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

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6 Responses to Option rookie’s dilemma: Poor advice from a trusted source?

  1. semuren 11/13/2009 at 6:36 AM #

    Greetings Mark:
    Maybe you did not re-print some relevant parts of CK’s message but it seems from what you did print that you are a bit alarmed. Actually, given that I do not know all the relevant context and so might be missing something important, I think the OIC instructor’s advice to concentrate on 4-5 vehicles (some or all of which might be stocks, others might be indexes, futures currency pairs, ETFs etc.) is a good idea. I think all this might mean is to not trade an underlying that you are not familiar with. That seems like good advice to me. If you are going to trade options on an underlying it only makes sense that you should have some sort of a feel for how it trades. Thus knowing things like the its IV and HV ranges as well as what important news might affect the underlying seems like a good idea.
    Maybe the problem here is that CK said stocks. Maybe he is using stocks to include a whole variety of underlyings.

  2. Mark Wolfinger 11/13/2009 at 7:58 AM #

    Hi S,
    Haven’t heard from you for awile.
    I omitted very little from the message. The way you present their argument makes the advice sound better.
    But she definitely was perplexed by: ‘how do I do that’ – and I agree. One cannot just go and learn how specific vehicles trade – and then buy puts or calls.
    Agree that getting a good feel for high and low IV for specific vehicle is smart, but that data is already available.
    What I don’t know, and the item that bothers me the most is whether OIC truly suggested that rookies in the class begin using options by buying naked long options in an attempt to catch up and down moves in undelying. IMHO, that would be horrible advice.

  3. Jesse 11/14/2009 at 12:31 AM #

    Although I’ve read a number of options book, but I’ve never started real options trading until after having digested “The Rookie’s Guide to Options.” This book is “The Practical Equity Options Trading Book”.
    Sincerely and eagerly hope that Mark will prepare an intermediate and then an advanced versions of “The Rookie’s Guide to Options”.

  4. Mark Wolfinger 11/14/2009 at 10:34 PM #

    Jesse,
    Thanks.
    My plate is already overflowng.
    This blog takes more time than you can imagine. Right now, I have no plans for such books, but hope that you will find the more advanced discusions on this blog to be vauable.

  5. Donald W. 11/16/2009 at 2:32 AM #

    I recently came upon this about cover calls and like to know is the math correct:
    Quote:”
    Okay, one more last thing: In our example above, we bought a Call option with Strike Price of $30 and we paid $9.80 for it, and the stock itself was available on the market for $39. In order to make any money, the Stock Price had better increase to $30.00 + $9.80 = $39.80 in the next 150 days. That’s a gain of $39.80/$39.00 = 1.02 or 2% (in 150 days). Is that too much to expect? It’s easier to compare if this gain factor is annualized: 1.02365/150 = 1.05 so it means our stock must increase at an annual rate at least 5% (over the next 150 days) in order to make money. Now that’s not asking much, eh?
    So, we ask ourselves (when buying a Call option):
    What annual Rate is necessary in order to make money, buying this Call?
    The result is sometimes surprising! Here’s an example:
    It’s Aug 25 and we look at AT&T oct/30 Calls. We can buy it for $2 5/8 = $2.625
    From Aug 25 to Oct 21 (when the Call expires) is 56 days.
    To make money, the Stock Price must exceed $30 + $2.625 = $32.625
    The stock is currently trading at $31.00
    That means a gain factor (in 56 days) of 32.625/31.00 = 1.052
    hence an annualized gain factor of 1.052365/56 = 1.40 or 40%.,

  6. Mark Wolfinger 11/16/2009 at 8:35 AM #

    What diffrence does it make if the math is correct?
    Why would you buy a DITM call? For one thing, the investor may not ave enough money to pay for stock and buys the option instead. I doubt that such an investor would consider how much premium is being paid in terms of growth required to overcome time premium.
    Next, ‘to make money’ is an absurd concept in the material you quoted. The numbers quoted refer only to situations in which the option is held to expiration. That is a bad idea. Option buyers are looking for trading profits, and not investments – most of the time.
    The AT&T example is clear. Why anticpate a 40% annualized return over a short priod of time? That’s very foolish.
    To make money, the option buyer only has to sell the option at a price that is higher than he/she paid. There is no good reason to hold through exp.
    NO, the math is not correct. The gain is from 31 to 32.625. That = 1.625/31.00; or 5.242%.
    The annualzed return is .0524 * 360/56 = 33.7 (assuming you use a 360 day year; use 365 if you prefer).
    Donald, the link you provided is broken ( deleted it), but I ask why publish this link? I took a quick look at this – it’s not material worthy of publicizing.