Sunday, October 16, 2005

Who Gets Rich with Options?

I picked up my local Sunday paper this morning and glaced at the lead story in the business section: "Bet on the future with options." As I scanned the article, I learned that options volume is now 5.6 million contracts, up about 1 million contracts (or 22%) from a year ago, according to the CBOE. Apparently the "little guy" is getting involved, writing covered calls, buying protective puts, and speculating with naked calls and puts.

I'm glad to see that more people are participating in the markets. However, unless this is just another dose of sensational journalism, we can be certain that the proverbial "little guy" is once again getting "fleeced" by seminar speakers, brokers, and financial professionals, who peddle products for fees and commissions and hardly give a second thought to pulling the wool over the little guys' eyes.

Let me explain my stance. First and foremost, options (along with futures and other derivatives) are a "zero-sum" game. For every derivatives contract, there are a buyer and a seller, who take positions on opposite sides of a market (stocks, bonds, currencies, commodities, etc.). As time passes, the market moves, and, when the contract expires, one party has a gain while the other has an equivalent loss. In other words, for every winner, there is a loser.

If that were the whole story, I wouldn't be so negative. Importantly (and this is the part that usually goes unmentioned), there are third parties involved who always come out ahead in the game. Brokers take their commissions, market-makers extract the bid-offer spread, and advisors (to the extent that they are involved) earn their cut. So, if a net amount (upfront premium plus final settlement) of $100 changes hands during the life of the contract, the losing party is worse off by $100, the winning party is better off by, say, $95, and the brokers, market-makers and advisors end up ahead by the remaining $5.

Because the fees and commissions in options trading are so much higher than in trading the underlying stock, and because options contracts are all by their very nature short-dated (volume becomes very thin beyond a few months), the annualized frictional costs for even moderately active options traders can easily run beyond 5% or 10% of the principal amount of the underlying stock. A hurdle this high is very difficult to surmount for any options players hoping to realize consistent profits.

Now, there are many who believe that they have a "knack" for guessing short-term market direction correctly and, consequently, can benefit from the leverage opportunity that options provide. Then, there are others who advocate the insurance aspects of buying puts or selling calls to reduce the volatility of underlying buy-and-hold positions. To the short-term market-timers, I say "best of luck"--in my opinion, making consistent profits in options trading, particularly with the high frictional costs, is as difficult and unlikely as winning consistently in Las Vegas. My rebuttal to the insurance argument is simple: Make sure that you really need the insurance against market volatility before you buy it--short-term profits are, of course, possible on the options component if you happen to be on the right side of the market, but in the long run you will likely be better off just riding the market's rollercoaster, without trying to smooth the bumps with calls and puts (and suffering from the frictional costs).

My advice is straightforward: Avoid options and save on fees and commissions. Accept the volatility of the market, patiently letting the market's secular rise propel the value of your portfolio upward over the long haul. There may be a few professional traders who have enough of an "edge" to profit consistently from options trading, but, if you're a little guy, the options cards are stacked against you from the start.

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Lloyd,
I agree with you that the large transaction costs together with the lack of any informational advantage makes option trading a losing proposition for most individuals.

However I don't agree that (in the absence of transaction costs) it is necessarily a zero sum game.

The retail speculator who has a view on the direction of the stock may be trading with a professional who has a view on the volatility of the stock; the latter will hedge as well as he can his delta exposure; both speculators can be right, and, in principal, both can win.

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Blogger Brijesh said...

This blog is really nice and informative. We are pleased to know this blog is really helping people and it’s our pleasure to post informative content on this useful blog created by webmaster.

Here’s our market view on American stock market for 10th October, 2008

The stock market has collapsed - since Sept. 19 the DJIA is down 25% and the S&P 500 is down 28% and down 42% from a year ago.

How can this happen so quickly and so dramatically when so many good things have occurred? Oil is down to $82 a barrel; interest rates are very low; the dollar is up; valuation levels are extremely attractive among many blue chip stocks.

What's the real problem? The problem that is killing the stock market is a lack of hope about the future.

Hope springs from optimism that is based on facts and history. Look at the history of America and really all of mankind. Life is full of setbacks and problems - that's just the deal. But this too shall pass, as all scary periods have.

Doomsayers have been around forever and their batting average is zero. Buying stock is based on hope - hope for the future. If one doesn't have hope, they shouldn't be in this business.

So what is the best service we, as professionals, can provide for our clients?

First, discuss the fact that we are dealing with serious problems but it is not at all like 1929. The Federal Reserve and the Treasury Department are doing many things to restore confidence in the financial system. There is global coordination in attacking the problem, which is lack of confidence.

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11:50 PM, October 13, 2008  
Anonymous ThePowerStocks.com Team said...

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Here's our market view on American stock market for 13th October, 2008

You all know my opinion - we have the characteristics of at least "a" bottom. Look at the scoreboard - Dow and S&P 500 down 18% last week, in only a week. If that doesn't show irrational dumping the only other environment that probably would is an official end of the world pronouncement from on high.

The VIX Index (69.96) soared to a record high; bears at extreme high levels, bulls no where to be found; valuation levels the best since Black Monday, October 19, 1987. And back then you could buy AAA long term munis yielding 10% or better vs. around 4.75% today.

No one can call bottom in advance with confidence, but we can correctly report that the conditions for at least a bounce are in place, assuming we are not headed for a 1929 depression.

We are not, but don't take my word on this. Last Tuesday, Oct. 7, Gary Becker the 1992 Nobel economic laureate, professor of economics at the University of Chicago stated in the Wall Street Journal - "we're not headed for a depression."

He states, "World economic growth will recover once we are over the present severe difficulty." Also he states, "Although it is the most severe financial crisis since the Great Depression of the 1930's it is a far smaller crisis, especially in terms of the effects on output and employment."

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Anonymous ThePowerStocks.com Team said...

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Here’s our market view on American stock market for 16th October, 2008

Stocks sold off sharply yesterday and the major averages have given back more than two thirds of the advance from last Friday's lows to Tuesday's highs.

The session got off to a bad start as investors began to react again to economic news: specifically, pre opening, the September retail sales and October Empire Manufacturing index were disappointing and stock futures sold off.

Pressure on the market came throughout the session on light volume in what we think was a classic buyers' strike after the significant volatility the past few sessions.

Many market participants were just content to stand aside and let the dust settle. Adding to the selling pressure was further second guessing of the government's rescue plan that we spoke of Tuesday carrying into yesterday's session.

The CBOE Volatility Index, the VIX, rose more than 14 points to 69.25, just shy of its record close reached last Friday at 70. The CBOE NASDAQ 100 indicator reached a new new record close at 72.93.

The number of bulls in the Investors' Intelligence survey fell to another multi-year low at 22.4%. The internals of the market were overwhelmingly negative: NYSE issues 8/1 negative and 97% of the volume to the downside. NASDAQ issues were 6/1 negative and 98% of the volume was to the downside.

Based on the extreme fear and dramatic sell-off on big volume last Friday, we believe the market has probably seen its lows for this bear market but a full retest is underway. Today - Worldwide markets were down overnight and U.S. stock futures are signaling flat to lower opening. Today will be a big test for the market.

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4:04 AM, October 17, 2008  
Anonymous ThePowerStocks.com Team said...

Name: ThePowerStocks.com Team
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This blog is really nice and informative. We are pleased to know this blog is really helping people and it’s our pleasure to post informative content on this useful blog created by webmaster.

Here’s our market view on American stock market for 17th October, 2008
The major stock averages had another dramatic day of swings yesterday, the Dow reversing from down 380 in the morning to close up 401 points. The averages finished just shy of their highs of the session and the NASDAQ Composite led the way.
Stocks briefly rose at the opening, then reversed lower as a plunge in the October Philly Fed index (reported -37.5 v. estimated -10) and disappointing reading on September industrial production (reported -2.8% v. estimated -0.8%) weighed heavily. Follow-through selling from Wednesday was also a likely factor adding to the pressure on stocks.
The measures of fear again reached record levels in the morning plunge. The CBOE Volatility Index, the VIX, and the CBOE NASDAQ 100 volatility indicator both rose to new intraday all-time highs of 81.17 and 84.62, respectively. Stocks steadily slid to their late morning lows. At that point, the DJIA was down 380 and the NASDAQ 62 point and the internals of the market were overwhelmingly negative for both the NYSE and NASDAQ.
From the lows, the Dow rallied more than 500 points in an hour, gave back 200 points from their early afternoon peaks and settled into narrow ranges. A late acceleration sparked another 500-point rally up to the close. With the stock market successfully holding onto to their gains, the VIX and NASDAQ Volatility indexes eased back into their closes. The broad market finished solidly positive. Volume picked up substantially from the previous day's low levels.
Today - Volatility will also rise as a significant amount of options expire in a triple-witching session. The opening looks lower.
ThePowerStocks.com Team
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