UnThreaded | Threaded | Whole Thread (20) | Ignore Thread Prev | Next
Author: MDCigan Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 11006  
Subject: Re: Why We Avoid Options Date: 1/4/2002 8:20 PM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 56
Here is a copy of an e-mail I sent him detailing my thoughts:

*************************************************************

Dear Bill,

Typically I do not feel the need to respond to articles written by TMF columnists. This is usually because I do not want to invest my time, and also I do not believe most of the TMF columnists have much credibility or influence. Therefore, a response is largely a waste of my time.

However, you are one of the few TMFs I believe is a rational, shrewd thinker who does have substantial credibility and influence. I have a great respect for your viewpoint and thoughts (you are one of my favorite Fools), and I make it a point to read your columns and message board posts.

I have mixed feelings about your options column today. In a VERY, VERY general sense, I agree with the spirit of your message which is that most individual investors should stay away from options. Beyond that, your column has some misinformation and factual innaccuracies which indicates you do not fully understand options, the options market, different option trading strategies, and the way they trade.

Are options complex? Yes. Are they difficult to trade successfully? Most certainly. Should the vast majority of individual investors (9 to 5 factory workers, airline pilots, even some professionals like scientists and doctors) stay away from them? Most certainly. No doubt.

But for those EXACT same reasons most individual investors should stay away from selecting individual equities, and yet TMF continues to espouse that the average Joe can beat the pro at that game. Therefore, it is extremely disengenous and contradictory to steer people away from options, but at the same time continue to push the message that the average Joe can pick individual stocks (I realize that you personally have not done this but TMF on the whole has). I think Whitney Tilson's article The Arrogance of Stock Picking did a good job of showing why most people should not be involved in this endeavor. Now, I realize that trading options is definitely higher on the ladder of complexity and risk (although there are several option strategies which are less risky then outright stock ownership) then picking individual stocks, but if somebody is smart enough, has the proper understanding of risk vs. reward, and probability based outcomes, if that person can be a good stock picker they can probably become a good options trader also. Even Warren Buffett has used options and derivatives at times.

Now on to responding to some of your exact statements:

<<First of all, unlike equities, there is no wealth creation at all in options.>>

This is one of those type of statements that sounds good but really doesn't mean anything. If a business is successful at growing earnings over time, producing free cash flow, it is creating wealth. If it is producing negative free cash flow, or earning a rate or return below cost of capital, it is destroying wealth. But for me the stockholder, when all is said and done, the only thing that matters as far as wealth creation in my personal account is that the stock price go up from where I bought it. Similarly, if I buy a call for 2 and sell it for 4, I've created wealth for myself. So whether the equity markets "create wealth" and the options market do not is really beside the point. The question is can I grow my own personal wealth by trading/investing in these vehicles.

<<As such, in any options trade, one of the two participants MUST be wrong. In investing it is not necessarily the case. Because investments in equities are essentially entitlements to future earnings from a company, it is possible for both the buyer and the seller to be correct in a trade. If I sell my Intel (Nasdaq: INTC) because I believe it will go up less than 10% per year, but someone else buys it because he thinks it is safe and it goes up 8%, we are both correct. Not so in options.>>

This is just plain wrong. If I buy stock XYZ at 30 and sell the 3 month XYZ 35 strike option and after say 1 month stock XYZ rises to 40. At that point the buyer of the option sells it for a profit (the option will be worth much more with XYZ at 40 then when I sold it at 30). Then on the day of expiration, stock XYZ is trading for 34.99 and thus the option expires worthless and the seller keeps the premium. Both the buyer and the seller of the original option trade made a profit. Both were winners. Now somebody probably lost somewhere on transactions relating to that particular option, but thats no different then individual stocks. As a stock price fluctuates, there will be countless numbers who buy and sell for a profit and countless numbers who buy and sell at a loss.

I could come up with literally thousands of examples of how particular option trades could result in both of the original parties winning (both making a profit). If you are interested in me proving that, I'll do so in a follow-up e-mail. What you are doing is making some mistaken assumptions. First of all, your point to some degree hinges on most option buyers holding to expiration. No successful long options trader holds to expiration. They are out well before expiration. Secondly, for most trades, the other side is the market maker who automatically hedges the position by either buying or selling stock, or hedging it with another option (spreading). He makes his money to some degree on the bid-ask and by making frequent adjustments to his position as the stock moves. Bottom line, the market maker is operating in a different time frame then you are. It is possible for both he and you to make money, although he most definitely has the edge.

<<There is no way for options writing to generate value.>>

Again, I'm not really sure what this statement means. If I am writing options, collecting premium, and then watching that option expire worthless, I am most certainly generating value for my personal account. Whether I am generating "value" in some broad, macroeconomic sense, who really cares? Writing options is akin to selling insurance, and like selling insurance you'll collect alot of premium and be subject to events that require massive capital payouts (such as a stock dropping significantly if you are short puts or a stock rising significantly if you are short calls). Whether you'll succeed and make money overall is dependent on the level of risk you are taking for the premium you are receiving. Option premiums do tend to become either undervalued or overvalued as determined by implied volatility levels. This misvaluation of option premiums is probably easier to spot then individual stock misvaluation. There are traders who specialize in trading this premium misvaluation (volatility trading) and have little to no exposure to change in security prices. Furthermore, writing puts can be used to acquire stock at a lower average cost basis. Say I like stock XYZ, and would be willing to buy it at 35 but it is trading at 40. I can sell the 35 strike put and collect premium. If the stock never hits 35, I keep the cash. If it drops below 35, I buy the stock at a cost of 35 minus the premium.

As far as using protective puts, it depends. As a portfolio wide strategy (i.e. buying puts on all your stocks that you own) I agree that's a bad strategy. The cost of the puts will eat away much of any stock return. On a case by case basis, there may be stocks where a protective put can be very wise. I'll give you two examples. KKD and EBAY. Both of these stocks have an EXTREMELY HIGH level of valuation risk. At the same time, both are in strong uptrends with strong fundamentals, and substantial institutional support. They both could easily double from here, BUT they could also easily get sliced in half or more on any bad news. If you were smart or lucky enough to buy them many moons ago, it would make sense to protect your gains. Of course, you could just sell the stock but then you miss out if they double again. So owning the stock along with the put is a way of participating in further upside without having to worry about a catastrophic loss.

Well, I am starting to ramble on now. I haven't even touched on many of the sophisticated spreading strategies or delta neutral trading strategies where it is possible to obtain some fairly high returns without ridiculous levels of risk. I'll tell you this. You'll often find that some of your shrewdest, sharpest individuals eventually gravitate towards options. Either exclusive options trading, or options in conjunction with stock. That isn't a coincidence. I know that you've corresponded with Bill Reschke (impliedvolatilty) in the past, and the use of options to hedge and define risk is central to his strategy. His results speak for themselves. Another poster PeterEidson exclusively trades sophisticated spreads. His returns and examples of his trades have been posted, and again they are impressive.

I guess in summary, I agree with the basic message you are stating here. But you should take a step further. The way I see it is there are 2 types of people in this game. The first type (which is the vast majority) should find a good, reputable financial advisor and have the bulk of their money in either index funds or solid mutual funds, and forget both selecting individual stocks and trading options. The second type is the active investor/trader who should avail themselves of all the tools available. That means fundamental analysis and valuation of businesses, technical analysis and charting, and the prudent use of options. The problem with TMF is it has ignored everything else other then business analysis. To the man with a hammer, everything looks like a nail.

Happy New Year and best to you in 2002

Mike

Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Print the post  
UnThreaded | Threaded | Whole Thread (20) | Ignore Thread Prev | Next

Announcements

Post of the Day:
Value Hounds

Medallion Financial: TAXI!
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Community Home
Speak Your Mind, Start Your Blog, Rate Your Stocks

Community Team Fools - who are those TMF's?
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and "#1 Media Company to Work For" (BusinessInsider 2011)! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.
Advertisement