Option FanaticOptions, stock, futures, and system trading, backtesting, money management, and much more!

Am I Worthy of Self-Promotion? (Part 3)

I feel grateful to have survived 9+ years trading full-time for a living. Do I have a successful story worth sharing? I dare suggest that I do.

In the last post I attributed some of my success to start-up capital available to help me through the learning years. That money did not just fall into my lap. I generated that capital by negotiating a respectable wage and studying to accrue investing knowledge. I put in the time to work and the time to learn. I put myself in a better position to start a business.

I also deserve credit for having the guts to leave a corporate job, which was stable income for me. It’s more complicated than “no risk, no reward” and for those who do take the risk and subsequently succeed, accolades should follow.

Plenty of people work in the trading industry but most are selling trading services or “education.” I am here to say you don’t need to pay for any service or education. Rely on yourself. Work hard to earn start-up capital and take it from there.

As a successful entrepreneur since 2008, I have been selling myself short over the last few years but none of this means it’s simply “game over.” I still need to maintain my efforts with strategy development and trading my system. Every day I need to be aware of the risk I take because it could all evaporate in a heartbeat. Although much of what I have is due to my own hard work and discipline, I will continue to be grateful for what I have each and every day because things outside my control have not blocked my achievements.

Am I Worthy of Self-Promotion? (Part 2)

I have traditionally avoided self-promotion or any activity attracting attention to my successes. In the last post I began to develop a case for why I do have a story worth telling about my trading business.

The oft-quoted statistic suggests 80-90% of all traders lose money. I have talked with a lot of traders over the years and only a couple have claimed to be trading for a living and making enough money to fully support themselves. Other industries have similar stories. The “mom-and-pop pharmacy” is an endangered species these days with the success of big chain pharmacies like Walgreens and CVS Health. How many lawyers advance to partner status? How many physicians own their own practices? The rest work for someone else and this includes the vast majority of engineers, teachers, and professors.

If survival as a tradepreneur puts me in the 80th-90th percentile then I am one who should be traveling to different investment clubs and groups across the country sharing my story about successful trading as a business. Starting with the advantages of options over stock and the necessity to understand discretionary versus systematic trading, my approach is somewhat unique.

One essential component that I believe has contributed to my success was the ability to save up start-up capital. This was provided by my job working pharmacy while I continued to pay student loans and a home mortgage. I negotiated a solid wage for myself and worked many overtime hours.

Stock investing also contributed start-up capital for my trading business. I have traditionally said that I was one of many to get lucky with my stock investments thanks to the bull market of 2004-2007. I did have that understanding of investing, though. Dad gets lots of credit for this because he initially spurred my interest in elementary school. I later went on to learn about stock screening. My statistical coursework taught me about models and curve-fitting, which probably put me in a better position to pick stocks that would later become big winners.

I believe having ample start-up capital to survive the lean, early years is the best way to start a business. Every business has a learning curve and very few entrepreneurs can expect to generate consistent, plentiful income right away. Without start-up capital, the added pressure to profit in order to afford basic needs is probably enough to crush most dreams of escaping Corporate America.

I will finish with the next post.

Am I Worthy of Self-Promotion? (Part 1)

Much of the background for today’s post was written here and here. Perhaps because my Dad dislikes attribution of my current professional status to luck or everyday trading strategies, casual reflection had me reviewing this idea once again. For the first time, I am starting to entertain the possibility that I am a success story worthy of self-promotion.

I have traditionally shied away from advertising or marketing my triumphs. More than shy away, even, I typically run away. I’m a believer in karma and I think arrogance is a trap for which we humans often fall prey. The moment we get too overconfident or arrogant is the moment we get stricken down—often solely a result of our own sheer folly. I may be exaggerating a bit but I do believe it happens quite often.

I believe Nassim Taleb’s Fooled by Randomness teaches some important lessons about trading. People often get lucky and have transient success. I would hate to start advertising such success at a time when harsh reality was just about to set in. I would only be able to look in the mirror and say “you got what you deserved” if I were to misjudge temporary, random success for a long period of developing skill through hard work.

Having acknowledged my caution toward arrogance and the possibility of fluke, I do believe I deserve an objective assessment just like anyone else. As I step back and take a broad perspective, what do I see?

The most significant observation is that I am currently in the ninth year of operating a successful trading business. I started out working 60+ weeks for the first few years and so far that hard work has paid off. I do all the trading and devise my own trading strategies. I supervise myself. I work from home. I have a flexible schedule. I can trade on the road while hardly missing a beat.

Perhaps anyone working as a successful entrepreneur has a story worth telling because it is such a rare occurrence. I only know a couple people who are running their own successful businesses. Many people have jobs they dislike. Many people live paycheck to paycheck. Many people are chronically burdened by job-related emotional and physical stress. None of these, thankfully, apply to me.

I will continue this in the next post.

Options are Better than Stock (Part 4)

I feel I have done a pretty good job of establishing that options are better than stocks for most investors. One exception might be bullish speculators.

I previously demonstrated option outperformance when the stock moves lower, sideways, or moderately higher. I also made a strong case that options provide more consistent returns.

I previously suggested that options are inferior with regard to bullish speculation but I actually believe the opposite. If someone tells me up-front her goal is speculation then I would make the case for option leverage. “Swinging for the fences” is pretty much synonymous with buying options!

While no one option strategy is better in all market environments, given any market environment one can come up with an option strategy that should outperform.

For the average investor trying to build a nest egg for retirement, I have made a strong case for options as the superior way to go. One may worry naked puts/covered calls are limited-profit vehicles but I would ask how often it happens that the market runs away to the upside? This could be backtested. Even if this happens enough to result in lower annualized returns, the greater consistency of option performance likely makes up the difference. Besides, speculation (i.e. gambling) has no place in building a nest egg.

I did an internet search for “why don’t financial advisers use options” and found one enlightening response:

      > You’re right to ask what the average financial
      > adviser (FA) knows about investing… But, I
      > think you’re underplaying a few additional points.
      > First, that most FAs don’t have options
      > registrations — so options aren’t even in their
      > world view…

Advisers as fiduciaries are bound to act in the clients’ best interests. In my opinion, if they cannot do this because they lack “registrations” then they simply should not be in the business. If advisers cannot do this because they lack proper option education then that is even worse.

      > Second, in this era of “low cost advisory” many
      > clients are on active missions to cut their
      > costs — expense ratios, trading fees — and make
      > no mistake, but any active option overlays are
      > going to have associated, non-trivial costs.

I would argue stocks and options to be comparable with regard to transaction costs. Given the proper know-how, any adviser can do either without significant material cost.

Bottom line: options options options, folks! This may be just what the industry needs to cure itself of the subpar returns people have been conditioned to expect and accept.

Options are Better than Stock (Part 3)

I believe I am already done if I were simply trying to argue that options are less risky than stock.

I have shown the naked put position to outperform long stock if the underlying trades down, sideways, or up “a little.” In the previous example, AAPL stock could trade up over 10% in one year and still lose to the naked put. I also argued for higher consistency of returns with naked puts over long stock. This means lower standard deviation of returns and lower volatility of returns. In this case, it also meant lower maximum drawdown for the option position.

All this suggests option strategies are a better choice for a large segment of stock investors. Options are more suitable for growth investors. Options are also more suitable for income investors given the non-refundable premium collected up-front.

I would say neither options nor stocks are suitable for “safety investors” who are most concerned with capital preservation. This may include the elderly and people in retirement. This does includes the extremely risk-averse. For this group, Treasuries, highly rated corporate bonds, or certificates of deposit would probably be a better fit. I think the option position can lose less than the stock position but when the market gets really ugly both can lose significantly.

The one category more suitable for stock than options would seem to be speculation. This involves stock selection with the hope of hitting a home run rather than singles and the occasional double. In the following graph, the blue line represents long stock and the red line represents a covered call position:

Long stock vs. CC (upside considerations) (9-13-16)

The yellow highlighting indicates that when the market races higher, the stock can outperform. The option position has limited upside potential whereas the stock has unlimited upside potential. This is a reason why many people like to buy stocks. For some it is like the lottery: people hope to see their shares double, triple in price—or more.

I could argue that options (e.g. long calls) also outperform stocks to the upside. Unfortunately, though, I cannot implement options in such a way to outperform in bearish, sideways, and mildly bullish conditions and also outperform in strongly bullish ones. And if I implement options to outperform in strongly bullish conditions then I would underperform were the market to trade slightly higher or sideways (although I would outperform were the market to move significantly lower).

I will wrap all this up in the next post.

Options are Better than Stock (Part 2)

As discussed in Part 1, I have taken a defensive posture on the stock versus options debate in the past. As seen in recent articles by Perry Kaufman and Craig Israelsen, today I am going to implement a more anecdotal approach. When studied this way, options very much seem like a better trading and investment vehicle than stock.

First, let’s revisit my comparison of long shares versus a covered call (CC) position from a 2013 blog post. The following graph plots the PnL of AAPL stock (blue line) and a CC position (purple line) 365 days after trade inception when the option expires. Stock dividends ($1,040) are included:

AAPL stock vs AAPL covered call (1-18-13)

The vertical, dotted line shows breakeven for the stock position after 365 days if the stock price falls. At this zero profit level, the CC shows a profit of $5,600, which is the profit from selling the call at trade inception. The CC also outperforms farther to the downside and to the upside through an underlying price increase of over 10%.

Second, I refer to the common interpretation of risk as potential maximum loss. To compare these positions when the market falls, we can shift the graph to the right:

AAPL stock vs AAPL covered call (2) (1-18-13)

The CC outperforms by the $5,600 mentioned above and this difference persists to a stock price of zero because the CC owner collects that non-refundable premium at trade inception.

Third, although a CC includes long stock, derivatives theory dictates that a CC is synthetically equivalent to a naked put. I illustrated this with graphs shown here. This is not anecdotal: this is universal.

Taken together, the first three points above argue for option superiority over long stock when the latter trades up a little, sideways, or down.

My fourth piece of evidence is anecdotal study of risk as volatility of returns. I cited studies here and here suggesting that returns are similar between stock and option positions with volatility 33% lower using the latter. Furthermore, my preliminary backtesting has shown lower maximum drawdowns for the naked put positions relative to long stock.

I will continue discussion in the next post.

Options are Better than Stock (Part 1)

Options folk enjoy debate about things like which trading strategy is best and which adjustment is best. Almost unilaterally when I hear a discussion like this setting up, an immediate answer pops to mind: neither is better or worse—they each have their pros and cons. I feel options are a better vehicle to trade than underlying stock but because of my reluctance to proclaim superiority, I rarely communicate this to others.

In 2014, I made the case for options with a six-part blog series. In Part 1, I wrote:

     > I actually believe that trading options is better than
     > trading stocks or futures. This would be very, very
     > difficult to prove, though. When it gets down to the
     > trading system, whether discretionary or systematic,
     > it would be extremely difficult to convince anyone
     > that options are unequivocally better.

For this reason I took a defensive posture with option trading. I suggested the financial industry represents option trading as making a “deal with the devil.” I then attempted to inject reasonable doubt to weaken that claim. I explained why options are not “too risky” and I went on to offer some advantages of trading options.

In this blog series, I am taking a more aggressive approach: options are a superior investment/trading vehicle to stock. I will make the argument with covered calls/naked puts, which I have blogged about at length.

Pay close attention because the implications of option superiority are significant and wide-ranging. For starters, it may rarely be in one’s best interest to own long stock shares without a hedge. To the extreme, perhaps the vast majority of the financial industry as we know it (e.g. financial/investment advisers) is completely wrong.

Let’s take this one step at a time.

Statistical Wisdom from CHiP’s

Today I feature a lesson on statistics brought to us courtesy of an episode of CHiP’s. The episode “Bio Rhythms” originally aired February 17, 1979.

This particular conversation took place between officers Frank Poncharello (“Ponch,” played by Erik Estrada) and Sindy Cahill (played by Brianne Leary).

      [Ponch] Hey Sindy. Feedback on the bio rhythms,
      right? Looks pretty good I guess, huh?

      [Cahill] Well it’s much too early to tell, Ponch.
      Ask me in a couple of months.

      [Ponch] Yeah but you must have enough to tell
      if the system works…

      [Cahill] Well, most everybody in chronobiology
      agrees that we all do have rhythms: cycles.
      But we don’t know exactly how it works or how
      the date of birth is involved. It’s going to
      take me a long time to run a large enough
      sample to eliminate coincidence. So for
      the moment, nope… I don’t have enough data.

      [Ponch] Sindy uh, listen… I’ve got a special
      interest. I mean, it does look good. Doesn’t it?

      [Cahill] Ponch, “looks good” is not a term we
      use in statistical study.

Many times I have heard traders speak with overconfidence about strategies that produced one or two winning trades.

I have also seen many casual traders extremely eager to pounce on any promising idea they hear, read, or see.

Both examples are germane to the conversation between Cahill and Ponch. Small sample sizes are susceptible to the possibility of fluke or, as Officer Cahill stated, coincidence. We therefore know nothing until we get a larger sample size. Heuristic thinking like confirmation bias is notorious for driving action during this phase and quite often, people circumvent the hard work altogether by not insisting upon (or being aware of) proper statistical validation.

Israelsen on Diversification (Part 3)

I want to offer one further critique of Craig Israelsen’s performance data included in the last post.

As shown in the table, over 15 years the 12-asset portfolio outperformed the 7-, 4-, 2-, and 1-asset portfolio (in that order). But was this a statistically significant result?

In response to my question, Israelsen wrote:

     > The issue of statistical significance pertains to
     > differences among samples that are drawn from a
     > population (inferential statistics). As the
     > different portfolios are not samples, the issue
     > of statistical difference in the returns is not
     > relevant. In other words, the return of the 1-
     > asset portfolio is not the mean return of that
     > type of portfolio, it is THE return of that
     > portfolio. Same logic for the 2-asset, 4-asset,
     > and 7-asset portfolio. In essence, any
     > difference in the returns is material.

I think Israelsen has a good point but I am still uneasy about his numbers. To get the returns presented, I would have to start investing on the exact same day he did. This is highly unlikely.

Alternatively, Israelsen could have created samples by studying rolling periods. This involves calculation of multiple returns over stated time intervals starting on different days. He could calculate a mean and standard deviation of all sample periods, which could then be compared using inferential statistics.

By providing one static return as Israelsen did, I believe he leaves the door open to fluke occurrence. Without knowing how likely different portfolio start dates are to dramatically affect average annual returns, no robust conclusions can be drawn. I believe Perry Kaufman made this same mistake in an article discussed recently.

I also believe Israelsen missed the point of diversification because he did not discuss drawdowns. While diversified portfolios may not result in higher annualized returns, I do believe standard deviation of returns (otherwise known as “risk”) decreases when non-correlated assets are combined.

Put another way, liked hedged portfolios I expect diversified portfolios to “lose” most of the time. This was mentioned in Part 2. However, with lower drawdowns the probability of investors holding positions through the rough times is increased. The worst outcome would be dumping the portfolio and locking in catastrophic loss from a market crash and missing a big market rebound that may be just over the horizon.

Israelsen on Diversification (Part 2)

Today I continue with some “words of wisdom” written by Craig Israelsen in the Feb 2016 issue of Financial Planning magazine.

     > Interestingly, many investors claim to want a low-
     > correlation portfolio that includes ingredients that
     > do not all zig and zag at the same time. But when a
     > few of their portfolio ingredients zag downward
     > while other portfolio ingredients are zigging upward,
     > the investor frets about the underperforming zaggers
     > and becomes angry he owns a fund or stock that is
     > losing money.
     > Many investors talk the talk, saying that they want
     > a low-correlation portfolio, but they can’t—or
     > won’t—walk the walk and actually experience one.

As mentioned a couple times in the last post, I completely agree on an anecdotal level based on what I have heard from multiple investors during casual discussion.

Israelsen continued by providing data for different “levels of diversification” over the last 15 years. He looked at a 1-, 2-, 4-, 7-, and 12-asset portfolio. The 1-asset portfolio was 100% U.S. large-cap stocks. The 4-asset portfolio was 40% U.S. large cap, 20% U.S. small cap, 30% bonds, and 10% cash. The 12-asset portfolio was equally divided into 12 different asset classes. Annualized performance through 11/30/15:

Portfolio performance of various number of asset classes (8-25-16)

I highlighted the best (worst) performance for each column in green (red).

Israelsen writes:

     > Over the three-year, five-year, and 10-year periods…
     > the one-asset class investment… was the best
     > performer. Finally, over the 15-year period, the
     > value of a broadly diversified approach manifested
     > itself with an annualized return of 7.08%…

If you’re a believer in diversification then this sounds like it took 15 years for the noise to shake out and the truth of diversified superiority to become evident.

However, from a statistical standpoint I doubt these numbers prove anything. The 12-asset portfolio performed worst over one, three, and five years. I believe one year is too short to conclude anything. 3-5 years, though? That’s at least intermediate-term. I would consider 10 years to be long-term and the 12-asset portfolio performed second worst over this interval. Given that it performed best over 15 years, I believe we have a set of performance numbers that, considered altogether, are inconclusive.

I also don’t think 15 years tells the whole story. I wonder what portfolio outperformed over 13, 14, 16, or 17 years? If it’s the 12-asset portfolio then Israelsen’s claims are substantiated. Based on the trend of numbers presented, though, I would not be surprised to see a more scattered distribution.

Israelsen writes:

     > …a broadly diversified approach will lag behind
     > when one particular asset class… is on a hot streak.

I don’t like this as a caveat for why the 12-asset portfolio lagged in all but the 15-year time interval. Some asset class is always going to be on a hot streak, which would suggest a broadly diversified approach will always lag. So if you want to choose a loser, make sure to diversify? That’s certainly what it can feel like and this feeds right back to the Israelsen excerpt at the top of this post.