Tag Archives | buying call options

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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Owning Stock vs Owning Calls

Hi Mark,

I think you taught me a lesson on not to get fixated on cost
basis. I have to tell you that cost basis is the thing I am obsessed
with since day one of investing and still is at the moment. It would
take a long way to move away from it but I’ll take your advice to focus
more on risk/reward.

However, I disagree with you on one thing, which is when you compared
the risk of holding stock vs long calls/call spreads. It is obvious
that I can easily lose 100% of my call/call spreads. It is also possible
to lose 100% if I’m long stock, but the possibility is very remote. In
terms of absolute dollars, the amount I can lose in a short period of
time is going to be a little more than the maximum loss in options, but
it is very unlikely that I’m going to lose all my money in DFS.

Long calls to me is a short-term speculative play and long stock is
for a longer term, and I am comfortable with my stock positions not
hedged. The amount I allocate for stocks is a lot more than I allocate
to options (since I’m still a relative rookie in options). The amount of
money I am willing to commit to one option position can only buy
some very OTM calls (which normally don’t end up ITM) but can buy
spreads that are more profitable. That should explain why I’m
comfortable with long stock but not the long calls.

F

***

Hi F,

1) It's my opinion that being obsessed with P/L is non-productive.  I cannot provide evidence that it's true.  The final choice depends on how you decide to manage your portfolio.  From my perspective, I own a position as it exists right now:  Do I want to hold it, sell it, add to it?  That's the decision.  Why should my original cost play any role in that decision?

2) I NEVER recommend owning long calls as a directional play.  I did suggest owning high delta calls as a stock replacement for investors who want to reduce downside risk.

I NEVER will recommend owning OTM calls for anything except protection – and I really don't like owning OTM options for any reason. So, if you took anything I said as a recommendation to buy such calls instead of stock, there was mis-communication.

NOTE:  This conversation refers to owning single options as a directional play.  [The kite spread uses OTM options, and that play is not relevant to this discussion]

3) If you feel comfortable owning stock, then by all means, own stock.  The idea of substituting high delta call options apparently does not appeal to you. 

It's good that you disagree.  Blindly agreeing with someone else is a bad idea.  Don't abandon your methods unless you are sure you are doing what is right for you.

Nevertheless, DFS offers an ideal scenario for stock replacement.   DFS Jun 13 calls carry very little time premium (20 cents).  For that small premium plus the 2 cent dividend, you can own insurance.  If the stock drops by 5 points, that's a lot worse than losing $3 on a call option. 

However, If you consider that time premium to be too much to pay, then your decision is based on complete knowledge of your choices.  That's ideal.

4) This is never mentioned, but stock can be thought of as a call option with a strike price of zero, and an infinite expiration date.  You prefer to own this zero-strike call.  There is an alternative: the Jun 13 call (an 8-week option) has a time premium of ~ 20 cents. 

5) You consider calls to be a short-term speculative play.  That's because you think in terms of which calls you would buy to gamble.  Those calls are very speculative and you are right to commit only small amounts to such plays.

Consider this:  You are willing to commit cash to owning the zero strike call.  And you are willing to speculate with a small sum on an ATM or OTM call.  But, you ignore the possibility of owning a high delta call. 

I know it seems as if I am trying to confuse you and take away your cherished beliefs.  But I find this philosophical discussions fascinating.  Analyzing a position and turning it into something safer, at a reasonable cost, is always worth considering.

But if you can even think about – as you say you plan to do – looking at risk/reward for positions after you own them, then perhaps you can consider stock substitution – especially when the cost is so little.  I agree that it is a more painful decision when the time premium of a 2-month 80 delta call is several dollars (obviously on a much higher priced stock).

6) I recommend owning high delta (~80) call options under these conditions:

a) You want to own stock
b) You believe the stock is headed higher, but don't want to take much risk

Under those conditions, selling the shares and replacing them with high delta calls solves the problem.  Solid participation on the upside and limited losses.

FYI, this trade is exactly equivalent to buying a put option to protect a stock position.

d) I never recommend buying calls.  But if you are a directional player who buys stock, high delta calls are a very reasonable alternative.  I never recommend buying protective puts.  But if the conditions stated above obtain, then stock replacement is an equivalent choice.

Regards

674


Coming in the May, 2010 Issue of Expiring Monthly:

  • Interview with Dr. Brett Steenbarger – trading coach and psychologist
  • The CBOE Benchmark Indexes
  • Pro and Con: Trading with House Money

and much more


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