Options for Rookies

Downside Panic vs. Upside Greed

Mark,

It's informative to hear your candid, albeit infrequent, opinion on the state of the market. My sentiments are in line with your summary and I feel this will be a flat, if not down year (once people realize that mostly the wrong people are benefiting from government stimulus).

I recently read an article that made a frightening analogy between our economic state and the fall of the roman empire... a tad extreme, for certain.

I was wondering why VIX spikes are correlated with market drops and not rallies... is it simply because the majority of options are bought as protection against market collapse? Shouldn't options trading be just as brisk during rallies or any other periods of high volume, where investors may use options for speculation, or to protect profits made, etc?

Andy

***

My track record tells me that my opinion on the state of the market is best kept to myself.  I am not a good prognosticator.

The 'wrong' people who are benefiting - they own Congress. Bought and paid for.  No Senator seems courageous enough to set things on the path of fair play and decency.  Wall Street owns America.

***

In 1984, a huge spike in the market drove IV higher.  Today, things are different. Rallies are never a panic situation because so few people are short the market.  People may want to jump on the bandwagon, but the sense of urgency isn't the same as when you see your life savings melting away.

Buying calls in an attempt to profit is not an act of desperation. There is no urgency to buy now and pay any price.  In addition, there are always investors willing to accept profits and they are in the marketplace, willing to sell calls to the buyers.  You said it in your question:  People who want to protect profits are more likely to be selling calls - dampening the effect of supply exceeding demand.  That helps keep option prices low. 

There are too few natural put sellers taking profits as markets decline.  Thus, the major volume is composed of panic buyers, and option prices soar. 

Since 1987, people understand that the market can be demolished - essentially overnight.  Thus, the 'need' to buy puts for insurance far exceeds the desire to buy calls to profit.

Human psychology is beyond my ken.  But people's reactions to events is sometimes predictable.  It's well known that losing a given amount of money is psychologically far more damaging than earning that same amount.  Losing what you own is devastating and people pay any price necessary to buy puts.  And they buy them right now, with no delay. 

Add to that the fact that when market makers sell puts, they are taking on an immediate risk.  They hedge as quickly as possible, but their desire to hedge adds to the problem because they must buy other options.  They buy calls plus stock to create synthetic puts or they buy other puts.  That places further upwards pressure on option prices, and IV grows with that demand.

Even when there is no panic, the skew is already in place.  Options with lower strike prices trade with a higher implied volatility than options with higher strike prices.

That's the way it will be - unless there is a change in human nature.

627

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Look at the Position Now; the Original Trade does not Matter

Mark,

Thanks for the detailed reply.

In some ways my example was too obvious (and I bought back the put a couple of days ago) because I had already taken 77% of the value of the trade.

At the other extreme, if the position were:

I originally sold a far out of the money SPX put option for $1.10 with 49 days to expiration, with a potential profit of $2.24/day.

Currently the option is priced at $0.60 with 27 days to expiration. This gives the same potential profit of $2.24/day. Then I see no point in closing the position.

Somewhere between the two cases is a transition point. It was that transition point I was trying to identify - and as you indicate, it's probably not mathematically identifiable!

Steve

***

I consider this to be a very important point - one that keeps too many traders from being profitable. It requires that you think about what you are doing - and looking for formulas is one way to be certain that you do as little thinking as possible.

I was trying to help you solve a problem, but this entire discussion is inappropriate.  I've written about this previously, and I know that many readers believe I'm as wrong as one can be.

But, if you learn to trade with logic and without emotions, the common sense of this approach should overwhelm any hesitancy you may have to adopt a similar trading philosophy.

The decision on whether to HOLD or CLOSE has nothing to do with the original trade.

Let me say that again.  It does not matter whether you sold the put and collected $6, $2, or $0.50.

The option price - at the time you made the trade - already reflects your trading style, tolerance for risk, your preferred time frame, delta and theta requirements for the trade etc.

The decision to hold or exit must look at the position NOW.  Does it still fit within your comfort zone?  Do you want to be short this option?  Do the parameters of the option - right this minute - still work for you?  Are you confident that $2.24/day time decay is all you need to know about an option to make a decision on whether to sell it?

Look at it another way.  If you were forced to exit every trade every morning (no commission expenses) and given the opportunity to keep that closing trade, or re-establish the position at the same price you just paid to temporarily exit (again no commissions or fees), would you re-establish the position?  Is the risk/reward acceptable? 

If the reply is 'NO' - then why are you holding?  How can the original selling price play any role in the decision?  It cannot and it should not.

624

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What Counts as a Trading Mistake?

I am a rookie to options. I think in all my previous endeavors to invest, I learned the most from my failures or mishaps.  So, if you option gurus can share your mishaps or failures in option trading with readers, it will be a tremendous help to all option rookies.

Sean

***

Thanks for the idea Sean, I know this was a suggestion for the new magazine, Expiring Monthly, but I thought I'd offer my opinion on this topic.  I am unable to provide what you seek.

If I tell you that I made a specific trade and lost $10,000, what can you learn from that information?  There is no 'lesson' to share.

To understand why the trade is considered to be a mistake, and not one of those losses that must be accepted as the cost of doing business, you would have to understand the details of:

• Why the trade was initiated
  

• The market conditions under which the trade was made 
  

• How risk was managed and whether adjustments were made

• The rationale behind each adjustment decision

• The rationale behind a 'no adjustment at this time' decision

• The decision to exit and why the trade was not held longer

• How much risk was involved in making the attempt to earn the profit

• The boundaries of my comfort zone and how it affected trade decisions

All you would know is that I consider the trade to be a mistake and how much was lost.

There is nothing to be learned from that.  How can you extract a lesson and consider it to be part of your options education?

I don't have the detailed records of all my trades that would allow me to even attempt to dig out the information that I would need to explain everything.

And if I did have access to the information, the explanation would be the length of a book chapter. 

My purpose in telling you about such an incident would be to help you learn something.  I don't believe in trivial explanations - not if the purpose is to enable the person asking the question to understand what went wrong, why it went wrong, and how the risk could have been managed more efficiently.

A collection of such trades may make for an interesting book.  However, lacking the necessary records, I cannot write that book.  Sorry.  Perhaps someone else can supply a better answer.

***

As a rookie, don't you think it's more important to understand what an option is and how an option works before being concerned with the mistakes of others? 

If you don't have a CLEAR understanding of how options trade, I don't believe you could understand an explanation of the mistake well enough to learn anything from that explanation.  That's the bottom line.

I believe you can achieve much more by learning the principles, not the specifics of a given trade.

There is no lesson  to be learned from 'mishaps' unless you have a very clear understanding of the error - why it was an error - and why the erroneous decision could have been avoided.

One more point:  When you 'learn by your mistakes,' I hope you don't make the grave mistake of grouping all losing trades into the 'mistake' category and all winning trades into the 'good idea' category.

I hope you understand one single point  - that you do not judge a trade to be a 'mistake' by whether it made or lost money.  It's a mistake when you should not have made the trade for good, basic reasons. Sometimes we get lucky and poor decisions are rewarded.  At times a very high probability trade loses when the unlikely event occurs.  That's the trading world.  You win some.  You lose some.  Avoid mistakes (trades for which the potential reward is not worth the risk involved) and understand what you are trading.  Do that, and you should succeed.

I am NOT a guru.

608

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Traders can Learn from Gamblers

Whenever I present a seminar to an audience of beginners, or write a blog post directed to people who do not yet know much about options, it's always important to warn these option rookies that they mustn't believe everything they hear. For one, options receive plenty of negative publicity and too many financial professionals consider the use of options to be gambling. 

These stockbrokers steered their customers away from using options by propagating a myth.  And if that's not enough, they also tell clients that options are too difficult for the average investor to understand.  Such brokers did their clients a great disservice.

There's much hype - all over the Internet.  As a result these investors must be careful to avoid the scams.  Some companies (or individuals) charge big bucks for introductory options lessons, when equivalent information is available at little, or no cost.  There are decent folks selling instruction, but it's not so easy to find them among the unethical.

Then there's the group that wants to teach you how to earn 5 to 10% per month - every month, with no losses.  Plenty of people fall for that, although common sense would tell you that these are unrealistic returns (One dollar becomes one million dollars in just over 12 years when compounded at 10% per month - ignoring taxes).  But too many novices pay for information first and only realize how foolish they were later. A good marketer knows how to grab attention, get people excited about unreasonable expectations, and smile as suckers willingly hand over their money.

I must mention that some people are honest.  They provide audited trading results, give you the opportunity to verify that the results are audited, and make good money.  It's okay to pay these folks for advice.  The point is that it's difficult to single them out from the scammers.

Gambling vs. Trading

Many option rookies are attracted to options because of stories about people making millions - very quickly - by using options.  Or sometimes the story is closer to home and they have a friend who bought some calls (or puts) and made $10 for each dollar invested.  It's easy to get excited when you hear 'how easy it is' to make quick money with options.

People love to gamble.  Lotteries sell the dream to people who cannot afford the cost of the tickets.  I suggest that rookie option traders avoid gambling with options.  But human nature leads many astray.

Is investing gambling? 

Technically it can be considered gambling.  If you buy stock, bonds, options etc. with the hope of selling later at a higher price, you are, in the technical sense, placing a bet.  That is gambling.

What separates gamblers from investors is the idea that investors have opportunity to gather information on the company whose stock they are buying, or the 'background' on the options they are trading.   Stock traders have fundamental reports on how the business is doing, or has done over the years.  They also have price and volume charts which allows them to perform technical analysis.

Option traders can look at implied volatility to get an idea of whether the option is priced reasonably.  They can also do the same fundamental or technical analysis on the underlying asset.  

It's true that a bettor can get the horse's (or football team's) past history as well as that of the competition.  There is a similarity.

The good news is that investors can learn from gamblers.

Dr. Brett

Regarding gambling and investing, Dr. Brett recently posted about how certain aspects of gambling can be intelligently applied to trading:

"When trading is compared to gambling, the implication is generally negative: that traders are little more than people who roll dice in hopes of a big payout.

There is another side to gambling, however, typified by the card counter. The card counter, dealt a hand, is aware of the odds of winning with those particular cards. The counter also follows which cards have been dealt already, dynamically updating the odds...

Yesterday's market is like a set of cards dealt to us...

As this analogy makes clear, a major source of trading edge becomes the decision to not trade. Just as a professional poker player will muck [fold] many hands when the odds are unfavorable, giving up a small amount to preserve the opportunity to bet large when circumstances are more favorable, the professional trader does not need to trade. Rather, the trader bets when the odds of winning are enhanced."

Keep in mind that Dr. Brett's advice is targeted to traders who hold positions for a very short time.

This specific advice still has appeal for traders who hold option positions for weeks or months.  Too many traders feel the need to be 'all in' and are always invested.  If that's part of your overall strategy, at least consider trading less size (fewer options) when conditions are not especially favorable for your chosen strategy, and perhaps increasing the size of your trade when conditions are more favorable.  

The card counter makes a large increase in bet size when the odds are improved.  You cannot do that - because conditions change so rapidly and you are invested for a longer time.  But you can open slightly larger positions when you like the odds of success, and slightly smaller trades at other times.

Sitting on the sidelines, waiting for better opportunities, is a mandatory practice for day traders.  It improves the odds when trading.  Iron condor traders seldom have the patience to observe the markets with no positions.  But decreasing trade size is one way to 'partially' observe the action with less at stake. 

We may not be able to count the cards, but we can see situations that provide extra reason to be optimistic or pessimistic.  There is no reason not to trade accordingly.

587

Mark to Make Believe

I have to share this gem from Barry Ritholtz:

"Thanks to the Congressionally mandated FASB rule changes back in March of 2009, Mark-to-Market has been changed to Mark-to-Make-Believe.

We do not know if these banks are actually profitable, whether they are barely solvent (Chase/JPM), somewhat insolvent (BofA) or totally insolvent (Citi)."

***

Barry believes the bonuses are based on 'massive fraud.'  The government gives money to the banks at 0% and then borrows that same cash by issuing bonds that pay 3%.  How difficult is it to make money when doing that?

I must agree.  Sure the bonuses make me angry, but the bonuses are not the major issue. It's that these banks were bailed out to contribute to the economy.  They were supposed to lend money to qualified borrowers and to help small business survive and prosper.

Why take that risk when the government hands them a free, 3% arbitrage opportunity?  This stinks.  And the new, proposed tax isn't good enough.

581

Options and the Real World

It's a privilege to write this blog for a devoted niche audience, and I truly appreciate every kind word that comes my way.

The frustrating part for me is being unable to have my message heard by a much wider audience of investors.  I consider my job to be the dissemination of information.  Once that is done, then each reader can accept or reject any or all of my suggestions/opinions. Or better yet, readers can voice an opinion by making a comment at the end of any blog post:

Each of you already knows that options can be used to reduce risk, and understand just how useful options can be in serving a dual purpose:

• Protecting your assets

• Increasing your chances of having a profitable trade
  

I've reached the point where I recognize there is no use beating my head against a brick wall.  There is simply no way (that I can see) to reach the millions of investors who can benefit from tearing themselves away from stockbrokers who churn accounts and whose commissions are far too high.

Also beyond my reach are people who depend on financial planners and advisors.  Those are the professionals who, in many (but not all) cases collect fees for investment ideas that are many decades old.  Although the investment ideas are not 'terrible,'  they are far less useful than investors deserve.

I plan to preach far less frequently about my frustrations with all those financial professionals.  I get it.  They earn their living by selling what they know to their clients.  There is zero incentive for them to do any better, learn anything new, or even admit to the possibility that there are risk-reducing investment alternatives that can truly make life better for their clients.  They want their fees first, last and always.  I cannot change that.

The new year (but, please: it's not a new decade) is about to begin and I hope to post articles that both interest and educate an audience of experienced option traders, option rookies, and option traders of the future.

I hope each of you had a wonderful Christmas, Kwanzaa, or Chanukkah.

561

A Loss Does Not Have to be Realized to be Real

Mark,

Let’s say I sell a covered call with the stock @ $10 and strike price is $12. As I understand it, there isn't any way my stock would get called away if the stock price goes to $5. What you are saying is I am losing money because of the stock I bought. You are presuming it is now worth less if I sold it, and not that it will be called away.

MDW: If you write a covered call, as you describe it, with the stock trading at $10 - and if the stock drops to $5, you lose money.

The money is lost because the stock is $5 lower than it was when you wrote the covered call. 

When the stock price declines, it's worth less than it was before.  That's the definition of losing money with an investment.  The stock was worth $1,000.  Now it is worth $500.  That's a loss.

That loss is decreased by the small premium you collected when selling the call struck at 12 (strike is 12).

Yes, I am not presuming that your stock will be called.  But, I am not presuming 'it is now worth less.'  It is worth less.  And that's true whether you keep or sell the shares.  It is worth $5 per share than it was worth when you wrote the covered call.

In other words, if the stock goes to $5, the buyer of my covered call could not buy it from me for $5. He would have to pay the strike price of $12 which he wouldn't do, right?

MDW: Right.  The option owner has the right to buy stock at the strike price, and at no other price.  In this example, that's $12 per share.

Right again. He/she would not exercise the option to pay $12 per share.

The falling stock price could hurt me only if it falls below my entry price. So if I own stock I bought at $2, and it goes to $10, then I sell a covered call with a strike price of $12, the stock retreats to $5. I have not lost money, have I?

MDW: No.  This is a very big misconception.  I do not understand why you would say this.  This stock was trading at $10 per share.  You decided to write a covered call against those shares.

That decision hurt you.

You could have sold the stock instead of writing the call.  You could have collected $1,000 per 100 shares.  Today you can collect only $500 for those same 100 shares.  Of course you LOST money. 

Your 'entry price' is completely irrelevant.  Your stock was worth $1,000.  Now it is worth $500.  That's a loss of $500.

It doesn't matter whether you paid $2 per share, $10 per share, or $100 per share.  It was worth $10.  Now it's worth $5.

When you say you have 'not lost money,' you are saying that you do not have a 'realized loss.'  You do not have a loss that is recognized by the Internal Revenue Service, or IRS (USA).  Thus, you cannot deduct that loss from your income.  But, it is a real loss nonetheless.

This is a blind spot that you share with the vast majority of investors.  They believe it's not a loss unless it's sold.  

When you own a stock and it declines in price, you lost money.  Past tense.

The money is not in your brokerage account

The money cannot be withdrawn or spent

The money cannot be used for margin

It's gone

How can you convince yourself that its not lost?

So one of three things will happen, right?

1.My stock gets called away at the strike price plus I keep the premium.
2.My stock does not get called away and I keep the premium.
3. I have only lost money on a stock when I sell it and that depends of course on my entry point.

MDW: #1 and #2 are correct.  You keep the premium.  Your stock either gets called or it doesn't.

As to #3, in my opinion, don't have to sell the stock to incur a loss.  You lose money when you decide to write a covered call - instead of selling the stock - and the stock price tumbles. 

The price you paid for the stock (yesterday, or last month, or 20 years ago) is irrelevant.

Thanks!

Regards,
Craig

***

Craig,

I am very glad you asked these questions.  It brings up a situation in which I disagree vehemently with 'common knowledge.'


"I only lost money on a stock when I sell it."

As far as the Internal Revenue Service is concerned your statement is true.  They don't consider it to be a loss until the trade has been closed and the loss becomes 'realized.'

In the real world that is utter nonsense. 

Sure, the stock can rally and return to the price at which you bought it.  That would eliminate the loss.

But so what? 

Any stock can move from today's price to a higher price.  If that happens, you MAKE money.  Well it's the same with a stock you already own.  If it moves from today's low price to a higher price, then you earn money from that position (starting from today).  At some point, that gain may equal today's loss - and when that happens you have broken even.

But none of that matters.  As of today you have lost money.  To me, it's wrong to say: 'I am currently losing money.'  You lost money.  If the stock rallies, then you can look back to today and say 'I made money.'

Today your account is worth whatever it's worth.  Your objective is to make it worth more tomorrow.  And more the next day.  The price you paid when buying an asset does not count.  Today's price counts.  You can hold or sell.  You are not locked into the trade forever.

Today, and every day you can sell your assets at current prices.  When you choose not to do so, it's exactly the same as if you made a decision to buy every asset in your portfolio (commission free) at its current price.  That's the reason the original price that you paid does not matter - except to the IRS.

It's ignoring reality to think the way you do.  And the vast majority agree with you.  And I'm in the  minority.

Even the government got into the act by allowing insolvent banks to avoid marking their assets to the market.  That means the banks got to pretend their investments were still worth the original cost and that they lost no money.  The banks were allowed to play make-believe and pretend they were solvent when they were insolvent - and should have been forced into bankruptcy.

557

Evaluating a Trade Idea from an Institutional Research Firm

When it comes to stock market predictions, few are shy about playing the game.  After all, it doesn't cost anything to take a stab at the future - and if incorrect, the prognosticators simply ignore the prediction.  When correct, they milk it for all it's worth.

It's not only stocks, but prognosticators exist in all financial fields.  Options are no exception.  Many individuals and firms claim results ranging from reasonable to unbelievable.

It's difficult for anyone to know how to evaluate the claims of those making predictions, but it's not a good idea to blindly follow.

Recently, Adam (The Daily Options Report) reported on a trade suggestion made by a professional institutional equity trading and research firm.  It's a perfectly reasonable suggestion, and one that normally goes un-noticed, unless the trade idea appeals to you.

But I cannot let this one go without a comment.  I suppose the reason is to reinforce the notion that trade suggestions are merely that: suggestions.  No matter the source, the strategy suggested may be well thought out, or naive.  It may be well suited to you, or totally inappropriate.  It's always your responsibility, as the consumer, to carefully consider the suggestion before acting on it.

Here's an abbreviated excerpt of their recommendation (taken from Daily Option's Report):

"Given our view that PALM has a solid downside floor and number of catalysts that could drive shares sharply higher towards our $20 target price, we highlight May 2010 risk reversals that  entail  selling  10  strike  puts  at  $1.70  to  buy  12  strike  calls  for  $1.55  and  net  $0.15  credit.  Note  that  these  prices  are  estimated,  based  on  the  pre‐market  trading  in  PALM  at  $10.80.  This  position  commits  to  getting  long  stock  at  the  equivalent  of  $9.85,  a  level  that  we  consider  to  be  compelling  value, and provides levered participation to the upside through the upcoming catalysts that we anticipate."

Here are my thoughts:

1) A 'risk reversal' involves buying one call and selling one put.

2) Selling the May 10 put and collecting $1.70 is very attractive for the bullish trader. 

a) If this idea turns out to be a loser, and if the trader is assigned an exercise notice, he/she owns PALM shares at $8.30.  That's a lot more attractive than paying $9.85 per share.

b) If the stock remains above $10 per share, the puts will eventually expire worthless.  The profit is $170 on an investment of $830 - and that's just over a 20% return on investment for a five-month trade.

3) Using the put proceeds of $170 to pay for the call options ($155 each) is a great way to own the call for no out of pocket cost.  The true 'cost' of the trade is taking the risk of owning shares at $9.85.

4) With the stock trading at $10.80 (at the time of the recommendation), that call option is out of the money by 11%, and it just feels wrong to pay that much premium for the this option.

5) Of course the recommendation suggests that PALM can rise to $20 per share.  If that happens, those calls will be worth at least $8 apiece.  A very nice profit of $815, or almost a 100% return on the same $830 (margin requirement) investment. 

6) Of course the stock can be any price when May expiration arrives.  But here's the dilemma as I see it.  If I want to make a bullish play on this stock (and I don't; this is merely a discussion of someone else's recommendation), is it good enough to sell the put and earn a 20% return if the stock remains above $10, and earn some profit if the stock remains above $8.30?

Or is it better to pay that $155 premium, buy the call, and hope that the people making this trade suggestion know what they are doing?  The potential gain is much larger, but the downside protection is only to $9.85 per share.

7) I choose selling the put with its much larger downside protection.  Others choose the risk reversal because the potential profit from buying the call is too large to resist.  But I don't like the odds of buying the call.  I prefer a higher probability of success, especially when the (5-month) 20% return is attractive.

556

NOTE:  Anyone relying on recommendations still has to take the time to consider the source, consider the strategy, evaluate the stock - and then decide if he/she wants to play or pass.  I pass on this one.

Investing in a world where ponzi schemes exist

How can any investor trust those to whom he/she sends money?  I'm sure everyone feels safe from fraud when buying funds from Fidelity or Vanguard, but how can any investor know if the manager of the investment portfolio is honest, ethical, or a cheat?

The truth is that there are very few ponzi schemes.  But when discovered they make for a big news story.  I compare it with an airplane crash.  The safe landings are ignored (not newsworthy) and only near misses and crashes make the news.

We are all told to do due diligence, but what does that mean?  You can't just walk into the company office and demand to see their brokerage statements and proof of authenticity - not unless you are investing a ton of money - or the firm is small and welcomes potential new investors with open arms.

The statement of auditors is supposed to provide the needed evidence of honesty, but Madoff proved that even auditors can be untruthful (or incompetent).

It's not so easy to know who can be trusted.  That's one reason for DIY (do it yourself) investing, and for most visitors to this blog, DIY is the method of choice.

But, there are investors who have neither the time nor inclination to make investing decisions for themselves.  Those who want to hire professionals ought to be able to do that with complete confidence that their money is safe from fraud.  Not safe from investing losses - just safe from theft.

***

There are plenty of financial planners who are eager to take your money, invest it according to 'prudent man' rules that were written decades ago, and charge a fee for that so-called service.   

There are few investment opportunities for those who want to own investments hedged with options.  There are some mutual funds that write covered calls, but they tend to be active managers who try to outperform the market averages by selling calls on only a portion of their holdings. That defeats the purpose of hedging.

If you are seeking such a fund, unless there's a broker who collects a commission for selling the shares, or the fund has sufficient assets to advertise, you are not going to know it exists.  Of course, each fund should have a web presence, but how do you know whether you can trust an investment company when the only information comes from the Internet?

In my city (Chicago) there are TV ads encouraging investors to 'investigate before investing' but there is no information on how to do that.  Who would trust the Better Business Bureau on an issue related to investing?  Not me.

All this brings me to my point:  I've been in touch with someone who runs a covered call portfolio.  Everything I see tells me this is an honest man, managing a portfolio of exchange traded funds.  He writes OTM covered calls on 100% of the portfolio, and to hedge market risk even further, one of his funds is equivalent to being short SPY (this is NOT a leveraged ETF).  All in all it seems to be a good place for the individual investor who cannot or will not manage his/her own funds. 

To top it off, he touches none of your money.  Each customer opens his/her individual account with a well known broker and the manager makes the trades.  Best of all, there's none of that 20% hedge fund management fee.  His fee is based on the amount of money under management, but approximates 1.5% annually.

I am not sufficiently familiar with the operation to sing it's praises, but I've learned enough to be satisfied that it's worthy of your consideration - if such an investment appeals to you.

My problem is: do I tell you who this is and how to get in touch?  It seems completely on the up and up.  I've seen records of positions.  If he never touches your money, there is no way this can be dishonest - or at least that's how I feel.

To learn more, write to Kevin Simpson:Invest@covered-call.com or visit his website. 

If you let him know you found his site via this blog entry, I would appreciate it.  Full disclosure: I'd earn a small referral fee.

525

Old standards vs new ideas

Larry MacDonald, of the Canadian Business blog recently published a  4-part series [Addendum: It's now up to 7 parts, and counting] that offered a number of quotes from people who vigorously support the merits of passive investing and its superiority to active investing.

I confess that I also believe that  for most individual investors who try to pick winning stocks or who buy mutual funds, that it's better to go passive and save the expenses and fees charged by traditional mutual funds.  So I'm a minor fan of index funds.

That rationale is part of the reason I trade options on a broad based index (RUT), rather than on individual stocks.

I left a comment on each post in the series, but received no replies.

 

Here's one such quote from Rick Ferri: "Asset allocation is the cornerstone of a prudent investment plan and is the single most important decision that an investor will make in regard to a portfolio.”

There is excellent evidence that the above statement was true.  The important question is: Is it still valid today? 

Those who support this idea never question how well it has done in recent years.  They have an idea that they can sell to the public to gain their trust - and then sell them investing advice - both fee based (better for the investor) and commission based (a very poor choice).

I believe the lessons of 2008 show that asset allocation no longer provides the safety net that it did at one time.  Today's investor should place less reliance on the powers of allocating assets and pay more attention to protecting the value of an investment portfolio by using options.  The global marketplace makes it much more likely that previously uncorrelated assets will rise and fall together.  There is no proof that my belief is true, but one more debacle similar to last year should be evidence enough.

*

I also post comments on Larry Swedroe's blog, Wise Investing. He and I have many areas of disagreement, but the primary one is that he fails to see the benefits of using options to hedge a portfolio.  He prefers buy and hold (long enough to convert profits to long term) coupled with portfolio rebalancing and proper asset allocation. That's just too old-fashioned for me. But it does keep his clients happy, and paying fees.

I trust a collar to protect my assets far more than I trust those out-of-date ideas.

524

 

My Turn to Rant

hi mark

Hello Jason,

thank you for answering my last question. To add a little more to it, I was wondering why traders are still using options for insider trading?  all of those guys who recently were caught were using options or some sort of strategy to make money off of their insider knowledge.

500 options are far less expensive than 50,000 shares of stock.
Also they are greedy and stupid - maybe 'ignorant' is a better word.

And every takeover since I have been investing has been preceded by suspicious option activity. Its not very hard to track down the specific trade and parties, so why bother using options.

Possibly because they believe the SEC is inept.

Its like they want to be caught.

Yes, it is.

And I dont know how market makers like peak6, goldman, Interactive brokers, and etc lose money on those insider trades.

They lose money when they sell options and are unaware of the takeover.

I was talking to friends and traders. all of those market makers have lists of potential takeover targets,deals, court cases, and have them on watch lists. And when suspicious trades appear on them, they are supposed to over hedge those positions.

Over hedging sounds good. Just how are they supposed to go about doing that? Buy stock and get killed if the stock collapses when the rumor proves false?

If I (as a market maker) sell 2,000 contracts and want to over-hedge, who is going to sell me the options I need? Every other market maker needs options. Hence higher bids and higher offers. That's normal. To expect something different is naive.

Personally I think its greed on some of these market makers.

I am not saying that market makers are the salt of the earth, but they get far too much abuse.

Greedy? Compared with whom? I believe this statement shows you truly have no comprehension of how this works. And if that's true and you are looking for information, why do you begin with the idea that the MMs are the bad guys?  When seeking information why not be attitude neutral? And if you TRULY believe the market makers you mentioned lose money, how can they be greedy at the same time?
 

For example in 07 macys was rumored to be taken over. Some trader would buy a simple 1k block of macys options, for 5-10 cents, and 2 hours later the premium jumps to 2 dollars.

How can you blame the market makers? When they sell 1000 at a dime, why can't the next offer be 20 cents? Then when they sell more, why can't the offer be 30 cents?

Would you stand there and sell and sell and sell - when there are nothing but buyers? I doubt it.

The whole point of raising the bids as buyers continue to buy is to find an equilibrium point that attracts some sellers so the MMs can get some help with the selling. But when no sellers appear, the price keeps rising, as it must.

Do you understand that when there are no other sellers, then the market makers take ALL the risk?   When they earn a profit because the option prices collapse after the news, you say they are greedy and charged too much for the options.   What do you say when Amazon runs up by 25% or GOOG runs higher by 90 points, or when there is a takeover and the market makers get creamed?  Do you still call them greedy?  I wonder if you chortle at their expense.

What really irritates me about your question, and frankly your attitude towards option market makers, is that no one ever complains when the stock specialists continue to raise prices. Everyone loves a good bull market, and rising prices are considered to be good news by everyone.  So why can stock specialists raise prices when demand exceed supply but option market makers aren't supposed to do the same thing?

I remember when President Dubya said that traders were selling stock short 'for their own personal gain.'  Did you, or anyone else, ever hear anyone complain when buyers bid prices higher and higher prices for their own personal gain? NO. You never did and never will.  People love rising markets and think they are good. They hate falling markets and look for someone to blame. It's crap. It's unfair. It's just wrong.

If you believe it's wrong for those options to be trading at $2, why blame the sellers? The total blame is on the buyers who are willing to pay any price, with no thought.  And how about YOUR share of the blame, Jason?  If you had sold 10,000 of these calls, perhaps the price would not have risen above $1.50.  How much of the blame do you accept?

 And those market makers sell thousands of options.

That's the point, isn't it?  The more they sell, the more risk they accept. If you think they should just accept that risk and not try to be compensated for it, then you can do your part. The next time one of these rumored companies has a huge rise in option prices, why don't you go sell five or 10 thousand contracts to help keep the price moderate?

And a day later when no merger happens, the options collapse again, and they make a lot of money.

The prices collapse, instead of falling gradually, because the same buyers become sellers creating an imbalance once again.  This time on the sell side.

Note this usually happens with really near dated options or options nearing expiry.

The public investor buys the near term option because it is less costly and he/she can buy lots of options. With a takeover, it's far better to own near term options. [No need to pay for time premium]

ps I really appreciate you sharing your knowledge and experience on options.

OK. But market makers are human too (some of them at least).

thank you

jason

Regards,
Mark

519

Option rookie's dilemma: Poor advice from a trusted source?

Hello Mark

Greetings from a fellow Chicagoan.

I am just starting out studying options. I recently attended classes put on by the Options Industry Council about options and I have a few (a lot of!) questions.

Good to know you picked a decent spot to begin your options education.  I trust the OIC to provide useful information.

One of the suggestions made by the Options Industry Council classes was to specialize in 4-5 stocks and learn the heck out of them. Fine and dandy, but how do I go about choosing the 4-5 stocks and what do I look at?

I'd need more information to be certain just what it was they were trying to pass along to you.  My best guess: don't begin trading options blindly, but be certain you are familiar with the stocks underlying those  options.

It's important to pay attention to the stocks.  For example, when writing covered calls, your overall success depends on the stocks you choose, and less on the strategy.

My idea for choosing stocks: they should be companies with which you are familiar.  Perhaps you are a customer, or admirer, or a current stockholder.  There is no rule I can provide for finding these stocks.

Your question on how to go about following the advice is the right question to ask, and the answer is - not so easily. I have no good answer.  The OIC instructor may be assuming you are already have experience as a stock trader and know which stocks (and when) to buy.

Each investor has his/her own methods for studying stocks.  For some it's following an advisory service (I hate that choice); for others it's doing all the reading and research and trying to determine whether the future prospects are good for the business.  To me, this is impossible. 

For some it's constantly watching the stock price, keeping charts, looking for price patterns, and then trying to predict future price moves.  Some people have the talent to succeed. I am not one of them, nor can I offer you guidance on how to join that elite group of people who can successfully predict market direction.

If your investing/trading plan is to buy options in the hope of using leverage to achieve good profits, in my opinion, that's an extremely difficult task. To succeed, you must get the direction of any move correct - OK, at least that's the same as when trading stocks.

You must also time the trade correctly because options have a limited lifetime. And because you are paying a premium to own the option, the stock must also move far enough to overcome the cost of the option.  Not impossible. Just extremely difficult.  Thus, I do not recommend the strategy of buying calls or puts.

If the OIC told you buy calls when you believe the stock is moving higher, that would be very poor advice - especially for the option rookie.  I spoke with Jim Binder, director of public relations at the OIC and he assures me that their approach is to provide education and that the OIC instructors tell students exactly what I said above: understand the stock before trading the options.  But Jim says that they do not provide any advice, such as 'buy calls.'

Is it the fundamentals of a stock I look at? Is it the technical analysis of the stock? Is it the earnings announcements? Conference calls?

Mostly yes to everything. You want all the information you can get - but only if you know how to use the information.  And no one can tell you how to do that.  That's a big problem.  There's far too much to read, and much is too difficult to comprehend. 

If you plan to become a short-term trader, then perhaps technical analysis will work for you. But I never use it. I don't believe in it. I do recognize that some people do VERY well with TA.

In my opinion it takes a lot of study before you have any chance of understanding technical analysis and applying it profitably. This is not a talent that is easily passed from one person to another. And most who try, fail.  I don't know how the instructor could leave you believing this is an achievable task.  That makes me question whether there was more to this portion of the class than you mentioned.  'Learning the heck out of a stock' should not be a stand alone idea.

Fundamental analysis? The professionals who manage mutual funds, pension plans etc. cannot beat the market averages on a consistent basis, and they use fundamental analysis when making trade decisions.

One TV jerk tells viewers to spend one hour per week with each stock in your portfolio. That's a lot of research.  If you are going to devote that much time, you must be able to generate good ideas from that research.  You must read all you can find, and understand it - and be able to draw accurate, subtle conclusions.  Conclusions missed by your competitors, the professional money managers. Does that sound reasonable to you? Not to me. It's far beyond my abilities.

My thought is that if the highly-paid professional money managers can't beat the market by using fundamental analysis, then I won't try to compete with them.

I find it difficult to believe that the OIC would pat their option seminar attendees on the head, and tell them to go off and pick a few stocks to trade. I'm not knocking them.  In fact I'm hoping that the information you provided did not represent the complete picture.  But I wasn't there, and don't know what they told the class.

Plenty of other option instructors (who charge big fees) take the same approach. And it's okay if you have the patience and ability to 'learn' how your stocks trade and correctly anticipate how they will perform when the market rallies and declines. To me, it's an impossible task for the vast majority.

I respect the OIC and find your story to be very unsettling.

Should one have a 'stable' of companies one likes to buy puts on, and others to sell calls?

Perhaps you meant to say: some for buying calls and some for buying puts. That would make more sense.  Please recognize how difficult it is to do profitably.  I don't recommend that approach and if the OIC suggested that, then I do quarrel with them.

This question is the heart of the problem.  Is it your idea to buy puts and calls, or did the OIC suggest it?

Perhaps if you called and spoke with the instructor, you may gain some useful information. I would have expected the OIC to teach you more about options, and less on how to trade stocks.  Stock trading cannot be ignored, but that should not be the emphasis for the OIC.  I am hoping there is some misunderstanding or mis-communication. Is that possible?

I would really appreciate any guidance you can provide to shed light on my confusion and lead me into the land of option profits.

Obviously, there are no promises. Those profits must be earned.  Not everyone can be a good trader or successful investor. The first step is understanding how options work. Here is a link to a page that describes the basic concepts of options.

Stock picking is a difficult task. I prefer using option strategies in which picking market direction is unimportant. Some people like that approach, others don't.  You must decide whether it's appropriate for you.

Regardless of how you want to earn profits with options, there is no substitute for understanding how options work.  Too many rookies go out and trade, guessing what to do, lose their money (quickly) and never return.

Don't let that happen to you.  You already made a good decision seeking guidance, and the OIC comes highly recommended.  Perhaps you just had the bad luck to find a poor instructor.  Or maybe there was something in the presentation you missed - something that would allow me to give you more encouragement to learn what else they have to say.

My philosophy, and the one I teach and believe is a good way to begin (I am not so arrogant as to assume this is the best approach for everyone, but it makes good sense to me and my readers agree) is to try to learn simple option strategies and apply them - rather than attempting to guess whether the stocks are moving higher or lower. 

When using a conservative strategy you quickly learn  how options change price in real world circumstances. Once you have a decent understanding of a specific strategy, make a bunch of trades in a practice account, gain experience trading a few stocks and their options, and then decide if you are ready to begin trading with real money.

Have some patience.  You want to learn now and trade later.

That's my approach. It may be as foreign to you as the OIC method you describe, but I want you to trade with the odds of success on your side.

Please avoid spending thousands of dollars for weekend seminars. If you are someone who likes to learn by reading (others prefer live talks or video), find a good beginner's book and go with that. I believe The Rookie's Guide to Options (if you choose to buy this book, please use this link and I'll get a small commission from amazon) is by far the best for beginners (I wrote it), and so do my readers. I explain options and how to use them, in detail. Lots of detail.  I do not leave you hanging with a bunch of unanswered questions.

I don't want you to think I am only promoting my own materials. I know it's the right book for a beginner, but the library and bookstore have other choices. And you can search for beginner books online.

One thing I strongly recommend is to open a brokerage account (deep discounter please). If you need a recommendation, let me know. Then use a practice (paper-trading) account. Have patience and don't use real money until ready.

I am NOT trying to discourage you. If your plan is to buy options, tread carefully. If you like the idea of selling options, as I do - many will warn you that it's too risky. Some strategies are risky, others are much more conservative trades with a high probability of success.  If managed well, these methods should be profitable over the long term.

Less risk and reduced rewards go together, and there is no need to be greedy.  You can do well with options, but in my opinion, only when you understand the basics.  That means making a trade and understanding how the option strategy can earn a profit.  It's not similar to buying a call and hoping the stock price doubles.  That's why I'm so discouraged by your quandary.

I trust this response sheds some light on the issue for you. I believe with all my heart that my advice is sound, intelligent, and a winning approach to using options. But there are those who prefer to buy options. You have to find a trading style that is comfortable for you.

Thanks and try to stay warm in this dank and chilly weather!

CK

518

Can You Beat the Market? Searching for Answers. Part II

See Part I.

I know that being able to find individual stocks that out-perform the market averages is a skill I lack.  I have not made the attempt in years.  If you have that skill, more power to you.

The question is:  can using risk-reducing option strategies enhance returns?  I'm looking for an investment strategy that increases my earnings at the same time that is reduces risk.  Isn't that what every investor wants to find?  Apparently not. 

Despite the evidence that using options gives investors (and traders) a better chance to beat the market - and with less risk - many shy away from options.  In fact, my quest (part I) to pique the interest of personal financial bloggers has not borne fruit. 

I'm not interested in only teaching investors who have an interest in options how to take advantage of this excellent risk-reducing tool, but what I'd love to accomplish is finding a way to get the average investor - who has never heard anything positive about stock options - to adopt option strategies as a method of guaranteeing that his/her retirement portfolio can survive any market crisis.  The strategy discussed today is not that effective and can offer no such guarantees.  Later in this series, such a strategy will be covered. 

The idea of buying options doesn't work for me, and I discourage that strategy whenever possible.  But for anyone who buys stock, or takes a passive investing approach and owns shares of broad-based ETFs (exchange traded funds), there is more than one option strategy that should be considered.

Covered Call Writing

Today the discussion is on covered call writing, which involves owning 100 shares of stock and selling someone else the right to buy your stock at a specified price for a limited period of time.  When you do that, you are selling (writing) a call option, for which you are paid a cash premium that is yours to keep - regardless of whether the option owner eventually buys your stock.

I consider this strategy to be one of the three basic conservative option strategies because it is among the easiest methods for an option rookie to use and understand.  

The purpose of this series is to compare the relative performance of various strategies, and data must be available.  Fortunately the Chicago Board Options Exchange (CBOE) has published indexes that measure exactly the performance of the investing methods we want to compare.  These are the Buy-Write (a term synonymous with covered call writing) Indexes. 

The first of these to be published was BXM, based on the S&P 500 Index.  Today, there is also BXN, an index based on buy-writing the NASDAQ 100 (NDX), and BXR, based on writing covered calls on the Russell 2000 (RUT) index.

The methodology for each of these indexes is the same, and can be found at the CBOE site.  The methodology involves:

Own a basket of stocks equivalent to owning the index.

On expiration Friday, approximately one hour after the market opens for trading, sell one call option that is out of the money, but as near the current index price as possible.  The call sold expires in one month and is held through expiration, when the process is repeated.  There are no adjustments.

Now that we know about these indexes, how did each of them perform, compared with their individual benchmark indexes?  This is a direct comparison between a covered call writing strategy vs. buy and hold for three different portfolios.

to be continued...

453

Revenge on the Banks: We can do it America.

Anyone angry with the banks?  Especially the big banks who helped cause the economic meltdown of 2008-2009?  I know I'm very angry. 

The bankers took enormous risk, they lost, and we paid the bills.  And they are back at the same old game, earning (Goldman, Morgan) billions for their risk-taking, senior employees.

Then there's the new credit card laws.  Because of the delay in the starting date for the new laws, the bankers changed their credit card policies and circumvented the new laws.

These people care nothing for their customers.  They are leeches on society.  They take from the poor - deliberately, actively - and give to the rich (themselves).

The latest brouhaha involves those overdraft fees for debit cards.  In case you haven't heard about this, the bank - as a courtesy to you - allows you to overdraw your account, with no warning, and hits you with a fee, typically $35 for going ten cents over your limit. 

Sure customers should know their balances, but this is deliberate, and it's big business for the banks.   And most banks do not allow you to opt out.  That means you must accept this overdraft 'protection.'  And even worse, many times customers have this 'protection' without being aware of it.

It's time to get even.  Tell these banks that we are 'mad as hell and not going to take it anymore.'

Here's how to do it.  A fantastic idea. Small claims court,  HT to Felix Salmon for bringing it to my attention.  Original poster is Karney Hatch.

452

Can You Beat the Market? Searching for Answers. Part I

Investors want to 'beat the market,' and continue the the search for alpha (a coefficient which measures risk-adjusted performance, based on the specific security and not the entire market). 

Professional mutual fund and hedge fund managers are paid big bucks to find alpha, and deliver enhanced performance to their investors.  Most are unable to beat the market on a consistent basis, and the search for alpha remains elusive.

There are those who believe actively trading in an effort to find that alpha is misguided and it's better to invest passively (thereby saving a bunch of money in trading costs and management salaries and bonuses) by owning share of index funds or ETFs.  Those funds charge very low management fees.

It's not my purpose to continue the debate over passive vs. active money management, but along the way I will mention some studies that have been made. 

Are there other ways to enhance market performance?  Can we use option based methods to produce the equivalent of alpha? That's the basis for this series of posts.

***

In late August 2009, one blogger (potato) wrote that "MW has been popping up in the comments sections of a lot of blogs recently touting an options collar strategy."  I wouldn't mention this if I weren't that 'MW.'

It's true.  I've been entering into discussions, where I feel it's appropriate, suggesting that personal finance bloggers give more support to the idea of using collars as a conservative investment strategy.

Here's the background:  Most PF bloggers take the position that active investing is inferior to passive investing.  The data supports their stance.  In other words, most mutual funds cannot match the performance of the appropriate benchmark (S&P 500 Index is the most commonly used benchmark). 

Why can't those funds, operated and managed by professional money managers beat the market?  The bottom line is that they can, on average, match the market.  But, it's been shown that the costs associated with active trading plus the management fees are high enough to convert the average fund from a market matcher to an under-performer.

Sadly most of the investing public is unaware of such studies.  In addition, there are many salesmen (earning hefty commissions) for those actively managed mutual funds.  Thus, most individual investors have no reasonable method for learning about the benefits of buying shares of index funds instead of actively managed funds.  The information is widely available, but most people trust their brokers and advisors, ignoring that free information.

Studies have also shown that individual investors have a higher opinion of their performance than that performance deserves.  Along the same lines, those who believe they are doing well tend to trade more frequently.  Additional data shows that those who trade the most, underperformed the most.

Thus, not only is passive investing more likely to produce a better result for professionals, but the same is true for individuals.  Less frequent trading of stocks yields better results.

The bottom line is that personal finance bloggers, who tend to be conservative and frugal, favor passive investing.

With that in mind, I entered the conversation on several blogs, suggesting that owning option collars (buy stock, buy puts, sell calls) represents a conservative strategy that is guaranteed to minimize losses.  The trade-off is that profits are also limited and that's a big turn-off for investors who believe it's easy to out-perform the markets.

Thus, one of my responsibilities when promoting the use of collars is being able to demonstrate that they produce reasonable returns and are not cost prohibitive. That is now possible.

Our path will include covered call writing as a method for enhancing stock market returns.  It may not strictly count as 'alpha,' but the cash earned is just as spendable.

to be continued...

451

Surfing the Internet. You Never Know What's Out There?

Following one link to another, I found my self visiting SqueezeAPenny.com, where I found this question:

"If you have small amounts of cash is it better to use it on penny stocks or options?"

I recognize that there are many people who have not yet learned anything about investing.  Many years ago, I spent a good deal of time in libraries and bookstores in an attempt to understand something about investing - before using real money.  I had seen my father buy mutual funds, to the benefit of his broker. [Hey, Tom Guella, are you still out there??]  And, not knowing any better, when I was still in school, I also bought some funds.

But times have changed and the Internet opens up a world of information.  I always find it sad when someone wants to get started (geez, I hope this questioner is first getting started), and is on a bad track.

Buying options or buying penny stocks.  Wow.  Neither is a good choice, especially when the investor doesn't have much cash.  Best is to begin a savings program until you have learned more about investing.

I extracted the following from a Boston Globe article by Jonathan Stempel and Lilla Zuill (Aug 13, 2009).

"Warren Buffett's Berkshire Hathaway  underestimated the risks of falling stock prices to its billions of dollars of derivatives bets...

The derivatives contracts are tied to four equity indexes in the United States, Europe and Japan, and are a big reason Berkshire's earnings fell for six straight quarters. That string ended in the April-to-June period as stocks rebounded...

Berkshire's Chief Financial Officer Marc Hamburg told the SEC that last year's 30 percent to 45 percent declines in the equity indexes 'are in excess of our volatility inputs.'

Buffett expects the contracts to be profitable and can invest upfront premiums as he wishes. This is one reason the world's second-richest person believes the contracts are unlike derivatives that are "financial weapons of mass destruction."

Yes, the market was more volatile than pretty much anyone (Nouriel Roubini, excluded) could have anticipated, even Buffett. 

428

Are You Trading Options Too Soon?

Everyone who has ever traded an option had to make the decision to enter an order for his/her first trade.  Some are seasoned investors, others are new to the stock market.

The experience you bring with you to that first trade makes a difference in how quickly you can learn to understand options and how they work.  Without that understanding, it's unreasonable to expect to use options effectively.

Please note:  All that says is that experienced traders can learn to use options more quickly because there are many aspects of trading they already understand.  It simply takes longer for the newcomer, because there is so much more to learn.

All that is obvious, so why mention it?

Because I constantly receive questions (e-mail, bivio.com, this blog, or through forums, such as EliteTrader, MotleyFool and TradeKing) from people who I know don't understand options well enough to be using real money to trade.  I always encourage them to spend some time on education and paper trading, but many have heard that options represent the path to instant wealth (I really dislike so many hypesters and liars  promoting that fairy tale) and want to get started as soon as possible.

The best I can do is provide guidance and education.

It's true that no question is too simple or too basic to ask.  If there is something someone doesn't understand, the best policy is to ask (the right person) to clarify the situation.  Over the years, I've been asked such elementary items as:

I own an option that is out of the money.  Must I exercise it?

I own an option.  How to I get my profit?

I paid $2 for an option.  Am I allowed to sell it for $0.50?

I'm not looking down on these questioners.  Just making the observation that people are gambling with options (I call it gambling if you don't understand what you are doing or how you can earn a profit) far sooner than they should be.

Learn first.  Trade later.

421

My Story and Risk Management

I repeatedly write about the importance of risk management when trading options.  Believe me when I tell you that I understand how much most of you are tired of reading about it.  How can I know that?  Because I've been in your shoes.

I firmly believe that if you don't pay much attention to what can go wrong and how much can be lost from a single position (or your entire portfolio), chances are very good that you will encounter an unexpected market move that will take your breath (and cash) away.  If you survived the turmoils of 2008, congratulations. That builds confidence.  If you are making money month after month with nary a problem, that builds over-confidence.  Be alert.

One of the sad things about trying to help others become intelligent option traders is knowing what can happen when things go wrong.  I remember my early years as a CBOE market maker.  I found it very easy to make money.  But sadly, I found just as easy to see it all go away.

Close friends warned me that my positions were too big and that I was asking for trouble.  I was a constant visitor to my clearing firm's risk management office, but instead of heeding the warnings, I decided that I knew better.  I was making good money, wasn't I?  Surely I could take care of any problem before it overwhelmed me.

One day in 1984, one of the company vice president's took me aside and told me that my best friend and I were #1 and #2 on the list of risky accounts.  I laughed it off with a comment similar to:  'It's just a computer searching for impossible situations that could make a big loss is possible.  Forget it.'

To make a long story short, the clearing firm (First Options) unhappily allowed me to continue to carry the positions.  It was just a few days later that my account was in deficit.  I had lost it all.  The explosive rally of August 1984 had done me in.  I had been in trouble before, but nothing like this.  I had to mortgage my condominium.  I was frightened.

I dug in my heels, found trading capital, traded very conservatively and worked my way back.  When the mortgage was repaid; when First Options had received every penny; I was greatly relieved.  But that was an ordeal to remember. 

I was finally convinced, but not cured.  I still carried risk, but nothing similar to those early days on the trading floor.  What's so sad is that I see it clearly now.  There was more than enough money to be made and there was no need to remain naked short so many options.  Today, I'm cured.  No naked options for me (unless I want to buy a specific stock - which I probably will never want to do again), and all positions have limited risk.

That's the background.  That's the reason I stress risk management.  Just as I had to learn for myself, I'm sure some readers will find that they have to learn for themselves.  I certainly hope it's a very small number of traders.  I refused to listen to people whose business it was to understand risk and how to maintain it at a reasonable level.  I'm offering you the same opportunity I had:  to be made aware of risk before something terrible happens.  I hope I'm getting through to you.

Good trading.

416

Is Current Value of a Long-Term Investment Important?

Mike, at The Oblivious Investor had an interesting post on 'sunk costs.'

I joined in the commentary, and Mike has graciously given permission for me to use those comments here.

***

For somebody with a long investment time line (30+ years) does it really matter if the investment is performing poorly right now? Wouldn’t I actually benefit by being able to purchase shares at a lower price?

Dave C

***

Yes, you can buy shares and pay a lower price.

But that is not relevant. You can buy those shares at today’s price – even if you had not bought any shares earlier. You are currently losing money on that original trade, and no matter what your time frame, that is not a good thing.

Wouldn’t you be better off if you had not bought those original shares and invested twice as much cash today?

The people who tell you that current price doesn’t matter don’t grasp the concept. They believe that if you are not exiting the position, it does not matter what the value of that investment is. Don’t fall for that.

Here’s what is true: There is nothing you can do about the fact that the price is lower. There is no need to shed tears over a trade that is losing money. Your decision is: Do you still want to own shares of this entity? If yes, continue to buy.

Obviously you have two conflicting hopes: a) You want your shares to be worth more in the future; b) You hope to buy lots of shares at what turns out to be a relatively low price.

You have no way of knowing what will be a low price in 30 years, so if you want to steadily invest, do so. But just because you are not cashing out today does not mean that you shouldn’t care about the price. After all, if the stock price doubles over a short period of time and you cannot figure out why that happened, then you may decide this investment is now too overvalued and get out.

It’s not that you are timing the market or taking a quick profit. It’s that you would rather own a different entity or different asset entirely – one that your research tells you is more fairly valued.

415

Q & A. Trading Options: Exercise and Assignment

Via email: "Would like more on the perils of assignment."

One of the recurring topics I encounter is a  new option trader's concern about being assigned an exercise notice on some option he/she has sold.

There are situations in which being assigned results in an unhappy ending, but they are few are far between.

Let's begin with simple definitions for option rookies:

Exercise: The process by which an option owner does what the option contract allows.  The call owner buys 100 shares of the underlying asset by paying the strike price. [NOTE: if the option is European style, the call owner may only exercise when expiration arrives and receives the intrinsic value of the option, in cash]

Assignment: The process by which an investor who has a short position (the option has been sold, but not yet expired or repurchased) in a specific option is notified by his/her broker that the OCC (Options Clearing Corporation) has issued an assignment notice and that the broker has designated the investor's account (randomly selected) to receive that notice.  The investor is now required to fulfill the conditions of the option contract by selling (if it is a call) or buying (if it is a put option) 100 shares of the underlying asset at the strike price.  The assignment notice is irrevocable.

If you have a position and receive such a notice, what can go wrong?  All that has happened to you is that an option has been converted to stock.  Unless you are trading in a small account and receive a margin call, you are now in better shape (risk-wise) than you were before being assigned.

If you wrote a covered call, the position has been closed, you earned the maximum possible profit from the trade and you received cash that allows you to make a new trade.

If you wrote a naked put, you now own the shares you were willing to buy when you sold the put.  No harm done, if you truly want to own the shares.

If you have a complex position, an option with 100 delta has been removed from your account and been replaced with stock.  If there are no margin problems, then this position has a better risk profile than you had before you were assigned.  I don't want to take the space for the details, but look at it this way:  If short a call, all you make on a decline is the call premium.  But if you are short stock as the result of an assignment, and the stock tumbles below the strike price, you earn more than you could have earned before.  In effect, the option you sold is now trading at less than zero.  How can that be bad for you?

There is one very troublesome situation, and that occurs when you sell American style index options.  That applies only to OEX options, so to avoid this problem, don't trade OEX options (they are ok to purchase if you are an option buyer, but don't sell them). A detailed explanation of why this type of assignment can cause problems is presented in this Investopedia article.

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Financial Planners. How do they survive?

Steady readers know that I have a problem with professional financial advisors.  I am so disappointed at how they appear to do well by their clients during bull markets (when their services are not needed) and do poorly during bear markets (when their help is desperately needed). 

I know these people cannot produce miracles, but in my opinion, the advice they peddle is essentially worthless.  I believe investors would do better to save the fees and spend time learning to become a do-it-yourself investor who adopts conservative option strategies.  And if that idea is unsuitable, owning a mix of index funds and bonds would probably produce results that are as good, or better - with no fees.

I found some interesting blogs on this topic yesterday:

Harriett Johnson Brackey, financial columnist for the Sun Sentinel, asks: 

"Why is it so hard to find a financial adviser (and I didn't even say a good one)?"

There has to be a reason, but I’m not sure what it is.

Why don’t advisers try to connect with the public? How do they expect the public to find them?"

Good questions.  Perhaps the answer is that they are too embarrassed by their inability to help clients.  How about it planners:  Are you allowed to advertise?  Why don't you?  

***

Then I found this piece on how well financial planners have done when earning money for themselves.  Of course, these are the fees they collect from clients, and not the result of their investing prowess:

Eric Shurenberg had this comment in April, 2009.  It's a video worth watching.

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Option Trading: Is Asset Allocation Still Important? Series Finale

MachineGhost left a comment regarding this series on the importance (or non-importance) of asset allocation:

"Good stuff. But to complete the series, how about giving various examples of how "easy" it is to actually hedge a stock portfolio effectively, as well as the various pitfalls to watch out for."

A reasonable request.  Not so easy to fulfill.

As a reminder, the underlying suggestion in this series is that 2008 was a devastating year for most stock market investors.  Asset allocation, along with diversification, may have failed some investors as a risk-reducing method during the market decline.  To the extent that such investors are seeking alternative methods to protect the value of their portfolios, I recommended adopting the collar strategy - but only after taking the time to understand how that strategy works.

For those who don't rely on the standard 'prudent investor' rules - in other words, for investors who either never believed, or now believe, that yesterday's rules are no longer sufficiently reliable to provide protection for their investment portfolios, collars can be used to guarantee that the value of a stock market investment never falls below a specified value. 

Collars are not insurance policies per se, but they resemble insurance policies sufficiently to describe them in those terms.  For review, look at the graph that compares the performance of SPX (long, unhedged investment in the S&P 500 index), BXM (same, hedged by writing covered calls), and CLL (same as BXM with the purchase of put options).

Collars reduce returns in bull markets and cut losses in bear markets.

***

1) The only way to hedge a portfolio 'completely' is to own a collar position for each 100 shares of stock in your portfolio.  If you have a diversified portfolio, or if you own odd lots, this is not an efficient method.

2) If you are a passive investor and only own shares of exchange traded funds - SPY (S&P 500) would be the one most commonly owned - you can easily collar that investment.

3) To provide reasonably 'effective' protection you can compare your holdings to certain indexes - selecting the index that most closely resembles your portfolio, and then collar that index.  This is 'doing the best you can,' and for many, that's not good enough.  It introduces the risk that your portfolio may perform very differently from the index that you collared.  This is a real risk, and could provide extra profits or losses.

Example, if you own tech stocks, you may find NDX (choose the ETF QQQQ) to be a reasonable choice.  If you own a diversified portfolio of large industrial companies, then SPX (choose SPY) is the index to follow.  Your portfolio may look more like a mid-cap index (MID, MDY) or a small cap index (RUT, IWM).

Once you choose your individual 'benchmark' index, you must decide how many puts to buy and calls to sell.

Let's take an example:  SPY is trading near $88 per share.  Take the value of your portfolio and divide by $8,800.  That tells you how many SPY options you need to build a collar.

Keep in mind that SPX ($872 per share) also has options, and if your portfolio is worth at least $87,000 you can buy one SPX put and sell one SPX call to approximate your portfolio.  For in-between portfolio values, buy some SPX collars and some SPY collars.  This works best with a low-priced broker.

Problems and thus, questions about effectiveness:

a) How well does the performance of your portfolio correlate with that of the benchmark index?  If you have not held this portfolio for a significant period of time, you will not have enough data to really know he answer.

b) When you collar an index that you do not actually own, your broker is going to look at the position as a naked call option.  Some brokers do not allow you make that trade.  If you have a broker who is less restrictive, the margin requirement (these vary, so ask your broker) for that naked call may impose a burden on your account.   You never want to have a margin call.  Do not fool around with these naked collars if your account is in danger of receiving such a call.

c) If you regularly trade in and out of positions, then part of the time you will be over- or under-hedged.

How effective is this:  Much better than no hedge, but there is that correlation risk to consider.

Strike prices:

That's a lengthy discussion in its own right, but it's similar to choosing a deductible when you buy insurance.  You can buy puts with a strike of 86 or 87 and get pretty good protection for your SPY position.  Those puts cost more than lower strike puts - but the question for you is: how much are you willing to pay for insurance? I cannot answer that for you.  I make this suggestion:  No matter how experienced you are, if you never previously considered trading this strategy, do so in a paper trading account.  That will give you a feel for how this works with a real position. And you may decide it's not for you.  Or you may decide to protect only half (or some other fraction) of your portfolio.  This is a very flexible strategy.

When you choose the calls to sell, there are two major considerations:

a) Do you want to collect as much, more, or nearly as much, premium as you paid for the puts?

b) Would you prefer to sell a call with a higher strike price?  That allows for higher profits in a rising market, but it also means that you will be paying cash for the collar position.  That often results in a small loss, even when the market moves a bit higher.

Bottom line: If you adopt collars as insurance, you don't have to depend on asset allocation and diversification as your primary risk-reducing investment methods.  But, please don't conclude that you need no protection.  And this strategy is not for everyone.  If you are bullish and want to play for a rising market, this strategy will severely hinder your performance, unless you buy cheap puts for just a bit of protection and sell calls that are far enough OTM to provide the chance for a good upside.

This strategy is worth understanding, but it is not a recommended trading idea for most readers.  It's for the conservative investor who is willing to accept limited growth in exchange for a guarantee than he/she will not be hurt if there is a market debacle.

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Option Trading: How Important is Asset Allocation? Part IV

Synopsis: Discussing a Wall Street Journal article from Apr 29, 2009.  It's written by Anne Tergesen and Jane J. Kim. 

Advisers Ditch 'Buy and Hold' For New Tactics

Facing Angry Clients, Pros Turn to 'Alternative' Products; Risk of Missing a Turnaround

"The broad decline across financial markets in the past year has persuaded a small but growing number of financial advisers to abandon the traditional buy-and-hold strategy -- which emphasizes long-term investing in a mix of assets -- for a new approach geared to sidestep future market plunges and ease volatility."

Another mention that professional advisors are moving away from traditional investing styles.  Now 'buy and hold' joins 'asset allocation.'  It's not true that everyone is discarding these time-honored methods for risk reduction, but what was once considered to be gospel is losing adherents.

"an adviser... used to counsel clients to buy a diverse menu of stocks, bonds and commodities, and hold on for the long run... Today, ... [he] keeps about 90% of his clients' money in such low-risk investments as short-term bonds, cash and gold. With some of the small amount that's left over, he uses leveraged exchange-traded funds to place magnified bets both on and against the Standard & Poor's 500-stock index."

90% in Bonds, cash and gold.  I love the fact that this financial advisor was thinking outside the box and was truly trying to help his clients.

As I said, a noble attempt.  Unfortunately the advisor made a big mistake when buying leveraged ETFs.  Those vehicles are designed strictly for day traders and holding them for longer periods lessens the investor's chances of earning a profit. Adam Warner writes the Daily Options Report and has made a significant contribution with his reports on why owning leveraged ETFs is a losing proposition.

"Buffeted by steep declines in stocks, many bonds, commodities and real estate, many advisers are questioning their faith in long-standing investment principles, such as controlling risk by building diverse portfolios. Some are adding increasingly exotic investments, including products that offer downside protection, to client portfolios. Others are trading more actively -- and say they plan to continue to do so until they see evidence of a new bull market."

'Trading more actively.'  There's no other way to interpret those words.  Some advisors are now attempting to time the market.  It's almost beyond belief. One of the most sacred tenets of professional financial advisors is that it's extremely difficult to out perform the market by timing trades.  Yet, here they are: abandoning buy and hold.  Giving up on asset allocation.  Timing market buys and sells.  It seems these advisors will be trying anything to salvage their clients accounts.  Well almost anything...options are barely mentioned in this article.

"By abandoning time-proven prudent techniques, they run a serious risk of destroying their own credibility and their clients' portfolios," says...an independent financial advisory firm that still practices buy-and-hold investing.

The changes come at a time when financial advisers are coming under pressure from clients who are tired of paying fees only to watch their savings evaporate. Advisers have "a lot of cranky clients."

And they should be cranky.  Clients don't expect miracles, but when paying fees for professional advice, they don't expect to under-perform the market.

"some are adopting even less-conventional approaches in an attempt to more effectively offset the risks of investing in stocks... Others are turning to "structured products," which are complex investments that often employ options to provide downside protection. Still others are using investments such as currencies or managed futures that they believe will rise when stocks fall."

Options?  Did she say options?  Unfortunately there is this statement later in the article: "Such products typically come with high fees and employ investment strategies that can pose complex risks."  Options are finally mentioned as an alternative, but are soon dismissed as involving high fees and 'complex' risk.

Then there's the last sentence of this article: Advisers are using items they believe will move in the opposite direction than stocks do.  Amazing.  Isn't that the entire purpose of asset allocation?  Are these advisors trying this for the first time now?  Something must be lost in the translation.

Another advisor is quoted: "Asset allocations built on stocks and bonds are best suited to secular bull markets... but the past nine years have proved that nontraditional thinking makes more sense in secular bear markets."

I could not agree more.  Almost anything works in a bull market, but it's the bear market from which investors need to be protected.  My suspicion is that the professionals who collect commissions and fees from their clients always knew this and were happy to take feels when everyone was happy.  But it's been quite awhile since investors have been happy.  Traders can make a living in any type of market, but trading is for the few and investing is for anyone who can save a little money on a regular basis.  Those people need help.

"Other advisers are looking even further afield for alternative investments... is also recommending greater exposure to alternative investments, including managed-futures funds, bonds that back construction and expansion projects at churches, hedge-fund-like mutual funds, gas-drilling projects, and private partnerships that invest in real estate. He also holds positions in two private partnerships that invest in railroad cars."

To me, this is scary stuff.  Railroad cars?  Illiquid investments?  These advisors go pretty far to avoid using options.  I do not understand why this is true.

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Option Trading: How Important is Asset Allocation? Part II

Subtitle:  How does an individual investor reduce the volatility of an investment portfolio and avoid devastating financial losses?

Part I

Tom Lauricella, writing in The Wall Street Journal, caught my attention with two recent articles.  The first discussed whether asset allocation should still play a vital role for all investors:

"Asset allocation, a bedrock of investing for decades, appeared to fail miserably in 2008. The conviction shared by most investors -- that they should spread their money across myriad asset classes to minimize losses -- was shaken as nearly all markets tumbled in unison...

"Many investors came away from the carnage believing that last year was an anomaly...But a number of influential investors and analysts... argue that asset-allocation strategies are fundamentally flawed. This wasn't a one-off failure, they say, but one that's been long in the making."

As Tom notes, not everyone agrees.  But asset allocation is a fundamental concept.  It's part of modern portfolio theory.  Diversification and asset allocation were gospel.  Now there's some doubt.

The second article was published just four days earlier. 

Trying to develop new funds for retirees, Deutsche Bank's DWS Investments executives chose an ok strategy but they ran into problems.

"The experience at Deutsche Bank's DWS Investments ... reflects the challenge facing mutual-fund companies and life insurers as they try to transform volatile stocks into stable investments that offer retiring baby boomers predictable income or protection from losses. As if that isn’t hard enough to accomplish, they are trying to do it at a low cost to investors and in a way that doesn’t lock up money for years, as has been the case with many traditional guaranteed investments such as annuities."

Let's see...

    Stable investments. 

    Protection from losses. 

    Something that's not difficult to accomplish.

    Doesn't lock up money for years.

 

If we stir the pot and put our minds to it, perhaps we can discover a way to accomplish those four goals.  I know it must be a very difficult problem because the top brains at banks, mutual funds, and financial firms everywhere cannot find an answer...

Eureka! It's not difficult at all.  Why can't these highly paid investment professionals see the attractiveness of creating a series of funds based on the conservative collar strategy?  Wow.  Can it really be as simple as that? 

Collars:

    Protect the value of an investors holdings by establishing an adjustable minimum value for a stock market portfolio.

    Cost very little (if any) cash out of pocket.

    Allow for limited growth when the markets move higher. 

Can it really be that easy?  Isn't owning insurance a far better method for protecting your assets than spending a lot of time on asset allocation and diversification? (These are not to be ignored, but they are far less important than you have been led to believe.)

Is there some obscure law that prevents the widespread use of collars?  Perhaps the problem is with me.   Perhaps I see a very simple solution to a very complex problem and there are obstacles that are beyond my understanding.  But I believe too many people have decided that options are not worth discussing and that's the 'end of story' (to quote Tony Soprano). 

To me, options are the perfect risk-reducing investment tool for solving this very important problem - how does the individual investor reduce the volatility of a portfolio and avoid those occasional financial disasters?  Not everyone is willing to place any limit of the amount they hope to earn by investing.  Such investors have to find their own solution for managing risk.  But surely investors who already have a nest egg that they cannot afford to lose will be interested.  Surely those who demand insurance against loss, but who are still accumulating the wealth would be interested. As would any conservative investor, regardless of age or net worth.

I wrote The Rookie's Guide to Options for individual investors who enjoy hands-on portfolio management.  No need to trust a broker or advisor to manage an account as a fiduciary should - with the best interests of the client being the only consideration.  Wall Street doesn't work that way - the broker comes first and the client comes next.  There's much to be said for doing it yourself.  For those who cannot manage their own finances, I'm out to get the financial planners and advisors of the world to join the 'options team.'  That will take some time.

Maybe it's the highly paid professionals who need this book the most:  The DWS team that tried to develop such a family of funds but failed to use options; financial planners who failed to protect the value of their client's assets; traditional stockbrokers who shun options.  These 'professionals' are amateurs to me.  I know that's harsh, but how can they be allowed to get away with ignoring the needs of the investing public?

Collars are not difficult to understand.  They are not difficult to employ.  They protect the value of an investment portfolio.  They allow room for profits to be earned.  Sure, they are not perfect because potential profit is limited.  But when the goal is protecting assets, especially among investors who want to keep what they already have, collars solve the problem.

With a family of funds, the investor can choose among actively managed funds and passive funds (mimic the performance of a broad based index).  There is no need to invest with 100% of your positions collared.  I recommend funds with 25%, 50%, 75%, and 100% protection.  Something for everyone.

Perhaps collars represent a solution that is just too simple.  Perhaps they are not sexy enough for mutual fund, life insurance, and bank executives.  After all, if it's as simple as I am suggesting, who would pay these people the enormous salaries and bonuses they earn?  I'd start my own managed mutual fund composed of collar strategies, but I'm a bit short on seed money.  Say a few billion dollars short.

Why are collars so effective?  As I described as a recent guest columnist for Steven Sear's column, The Striking Price, in Barron's, collars can be used by both active and passive investors.  Collars contain a built in insurance policy (buy put options) - and you choose your deductible.  Collars include an income stream (sell call options) that pays for the cost of the puts. 

The problem, or the sacrifice one makes when adopting a collar, is that profits cannot exceed a specified maximum.  That's true because you sell call options and those calls give someone else the right to take your stock by paying a previously agreed upon price (strike price).  Thus, if the underlying investment moves higher than that price, all profits above that price go to the call owner.

To me, this is an ideal situation.  You can use collars for any portion of your holdings, or for the entire portfolio.  That allows you to have as much protection as you feel you need, and enough upside potential to grow your net worth.

P.S. Collars are just to get investors started with options.  There are simpler strategies that provide exactly the same protection and returns as collars.  Options are truly flexible investment tools.

to be continued...

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Learning about Options. How Much Detail is Too Much Detail?

I received an interesting e-mail message from a reader that inspired today's blog post.  I'll get to his comment later, but first some:


Background

One of the facts of life is that some people are very good listeners (I admit to being not so good at this) or readers, and understand the points being made by the speaker/writer.  Nothing is misunderstood.

On the other hand, some people are lazy listeners and 'hear what they want to hear.'  They ignore details, and that often results in bewilderment, as the speaker finds him/herself thinking:  'How can you possibly think I said that?  I said almost exactly the opposite.'

The same can be said for the speakers/writers.  Some supply all necessary details, while others speak in such broad terms that the detail-oriented listener/reader yearns for clarification.

I frequently find myself in uncomfortable situations due to my need for detail.  I have one specific friend with whom conversations are often painful.  I'm expected to understand what he means when his words are ambiguous.  But it's even worse when I speak.  I explain in detail, but those details are lost because they are unimportant to him.  It's as if we are speaking different languages.

I don't know if this is a character flaw on my part, but it's the world I live in.  Which brings me to today's comment.  I believe I provide careful, detailed explanations of the concepts of options: how they work, and how you can use them to reduce risk when investing in the stock market.  But is that true?  Are many readers confused by my writing style?  I'm not looking for an ego boost here, nor am I asking anyone to reply.  It's a rhetorical question - but I'm wondering what went wrong in this example.  or perhaps I'm overly concerned about something unimportant.

The Comment

His opening comment, referring to data received from his broker, was: "I often see Delta, Theta and Vega expressed in both positive and negative and I don't know how that is affecting my spreads."

The bottom line is that none of the Greeks are 'affecting' his spreads.  They are merely measurements of specific risks associated with the positions.  If any of those risks are unwanted - in an attempt to earn a profit - the beauty of trading options is that risk can be reduced or eliminated.

It's the word 'affected' that throws me.  My interpretation of this comment is that he is missing something.  But it may just be my problem - reading too much into a single word.  I Take his words to mean that the Greeks affect his positions, but he is not sure just how that works.  On the other hand, it may simply be a less detailed way of saying that he's a bit uncertain just how to use the Greeks.

The latter I can understand.  We learn what the Greeks are and what they represent.  How we should go about using them to our advantage may not be immediately obvious.  It takes analyzing some positions, and thus, trading experience, to grasp the concepts.   I know the Greeks are easier to understand with a clear explanation, but perhaps I failed to provide that.  Or perhaps my 'too many details; approach may have made it more difficult for him to grasp the meaning of my words.  This is a big problem because my goal - my job - is to explain things so that readers understand as quickly as possible.  The idea is to prevent the unnecessary loss of money.

I believe in details; I live for the details.  I don't know how else to accomplish my goals of helping the average individual investor learn to use options to mitigate market risk. 

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Why a Single Trading Strategy is Insanity

I'm returning to one of my recurring themes today because I found a great blog post by The Pragmatic Capitalist:

"Nassim Taleb is the analyst community’s biggest critic.  He recently said: “We have to build a society that doesn’t depend on forecasts by idiotic economists.”  This goes back to our flawed system of thinking.  Too many investors have been suckered into the belief that one investment approach is the best way to invest.   Can you imagine if an Army General had ONE battle plan?   Every war is different and requires a unique battle plan.  Economic cycles aren’t so different [from wars].  Each cycle is different and each cycle is going to reward different assets in different ways.  But investors have been schooled to believe that you can apply one school of thought or one investment approach to each cycle...

The same can be said of buy and hold for many small investors.  Unfortunately, we’ve discovered over the last 10 years that buy and hold isn’t always applicable.    All economic cycles are unique and asset responses to each will vary widely.  Investors need to learn that a multi-strategy, flexible approach is the best approach."

***

I believe the above quotation sums it up nicely.  Buy and hold was good advice as the markets soared from the end of the depression through 2000 - with some notable pauses along the way.  But for analysts to claim that the markets are bound to hit new recovery highs anytime in the foreseeable future are simply pie-in-the-sky wishes - as far as I'm concerned.  We can never know - in advance - which is going to be the best strategy going forward.  Thus, prudence, conservatism and insurance are essential for long-term success.  Why is that so difficult to understand? 

Investors should continue to invest - but only when their portfolios are insured against a disaster.  Without insurance it's just another form of gambling.  And if that insurance limits the upside, what's so terrible about that?  Isn't it better to be sure you have a nest egg when you need it - even if it turns out to be a smaller nest egg than it might have been had you not bought insurance - as opposed to being in need and not having the wherewithal to retire at all, let alone retiring comfortably?

Why don't financial journalists jump on this bandwagon?  Why don't all financial planners and advisors see the merits of sacrificing some upside for a guarantee of no more heavy losses?  I know it's not that simple.  Even if everyone were suddenly to decide that owning collars for all investments was a very sound, intelligent idea (which I believe it is), who's going to make all those option trades for the masses of individuals who need to make them?  That's the biggest hurdle. Educating people on how to protect their assets.

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Philosophy of Options Trading. Part IV

In this final installment (for now), I'll share more of my ideas about trading, and options trading in particular.  The purpose is to provide guidance for readers.  I'm not suggesting that you agree with, and adopt, all (or any) of these ideas.  Instead the purpose is to get you thinking about your own philosophy of trading and why my ideas may or may not be appropriate for you.

The bottom line is there's more to option trading than merely slapping on a position and then waiting for the options to expire.

1) Make the best decision you can at the time the decision must be made.  Do not berate yourself if it turns out not to be the winning decision.

2) Stay within your comfort zone.  Never 'hate' any position you own. It's easy to exit and find a better trade. 

3) "It's not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment." So says, Dr. Brett - and I agree.

4) Don't depend on 'hope' to salvage a bad position.  Use your intelligence to make a good trading/risk management decision.

5) I find that it's too risky to try to earn every every last nickel from a trade.  Exiting a position early locks in profits and gives you a quiet period with no risk.

6) Don't sell naked options.  The exception is for investors who want to buy stocks as prices decline.  For those investors only, writing naked puts is a satisfactory strategy.

7) Don't use options to gamble.

There's always more to say on any topic.  If you are so inclined, please share any of your basic trading tenets.

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I'l Like to Teach the World to Trade Options (Conservatively)

What is about option trading that makes me write so passionately about it?  In addition to this blog, there are books, magazine articles and a web site.  I teach the basics and beyond, explain how to adopt limited risk strategies, preach the importance of risk and money management.  I want people to have a more secure financial future, and believe they have a much better chance of reaching that goal by using options to reduce risk while owning stock market investments.

Teaching is not enough for me.  I also express my frustrations (outrage) with a system that discourages investors from adopting option strategies. 

• Most brokers have taken a neutral to outright negative bias towards options.  In recent years, several brokers arrived on the scene, with a distinct bias towards options.  They actively promote the use of options and make a strong effort to educate their clients.  These include: TradeKing, OptionsXpress, thinkorswim and OptionsHouse, but there are others.

I'm hoping that these brokers will change Wall Street's mindset.  The old school is definitely too old, and out of touch.  There's even one broker (Raymond James) that does not allow clients to use options.  Can you imagine refusing to let a client reduce the risk of investing?  Do they deserve to stay in business? 

• The situation with financial planners and advisors is even worse.  Very few know anything about options and that means that options don't exist as far as their clients are concerned.  What a loss for those clients!

• Many personal finance bloggers supply great advice to readers: Choose passive investing over actively managed mutual funds.  No need to pay fees to managers who cannot do better than the market averages.  But they miss the opportunity to make passive investing even better by not educating their readers about the benefits of protecting portfolios with occasional option trades.  Those of you who choose to own SPY, QQQQ, or any of the many other exchange traded funds with listed options, can readily adopt option strategies for added safety
  

I'm not the only voice in the wilderness.  There are other bloggers who want to spread the good word about options.  They educate and discuss various aspects of trading options.  Alas, there are also the hype artists who talk about using options to make great sums of money in a short time.  Sure you can use options as a lottery ticket, but why would anyone try to teach investors to  gamble?  These hypesters charge large sums to teach one or more simple strategies.  There are several excellent places where investors can learn those methods for little or no cost.

Those hypesters give options a bad name, and I'm distressed that one them was recently taken over by a reputable broker.

Options for Rookies may be a voice in the wilderness, but if you, readers of this blog, agree with what I'm trying to accomplish, you can help.  Encourage other investors to visit this blog.  Recommend posts you find worthwhile by linking to Digg or del.icio.us (links below each post). 

And more than that - if you have specific topic you would like to see discussed, please make the suggestion as a comment.  If you see a post or comment with which you agree, or especially disagree, please feel free to post a comment - explaining why you disagree.  Lively discussion is a big part of the education process. 

I have strong feeling and express them freely.  But they are not gospel, nor are they to be adopted by everyone.  I always urge readers to think for themselves and adopt trading methods that place them securely within their individual comfort zones.

I'd like to teach the world to sing trade options.  You can help.

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Problems with Your Stockbroker?

Note:  There's a new search feature in the upper left column, below the Chicago image.  Use it to find content from this blog and - if it's working correctly - my other online writing.

Below is a portion of an e-mail that arrived recently.

Mark,

My broker is xxxxx. Apparently they send my orders to preset exchanges.  Also when I enter an option order, near the close on expiration day, those orders are sent to their trading desks for review.

On another matter, when complaining about my inability to get filled on an order, the broker I talked to said I could file a complaint, and they would review it - but he persuaded me not to bother since the customer always loses and the decision goes to the broker.

JM

One of the biggest problems for customers of the brokerage industry is that the brokers work for themselves first, second and always.  Oh sure, they'd like their customers to make money.  After all, profitable customers are likely to continue trading - and trading  more actively (as their accounts grow).

But, the customer just doesn't matter in the long run.  There are always new customers - or at least that was the belief at one time.  Almost all brokers will disagree, pointing to the huge efforts they make to offer good customer service.  And customer service is important - I frequently ask questions of my broker.  But when it comes down to money, that's the point at which service ends.

There are always news stories about brokers churning (over-trading to earn commissions) accounts and people suing because the broker made inappropriate investments for them.  I have no sympathy for this latter group.  If you allow a stock broker - who knows nothing about how to make money in the stock market (or else he/she would be wealthy from investing) - to have discretionary power over your account, you deserve what you get.

But when brokers put commissions first and suitability of an investment second, that usually ends badly for the customer.

JM, your broker sends orders to pre-determined exchanges for one reason.  That exchange is the one that offers the largest bribe for order flow.  Of course, in the brokerage industry, the term 'bribe' is not used.  The gentlemanly term is 'payment for order flow,' and it's legal.

Thus, it's possible for your order to sit by it's lonely self on one of the smaller exchanges at the same time that many of those options are being bought and sold at your limit price on other exchanges.  If the volume is significant, the probability is high that your order will be filled.  But, there's no guarantee.  Your broker is gambling with your trade.  If the order is filled, he gets the highest fee.  If it's unfilled he gets nothing.  Your desire/need to make the trade is ignored.

Review

It's annoying to have your orders delayed for review, and I would not tolerate it from my broker.  But the reality is that too many people don't know how options work, have no conception of the exercise process, cannot determine if a trade may result in a margin call (after expiration), and need to be protected.  These are investors who are NOT regular visitors here and who have not read the Rookie's Guide to Options.  Thus, the firm is doing them a service.  But it's an inconvenience for you and other more experienced traders.  I know of no solution, except to find another broker.

Arbitration

In theory when there is a dispute, a customer can get an arbitration hearing with the broker.  But as you were told, the game is unfair and your chances of success are minute.  The rules are such that it's easy for the broker to receive a favorable ruling (most of the time).

349

Criminal Minds, Bernie Madoff, and Options Trading

Please don't get the wrong impression from the title.  There is nothing wrong with options trading.  In fact, as you know, I strongly believe it's an effective and efficient method for investors to reduce risk when investing in the stock market.

But 'options' have a bad reputation in some circles - and there's no good reason for that.  Bad publicity resulted when certain individuals caused financial catastrophes by gambling, and then losing, other people's money.  Remember the rogue trader (Nick Leeson) whose losses resulted in the failure of Britain's venerable Barings Bank in 1995? (Was it really that long ago?)

And then there's Bernie Madoff.  There are no words to describe his despicable actions, but he does bring to mind a TV show:

His ponzi scheme was founded on a sensible option strategy - a variation of the collar.

Options are versatile investing tools and there are a good variety of strategies available to the option trader.  I recommend collars for those who are very new to options and want to preserve the value of their investment portfolios.  It's a method worth learning.

In summary, collars involve stock ownership, coupled with the writing (sale) of a covered call option (to generate cash) and the purchase of a put option (using the cash from the call sale).  The put acts as an insurance policy, guaranteeing a pre-determined minimum value for the investor's assets.  That minimum allows investors to avoid painful losses when markets tumble.

347

Is It Deja Vu All Over Again, circa 1982?

I published the following on Feb 3, 2009.  I'm re-posting the very slightly modified version because I find myself in the same uncomfortable situation.

I cannot believe the market has seen the lows and that it's going to move much higher from these levels.  Why is that?  As bad as things look, there is the possibility that the worst is over and that the recession will come to an end soon.  There is the possibility that this is still a once-in-a-lifetime buying opportunity.  But I still cannot believe it. And I suppose that disbelief, all by itself, is a contrary indicator.

If anyone out there is thinking as I am right now, the following is posted as a warning as to what can occur.

***

I remember the summer of 1982 very well.  The market had been heading lower and the DJIA was about 800, or one tenth of its current value.  One blowhard, but very influential, market prognosticator (Joe Granville) was predicting the markets would move still lower.  And I bought into that.

As a CBOE market maker I carried large positions that were short many delta (and gamma).  I traded primarily Hewlett Packard and Dupont.  I planned to make a killing on the continuing decline.  1981 had been a fantastic year for me, and I was going to make even more money in 1982.

Then, a funny (not really funny) thing happened.  The market rose.  And rose some more.  Being as undisciplined as possible, I remained short - confident that this newsletter writer had it right and that I was going to get the rewards I deserved.  And so I did.  The markets moved higher and higher and, eventually, I had to give it up.  I owned a large short position at the bottom, made too few adjustments, and paid the price.

Why mention this story?  Because I feel I'm there again.  Is it really 'deja vu all over again?'  

I see no reason why this market should do anything but recognize that our economy is in horrible shape; that things are going to get far worse than anyone believes, and that we may even find ourselves in a depression (update: I no longer believe it can get this bad). Under those conditions, the stock market should get crushed.

But, I also know I have a very poor track record when predicting market direction.  And I'm much more disciplined today.  Thus, I can ignore my bearishness and avoid placing myself in jeopardy in case the market bottom is already in place.  What I know for certain is that I have no idea what the future holds.  I fear a debacle, but cannot afford to bet on it.   Nor can I allow myself to get clobbered if it comes to pass. 

Thus, I'm really in a good place - not exposed to a large loss if we see a dramatic rally and not exposed to a big loss if we find ourselves in the midst of a stock market catastrophe.  In fact, I own enough positive gamma to profit from a huge move in either direction.   And if neither occurs - if it turns out that we are range bound for awhile, my iron condor positions will provide a small reward.

If I'm in such a good place (for now), why does that make me uncomfortable?  Common sense and a disciplined approach to trading is supposed to be a good thing.  I know it's a good thing.

Dr. Brett, where are you?

344

The Blogosphere. Be Careful Out There (Amended)

Amended

The blogosphere is a fantastic place and serves the needs of  millions.  As it gains more and more publishers and readers, its influence grows.  The open question is when bloggers will be given the same respect as other writers - such as newspaper columnists and reporters.

One problem is that the quantity of garbage that's posted is almost beyond belief.  Most contributors try to be honest, but some make mistakes that can cause harm to others.  Some deliberately disperse misleading information in an attempt to make money or further some political cause.  One of the wonders of the blogosphere is that anyone can write a blog and send his/her thoughts out to the world.

Some bloggers write for themselves and have a small audience.  Others are very influential and have huge audiences.  But regardless of the audience, there is no way to control the spewing of nonsense.  Sometimes it's worse than nonsense - it's harmful information that damages those who have no way to know that the mis-information is not true.

I'm sharing my 30+ years experience with you, and truly believe the guidance I offer is helpful.  Your kind comments tell me that I'm succeeding in that regard.

But what is there to distinguish Options for Rookie's from the blog described below?  There is no way for a reader to 'know' who is right and who is wrong when contradictory advice is offered.  Part of the time the disagreement is subtle and may be the result of using an ill-chosen word.  But sometimes the difference is factual.  It's up to the reader to distinguish fact from fiction.

 

***

A recent question from a reader indicated that he believed a married put (long one put and long 100 shares of stock) is superior to owning a call option.  I explained: because those positions are equivalent, neither is better than the other and that when the options are priced efficiently - at expiration - the position disappears, and each provides exactly the same profit and loss - within a dollar or two.  Of course, this must include everything (except commissions), such as dividends collected, interest not earned because cash was invested in the position (this is called the cost to carry), margin interest paid to the broker, etc.  Sometimes one position is more efficient to own because it requires fewer commissions, but that's not considered when we speak of positions being equivalent.

When I asked why he believed as he did (and I'm not certain I convinced him, even after four e-mail exchanges), he gave me a web site as his source.  Sure enough, the following was published in a blog:

[This is from a blog that I will not name.   I'm sure you can find it if you so desire, but what's the point?  It's merely one example of people selling books and courses and newsletters with incorrect information.  It's just another case of buyer beware.] 

I am amending this post on 5/29/2009 at the request of Kurt Frankenberg, publisher of the blog, Radioactive Trading.  He disagrees with my statements and feels very strongly that the strategy he describes is one that truly benefits those who follow his advice.  I apologize for omitting his name and link to his blog.

I stand by my criticism of the married put strategy, but you can learn more about that method by visiting his blog.

Long Calls vs. Married Puts

Question:
What is the advantage of buying stock with an in the money married put over just buying the call of the same strike price to start the trade?

[Note: this assumes there is such an advantage, when there is not.]

Answer:
The most powerful benefit is that this arrangement doesn’t allow you to become overextended. It FORCES a position size that doesn’t hurt too badly if it goes against, whereas someone wishing to invest in the same issue with the same sentiment might be tempted to over-trade their available capital.

[Note: He is saying that if you decide to buy 1,000 shares and 10 puts, you will not be intelligent enough to buy only 10 calls, and that you may be tempted to buy a much larger number.  That's insanity.]

Also, there are adjustments that can be done with the put that cannot be done at a profit with a long call.

[NOTE: An incorrect statement.  There are no risk-free adjustments that can be made to one position that cannot be made with the other.  Why?  Because the positions are equivalent.]

Finally, there is the fact that many accounts cannot be traded with pure options plays, or that people may own stock as a part of their compensation plan at work, and these strategies directly benefit those situations.

[NOTE: a) I have never seen a broker allow married puts and not allow long calls.  b) If you own long stock and want to buy the married put, you can do so.  But the equivalent position is to unload the stock and buy calls instead.  That works because (stock + put) = call).]  

***

In one of his videos he states "The put option is the only risk management strategy that works for all markets." Here is a link to his videos at YouTube.

I hope you all recognize that this statement is not true.  If puts work, then calls always work also - when you make a synthetically equivalent trade.

***

These mistakes are not so horrible that the reader is going to do something stupid.  But this blogger is defending his incorrect statement because his whole premise is that he has discovered a great way for investors to limit losses - the married put.  And guess what? He profits from that idea by sell materials that show readers how to adopt that married put strategy.

I'm not picking on this blogger for any specific reason.  He may truly believe what he says is true.  But that's very unlikely.  Instead, it's just a general warning that not all bloggers are honest and not all are competent.  I suspect most of you already knew that, but the person who sent those email messages is confused and that bothers me.

It's far easier to buy call options and it involves fewer commissions. NOTE: I do not recommend buying call options, but I do prefer it to buying married puts.

Further note:  This post is about blogging and incorrect information - it's not about whether a married put provides a tax advantage in a specific situation.

342

Is Passive Investing the Road to Wealth?

I'm one of those who has looked at the record and decided that active mutual fund managers cannot - on a consistent basis - outperform the market averages.  Obviously there are always going to be a few exceptions, but it's impossible to know - in advance - which funds to buy.  There are always some big winners and losers.

To me the obvious conclusion for the mutual fund investor is to skip the payment of large expenses and management fees and invest in index funds, or the some of the ETFs with very low management fees.  Just saving that one to two percent management fee, along with trading expenses, puts the investor ahead of the game.

But not everyone wants to own funds.

The evidence is also clear that the vast majority of individual investors who choose their own stocks cannot do any better than the professionals, and also under-perform the stock market averages.

That's one of the reasons you are visiting this, and other blogs that are devoted to options education.  Conservative option strategies and prudent risk management increase your chances of being a successful investor.

But what about passive investors?  Must they just take their chances and hope the markets rise steadily over time, or can they also take advantage of options? 

Options work nicely for passive investors. When they own optionable exchange traded funds (ETFs), passive investors can adopt conservative strategies, and in exchange for limiting profits when the market soars, use collars to protect the value of their stock market portfolios.  Imagine the benefits for passive investors.  They usually are content to accept average returns over the long run.  Options provide a much better chance for those investors to outperform most mutual funds - and they get the advantages of owning portfolios that are protected from incurring a huge decrease in value.

What puzzles me is that I have not found any financial writers, bloggers, or professional advisors who recommend using options together with passive investing.  Passive investors are merely one additional group of investors who are missing out on the benefits of investing conservatively with options.

Follow me on twitter.

340

Risk Management vs. Strategy Selection

When trading stocks, the idea is to buy stocks that are going to move higher, or as Will Rogers said: "Don't gamble. Take all your savings and buy some good stock. Hold it till it goes up, then sell it.  If it don't go up, don't buy it."

                          

The good news and the bad news about option trading is that it's much more involved than trading stocks.

Option prices don't always move as anticipated because many factors come into play when options are priced.  As we recently discussed when talking about measuring risk using the Greeks, one factor that may drive the price of a call option higher (rising stock price) may be offset by other factors, such as the passage of time or a decrease in the option implied volatility.  Understanding how options are priced, is essential to trading options successfully.  It depends on more than whether the markets are heading higher or lower.

That's the reason risk management is so important when trading options.  The idea behind this post is to help rookies understand that strategy selection is not all there is to trading options.  It's easy to hear someone rave about the profits he/she earned by writing covered call or owning iron condors - but the truth is that such successes are often followed by significant losses, unless the investor/trader understands  how to manage the trade. 

Anyone can write a covered call and profit most of the time.  Only the person who understands risk management can survive serious market declines.  Anyone can own iron condor positions.  In fact, it's a strategy that is touted far and wide on the Internet and there are many advisors who will be happy to sell you costly lessons on how to trade iron condors, and even more who will take your cash, and, for a measly 20% of the profits, will trade iron condors for you.

But the investor who understands how to manage risk can trade those positions without paying large sums to others for either trade execution or costly lessons.  Managing risk - and by that I mean keeping all losses under control - is the single most important contributor to your long-term success as an option trader.

It's okay to take small losses - in fact, it's inevitable.  But eliminating large losses means you will never go broke.  When you trade spreads that have a high probability of being profitable, you will win most of the time.  Couple those profits with small losses and you achieve success.

339

Q and A. More on Married Puts vs. Long Calls

My recent post brought a lengthy reply.

Mark,

I am quite new to options trading. We have become involved with a program in the UK that calls itself The Protected Trader. It buys 100 stocks (DJIA) [NOTE:  DJIA only has 30 stocks, but the specific index traded is not important to the discussion.]  at the same time buys a put option 5% above stock price 6month or more out with a maximum risk of less than 8%. Again at the same time sell OTM one or two month call option with 5% or greater premium.

[I took one quick look at the web site.  This is what I noticed:  A lot of hype - touting 'no risk investing.'  All by itself, that should be a warning, but to his credit, I see no promises of specific profits.  He offers a free video, so at least he is not charging too much.  He claims his fee is $10,000 for a one on one session to teach his system.  I have no idea of the value of what he teaches, but that price is unreasonable.  Period. And the 'no risk' part frightens me.]

This appears similar to the strategies put forward in the Blueprint to which I believe you allude in this blog. 

[I am unfamiliar with the Blueprint, and that is not the program I mentioned.]

Apparently you are buying puts that are already in the money, and those are costly.  Besides the intrinsic value (amount ITM), you are also paying up to 8% in time premium for a put with a lifetime of 6 months.

Next you are selling shorter-term call options that carry a time premium of 5%.

I am having difficulty visualizing this, so I went to the marketplace to look for an example.  Using OEX, the S&P 100 Index, I found:

OEX = 418

DEC 460 puts are $64.  $42 intrinsic value and $22 time value (almost 8% of the $41,800 investment).

Aug 420 calls are $23, just over 5% time premium.

If OEX crashes, the puts provide ultimate protection, limiting losses by allowing you to sell the index at 460.  Your cost was 418 + 64 - 23, or 459.  Most, if not all, of the $22 in put time premium may be lost, but you keep all $23 from the call time premium.  All in all, not a bad result in the event of a crash.  No loss, and a small gain.

If OEX surges to 500, you are obligated to sell at 420.  That's not so bad by itself, but you paid $64 for puts and collected $23 for the calls.  Of course you can still collect some cash for your puts, but it looks as if you are out a good portion of the $4,100 you paid in premium - less the $200 profit you have from buying at 418 and selling at 420.  Not a good deal.

Maybe I'm using bad numbers, but I don't see how this works in a strong market.  Sure, it works fine when the markets are steady, but buying those 6-month puts is costly.  I prefer to own a true collar in which all options expire on the same day.

The same person also wrote this response to Chris Smith's review (below) to justify married puts over long calls:

Aren’t Long Calls and Married Puts the Same Thing?  [Yes, assuming the options are priced efficiently.]

Chris Smith actually bought The Blueprint. I’m okay with his review, except he should be informed that:

1) The Blueprint’s chapters HAVE been revised to name the Income Methods with the traditionally accepted terms, so that part should be eliminated if he wants a current, accurate review and be reminded…

2) The benefit of the married put at the outset is that it defines risk more readily, in a more understandable way for many. [I cannot deny that if it really is 'more understandable' then that would be one reason for recommending one idea over another.  But I don't see how that applies here. 

To me, buying a call and paying $5 defines the risk as $5 - and anyone can understand that.  To buy stock plus an ITM put, and pricing the put so that no more than 8% of the investment is tied up in time premium, is much more difficult for the unsophisticated trader to understand.]  

A married put is NOT the synthetic equivalent of a long call; it is the synthetic equivalent of a long call WITH that long call having a commensurate amount of capital on deposit in a free interest account. That’s intellectual honesty. [That argues more in favor of the long call, but it's really not important.  When options are priced correctly, the cost of carrying long stock is priced into the options.  And if the stock pays a dividend, that's also priced into the options. Agree that you want your investor to understand this point and understand what he is being advised to trade, but because it should not make any monetary difference in the outcome, it's not an essential point.]

That is why the time value premium of an OTM call is always higher than the time value premium portion of an ITM put at the same strike. The free interest rate is priced in. [When the options are priced correctly - which is almost all the time - It's not relevant when choosing which method to trade.  Because they are equivalent positions, the financial result will be the same.]

Folks that want to trade an ideal amount of risk will find that using a married put will do the heavy lifting for them intellectually. They simply decide their risk parameters and use the PowerOptions search screen… no problem. [I think I see one problem:  The need to sell the idea that others must use this search screen.  Sounds like self-promotion to me, and the truth be damned.]

At one point, Chris shared with me that he was trading an amount of $5,000 and had a $1,000 gain in the same period of time that I was trading $100,000 and had a $2,10O gain. His implication was that pure options did better. [An unreasonable conclusion, even when ignoring the important discussion below.  Was he trading the same underlying?  Did he buy/sell options at the same time at equivalent prices?  Are your commissions and other expenses equal?]

I pointed out that it might appear that way on the surface… a 20% gain versus a 2.1% gain… but that after all, his $5,000 SHOULD represent $100,000 of total trading capital because he was risking 100% of the capital that he was betting on each long call, while I was risking 5% of the capital I was betting on each married put.[Agree]

In other words, 5% of $100,000 is exactly equal to 100% of $5,000…. by that standard, and by the dollar amount both of our accounts returned, my 2.1%, highly protected gain was greater than his highly leveraged, 20% gain. [Yes, his gain was larger, but it's not fair to label one account 'highly leveraged' and the other as 'highly protected' when in fact, the accounts are equivalent, and the risk is the same.  It's merely an illusion that he is more leveraged. 

He did find a way to mimic the performance of your portfolio with 'only' $5,000 and by the traditional definition, he is highly leveraged.  But in the context of this discussion, they own the same portfolio with the same amount at risk.  The other guy just uses less cash.  That doesn't feel leveraged to me]

If we’re going to talk leverage, let’s talk leverage. A trade that goes against me costs 5%, the same trade that goes just as sour against a pure options guy costs 100%. [This is the epitome of illogical thought.]

100% of $5k is the SAME as 5% of $100k.  [Yes.  Is it possible that people cannot see this?  Investors have blind spots all the time, and this is just another one of those.  It never ceases to amaze me.  I've been told:  'If I own the call, my whole investment can disappear, but when I own the married put, that's not possible.'  They just don't get it.  The time decay (including interest costs) is the same.  The profit/loss is the same.  The positions are equivalent.  But the fact that one trade loses 100% blinds them to everything else.]

RadioActive Trading [This is the guy I was quoting in my post]  with a married put ENSURES that a trader, ESPECIALLY a beginner to options or to money management, does not take risks that are too big. Meanwhile, it still affords the trader the opportunity to take dividends, or to play these strategies on the company that he works for when he receives stock as an employee benefit. [Yes, if you get stock as a benefit, it's easier to buy puts.  But that does not make it reasonable to conclude that the married put is better for all investors.  This is insulting to the investor.  He is saying that someone who would buy 500 shares of stock and five puts would not understand that the correct number of calls to purchase is five.]

The Blueprint may not be the publication of choice to the seasoned options trader that [sic] already understands deep principles of money management, but that’s not to whom it is addressed.[OK.  But does that make it ok to mislead individual investors who are option rookies - just to sell whatever it is that he has to sell?  Telling them married puts are better than long calls is just not being truthful.]

Mainly, I’ve been trying to benefit the thousands that have been burned by the snake oil gurus in the covered call seminars, the case for writing covered calls, ignoring downside risk. [But there are other ways to mitigate downside risk, other than the married put.  To me the collar is the best compromise, but that's for my comfort zone.  There are other choices.] ...

ANYway…this helps answer folks that [sic] keep coming up with the same old tired argument: Trading long calls and married puts is IDENTICAL.  [The reason it appears to be a tired, old argument is because it's the truth.  It's honest.  The truth is often boring.  I NEVER encourage anyone to buy call options as part of an investment portfolio, but that has nothing to do with the fact that the play is equivalent to owning married puts.]

Hogwash. If there wasn’t a difference than why prefer the calls? There IS a difference, and though that difference may to some only be a matter of how to manage them… it’s that difference that makes them a simple choice for the folks to whom The Blueprint is addressed: People that heretofore have ignored or not understood the principles of safe money management. I believe in my soul that it will help those whom it’s designed to help, and perhaps the review could reflect that. [I'll grant that owning married puts is safer than owning stock.  To that extent it 'helps' those 'folks.'  But, they would be better served owning a call portfolio that's equivalent to the married put portfolio.  There is no difference - when options are priced efficiently, but it's easier to trade and easier to understand, despite his contrary belief. 

I get the 'in my soul' part.  He sounds sincere, just as I know I'm sincere.  But sometimes the most sincere guys can make mistakes, just like anyone else.  Teaching that married puts is 'better' than naked long calls is not a good thing to do.  Teach equivalence, then explain why he believes that one is more effective than the other. 

I prefer naked put selling to covered call writing - but only because it's less expensive to trade and easier to shut down the trade.  The positions are equivalent.  I would never argue that one is 'better' - just more efficient. 

It appears to be the same here.  He knows they are the same, but refuses to admit it because he prefers to trade the married put.  He has a vested interest in convincing others that the MP is better, and that vested interest makes him like any other salesman - he pushes what benefits himself.   He doesn't want to recommend buying calls because it's possible for the investor lose it all.  It's easier for him to go for the married put where losses are limited - even though the dollars lost are identical.]

Mark, we are trying to learn these strategies to assist with capital accumulation and/or income. Do you feel that they are flawed and if so could you indicate why so that we can understand as it is difficult to get independent information.

[If you don't like the idea of investing all your assets into owning naked calls - and I surely don't, then there is no reason to like the idea of owning married puts.  But earlier you mentioned the extended collar.  I think that type of collar has too much upside risk, as detailed above, but I do believe that collars are the investment strategy that can work for you. Excellent protection, limited profits.  Much will depend on your ability to manage positions and risk, but if there is one (and I'm not saying there is) strategy that requires minimum  risk management, it's the collar.  if you go that route, be certain you understand pin risk.  That can be a problem.

One more thought.  You can open paper trading accounts and practice a variety of alternative positions at the same time that you are managing your real money.  That will give you an opportunity to try collars, extended collars, married puts, and anything else that occurs to you.  If you go that route, give yourself a year before deciding any one specific strategy looks better than another.

Regards

Ditto

P.S. Pin risk is carefully described in The Rookies Guide to Options.

330

Q and A. Trading Options: Married Puts vs. Calls

Thanks Mark.

When we start off on a process of study/education to improve our financial status, the difficulty is that we don't know what we don't know. We try to have a healthy skepticism to certain claims but we hope that within the strategies put forward there is reasonable kernel of truth. So if claims of Married Put and selling Calls strategy producing 3-6%/month are unfounded we do not really mind. As long as somewhere around 1% per month (or annual equivalent) is feasible once adept in the strategy then we would be comfortable with that-provided that the capital preservation aspect of the strategy is valid. We have up to £500K available but that forms a significant part of our assets.

Many thanks for you assistance,

Regards
Roy

Roy,

Knowing that 'you don't know what you don't know' puts you ahead of so many gullible investors who just assume that everything they hear or read is the gospel truth. 

I try to keep things as simple as possible, and leave the part of option trading that can best be handled by the quants to those with advanced degrees in math, physics or perhaps some other discipline.  My chemistry degrees are of no help.

The strategy you describe is a collar.  Sure it can be called 'married puts with selling calls' - but it can just as easily be referred to as 'writing covered calls with long puts.'  Nomenclature isn't the issue.

With the collar strategy, the purpose of the puts is to gain the peace of mind that comes with knowing your assets are protected.  The purpose of the call sale is to pay for the puts.  Otherwise buying those puts - without the call sale - is very costly and it would be difficult to overcome those costs and earn any profits - without a huge market surge.

The call sale limits profits, but to me, that's a good trade-off when your major objective is to avoid large losses.

Your skepticism is necessary because option trading is one of those fields in which it's easy for anyone to make any claim.  After all, it's statistically possible to double your money every month with option strategies.  But the chances of that happening are so minuscule that for anyone to claim that as a possibility is essentially not telling the truth. 

Some who promulgate those untruths are using hype to make money by selling educational materials.  Others are simply misinformed, and mean no harm.

I can tell you that if you own puts that are only 5% OTM, then you can be certain the capital preservation aspect of your strategy will work.  Of course, if you lose 3% every month, that's not so good and your capital will disappear.  But that is also statistically very unlikely. 

When you sells calls and collect enough call premium to more than offset the cost of those puts, then there's an excellent chance of increasing the value of your portfolio on a consistent basis.  Obviously, if your underlying asset declines by 2% or more every month, you will not be profitable.  But the collar strategy will lose less than if you held the portfolio unhedged - and it certainly performs much better in a significant downtrend - by limiting losses.

As to the claims of 3-6% per month, that is really going to depend on market movement.  You cannot expect to earn those profits if your investments don't increase in value on their own.  Part of your profit comes by collecting more premium than you pay, but part must also come from the fact that your portfolio holds its value.

The collar offers inexpensive, or free, insurance, but cannot guarantee a profit when your portfolio declines in value.

329

Opinion: The Importance of Integrity

Why do investors buy shares of actively traded mutual funds?  Most of those funds charge a hefty sales commission (front-end load), charge an annual management fee and force customers to share advertising expenses.  And to make matters worse, they cannot out-perform their benchmark indexes before those fees are extracted from the investor's account.  Why are customers willing pay all these fees and accept less than average returns?  They just don't know any better.

Things are even worse in Canada.  The Canadian Capitalist comments on the same topic.  As does Preet who discusses advisors recommending actively managed funds. 

No-load funds exist, and some are quite successful in nabbing investor dollars.  Index funds are available and not only are they free of sales commissions, but they charge much lower annual fees  and never under-perform the benchmark index - because they are the benchmark index.

So why do investors make poor choices and choose to pay high fees and accept lousy results?  The only reason I can find is that there exists a sales team that earns juicy commissions for convincing clients to make these money-losing investments.   Stockbrokers earn good commissions when selling mutual fund shares.  Many brokerage houses run their own funds, collecting both management fees and sales commissions.  Insurance companies sell mutual funds.  In short, there's no shortage of salespersons to market these below average products.

Why can't these brokers tell the truth to customers?  Why don't they tell customers that no-load index funds are more likely to provide better performance in the years ahead, as they have in the past?  The answer is lack of integrity.  Greed, and the need to earn commissions, regardless of how it affects their clients - that's Wall Street's way.  The good advice slogan 'pay yourself first' certainly applies to salespeople on Wall Street.

It's not so different (it's just less harmful) than the sales pressure exerted by mortgage brokers who encouraged people to lie on their applications and refinance mortgages - knowing that the client would be unable to make payments when rates readjusted in two years.  All in the name of earning a fat commission for themselves.

This is nothing new.  It's been going on forever.  One person takes money from another any way he/she can.  I'd go so far as to call it a scam to sell mutual funds.

Look at Bernie Madoff for example. He does not cooperate with authorities.  He tells no one where the money is hidden and spends the rest of his life in prison.  But his family gets to keep that money.  There's no effort to return it to those from whom it was stolen.  There's no integrity; no interest in trying to do the right thing.

For my part, I'm trying to help investors learn to protect their assets with option strategies.  But, there's no sales team.  There are no commissions to be earned.  So I, and other bloggers, who do the individual investor a good service, accept the good feeling that comes with providing that good education - with little financial reward in return.  Too bad my message cannot find wider acceptance, but with no commissions to be earned, few are willing to take the time and effort to spread the word. Integrity - a job well done.  That's my pay.

328

Options Education for Individual Investors

I'm in a strange mood, so I'll get on my soapbox again.

Since the year 2000, I’ve turned my attention to educating individual investors about the benefits of using option strategies as part of their trading arsenals.

I don't tout expensive seminars, nor is my purpose to promise that trading options will produce instant wealth.  The infomercials you see on TV or the full-page newspapers ads you read promise much.  But common sense tells you they cannot deliver as promised.

My philosophy on adopting option strategies is that it's worthwhile because it provides two essential benefits when investing:

• Reduced risk.  In real world terminology, that means if unforeseen events occur (such as the year 2008 or the bursting of the technology bubble a few years earlier), your portfolio is protected against significant losses.  You can use options as an insurance policy, in which you establish your own ‘deductible.’

• Fewer and smaller losses.  As a corollary, you will have more winning trades, but the gains are not unlimited.

Why doesn’t everyone use options?  Because there is a downside.  If you adopt the strategies that I recommend, then it’s true that losses are limited.  But in return, profits are also limited.  Here’s the key: profits are not minimal, and you can earn excellent, but limited, returns.  Some investors have the dream of finding stocks that double (quickly) and then double again and again.  Most of us realize that those days are over, but if that’s your dream – if you are seeking a huge profit when investing, then the basic option strategies that I love (and use for my personal trading) are not for you.  You can use options to gamble, but I prefer to discourage that.  If that’s your goal, learn about using options from someone who touts those gambling, high risk methods.

The basis for my website, this blog  and my latest book, The Rookie’s Guide to Options, is to educate investors on how to use options conservatively – and that means to reduce risk and increase the probability of earning money – when compared with buy and hold investing. 

If you already bought into the hype of those infomercials, this blog may not be exciting enough for you because there are no get rich quick schemes. I offer education.  I’ll teach you to understand how options work and how to make intelligent trading decisions when using options.  I’ll carefully explain how to monitor the position and how to manage risk.  I believe in detailed explanations so that you understand and can learn how options work for yourselves.  You don’t want to be dependent on someone else to make specific investment decisions or recommendations, do you? 

I believe that risk management is the key to success.  If you make your primary investing goal the elimination of large losses, then your chances of success are excellent.  The steady profits, coupled with small losses, will provide for your financial success.  But disasters must be avoided. 

I have four rules for investors, and it’s important to use them in this sequence:

• First: Don't go broke.  Protect your assets

• Next: Make money

• Then: Build wealth

• Always: Never forget the first rule

321

Hedging

"Prophesy as much as you want, but always hedge."

 The  wise words of Oliver Wendell Holmes, Sr in 1861.

Oliver Wendell Holmes, Sr
Poet, Father of Supreme Court Justice

Hedging.  Good advice then, excellent advice now.

hedge

hedgehog

293

Mark To Market Rules

Here we are in the midst of a huge rally, and I'm not happy with my iron condor positions.

Playing conservatively, I've already closed 1/3 of my RUT 460/470 call spreads.

I own extra calls, but they are not enough to offset pending risk, and market volatility.   As my account is losing value, I'm rolling some short call spreads to higher strikes.  Moved the RUT May 460/470 spread to 520/530 and moved some Jun 460/470 spreads to 530/540.

I did not sell extra call spreads.  Not happy, but I must do what I must do and my comfort zone had definitely been violated.  Feel better now.

***

I just don't understand this whole process.  The banks - which would be officially insolvent if they had to mark their toxic assets to the current market - have been given a reprieve by the FASB (Financial Accounting Standards Board).  But, IMHO, they are still insolvent.  So why the rally?  These banks are not going to begin lending money to each other - because they know each other bank is also insolvent.  So how does this MTM rules change help anyone?  And nothing has been done to encourage banks to begin lending again. 

Naive me thought that the whole idea to salvage our economy was to encourage banks to lend to small business and individuals.  I guess the idea was really to do anything to prevent the banks from doing what you and I and each trader must do - and that's recognize the true value of our positions on a daily basis.

290

The Cost of Not Knowing Enough

I read a very interesting post (hat tip to JD) by Carl at behaviorgap.com

It's  entitled 'The Simplicity Premium.'  This post is based on Carl's.

Background:  When someone doesn't know any better, he/she often pays an 'ignorance premium.'  That phrase refers to an extra cost associated with overpaying because the buyer lacked significant information.

Is it worth the effort to save that premium?  There's no correct reply because it takes research.  If you spend too much time learning what you need to know, saving the ignorance premium may not be worth the effort.  Or, it may be worth far more.  It's not so easy to know, in advance, if the deal you are being offered is reasonable or overpriced. This situation occurs frequently - when you buy a car, home, or furniture.  When you shop at a flea market or farmer's market.  When you shop online, there's an increased risk of  paying for a counterfeit. 

The ignorance premium is used by salesmen to convince consumers to overpay for almost anything.  I'm thinking of those over-priced, over-hyped, multi-thousand dollar option seminars.

The Simplicity Premium

Carl has coined the phrase 'simplicity premium' to represent the added cost of valuing simplicity.  The idea is that people are willing to pay a premium to make their lives easier.  We hire people to do tasks we can easily do ourselves.  But sometimes, the premium is really inexpensive - and you get good value and an easier life. 

Carl's prime example:

"Investing is simple. But... not easy.

There really are only a few things that you have to get right (simple), but because there are so many ways to get it wrong, it seems complex.

It’s simple, but not easy...

There are so many ways to invest. So many people willing to sell you crap. So many entertainers pretending to provide advice."

It's true.  That's one reason why investors buy front-end load funds instead of no-load or index funds.  They take advice from a broker who makes a living by selling funds with loads (up-front sales commissions).

The financial industry is loaded with people (some aim to harm you deliberately) who look out for themselves first.  That means they want their fees and/or commissions, and if the customer doesn't buy something appropriate, too bad.  Just look at those mortgage brokers who convinced the ignorant to buy homes they could not afford and/or trade fixed rate mortgages for variable-rate mortgages, with incredible interest rate leaps.  True, many home buyers did it to themselves, but not all.

It's the same in my world.  There are those who love taking large sums to impart knowledge that's available for little or no cost.  They sell pricey lessons and materials at very high prices to those who don't know where to get good information for next to nothing.

I live by the simplicity premium, when it's affordable.  I just never gave it a name.  And that's how I operate when helping others learn to trade conservative option strategies.  There's plenty of free material in this blog, or on my website

Thank you Carl.

287

Can You Make Money With Options?

In a forum I frequent, I recently came across this innocent sounding question: "Can anyone make money consistently when trading options?"

I don't know if the poster was thinking about learning to trade options and wanted an opinion as to his prospects, or whether he's been unsuccessful and wants to know if he is in the minority.

What I dislike about this type of question is that it serves no purpose.  That's equivalent to asking: "Is eating food good for you?"

The answer is yes, most of the time.  You need it to survive.  If someone eats only at McDonald's, that's certainly bad.  But, if the alternative is to eat nothing at all, then McDonald's becomes  healthy in comparison.

It's not the 'trading of options' that turns an investor into an investing wizard.  Options are a tool.  Tools are instruments that provide help in the completion of a task.

Options provide investors with investing alternatives not otherwise available.  The investor can write covered calls in an attempt to collect extra dividends.  An investor can buy puts or collars to protect the value of his/her holdings.  And investor can adopt conservative strategies with limited gains and/or limited losses and there's always the opportunity for gambling - something I believe is best avoided.

It's not necessary to trade stocks, because options allow all stock market investing methods without ever trading a single share. 

Don't forget, an option's primary purpose (at least in my opinion) - is to allow hedging, or risk reduction.

It's not an option that makes money, it's the investor and his/her decisions, strategy selection, stock selection, and risk management technique.

Yes you can make money with options.  But no one is going to hand it to you.  As with anything else in life, it takes some effort to learn to invest wisely with options.  If you are diligent and careful with risk, you can make money with options.

280

Q and A. Is Hiring a Mentor a Good Idea?

Mark,

As an active options trader I would like to bring up an issue: 

Even after you've got a solid self education (books, internet sites and webinars, paper trading and even live trading) - the nature of the options world is that there is always a lot to catch up, in this risk/reward sophisticated area. The issue is: after "graduating" yourself... does it make sense to practice with real money on your own (starting with modest amounts, of course), or to get a mentor to walk you through complicated stages like: making the right entry to the right strategy, set up exit points, adjustments, repairs and more. There are companies out there which charge a couple of grand, usually accompanied by risk free guarantee (if you don't make money, you get refund). As for myself, I do try to get around on my own, unless I find some mentoring program in which I pay gradually reasonable amounts, and see results as I move forward. What do you think?

Gil

Good questions. And it brings up important points.

There is a huge difference between being a very short term trader and an investor.  They develop different skills when learning their craft.  You must know which skills you need.

For example, timing is far more important for a very short-term trader than it is for an investor.  I consider myself to be a short-term investor.  The strategies I teach are not for day trading. They are meant to be held for a period ranging from a couple of weeks to two years (if you use LEAPS options).  Thus, timing is not at the top of my list of things I believe someone must master.  But, more than that, I don't believe it's a transferable skill.  It takes a big effort and years of experience to become a successful market timer.  I know those who love technical analysis disagree, but this is an argument that may never end.

"Setting up exit points" is also a method associated with day-trading.  An investor modifies such decisions as conditions change.

If you find a mentor who can transfer his/her knowledge of technical analysis and years of experience so that you become able to pick the 'right' entry point for a trade, more power to you.  I don't think it can be done.

1) When ready to trade with real money, I prefer to see an investor/trader begin on his/her own, trading a small number of option contracts.

2) It's far too soon to hire a mentor.  The new trader must gain real world experience because for some, virtual trading is of minimal help.  That's true for those who didn't take it seriously because it was 'only' play money. 

You don't want to hire a mentor and say "Teach me."  It's better to discover the areas in which you want additional help, and find someone who has a proven record of being able to teach those specific skills.

3) Can a mentor help?  Part of the answer depends on how you define 'mentor.'  It can be a teacher or a trainer.  Some may confuse the mentor with a trading coach.

a) For example you say you'd like help with 'making the right entry.'  I believe very few people can time the market and make the 'right' entry.  And if you find someone who can do that, as I mentioned, it's not something that can be easily taught.

b) Yes, there is a great deal to more to learn once you begin trading.  In my Rookie's Guide, I explain 'what to look for' when entering a position and how to manage risk.  That includes exit strategies.  But for an investor, it's not necessary to make the 'right' decision all the time.  I believe the goal is to make a good decision - I call that process 'making the best decision you can make at the time you must make it.'  If you understand a given strategy, if you understand the risk of adjusting a trade compared with not adjusting, if you can take a loss and move on - then your chances of being successful are excellent.  Those are not the sort of items you said you are seeking in a mentor.

c) I don't believe a mentor can do those things.  If you want to be a very short-term trader, then the strategies I discuss are not for you.  As an active options trader, you already know the difference between opening hedged positions vs. naked longs or shorts.

The day trader probably wants to buy calls or puts with high delta, and profit by predicting market direction.  I suppose some short-term traders use option spreads, but that's a very difficult thing to do (too many trades, too much slippage).  It's much easier to day-trade stocks or single options.  But, if you want to be a day trader, then a trading coach may be helpful.  To me, that's not the same as a mentor.

d) I consider myself to be a mentor - but not under any of the conditions discussed so far.  I believe a mentor is a teacher.  Someone who can explain - so the student can understand well enough to go out and make decisions for him/herself. I wrote the book with that in mind.  And I reply to follow-up questions from readers. 

I also take on a few as clients - when they want to get more detailed information on specific strategies or want to discuss various aspects of using options.  But I am not into technical analysis, and never know the best time to enter or exit a trade.  I think you are discussing a mentor who is more into helping you learn about active (vs. passive) trading skills.

e) I consider adjustments and repairs to be part of the education process and not something that an option trader learns to think about after positions are owned.  I recognize that many trades require no adjustment and thus, the newbie gets less practice in a crucial area.  That's one good reason for trading with smaller sums when beginning.  It's not just that the trader is a rookie, but it's also because he/she has no experience with the (sometimes frightening) idea of making an adjustment and locking in a loss.  It all takes time to become comfortable with the entire process.

4) Regarding firms that charge thousands, promise refunds, and spend a great deal of time (that you paid for) telling you that you need more seminars: Don't do it.  They always (randomly) have successful students who provide testimonials, but they will not tell you about the losers.  I have no idea how easy it is to receive a refund.  There is no need to pay that much money.  You have good books.  You have the OIC and CBOE web sites.  You have blogs such as this one where you can learn and also ask questions.  Use the money you would have paid for those seminars to trade, or buy other educational material.

A mentor may be appropriate for you - but please understand just what it is that you want help learning - and most importantly whether someone can teach you those skills.  I'm sure someone may be able to help you better understand specific trading techniques: how to enter an order, should you enter a position as a spread or as individual legs (spread is my answer), why one strategy may be better for you (as you discuss your ideas, the mentor may offer good guidance).  But teaching you to time the market.  No way, IMHO.

279

Financial Professionsals. Do They Serve Any Purpose? Part II

Since my recent rant about financial planners, I learned a few things.

1) A former industry professional, with more than 20 years experience writes that: "There is an unbelievable lack of understanding of options amongst all levels and all participants within financial institutions...The regulatory requirements for brokers, managers etc is antiquated and insufficient. For that reason many professionals do not understand today's options markets." 

He goes on to say that too many not only don't understand options, but also are more concerned with not being sued if a client loses money, than they are in providing clients with the ability to reduce risk.

2) Preet writes an excellent financial blog from Canada.  He was primarily a financial advisor until recently, and offers this: "I’ll try not to bite the hand that feeds me too much (I’m still in the industry), but many of the criticisms of the industry stem from the fact that advisors are paid as salespeople and not advisors, and training is focused on sales techniques not portfolio management."

3) Gail, A well-respected financial journalist writes: "The calls for help are frantic.  Please send me an investment advisor who will stop losing my money." 

The fact that such advisors are unable to provide worthwhile advice on how to avoid huge losses, is a disgrace. 

Conservative option strategies, anyone?

 

Gail describes how a 77-year old woman was told to invest 60% in stocks and 40% in bonds by an advisor who never bothered to get in touch with her over the past five years.  When the client finally called the advisor, the advice was to keep only 25% in stocks. 

That's it?  Go to 25% now?  He never called.  He left her stranded.  Why?   Financial advisors charge fees for this non-service?  How do they sleep at night? 

My opinion: This is just more 'business as usual' in the investment universe; earn commissions and ignore the client.

4) Ron Leiber, financial columnist for the NT Times "turned to financial planners and investment advisers who got their start as psychologists...I asked them this: At this troubling moment, what’s the best way to reorient how we think about money, before we make any rash decisions."

One advisor offered this nonsense:  "His answer to clients who articulate that nightmare is this: the markets will eventually recover."

I cannot imagine how anyone who gets paid for advice can offer that garbage to clients.  It's true that the US markets have always recovered in the past (sometimes slowly).  We're currently trading at 12-years lows and yesterday, the Japanese markets established a new 26-year low.  Does anyone truly believe that can't happen here?

 

Bottom line is that too many planners/advisors may have passed exams that allow them to be licensed to offer advice, but they are failing clients just the same.  No one expects them to pick individual stocks or recommend only winning mutual funds, but they lack the skills to protect their clients.  They, like almost all investors, make money during bull markets, and it's likely that their clients are unaware of how much (or how little) the planner's advice affected the bottom line.   But when the bear markets arrive, as they always do, the licenses aren't worth very much because the advisors simply do not understand how to reduce risk by hedging with options.  Who loses from that: the planner or the client?  Someone must protect those clients.  I'm trying.

267

Mark To The Market

Hi Mark,

I would love to hear your take on the mark to market debate. I have been saying for awhile now that mark to market is responsible for the steepness of this banking crisis, but obviously not the root cause itself. Do you agree that the financials and the market in general would benefit from abolition of these rules? Do you agree that this is an issue that should have been addressed months ago?

Mark to market helped the financials skyrocket in boom periods and has sunk them in this crisis.

Income Trader

Hello IT,

I'm no expert on this situation, but I do have strong opinions.

1) Yes.  I agree that this issue should have been resolved months ago.  And must be resolved now.

2) Here's a question for you:  Assume you have a large  position that is short a substantial number of long-term strangles and that you have a downside bias - i.e., you are delta short.  Further assume that market conditions become uncertain and implied volatility soars to record levels. 

You love your position.  The market declined and starting with acceptable risk, believe you are in great shape.  After the market decline, you are now delta neutral and anticipate that the strangles will begin to shrink in value.

There's one little problem.  The strangles you sold @ $30 when VIX (CBOE Voltaility Index) was 50, are now trading @ $180 and VIX is 120.  Your account cannot take the loss of $12,000 per strangle because you sold too many.  Your account is in deficit.

When your broker threatens to liquidate your account unless you wire a huge influx of cash, do you believe you can tell the broker that: "It's just marks.  If we ignore mark to the market, my account is in great shape.  See how neutral I am."

You know you cannot.  You are over-leveraged and lost far more money than you thought possible.

How can your broker evaluate your account by any method other than mark to the market?  And if you cannot repay your debt, it's their money on the line.  They are going to liquidate - and probably at very unfavorable prices.

3) Thus, I'm a big believer in MTM.  If the financial institutions were forced to MTM daily, it would have been obvious that they owned assets in trouble (worth less than the value carried on the bank's books), and would have been forced to begin unloading them far sooner.  I don't know who would have bought these positions, but being allowed to continue to hide losses, become more and more over-leveraged, and essentially gamble with (what turned out to be) taxpayer money, is not right. 

I believe MTM is essential and levels the playing field for everyone.  The problem is, that it should have been enforced far sooner.  We would not be in this mess (It would be a different mess) if MTM had been enforced from the beginning.  Enforcing it now is going to make things more difficult.  But the fact that MTM was not enforced earlier is not an adequate reason for not enforcing it now.

4) I believe several of these big banks are insolvent, will remain insolvent forever, and have zero chance of recovering.  I admit that I do not fully understand the consequences, but I'm for nationalization right now. 

I believe the government should take all the garbage assets (we are paying for them anyway) and create new, clean banks.  Imagine Citibank with all of their assets: branches, customers, deposits, etc - and no bad loans on the books.  That would be worth many, many billions of dollars - and the taxpayers would benefit as the government sold 80% of that bank (gotta retain some ownership in the new, thriving business) to new, qualified investors.  Current officers, not eligible.  These healthy banks would have no reason to be afraid to lend to each other, or to the public.  Thus, the economy would have an increased chance of recovering quickly.  Continued stalling is not going to help these banks become solvent.

One more point.  I know there would be a market for all those currently toxic assets.  The government could sell those positions to anyone who wanted to bid.  That way, the taxpayer would no longer own them, would no longer have to throw good money after bad, and would have temporary, partial ownership in the recovering banking system.

Naive?  Perhaps.  But it sounds right to me.

266

This 'n That

It's the weekend again and who knows what news awaits us on Monday.  Bank closings?  Bank nationalizations?  Bankruptcies - GM for example?

It makes me nervous to hold positions with negative gamma when market-moving event can so easily be announced.  Just another reason for owning portfolio protection.

I'm waiting for Treasury Secretary Tim Geithner to say something useful, but at the same time I'm concerned that his next speech will be no better than his last.

Because I no longer trade individual stocks (or their options), I seldom pay attention to where stocks are trading.  But, when I look at prices, it's so difficult to believe I'm living in the same United States of America that I know:

GM     1.46
EK   2.24
F     1.70
C     1.03
BAC    3.14
GE   7.06

The VIX (CBOE volatility index) is elevated, but far below the highs reached last autumn.  And that's reasonable because the market is less volatile now that it was then.  But many investors believe that a falling market is always paired with sky-high VIX values.  This time (so far), VIX is lower than many would have guessed - and thus believe that the bottom cannot be reached without a large spike in the VIX.  I disagree.  A bottom is possible without that spike.

There's plenty of fodder for political argument.  The right blames it all on Obama and his 7 week presidency.  The left blames it all on dubya.  Where's the bipartisanship we voted for?

265

Financial Professionsals. Do They Serve Any Purpose?

I recently read a column by a financial journalist whom I respect.  Not all such writers deserve respect. 

The discussion was about how difficult times have become for those who are saving for retirement and that many may not have a net worth that's sufficient to get them comfortably though their 'golden' years.

For that column, our writer interviewed several people who earned the title of financial advisor or financial planner.  Readers were told that advisors are currently worried that too many people aren't thinking clearly, and are not focused on making their next eggs last through retirement.  It's not so easy to think clearly when your life savings may have been cut in half.

One such planner, who works for a large firm said that she (the advisor) decided that she "could not let people continue to spend money as usual" because today's conditions were too extraordinary. Why would anyone take advice from her now, after being hung out to dry?

From the interviews, the journalist said that "most advisors 'can't allow' people to hope the stock market eventually will fix everything."  They certainly allowed that before - why would anyone follow their advice to abandon stocks now?  Isn't it too late?

What I find most disturbing about this column is that these financial professionals were supposed to protect their clients from losing such large portions of their nest eggs.  Their job was to help clients prepare for the future and that includes an understanding of the risks associated with investing.  As far as I'm concerned, they do not do enough.  Telling people to diversify, allocate assets, own some gold, buy and hold etc. worked just fine when the markets were soaring.  In fact, the advisors didn't have to do anything during those bullish times.  Oh yes, they did have one thing to do: charge fees.

But when the markets headed south, when good advice was needed, when investors needed protection, I ask: where were the advisors?  What did they do besides charge more fees?  I don't have evidence to prove anything improper was occurring.   In my opinion, it's just a case of the almost blind leading the blind.  But I intend to do some research on professional planners and advisors to see what I can uncover.

There ought be be a requirement that advisors learn, understand, and instruct their clients on how to reduce risk and protect themselves from a catastrophe by adopting hedging strategies.

The best way to do that is to use options to protect the value of a portfolio.  Does the education of planners include any study of derivatives, including options?  I'd like to know.

I recognize that too many individual investors don't have the time or willingness to learn how options work.  That's the job of those who are in charge of protecting their investments.    But do advisors understand how options work?

It's not my favorite approach, but put options could have been purchased as an insurance policy.  That insurance is costly and perhaps collar strategies could have been used.  Either would have prevented a disaster.

The point is that these advisors failed their clients, and now some of them are expressing the thoughts quoted above.  The advisor has the gall to state that she would NOT ALLOW people to spend.  Allow?  As if it's her decision.  As if she is coming to the rescue.  It's far too late for that. 

Now?  Why not earlier?  I know why.  They are being defensive.  Feeling badly that they hurt their clients, too many advisors are probably trying to earn additional fees by providing the same old, traditional advice now.  But to me, it appears as if they are issuing commands:  Thou shalt not spend.  Thou shalt save more money.

And this is my favorite:  After years of telling clients that buy and hold was the best strategy and that it was right not to panic during the markets decline of more than 50% - now - now these people are not ALLOWING clients to depend on the stock market.  What nonsense. Don't panic when the DJIA falls to 13,000 or 10,000 or 9,000.  Now, at sub-7000, now is when clients are advised to no longer hope the market can eventually fix everything.  I'm not saying that such hope will be rewarded, but it's certainly a bit late to be offering that advice.

I don't know that much about financial advisors and planners, including where they get their education and why they are allowed to peddle their advice, but I intend to look into this topic further.  If any of you hire planners or have information you believe is useful, please post a comment or send email to blog (at) mdwoptions (dot) com.

262

No Good Deed Goes Unpunished

I found this post to be so appalling that I had to bring it to the attention of readers of this blog.

Barry provides a great description of how a couple of honest  brokers hurt themselves by taking great care of their customers.  The motto for them is: No good deed goes unpunished.

Another blemish for an industry that doesn't have room for additional blemishes.

Addendum: 2/3/2009 7:40 PM

GMG comments: That's pathetic and very short-sighted. I'm pretty young, so can you tell me, has it always been like this in finance?

There was a time in America (and I assume elsewhere) when people had pride in their work. A time when guarantees and promises meant something. A time when people understood the meaning of having a fiduciary responsibility to the client. I don't understand how or when that disappeared, but it's a rarity these days. And Barry's post illustrates a fine example of people with integrity doing a good job. And they are the ones who were punished. It's very sad.

Over the past few years, risk takers were given greater and greater incentives to seek huge rewards.  Among those with huge incentives where company CEOs.  To earn those gigantic rewards, it's necessary to take huge risk. It's not so easy to have the integrity to keep risk under control, when the personal gains are so large (enough money to last a lifetime). Who can blame them for taking that risk - especially when they had nothing personally to lose (except perhaps a job)?  Not everyone has the integrity to resist.  And last year, those risk takers lost vast sums.

Consider the mortgage brokers who made high commissions by selling loans to people they knew would default. They knew their clients would never be able to make payments - yet they sold the mortgages anyway.

There are plenty of people who make a sale just to get their commissions, knowing that the customer is often shafted. Apparently this is common in today's brokerage world.

Integrity used to mean something to people. I don't know how we became a nation of people who care only for themselves and their cronies. Perhaps integrity can return to this land. I hope so.

***

Here' the post to which  referred in te opening line.  It's despicable.

By Barry Ritholtz - March 3rd, 2009, 7:09AM

Its fairly well known in the traditional retail investment world that the client and the advisor often have opposing, and sometimes contradictory, interests.

I sometimes forget just how much so in my little world of boutique asset management (We charge about ~1%). A conversation with a couple of brokers from a large firm that I can’t name (hint: Rhymes with Schmerrill) reminded my just how misaligned the incentive system is, and how screwed up it must be to work at a huge, publicly traded, mega asset management firm.

To wit: These two gents run a few $100 million dollars in managed accounts. They are mostly stock jockeys, but they have a smattering of bonds as well. Their assets are spread out amongst stocks they selected, in house managers, and other mangers on their firm’s platform. Typically, the clients are charged 1.0-1.25% on their assets. Various products (I hate that word) will pay the broker more or less depending upon the fund manager’s arrangements with the house.

As is typical of brokers with this size asset base and seniority, their payout was about ~43%.

Let’s do some quick math before we get to the heart of the conflict: On $300 million in assets, let’s call it $3.3 million dollars in gross revenue to the firm. That’s about $1.4 million to them, from which they pay a few sales assistants, T&E, etc. Thus, they each should be making about half million dollars annually before Uncle Sam takes his.

Here’s where things get interesting: Early in 2008, they moved aggressively into cash. (Obviously they are TBP readers). For most of the year, they run about 20% bonds, plus 5% percent stocks (some client would not sell). All told, about 75% of their asset base is in money market funds, which pays out essentially nothing to the broker — but preserves the clients investments. Late in the year, they put a toe back in the water.

Overall, the clients do very well. In a year where the markets are practically cut in half, their clients lose about 10%. The investors are ecstatic, and while the two brokers annual compensation was schmeissed — they went from over $3 million gross to under $1 million — they have happy, referral making clients to rebuild their business upon. Its a short term income hit that should generate gains over the long term. And, they got there by doing the right thing.

Now, that drop in income alone raises conflict issues. I tell clients who ask why they are paying 1% to sit in Cash that they are not — they are paying 1% to not be losing 45% in equities, and to have us tell them when to go back into stocks. We think that’s worth 1%, and if you disagree, well talk to your friends who have seen their investments destroyed.

Here’s where things get completely misaligned. When 2009 rolls around, their manager calls them into his office, and says: “Bad news, boys. Your revenues dropped so much last year you are in the Penalty Box. As per your contract, your payout for this year is 30%.”

Let me make sure I understand this: We did the right thing by our clients, and although we took a big short term revenue hit, we hope it pays off over the long run. And the firm response is to drop our payout even further? So the entire system is set up to discourage doing the right thing by the client?

(Hence, why they are talking with us).

We’ve previously discussed the misaligned compensation system of bankers and the short term incentives that led to the entire credit crisis. But did you have any idea that the entire industry was so utterly conflicted?

I find this utterly ridiculous. No wonder we get so many inquiries from (soon-to-be-former) clients of the big houses:They have been cut in half, but at least the firm got its 1% and the broker’s payout remains at 43%.

And that’s all that matters in the end, right?

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Random Thoughs On Various Topics

The market has undergone back-to-back days of high volatility - first a decline, then a rally.  But the volatility indexes (VIX, the CBOE volatility index) and the one I watch, RVX (Volatility index for the Russell 2000 index options) are significantly lower than they were before these two volatile days occurred:

VIX declined from 49 last Friday  to 45 on Tuesday.
RVX declined from 53 to 50.

Uncertainty surrounds us.  Will last night's presidential speech to Congress give the market some direction?

*****

Bear market rallies are often fierce.  If the markets head higher Wednesday,  we'll all have to decide if we are seeing one of those rallies, or if the bottom has been seen.  I'm not planning to guess.

*****

I'm personally rooting for another day's rally because I'm short some put spreads that I'd like to cover - at good prices.

*****

Can the government really encourage (ok, force) the banks to lend money?  That's what's needed to the economy working again.

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An Unnecessary Warning

I enjoy participating in online discussions concerning options, and frequently visit and post at online forums.  I recently encountered a suggestion that was so absurd, that I thought the poster was attempting to make a (poor) joke.

Nope.  It turns out that he was serious.  I hate the idea of publicizing his idea, but am doing so just to be certain every reader of this blog understands options well enough to run away - at warp speed - from anyone who suggests that you consider adopting a strategy that is in any way similar to this (I have no polite adjective to insert here) poster's idea.

I'm sure this warning is unnecessary, but just in case...

The idea?  On expiration day, sell 10,000 options that are 'way out of the money' for the princely sum of $0.01 each.  Yep, that's a total of $1.00 per contract - before commissions are deducted.

This joker believes that trade yields a profit of $10,000 per expiration - and apparently thinks it's free money.  He actually calls this 'guaranteed way to make big, risk free money in options.'

Reality:  Selling very cheap options is a losing strategy.  Sure these options expire worthless almost all the time.  Just think about the one time when this turns out not to be true.  Stocks can, and do, make major moves in the final few minutes of trading on expiration Friday.  Attempting to make such a tiny amount of money is financial suicide.  Think about the loss if just one of these trades results in an option moving into the money.  With 10,000 contracts, that costs $1,000,000 per point.  Not only that, but can you imagine how your order to buy 10,0000 (now in the money) calls is going to affect the price of those options when the stock price is surging?

I understand this is an idea that will attract no followers.  But what I fear is that someone might think it's a good way to pick up a few extra dollars by selling 10 or 20 contracts.  Please don't do it.  And if the price is $0.05 per contract, the idea is no better.

By the way, the margin requirement for selling naked call options does vary by broker, but a reasonable minimum is $250.  (Many brokers do not allow the sale of naked call options under any circumstances.)  Thus, it takes $2,500,000 to meet the margin call on this play.  Do you think anyone who has two and one-half million dollars worth of free margin would jeopardize his/her account in an attempt to earn peanuts* ($10,000 less commissions)?  I don't.

* Peanuts for that investor, not necessarily for the rest of us.

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