How put-and-call acrobats are turning dull markets into profits

Wrapped in a dapple gray mink, a mustachioed Chicago options trader leans casually on his $70,000 Rolls-Royce. The proverbial portrait of a winner. But this photo, twinned with a recent article on stock index options in a business magazine, may be misleading. ``An option buyer of puts and calls will lose money 80 percent of the time,'' asserts David L. Caplan, head of institutional options trading at Jesup & Lamont Securities in Los Angeles. ``People liken commodity or stock index options trading to gambling. I tell them that's definitely not true -- because in gambling you have a chance of winning,'' he says.

In two years, index options have become tremendously popular. Trading volume on the Chicago Board Options Exchange is now second only to the New York Stock Exchange. The appeal: a relatively inexpensive bet on the direction of a market. An option buyer knows the most he can lose is the price of the option, but his potential winnings can be huge.

But this is a zero-sum game. If most index options buyers are losing, who is winning? ``On balance, although more risky, the sellers are the ones that make money,'' answers Jon Bloom, an options and futures strategist at Goldman, Sachs & Co. in New York. Indeed, because institutions and brokerage houses have the time, the capital, and the computers to sell options most effectively, critics have derided index options as merely a way of shifting wealth from the unsophisticated to the sophisticated.

So how is the trading done? There are probably hundreds of ways sellers can play index options profitably. In the last year, one strategy has gained some renown for making money when the markets go nowhere.

``The `strangle strategy,' '' asserts Mr. Caplan, ``will make money for you over 80 percent of the time.'' (Some other traders who have used the strategy suggest 70 percent is more accurate.) In any case, Caplan explains that most of the time, stock, bond, and commodity markets are trendless or at least trade within a 5 to 10 percent range. When one stops to consider this, the investment community does spend oodles of time prognosticating and waiting for the market to move. Actual major moves seem few and far between.

Enter the strangle (or neutral option spread) to take advantage of the doldrums. To set up a strangle, one sells both an out-of-the-money put and call. Out-of-the-money options are ones with strike (exercise) prices above or below the current market price. Suppose, for example, the Standard & Poor's 100 stock index is at 180. You sell a 190 call (an option to buy) and sell a 170 put (option to sell); both expire in a month. For the two options, the buyer pays perhaps $1,200 in premiums -- prices fluctuate with traders' expectations about the direction of the market.

(Index options, if exercised, are settled in cash; no stocks change hands. The value of the underlying option is set for each index. For example, an S&P 100 option is worth, in dollar terms, 100 times the index. So if the index is at 180, the underlying value of the option is $18,000. Settlement is based on the cash value of the difference between the strike price and the closing value of the index on the day the option is exercised.)

If the market moves up, the call appreciates in value while the put decreases -- and vice versa if the market turns south. So your position remains protected. As each day passes, however (and the likelihood decreases that the market will reach either 170 or 190), the premium loses some value. This time decay factor is how the strangle makes profits for the seller.

As one trader put it, an option is a shrinking asset. The put and call combination, which you sold for $1,200, may only be worth $1,000 a week later. So if you turn around and buy it back, your gross profits at that point would be $200. The less the market moves, the more the value of the call and put will drop, thus boosting the profit on both sides of the trade. If the option expires without being exercised, the $1,200 premium is yours. Also, you may earn interest at Treasury-bill rates on the margin funds all sellers are required to deposit with their brokers and on the full $1,200 in premiums from the day of sale until you close out your position.

A key to making the strangle work is that out-of-the-money options tend to be ``overpriced.'' By using computers, options sellers can calculate when options are fetching too much. The more that speculators are willing to pay for these options, the greater the potential profits for sellers.

But it can be ``a bit like betting against the masses,'' says Mr. Bloom at Goldman, Sachs. The buyers are betting the market is going to be volatile, and you're selling and setting up strangles with the opposite belief, he says.

The rewards for playing chicken with the masses?

Gerald Appel says he chalked up returns of about 25 percent annualized by running a stock index strangle ``almost continually'' last year. Bear in mind, most money managers lost money last year and the S&P 500 barely moved. With greater leverage, using more margin, he says returns could be higher. Mr. Appel is president of Signalert, a Great Neck, N.Y., investment advisory concern with $40 million to $50 million under management; he also publishes the Systems & Forecasts newsletter.

When a person is margined to the 10 percent limit, Bloom says studies have shown it is possible to get 40 percent or more annualized returns on stock-index options. Caplan is one of the few who set up strangles in both commodities and stock indexes. And with admirable success. On Dec. 1, 1984, a $10,000 account was opened and the actual trades tracked in his newsletter, Opportunities in Options. The account, including commission fees, is up 53 percent as of March 1.

Says Appel: ``Dave [Caplan] uses close to minimum of margin. I don't, because every so often you're going to have a losing position. We usually have 40 spreads on a $300,000 account. That account will be bringing in interest on $300,000, plus the premiums. If you were margined to the limit, you could have 40 options spreads on a $60,000 account, but if you had to take losses you could lose half that amount in no time.''

The strangle options game is more risky than buying options. The most you can make is the premium plus interest. The losses are potentially unlimited if you don't move your spreads or close out your position in time.

In January, when the market surged up, you could have lost a bundle sticking to strangles. ``A month like that could completely offset six months' or a year's worth of gains,'' Bloom agrees.

Finally, like so many investment strategies, as more people discover the strangle, the less effective it becomes. Already, traders have noticed that markups on premiums have been less drastic, thus reducing profits.

So why talk to reporters? Aren't you undermining future profits by publicizing that you are making money by selling options to hapless speculators?

``There's nothing I could possibly do to stop people from buying index options,'' says Caplan. ``It's just greed. The kind of thinking that even though everyone else lost, they will be the ones that hit it. They will outsmart the market.

``On top of that you have brokers on television and in newsletters all over the country pushing options,'' he adds. ``And of course they want their clients to buy options because they get the commissions. A broker can make a lot more getting clients to buy options than sell them. You need a larger account to sell options, because there's margin. There's more risk involved in selling, and 9 out of 10 brokers don't know how to manage an option sale.''