Ratio Spread

Ratio spreads are neutral in the sense that you don't want the market to move much either way once you make the trade.

While call and put ratio spreads can be effective strategies when you are expecting relatively stable prices over the short term, they are not without risk. By definition, a ratio spread involves more short than long options. If the trade moves against you, the extra short option(s) expose you to unlimited risk.

(You might want to also review a call back spread, which is a ratio spread that involves more long than short options. As such, it is a limited risk, unlimited reward strategy.)
Put Ratio Spread

To create a put ratio spread, you would buy puts at a higher strike and sell a greater number of puts at a lower strike. Ideally, this trade will be initiated for a minimal debit or, if possible, a small credit. This way, if the stock jumps, you won't suffer much because all of the puts will expire worthless. However, if the stock plummets, you have unlimited risk to the downside because you will have sold more options than you bought. For maximum profitability, you want the stock price to stay at the strike price where you are short options.
Example

Using Merrill Lynch (MER), we can create a put ratio spread using in-the-money options. With MER Trading at $39.68 in May, you might sell three of the JUL 40 puts and buy one JUL 50 put.
MER trading @ $39.68
Buy 1 MER JUL 50 Put @ $10.60 $1,060
Sell 3 MER JUL 40 Put @ $2.40 ($720)
Cost/Proceeds $340

The profit/loss above does not factor in commissions, interest, or tax considerations.
Ratio Spread Chart Ratio Spread Graph

In this case, you would pay a $340 debit for putting on the trade. If the stock jumped above 60, you would only lose the $340 paid for the spread. However, the real money would be made if the stock stayed right around $40. Here, the short 40 puts would expire worthless and the long 50 put would be worth $10. The value of the 50 put, minus the initial $340 debit would bring the net profit up to $660.

A big move to the downside in this case would spell trouble. The downside breakeven point occurs when the stock price equals 36.70, below this point the risk of losses exceeds $7,000.

The Butterfly

The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast � when you expect the underlying stock price (or index level) to change very little over the life of the options. A butterfly can be implemented using either call or put options. For simplicity, the following explanation discusses the strategy using call options.

A long call butterfly spread consists of three legs with a total of four options: long one call with a lower strike, short two calls with a middle strike and long one call of a higher strike. All the calls have the same expiration, and the middle strike is halfway between the lower and the higher strikes. The position is considered "long" because it requires a net cash outlay to initiate.

When a butterfly spread is implemented properly, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited.

The total cost of a long butterfly spread is calculated by multiplying the net debit (cost) of the strategy by the number of shares each contract represents. A butterfly will break-even at expiration if the price of the underlying is equal to one of two values. The first break-even value is calculated by adding the net debit to the lowest strike price. The second break-even value is calculated by subtracting the net debit from the highest strike price. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices. The maximum risk is limited to the net debit paid for the position.

Butterfly spreads achieve their maxim profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration.

As with all advanced option strategies, butterfly spreads can be broken down into less complex components. The long call butterfly spread has two parts, a bull call spread and a bear call spread. The following example, which uses options on the Dow Jones Industrial Average (DJX), illustrates this point.
DJX trading @ $75.28
Buy 1 DJX 72 Call @ $6.10 x 100 $610 (wing)
Sell 2 DJX 75 Call @ $4.10 x 100 ($820) (butterfly body)
Buy 1 DJX 78 Call @ $2.60 x 100 $260 (wing)
Net Debit from Trade $50 ($870 - $820)

In this example the total cost of the butterfly is the net debit ($.50) x the number of shares per contract (100). This equals $50, not including commissions. Please note that this is a three-legged trade, and there will be a commission charged for each leg of the trade.

An expiration profit and loss graph for this strategy is displayed below.
Butterfly Chart Butterfly Graph

*The profit/loss above does not factor in commissions, interest, tax, or margin considerations.

This profit and loss graph allows us to easily see the break-even points, maximum profit and loss potential at expiration in dollar terms. The calculations are presented below.

The two break-even points occur when the underlying equals 72.50 and 77.50. On the graph these two points turn out to be where the profit and loss line crosses the x-axis.
First Break-even Point = Lowest Strike (72) + Net Debit (.50) = 72.50
Second Break-even Point = Highest Strike (78) - Net Debit (.50) = 77.50

The maximum profit can only be reached if the DJX is equal to the middle strike (75) on expiration. If the underlying equals 75 on expiration, the profit will be $250 less the commissions paid.
Maximum Profit = Middle Strike (75) - Lower Strike (72) - Net Debit (.50) = 2.50

$2.50 x Number of Shares per Contract (100) = $250 less commissions

The maximum loss, in this example, results if the DJX is below the lower strike (72) or above the higher strike (78) on expiration. If the underlying is less than 72 or greater than 78 the loss will be $50 plus the commissions paid.
Maximum Loss = Net Debit (.50)

$.50 x Number of Shares per Contract (100) = $50 plus commissions

By looking at the components of the total position, it is easy to see the two spreads that make up the butterfly.

Bull call spread: Long 1 of the November 72 calls & Short one of the November 75 calls

Bear call spread: Short one of the November 75 calls & Long 1 on the November 78 calls
Summary

A long butterfly spread is used by investors who forecast a narrow trading range for the underlying security, and who are not comfortable with the unlimited risk that is involved with being short a straddle. The long butterfly is a strategy that takes advantage of the time premium erosion of an option contract, but still allows the investor to have a limited and known risk.

Naked Call

Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. For this reason, options with different strike prices and the same expiration are often referred to as vertical spreads.

In simplest terms, a long calendar spread involves buying an option with a longer expiration and selling an option with the same strike price and a shorter expiration. For example, imagine that Dell Computer (DELL) is trading for $45 per share. To initiate a calendar spread, you might sell the Dell June 45 calls and buy the July 45 calls.
DELL trading @ $45

June

July
Dell 45 Calls 4.50 6.50
Time to Expiration 2 months 3 months
Spread value: $2 (6.50 - 4.50)

Like most long positions, there is a cost to put on this trade. In this case, the cost is $2. For the time spread to work, the June option must lose its time premium faster than the July option. If the stock price remains relatively stable as the June expiration approaches, the value of the spread should increase. With only one month remaining before the June expiration, the option prices might look like this.
DELL trading @ $45

June

July
Dell 45 Calls 1.50 4.50
Time to Expiration 1 months 2 months
Spread value: $3 (4.50 - 1.50)

In this case, the position could be closed for a one-point profit by selling the July calls and buying back the June calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.

Calender Spread

Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. For this reason, options with different strike prices and the same expiration are often referred to as vertical spreads.

In simplest terms, a long calendar spread involves buying an option with a longer expiration and selling an option with the same strike price and a shorter expiration. For example, imagine that Dell Computer (DELL) is trading for $45 per share. To initiate a calendar spread, you might sell the Dell June 45 calls and buy the July 45 calls.
DELL trading @ $45

June

July
Dell 45 Calls 4.50 6.50
Time to Expiration 2 months 3 months
Spread value: $2 (6.50 - 4.50)

Like most long positions, there is a cost to put on this trade. In this case, the cost is $2. For the time spread to work, the June option must lose its time premium faster than the July option. If the stock price remains relatively stable as the June expiration approaches, the value of the spread should increase. With only one month remaining before the June expiration, the option prices might look like this.
DELL trading @ $45

June

July
Dell 45 Calls 1.50 4.50
Time to Expiration 1 months 2 months
Spread value: $3 (4.50 - 1.50)

In this case, the position could be closed for a one-point profit by selling the July calls and buying back the June calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.

The Strangle

A Word on Strangles as Neutral Strategies

Although long and short strangles differ in their response to market movement, we have chosen to list both as neutral strategies. In a pure sense, the short strangle is a neutral strategy because it achieves maximum profit in a market that moves sideways. In contrast, the long strangle benefits from market movement in either direction. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction--as long as movement occurs.
Long Strangles

Long strangles are comparable to long straddles in that they profit from market movement in either direction. From a cash outlay standpoint, strangles are less risky than straddles because they are usually initiated with less expensive, near-the-money rather than at-the-money options.

Like long straddles, they have unlimited profit potential on both the upside and downside. For example, let's imagine that a particular stock is trading at $65 per share. The following chart shows where the near-the-money and at-the-money options are trading.

Stock @ $65
Strike Price Calls Puts
60 7 2.25
65 5.25 5
70 2.50 6.75

Calls and puts used in strangles have the same expiration.
Long Strangle
Buy 1 60 Put @ $2.25 $225
Buy 1 70 Call @ $2.50 $250

If we opted for the strangle, we could buy the 60 put for 2.25 and the 70 call for 2.50. Thus, our out-of-pocket cost-and maximum loss-would be 4.75 plus commissions. With the stock anywhere between $60 and $70, we would incur the maximum loss of $475 (4.75 x 100). Anywhere below $55 or above $75, the position will begin to show a profit.

Value at Expiration:
Stock Price Profit (Loss)
$50 $525
$55.25 $0
$60 ($475)
$65 ($475)
$70 ($475)
$74.75 $0
$80 $525

The profit/loss above does not factor in commissions, interest, or tax considerations.

The long strangle can also be created using in-the-money options. Using the example above, this would involve the following:
Long Strangle (less common alternative)

Buy one 60 call @ $7
Buy one 70 put @ $6 3/4

This is an interesting position for a number of reasons. First, it's guaranteed to have some value at expiration because at any price at least one of the options will have intrinsic value. More specifically, with the stock between $60 and $70, the position will be worth $10. Thus, the maximum loss will be 3.75 (13.75 - 10).

It's also worth noticing that the maximum loss using in-the-money options is lower (3.75 vs. 4.75) even though the out-of-pocket cost to initiate the position is much higher. The reason for this is that generally speaking, the time premium for in-the-money options is lower than it is for out-of-the money options. In the first example, neither the 70 call nor the 60 put had any intrinsic value with the stock at $65. Thus, the price of the options was primarily time premium.

In the second example, the 60 call and the 70 put each had $5 of intrinsic value with the stock at $65. When you subtract the intrinsic value from the total price of the options, you see that the time premium for these in-the-money options is lower than the time premium for options equidistant from the current stock price but out-of-the-money.

The Straddle

A Word on Straddles as Neutral Strategies

Although long and short straddles differ in their response to market movement, we have chosen to list both as neutral strategies. In a pure sense, the short straddle is a neutral strategy because it achieves maximum profit in a market that moves sideways. In contrast, the long straddle benefits from market movement in either direction. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction--as long as movement occurs.

Long Straddles

Have you ever had the feeling that a stock was about to make a big move, but you weren't sure which way? For stockholders, this is exactly the kind of scenario that creates ulcers. For option traders, these feelings in the stomach are the butterflies of opportunity. By simultaneously buying the same number of puts and calls at the current stock price, option traders can capitalize on large moves in either direction.

Here's how this works. Let's imagine a stock is trading around $80 per share. To prepare for a big move in either direction, you would buy both the 80 calls and the 80 puts. If the stock drops to $50 by expiration, the puts will be worth $30 and the calls will be worth $0. If the stock gaps up to $110, the calls will be worth $30 and the puts will be worth $0.

The greatest risk in this case is that the stock remains at $80 where both options expire worthless.

Here's what the trade might look like:

Long Straddle
Buy	1 80 Call @ $7.50	$750
Buy	1 80 Put @ $7.00	$700

At these prices, every straddle will cost about 14.50. Since you are buying two options, a call and a put, you might get a slightly better price than the offer for each individual option. But, to keep it simple, we'll assume the prices listed above are the best available for the straddle. The 14.50 or $1,450 you pay for the straddle will also be the most you can lose if the price remains close to $80. Since the position profits from big moves in either direction, it has both an up- and a downside breakeven point calculated as follows:

Upside breakeven: Straddle Strike + Cost of Straddle

80 + 14.5 = 94.5

Downside breakeven: Straddle Strike - Cost of Straddle

80 - 14.5 = 65.5

Given this, the position will show a profit as long as the stock moves above 94.5 or below 65.5. Between those prices, the position will show a range of losses with the maximum lost right at the strike price where neither option has any value.

* The profit/loss above does not factor in commissions, interest, or tax considerations.

The Collar

To protect an existing stock position, some traders will put on a position known as a collar. The collar is also known as a fence or cylinder.

Protecting a Long Stock Position

When the stock position is long, the collar is created by combining covered calls and protective puts. From a profitability standpoint, the collar behaves just like a bull spread. The upside potential is limited beyond the strike price of the short call while the downside is protected by the long put.

Example

Suppose you purchased 100 shares of Network Appliance (NTAP) at $12.84 in May and would like a way to protect your downside with little or no cost. You would create a collar by buying one JUL 10 Put at $0.60 and selling one JUL 15 Call at $0.80.

The long stock behaves the same as any long stock position--it gains when the stock goes up and it loses when the stock drops. However, the maximum profit is achieved when the stock is at $15. Above 15, the profit on the stock is exactly offset by the loss on the call option that was sold. On the downside, the maximum loss occurs with the stock at or below $10. Below $10, the profit from the put offsets the loss from the stock.

NTAP trading @ $12.84
Buy	100 NTAP @ $12.84	$1,284
Buy	1 NTAP JUL 10 Put @ $0.80	$60
Sell	1 NTAP JUL 15 Call @ $0.80	($80)
Cost of Trade		$1,264

The collar strategy is best used for investors looking for a conservative strategy that can offer a reasonable rate of return with managed risk and potential tax advantages. The key to implementing the collar strategy is selecting the appropriate put and call combination that allows for profit while still protecting the downside risk. Many investors will roll the puts and calls in the collar strategy each month and lock in a 3-5% monthly return. By rolling, you would buy back the short calls and sell new calls for a later month and perhaps different strike price, and do the same with the puts. Hence adjusting the collar based on the movement in the stock price. There may be tax benefits associated with long term capital gains on the stock in the collar strategy versus short term capital gains in a pure option strategy. Consult your tax advisor for more details.

In addition to retail investors, many senior executives at publicly traded companies use collars as a way to protect their personal wealth that might be heavily concentrated in their company's stock. By collaring their stock, an executive can insure the value of his/her stock without paying huge premiums for put insurance.

Important

Before using Universal Broker's spread and combination one-step trading screens, options spread traders MUST understand the additional risks associated with this type of trading.

Conversions

Conversions are primarily a Floor Trader strategy. To capitalize on minor price discrepancies between calls and puts, floor traders and other professionals will sometimes put on a trade known as a conversion.

Like all arbitrage strategies, the conversion involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists.

Traders do conversions when options are relatively overpriced. To put on the position, the trader would buy stock on the open market and sell the equivalent position in the option market. When the options are relatively under-priced, traders will do reverse conversions, otherwise known as reversals.

Theoretically, conversions and reversals have very little risk because the profit is locked in immediately.

The idea behind a conversion is to create what is known as a synthetic short position and offset it with a long position in the same underlying stock. The synthetic short position is created by selling a call and buying a put with the same strike price and expiration.

synthetic short position = short call + long put

Combining the synthetic short position with a long stock position creates a conversion:

Short call + long put + long stock

To see how this might work, imagine that a stock is trading at $104. At the same time, the options are priced as follows:

Option	Bid	Ask
August 100 call	7.60	7.75
August 100 put	3.35	3.50

In the absence of any price discrepancies, the following will be true:

Call price - put price = stock price - strike price

In other words, if the stock is trading for $104, the 100 calls - the 100 puts should equal $4. At the prices above, this calls and puts are relatively overpriced because the synthetic short position (short call and long put) can be done at 4.10.

Thus, by buying the stock for $104, selling the call for 7.60 (the bid) and buying the put for 3.50 (the offer), the trader will lock in an .1 point profit.

Individual investors and most other off-the-floor traders don't have an opportunity to do conversions and reversals because price discrepancies typically only exist for a matter of moments. Professional option traders, on the other hand, are constantly on the lookout for these opportunities. As a result, the market quickly returns to equilibrium.

Reversal

Reversals are primarily a Floor Trader strategy. Sometimes, to capitalize on minor price discrepancies between calls and puts, floor traders and other professionals will put on a trade known as a reverse conversion or reversal. As the name implies, this is exactly the opposite of a conversion.

Like the conversion and other arbitrage strategies, the reversal involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists.

Traders do reversals when options are relatively underpriced. To put on the position, the trader would sell stock on the open market and buy the options equivalent in the option market. When options are relatively overpriced, traders do conversions.

Theoretically, conversions and reversals have very little risk because the profit is locked in immediately. For this reason, traders will do conversions and reversals as many times as the market will allow.

The idea behind a reversal is to create what is known as a synthetic long position and offset it with a short position in the same underlying stock. The synthetic long position is created by buying a call and selling a put with the same strike price and expiration.

synthetic long position = long call + short put

Combining a synthetic long position with a short stock position creates a reversal:

long call + short put + short stock

To see how this might work, imagine that a stock is trading at $104. At the same time, the options are priced as follows:

Option	Bid	Ask
August 100 call	7.35	7.50
August 100 put	3.60	3.75

In the absence of any price discrepancies, the following will be true:

call price - put price = stock price - strike price

In other words, if the stock is trading for $104, the 100 calls - the 100 puts should equal $4. At the prices above, this calls and puts are relatively underpriced with the stock at $104 because the synthetic long position (long call and short put) can be purchased for 3.90.

Thus, by selling the stock at $104, buying the call for 7.50 (the offer) and selling the put for 3.60 (the bid), the trader will lock in a .1 point profit.

Individual investors and most other off-the-floor traders don't have an opportunity to do conversions and reversals because price discrepancies typically only exist for a matter of moments. Professional option traders, on the other hand, are constantly on the lookout for these opportunities. As a result, the market quickly returns to equilibrium.

Naked Put

Let's take the case of selling naked puts. When a put option is assigned, the seller (i.e., option writer) is obligated to buy shares at a fixed price, regardless of where the underlying market is. For example, the stock might be trading at $20, but if the strike price of the option is $45, the option seller must buy the stock from the put holder for $45 per share.

Given this scenario, it's easy to see why an individual investor would probably view selling naked puts as having limited reward and substantial risk. After all, the maximum profit that can be achieved is limited to the premium received from the sale of the options. A fund manager, on the other hand, might view the situation differently.

By selling slightly out of the money puts, one is able to buy the stock at a discount relative to where it currently trades if the stock moves down in price. At the same time, the position would have earned additional income from the premium associated with the options. If the stock advances, naked put writers haven't missed out entirely because they keep the premium collected from the options that expire worthless.

Example

To truly appreciate this strategy, let's look at the following hypothetical example. Imagine that you want to buy International Business Machines (IBM) but think it is due for a slight correction from its current price, $82.83. By selling the $80 puts at $5.10, you collect $510 ($5.10 x 100 shares) per contract. If the stock drops to $75 and the puts are assigned to you, you will pay $80 for the stock. However, your net cost is really $74.90 per share ($80 strike - $5.10 premium) � a relative bargain compared to buying the stock outright at $82.85!

New facility from Blogger

Would you like to know who enjoys reading your blog? Or stay updated with your favorite blogs right from your Blogger dashboard? You can do those things and more with Blogger’s new Following feature.

By following your blog, your readers tell you and the world that they’re a fan of what you post. Your Dashboard now shows you how many followers each of your blogs has. With a click on the Followers icon, you can browse your followers, see what blogs they write, and read the other blogs they’re following.

Now that you know who your Followers are, you can show them off by adding the Followers gadget to your blog’s sidebar. From the “Layout | Page Elements” tab, click “Add a Gadget” and select “Followers” from the gadgets list. The Followers gadget shows the profile pictures of your followers and gives your readers a “Follow This Blog” link to join up, too.

Your followers can stay updated with your blog with the Reading List that we’ve added to the Blogger Dashboard. The Blogs I’m Following tab automatically shows the latest posts from all the blogs you follow. You can follow any blog from your reading list, even blogs that haven’t added the Followers widget or aren’t hosted on Blogger. Just click the “Add” button and type in the blog’s URL.

If you’re a Google Reader user, you’ll now see a special folder in Reader called “Blogs I’m Following,” full of the subscriptions for all of the blogs you follow. You can follow blogs you’ve subscribed to in Reader, too: From the Reading List on your Blogger Dashboard, click “Add,” then “Import from Google Reader.”

And.... there's more to come! We are also in the process of integrating with Google Friend Connect so you can give your readers more engaging social features.

For more details about what we've launched, check out the help articles here:

• What is Following?
• How do I add the Followers gadget to my blog?
• How do I use the Blogger Reading List?
• Following a Blog Publicly vs. Anonymously

Call Back Spread

Call back spreads are great strategies when you are expecting big moves in already volatile stocks. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price. Ideally, this trade is initiated for a minimal debit or possibly a small credit. This way, if the stock heads south, you won't suffer much either way. On the other hand, if the stock takes off, the profit potential will be unlimited because you have more long than short calls. To maximize the potential for this position, many traders use in-the-money options because they have a higher likelihood of finishing in-the-money.

Example

Using International Paper (IP), a company that historically has been quite volatile, we can create a ratio back spread using in-the-money options.

In this case, you might buy two of the JUL 45 calls at $1.05 and sell one 40 call at $4.00.

IP trading @ $43.46
Buy	2 IP JUL 45 Call @ $1.05	$210
Sell	1 IP JUL 40 Call @ $4.00	($400)
Credit from Trade		($190)

In this case, you would receive $190 ((4.00 - 2.10) x 100 shares) for putting on the trade. If the stock dropped below $40, you would keep the $190. However, the real money would be made if the stock made a huge move to the upside. The upside breakeven for this trade would be $48.10. At this price, the 40 calls would be worth $8.10 (8.10 x 1) each while the 45 calls would be worth $6.20 (3.10x2). Factoring in the initial $190 credit, the ROI at this price would be 0. Above $48.10, the profit potential is unlimited.

Calculating the Breakeven

The easiest way to calculate the upside breakeven is by using the following formula:

Upside Breakeven = Long strike price + [(Long strike - short strike) x # of short contracts] - net credit/100*

*(or + net debit)

Using the data for this example, the breakeven calculation looks like this:

45 + [(45 - 40) x 1] - 190/100

The maximum loss for this trade would occur with the stock at 45 because the long calls would be worthless and the short call would be worth $5. Factoring in the initial credit of $190, the maximum loss on this trade would be $310 (1 contact x $5 x 100 shares - $190 credit).

Important

Before using Universal Broker's spread and combination one-step trading screens, options spread traders MUST understand the additional risks associated with this type of trading

Bull Put Spread

When your feeling on a stock is generally positive, bull spreads are nice low risk, low reward strategies. One way to create a bull spread that you might not immediately consider is by using put options at or near the current market price of the stock.

Example

If you have a bullish short-term feeling about Coca Cola Co. (KO) when it is trading at $54.14, you might put on a bull put spread by selling the 55 put for $2.55 and buying the 50 put for $0.85. In this case, the maximum profit would be the $1,700 you received when you initiated the position.

The maximum loss would be the difference between strike prices less the $1,700 credit you received for putting on the trade. In this example, the maximum loss would be $3,300 (((55 - 50) x 1,000) - $1,700). For margin purposes, however, the maximum loss is considered to be the difference between strike prices-in this case $5,000-because that is the amount that must be available should the position reach a maximum loss.

KO trading @ $54.14
Sell	10 KO AUG 55 Put @ $2.55	($2,550)
Buy	10 KO AUG 50 Put @ $0.85	$850
Credit from Trade		($1700)

If you like the idea behind the bull put spread, be sure to check out bull call spreads and bear put spreads. These can be comparable strategies depending on your objectives.

Important

Before using Universal Broker's spread and combination one-step trading screens, options spread traders MUST understand the additional risks associated with this type of trading.

Bull Call Spread

When your feeling on a stock is generally positive, bull spreads represent a nice low risk, low reward strategy. The easiest way to create a bull spread is using call options at or near the current market price of the stock. If the underlying stock is trading at $26, you could buy a 25 call and sell a 30 call.

Example

With DELL Trading at $26.85, you might buy one JUL 25 call and sell one JUL 30 call. By selling the 30 call, you lower your exposure, but you also lower your upside potential. You would have paid $2.95 for the 25 call and sold the 30 call for $0.50. In this case, your total cost-and the most you could lose-would be $245 ($2.95 x 100 - $0.50 x 100).

DELL trading @ $26.85
Buy	1 DELL JUL 25 Call @ $2.95	$295
Sell	1 DELL JUL 30 Call @ $0.50	($50)
Cost of Trade		$245

Your maximum profit is $255, the difference between the strike prices less the $245 you paid to put on the position. Even if the stock goes to 50, you still only stand to make $255 because while your 25 call is worth $25, the 30 call you sold is worth $20. To close the position, you would have to pay $20 for the 30 call when you sell the 25 call for $25. This limited upside is the price you pay for lowering your exposure (from $295 to $245) through the spread.

If you like the idea behind the bull call spread, be sure to check out bull put spreads and bear put spreads. These can be comparable strategies depending on your objectives.

Important

Before using Universal Broker's spread and combination one-step trading screens, options spread traders MUST understand the additional risks associated with this type of trading.

Protective Puts

With the market volatility we've seen over the past few years, more investors are recognizing the value of using puts as part of their everyday trading strategy.

For investors who put money in the volatile Internet or biotech sectors, the rewards can be enormous. But so can the risks--if the stock price rises instead of falls, this strategy may limit the upside potential by the cost of the put. By adding put options to their overall investment strategy, investors can better position themselves for any direction the market may head.

Using protective puts is simple and can be relatively inexpensive given the insurance value. For each 100 shares of stock you buy, buy one protective put at a strike price or two below the current market price. For example, if you buy a stock at $50, you'd buy either the 47.5 put or the 45 put. That way, if the stock plummets, you'll be able to sell the stock for close to what you paid for it.

On the other hand, if the stock jumps as you hope, you'll participate fully in the upswing less the small amount you paid for the protective puts. In this way, the puts act as an insurance policy.

Example

Let's look at AMGEN INC. (AMGN) trading at $50.66. It would take $5,066 to buy 100 shares. If you buy the shares, your downside risk, theoretically, is $5,066, with a potentially unlimited upside reward. Buying one protective put (to cover all 100 shares) limits the amount you can lose, should the stock fall.

To see how this works, consider the following:

AMGN trading @ $50.66
Buy	100 AMGEN INC @ $50.66	$5,066
Buy	AMGN OCT 45 Put @ $2.55	$255
Cost of Trade		$5,321

No matter how far the stock drops, as long as there is a protective put, the combined position will be worth $4,245.

Rolling Your Options

As the stock moves higher, you might want to roll the put up by selling the contracts you own and buying another one at a higher strike price. This way, you can lock in profit from the move higher. Too many investors have learned the hard way that what goes up rapidly can drop with equal momentum. So, if the stock jumps from $50 to $122, the 45 puts won't provide much downside protection. That's why it would be advisable to lock in profits by rolling the puts up to the 115 or 120 strike.

Knol

A few months ago, we announced a new web authoring tool called Knol.

Well, today we've announced its public launch, and we wanted to tell you a little bit more about it and how you might use it to complement your blog. Blogs are great for quickly and easily getting your latest writing out to your readers, while knols are better for when you want to write an authoritative article on a single topic. The tone is more formal, and, while it's easy to update the content and keep it fresh, knols aren't designed for continuously posting new content or threading. Know how to fix a leaky toilet, but don't want to write a blog about fixing up your house? In that case, Knol is for you.

Except for the different format, you'll get all the things you've come to expect from Blogger in Knol. Like Blogger, Knol has simple web authoring tools that make it easy to collaborate, co-author, and publish. It has community features as well: Your readers will be able to add comments and rate your article, and, if you want, they'll be able to suggest edits that you can then either accept or reject. And, just like in Blogger, you can also choose to include ads from AdSense in your knols to perhaps make a little money.

One other important difference between Knol and Blogger is that Knol encourages you to reveal your true identity. Knols are meant to be authoritative articles, and, therefore, they have a strong focus on authors and their credentials. We feel that this focus will help ensure that authors get credit for their work, make the content more credible.

All in all, we think Knol will be a great new way for you to share what you know, inform people about an issue that is important to you, raise your profile as an expert in your field, and maybe even make some money from ads

New Information from Blogger about SPAM

You knew that already, and now we do too. We have now restored all accounts that were mistakenly marked as spam yesterday. (See: Spam Fridays)

We want to offer our sincerest apologies to affected bloggers and their readers. We’ve tracked down the problem to a bug in our data processing code that locked blogs even when our algorithms concluded they were not spam. We are adding additional monitoring and process checks to ensure that bugs of this magnitude are caught before they can affect your data.

At Blogger, we strongly believe that you own and should control your posts and other data. We understand that you trust us to store and serve your blog, and incidents like this one are a betrayal of that trust. In the spirit of ensuring that you always have access to your data, we have been working on importing and exporting tools to make it easier to back up your posts. If you'd like a sneak peek at the Import / Export tool, you can try it out on Blogger in Draft.

Our restoration today was of all blogs that were mistakenly marked as spam due to Friday's bug. Because spam fighting inherently runs the risk of false positives, your blog may have been mis-classified as spam for other reasons. If you are still unable to post to your blog today you can request a review by clicking Request Unlock Review on your Dashboard.

New Information about Paypal in Indonesian

Hi everyone, I’m Vivian Hsiang, and I work on PayPal’s international products. I’m excited to tell you that PayPal is continuing to expand our presence around the globe. As you may remember, we recently announced PayPal’s expansion into 190 markets worldwide. We also added the ability to view PayPal.com in four languages including English, Spanish, French and simplified Chinese – allowing PayPal customers to shop online safely and easily in the language they prefer. New today, PayPal now offers account balance withdrawals to Visa-branded credit, debit, or prepaid cards in 26 international markets. This feature greatly improves the utility of PayPal accounts in these markets and is accomplished through an easy 3-step process.

This new feature is particularly valuable to PayPal account holders in markets where customers could use PayPal to send money, but had limited ways to receive or withdraw funds. A good example is Brazil. In the past, customers in Brazil could only withdraw funds via a paper check. Now, Brazilian account holders can withdraw money in a secure environment and have their funds available for online and offline purchases using their preferred Visa card.

It is also exciting for our Italian customers where local PostePay cards are widely used. The new withdrawal method gives them the freedom to easily move funds from their PayPal accounts to the payment cards they prefer to use online or offline.

This new functionality is available in: Argentina, Brazil, Bulgaria, Chile, Cyprus, Estonia, Gibraltar, Iceland, Indonesia, India, Israel, Italy, Latvia, Lichtenstein, Lithuania, Luxembourg, Malaysia, Malta, Philippines, Romania, San Marino, Slovakia, Slovenia, Turkey, UAE, and Uruguay.

At this time, only cards with the Visa or Visa Electron brands can be used.

Today’s news offers great opportunities for PayPal to become even more relevant to merchants in many of our international markets. We are constantly evaluating new functionality around the globe, so stay tuned and visit our PayPal Offerings Worldwide page for updates.

RESPONSE FROM INDONESIA

Hi Vivian, I am from Indonesia. I really happy with the news. At least we are from south east Asia specially from Indonesia can more productive in Internet Business with Paypal. By the way, can you please inform me, which Indonesian Bank that can be approved to their debit card?
Thanks.
Best regards,
Andi

Covered Calls-Bullish

Covered calls are a way to earn additional income on your stock portfolio. For conservative investors, selling calls against a long stock position can be an excellent way to generate income.

Example

Let's imagine that you would like to purchase 100 shares of Disney (DIS) stock with the stock at $24.40. Pleased with the overall growth rate, you would like to hold the stock rather than sell it. Rather than just sitting back and collecting the Disney dividends, you can use options to generate additional income at minimal risk to you. You can do all of this in one transaction using our Covered Call screen.

With the stock at $24.40 you could sell one 27.5 call in the near month at $0.90. As each call is valid for 100 shares you are only able to sell one call.

DIS trading @ $24.40
Buy	100 DIS @ $24.40	$2,440
Sell	1 OCT 27.5 call @ $0.90	($90)
Cost of Trade		$2,350

Knowing the stock price hasn't fluctuated much, you might have confidence that it isn't going to move higher than $27.50 in the short term. After all, that would be a more than 10% move. At expiration, if the stock is still below $27.50, you keep the $90 you received by selling the calls and the 100 shares of stock. At that point, you might decide to write another call for a future month.

Should the stock rise unexpectedly above $27.50, you will have two choices. You can either buy the calls back and keep the stock. Or, you can let the stock be called away and sell your 100 shares (1 contract x 100 shares) at the strike price of $27.50. The good news, in this case, is that you participated in the rise from $24.40 to $27.50 on the 100 shares you sold at 27.5. In doing so, you locked in an additional $310 in profit. The bad news is that you may have capital gains tax issues to deal with-especially if you've owned the stock for a long time and your cost basis is low.

Using Near Month Options

When writing covered calls, most investors tend to sell near month options for two reasons. First, the earlier the expiration, the less opportunity the stock has to trade through the strike price. Second, and equally important, is the role time decay plays in the value of the options. Like all out-of-the-money options, the call in the example above has no intrinsic value. As such, the only value is the time premium or time value which, in the final month before expiration, decays more and more rapidly. For these reasons, investors often sell options that have one month remaining until expiration.

Long Call - Bullish

Let's imagine you have a strong feeling a particular stock is about to move higher. You can either purchase the stock, or purchase 'the right to purchase the stock', otherwise known as a call option. Buying a call is similar to the concept of leasing. Like a lease, a call gives you the benefits of owning a stock, yet requires less capital than actually purchasing the stock. Just as a lease has a fixed term, a call has a limited term and an expiration date.

Example: Let's look at an example option. Microsoft (MSFT) is trading at $55.00, it would take $55,000 to buy 1000 shares of the stock. Instead of purchasing the stock you could purchase a MSFT "call option" with a strike price of 55 and an expiration 1 month in the future. For instance, in May you could Buy 10 MSFT JUN 55 Calls for $2.50. This transaction will enable you to participate in the upside movement of the stock while minimizing the downside risk of purchasing stock.

Since each contract controls 100 shares, you bought the right to purchase 1000 shares of Microsoft Stock for $55 per share. The price, $2.50, is quoted on a per share basis. As such, the cost of this contract is $2500 ($2.50 x 100 shares x 10 contracts).

MSFT trading @ $55.00
Buy	10 MSFT JUN 55 Call	$2,500
Cost of trade		$2,500

If the stock stays at or below $55 before the options expire, $2500 is the most you could lose. On the other hand, if the stock rises to $65 at expiration, the options will be trading around $10 (current price: $65 - strike price: $55). Thus, your $2500 investment will be worth $10,000 ($10 x 100 shares x 10 contracts).

If the stock price increases, the option gives you two choices: sell or exercise the call. Many investors choose to sell because it avoids the substantial cash outlay involved in exercising your call option. In the example above, to exercise you would pay $55,000 ($55 x 1000 shares) to buy the stock when you exercise the options. At a market price of $65, your shares would actually be worth $65,000. Not including commissions, you would have made a $7,500 profit on your $2500 investment ($10,000 - $2500).

Compare this to selling the options: you realize the same profit without spending the money to buy the shares. With the stock at $65, the Jun 55 calls would be worth $10 per contract. Thus, each option contract would have a value of $1,000 ($10 x 100 shares * 10 contracts). Not a bad return for a $2500 investment!

The scenario described above is a great example of the leverage that options provide. Just look at the returns on a percentage basis.

	Purchase $	Sale $	Profit	% Gain
Stock Price	$55	$65	$10	18.2%
1000 Shares	$55,000	$65,000	$10,000	18.2%
10 Jun 55 Calls	$2,500	$10,000	$7,500	300%

As the chart above demonstrates, if you bought 1000 shares of stock at $55, you would be putting $55,000 at risk. If you sold the stock when it rises to $65, you make $10,000 on your $55,000 investment, a 18.2% return. In contrast, investing $2500 in call options only puts $2500 at risk. In this case, the return is 300%.

Now, let's see what happens when the stock drops.

	Purchase $	Sale $	Profit	% Gain
Stock Price	$55	$45	($10)	(18.2%)
1000 Shares	$55,000	$45,000	($10,000)	(18.2%)
10 Jun 55 Calls	$2,500	$0	($2,500)	(100%)

While this scenario looks scary on a percentage basis, when you look at the raw numbers, it's clearly relative. If the stock drops, your calls may expire worthless, but your loss is limited to your initial investment, in this case $2,500. In contrast, the stockholder sustains a far larger dollar loss of $10,000. When you compare the limited downside and the unlimited upside potential of call options, it easy to see why they are such an attractive investment for bullish investors.

Volatility & Equity Options

Successful equity option trading requires opinions on three variables concerning the underlying stock: expected price direction, timing of the expected move, and the stock's future volatility. Although most investors appreciate the importance of a formed opinion on price movement and timing when selecting an option, it is consideration of the stock's future volatility that is usually ignored or not understood.

What is volatility? Mathematically, volatility is the annualized standard deviation of daily returns. A simple definition, however, is the fluctuation of stock prices without regard to direction. Big average daily stock price changes (up or down, in percentage terms) means high volatility, and small average daily price changes means low volatility.

To be able to make a forecast of a stock's future volatility we need to have an understanding of the role that volatility plays when pricing an option. The easiest way to accomplish this is comparing the pricing of an option contract to the pricing of an insurance contract.

Options can serve as insurance policies? In a manner of speaking, yes. Just as the insurance policy owner desires to transfer the risk of owning real property to someone else at a fee, an investor can purchase an option contract to protect their cash or stock positions against market fluctuations by paying a premium to someone else to assume the risk. Because of the leverage options convey, many investors assume they are meant only for speculation. By definition, however, options are instruments of risk transfer. They evolved because of a need for protection, or insurance, against wild price fluctuations in agricultural markets. To understand further how options work as insurance products, consider the following two examples.

Through the purchase of equity puts on a share-for-share basis with owned stock, an investor has the right to sell the underlying stock at a fixed price for a specific length of time. This right to sell may protect the owner of the underlying stock against a decline in price until that option's expiration. By purchasing equity calls, an investor has the right to buy the underlying stock at a fixed price for a specific length of time. This right to buy may insure a cash position against a price increase in the underlying stock until the option's expiration. Although the put protects against a "real loss" and the call against an "opportunity loss," both types of options may protect an investor from unfavorable events, acting as insurance polices in every respect.

To continue the comparison, both the insurance company and the options marketplace must consider risk when establishing a contract's premium. Insurance companies hire actuaries to evaluate the potential risk of writing policies. When would an actuary's job be the most difficult? Consider an actuary sitting in a client's home with a hurricane expected to arrive in hours trying to evaluate the risk factor for the homeowner's policy. In this case, the actuary could justify inflating the policy's premium because of the potential for damage that the hurricane's winds pose. If the hurricane suddenly diverted its course away from the house, the risk would diminish considerably and the actuary might price the policy at a more modest level.

As with an insurance policy, potential risk is considered in the pricing of an option contract; however, the risk comes from the possible price fluctuations of the underlying stock, i.e. its volatility. A market maker pricing that option in the marketplace makes a forecast of the stock's future volatility.

When might pricing an equity option be difficult? Imagine a market maker pricing an option on the underlying stock of a company expected to announce earnings the next week. A discrepancy between the analysts' expectations and the announced earnings could cause the stock price to fluctuate dramatically. The market maker might inflate the option's premium in order to offset this potential volatility risk. If after the earnings are announced there is reduced uncertainty about future stock price changes, the market maker could justify lowering the option's premium.

Taken to another level, volatility can be considered three ways. First, there is historical volatility, which is simply the measure of actual stock price fluctuations in the past. Second, there is forecasted volatility, or an estimate of the future volatility in an underlying stock. Third, there is implied volatility, or the volatility assumption that results in the actual price of an option in the marketplace. It reflects a consensus of the marketplace as a whole on the forecasted volatility of an underlying stock.

Using this new vocabulary let's apply it to an example. Companies which are in the headlines are frequently the favorites of speculators buying options. When doing so many will have opinions on just price direction and timeframe, and pay little attention to implied volatility. Consider this scenario.

With the historical volatility of XYZ stock at 27%, a XYZ 30-day at-the-money call option was initially trading at an implied volatility of 25%. However, because of a recent 2 for 1 stock split announcement by XYZ, the implied volatility of the option contract had risen to 40%. As a result of this increase, the option contract, which previously traded for $1 �, or $150, was now trading for $2 �, or $250. News of the split prompted a speculator to purchase this option with the expectation of reselling the contract at a 100% return on investment in a week's time. However, the speculator did not consider implied volatility and paid $250 for an option contract which had historically been trading for $150. In this case, after the initial reaction to the news subsided, the implied volatility returned to historical volatility levels, resulting in a decrease in the option's premium. Although fluctuation in an option's premium is often the result of movement in the stock price, the fluctuation of this option's premium was the result of movement in its implied volatility. Because of implied volatility fluctuation, the speculator must now wait for a larger movement in the stock's price to reach the investing goal of 100% return.

Understanding how volatility affects option premiums enables traders to complete a three-part forecast: expected price direction of the underlying, timing of the expected move, and the stock's future volatility. Although there is no guarantee that a forecast will be correct, including a prediction on the stock's future volatility in the decision-making process gives traders an improved chance of achieving their intended results.

Volatility

If you are unfamiliar with the concept of volatility, you might want to review the previous section on pricing options.

Implied Volatility

Before we examine the ways professional traders use volatility in conjunction with theoretical pricing models, it's important to note that these calculations are all done by computer programs. What typically happens is that traders plug their volatility assumptions into the computer and have instant access to theoretical option values at a wide range of stock prices.

Although not all traders rely on models, those that do use a volatility assumption, usually based on a historical value, as a barometer for where they believe options should be trading. At the same time, traders monitor the actual market prices to determine what is known as implied volatility. By plugging real-time option prices into a theoretical model (instead of a volatility assumption), the same equation can be used to calculate the volatility of each option. For example, while the 90 day volatility of a stock may be 25%, the current option prices may imply higher or lower volatilities even for the same expiration month.

Stock XYZ Corp:

Price $54 per share
Historical Volatility: 25%

Option	Implied Volatility
Sep 40 call	18%
Sep 45 call	23%
Sep 50 call	38%
Sep 55 call	42%
Sep 60 call	27%
Sep 65 call	29%

Some professional traders have sophisticated programs that continually monitor the implied volatilities of every exchange traded option looking for options that are significantly underpriced or overpriced relative to their historical volatility. These options are then either bought or sold and hedged against other options or stock. In the example above, if a program determined that the volatility of the September 55 call (42%) was statistically significant relative to other options, the trader might decide to sell the 55 calls and buy the 40 or 45 calls as a hedge.

Trader Psychology

Discipline

Anyone seriously interested in trading would do well to buy a copy of Jack Schwager's books Market Wizards and The New Market Wizards. Through interviews and conversations with America's top traders, Jack extracts the wisdom that separates successful traders from those who, through their trading, simply add to the wealth of successful traders.

One of the key factors mentioned by almost every good trader is discipline. Discipline, as you might imagine, takes a variety of forms. For beginning traders, one of the toughest challenges is to keep trades small. Believe it or not, more than a few top traders don't allow any one position to account for more than 1% of their total portfolio. Linda Bradford Raschke, one of the traders featured in The New Market Wizards, attributes much of her success to managing risk in this way. As a result, her average trade, at the time the interview, had a profit of only $450. At the same time, her average loss was only $200. Keeping her position small didn't impede her profit though. By remaining disciplined, she earned over $500,000 trading that year.

Limiting Your Losses

Another aspect of trading that involves discipline is limiting your losses. Here, there isn't a magic formula that works for everyone. Instead, you have to determine your own threshold for pain. Whatever you decide, stick to it. One of the biggest mistakes people make is to take a position with the intention that it be a short-term trade. Then, when the position goes against them, they make a seamless and unprofitable transition from trader to long-term investor. More than a few people have gone broke waiting for the trend to reverse so they could get out at break-even. If you are going to trade, you have to be willing to accept losses--and keep them limited!

Another mistake novice traders make is getting out of profitable positions too quickly. if the position is going well, it isn't healthy to worry about giving it all back. If that's a concern, you might want to liquidate part of the position or use options to lock in your profit. Then, let the rest of it ride. Mark Ritchie, one of the founders of CRT, an extraordinarily profitable Chicago-based trading company, once kept a trade on for 4 years because it kept working for him. Not every trader has that kind of patience. And not every trader makes as much money as Mark Ritchie.

It isn't uncommon for people to view trading as a fast-paced, exciting endeavor. Fast-paced? Absolutely. Exciting? Now that's a matter of opinion.

The Importance of Remaining Even-Tempered

More than a few traders interviewed in The New Market Wizards emphasize the importance of remaining unemotional and even-tempered. To these people, trading is a game of strategy that has nothing to do with emotion. Emotion, for these traders, would only cloud their judgment.

In the book, Charles Faulkner, a Neuro-Linguistic Programming trainer talks about one trader who was extremely emotional. Although Faulker was able to show him how to be less emotional and more detached, it became quickly apparent didn't enjoy being emotionally unattached. He found it boring. Unfortunately, emotion involvement in trading comes at a high price. Before too long, that trader went broke. The morale of the story is simple: If you insist on being emotionally attached to your trading, be prepared to be physically detached from your money.

Acceptance and Responsibility

One of the most interesting interviews in the book was with Robert Krausz, a member of the British Hypnotist Examiners Council who specializes in working with traders. According to Krausz, one of the biggest mistakes traders can make is to agonize over mistakes. To beat yourself up for something you wish you hadn't done is truly counterproductive in the long run. Accept what happens, learn from it and move on.

For the same reason, it's absolutely crucial to take responsibility for your trades and your mistakes. If you listen to someone else's advice, remember that you, and you alone, are responsible if you act on the advice.

Another Way to View Losses

Perhaps the most striking example of emotional distance in trading mentioned in Schwager's book was attributed to Peter Steidlmayer who reacts to positions that go against thinking to himself, "Hmmm, look at that." If only we could all be that calm!

Of all the emotions we could possibly experience, fear and greed are possibly the two most damaging.

Fear

Of all the emotions that can negatively impact your trading, fear may be the worst. According to many of the traders interviewed in The New Market Wizards, trading with scared money is an absolute recipe for disaster. If you live with the constant fear that the position will go against you, you are committing a cardinal sin of trading. Before long, fear will paralyze your every move. Trading opportunities will be lost and losses will mount. To help deal with your fear, keep in mind what fear is:

Confidence

The flip side of fear is confidence. This is a quality that all great traders have in abundance. Great traders don't worry about their positions or dwell on short-term losses because they know they will win over the long term. They don't just think they'll win. And they don't just believe they'll win. They KNOW they'll win. As Linda Bradford Raschke put it, "It never bothered me to lose, because I always knew that I would make it right back." That's what it takes.

To Talk or Not to Talk

For many traders, sharing opinions and taking a particular stance only magnifies the stress. As a result, they begin to fear being wrong as much as they fear losing money. Although it may be one of the hardest lessons to learn, the ability to change your opinion without changing your opinion of yourself is an especially valuable skill to acquire. If that's too hard to do, the alternative may prove much easier: Don't talk about your trades.

Greed

Greed is a particularly ugly word in trading because it is the root cause of more than a few problems. It's greed that often leads traders to take on positions that are too large or too risky. It's greed that causes people to watch once profitable positions get wiped out because they never locked in profits and instead watched the market take it all back.

Part of the remedy for greed is to have, and stick to, a trading plan. If you faithfully set and adjust stop points, you can automate your trading to take the emotion out of the game. For example, let's say you are long the 50 calls in a stock that rises more rapidly than you ever expected. With the stock at $77, the dilemma is fairly obvious. If you sell the calls, you lock in the profit but you eliminate any additional upside potential. Rather than sell the calls, you might buy an equal number of 75 puts. The $25 profit per call that you just locked in will more than offset the cost of the puts. At the same time, you've left yourself open to additional upside profit.

Gradual Entry and Exit

Another strategy successful traders use is to gradually get in and out of positions. In other words, rather than putting on a large trade all at once, buy a few contracts and see how the position behaves. When it's time to get out, you can use the same strategy. Psychologically, the problem people have implementing this strategy is that it takes away the "right" and "wrong" of the decision making process. It's impossible to be completely right or completely wrong using this strategy because, by definition, some of the trades will be put on at a better price than others.

Awareness & Instincts

For floor traders especially, instincts often play a crucial role in trading. To truly appreciate this, just close your eyes and imagine making trades in a fast market with dozens if not hundreds of people screaming around you. In this environment, it becomes absolutely essential to maintain a high level of awareness about everything going on around you. Then, to have the confidence to pull the trigger when necessary, you have to trust your instincts. It's absolutely amazing to see how some floor traders, even in a busy market, know exactly who is making what trades. For these traders, expanded awareness is often a necessary prerequisite to fully developing and trusting their instincts.

The same is true for off-the-floor traders as well. Watching how markets behave and developing a feel for the price fluctuations is truly time well spent. Unfortunately, in this era of technology, people have become so removed from their natural instincts that many are no longer in touch with their intuition. This is unfortunate because intuition functions as a wonderful inner guidance system for those who know how to use it.

One trader interviewed by Jack Schwager in The New Market Wizards relies so heavily on his intuition that he didn't want his name in the book for fear his clients would be uncomfortable with his strategy and move their money elsewhere. Speaking anonymously, he described in detail how he establishes a rhythm and "gets in sync" with the markets. In this way, he has learned to distinguish between what he "wants to happen" and what he "knows will happen." In his opinion, the intuition knows what will happen. With this knowing, the ideal trade is effortless. If it doesn't feel right, he doesn't do it.

When he doesn't feel in sync with the markets, this trader will virtual trade until he feels back in rhythm. But even here, he keeps his ego and emotion out of it. His definition of out of sync is completely quantifiable. Being wrong three times in a row is out of sync. Three mistakes and it's back to the virtual trading. Now there's a strategy almost everyone can benefit from.

Time & Risk

Quick changes can speed you forward or take the wind out of your sails.

Volatility is the speed with which an investment gains or loses value and the frequency of those changes. The more volatile an investment is, the more you can potentially make or lose in the short term. For example, equities tend to change price more quickly than most fixed-income investments (bonds and bank deposits). But it's not always that simple. The price of stock in large, well-established companies tends to change more slowly than stock in smaller, or newer, companies. And the more predictable a company's business, the slower the price fluctuation is apt to be. There are other factors to consider, too. Low�rated, high-yield bonds, often known as junk bonds, and some bond funds fluctuate in price at least as often as stocks, and offer some of the same opportunities for gain � and loss. Junk bonds may provide higher income than other bonds in the short term but are more likely to default on their obligations to pay principal and interest, just as some speculative stocks may lose all their value.

Time and Risk

Volatility poses the biggest investment risk in the short term. Sometimes if you wait, and hold onto your equity investments until a market downturn ends and recovery begins, its effect may be reduced. Similarly, if you hold onto your bond investments until maturity, changing market values have no impact on their par value or their interest payments.

Volatility may pose several serious problems, though. If you have been planning to sell an investment to pay for the down payment on a home, college tuition, or any other goal, you may not have enough to cover your costs if its price has fallen dramatically. Or, you may be so concerned over the falling value of your investments that you sell. Not only does that lock in your loss, but you'll no longer own the investment. If its price rebounds, you can't share in its potential recovery. But, of course, your investment may not recover even if the market rebounds.

Historically, major drops in the stock market � including market crashes and bear markets, when the value of stocks drops 20% or more � have been ultimately followed by a period of recovery. If you look at the big picture, you'll discover that what seems to be a huge drop in price often evens out when it is part of a long-term pattern.

Another way to deal with volatility is to capitalize on it. If an equity increases dramatically in value, you can sell it and make another investment. Then, if the price of the equity you sold drops, you can buy it again and wait to see if the cycle will repeat itself. The one investment strategy that's pretty much doomed to failure is trying to time the market, or predict what the stock and bond markets are going to do next so you can be in the right place at the right time. The reason? It can't be done. Or at least nobody has been able to do it successfully over a period of time.

Watching the Movement

If you recognize a certain trend in stock prices, you may be able to turn it to your advantage. For example, some investments, known as cyclicals, move in identifiable patterns, up in certain economic climates and down in others.

If you invest when a cyclical stock is down and sell when it's up, you benefit from the movement. One problem, of course, is knowing when to get in and out.

Other investments are more volatile and less predictable. For example, technology stocks (and the mutual funds that invest in them) jumped dramatically in value during 1995. But in the years before that many of them performed rather poorly.

Reading the Wind

The range between an investment's high and low price over a period of time � often a year � is one measure of its volatility. The smaller the percentage of change the less volatile the investment.

For example, a stock that increases in value from $15 a share to $20 a share over the course of a year has a 33.3% volatility rate, while a stock that increases from $45 to $50 over the same period has a volatility rate of 11.1%. The assumption is that a stock that increases by a large percentage could easily fall by the same percentage, providing a potential loss.

One strategy some investors use to avoid volatility is to sell stock when its price increases or drops a predetermined percent, often in the range of 10% to 20%. One way to handle this approach is to put in a limit order, an instruction to your broker or advisor to sell any investment automatically when it drops to the level that you set.

No Pain, No Gain

Illogical as it may seem, predictability is sometimes a bigger stumbling block to achieving your long�term investment goals than volatility. For example, the rate of return on a bank issued certificate of deposit (CD) is predictable. The problem is that while what you earn on the CD may be higher than the return on a stock, bond, or mutual fund during a market downturn, it doesn't have the potential to increase in value. When the CD matures, you can roll the principal and interest into a new CD at whatever the current rate is. But you can't sell the CD for more than you paid for it, and you can't earn more than the current rate that's being offered. What's more, while what you can earn on a CD increases when interest rates are high, your real rate of return, after taxes, is rarely greater than the rate of inflation.

Volatility's Reward

Don't get the mistaken impression that volatility is to be avoided at all costs. It can work in your favor at least as dramatically as it can work against you. In fact, a strong stock market often produces rapidly increasing prices in a relatively short time. That, in turn, can increase the value of your investment portfolio.

Leveling Out Your Risk

You can neutralize the impact of volatility with a buying strategy known as dollar cost averaging. Using this approach, you invest the same amount regularly in a specific investment, such as a mutual fund, paying whatever the going price is. When the price goes up, your dollars buy fewer shares. When it goes down, they buy more. The effect, over time, can be to lower the cost of the average share of stock or mutual fund you buy, so that you end up with more shares for less money. But remember that while dollar cost averaging has advantages if you invest consistently over time, it doesn't guarantee a profit or protect you from losses in a falling market.