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Stock Options: White Hats or Black?

Remember early TV days when the 'good guys' wore white hats and the 'bad guys' wore black?  It was easy to tell them apart.  Today, the white hats of the investment world are seen as wearing black hats by far too many.  Options.  Those are the good guys.

White hats

This post was first published at The Options Zone.

The word
‘options’ evokes a negative emotional response from people who never use them,
don’t understand how they work, and who prefer to remain in the dark.  Many investors truly believe that options are
risky investment tools, used only by high-rollers.  Thus, they make no effort to see ‘what all the
fuss is about.’  Surely they know that
huge numbers (several billion per year) of options trade, but they have no
curiosity.  Why?   I’d guess that an uneducated broker once
told them that options are ‘dangerous’ and are too complicated for the
individual investor to understand.  The
truth is that those stockbrokers were unwilling to learn, and provided a
disservice to their clients.

Today, the
world is more efficient, with useful information (along with misinformation and
hype, so please be careful) all over the Internet.  Options Zone is a safe place to learn about
options, and that’s the reason I accepted an invitation to participate.


Those of
us who understand how options work reap the benefits.  Those who prefer ignorance, must trade with
much more risk than necessary.  For most
investors, bull markets provide profits and bear markets bring the realization
that investing is not a gimmie.
Options are unique.   

The
first obvious difference between options and other investments is their limited
lifetime.  However, the most important
feature of options – the one that makes it an indispensable investment tool –
is that options allow an investor/trader to measure and manage risk. 

  • If you choose not to be hurt during a bear
    market, you can own insurance against large losses
  • If you prefer to use leverage, you can attempt
    to turn a small investment into many times that amount.  This is the ‘gambling’ aspect of options
    that I don’t recommend – but it’s your money and you make the decisions
  • You can own an option position that benefits
    when specific stocks, or indexes, trade in a narrow range.  Or you can own a different position that
    earns money when a specific stock moves much higher or lower
  • Whatever your outlook for the market – bullish,
    bearish, neutral – there is a hedged options trade that earns a profit if
    your outlook becomes reality.  NOTE:  This sentence is not what the hypesters say.  Their line is 'you an make money in any market.'  Sure, but you have to be correct in your forecast.  You cannot take a bullish stance and expect to profit when the market crashes
  • The bottom line is that each of these objectives
    can be attained with limited risk.  There’s
    no need to invest large sums to buy stock. 
    Options can be used to meet the needs of anyone who trades stock,
    commodities etc.

When you
own options, the passage of time is your enemy. 
But you can earn a profit when your prediction comes true.  By hedging the trade and accepting a limit on
profits, ‘time’ risk can be cut considerably. 
When selling options, you earn profits as time passes.  However, other risk factors make this idea
too risky for most investors. Again, by hedging and accepting a smaller limit
on possible profits, that risk can be cut dramatically.

My
purpose today is not to compare the advantages or disadvantages of adopting
various option strategies.  Instead it’s
to point out that you can measure, and reduce, the risk of investing.  That’s why options are special and worth the
time to understand how they work.

More
experienced option traders know better than to try to make money by constantly
buying or selling options and predicting how the market will move.  They understand how difficult it is for the
vast majority to have an inkling of what’s coming next in the stock markets of
the world.

These
investors trade spreads, or reduced-risk, hedged positions.  I’ve discussed the best features of
some basic spreads and explained how to benefit by adopting them (see 'categories' in the right-hand column).

Today,
the idea is to help option rookies understand that options are used to hedge
trades – on a continuing basis – to reduce risk.  Note: options are not perfect.  If you want the combination of zero risk and guaranteed
profits, you are living on the wrong planet.

One
example is the popular strategy: covered call writing.  Investors earn profits when the underlying
stock moves higher, holds steady, or declines by a small amount.  It’s very popular among new option traders,
but serious, experienced investors also use this method.  In fact, there are mutual funds dedicated to
writing covered calls.  The point to be
made is that this method comes with risk. 
If the market tumbles, covered call writers perform better than those
who simply buy and hold the same stocks. 
But, by using options judiciously, risk can be reduced even
further.  By varying the specific options
traded, the covered call writer can enhance the upside or gain additional
protection against a downside move. 
Options are versatile investment tools.

Option
strategies can be used to reduce risk and enhance the probability of earning a
profit.  The profits may be limited, but
the combination of more winning trades and smaller losses is appealing.  Only options can do that for an individual investor.

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Lessons_Cover_final Are you a fan of Options for Rookies?  Have you benefited by reading
this blog?  Are you one of the many readers who has sent congratulations
and thank you messages for proving valuable content? 

I thank you for the kind words of encouragement.

 


  Buy Now

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Risk of Ruin. An Unpleasant Topic for Traders

This post recently appeared at OptionsZone.com, where I am a contributor.  Take a look at Options Zone – you will discover options articles of interest.

***

For some, investing is a necessary evil.  Such investors don't want to be bothered, and often hire professionals to handle their investment decisions.  Others love the idea of making trades, and if they encounter a winning streak, may seriously consider the idea of quitting their jobs and becoming full-time traders.  Trading is one of those enticing, glamorous careers.  The idea of being self-employed, taking vacations whenever you want, earning tons of money – it all sounds like a dream come true.

It is a dream, but the truth is unpleasant.  The average income for people who try to become full-time traders in an attempt to support themselves and their families is less than zero.  In other words, it's not that they don't make enough money to survive as a trader.  It's that they don't make any money.  The vast majority are forced to give up the dream and go back to the real world. 

We don't see people trying to practice law or medicine without the proper education, training and licenses, yet many individual investors believe it cannot be difficult to trade for a living.

There are many reasons why the majority cannot succeed as traders.  The obvious is that not everyone has the required skills.  It takes an education, the ability to understand what's required, and a special skill set to be a surgeon, professional athlete, or novelist.  The profession of trading has similar entry points.  The problem is that few believe that to be true. 

They put together a small pile of cash, make some trades and are disappointed when they realize how difficult it is.  Making money is tough enough, but when trading expenses are added to the picture, the burden is too great and profits are not achievable. 

And for those who do well, i.e., they do better than average and eke out a small profit – they never consider that choosing the wrong broker – one with high fees – may be more than enough to make frequent trading unprofitable.  Or perhaps they go the other route and sacrifice good trade execution for low rates.  Poor decisions along those lines may be enough to sink a trading career.

Trading looks easy.  You buy, and then sell at a higher price.  Or perhaps you sell short, and then buy at a lower price.  What's so difficult about that?  Those TV ads of the 1990s technology bubble convinced many that it's a cinch to get rich in a hurry.

Today's post is not about the requirements per se; it's about one simple idea that is virtually ignored by both professional and amateur traders/investors: Statistics and probabilities. 

Something as innocuous as being unfamiliar with statistics can make all the difference. Few traders have any understanding of this mundane mathematical science.  And those who may have some passing knowledge fail to recognize how vital it is to pay attention to statistics and the lessons they teach. 

Option traders may talk about probability of earning a profit for a given trade, or recognize the probability that a specific option will be in the money when expiration arrives.  However, the majority have never paid any attention to, or possibly never heard about, one vital statistic:  The Risk of Ruin.

I've published a list of my four important trading rules.  At the head of the list is the simple command: Don't go broke.  The problem is that I am guilty of not delving into how the trader avoids going broke.  Sure I talk about managing risk and being careful with position size, but there's more to it.  It's important to understand the risk of ruin.

Definition

The risk of ruin, sometimes referred to as 'gambler's ruin' is the probability of losing your entire investment account.  It's also the probability of losing so much of the account that there is too little remaining to allow you to continue trading.

There is a formula, and thus a calculator, that can be used to quantify the investor's risk of ruin.  Because gambling and investing/trading have much in common, the mathematics of the calculation are the same.  The key for investors is to translate the calculator inputs from gambler's language to investor's language.  A trusted friend has done that for us.  See Dr. Brett's description of the risk of ruin, including a link to a calculator and examples of how small changes in your approach can make a huge difference in the probability of losing everything.

This risk of ruin applies to retirees.  If you are invested and withdraw a portion of your assets every year, there is a chance of outliving your money.  That's certainly equivalent to blowing a trading account in that it's something that must be avoided.

It's important to pay attention to risk of ruin (RoR), but as mentioned previously, most traders have no idea that such a concept exists, let alone that it can be measured.


Philosophy

RoR calculators are designed for people who take frequent risk-taking chances.  They are appropriate for a day trader, or gambler, not for someone who travels to Las Vegas once every three years. 

Applying the numbers to investors with longer time frames is more difficult.  But, if you understand the concept, you can find probabilities that apply to your situation.

Subtle-looking changes in your trading style can make a huge difference in the probability of ruin.  The first item in the list is often the killer.  Trading with too little money makes it difficult to succeed.

The following increase the risk of ruin:

  • The size of your initial bankroll decreases
  • Trade size increases
  • Trade frequency increases
  • Your win rate decreases; you begin to win less often
  • Your 'opponent' has more money than you (in other words, his/her risk of ruin is much smaller than yours)
  • Your 'edge' decreases, and your average profit becomes smaller
  • Emotions begin to affect decisions

One reason so many trader wannabes are forced out of the game is that their initial stake (account size) is too small.  Another is that they trade too often, especially when attempting to recover losses.  When investing, your opponent can be considered to be the vast sum of money collectively owned by 'everyone else.'  There's nothing you can do about that negative feature, but you can be aware of it.

If you begin trading with emotion instead of developing a plan, your edge decreases.  That's a very quick path to losing it all.

Bottom Line

Understanding the probability of going broke is a major requirement of the wannabe trader.  I certainly wish I had been aware of these statistics earlier in my career. 

How do you use the numbers when you get them?  I have no answer to that.  If you are trading with your life savings or retirement nest egg, would you be glad to have a risk of ruin that's 'only' 3%?  Or would you consider that to be far more risk than you can afford?

One way to use the numbers is to see how the effect of position size (money at risk) makes a large difference in that risk of ruin.  However you choose to use this statistic, my suggestion is that ignoring it is not viable if you plan to have a long career as a trader.

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