(Rich Cash, a wise and prolific contributor to the Rick’s Picks forum, as well as a blogger of note, has written insightfully and with good humor on a subject near and dear to our heart – i.e., the put-and-call game. Fortunately, we retired our powder-blue market-maker smock and badge (#K30)  just before the Feds started using RICO laws to prosecute white-collar criminals. We were a scurvy lot, for sure, and Rich has captured the flavor of the game in a way that explains what drew so many of us sleazeballs to the options trading floor. RA)  

On Monday, some of the Fast Money Crowd were ready to jump off the bridge after INTC, JPM and GOOG flamed out on brilliant earnings. Tuesday, they were extolling weekly call options on AAPL with 70% volatility premiums. That’s right — if a security that expires in a month is not a risky enough disappearing asset, now we can buy weekly options at a price almost guaranteed to absorb all price fluctuations and expire worthless.

Options have a long and checkered history that dates from the seven years Isaac worked to marry Rebekah, only to wake up in the marriage bed with her older sister Leah, and work another seven years for the woman he loved. In the early 1900s, Jesse Livermore frequented options parlors known as bucket shops. For a small amount of money down, you had the brief right to buy or sell a security at a fixed price. If it went higher in that short amount of time, you made money. If not, you were out of luck. The bucket shops were so good at pricing option premiums they usually bucketed the orders rather than enter them.

Livermore was one of the few that did well enough in the bucket shops that he was banned. In the Roaring Twenties, Over-the-counter option writers sold puts and calls to anyone on anything that moved in the markets. Since most of the options expired worthless, they just pocketed the money. When put buyers came around to collect after 1929, most writers were long gone. A variation of this mindset may account for what and why Banks did with OTC derivatives, off-balance sheets, and out-of-the-country subsidiaries up until the 2008 crash and taxpayer bailout.

It took a bridge player named Bill Sullivan to formalize option rules to create the Chicago Board of Options Exchange in 1973. They used a normalized gaseous diffusion equation adopted by Fisher Black and Merton Scholes to price option premiums rationally.  Bill created not only standardized, transparent, market-price cleared contracts, but a private third-party AAA credit guarantor in case either side defaulted. This model falls apart during Black Swan market distributions with long tails over long times, something the man who called derivatives “weapons of mass financial destruction” cited to shareholders to rationalize writing a lot of long-term options without collateral. Now, after his firm’s credit rating was reduced, FinReg may require him to post margin, a giant margin call that may also impact earnings, since he had the integrity to mark his naked option shorts to market.

Taking It Public

Too bad Banks, Congress and Regulators did not enforce the CBOE derivative lesson before defaulting and leaning on taxpayers. The CBOE waited 37 years to go public, just before Summer 2010, and traded from 34.18 to 26.10, the fate of many hot IPOs and options.  Of interest, options may have value as a leading market sentiment indicator.

The International Securities Exchange, now the leading option exchange, developed the 20 minute daily ISEE Sentiment Indicator index that excludes market maker and firm transactions to focus exclusively on the ratio of opening Call to opening Put customer transactions. ISEE has a pretty good history of calling market turns, including the March 2009 bottom and April 2010 top. The last few days, the ISEE set annual records with up to 224 Calls bought for every 100 puts bought, suggesting market sentiment is pretty complacent, if not ebullient. We may see in the short fullness of time if the complaint of the man who claimed he could make love to 100 women in a night was valid — that he had practiced too much that afternoon. We observe AAPL at 252 had a Point & Figure downside target of 216. We leave it to former P-Coast market maker, Blue Fin fund manager and financial journalist Rick Ackerman to make profitable picks and sense of all this…