Whenever I present a seminar to an audience of beginners, or write a blog post directed to people who do not yet know much about options, it's always important to warn these option rookies that they mustn't believe everything they hear. For one, options receive plenty of negative publicity and too many financial professionals consider the use of options to be gambling.
These stockbrokers steered their customers away from using options by propagating a myth. And if that's not enough, they also tell clients that options are too difficult for the average investor to understand. Such brokers did their clients a great disservice.
There's much hype – all over the Internet. As a result these investors must be careful to avoid the scams. Some companies (or individuals) charge big bucks for introductory options lessons, when equivalent information is available at little, or no cost. There are decent folks selling instruction, but it's not so easy to find them among the unethical.
Then there's the group that wants to teach you how to earn 5 to 10% per month – every month, with no losses. Plenty of people fall for that, although common sense would tell you that these are unrealistic returns (One dollar becomes one million dollars in just over 12 years when compounded at 10% per month – ignoring taxes). But too many novices pay for information first and only realize how foolish they were later. A good marketer knows how to grab attention, get people excited about unreasonable expectations, and smile as suckers willingly hand over their money.
I must mention that some people are honest. They provide audited trading results, give you the opportunity to verify that the results are audited, and make good money. It's okay to pay these folks for advice. The point is that it's difficult to single them out from the scammers.
Gambling vs. Trading
Many option rookies are attracted to options because of stories about people making millions – very quickly – by using options. Or sometimes the story is closer to home and they have a friend who bought some calls (or puts) and made $10 for each dollar invested. It's easy to get excited when you hear 'how easy it is' to make quick money with options.
People love to gamble. Lotteries sell the dream to people who cannot afford the cost of the tickets. I suggest that rookie option traders avoid gambling with options. But human nature leads many astray.
Is investing gambling?
Technically it can be considered gambling. If you buy stock, bonds, options etc. with the hope of selling later at a higher price, you are, in the technical sense, placing a bet. That is gambling.
What separates gamblers from investors is the idea that investors have opportunity to gather information on the company whose stock they are buying, or the 'background' on the options they are trading. Stock traders have fundamental reports on how the business is doing, or has done over the years. They also have price and volume charts which allows them to perform technical analysis.
Option traders can look at implied volatility to get an idea of whether the option is priced reasonably. They can also do the same fundamental or technical analysis on the underlying asset.
It's true that a bettor can get the horse's (or football team's) past history as well as that of the competition. There is a similarity.
The good news is that investors can learn from gamblers.
Regarding gambling and investing, Dr. Brett recently posted about how certain aspects of gambling can be intelligently applied to trading:
"When trading is compared to gambling,
the implication is generally negative: that traders are little more
than people who roll dice in hopes of a big payout.
There is another side to gambling, however, typified by the card
counter. The card counter, dealt a hand, is aware of the odds of
winning with those particular cards. The counter also follows which
cards have been dealt already, dynamically updating the odds…
Yesterday's market is like a set of cards dealt to us…
As this analogy makes clear, a major source of trading edge becomes the decision to not trade.
Just as a professional poker player will muck [fold] many hands when the odds
are unfavorable, giving up a small amount to preserve the opportunity
to bet large when circumstances are more favorable, the professional
trader does not need to trade. Rather, the trader bets when the odds of
winning are enhanced."
Keep in mind that Dr. Brett's advice is targeted to traders who hold positions for a very short time.
This specific advice still has appeal for traders who hold option positions for weeks or months. Too many traders feel the need to be 'all in' and are always invested. If that's part of your overall strategy, at least consider trading less size (fewer options) when conditions are not especially favorable for your chosen strategy, and perhaps increasing the size of your trade when conditions are more favorable.
The card counter makes a large increase in bet size when the odds are improved. You cannot do that – because conditions change so rapidly and you are invested for a longer time. But you can open slightly larger positions when you like the odds of success, and slightly smaller trades at other times.
Sitting on the sidelines, waiting for better opportunities, is a mandatory practice for day traders. It improves the odds when trading. Iron condor traders seldom have the patience to observe the markets with no positions. But decreasing trade size is one way to 'partially' observe the action with less at stake.
We may not be able to count the cards, but we can see situations that provide extra reason to be optimistic or pessimistic. There is no reason not to trade accordingly.