Many years ago when I was in college, my family was contacted by a major oil company. They asked if we would be willing to have an oil well placed in the middle of our property. We had 10 acres with nothing on it that we rarely visited. Each member of the family owned an equal share of the property. They contacted all the surrounding property owners also. They offered each owner a portion of the profits from the well. Since the well was in the middle of our property, we got the largest share of the profits. My family had no idea what a good offer was, so we just took what they offered us.
There are no limits to the things you can do with options. Many people are already familiar with the use of options for hedging risk and increasing leverage. Today, I want to talk about the use of options for simulating trades that usually require equity ownership and therefore demand a large use of capital. A thorough understanding of options and their characteristics can allow you to design trade structures that yield most of the benefits of stock ownership without having to own the underlying stock. For the purpose of this article, I am going to ignore the effects of the bid-ask spread, interest rates and dividends, in order to simplify the explanation. In reality, these things do matter, but if you apply these concepts to a highly liquid equity that does not pay a large dividend, they should not matter much.
I love the quote attributed to Jack Welch “As long as we are going on opinion I’ll use mine” or something like that. Trading options involves lots of opinions. I’ve already covered the fact that there are people that believe trading options is risky. And it is. However, I maintain that it CAN BE FAR less risky than trading without options. However, that is just my opinion, based on my years of experience trading options successfully, which is a fact. The three “legs” of due diligence all involve opinion and some facts.
When I was a child, my parents read me a bedtime story that gave me nightmares for years. It was called, “Rusty in Orchestraville.” It had no monsters, no witches, no violence of any kind, but it terrified me. It was the story of a boy who loved music, but could never decide which instrument he wanted to play. Every time he chose one; he started to worry that there was another, better instrument for him out there. He kept abandoning each choice to pick up something new. As an old man, he realized that although all his friends had become great musicians, he had let his opportunities slip away from him because he was unwilling to make a decision. I understand Rusty’s anxiety. In many areas of our lives, picking one thing feels like closing a door on so many other options. This phenomenon can trip up your trading just as easily as it can any other area of life.
As the S&P 500 continues to defy gravity and head to all-time highs, investors are facing a bit of a dilemma. The “greed” monster on one shoulder wants to stay long the market and continue to benefit from potentially higher equity prices despite the fact that this index has not had a 10% correction in several years and is potentially overdue for just such an event. The “fear” monster on the other shoulder wants to book profits now and “run for the hills” or perhaps be even more aggressive and enter bearish trades in advance of a true market turn lower. What’s an educated investor with great knowledge of options instruments likely to do? The collar trade of course.
In 16th century London, the phrase “Black Swan” was a metaphor used to connote something fictional: something that did or could not exist. In 1697, explorer Willem de Vlamingh discovered actual black swans in Western Australia. In a flash, one metaphor died, and the Black Swan rose, phoenix like, with an entirely new meaning. The term “Black Swan” is now commonly used to mean an unpredictable or random event that creates an extreme or disruptive impact. Such events can be negative like a natural disaster or the 9/11 attacks, or positive, like the discovery of a radical new technology. In either case, they pose a difficult problem for traders and investors.
Do you know Jordan Belfort? He is the author of the book that was the basis of the movie with this title. Friends who recently saw the movie, THE WOLF OF WALL STREET, expressed different opinions of it. Some said that the movie was repulsive, and others said that it was so entertaining that they paid to see it a second time in a short time span! What do you think the underlying basis for this opinion is? I viewed those who were repulsed as non-traders who were freaked out by the viciousness of trading and wild drug/sex behavior. Those who were spell-bound may be folks who don’t mind being in full competition with peers. (And, they may not be offended by wild drug/sex behavior!)
Years ago, I became a student at Options Animal because they promised to teach me something that seemed almost like magic — how to “adjust” a trade that wasn’t working into something profitable. Adjusting is indeed a powerful tool. The techniques I learned at OA and that I now have the privilege of teaching to others have made my trading safer and more profitable. However, I also learned something just as valuable – that there is a time to walk away from a trade and move on to something new.
The market can be fickle. Some days, there are “hurricanes” of bad news and the market seems to chug along. Other days, a whisper of a wind seems to send the market into turmoil. What is moving the market today is most likely due to investor fears around weakness in the global market, strengthening of the US dollar and the unwinding of quantitative easing.
A fact of life is that emotions can wreck the boat in trading! Could they also help keep the boat afloat? There are a variety of four-letter-words involved: FEAR, HOPE, RISK, RICH, POOR, EDGE, SELF, EXIT, PLAN, SIZE, TOOL, GOAL, TASK, GAME, LOSS, WINS, NEWS. Which ones are the critical ones for us? I find goal, wins, and size the most critical ones for me, with the others taking their place within these three. How could I have a goal if I was not thinking of creating wealth (RICH) by monitoring my RISK, and seeking a high probability trade through TASK on my list of action. Can I create a WIN without an EDGE, and appropriate TOOL for my GAME? What SIZE is the best for me? I want to prevent a LOSS by utilizing a PLAN, and observing an EXIT in the right place. I am not seeking to FEAR the market, or win with HOPE. Although I included the word NEWS in this group of four-letter-words, I wish that it was not what was driving the equities up or down in price!