Interview: Options for Rookies

by Manshu on June 23, 2009

in Opinion

I am happy to present my interview with Mark from Options for Rookies. I wrote a brief intro about him yesterday, which can be found here, and I know that readers are always looking for useful e-books, so I want to point you to two free e-books from Mark, one is a rookie’s guide to options and the other is a book about basics of options.

Please consider subscribing to his feed, and here is the interview.

1. Your site is named — Options for Rookies, but are options really meant for rookies? Isn’t the average investor, who invests in passive funds, better off staying away from options altogether?

This is quite a question.  It gives me so much to say about topics that are important to me.

a) When I use the term rookie, I’m referring to people who already have some investing experience, but are new to options.  I do tell an investment rookie that lack of stock trading experience should not make it any more difficult to understand how options work – but the trading aspects of investing have to be learned from the beginning.  I write, based on the assumption that the audience has experience with the stock market.

b) I don’t accept your premise that the average investor invests in passive funds.  The mutual fund industry, composed of actively managed funds, and which employs a huge sales force to encourage individuals to entrust their money to those active fund managers, controls far more money than index funds or exchange traded funds (ETFs).   I honestly believe that passive funds are much better than actively managed funds for the vast majority of investors.  But there is a large group of people who enjoy making their own investment decisions.  Some trade in and out of mutual funds, trying to time the market  or find the ‘hot’ fund manager (a very poor methodology, in my opinion).  Many short-term traders use charts (technical analysis) to make trading decisions, and some love picking their own individual stocks.  The data has been collected and studied and tells us that those who trade actively, picking stocks and funds, perform worse than those who trade less often.  Part of that decreased performance comes from paying commissions.  Active trading may not translate into more profits for the average investor, but they continue to trade actively, nonetheless.

c) The final part of your question represents a view I see (too) often.  Why do you take the stance that staying away from options would be a good thing for investors?  Did you know that options were invented (centuries ago) as risk-reducing investment tools?  That’s how I teach people to use options.  I only recommend strategies that are less risky than owning stocks.  By that I mean, when the stockholder loses money, the option trader who is long the same security either loses less money, or earns a profit.  When the stockholder earns a small profit, or perhaps owns a position that is nearly break-even, the options trader earns a profit.  The option trader outperforms the stockholder in the vast majority of situations.  With conservative strategies, the only time the stockholder does better occurs when there is a large increase in the stock price.  Yes, that happens, and that bonanza possibility is what makes investors try to pick their own stocks.  The options trader, with his limited profit positions may feel short-changed when those large gains are being made by everyone else, but those surging markets don’t occur very often.  Depending on the option strategy chosen, the option trader always loses less when the market moves against the stock trader, always makes more profit when the markets are stagnant, and outperforms in a rising market – but only up to a certain point – because profits are limited.  How can that not be considered conservative?  Why wouldn’t that scenario be attractive to the average individual investor – if only he/she were made aware that this opportunity is available.

But as badly as he/she may feel during surging markets (the technology bubble of the 1990s, for example) think how much more relieved they are to avoid the massacres that occurred when that bubble burst or in the 2008 – early 2009 bear market.  The protected, hedged investor is better off.  And that’s why I disagree with the premise that passive investors would be better off without options.  The evidence is strong that they would be much better off by adopting options strategies.  But, there are financial planners, and personal finance writers – both in the blogosphere and the national press – who stress the same stuff year after year: the importance of diversification, asset allocation, continuing to invest during bull and bear markets – that it’s impossible for an investor to find an opposing view.  That minority view is mine:  options reduce risk.  Options are advantageous for both passive and aggressive investors.

I don’t understand why ‘staying away from options’ is considered to be the norm when any intelligent investor ought to want to learn about options and how they work – and then decide if using options is appropriate.  But they never go that far.  Options are just dismissed from consideration because they appear to be risky and made only for speculators, because they get bad press when a rogue trader loses billions for a bank.  Options are not for everyone, but any conservative investor who likes the idea of preservation of capital can do well with collars, or other option strategies.  Too many investors gamble with options and get wiped out.  But, that’s the result of gambling, not of using options.

2. You talk about trading in options conservatively. This is the first time I have heard the two words — conservative and options in the same sentence. How can someone trade in options conservatively?

As I said earlier, options were designed to be conservative tools.  Just because many investors use options to gamble does not make options risky.    The fact that too many people adopt option strategies for which the odds of success are stacked against them does not make options trading risky.  It just means that too many option traders decide to gamble with options and not reduce risk.

Options trading is conservative because it reduces the risk of investing in the stock market.

When adopting my favorite strategies, compared with the stockholder, the option trader

  • loses less often
  • loses less when a loss occurs
  • wins far more often
  • and only occasionally performs worse than the stockholder

Option trading can also be combined with passive investing.  I’m sure most people who believe in passive investing own shares of a fund that  mimics the performance of the S&P 500 Index.  Well, an option trader can also build a position in that passive index – without owning shares.  By using options, the trader can hold a much less risky, but still passive, investment than the fund owner.  The word I have not yet used is ‘hedge.’  To hedge means to ‘reduce the risk of owning.’  That’s what options allow the investor to do – invest with less risk.  Just because an investment is passive does NOT mean it will do well.  The year 2008 illustrates that even passive investing can be dangerous.  But the option trader who owned shares in SPY (the ETF that mimics the S&P 500) could have hedged risk and as a result, not incur the large losses of the average (so-called prudent) investor.  Everyone thinks investing in the market is a good, wise, and prudent thing to do.  Most of those same people think trading options is risky.  That’s just wrong.  Options can be used to reduce risk – and should be so used by the majority of investors, not by only a small minority.

That’s my definition of being conservative with options.

3. What is the best way for a rookie to start trading in options?

When it comes to trading I don’t ever like to use the word ‘best.’  Each investor has his/her individual comfort zone that must be satisfied when trading.

But to me, the right method for beginning is to read.  Learn how options work.  Here’s a link to some of the most basic concepts about options.  Options are simple, not complicated.  In this country, if you go to a store to buy something offered at a special price, when the store is out of the item, the customer is given a rain check that allows him/her to buy that item (when the store has more of them) at the same price for a limited time.  That rain check is a call option.  Options are just that simple.  A call is the right to buy at a given price for a limited time.  Equivalent to a store’s rain check.  Strategies may be simple or complex, but options are very easy to understand.

After having an understanding, practice trading with play money, or if you must, use real money – but trade a small amount of dollars until some hands-on experience makes you feel more comfortable.  Keep reading.  Keep learning.  Do not assume options are the path to instant riches.  They are not.

And have patience.  You have the rest of your life to trade.  Learn and understand first.

4. What are some trades that a rookie investor should stay away from?

That’s easy.  Any trade you don’t understand.

If you don’t know which expiration date to chose, if you don’t know which strike price, if you don’t know whether the options you are buying or selling are trading at a fair price or are either a bargain or way over-priced, then do not trade.

And more importantly, if you don’t know know how the price of your option(s) will be affected when such and such occurs in the marketplace, you cannot trade.

Don’t trade if you don’t know how much money you can lose on the trade.  Or what your profit target is.  Or what has to happen for you to earn your target profit.  If you don’t yet understand how they work, don’t trade options.  It’s unbelievable how many investors think there’s nothing to it, jump right in, and lose all their money.  All that without the slightest idea what they are trying to do.  It’s because of traders such as these that options are not considered to be a conservative investment tool.

5. What are some good ways to hedge your positions using options?

There are many possibilities because options were designed to hedge, or reduce risk.

In no specific order (and some of these I don’t recommend), to hedge a long position, an investor can sell a covered call, sell extra calls, buy a protective put or buy extra puts, sell a call spread, buy a put spread, own a collar position (buy a put and sell a call).  There are other choices.   I hope no one would consider making any of these trades without further information.

This was the third interview in our series, which started with Weakonomics and then TIE. I really enjoy doing these interviews, and if other bloggers are interested, please contact me using the contact form.

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