BiggerPockets

Many people have succeeded at it in the same way that many people succeed at tossing a coin and coming up heads. If you take a hundred people and ask them to toss a coin, around fifty will toss heads. They think they are smart. Then you ask them to toss again and around 25 will get heads twice in a row. They think they are very smart. Get them do to it again, and around 12 people will be ready to start their own hedge fund.

That, unfortunately, is the reality of our fund "management" industry. This is not a rant - there have been numerous studies done on this since the 1960s to demonstrate that almost all above-normal returns with derivatives are due to luck and not skill. These studies have created a hypothesis about the markets being efficient.

Fortunately for the rest of us, the efficient market hypothesis seems to be valid for 99.9% of investors but not for the remaining few.

There are a couple of ways to actually consistently make money with stocks and derivatives. One requires huge resources and involves lots of trading with miniscule margins. These "quant" techniques seem to work 99% of the time and they also tend to bankrupt the firms the remaining 1% of the time. A classic example is what happened to LTCM several years back and to Bear Stearns, Lehman, etc. last year. (Some firms have gotten around the bankruptcy problem by getting their former CEOs to become the Treasury Secretary.)

There is another way to make money with stocks and derivatives that does not involve a lot of risk but does involve a lot of skill and knowledge. And that is to understand how to evaluate a business, its industry, its competitors, the barriers to entry, pricing power, etc. and determine if the business is undervalued. If it is undervalued, you can use derivatives to make a pretty good return on your investment. You can also use plain old stocks to make a decent return. How to evaluate a stock is beyond the scope of a forum post but if you have anything specific that you would like me to look at, I will be happy to do so.

P.S. If you like the quant strategy, check out Renaissance Technologies. They are supposed to be one of the better quant funds. I had actually developed some quant algorithms in the past that back-tested well. But there are easier and safer ways to make money in the stock market.

Tom, a lot of these strategies make money for some time and then make you go bust. In the same way as flipping a couple of heads doesn't make you a great coin-tosser, making money on these strategies does not show that the strategy itself is useful.

Your strategy, essentially, is a combination of two things:

1. A covered call. This is a pretty poor strategy in the long run because you give up most of the upside for a higher current cash flow. I once created a covered call-writing program for what is now Morgan Stanley (then Dean Witter Reynolds) so I know what I am talking about. There are also numerous studies that show that a covered call writing strategy actually has lower returns than simply holding the underlying stock and not writing any options on it.

2. The put with cash as collateral is one more such strategy with limited profits and the potential for a complete loss.

So what you are doing is essentially taking small amounts of money regularly in the hope that bad things won't happen. Unfortunately for such strategies, bad things definitely do happen and when you least expect them and they will wipe you out.

There's actually a great book for anyone who wants to trade in options. It is called The Black Swan. The book is very poorly written because the guy who wrote it became enamored with his own knowledge. But it nevertheless discusses some very important statistical things that are important to know if you wish to trade options (if you wish to make money in the long run).

And Tom, your advice about buying puts and calls being too much of a gamble is not correct. That is actually one of the low risk strategies with options if you do it right. For example, you could structure your portfolio such that a big portion of it is in fixed-income securities with a maturity value equal to the total portfolio size. The remaining money can be used to buy calls if you think the underlying is undervalued. Such a system has a maximum portfolio loss of zero and a maximum gain that is unlimited. That's how you should play the game if you wish to. (BTW, wealthy investors with private banking relationships often get structured products based on these kinds of underlying strategies. These structured products often promise to pay 120% of the S&P 500 over the next 5 years with capital guaranteed, etc.)

To be honest, I do not recommend any of these advanced strategies for the typical investor. It is much easier and safer to find good companies with undervalued stocks and buy and hold the stock until it reaches fair value.

P.S. No offense Tom, but your strategy is sometimes compared to picking up nickels in front of a steam roller. You make some money until you get run over.

85% of option contracts expire worthless. Over a given period of time, prices will stay within a modest range. Especially with blue chips KO/JNJ/WMT/PG. The odds favor the seller of options, not the buyers. Buyers must be right not only about direction, but within a given time. Time favors the option seller. The sellers are like the casino owners, the buyers are the gamblers.

This strategy is to sell a BOTH a put AND a call (VIKRAM did you read that?). You also purchase shares so the call portion is covered.

I used this strat with KO shares in feb of this year. Bought the shares at $41, sold a 45 call, and a 38 put. So my purchase price of 41 is being "strangled" by countervailing short positions at 45 and 38. I Collected around 700 bucks in premiums.

So if the contracts expire between those strike prices, my return would be 700/4100 = 17% (not including dividends), and I would still own the shares.

If the shares expire over 45, the shares will be called away and I'll have another 10% capital gain (45-41)/41, or a total of 27%, and the shares would be gone.

If the shares expire below 38, I'll have to buy another shares at that price. I would own 200 shares at an avg cost of 36 per share.

As of today, price of KO is around 52 bucks.

You don't have to wait until expiration. I actually sold the shares last week and bought back the option contracts. I made about a $1100 off the shares (52-41) x 100, and the price of the call/put contracts evened out.

This is basically an alternative way to acquire shares.

The book is written by a guy named David Funk. But there are a lot of good books on "option SELLING".

Thanks for the info.
I will check them out.

All the online info and books I am reading is confusing. It never explain things chronologically or start from the basics.
No wonder no a lot of people are in options.

I have the time to study and learn them currently.

Also if you are serious about options I highly recommend taking an options/futures/swaps course at a local university, check with the finance department about open enrollment.
Fundamentally, you want to understand what options are, how they work, and how they are priced (Black-Scholes option pricing model, etc).

Only with a firm understanding will you be able to employ successful arbitrage strategies.

There's a number of free and useful resources at http://optionstradingresource.blogspot.com

Have fun~

Arbitrage is the only trading model that works and is the model used by almost all market makers.

LTCM was a beta house and that is how the lost their money, they had loads of money in correlation trades especially in the bond areas, not pure arbitrage.

The Goldman Fund that melted down recently was another example of a Beta fund, tracking correlations between obsure unrelated securities. When the betas broke down, they lost a fortune.

Pure arbitragers consistently make money when properly managing their risk. The basis for the arbitrage model is the basic and expanded option pricing models.

"Options as a Strategic Investment" was my first options book but is more of a trading book for beginners then a real explanation of the arbitrage model, though it is brought up toward the end of the book.

"Option Pricing and Investment Strategies" by Richard M Bookstaber ,was the book that really turned on the light bulb for me.

For a deep math understanding, though a tough book and required reading when we were on the street, "Options, Futures, and Other Derivative Securities" by John Hull.

An easier and more readable book, "Black-Scholes and Beyond" by Neil A Chriss. A nice discussion of different models and limitations. It also has a toolkit that you can get to play with the models.

Comparison of different option models,
"From Black Scholes to Black Holes" from Risk/Finex.

For the pure Buying and Selling of volatility trading approach, this is what we use today mostly for longer-term market neutral vol plays on liquid issues, "Buying and Selling Volatility" by Kevin B Connolly is a good, simple book.

But you had better polish off one or two of the others first as it expects you to have a full understanding of the options model and greek-based risk management.

Once you have a basic understanding of Options, there are some great resources on the web that you can use for trade research and play. The first actaully can be useful for a starter.

http://www.cboe.com/

The CBOE has some tutorials. Under their Trading Tools in the Volatility Optimizer area is a nice option pricer ties into a volatility database. A really good site for the beginner and pro alike.

http://www.optionstrategist.com/

For Historical volatility data, McMillan, same as "Options as a Strategic Investment" fame, has a web site where you can down load them for free.

You can consistently make money with options if you study first and fully understand your risk, otherwise you can lose your money so fast you will scratch your head wondering what just happened.

Most option traders lose as they do not have the patience to fully learn or to follow the models, and instead of following a well-designed trading scheme, react to the stress of their own mishedged risk profiles.

It can take years off your life, there are not many older traders.

These days we mostly do longer-term long and short vol plays, and make some nice returns on cash invested with minimal stress.

If you follow through on your interest, I recommend you take a lot of time an study, trade on paper first, and you will have a nice new tool for investing.

Has anyone experienced enrolling in the Chicago School of Trading options mentoring program? Their website is [http://www.thechicagoschooloftrading.com/]

I recently decided to learn something about stock options, and I just read this discussion on Jet_Speed's post. I have a a question on Vikram's comment on Tom's response. Vikram said:

"And Tom, your advice about buying puts and calls being too much of a gamble is not correct. That is actually one of the low risk strategies with options if you do it right. For example, you could structure your portfolio such that a big portion of it is in fixed-income securities with a maturity value equal to the total portfolio size. The remaining money can be used to buy calls if you think the underlying is undervalued. Such a system has a maximum portfolio loss of zero and a maximum gain that is unlimited."

My question is what happens if the securities drop in price? Don't you lose on the securities and the calls?

Originally posted by Vikram C.

Fortunately for the rest of us, the efficient market hypothesis seems to be valid for 99.9% of investors but not for the remaining few.

I remember having knock-down, drag-out arguments with someone on another message board during the heyday of the market around 2005ish about ALL of the securities and derivatives markets being highly efficient. I cited Malkiel's work and countless studies done over decades and all of the geniuses (MBAs, doctors, lawyers, etc.) swore up and down that they were too smart for the rules to apply to them! This was an excellent lesson in the lunacy of smart people and behavioral science! I guess that playing to one's ego is always in style :D

There are certainly many who benefit from promulgating the fantasy that average Joe can sit around and day trade some financial products in their shorts and make a living doing it. These are the same folks that benefit from helping to trade these products, but they are not the lemmings believing in the fantasy.

Real estate has high transaction costs and is highly INEFFICIENT in distressed sales. That is how great spreads are generated and is the primary reason I choose to park my money there. There are plenty of ancillary reasons, but other investments would make a lot more sense if the market wasn't so inefficient.

Millions of eyeballs hitting a financial product tend to do a very good job of pricing the product fairly. I have never understood how seemingly rational people can expect to extract intrinsic value out of these products when you have to be smarter than TENS OF THOUSANDS OR MILLIONS of other people to do so. I know I'm not smart enough to do that...perhaps others are!