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Options, Advertising and Simplicity
You may have noticed that I have not written articles for the last two weeks. Two weeks ago I was on a family vacation at the beach and couldn't take a chance of my computer getting wet. Then last week I spent teaching options, which takes a lot out of me. I did have a chance to review some of the endless stream of options trading advertising that I receive. Usually, I just toss them into the trash.
Lately there seems to be two consistent themes. First, companies emphasizing their winning percentage of trades, and how that must imply a winning trading system. And those offering advice and systems on how to trade options "simply". I'm somewhat upset by what I've seen and I reject both of these premises. Here are my reasons why.
Advertising
Like I said, I spent some of my vacation time reading and reviewing options advertising. Remember, I'm a trained actuary and as the old joke goes: Q. What's an actuary? A. Someone who is good at mathematics who doesn't have enough personality to become an accountant!
I've seen advertising, stating a 95% win rate. On the face of it, you might think that over any significant period of time, that would be impossible to achieve or maintain. Well the truth of the matter is that it is actually very easy to design a trade with a very high win rate, but there are other issues. For example, yesterday the S&P 500 Index (SPX) closed just under 1,275. The SPX Sept 1075 Put was quoted as bid .25 x .35 ask, meaning I could sell the Put for at least .25. (If I was actually going to do the trade, I'd try to do a little better and offer at .30.) This Put is 200 points out of the money and there are only 12 trading days to expiration. I ran some numbers on my probability calculator, and even using a fat tails distribution, the probability of the option finishing in the money, i.e. SPX being less than 1,075 at expiration, is less than 1%. That implies a 99% win rate! The problem is that in that other 1%, there is a time bomb waiting to go off. And when it does, it can take back months or even years of profits and have disastrous results. Remember, in the selling Puts example above, the best case scenario, is that you can make $25 per contract. However, if the unthinkable happens and SPX loses 20% of its value in one day, as it did in the crash of 1987, the Put that you sold for .25 would have at least $55 of intrinsic value. Even a few contracts would cause a lot of pain.
Don't get me wrong, a high win rate is something that potential customers like to see when evaluating a trading system, but there are many other factors that need to be considered. I won't go into them now, but I'll tell you of a recent conversation. I was talking to a very successful options trader who was considering advertising his win rate of about 55%. On the face of it, it sounds like you could achieve that rate by throwing darts at a list of options. However, the rest of the story is that the winning trades averaged about $1,600, while the losing trades averaged about $1,200. Overall a decent system, but one that might not sell very well based on advertising the win rate.
Simplicity
A hero of mine, Albert Einstein, once made the following comment which I have incorporated into my own philosophy: "Everything should be made as simple as possible, but not simpler." There seems to be a message going around that options trading has been made more complicated than it really needs to be for the purpose of selling newsletters, magazines, trading systems and other reasons. While there may be some truth to this, the undeniable fact of the matter is that yes, trading options is relatively complicated. Options are a derivative product, and as such they derive their value from a primary product, such as stock. However, unlike stock, which has a fixed number of shares that are traded, options are contracts that are continuously being created and extinguished. The supply of any particular option is theoretically unlimited. But it doesn't end there; there are also the added dimensions of time and volatility.
To give you a feel for the impact of these variables, consider two stocks ABC and XYZ both trading at $102. The only difference is that ABC is not particularly volatile, with options trading with about a 20% implied volatility, while XYZ is very volatile and its options are trading with an implied volatility of 80%. Look at the difference in the pricing of the 100 Strike Call options with different amounts of time to go to expiration:
TIME TO EXPIRATION |
Stock |
Volatility |
1 year |
180 days |
90 days |
45 days |
expiration |
ABC |
20% |
10.65 |
7.52 |
5.50 |
4.16 |
2.00 |
XYZ |
80% |
33.47 |
23.96 |
17.25 |
12.49 |
2.00 |
Keep in mind that as the stock price is changing the volatility may also be changing and time is certainly moving forward. Trying to make order out of this type of continuous movement is not easy and in fact, as I mentioned in a previous article, was the basis for awarding a Nobel Prize in Economics in 1997 to Myron Scholes and Robert Merton.
The belief that there is easy money to be made trading options, i.e. to be given away by other traders, by simply buying Calls when a stock (or any other underlying asset for that matter) has fallen to a level of support, or buying Puts when the asset has reached resistance, is in my opinion, simplistic and just not true. Sure it would be nice, but so would winning the lottery, or receiving an inheritance from a rich uncle that you never even knew you had.
Let's think about it logically. What other profession with the potential to make a high net income do you think lends itself to "easy money?" How about being a doctor, lawyer, accountant, actuary, business owner, insurance executive, mathematician, computer scientist, airline pilot, need I go on? So why would it be different being an options trader? Everything in life is complicated, except options trading; I don't think so. Some things are just inherently not simple, and require a large investment in training and education, time and practice. Be real - unless you're lucky, do you really think it could be that simple to make consistent profits with minimal risks? Remember, trading options is a zero sum game. So who do you think is on the other side handing the money to you? Truth is only about 25% of options traders make consistent profits. Thank goodness that the other 75% doesn't realize that by simply drawing in a couple of support and resistance lines they too could join the ranks of the profitable!!!
I have to wonder if the proponents of the keep it simple idea actually understand the systems they criticize as being too complicated, or if they actually trade for a living. The bottom line is that like any other trade or profession, making consistent profits trading options takes a lot of hard work; and while it's not rocket science, there's a lot more to it than it may seem to some. It's probably not right for everyone. You have to be more motivated, work harder and smarter than the competition. Sometimes that requires putting on complicated positions, making adjustments along the way, and having a plan to handle all of the contingencies that will show up during your career as an options trader.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!