If options trading has a bad rap, it got it as a result of the Crash of 1987. In fact, that single event has, to date, changed the way people price options. (More on that in a later chapter.) During the crash, there were stories of traders losing everything as a result of being short “naked puts.” Does that mean there is truth to the statement that options are too risky? Let me answer that question with a question. Most people are comfortable owning stocks. Which trade carries more risk, owning 100 shares of XYZ stock or being short an XYZ put (which commands 100 shares of stock)? Would you be surprised to know that owning stock is actually riskier? And would you be surprised to know that you have better odds of making money being short an out of the money put than being long stock? The difference in the odds can be considerable and quite surprising to many.
Maybe you have done your homework and have discovered that option pricing models are generally based on either some form of the Black-Scholes model, which is a partial differential equation, or the binomial model, which is a decision tree–style model. Your eyes have glazed over already! Calculus! Complex math! Time to find another book to read? Well, hold on a minute. As a retail options trader, you have no need to understand the calculus behind the models. In fact, your (carefully chosen) broker should provide you with all the calculus-induced models you need to trade effectively and profitably! And some do so at no charge to you! Before you think, “No math? Awesome,” I need to burst your bubble. I did not claim there would be no math. I said there would be no complex math. For you to be effective at options trading, instead of the calculus behind the pricing models, you need to understand the odds, or probability theory, behind options. You do not need to become a statistician. You merely need to understand a few basics, which I will address in this book. In fact, it is the probability basis of options that makes trading so much fun (and profitable) for me. I am, and have always been, enamored of games. Games can keep me interested for many hours, days, weeks, and months on end. And when they put money in my pocket, all the better!
You may be thinking, “I do not have a lot of time to devote to this.” While it will take some time and effort to learn to trade options effectively, once you get the hang of it you can trade by devoting 10 minutes per day to it. As I write this book, I am teaching individuals and groups how to trade, I am teaching college finance classes, I am commentating on TV every week, I am speaking at conferences, I am preparing research, I am attempting to be a good father and husband, and, yes, I am trading around 10 minutes per day. My return on capital year-to-date far exceeds the market’s return, which is in turn having a nice year! In fact, my trading has been profitable for each and every one of the 26 years I have traded. I am certainly no trading savant. I have just learned how to effectively take advantage of the probabilities that options provide any investor. We will explore this in detail.
Is it worth the trouble to learn to trade options? Well, that is a personal decision. While there are some people who I believe should stay away from the options markets, they are few and far between. If you like games of chance (in which you have the odds in your favor) and you like to earn money, you might want to put a bit of time into learning to trade options. I believe you will find it fun and rewarding! But be prepared. In my experience, you cannot take the training wheels off until you have been trading for around 18 months, on average. Of course, some people catch on much quicker, and I have coached traders who had never made a trade before to be consistently profitable after only three months of effort. And I recall one person in that group who was simultaneously working 60 hours per week at their systems development job.
As for the fear that the professionals will “clean your clock,” know that options trading is a much less personal experience. It is not “us against them.” I find that retail traders often make money because of the professionals, and not despite the professionals. We talk more about that later.
With all this being said, there are a plethora of books written on the mathematics of options. And there are many people who trade options full-time who are struggling to make money. In this book, I will subscribe to the K.I.S.S. (keep it simple…) method and stick to only the things you must know to trade effectively and profitably. I hope you will stay with me as we explore the world of options.
CHAPTER 1
Why Trade Options?
I am frequently asked, “With so many places to invest and with the complexity of the markets, wouldn’t I be better off letting a professional manage my money rather than trying to trade options myself?” Couple that with money managers asking, “You wouldn’t do your own brain surgery, would you, so why manage your own money?” I understand one’s reluctance to enter the world of self-directed investing. But after 33 years in the business world and over 26 years in trading, I can assure you that no one cares for your money like you do. Many money managers go through a three- to six-month training program and they are off and running trading your hard-earned savings. Compound that with the fact few managers beat the S&P 500 returns (after fees and commissions) on a consistent basis, and you should begin to wonder why you have not been investing your own capital all along.
The next questions that arise are “But options are so complex, am I not better off just trading stocks?” and “How could I possibly compete with the options professionals?” As a long-time professional options trader who now trades “retail” right along with self-directed investors, I have much to say on this topic. So, let’s begin by looking at the nature of options.
If you put three or more market professionals in the room and ask, “Which of you can predict market and individual stock direction the best?” you better be ready for the heated argument that will ensue. The economist will explain that she can, because she understands the mechanisms that drive the market in the long term. The fundamental analyst will tell you that everyone knows the market goes up in the long run but he can differentiate which stocks will go up the most. The technical analyst will say, “Hey, people, the market moves in two directions. And I can tell you when you will be near support or resistance levels, and when the Fibonaccis have retraced.”
Though always a hot topic of debate, research shows that market movement is mostly random in the long run. And this premise of random (Brownian) motion is actually at the heart of every option pricing model. If markets move randomly, then how does anyone make money in the markets? Well, markets actually move randomly, but with a “positive drift.” This means that in the long run almost everyone who owns a diversified stock portfolio should make money. And that amount should be around what is known as the “risk-free rate of return.” Over the past 50 years, that has amounted to a bit over 6.2 percent per year. Now, that’s a fair bit of change, so you could do worse with your money. But you can also do better – a lot better, actually.
As the technical analyst said, the market moves in two directions. In fact, over the past 50 years, the market (as represented by the S&P 500 index) has gone up on 52.89 percent of the days and down on 47.11 percent of the days. So why try to make money by guessing which stock will go up the most? Options allow you to profit from movement in either direction or from no movement at all! In other words, options are strategic without being directional. You can make money from virtually any scenario if you craft your trade properly.
Leverage is a concept that is often vilified. Yet when leverage is used appropriately, it is one of the most powerful means of enhancing portfolio returns available. Why are we talking about leverage and how does it relate to options?
Leverage is when you use borrowed money to enhance the return on your investment. And before you ask, yes, leverage increases risk to your portfolio. But if you are to be successful at trading, you must understand that risk can be a positive concept. All financial instruments are merely means of transferring risk. (Even the