Stock Option Trading?
Real Estate Investor · Seattle, WA · Member since 2009 · 308 posts · 61 votes
Stock Option Trading?
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Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes
16yI agree with Niman. It is important to have a good theoretical understanding of options in order to successfully use them in the long run. And when you study the Black Scholes model, make sure you learn about the assumptions underlying it. IMHO, the model undervalues long duration options.
One other important thing to understand when dealing with the financial markets is the types of errors in thinking that are common to our species. The field that studies this is called Behavioral Finance or Behavioral Economics. Learning a little bit about errors such as anchoring, recency bias, the assymmetry between our reactions to profits and losses, etc. allows you to exploit them for higher returns. If you want a simple book to read that talks about some of these errors, you could buy "Fooled by Randomness" by Nassim Taleb, who also wrote the harder-to-read Black Swan.
I think learning the techniques of options trading without learning the underlying economics of it is very dangerous.
33 Replies
- Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes16y
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.
- Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes16y
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.
- Real Estate Investor · Seattle, WA · Member since 2009 · 308 posts · 61 votes16y
Thanks for the responses guys. I know you can make and lose money. I want to learn more about how to do it haha.
Tom how did you learn?
Any book recommendations?I went to the Rich Dad Poor Dad Seminar this week and it was a joke!
Its a big pyramid scheme. I figured they made $300K off people who signed up yesterday.They went over only about 4hours of basic content in 3 full days. All the things in the first few chapters in a basic stock book.
Just a sales pitch as expected. So many people handed over $9K the third day.
They study the crowd while over the days and know who will not sign up.
So sad to see all the well wishers lose more money!
- Real Estate Investor · Ocala, FL · Member since 2008 · 742 posts · 463 votes16y
Jet,
Here are a few books that I have found useful and enjoyed. Hope they help:
1)Greed Is Good: The Capitalist Pig Guide to Investing By: Jonathan Hoenig
2)Trade Options Online (Wiley Online Trading for a Living) By: George Fontanills
3)The Option Trader Handbook: Strategies and Trade Adjustments By: George Jabbour
James
- Real Estate Investor · Seattle, WA · Member since 2009 · 308 posts · 61 votes16y
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.
- Real Estate Investor · Oakland, CA · Member since 2008 · 63 posts · 17 votes16y
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.
- Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes16y
I agree with Niman. It is important to have a good theoretical understanding of options in order to successfully use them in the long run. And when you study the Black Scholes model, make sure you learn about the assumptions underlying it. IMHO, the model undervalues long duration options.
One other important thing to understand when dealing with the financial markets is the types of errors in thinking that are common to our species. The field that studies this is called Behavioral Finance or Behavioral Economics. Learning a little bit about errors such as anchoring, recency bias, the assymmetry between our reactions to profits and losses, etc. allows you to exploit them for higher returns. If you want a simple book to read that talks about some of these errors, you could buy "Fooled by Randomness" by Nassim Taleb, who also wrote the harder-to-read Black Swan.
I think learning the techniques of options trading without learning the underlying economics of it is very dangerous.
- Real Estate Investor · Seattle, WA · Member since 2009 · 308 posts · 61 votes16y
Thanks,
I bought Options University Options Mastery Series - 20 Vid set.
I watched about 4hours and it is real good.
Learning options is very challenging. Now I know why a lot of people do not go into learning it.
It is like learning trigonometry in a foreign language.
I also got Options as a Strategic Investment. Good thick book but hard to grasp it all just with the book if your new to options.
Also been reading the CBOE.
I am excited to learn. - Real Estate Investor · Sentenhart, Wald · Member since 2009 · 110 posts · 75 votes16y
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.
- Member since 2010 · 2 posts · 0 votes16y
Has anyone experienced enrolling in the Chicago School of Trading options mentoring program? Their website is http://www.thechicagoschooloftrading.com/
- Homeowner · Commack, NY · Member since 2010 · 1 post · 0 votes16y
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?
- Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes16y
If the bonds drop in price, you lose money if you sell them at that price.
My main point was that buying calls and puts are not as risky as one may think if it is part of a complete portfolio strategy. If you put all your money into buying puts or calls, it is much more risky than if you use it to play the market while having a different part of your portfolio that protects your capital.
- Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes16y
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 :DThere 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!
- Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes16y
Bryan, the stock market is actually less efficient than you would think or the EMH suggests. I know that I can consistently beat the market. If you want a more authoritative voice on this subject, you may wish to read the transcript of a speech by Warren Buffet:
http://www.tilsonfunds.com/superinvestors.pdf
But what you say is also true. You cannot beat the market based just on a hunch, or through day-trading, or even by following the herd. In order to beat the market, you have to do it the old-fashioned way. You will have to value many companies until you find one that is undervalued. Then you buy that stock and wait for it to appreciate to its fair value. The concept is really quite similar to what we do in RE - finding the one undervalued asset from among hundreds of fairly valued ones.
The main problem with the stock market, in my opinion, is that it requires the synthesis of many more variables. You will need to figure out the long-term trends of various industries, the prospects for companies within those industries, the quality and honesty of management, etc. Comping real estate is much easier and therefore more suitable for most investors.
Finally, I do need to mention that there are also other ways to beat the stock market. But they tend to require large resources that are hard to come by for the average investor. (e.g. arbitrage, exploiting certain types of cognitive errors such as the systematic mispricing of options, etc.)
- Irvine, CA · Member since 2012 · 1 post · 0 votes14y
I've been trading stocks for about seven years now with good success, but recently have been looking to get into option. Here are a couple of books I found useful/
Get Rich with Option - Lee Lowell - You have to be cautious with these books that have the 'Get Rich' titles. There are some good strategies in here, but it doesn't cover how to get out of positions and is overly optimistic.
McMillan on Options - Lawrence McMillan
Getting Started in Options - Michael Thomsett - Real Estate Agent · Virginia Beach, VA · Member since 2012 · 2k+ posts · 1k+ votes14y
Most of the online trading sites, Fidelity, Etrade, etc., have free online courses for account holders to learn step-by-step. I liked how basic they were. Also, some offer in-house seminars. I went to one on different beginning option strategies, and they took the time to explain it well, although the reality of doing it was harder than in the class as higher margin requirements come into play as well.
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes14y
I looked at stocks before but it always comes down to how much will be involved of my time and learning curve adding the additional income stream.
If it becomes anticipated that it will be too intensive for the return than I don't do it.
- Real Estate Investor · Seattle, WA · Member since 2009 · 308 posts · 61 votes14y
I have been studying options since I made the first post here.
I am making consistent returns and I do not know why more people trade options. There is very little risk once everything is understood. There is a lot to learn.I am turning away from real estate with more leverage, less risk, and higher returns.
I have been taking classes from a very respected market maker.
- Investor · North Richland Hills, TX · Member since 2011 · 789 posts · 403 votes14y
Not that anyone wants to hear my lame a$$ story...but many moons ago I quit my job to become a stay at home day trader because my wife was expecting our first little girl...
Become a self taught day trader is like becoming a self taught real estate investor...in more ways than one....
When all was said and done...I actually put food on the table each month trading options.
I sold cover calls and would make about $1200 a month and that paid the bills at the time..again..MANY moons ago....but I had a system...
I sold slightly out of the money covered calls on the first week of the month.
Of course the 3rd week is when they sell options so I'd get $$ in my account and do it again. - Investor · Atlanta, GA · Member since 2012 · 28 posts · 3 votes13y
I've been an options trader for about 10 years now. If you know what you are doing, it's a great way to produce consistent returns. You would have to pay me to buy a stock :).
I even started a website about teaching people to sell puts for income, a vastly overlooked technique.
But like all things, the devil is in the details. The learning curve is steep, and amateurs can lose a lot of money doing stupid things.
- Miami, FL · Member since 2012 · 2 posts · 0 votes13y
Recently what has really caught the market is the binary options, I've been trading for about 6 months, very risky if you dont know what your doing, go my account at VIP binary.
- Canberra, ACT · Member since 2013 · 1 post · 0 votes13y
As someone who teaches options trading to retail investors I've followed your debate on options trading with interest. The EMH has been discredited in recent years, and is particularly suspect when it comes to options pricing.
Therefore, if you are smart - and of course well taught :-) - it is possible to do well. The key is to aim for 2-5% every month and limit losses (ie by selling before they get large). By doing this 20-25% a year is achievable.
The problem is there are lots of pretty shonky operators out there claiming 20% a month which makes this very respectable return look weak.
Anyway, I think if you're prepared to put in the effort options trading is a good diversification to all your real estate efforts...
My 2c anyway...
Chris
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