Monday, October 4, 2010

Fullman, Increasing Alpha with Options

Scott H. Fullman’s Increasing Alpha with Options: Trading Strategies Using Technical Analysis and Market Indicators (Bloomberg Press, 2010) is not a book for option traders. Its intended audience is money managers who want to improve their equity returns and smooth out their P/L curve by adding options to their portfolios. The strategies are sufficiently elementary that I see no reason the individual investor couldn’t learn from Fullman’s book as well. That said, the investor or money manager who wants to implement any of the author’s strategies should have a solid understanding of option fundamentals, which this book was not designed to provide. A foundation in technical analysis would also be a plus.

Fullman concentrates on directional option strategies--calls and puts (and he’s not squeamish about being naked) and vertical spreads. He outlines a series of scenarios in which it could be advantageous to buy or sell options rather than stock, to replace stock with options, or to hedge a stock position or a portfolio with options.

Here are a couple of examples that use simple option strategies in not so simple ways. The first is a pairs trade that keys off of the relative strength of stocks within an ETF. Assume that you own XLB, the materials ETF, and that it is outperforming the S&P 500. Of the ETF’s 29 component stocks IFF, a former leader, is experiencing weakening relative performance and its momentum is turning lower. Consider the following two possible trades, both seven weeks to expiration. First, with IFF at $30.48 buy the 30/25 bear put spread on IFF. Second, write 30 strike IFF calls. A variation on this theme occurs when a sector “appreciates past the point at which its initial leaders begin to lose upward power, pushed by lagging stocks that often appreciate for longer than the leaders—though not necessarily for an extended time period.” (p. 97) In this case a fund manager could sell the XLB stock and buy a call on a laggard in the ETF.

One of Fullman’s favorite strategies is the covered combination in which “managers use a margin account to purchase between one-quarter and one-half of the manager’s normal position in the underlying shares, then write an equivalent number of out-of-the-money calls and out-of-the-money puts.” (p. 81) This strategy makes money if the stock goes up or remains unchanged. If the stock drops below the strike price of the put and the contract is assigned, “the manager buys the remaining one-half or one-quarter of the position, depending on the number of contracts sold, yielding a lower average purchase price than that offered by the stock’s original value.” (p. 82) Of course, some people would consider this an example of the often dangerous practice of doubling down.

Readers of books on investing and trading often complain that they are long on theory and short on practice. Fullman’s book offers specifics. It’s up to the manager to decide what kinds of strategies fit the risk profile of his fund and what he personally is comfortable with.

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