in foreign markets involves currency and political risks. The risk of loss in trading commodities can be substantial.

Author's Background:
Michael "Mack" Frankfurter is a co-founder and Managing Director of Operations for Cervino Capital Management LLC, a commodity trading advisor and registered investment adviser based in Los Angeles, California. Mr. Frankfurter is also the Chief Investment Strategist and an Associated Person of Managed Account Research, Inc., an independent Introducing Broker focused on advising its clients in managed futures investments. In addition, he is a Managing Partner of NextStep Strategies, LLC which provides consulting services for companies in the financial industry. Occasionally, he pens articles as a freelance financial writer.

Copyright © 2006-2009 Michael "Mack" Frankfurter, Author. All Rights Reserved.

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