Options . . . an introduction
By Alex Elder
Trader, psychiatrist, author, Trading for a Living : Psychology, Trading Tactics, Money Management
Reprinted with permission.


My good friend Roger Perry (rightline.com) called about a month ago and asked me to write a brief guest editorial for him on options. Little did Roger know that his casual request would send me back to my long-dormant manuscript. I have a new book on trading that I keep writing on and off (and maybe I will finish it some day) but Roger prompted me to write two chapters on trading options. Here is the opening section of the first chapter:

OPTIONS AN INTRODUCTION

Aren‘t options great! They offer you leverage the ability to control great many stocks with a small outlay of cash. They promise unlimited profits but limit your risk. They allow you to make money fast, but if the market turns against you just walk away and owe nothing! This is the standard flow of brokerage house propaganda. It attracts hordes of small traders who cannot afford to buy stocks but want a bigger bang for their buck. Unfortunately, the thing that goes bang is usually the option buyer’ head.

An option is a bet that a specific security will reach or exceed a specific price within a specific time. Please stop and reread the previous sentence. Notice that the word specific occurs in it three times. You must choose the right stock, predict the extent of its move, and forecast how fast it will move. You must make three choices and if only one of them is wrong, you will lose money.

When you buy options, you must jump through three hoops in a single leap. You have to be right on the market, on the price move, and on the timing. Ever tried tossing a coin through three rings at an amusement park? This is why options are such a deadly game for nearly 100% of those who buy them.

My company, Financial Trading, Inc., has been selling trading books for years, and I have noticed long ago that buyers of options books never return. When a person comes back and buys another book, it is a clear sign that he or she is active in the markets. Many clients return and buy books on stocks or futures every few months or even years. But when a first-time buyer orders a book on options, he or she never returns. Why? Do they make so much money so fast they never need another book? Or do they wash out of the markets faster than it takes to read a book?

Options are very bad for beginners who have not learned to trade and buy calls because they do not have enough money for stocks. Futures traders beaten up by margin calls sometimes turn to options on futures because there are no margin calls. Losers switch to options rather than deal with their own inability to handle markets.

I am not against options. Successful stock and futures traders sometimes reduce risks or increase profits by putting on options trades. Serious traders use options infrequently, in special situations, some of which are described in the next section of this book. Options are a terrible instrument for poor people who use them as a substitute for stocks because they cannot afford the real thing.

The industry takes full advantage of starry-eyed beginners who crowd into options. Their bid-ask spreads are terrible. If an option is bid 75 cents, offered at a dollar, you are 25% behind the game the moment you buy. The expression "loss is limited to what you paid for an option" means you can lose 100%! What is so great about losing everything?

One of my clients used to be a market-maker on the floor of the American Stock Exchange. She came to several seminars to learn screen trading because she was pregnant and wanted to get off the floor and trade from home. "Options, - she said, - are a hope business. You can buy hope or sell hope. I am a professional I sell hope. I get to the floor in the morning and watch what the public wants. Then I price that hope and sell it to them."

Professionals tend to write options, and while writers as a group make money, their returns in percentage terms do not impress gamblers. Also, writing options is a capital-intensive business. You need hundreds of thousands of dollars to do it right, and most successful options writers operate with millions. And even theirs is not a risk-free business. A friend of mine, formerly a top money manager landed on the pages of The Wall Street Journal after losing 20 years of profits in a single bad day of writing naked puts.

Covered writers buy the underlying security and write options against it. Naked writers sell calls and puts against stocks or futures they do not own, backing their writes with the money in their accounts. Writing naked options feels like taking money from thin air, but a violent move can quickly put you out of business. Writing options is a serious, non-trivial game, suitable only for disciplined and well-capitalized traders. Even they occasionally lose money, but a rookie who does not have enough money to buy stocks and uses options to get more bang for his buck invariably ends up getting banged up himself.

The time to learn about options comes after you have proven your ability to consistently make money trading. You need a minimum of one year of successful trading experience in stocks or futures before getting into options.

Most beginners reach for options after losing money in stocks and futures, like a drowning man grasping at straws. Do not be like everybody else! Become a successful trader of stocks or futures before you touch options. Then use them in the markets you already know, be they stocks, futures, or currencies.

&&&&&&&&&&&&&&&&&&&&

Best wishes for successful trading!
Dr. Alexander Elder
Thursday, July 1, 1999

POSTSCRIPT
And you will be interested in the followup, received from Dr. Elder eight days hence . . .

Dear Friend,

I enjoy reading emails that arrive each time after we send out BOOKS &
TRADES. My last letter, on options, seems to have created a shock of
recognition in many people. Most of us had the experience of being right on
the market, right on the stock, and still losing money on the option.

I was especially gratified by the praise from professionals who provide
options trading advice and/or software (ED. NOTE: Option Wizard).

Option trading is a serious, non-trivial game, and they do not want green amateurs to stumble in and get
hurt. (UNDERLINE OURS, our purpose in publishing his remarks)

I did get a chuckle out of a single very nasty reply - that must have
been from an options broker...

Best wishes for successful trading!
Dr. Alexander Elder
Friday, July 9, 1999

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