“Free money with a few clicks using this Wall Street secret!” Who wouldn’t want that? It’s the sort of thing often claimed by options trading services. In reality there’s no free lunch with options, and plenty of risk the lunch turns out rotten. So let me explain why I never trade stock options.
Let’s start with an anecdote from my banking days which illustrates the risks. Back in the 1990s (‘96?, ‘97?) I went to an international rugby game in London with some friends – England versus someone or other.
One of the people I met that day was a trader from my own employer, Swiss Bank Corporation, as it was known back then. I can’t remember his name, but let’s call him Bill.
He was a fast talking, hard drinking character. Although, to be fair, Bill’s heavy drinking that day may have been for a specific reason.
I happened to know that he’d lost about US$50 million of SBC’s money the previous week. Back in the 90s that was a lot.
Okay, it still is. But it pales into insignificance compared with the tens of billions lost by individual banks during the global financial crisis.
Bill had lost all this money trading stock options. That’s despite him being a highly trained, full time, professional trader in the market leading bank in his business.
I’ll get back to Bill later. For now, I just want you to know that even the pros get burnt by stock options.
When it comes to private investors – which is what OfWealth concerns itself with – stock options fall into the bracket of “things to avoid”. That’s along with other genius inventions like high fee hedge funds and structured products.
“Normal” investment – in things like stocks, bonds and gold – is complicated enough for most people. Options ramp up that complexity by an order of magnitude.
Not just that, but all option strategies – even the supposedly low risk ones – have substantial risks which aren’t always obvious. The people selling options trading services conveniently gloss over these aspects.
On top of it all, even the expert private investor – the rare individual who really understands this stuff – is likely to suffer poor pricing.
Oh, and it’s a lot of work. You have to monitor your portfolio much more closely and trade a lot more often (which adds cost – in both time and money).
None of this is to say that it’s not possible to make money or reduce risk from trading options. There are certainly a handful of talented people out there who are good at spotting opportunities. Maybe you’re one of them, or get recommendations from someone.
If you do, that’s fine and I wish you luck. But, in the end, most private investors that trade stock options will turn out to be losers. You don’t have to be Bill to get caught out.
Let’s take a step back and make sure we’ve covered the basics. Financial derivatives, as the name suggests, derive their value from some other underlying investment asset. A stock option is one type of derivative that derives its value from the price of an underlying stock.
There are two types of stock options: “call” options and “put” options. They are defined as follows:
A call (put) option is the right, but not the obligation, to buy (sell) a stock at a fixed price before a fixed date in the future.
That fixed price is called the “exercise price” or “strike price”. The fixed date is the “expiry date”. The cost of buying an option is called the “premium”.
So, for example, let’s say XYZ Inc. stock is trading today at $95. I could pay, say, $1 to buy a call option that will allow me to buy the stock at $100 any time between now and 9th May. The strike price is $100 and the expiry date is three months away.
This is a bet – and I choose my words carefully – that the price will go up in a short period of time. But if it doesn’t go up enough then I’ll lose all or most of my $1 premium. The option will “expire worthless”.
My example is also what’s known as an “out of the money” option. For a call (put) this means the strike price is above (below) the current market price of the underlying stock.
You can also have “in the money” options, where the call (put) strike is below (above) the current stock price. Finally you can have “at the money” options, where option strike price and stock price are the same.
Confused yet? Well, prepare yourself. It gets much worse. (Remember, I’m not doing this for fun. I’m just trying to persuade you not to be tempted to trade options.)
Next we get to pricing. Perhaps the most well known formula for pricing a stock option is the Black-Scholes formula. It’s named after its creators Fisher Black and Myron Scholes and was published in 1973.
Black-Scholes was what I was taught in 1993 during the graduate training programme at S.G. Warburg, a British investment bank. (“Warburgs” was bought by Swiss Bank Corporation in 1995, which was merged with Union Bank of Switzerland in 1998 to create UBS. Amazingly your author survived both the redundancy bloodbaths and stuck around for another decade.)
Are you ready? Here’s what it looks like when applied to pricing a call option (C):
Black-Scholes pricing model for a call option
Got that? Easy peasy. Right?
On top of that there are competing methods for pricing options. One is the “binomial method”. Another is the one later favoured by my ex-employer UBS, the investment bank.
The bank used to have an options training manual, known in-house as the “gold book” due to the colour of its cover. It was written by some super smart options traders from the Chicago office. For all I know they still use it. (I still have my copy published in 1994 and an update from 1999).
This is the alternative formula they had in the gold book:
Call value = Parity + Basis + Volatility value – Carry cost of option price
Parity = Spot price – Strike price
Basis = Forward price – Spot price
Carry cost of option price = option price x interest rate x time
UBS also had an alternative definition for options. It goes thus:
A call option is a substitute for a long forward position with downside protection.
Got all that as well? Everything clear so far?
Clear as mud more like. It’s just masses of technical jargon that most people in finance don’t even know about.
Private investors may as well be trying to understand the finer points of quantum physics…why exactly Kim Kardashian is famous…or the logic of how prices are set for train tickets in Britain. (If you’ve been there you’ll know what I mean.)
By now you should be starting to get the picture. Options are seriously hard to understand. Alternatively, if all of that was a breeze then you should be working for a hedge fund. At least you’ll get paid well.
Still, it gets worse. Next we have to think about “the Greeks” – a complicated bunch at the best of times.
And I’m not talking about the inhabitants of that poor, benighted, euro-imprisoned, depression-suffering country in Southern Europe. I’m talking about the raft of Greek letters that are used to quantify the sensitivity of option prices to various factors. So let’s learn some Greek.
“Delta”: the sensitivity to changes in the price of the underlying asset (a stock in this case)
“Gamma”: the sensitivity to changes in delta caused by changes in the price of the underlying asset.
Or put another way:
“Gamma”: the sensitivity to changes in the sensitivity to changes in the price of the underlying asset caused by changes in the price of the underlying asset.
Got it? Or this one:
“Vega”: the sensitivity to changes in the volatility of the underlying asset
The thing is, as a stock price moves up and down along a straight line, an unexpired option price follows a curve (the angle of the curve is delta). The amount it curves also varies at different points (that’ll be gamma). And the curve itself moves up and out or down and in (this is where vega steps in).
Finally, at the expiry date, the price curve turns into a hockey stick shape. Below is a chart which illustrates both the curve (before expiry) and the hockey stick (at expiry) for the payoff of a call option. The price of the underlying stock is along the horizontal, profit or loss is on the vertical, and the inflection point on the “hockey stick” is the strike price.
Now let’s get back to “Bill”, our drunken, mid-90s trader friend. Remember him?
Bill traded Swiss equities (stocks / shares), which as you can imagine was a big job at a leading Swiss investment bank. One of the things the bank did in this business was “writing” call options to sell to customers. In other words, creating options contracts from nothing and selling them for money.
That meant taking on market risk. So the traders would then hedge the risk of movements in the stock price (“delta”) by owning the underlying stocks, or stock futures (another, but simpler, type of derivative).
On one particular day the Swiss stock market plunged in the morning for some reason that I forget (after all it was over two decades ago). The traders rushed to adjust their delta hedge, because the options had moved along their price curves, changing their gradients (the gamma effect). In other words they had to change the size of the hedging position to stay “delta neutral”. So far so good.
But then the market suddenly spiked back up again in the afternoon. So the hedging changes had to be rapidly reversed. In the turmoil, they lost a small fortune. The hedges had to be sold low and rebought higher. Oops.
That’s just one example of the pros getting caught out. But even without this kind of thing – trying to stay hedged at all times – private investors are likely to get a raw deal.
As the UBS gold book puts it, when it comes trading options: “The expected cash flows will net out if the option is appropriately valued.”
In other words, over time and across many trades, you’ll only make money if you know precisely when options are overpriced or underpriced in the market, and then trade accordingly.
Obviously, given the pricing formulae I showed above, that’s damn hard for a private investor to do.
But it gets worse. Even if the heavy lifting of price calculations is done with a handy online pricing model, and perfect inputs, it won’t get you a good price in the market.
Consider this. If you buy or sell options through your broker, who do you think the counterparty is? Who is taking the other side of the trade?
Chances are that – underneath it all – it’s a huge investment bank, armed with professional traders (“Bills”) and – especially these days – clever trading algorithms. And intermediaries like your broker will take their cut as well.
Who do you think is getting the “right” price? Or better than right? It surely isn’t you.
As Warren Buffett once said: “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”
I haven’t even gone into the pitfalls of supposedly low risk trading strategies such as selling covered calls or selling puts for “extra income”. (That’s the claimed “secret free money” by the way.)
Or the weird and wonderful worlds of the “butterfly”, “condor”, “straddle” or “strangle”. Nope, they’re nothing to do with ornithology, pornography or animosity. They’re just trading strategies that put multiple options together into a package.
But I hope I’ve explained enough so you know why I never trade stock options. I recommend you steer clear as well.
However, if you do choose to trade options, I wish you the best of luck.
Stay tuned OfWealthers,
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