|
Jenna,
Since you posted on the Fore thread, I will post my thoughts on options here too. I hope it helps someone.
In my opinion, it is possible to make money trading options,
but the problem with options is that they seem to encourage
all the behaviors that cause investors, and short-term
traders in particular, to be unsuccessful in the stock
market. From my perspective, there are seven primary
reasons:
1. Excessive leverage
2. Position sizes too big
3. Excessive trading frequency
4. Insufficient knowledge
5. Insufficient diversification
6. Excessive hope
7. Undercapitalization
You see, only the simple strategy of option purchase is
vulnerable to the "three hard predictions" problem. But the
real beauty of options, IMO, is that they can be used to
construct virtually any profit/loss profile. The simple
strategy of straight premium buying is just the simplest.
It is not necessarily hard to make money with this strategy,
just hard to do when applied in a speculative fashion. The
point is that options should be treated as any investment --
with strategy and discipline, not like the craps table.
So, what is an example of a disciplined option strategy?
The simplest, which comes highly recommended by Larry
McMillan, author of "Options as a Strategic Investment", as
well as net.guru Michael Burke, is the 95/5 or 90/10 option
purchase strategy. 90 or 95% of the money goes into safe
short-term interest earning instruments (money market or
T-bills) and the remaining small percentage is used for
option purchases. That is, in any year, 5% or 10% of the
capital is at risk. Take the 95/5 strategy. This is a very
low risk strategy. Annual losses in real terms are
essentially limited to inflation, since the interest earned
on cash basically replaces the annual option losses even if
all trades are complete losses. Yet, just a few accurate
speculations can produce very healthy returns, 15-20% or
even more in a lucky year. And, if you consistently follow
this strategy, chances are good you will catch an occasional
big move.
Take Burke, a vocal practitioner of this technique. 20% of
his total capital is in the 90/10 strategy. He puts on
trades 1/3 at a time, diversifying across ten or so option
positions. So on each trade, something like 0.5% of his
capital is involved. Each trade has small risk.
Contrast this with some of the behaviors I see novice option
traders engaging in on these boards, like first-time traders
starting out with ten-contract covered call writes. Naked
writes on 1000 shares, first time out of the box! Crazy!
Or people who plunk 10% of their capital into a single
option purchase.
There are lots of other strategies, but this one best
illustrates the need and advantages of discipline, sufficient
capitalization, risk control, and diversification.
So, having said that, let me now discuss the Seven Sins of
options trading:
1. Excessive Leverage. That Jan 165 call on IBM may only
cost $250, but it controls $15000 worth of stock. Buy ten
contracts and you are talking real money! There is so much
leverage in these instruments, especially the
out-of-the-money ones, that it is tempting to take position
sizes larger than needed on the long side, and it is easy to
get into real deep doo-doo on the short side.
2. Position sizes too big. Similar to 1. Hey, that $250
seems puny, so why not buy a ten-lot for $2500? After all,
that's what the minimum on my mutual fund is! Yeah, but
your mutual fund doesn't expire.
3. Excessive trading frequency. Because of the leverage,
small swings in the underlying lead to big moves in the
options, and those volatile tech stocks can produce truly
spectacular option fireworks. That makes options fun, and
addictive, to trade. Overtrading follows easily. Plus,
options expire, so if lots of short-term options are
involved, unless the position sizes are quite large,
transaction costs can be a real drag on performance.
4. Insufficient knowledge. It is truly amazing how many
people jump into options without good background knowledge.
My PhD is in numerical analysis and it took me the better part
of a month to read to a level of what I consider basic,
adequate knowledge. I am not talking about going into the
academic mathematical finance literature, though I have the
background to do that, I am talking about reading the basic
stuff like McMillan, Nastenberg, etc. Again, I see people
on the net who spend an evening reading some 30-page
how-to-get-rich-with-options paperback, and they are looking
around for hot tips on what ten-lot tech stock option to
buy. Crazy! I mean, if one is going to put money with more
than one or two zeros at risk, isn't it worth a couple
months of study and paper trading?
For example, 95% of the people I see posting on the net
about options don't even understand simple arbitrage
equivalences. Many of these people are paying double
transaction costs (commissions, slippage, and spreads) on
synthetic positions requiring two trades that could be
accomplished more naturally with a single instrument. The
most common abuse here is the covered call write (long
stock, short call) which is equivalent to a single short
put. Runner up is the synthetic long put (done by short
stock, and a "protective" long call) which has the added
virtue of costing margin interest. Just plain idiotic.
5. Insufficient diversification. Diversify, diversify,
diversify. Short-term instruments have to be watched more
closely, which means more work per position, which tends to
lead to fewer positions, which tends to mean trouble.
Diversification in time is important too. Not all
strategies work all of the time, but if you have one you
have to apply it consistently, not spottily.
6. Excessive hope. Be realistic. Consistently buying
near-term way-out-of-the money options is not a realistic
strategy. Neither is shooting for regular 200% annualized
gains. Pony up the cash for the extra month and nearer
strike. If those are too expensive, you are
undercapitalized. Shoot for the five-baggers, not the
hundred. Those are too rare to form the basis of a
consistent strategy. Consistency means compounding, and
compounding is the magic of investing.
7. Undercapitalization. Related to 1, 2, and 5. If ten
separate positions are the minimum for diversification, and
a 90/10 rule is followed, that means realistically at least
a $50-100K or so portfolio of risk capital, which implies a
total portfolio size of $250-500K or so to have reasonable
risk management. Needless to say, most do not have liquid
assets of that size, but the lure of easy money is soooo
attractive.
The point is, it may well be possible to be successful
trading options, but the emotional and financial states of
many are not conducive to such.
The problems of predicting direction, time, and magnitude
are often given as the reasons most option players fail.
Many gurus, from the net.flacks who call themselves the
Motley Fools to legendary investors Buffett and Lynch, give
such reasons and write off options trading as a big casino.
Such conclusions are, IMO, a combination of varying degrees
of hubris, misinformation, and lack of understanding.
Options are a financial vehicle like any other. It is just
that the dangers are more subtle than most. The real
problem is bad investment practices.
|
