The very idea of stock options can invoke terror in the minds of a typical buy-and-hold investor. “Too risky,” is the common reaction from the uninformed.  

But why would investors have that irrational fear? Because Wall Street money managers earn billions by discouraging clients from directing their own investments and taking advantage of options. These are the ivy league educated yuppies who send their kids to ivy leagues schools and drive around in BMW’s and Benz’s. They make money of your hard earned money while you are the one taking the market risk, holding the bag. 

Uninformed, timid investors, lost opportunity, or dare one say it, lost optionality. 

For starters, timid, unsure investors should start with the no-risk covered call strategy. 

Proactive investors who use covered call options (sometimes called buy-writes) actually take less risk than they would passively buying and holding a stock. In fact, for the past 26 years properly implemented covered calls have had half the largest annual drawdown of a passive buy-and-hold methodology. 

How can covered calls reduce drawdowns by nearly half? What’s the catch? There isn’t one. It’s a transfer of risk. Investors are gaining downside protection and increasing their chances of making a profit in exchange for giving up a bit of upside potential when the stock price increases. There is no risk per se.

Over time, the credits received by writing calls against a stock position can reduce its breakeven. Do it long enough, and breakeven can theoretically go to zero.

Think of it this way – if an investor bought a stock for $0, how much risk does it have? $0!

The stock can only go up and make money. So lower the cost (or breakeven point) of a stock, the better. One of the most effective ways to lower the cost is to sell calls against a stock.  

Covered call credits: consistent cash credits reduce portfolio risk

If investors used this strategy during the last three months of 2018, each time the call was sold, they would have reduced the position’s breakeven by an average of 1.4%.

A 1.4% reduction in the breakeven may not seem like much, but that’s only for one month. Now consider that the dividend yield on the S&P 500 is a little under 2% for the entire year. Some stocks and exchange-traded-funds (ETF’s) make money selling the call of up to 3% or more of the price of the stock per month. They can amount to a breakeven reduction of 25% to 50% per year. The money from selling covered calls is credited directly to the investor’s account. To put that in statistical terms, the gain using covered calls is approximately 67% as great as with passive approach, yet the losses are 50% of the passive buy-and-hold methodology. 

Proactive strategies like the covered call can reduce monthly swings. Volatility can suppress returns because of larger drawdowns. A covered call strategy carries less risk than a passive, buy-and-hold investor philosophy. ETF’s can be a lower-risk place to start using the covered call strategy.

Tom Sossnoff  Co-founder of a $1B, “Think Or Swim”, a very popular trading platform and brokerage, has over 50 years of experience trading options shares his insights and it is worth knowing when trading options and investing.

People have this issue of  being too risk adverse in markets and in life.

People should value the value of intellectually challenging themselves with respect to finance.

He loves Options because they are strategic, which is very different. Futures and stocks are very black and white.

You either pretty much buy Stocks or sell them and there is no gray area. You’re either right or wrong based on pure direction. I learned quickly in options that it’s much more than direction.

It’s a very strategic, it’s a gray area game, and you can be right and lose money, you can be wrong and make money.

What are some of the misconceptions outsiders often have about options trading?

Sure, well, the most popular misconception out there is this, that 85% of the people lose because there’s a ridiculous amount of risk with naked options. And the reality is, the only way to be successful in the world of options is to learn how to trade small, how to manage your profits and how to sell options naked.

I believe in the statistics. I believe in the mechanics behind the statistics. And if you have a statistical chance of success that is better than a statistical chance of failure, then all you need to do to meet that probabilistic outcome is to create enough occurrences.

So I believe in act of trading, and I believe it’s important to create as many occurrences as possible in order to be successful.

But there’s never been a customer, institutional or retail, that has created a quantitative model that can beat the markets. So the answer is that doesn’t exist.

We all know that, but there are no other models other than creating. The only way to be successful is to create, that’s why hedge funds don’t make money

That’s why nobody makes money in cyclical markets. And the only time anybody makes money is if benchmarks go higher.

Well, the way you make money is that the derivatives marketplace overprices fear, which means that we charge too much money for fear and we charge too much money for limited profitability by definition. So if you’re willing to limit your profitability and fear is expensive relative to itself, then for us, that’s an opportunity.

I mean, anybody can do it, which just means when implied volatility gets really high, we sell it and you sell it in the form of selling derivatives so that you have an opportunity to collect time decay as it contracts. And it contracts twice as often as it expands.

And if the masses are the consumer, if the masses are this huge global consumer, then the only way to do it is to put yourself in a position where the statistics favor you. That’s it.

So we live in a world, if you want to learn how to make money, you’ve got to learn how to sell overpriced fear. It’s the only given out there that has a contraction, contraction that has a reversion to the mean characteristic that works, and that’s it. And it’s not something tricky, it’s just the nature of the beast.

Well, here’s a couple of things that are crucial. Number one, you need to be product indifferent, which means you can’t worry about what product you’re trading. Number two, you need to be strategically indifferent.

So yo are product agnostic and you’re essentially strategy agnostic. Now, the next step after that is understanding the value of liquidity.

Then you’ve got to learn some basic things, which is number one, you’ve got to learn how to create enough occurrences so that you can create the outcome that you’re hoping for.

Number two, you have to learn how to maximize your success rate, and that happens from managing your winners, not worrying about your losers. That’s the next step. And then ultimately, you got to understand the math behind it and why certain things work.

Why is price not mean reverting, but implied volatility is? And then what is implied volatility? You know, is it a factor of what?”

When we know it means expected move, but what drives implied volatility? Why is sometimes implied volatility high and why is sometimes implied volatility low?

The law of large numbers comes into play.

If you can order a pizza, and I know you can order a pizza, if you can order a pizza, you can trade. This is not, it’s not rocket science.

And if you’re going to trade in today’s markets, and you’re going to trade as an individual investor, you are not disadvantaged to the professional marketplace. You’re not disadvantaged at all.

You have better technology, better content, and your fees are almost exactly the same. So your disadvantage is the know-how. If you don’t have the know-how, you can’t compete.

Our society is… We’ve created a society of enablers, and so we make people feel good about their inept financial abilities, their lack of know-how. It’s not because they don’t have the right trader psychology, or they’re not seeing the right trader psychologist.

The reason people aren’t successful is because they don’t take the time and the commitment to be successful. That’s all it is. And I’m tired of enabling people and trying to make everybody feel good when the industry is conflicted by the true sense.

This industry makes money by managing other people’s money, and by selling people money, and by selling fear. And the only way to get around that and to change that culture is to develop the know-how yourself. And 99% of the people are unwilling to develop that know-how.

So the idea that there’s some trader psychology out there, it’s complete nonsense.

“So no, I’m poo-pooing the whole psychology aspect to it, and I’m suggesting that it’s a lack of know-how, it’s a lack of desire, and until we get people willing to take on that intellectual challenge, we’ll give ourselves a crutch and call it psychology.

Courtesy: Luckbox Magazine – Premium Issue Apr 2019