Blog Post #714. Babe Ruth and Trading Options

Options for Rookies first appeared two years ago today.  Thus, it's our blogging anniversary.

Today's post is #714, and whenever I see that number, it instantly brings to mind the name Babe Ruth.  His career home run record (714) stood for more than four decades until broken by Hank Aaron on Apr 18, 1974. 

As a tribute, this post is dedicated to Babe Ruth and how his career provides excellent trading advice for us.  NOTE: This idea is not original with me. The Crosshairs Trader Blog, posted on this topic earlier this year.

In turn, that blog post was based on an excellent article written in 2002 and published by Credit Suisse/First Boston.  The following quote comes from that source:


Babe-ruth
Babe Ruth

Principle: "The frequency of correctness does not matter; it is the magnitude of
correctness that matters."

Translation for traders: Babe Ruth struck out many times in his career.  But he is remembered as one of the greatest hitters of all time.  Those home runs contributed to Yankee victories far more often that his strikeouts resulted in losses.

As a trader, it is not how often you win that counts.  When you consider your success or failure as a trader, the only number that matters is the number of dollars earned.  Over a short time span, luck plays a big role.  But as you trade longer, you discover that keeping losses (strikeouts) small – even when they occur more than 50% of the time – is the key to success.  Collecting both small (singles) and large (extra base hits) wins makes you a winner.  

Sure it feels good to have a string of winners and I always emphasize that feeling psychologically satisfied when trading is of value.  But when you look at your results, you know it's far better to earn $100k when winning 40% of the time than to earn $60k with a 60% win percentage.

I'm not suggesting being reckless and consistently targeting home runs.  In fact, there is no need to seek them.  Some of your plays are going to work spectacularly well (yes, even when you adopt limited profit strategies).  That's part of the game.

Your task, as risk manager, is to prevent the opposite – spectacular failures from occurring.  You must not ignore risk when trading. 

Skillfully managing risk, and minimizing the significance of your strikeouts, allows those home runs to play a big role in your profit/loss picture.  If those big wins are accompanied by large losses, you are not likely to succeed. 

Do not ignore the value of singles and sacrifice bunts (exiting a trade that has become too risky).  Those are the bread and butter trades that feed your family.  The home runs pay for the luxuries.

714



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12 Responses to Blog Post #714. Babe Ruth and Trading Options

  1. Josh 06/11/2010 at 7:49 AM #

    Happy two year anniversary!

  2. Mark Wolfinger 06/11/2010 at 8:15 AM #

    Thank you
    It’s been a happy and busy undertaking

  3. Brandy 06/11/2010 at 7:21 PM #

    Congratulations on the anniversary. Your work has been very helpful to me in getting a practical approach to options trading. Best wishes.

  4. Mark Wolfinger 06/11/2010 at 9:26 PM #

    Thank you

  5. Donald W. 06/12/2010 at 12:59 AM #

    Same as Brandy and Josh above. Your two books Options for Rookies and Create your own Hedge Fund as well as this blog site has been extremely valuable to me after losing almost everything I had in the Market. Recommend you at various site from time to time. Thanks a lot.

  6. Mark Wolfinger 06/12/2010 at 9:33 AM #

    Thanks Donald

  7. Anonymous 06/13/2010 at 12:15 PM #

    Mark, Is it a virtual certainty that if a stock merely reaches the strike price it will be called away? My question is “Why?” We need an example: Strike price $30.00, Premium $1.00. It seems that if the stock just reaches $30.00, the buyer actually pays $31.00 for the stock. Why wouldn’t he wait for the stock to exceed $31.00 before he exercised his option?
    2. Is it true that the buyer almost always waits until expiration to exercise his option? Why would he wait until the expiration date in the case where the stock quickly rises above $31.00. It seems that in a case such as that the stock has prospects of continuing to rise, so he would want to own it early.
    Thanks,

  8. Mark Wolfinger 06/13/2010 at 3:24 PM #

    1) No. It is a virtual certainty that the stock will NOT be called away. [EDIT: NOT CALLED AWAY NOW – ‘NOW’ BEING DEFINED AS WHEN THE STOCK REACHES THE STRIKE PRICE]
    1) Please supply one reason why you ask this question. I have seen this question over and over again and for the life of me I just cannot understand why anyone would ask. if I can understand why that happens, maybe I can give a better response.
    As a favor – please tell me what gives you the impression that the call owner would exercise the option. Please. I answer your questions, you can answer just one of mine.
    2) What does the price paid for the option (premium) have to do with the decision to exercise? The answer is: absolutely nothing. It is completely irrelevant. Furthermore, as an individual investor, I would give you the general advice to NEVER EVER exercise an option. Just sell it. Why do I say that? You have no idea if or when to exercise, so it’s far better for you to NEVER exercise.
    3) Yes. The buyer who is not a moron waits until expiration before exercising a call option. There is an exception when a dividend is involved.
    4) If the call buyer wanted to own stock, why did he buy an option? Why didn’t he buy stock> Figure out the answer to this question before you ever trade another option.
    5) If the stock continues to rise, do you believe that it is better to own the stock than to own the option? If the stock moves to 40 do you believe that the option owner is missing out on some profit potential?
    If yes, please tell me why? If you exercise you must pay $3,000 for 100 shares. You also sacrifice any time premium that remains in the option. If you hold the option instead, you don’t have to pay anything more than you already paid. So which is better? Putting up $3,000 or putting up zero? Throwing out time premium or salvaging it?
    If you don’t want to hold the position any longer, just sell the option. Why in the world would you exercise? Please be kind enough to reply.
    And after you exercise what happens if the stock tumbles to 25? Does that question give you any understanding why only a moron exercises early? [There are exceptional circumstances in which an exercise is desirable, but you are not referring to those]
    The problem here is that you have no understanding of how options work. I know this is an education blog and I always try to be kind and offer useful replies, but this question makes me angry. Why do I see it again and again? Some idiot out there is mis-educating beginners and I cannot get any clue as to who that person is.
    I hope to hear from you again. Regards,

  9. Anonymous 06/13/2010 at 4:10 PM #

    Mark, I’m sorry you’re so angry about answering my question. This is the first time I asked the question, so your anger is misdirected. As you know, there are a lot of nuances to trading options so for us beginners, it’s not as easy to grasp as it is for you. And expiration can be confusing. I appreciate your reply but not the sarcasm.

  10. Mark Wolfinger 06/13/2010 at 4:53 PM #

    You are correct in that my anger and frustration are misdirected. But you hold the clue and won’t share.
    You learned this notion about exercising options someplace. Where?

  11. Anonymous 06/13/2010 at 5:28 PM #

    I read it in a book but I believe I misunderstood what the author was saying. I got confused between “reaching” the strike price and “going above” the strike price. Thanks for clearing this up. It is confusing, but I’m slowly getting it.

  12. Mark Wolfinger 06/13/2010 at 5:40 PM #

    Great. There is nothing wrong with getting there slowly. You have the rest of your life to trade options and when you do understand you will be amazed at just how simple options are to understand.
    Trading and making money is not as simple. But understanding the concepts is uncomplicated. People expect it to be difficult and establish roadblocks that do not exist.
    Best of luck to you.