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A Key Options Myth

In 'the old days' I traded mostly options. This was before the immense popularity of the e-mini contracts, the huge popularity and ease of trading commodity futures contracts electronically, and the advent of the FX market for the average person. I used to say that there is nothing I can do with a stock that I can't do better with an option. That was, and still is, my opinion today. The only place I see an advantage in stock over options is in very short-term scalping, but since I didn't play stocks that way, that wasn't a way I compared stocks and options.
Today options seem 'dead', as far as most traders. I rarely get asked about them, and I almost never see anything on any forums about them. In 'the old days' we would have meetings, you know, the ones like they had all over during the bubble days, and people would say 'Jim's here, you can ask him about options.' People who knew me would come up to me and ask if they could introduce me to this or that person because they had option questions, and I was 'the option guy'. People would say to me 'Oooh, you know something about options?' The point isn't that Jim thinks he's an option guru, it's that people wanted to know about options, and nowadays, it's the mini's, or FX, but rarely options.
When I first started writing my books I had several option books laid out, but I never got to them. It just didn't seem like the interest was there any more. Given all this, I still wanted to write up this article on the most pervasive option myth I have ever heard. It persists with unabated enthusiasm, even among well-respected options people, and is also the bait for many vendors peddling options as the answer to making a fortune in any market. Since this myth is one that common sense and a basic mathematical understand of any 'closed' system would dispel, and it hasn't been dispelled to any extent (or even discussed anywhere I have ever seen), I wanted to explain this, and put my two cents in.
Before I start let me make a few comments about options in general. The main reason I like options is that they give the ability, by using limited risk strategies, to completely cap my risk. You always hear me say 'theoretical risk' because there can always be a market shock event that blows out your stop, and you lose more than you intended. With leveraged futures, especially on the short side, the risk is, in theory, infinite. With certain option strategies you can define the risk beforehand, and the risk is strictly limited to that amount, no matter if the entire world implodes. This is an advantage that can't be overstated when examining long-term survivability of a trading business.
Options also allow me to construct a much more detailed premise, instead of just 'long' or 'short'. Essentially no matter what the scenario there is an option strategy to fit that. Maybe I see big upside potential, but also the possibility that the issue could go down. All I know is that I suspect it likely won't stay here, and the upside is a higher probability. Then I could look at a call ratio backspread, for example.
One can create a huge variety of combinations that completely quantify and limit the maximum risk, and also suit the premise, which may be more detailed than 'up' or 'down'. Factors like 'when' can be played, and a slew of other aspects than one can work into the mix. We get paid for being positioned for things to happen, and options allow one to get in position for a lot more than 'up' and 'down', and cap the maximum risk.
Now, I am in no way promoting options here, or trying to talk anyone into using them at all. (In fact, if you are even thinking about them, consult a professional, read Characteristics and Risks of Standardized Options, and do all your homework.) I just want to point out some of the factors that drew me to options in the first place, and how they offer many opportunities that simply don't exist for simple stock plays. I am going to focus now on a key myth about options. I simply wanted the reader to have some background on how I view options before we started.
The options myth I want to dispel is the idea that the money is all made by the option sellers. The suckers buy options from the smart sellers. All the 'pros' are sellers, they say. Usually this is in the context of a course to teach you how to sell options. Now here's what I contend: there is no advantage to buying or selling, since both sides are balanced in this zero sum game. Later I will offer up one more viewpoint on this, where perhaps the equation isn't perfectly balanced, but that won't favor one side over the other. For now, let's explore what I just said.
If we assume the entire options market, as a whole, is a zero sum game (with all the middlemen with their hands out, it could be considered a less than zero sum game), then what does that mean? In a simple sense, if you make some money, someone else has to lose it. Net overall, money only changes hands within the system. But someone comes along, and dividing the entire system into two 'halves', buyers and sellers, says the buyers are the suckers, and the sellers are the smart money.
Before I get into my thoughts on this, let me mention a few ideas about some things I hear all the time regarding options. One is that 90% of all options expire worthless. Even if that is the case, so what? You see, not all option plays are speculative, perhaps only a small percentage are. Options are used heavily for 'insurance' or to lock in a position. They are used to hedge risk in many complex structures, and they need both buying and selling for that to happen. Looking at buying, or selling, as a side of the market, like it's the entire story, is not only oversimplified, but downright misleading.
Say I sell a covered call. My goal is to keep the premium, and I'd prefer not to be called out. The option expires 'worthless', and I'm very happy. Hmmm, I thought an option expiring worthless means some poor sucker lost money because he's so dumb? Okay, then it must have been the sucker on the other side, the one I sold my option to, he's the chump, right? Many people buy options as a hedge, and not just puts.
How about this scenario. A guy wants to offset a short stock position, basically 'zero it out', for some period of time, for whatever reason. He creates a synthetic long to offset this by buying a call and selling a put. But this is the guy who bought my call. The call expired worthless, yet he is happy, because he accomplished what he needed to with his position, and he wasn't speculating, hoping a particular thing would happen, he just wanted to lay off his risk at that time for a set period, and he did that.
Think about insurance. You pay for your homeowner's insurance, and you make it through the year without a claim. No fire, no theft, everything was great. Do you feel gypped that you paid all that premium and didn't have a claim? No, you feel great. Great that you paid a premium and the policy wasn't used, even though you paid. Now think about this. A guy buys a put to protect his portfolio because he feels the market may take a sharp dive right now, and he doesn't want the tax and other consequences of selling and trying to buy back. The market doesn't dive, and the put expires worthless.
Now, is this guy unhappy? Is he saying 'Gee, I wish the market would have tanked so the put would have been worth something, and although I lost a lot of money it wasn't near what it could have been without some put insurance?' Heck, no, this guy is thrilled the put expired worthless. His most fervent wish was that it expire worthless. He's some kind of sucker, huh? You see, there are many, many ways options are used (I could cite many more examples just like what I have) that the wish is for the option to expire worthless. So, what good does that 90% figure do us? I feel it is very deceptive.
Next, many options pros are not speculating in options, they are buying and selling them, on the floor for example, to various clients who, either through their broker in the old fashion way or via an electronic platform, are sending in orders for this or that option. The various players make a market in that option, and then hedge that off with other options and stock. Are they the 'smart money'? They know how to hedge their risk, but they are not playing for movement, or playing any of the strategies I have discussed, they are simply making a market. I contend that there are not a lot of 'speculating' pros, and even if there are more than I think, the option market is huge, and they could not be a big part of the entire market.
What I am getting at is that it seems most of what I hear and read about options is very deceptive, if not downright misleading. While the statistics may be true, albeit I feel 'out of context', using them the way I see them used does not paint an accurate picture of what is going on. A great deal of this I attribute to a simple lack of understanding of options, and markets in general, and part I feel is due to deception in order to sell option seminars or systems.
Let's get back to the myth. If we have a zero sum game, then it must be balanced. If it isn't, all the money would flow to one side. In this way it is like our trade deficit. We have a trade deficit with a certain country, or the world, and what that means is we give them more of our money than they give us back for the net sales and purchases we all do. Since money is a finite resource (well, they do crank the presses and attempt to print it in unlimited quantity, but that's another article...), this net deficit will soon have every dollar in print in the hands of this other country, or the sum of all of our net deficit trading partners out there.
I know this is hard to conceptualize, or accept, but it's a simple mathematical certainty. In order to keep that game afloat, they must loan us back our money (buy our bonds), and then we have that cash again to buy more, and ever worsen the problem. Although I'd love to go off on this subject, as I said, that's for another article. The point is that if we have a deficit, without some measure like getting the cash back via bonds, all the money winds up on one side and the game's over.
So it would be with options. If the sellers made all the money from the poor dumb buyers, soon all the sellers would have all the money, the buyers would be broke. Game over. But the game goes on. I think the sides are balanced, and hence the game goes on forever, and the equilibrium is maintained. If that is not the case, then we must find the manner that money is being returned back to the losers, or the losers are finding ways to come up with more money from outside the system.
The latter case is possible, at least to some extent. I recall way back I heard that the number one source for money in Tucson, Arizona (forgive me, Tucson, if I am misinformed) was young men coming to the city to 'make it', only to slowly use up their money and leave, to try again later when they had more money. Jobs weren't easy to come by. The second largest source of money was the tourism. I know when I first moved to Tucson I fell right into that category, and left, only to return once again. I also have a relative, and he followed the same course.
This relates to the option picture in that maybe the suckers lose all their money to the other side, and then quit. Maybe they come back after they save up more money from theirs jobs or whatever, or maybe a new crop of suckers just comes in. But that may be the nature of all markets, and there is nothing specific to options about any of that. So even if that is the case, it is no evidence that one side, buyers or sellers, is the 'smart' side, or that all the money is made there.
Another thing you hear is that sellers make money 80%, 90%, or even more, of the time. That may be true, but it means nothing to this discussion. You should understand that if you've read the realistic expectations articles. You see, sellers, in general, make almost sure small money by accepting unlimited, or nearly unlimited risk. When they lose, it can frequently be big. Buyers have a much lower percentage of winners, but have limited risk, and a high reward/risk ratio.
Now, what we learned in the realistic expectation articles is that you mostly just move on the expected value curve, from low percentage of winners to high percentage of winners, all other things being equal, without a lot of change in the net profitability, because the reward/risk usually goes down as the percent of winners goes up. Since this is a zero sum game, the options example here is showing one from one end of the curve, and another from the other end. Since it all has to balance, they make, or lose, the same, overall. The equation is balanced.
This concept is hard for many to understand, or accept. I just don't see any easily unidentifiable area as the 'smart' area, such as selling. If that were the case, the big money, the commercials, would just pour money into that, and the market would be glutted with sellers, and the buyers, which are small, 'dumb' money, would be limited. And with more and more big guys fighting for a small pie, it wouldn't pay for them to do it. But this isn't the case, as far as I can see. The money is made by the smart players, just like it is in any other market, and it isn't with a simple concept that would be obvious to everyone.
Just like when I said that I don't feel you can earn a living in trading with one codable, simple setup and no comprehensive 'Trading Plan', I don't feel you can 'win' in options by being a 'smart' seller instead of a 'dumb' buyer, like the infomercials and vendors say. There is no discernible edge that I can see on either side. The edge, in my opinion, comes from creating the best strategy for the scenario you are playing. The edge in options is in taking advantage of how precisely you can tailor a strategy to what you suspect is unfolding. You get paid for your business vision, not for being a seller, or buyer, or whatever.
I see people always trying to oversimplify trading, or any business. What we have covered today is no different with options than any other aspect of trading, and that only makes sense to me. This business takes skill and a lot of work, like any other profession. Many vendors and dream merchants are trying to suck people in who want something for nothing, and don't want to do the work. As soon as you change your perspective to one of doing the work and developing your craft, you should be a lot better at the type of critical thinking needed to figure out things like I have shown here, on your own. If so, then my time here was well spent.
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