Less is More

Something I don't mention very often is my time spent trading options. In my time as a trader I was involved in all sorts of interesting option combos. I dealt with a few people that were absolute rocket scientist, some complete morons, and a lot of pros in the middle.

Options can be as simple or complicated as you want to make them. My experience tells me that for most, not all, people options are best left alone. Too often investors don't really understand enough about how options price, or implied volatility (IV), or time decay (known as theta), or messages from the options market or a whole host of other things that could determine the outcome of a trade.

Here is an example from the internet bubble days that might give a hint as to what I mean. We had one guy, I'll call him David, who would call into our desk and place enormous trades, 4000 or 5000 contracts at a time. There was one quarter that David expected Yahoo's earnings to disappoint the street. So he bought 4000 slightly out of the money puts expiring the next month two days before the report. David was right about the earnings and the stock dropped a couple of bucks but the put options dropped slightly in price even though the stock dropped. What happened is that the IV dropped because there was no longer uncertainty about the report. David's lack of understanding about a very basic thing cost him about $0.20. Twenty cents means $20, on 4000 contracts. You can do the math if you want. Any trader will likely have a bunch of stories about boneheaded trades.

I am no fan of things like straddles, butterflies, or credit spreads. These are not the types of trades that most people need to reach their goals. How does an options combo with a risk of $400 and a reward of $325 fit in with the typical person's financial plan?

This posting may draw some "yeah but I know what I'm doing" or maybe people telling me I am an idiot. Maybe so.

Obviously there are plenty of people that really know what they are doing but there are even more people that think they know but don't.

I do occasionally trade an option for clients or myself. Every now and then I will sell a covered call but with interest rates and volatility so low there aren't a lot compelling trades to do.

The other trade I will do, just for me not clients, is to buy a deep in the money call as a proxy for the underlying stock. Here's an example with a stock I don't own. Network Appliance (NTAP) closed at $34.09 on Wednesday. The $17.50 call expiring in January 2006 was offered at $18. The time premium in this option is $1.41 and the rest is intrinsic value. An option this deep in the money will have a delta of almost 1, meaning it will move just about point for point with the common. So you get the same effect of owning 100 shares for half the capital. If you would normally buy 400 shares this is not a chance to buy eight options. Remember you are feeling the gain or loss of 400 shares. A 400 share buyer should not own 800 shares. The other neat little thing about the "call option as a proxy" trade is that if NTAP drops a lot suddenly and unexpectedly the call option is likely to drop less as the delta would drop and the IV would go up. You can email me for more of an explanation on that one. Also this is not a good trade if the stock pays a dividend. Dividends only pay out on the common not call options.