Remember the COVID lock-down era when we were encouraged to hunker down and avoid direct contact with other humans? Did you pick up any new hobbies or binge-watch some shows? Well, I did both of those things. I picked up golf and watched a lot of Larry David’s, “Curb Your Enthusiasm.” His manic and unfiltered energy was extremely cathartic and to be honest, he is my spirit-animal. We won’t talk about my golf game.
But that’s not all. I also decided to try my hand at trading options. An acquaintance of mine was a former bond-trader on Wall Street, and he offered to mentor people for a small fee. I had some money burning a hole in my pocket and hadn’t been introduced to David Bahnsen’s dividend growth investment thesis, so I thought, “why not?” Maybe I could learn something and make a few bucks… or maybe I could even become the greatest options trader of all-time and work remotely from a cabana in the Caribbean. Anything seemed possible.
Spoiler alert – I am not doing this blog from a white-sand beach on a tropical island while sipping an umbrella-drink. To my disappointed and ego-shattering surprise, I basically broke-even by the time I decided to stop actively trading options. My up-and-down-and-up-and-down story is entertaining, but I will save it for another time or maybe the podcast.
My intent for writing this article is two-fold. First, I think a more in-depth exposure to this dimension of capital markets builds significant financial literacy. Second, for those who have contemplated wading into this space (or know those who have), I want to offer some hard-won wisdom.
Cautions, Clarifications & Caveats
If this blog was a consumer product, it would come with a red warning label on the front. CAUTION: TRADING OPTIONS CAN RESULT IN SEVERE FINANCIAL LOSS. But please note that is not the same thing as saying that options trading is morally compromised or economically irrational. Not at all. Options have a very legitimate place in our world and some people/strategies are well-suited to using them. My point is that options offer a specific risk-reward profile that participants need to fully understand. I could write a book entitled, “There’s No Free Lunch,” but I think someone has already done that.
A couple of clarifications are also in order. First, I am going to unpack this topic at the level of individual retail-level trading, not institutional products or usage. There are various funds and institutions that employ strategies like covered calls and such, but I’m not going to be engaging at that level of things. Our perspective is going to be constrained to how individuals might use options for their own portfolio.
Second, it is helpful to know that options trading is NOT the same thing as day-trading (although options can be day-traded). Day-trading is exactly what it sounds like. Traders are in-and-out of stock positions on the same day, hoping to clip profits on small fluctuations in price. Options trading is a different discipline as I will attempt to unpack below.
A final caveat. There is no way to do all the nuances of options trading justice in the space of a blog like this. So, despite its relatively long length, do not be deceived. This is a high-level introduction at best and nowhere near comprehensive.
Options 101
There are innumerable sources on the interwebs to learn about options basics, so I won’t belabor it here. But for the sake of this exercise, I’m going to sketch out a framework for the uninitiated:
- What is an option? It is a time-specific contract to buy or sell 100 shares of a particular stock at a certain price (strike). Options are “derivatives” because their existence is entirely “derived” from the existence and ownership of an underlying stock.
- Why do options exist – what is the point? When you own a highly liquid asset with a price that fluctuates daily, that volatility creates risk that can be monetized to both hedge against AND compensate for price fluctuations.
- How are options traded? Options are traded in public markets, just like equities. The most established exchange is the CBOE and the central clearinghouse for trades is the OCC. Similar to the buying and selling of stocks, the counterparty to your trades is invisible to you.
Most major online brokerage platforms have an options trading interface. I personally used a platform that was designed explicitly for options trading and comes with a ton of tools to help people understand what they are doing.
- How do options work? There are two types of options:
- An owner of a “call” has the contractual option to call shares away from (buy) the counterparty at a certain price.
- An owner of a “put” has the contractual option to put shares to (sell) the counterparty at a certain price.
- What is the logic behind buying or selling calls and puts?
- How are options priced?
We won’t tumble all the way down the rabbit hole on the complexities of this. Suffice it to say that there is a complex mathematical (Black-Scholes) formula that considers the price of the stock and various strike prices, the historical and implied volatility of the stock, and the timeframe for the option contract. That spot price then creates a potential bid-ask spread which may be wide or small depending on the number of interested counterparties.
Options are priced on a per share basis even though they represent even lots of 100 shares. So, if a strike price shows $1.50, that means the option position will cost $150 ($1.50 x 100). The math isn’t hard, so don’t be confused by the optics.
An important concept to keep in mind is that option contracts take on their own variable value once incepted, thus the concept of option “trading.” Once an option position is established, it may be able to trade for whatever value and liquidity it has at that time. An option doesn’t necessarily result in a transaction on the underlying stock.
- What are the risks and rewards of trading options?
Rewards: The potential rewards of options trading are extremely alluring and compelling. It doesn’t require a lot of capital, and you can use leverage to get asymmetric returns in a matter of days and weeks. In most cases, you can completely define your risk. You can know – to the penny – how much you have on the line. And as you can imagine, it is exhilarating and ego-affirming to see trades returning 50%+ in a short period of time.
Now, to be clear, not all options strategies or positions are swinging for the fences on a trade-by-trade basis. There are some strategies involving relatively large sums of capital that are looking to generate lots of small and relatively low-risk gains.
Many options trades trade high probability for low payoff, or low probability for high payoff. Knowing which strategy you are employing matters.
Sounds good! What could possibly go wrong?
Risks: Hopefully, you know that significant rewards come with significant risks. While options can offer out-sized returns over short time periods, your capital can evaporate just as quickly. Sure, you might get a 50%+ return on a position in two days. But you could just as easily watch another position go to zero (or less!) in the same amount of time.
It is one thing to win on a single trade and another to consistently string together enough winning trades to outpace and recover from your losing trades. And God forbid you get greedy or stupid and take on too much risk – or worse, you miscalculate your risk and take on a position in error or ignorance… you could be wiped out. Leverage tends to magnify both your wins and your losses. Take it from me, big margin calls against losing positions are NOT fun. Staring into the abyss can be far more debilitating and daunting than the thrill of any upside emotions. I had some scary moments, but I didn’t ruin myself. Many others have not been so lucky.
David Bahnsen recently wrote a Dividend Cafe on the gamification of capital markets, and I humbly submit that his thesis is the most applicable and relevant to this space. Be forewarned that as legitimate as the options trading space is, it is not a game. Play stupid games, win stupid prizes.
Conclusion – Wisdom from a Break-Even Survivor
Making sense of all that information probably feels like trying to solve a Rubik’s cube while riding on the tilt-a-wheel and saying the alphabet backwards. That’s normal. It takes time and practice before this becomes intuitive. Many people sitting for their Series 7 exam report the options section as the hardest to master.
Despite the esoteric complexity, I hope you picked up some core principles as we unpacked this bag. But if your head is still swirling, I’ll offer up a few concluding thoughts:
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- Get Rich Slow: I truly believe the best way to build durable wealth is to get rich slow. If you’re going to chase yield or huge returns trading options (or anything else), you’re going to have to do it with significant downside risk. Do not be deluded into thinking that this is a get-rich-quick strategy. For most people chasing glory, trading options will be a get-poor-quick strategy. If you confuse opportunistic trading with long-term investing, you will probably hurt yourself and your financial future.
- Your Crystal Ball is Broke: Or to put it in financial parlance, technical analysis will fail you. Looking at lots of stock charts will work until it doesn’t. If you do this long enough, you will see that you struggle to make consistent and investable predictions about the direction of various stock prices over the short-term using stock charts. You can use all kinds of sophisticated graphs and models and Bollinger bands and probability-based expected moves and relative strength momentum metrics… the quantitative tools are endless – and you just can’t consistently predict the direction of stock prices over a short period of time.
- Beware Success: If you endeavor to go on this adventure, I wish you much success, but not too much – especially too early. This is what happened to me. When I started, I kept selling puts (bullish) in a roaring bull market. I couldn’t lose – I was understandably euphoric. The Caribbean was in sight, and I’m not exaggerating. I was making money hand over fist. And when the bull run ended, and things got choppy, I kept making bullish bets because that was how I had made money. And by the time I realized that I needed to pivot, I had not only lost a lot of my gains, but I was inept at navigating anything but a bull market. Becoming a victim of your own success is a common trap. Be forewarned. Placing some winning trades is easy. Sustaining double-digit returns over the long-term is NOT.
- Cottage Industry: For those who want to go on this safari, rest assured, there are many safari guides, maps, newsletters, and YouTube videos available to you. Many at a price. Please give that some careful thought. If someone really had cracked-the-code on how to make a fortune trading options, would they really be interested in your measly hundred or thousand bucks? I’ll go ahead and answer that for you – the answer is no. That’s not to say there aren’t legitimate people who will teach you – they will. But the minute you start seeing anything representing x% returns based on the trading signals, etc, please be skeptical. And by that, I mean, don’t subscribe to said service. Don’t be the sucker that is born every minute.
- A Humble Pie Diet: I love pie over cake, all day, every day. But humble pie – ugh. It’s tough to swallow. If you spend any time leaning into capital markets, chances are you will eat more than your fair share of humble pie. To switch metaphors, knowing how to shoot a gun does not qualify you to be part of the local SWAT team. A little knowledge can be a very dangerous thing. It’s fun to know what options are and how they work, but don’t mistake that for a pathway to sandy white beaches and umbrella drinks. Stay humble, my friends. Ancient wisdom has told us that pride comes before the fall and the humble shall be exalted.
Brett Bonecutter
Private Wealth Advisor
