Option Trading Exposed|Be Aware Of The Pitfalls
Option Trading: Another Secret Recipes to Wealth and Financial Freedom?
Do ever ever dream to achieve Financial Freedom using Option Trading?
Everyday, I am sure you are bombarded with Option Trading seminar advertisement that promise to make Fast and Easy Money.
Some of them them even claimed the return can be above 110%!
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.
Option contracts also provide traders with a large amount of leverage.
Because of this, option trading can also be a very risky venture for the newbie.
Of course, option trading can make you very large sum of returns in small amount of time, but trading options can also lose you the same amount if you are not careful in the world of Option trading .
Option Trading is a short term term investment and you are betting on a high volotile price movement.
The sure thing here is that you will Lose your money.
It is just only a matter of time!
Pitfalls of Options
by Bill Wermine
Imagine visiting Genting Casino and playing roulette.
There are 18 black numbers, 18 red numbers and 1 green zero.
If you simply bet red or black you will be paid even money should red or black come up.
However if you bet red or black and the green zero comes up you will lose your bet that you placed on red or black.
The green zero represents the house edge which is 2.6 %.
If you play the options game by buying options the odds are about 80 % against you versus 2.6 % against you if you play red or black at Genting.
This report will show the reasons why the odds against the small options trader are overwhelmingly negative.
“Options are one of the greatest and most costly frauds ever perpetuated on the trading public.” FH Goslin, Market Wizard and author of Trading Day by Day
Options have limited risk for the buyer and unlimited risk for the seller.
That is why most small traders buy options rather than sell them. Unluckily for the small traders, the buy side of options has many built in disadvantages.
The odds are stacked against the buyers (primarily uninformed, small traders) and in favor of the sellers who are for the most part institutions, large hedge funds and big money interests.
The major problem with options is that they are time depreciating assets. If you buy a share or futures contract and a month later the price is unchanged you lose nothing. You will be even.
If you buy a call or put option and the price of the underlying stock or future is unchanged a week later, you will have a loss. Every day you own the option the value depreciates.
This means that time is working for the seller (big money) and against the buyer (small money).
Because of time erosion, it means not only must you get the direction right, your timing must be exact and the move in your favor must be substantial.
Getting timing right as well as direction is hard enough as a trader. When you add in the need for a substantial move (to cover the cost of the option) the probabilities of success are very low.
In shares or futures, the odds are 50-50 as shares and futures are simply an up and down game. In options, the game is closer to an 80-20 game against you the options buyer.
No matter how good you are as a trader, these are difficult odds to overcome on any regular, consistent basis.
You may ask, if the odds are so much against the options buyer, why not be a seller?
The risks as an options seller are also formidable: These include high margin requirements and unlimited risk should the market move in the wrong direction.
These risks make it difficult for small money players to participate and profit as options sellers on a consistent basis.
To properly take advantage of the odds for the seller requires an account to be capitalized with several hundred thousand dollars. Very few individual traders have an account this size to develop to an options selling program.
Large traders sell thousands of options with various strike prices just like a life insurance company sells life policies.
Yes, an option will go bad just like a life insurance company will have to pay death benefits. Because the risk is spread the life insurance company will have no problem paying off a policy.
Because a large trader sells thousands of options he has no problem covering the occasional loss. The economy of scale insures that the options sells odds work for him.
A small trader who sells a limited number of options is gambling and risking much more. He has no economy of scale and runs the risk of substantial losses should just one trade go bad.
The pricing of options
Options prices are arbitrarily set by the sellers. They are determined by options pricing models which are skewed to the benefit of institutions and big money interests.
In other words they are not really set by free auctions between buyers and sellers.
Options are priced by options sellers based on time value, intrinsic value and volatility.
If the dollar values for volatility and time are too low, the buyers will have the advantage. If they are set high, the sellers will have the advantage.
Understandably, since the options industry overwhelmingly sells options, the time and volatility factors are set up to produce high prices.
They are set up arbitrarily to inherently favor the sellers (who control the options industry) and against the buyers who are the customers of the options industry.
Bottom line
The actual payout is too low in relation to the true odds.
The pricing formula insures that the payouts are much less than the true odds. Just like a casino, although the odds are much better for the player in a casino than in the options markets.
Again it means the odds are tilted in favor of the sellers.
The pricing formulas which are biased statistically insure there is no real risk in selling options for a large fund as risks are spread unlike a small trader who risks ruin by not having the funds to spread risk.
The clever Nobel laureates who awarded a Nobel Prize for he Black Scholes Options pricing model handed a gift to the options industry. They gave a pricing formula which could easily be rigged to permanently favor the sellers.
Some might argue that options is a fair game.
Why are there many hedge funds whose sole function is to sell options?
I have never heard of one whose mandate is to buy options.
The reason is simple: No one in the fund industry is so foolish to believe that a fund whose sole purpose is to buy options could ever be a profitable business.
Many options experts would vigorously argue these points:
They would say using delta neutral strategies, spreads and numerous fancy techniques are profitable.
Reality is different. It boils down to getting timing and direction right not that simple or easy.
These fancy strategies may help limit loss but is this any consolation?
If you should absolutely insist on buying options, stick to deep in the money options with little time value and use a disciplined risk management strategy.
Even this strategy has disadvantages but may show minor profits.
My bottom line advice: Just ignore options; act like they do not exist.
Your bottom line will be better for it.
Good note on economy of scale part, small trader definitely can’t afford a single stock price going the wrong direction.
On your point of buying a put/call option then the stock price stay unchanged and option value depreciated/expired. I think it is very important to think of option as insurance to the price of share you are holding. Just like buying a life insurance, even you paid a month of premium and nothing happen to you in the next month doesn’t mean you lose. Same as option, you buy a put option if you’re too scare the price will go down that you have to sell at a lower price. Put option allow you to sell at the pre-determined price within a period of time. Of course when volatility is high, option will be more expensive. Same as when you get older and your premium getting expensive.
Knowing insurance company is making huge amount of money having you betting on the odd, doesn’t mean you should stay out of it. Because if something really happen to you, that’s where you get the financial security.
This is a great article, I should trace and respond this back later …
I agree with your final recommendation, avoid at all costs … but I would add another to it, unless you have 1 million for it. Actually $100,000 is enough to start option trading but it wouldn’t get you far.
Although what this article mentioned is correct but it doesn’t have to be an ALL BAD thing … we can always learn something and decide how to best use it …
1. you can exercise options with the intention to fulfill the rights
2. you can use options to hedge against your main stream of income – the just in case scenarios
generally above comments make more sense dealing with commodity.
As in pure investment purposes, one should NEVER execute a single option transaction (due to the reasons you mentioned in this article), a series of call put options should be executed at the same time, that way, you neutralized the risk while maintaining the potential rewards … but by then, you have to be full time watching the movement …