Options: How not to use them

Mark Hulbert, at MarketWatch is primarily known for his ratings of advisory newsletters.  But he also  writes about some very interesting stuff.  Here's an example from yesterday.  The story is about a completely irresponsible use of options – by someone who should know better.

Indented text is Hulbert's (slightly edited) words

"Michael Murphy is the editor of an investment advisory service
called New World Investor. Among several portfolios that he
reports on in his service is a college fund that he created for his
seven-year old daughter. He typically allocates 100% of this portfolio
at any given time to just one security."


There is no question that this is a kill or be killed investment approach.  I've never heard of anyone using such a strategy for a college savings program.  I'm assuming he is sufficiently wealthy that this is not truly the only assets available for his daughter's future.

"last Wednesday night, Murphy went even further out the “go the
broke” spectrum: He invested his daughter’s entire college fund in just
one option—the Jan. $10 calls on Arena Pharmaceuticals"


(ARNA). 

"The call options
Murphy bought are now worth about 90% less than where they stood last
Wednesday evening.

The reason for the big drop: A Food & Drug Administration advisory
committee voted 9-to-5 against recommending that the FDA approve a new
drug that Arena is trying to develop.

Murphy had been betting that FDA
approval would be forthcoming, and had timed his purchase of Arena’s
call options to occur on the eve of the FDA announcement."


The fact that anyone would do any of the following, disqualifies him as an investment advisor – at least from my perspective.  And Murphy did all of them:

  • Invest an entire portfolio on a single investment
  • Buy call options – in a size trade – as an investment
  • Buy options when they are priced at their very highest – and that occurs just prior to a known news release
  • Admit to anyone that you made this trade – if you want to continue to have an audience for your newsletter.  Even if the investment result had been spectacular, it's not the type of gamble that you want to advertise.


"There are plenty of investment lessons to draw from Murphy’s experience,
and perhaps the most important is how one misstep can more than negate
many brilliant investment decisions."

Why would Murphy pursue such a high-risk strategy—one that some might
even characterize as reckless? I have no idea, but I do know that, for
many people in the investment arena, the excitement surrounding such
strategies is what makes them irresistible.


Just as some people go to a casino for the thrills of
possibly winning big, while simultaneously recognizing that they
probably will lose, some investors choose high-risk advisers for the
same reasons. And that’s entirely OK.

The problem [with investing this way] arises when you kid yourself into thinking that your
motivation is wealth building, when it is thrill seeking. You are likely to allocate more than just your play money to a
particular adviser or strategy—with all-too-predictable dangerous
outcomes, when this or that trade doesn’t work out"

Hulbert offers a very good analysis of the thrill-seeking (non) investor.  if you are serious about trading or about making money, don't be that thrill seeker when using your 'regular' trading account(s).

794

Coming soon, a major announcement from Options for Rookie's.  It's too soon for details; still in the planning stages.

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5 Responses to Options: How not to use them

  1. Marty 09/22/2010 at 11:44 AM #

    “Against stupidity, the gods themselves contend in vain” -Schiller
    Why would Murphy pursue such a high-risk strategy—one that some might even characterize as reckless?
    Two possibilities:
    1) He has just enough knowledge of options to be a serious danger to himself (and his daughter’s hopes of ever going to college), and he really didn’t understand how overpriced the calls were or how fast they would lose money on bad news.
    2) On the other hand, maybe he felt the FDA approval was in the bag and banking a huge leveraged gain with call options would make him look like an investment rock star to his readers who may have even less options knowledge than himself. But anyone who knew the true risk of those calls wouldn’t have been very impressed, even if the FDA announcement had gone the other way.
    Either way, a good example of why advisors selling specific equity picks are a waste of money…IMHO.

  2. Mark Wolfinger 09/22/2010 at 12:11 PM #

    Thanks Marty

  3. Kim 09/22/2010 at 1:47 PM #

    Marty,
    I completely agree with your two points. I disagree that “advisors selling specific equity picks are a waste of money”. I might agree to add “most” in front of your statement, but I do know couple of newsletters that can actually give you pretty good advice, even in straight options buying. Of course the key is risk management and position sizing. When buying calls or puts, I would normally have 25% stop loss and put only 5-6% of my total portfolio in one position. In this way, I would risk about 1-1.5% in any given trade. By using reasonable profit targets, you can generate 10-15% per pick including losers.
    There are many good ways to play FDA announcements, buying straight calls or puts is not one of them (unless you have inside information which makes the whole thing illegal).

  4. Dave 09/22/2010 at 11:09 PM #

    Announcement? Major? Oh, fun!

  5. Mark Wolfinger 09/23/2010 at 8:00 AM #

    Dave,
    At first, I thought you wrote ‘mayor’ not ‘major’
    Sadly I live about 200 feet outside the Chicago border, and am not eligible to join this circus.