Friday I related reader Jonathan Huffman’s remarkable success running $4,000 up to $75,000 in twelve months trading options. (He did it in his spare time, while running the fundraising for a Miami arts organization.) At the same time, I offered my own dour thoughts on puts and calls — the occasional winner like Jonathan notwithstanding.

Still, I had a nagging curiosity, as you may have had, as to his method, so I gave him a call. “It’s a lot less science than instinct,” he told me.

And it’s been a little rough lately, he said. When the market’s zooming or crashing, you can do fine with options. But when it’s just sort of sitting, becalmed, buying puts and calls is a way to watch your dollars evaporate along with the “time premium” you pay for them. A becalmed market is a good environment in which to write (sell) puts and calls. But that’s an even riskier game (if you’re writing them “naked”) and not the cakewalk some think it is (if you’re writing them “covered.”)

Jonathan says he generally buys puts and calls that are within three to six months of expiration.

(I ordinarily prefer LEAPs, which are long-term options. LEAPs give you up to a couple of years to be right, plus the possibility of long-term capital gain tax treatment — and what seems to me often to be a less outrageous premium. They’re not available on all stocks, but on some. For example, I own some American Express January 1999 calls. If Warren Buffett is right about American Express, maybe these LEAPswill work out. Then again, in 1999 American Express could be temporarily in the tank, wiping me out — while Warren would still own the stock and would have been collecting dividends along the way.)

Jonathan also makes it a point to sell his options about 4 weeks prior to expiration, because after that, he says, the premium begins to evaporate very quickly.

(This assumes, perhaps rightly, that the premium in the option is irrational — that people are paying more for it with 4 weeks to run than it is really worth, and enough more to justify the costs of selling. Whether or not Jonathan is right about this, and he may be, this strategy has a hidden psychological cost: once in a rare while it will make you want to kill yourself. This happens when, shortly after you sell out, some major event occurs to make your just-sold option a huge winner. So, rightly or wrongly, I almost always hang on to my options until the bitter end.)

Jonathan diversifies by industry, because he finds that entire industries may move roughly in tandem. And he avoids buying options on stocks where there’s already a high put or call ratio — i.e., where a lot of other people already seem to be expecting the same thing.

Even so (like me), Jonathan couldn’t resist buying Presstek puts. In fact, knowing how crazy Presstek was, he recently bought a “strangle.” With the stock selling around 108 (up from 20 a few months earlier), he bought a June 100 put and a June 130 call. First he made money on the call, when Presstek rose to 200 on May 21 (not to say he sold out at the top, but he did make money); and then he made money on the put when it fell, a few weeks later, well below 100.

This is the stuff speculative dreams are made of, and it sounds easy with hindsight. But bubbles like Presstek don’t come along often; and when they do, the premium you pay for an option is enormous. Had Presstek just stalled between 100 and 130 through mid-June — as it certainly could have — Jonathan would have quickly lost every dime he bet on these super-expensive puts and calls.

Sensibly, he never puts more than 10% of his pot into any single trade. And the profit target he shoots for depends on the market environment, he says. He has a rule of thumb that involves targeting a profit equal to “one-fifth the expected annual move in the Dow.” (This part didn’t resonate for me.) In other words, he says, if the Dow is forecast to rise 1,000 points over the next year (by whom? who cares?), he’d be shooting for 200% profits on his options positions. But if it’s expected to move less, he would take profits earlier.

As for where he got his market intelligence, Jonathan says he managed to run his $4,000 up into $75,000 based on readily accessible sources of information — principally, The Wall Street Journal, Investors Business Digest, Barron’s, Business Week, and The Motley Fool.

He says his favorite kind of stock is not a high-flying “growth” stock, where the option premiums are high because growth and volatility are expected, but rather a “value” stock that seems to be showing signs of growth. I.e., an old plodder that seems now to be taking off. His favorite in this regard was GTE. He bought December 40 calls at 5/16 that he was able to sell at 3-5/8.

So there you have at least an idea of how Jonathan did it.

All that said, and with great regard for Jonathan and appreciation for his sharing these ideas, I stand by my dour comment Friday. Avoid speculating in options. Sooner or later, you’ll lose your money.

Tomorrow: A Way to Make Money Almost All the Time

 

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