Wednesday, October 17, 2007

Option 3

Third in our series of "investment" products, today we're going to debunk the option myth.

Feel free to refer back to the great discussion at this post.

For the past few years on late night and Saturday afternoon TV we've been inundated with infomercials convincing us to attend "free" seminars offering to teach us how to dump our jobs, get rich quick and lead the lifestyle that Bill Gates wishes he could. And just what are these "gurus" offering to teach us? How to flip real estate and how to trade trends and use options.

Now again, I'M NOT A FINANCIAL ADVISOR, nor am I a trading expert. If you asked me over a beer how much I know about options, I'd say more than most people but less than someone who trades them. I've never touched the things. But man do I want to.

I'll admit, I enjoy a good game of poker. There is something about gambling with skill and a bit of intelligence that is oddly exciting. I figure options would be the poker equivalent of the stock trading world. And they certainly don't qualify as an investment using our definition form the above-linked post. Nope, pure speculation.

Here's how it works: you borrow stocks betting their prices will go up or you lend stocks betting the prices will go down. The price you agree to pay is the price they were worth at the time of the contract. You collect the difference between the two prices if the contract is exercised. Really sophisticated options traders can even borrow stocks to lend out and thus play the game at both ends. These transactions are called "puts" and "calls." And they are complicated by time limits, so just when you think things may be looking your way finally, ding, ding goes the bell.

This is an overly simplistic explanation that is full of inaccuracies, but you get the idea, non? It's trading on margin and you can lose as big or even bigger than you can win. Think buying a house right now and watching its value drop 40% in 6-months and you still owe the bank and you can't sell the house.

Last I checked, you had to have considerable experience with a brokerage and considerable wealth to get into this game and stellar credit. You also had to have a brass jock or jill; these kinds of investments when they go wrong feel like a swift kick to the groin, I'm willing to bet.

The best way you and I can get a taste of the action, without the knowledge or finances to back it up, is through investing in hedge funds. Even those are super risky. Just ask those people invested in the Bear Sterns hedgies that got dragged down to their death by the US housing market downturn.

Anyone reading this playing this game? How's it going for you? Do you do it through an online trading system like Action Direct or E-trade? Inquiring minds would like to know.

17 comments:

vg said...

HHV,

I have been studying them the past 6 months off and on and they are calculated gambling but if you use a good chart system and play US stocks only (for the volume)when the indexes are seriously overvalued or undervalued it is possible to make a 3-4 bagger in 1-2 weeks. As you say a pair brass monkeys is essential. Also be prepared to get out and take a 50% loss if your charts didn't prove you right.

My 4 paper trades the past few months have all made 3-4 times fairly quick,one on the VIX would have made more like 5 or 6 times.One tripled in a few hours,that was painful to not have the cash laid down. So you can see why people play them but we are talking violent moves in less than an hour or two if something backfires. You gotta be close to the PC to watch it too.

Anonymous said...

I can't see how you would get out and cut your losses.

Put and calls are all or nothing plays. If you are out of the money then the option expires and you have no ability to dump it for a smaller loss.

Futura said...

Puts and calls are the used car sales of the financial sector. One step up from red light/green light trading software. It's for the cronic self abuser who dreams of a job he can do in his bathrobe for obvious reasons, because nobody at work likes him. (Either that or I just get annoyed at myself because I can't keep track of which one is which.)

On the real estate front the Juliet at 760 Johnson (set to start leaking in 2008) just posted a price reduction on PCS. A $294,900 unit just fell to $259,900 while one a $279,900 dropped to $255,000.

hhv said...

Futura,

Those are big drops. 12% and 9%. I guess this time it really is different.

Anonymous said...

When are we all having that drink at the Bengal Tiger Room?

S2

olives said...

I've had options twice (through a family member) and both times I lost everything I put into them (which wasn't much). He has been very successful with them however over the years. I view them as gambling - you just can't risk more than you would mind losing completely. Maybe if I had made money I would see it differently!

On another note, Canada's credit crunch is in the news today:

http://www.reportonbusiness.com/servlet/story/RTGAM.20071018.wbocmonetary1018/BNStory/Business/home

vg said...

"If you are out of the money then the option expires and you have no ability to dump it for a smaller loss."

I guess thats why I am still studying them and not using real cash yet,lol... I assumed you could still sell them at some point well before expiry even if they were out of the money, as someone buying them from you would be taking the risk if things turned the other way before expiry and they went back up but would be getting them cheap.

Thats why I thought people trade options,cause you aren't forced to hold them til the expiry date.

Either way I would never get into one with more than a few hundred or so at a time as it is pure gambling but calculated at the same time.

vg said...

"Put and calls are all or nothing plays. If you are out of the money then the option expires and you have no ability to dump it for a smaller loss."

anon 9:47,

I'm afraid you are wrong on that and I was correct in the first place. I just talked with TD Waterhouse Options strategist and you buy and sell options like a stock.

If you are down 50% then you sell and take your 50% loss,not sure where you are getting your info from. You aren't stuck with them for good just cause they are out of the money.

vg said...

"Last I checked, you had to have considerable experience with a brokerage and considerable wealth to get into this game and stellar credit. "


Decent credit yes,needed to get the margin account.

Don't need that much experience with a brokerage other than any of the bank related broker accounts.

Considerable wealth ? a few hundred or so will do it to start with depending on the cost of the option.

As I mentioned,the brass monkeys are a requirement but the most important is to not get overwhelmed with all the strategies.

My plan is to keep it simple and play the indexes or main index leader stocks and be ready to get out quick if you guessed wrong.

Tony Danza said...

Hey HHV, Thanks for the interesting posts, keep up the good work.

I know you made this post with the intention of providing a quick summary of options for the layman, however...

Options are not necessarily gambling anymore than buying shares in the underlying security is gambling. If you are talking about writing (ie selling) naked puts or calls (where you don't own the underlying security) then yes you can potentially lose everything, and I mean everything as in bankruptcy! However, if you buy puts or calls you will only lose your initial investment in the worst case.

Options are actually a form of insurance for prudent investors. I won't get into it here, interested investors can check out the thousands of investing websites for more info. Basically put options will protect you on the downside of a long investment and calls can protect you somewhat on a short trade. That was what options were originally marketed as, insurance, but of course they are really a way for the investment banks and brokers to collect even more fees from greedy specuvestors.

BTW you need way more equity to invest in hedge funds then you do to begin trading options, if you can fog a mirror you can trade options.

vg said...

Good points Tony Danza, I went to a seminar at TD and that was the main theory they liked to use is as a form of insurance to cover your stock holdings. You can hire them there for a set fee to advise you if you have some serious money involved and need some guidance.

It's all about timing with options too,the interesting thing I found was the timing of the markets direction with the expiration dates as if these areas were almost rigged,but that is a whole other discussion that has some credibility to it with the Plunge Protection Team and their suspicous interventions.

hhv said...

Why am I under the understanding that most brokerages will only let you trade up to 20% of you net asset value in options? Am I making this guideline up?

I figured you'd need a few grand minimum to make a go of any kind of options trading strategy, and that could disappear very quickly if your luck is down.

Futura said...

I have been watching this condo at 306-2095 Oak Bay. A very tastefully decorated one bedroom.

It came on market on September 6 for $293,500 mls#235239.
On September 21 reduced to $285,000. On September 28 reduced to $275,000 with a free flat screen tv.

On October 18 it was taken off the market only to return a few hours later with a new MLS number 237117 and a further reduction to $249,900.

vg said...

hhv,
I am not aware of that rule but you may be right. I think they do set limits in the beginning so you don't get smoked right out of the gate and then it moves up as per your account level.

Alot of strategies revolve around straddling both sides at the same time but it can get complicated.
I was shown to play "at the money" options and stick to the Nasdaq QQQ or the DOW Diamonds. Problem has been the last 6 months is traders have been going broke trying to predict a correction with all the bad news out there while the DOW miraculously climbs higher. It's almost time to take a chance on shorting the DOW as the Bear ETF's have been giving some buy signals the past few days.

Tony Danza said...

HHV, I use TD Waterhouse for my investment activities, they have no requirement regarding % of net assets used for options trading that I know of, I have in certain circumstances (2000-2001) had way more than 20% of my net asset value in options.

As far as how much you need for an option trading strategy? Say you have 100 shares of MSFT and you want some downside protection, I can buy an in the money put contract (100 shares) for $370 plus fees that expire more than two years from now.

Holgs said...

Hey guys,

Ive been in the options game for a few years now and taken my share of hits as well as some profits. I am holding some puts on C and St Joe at the moment.

Dont really have time to go into details now, but I think you have confused shorting and options. With shorting or selling naked puts or calls you can lose your shirt. Buying a put or call option, worst case scenario, you lose the whole investment. However, in some cases the cost of the put might only be a couple hundred, so you wont end up in the poor house.

I use RBC action direct, and with no history they let me get into options and margin right away, with a 10000 initial investment. Just be careful. I was a bit of an idiot when i started and thought that goog was for sure the next bubble... back when goog was at 200! Obviously, that 4000 LEAP wasnt such a good investment, and i have since learned the hard way think further ahead and to limit the risks.

Shorting through RBC has been awesome this year. You can short a US stock and put the money you get from the initial short into your CDN account. Whats been happening for me is that even if the stock doesnt drop in USD, it certainly drops in CDN!

Although very wrong in its timing, Conquer the Crash can be picked up at Chapters and goes into the details of options and shorting. As Im finally back at a profit now after my initial foray, I fully recommend to everyone else to at least start playing around with options and the short side... Just make sure to use money that you can afford to lose. The best way to learn is through experience, and it has taught me to be less emotional about investments and to think long term rather than short... One reason why I now prefer shorting to options... short the sure thing then sit back and wait. I only wish Id shorted HOG like I almost did back when it was at sixty!

Sorry for the lack of punctuation... Dark room and dark keyboard.

Holgs said...

When I said 4000 option, I meant that was the final price of the LEAP that I bought, 40 bucks a share times 100 shares.

The leap was at 300, I think, so if goog had dropped to 200, it would have been worth 10000, or 20000 if the stock had dropped to 100. I finally sold the put when it was only worth 1000, so I lost 3 grand. Ouch, painful, but I will never be that stupid again.