Why Options? (Part 5)

Today I will continue advancing the case for options by presenting two additional advantages to trading them.

The fourth advantage to trading options is their ability to lower cost basis (CB) of stock. CB is the amount paid for an investment and to be honest, this is really an accounting designation rather than an official tax designation. Whether one classifies sold premium as lowering expenses or increasing revenue, the effects are very real. To put this in Real Estate terms, options allow me to “rent out” my stock by selling option premium in exchange for the obligation to sell the stock at a particular price if the stock moves higher. In selling the stock I realize the profit. If the stock does not rise to the strike price then I may repeat the process to further lower my CB.

With stock alone, the only way to really lower CB is by waiting for it to fall and buying more to lower the average CB of all shares (dollar cost averaging). One could consider dividends to lower CB as well. If the stock pays dividends then I can often sell premium against it as a second means to lower CB.

The last advantage I will describe of trading options is probably the most exciting: position adjustment to match the underlying trend. Once I buy stock shares, my choices are to sell some shares, sell all shares, or buy more shares. I basically either hope the stock goes higher or choose to cut downside losses by getting out. Option adjustments can allow me to profit when the trend turns sideways or even lower. The potential adjustments are almost limitless to ride these changing trends. This is a blessing and a curse because while choices are good, there is no “one best adjustment.” Either way, many option traders live for this opportunity to adjust if needed.

Some concluding remarks in my next installment…

Why Options? (Part 4)

After getting past an option myth and finally mentioning some option truths, today I will begin talking about some advantages to trading options.

What follows is content that few people in the financial industry will tell you about.

First, options allow for cost efficiency:  the ability to almost mimic a stock position at a big cost savings.  Consider stock replacement as an example.  Purchasing 400 shares of a $40 stock costs $16,000.  Purchasing four $10 calls may be done for $4,000.  Since one option contract represents 100 stock shares, this is a very similar position.  The leftover $12,000 can stay safely in cash or be used for another position.

A second advantage is that options offer a limited-risk alternative. A long option position can never lose more than its original cost. In the previous example if the stock goes to zero then the stock position would lose $16,000 whereas the option position would only lose $4,000.

Advantage #3: options can succeed where stop-losses can fail. Suppose XYZ is purchased for $50 with a stop-loss order entered at $45 to prevent loss of greater than 10%. After the close, XYZ announces allegations of high crimes among the upper management. Next morning, stock opens at $20 and the stop-loss order triggers immediately for a 60% loss.

Now consider the purchase of a $45 put instead of placing that stop-loss order. The put does cost a few dollars whereas the stop-loss order is free. As with any insurance, though, you get what you pay for. The most you can lose on the put is the price paid but it will hold (gain) its value point-for-point for each dollar below $45 the stock falls. In addition, a volatility spike in the midst of a huge selloff would cause the put to increase even more.

I will continue discussion of option advantages in the next post.

Why Options? (Part 3)

This blog series is focused on making the positive case for option trading.  In the last installment, I gave some historical backing for why the financial industry may be telling us that options are too risky.

The suggestion that options are “too risky” is, in my opinion, complete myth. From http://www.marketwatch.com/story/5-options-trading-myths-2012-05-07:

“Myth #1: Options are too risky
This myth has survived for centuries because some people have misused options… [which has given] them a bad name.”

From http://www.dailyworth.com/posts/2476-how-risky-is-it-to-invest-in-options:

“Options have the unfair reputation of being considered riskier than other investment vehicles… in a book written by a well-respected duo of female financial advisors… Whereas they consider stocks to be moderate-risk investments, they include options in the high-risk category along with junk bonds, highly leveraged real estate and penny stocks.”

Some truth about options is given in The Rookie’s Guide to Options (2008) by Mark Wolfinger:

“Options were designed to be risk-reducing tools.”

“[Options] are used to hedge risk, so the myth that options are too risky is not true.”

“Options are risky if you don’t understand how to use them… but by themselves, options are not risky… the real risk is with the options trader.”

In the next post, I will begin discussing some benefits to options as a trading vehicle.

Why Options? (Part 2)

I’m just getting started with a new blog series aiming to make the case for options trading.

Options are tradable instruments of value that represent rights to ownership or sale of the underlying stock or future.

I do not believe society’s fear and reluctance toward options can be understood without knowing about the debacle of Long-Term Capital Management (LTCM): a hedge-fund management company that employed options in its trading portfolio. On the LTCM board of directors were Myron Scholes and Robert Merton, who shared the 1997 Nobel Prize in Economics for a new options pricing model. Over its first three years, LTCM posted net gains of 21%, 43%, and 41%.

In 1998, LTCM lost $4.6 billion over a 4-month span. LTCM did business with many key financial firms. Wall Street feared a LTCM failure could cause a chain reaction, which might cause catastrophic losses throughout the financial system. As a result, the Federal Reserve supervised an agreement among 16 financial institutions for a $3.6 billion bailout.

While being supervised by the very deans of options pricing (Merton and Scholes), the trading approach failed!

From http://www.nytimes.com/2008/09/07/business/07ltcm.html?pagewanted=print: “A financial firm borrows billions… to make big bets on esoteric securities. Markets turn and the bets go sour. Overnight, the firm loses most of its money… Fearing that… collapse could set off a full-scale market meltdown, the U.S. government… encourages private interests to bail it out. The firm isn’t Bear Stearns — it was LTCM… and the rescue occurred 10 years ago this month.”

“The LTCM fiasco momentarily shocked Wall Street out of its complacent trust in financial models, and was replete with lessons… But the lessons were ignored, and in this decade, the mistakes were repeated with far more harmful consequences. Instead of learning from the past, Wall Street has re-enacted it in larger form, in the mortgage… credit crisis.”

The financial industry sends a clear message: trading options is like making a deal with the devil.

Is this understandable based on the historical arrogance and mistakes of highly-respected professionals?

Why Options? (Part 1)

I’ll admit it:  as a full-time, independent, retail trader, I think options are the way to go.

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.

I certainly think I can do things trading options that I cannot do trading anything else.

In this blog series, I’ll settle for demonstrating why trading options is not as bad as most people think.

Aim high?  The Air Force does but I am aiming lower.

I will not make the case for options as best.

I will not make the case for options as better.

I will only make the case for options being not as bad as everyone thinks they are.  Even this could be a paradigm shift just waiting to happen.