Thursday, November 03, 2011

Investing in Options

I do not like to invest in options. My reasons are:

  • The price of the option is decided by an expert who takes the other side of the trade. This expert is likely to fix a price that will give him a profit (after allowing for the future possible outcomes). As the other party to this "bet", the retail investor is likely to make a loss.
  • It is possible for the option issuer to manipulate the price of the underlying shares to avoid making a loss. For example, if the option pays out a large sum of money when the underlying share hits a certain price, the option issuer will buy or sell the underlying share to avoid hitting the strike price. The cost of buying the manipulating the price of the underlying share will be lower than the  payout on the option strike.
If a retail investor wishes to speculate, it is better to buy or sell the underlying share, rather than buy an option. For long term investors, it is better to buy blue chip shares and keep for the long term to enjoy the dividends and the long term capital gain (and forget about short term fluctuation in the share price).

Lesson: Do not invest in options or other derivatives. Buy or sell the underlying share. Speculating in futures is all right, as the price is a direct reflection of the underlying share index.


4 comments:

Anonymous said...

The problem herein lies the the simple mentality of retail investors, especially here in Singapore, where they only know how to "BUY" a financial instrument (ie blue chips shares, unit trust, etfs, etc).

With options and futures, you can can go both ways. You can initiate a SHORT (SELL) position and close out your position later with a LONG (BUY).

If you just know how to BUY options, of course you will lose money because 3/4 of all options expires out of the money. Options writers are like your Singapore Pools and options buyers are like your punters. There will be only 1 first prize.

If you are properly train and educate yourself with the necessary knowledge, you should be able to write option like the market makers. and contrary to most misguided belief that writing otpions has "unlimited" risk, it is less risky than buy a stock outright.

The options professional preys in ignorant and lazt investors who dont want to spend time and effort learning. Like Singapore Pools, they hope as many people buy options from them as possible. On the expiration day, the price of the underlying can only be at one place.
If you have bought an option, there are only 3 probable outcomes: it expires In The Money (you gain the difference), it expires Out Of the Money (you lose your premium paid) or it expires AT The Money (you also lose the premium paid).
Your chance of winning is 1 out of 3 events.
As for the option writer, his odds is 2 out of 3, since he will pocket all the premium for options that expires Out Of the Money and At The Money.
Its the same principle here as insurance underwriter.
So, in a nutshell, if you want to trade options as a retail investors, do what the professionals do. But first, go educate yourself with the necessary tools and knowledge, which requires time and effort. Otherwise, just join the queue at your nearest Singapore Pools outlet or go open a stock trading account and "BUY" yourself some hope. You may get lucky on a few occasions over the next10 to 20 years.

Anonymous said...

Dear Mr Tan
Your point number 1 is true. Especially for stock options on less liquid stocks.

It is not true for options on very liquid stocks or ETFs (e.g. SPY, the ETF for S&P 500).

Also, the theoretical price of an option can be calculated from the Black-Scholes Model. For the very liquid stock options, the prices offered are very close to the theoretical price. In fact, I've been able to get better than theoretical prices on many occasions!

Your point no. 2 is a hypothesis (sometimes called Max Pain) that has not been proven to be true or false.
Here is the website that calculates the pricing point for S&P 500 for 19 Nov 2011 options expiry. The max pain price at this point is $124.00
http://www.optionpain.com/OptionPain/Option-Pain.php

You can also avoid this "problem" by buying longer dated deep-in-the-money options. I never buy an option with an expiry date less than 3 months.

Options are like cars. If you have a bad driver, accidents are inevitable.

Your viewpoints are not wrong.

I'm only respectfully disagreeing with you because options (like anything else in life) can be a useful tool ... if used correctly.

In general, I share your deep distaste and distrust of derivatives.

I make an exception with American stock options because they are standardized contracts that are traded on the open market at a well regulated and established exchange - "Chicago Board Options Exchange".
As a result, I'm protected by American laws.
And American lawyers are allowed to represent me on a "no cure, no pay" basis. Singapore lawyers are not allowed to do this.

Just my humble 2 cents worth of caution about not throwing the baby out with the bath water.

Anonymous said...

The volatility in options is one of the key variable in pricing model of options and it is mostly determine by market forces. Market makers such as those that issues warrants are able to arbitrage in market volatility disparity. Most warrants issued locally are priced at high volatility premium to the retailers while the maker makers hedge their exposures by offsetting their exposure with a trade that has lower volatility premium. This is one of the many ways they make money on issuing warrants.

Its is thus important for anyone wanting to trade options to understand the all the greeks in the pricing of options (delta, gamma, veta and theta).

Most retailers buy warrants/options as a way of leverage punting which is basically like I have mentioned in previous post is no different from buying lottery where you hope to strike big with a small bet. They are just feeding the market makers.

Given the right knowledge and understanding, options trading is a lot more versatile as it allows you to position for ALL types of mkt condtion. It is not a tool for those who just know how to BUY and wait for market to go up.

Market can go 3 directions, UP, DOWN or SIDEWAYS. Simple stocks punters knows only how to BUY and wait for price to go up. They average on the way down or cut their loss if they cannot take the pain anymore.

Better educated traders know how to SELL and than BUY back later, using products that allows them to SHORT the market. But if market goes sideways, they too can't make money

Professionals traders can trade all 3 types of mkt condition. They can position themselves with trades that make them money even if the mkt goes sideways. They take advantage of time decay (theta) on options to gain on premium receive. They put on spread trades to limit loss on runaway mkt. They can buy call or sell call or put spreads. There are so many ways to manage their risk exposure using various options strategies.

But it takes effort and time to learn. Most people are lazy that why they prefer the tradition BUY and wait approach.

Anonymous said...

The Black-Scholes Model is only for academic purpose, once you start your investment bank career, you will know bank trader don't use this theory to calculate the vol. For most of the retail investors, they are just simply speculating and how many of them have such strong mathematical background to study those equations? I also wondering how those trainers teach people to trade option by taking a 2 day option course, same as those Forex course in town, if you really know the FX market structure and insider trading is legal for forex ( I was told by a UBS FX trader when I attended a finance seminar in NUS this year) Do you still believe the FX coach said to you that you can make 8% every month without stress. Starting with 10K capital, you can become a millionaire 5 yrs later, I just know the coach will become a millionaire in a year by collecting school fee

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