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Understanding Options

The more you understand options and how traders think about them in different situations, the better you’ll be able to understand new strategies and develop your own.
This chapter is from the book
  • He who knows when he can fight and when he cannot, will be victorious
  • —Sun Tzu

Before trading options, you need to understand the nature of options. Unfortunately, some stock traders are not exactly clear on this—or on the distinctions between trading and investing. Before stock traders can transition to options trading, they first need to know what to expect as a trader.

What Is a Stock?

A stock is a fractional ownership in a company. It is an asset, a two-dimensional instrument easily represented by a single line on a chart where value goes up or goes down. Privileges such as voting rights and dividends come with that asset ownership. But is owning an asset the same thing as investment? The average person considers an investment as money handed over to a company to make the company more competitive, which is not what happens when you buy stock. The only real “investors” are those who buy a stock during the IPO. That money goes straight to the company. After that, the stock is bought and sold among traders and not with the company unless the company executes a stock buyback, in which case shares are retired permanently. So “investing” is a misnomer for owning stocks.

The question is whether a person who buys a stock and then sells it at some point in the future is best described as an investor or a trader. The answer is not as obvious as it may seem. Investors are said to be in “for the long term,” and traders want to make a quick buck and don’t care about the company being traded. Most people only care about the company stock price going higher. In this respect, there are no such things as investors, just traders.

In order to make the transition from stock trader to options trader, you need to see both long-term and short-term trades as trades and not see one as an investment and the other as a trade. You need to let go of the aura of respectability that the term investment connotes and accept that you are a trader. Regardless of how you came to your conclusions of when and why to buy a stock, your intentions are precisely the same as those of a short-term trader: to buy low and sell high.

So where does this distinction between investors and traders come from? One answer is how the U.S. government taxes capital gains. The government wants you to be an owner of stocks and gives you tax incentives. Stock held for more than one year is considered long-term capital gains, and anything less is considered short-term. The long-term capital gains tax rate is lower than the short-term rate, which is taxed at the same rate as your earned income. The tax differences provide an incentive to hold stocks “for the long term.” Even if the government seeks to incentivize larger time frame behavior through the tax code, it doesn’t change the motivation behind the transaction itself: making money on the trade. Time frames do not matter because everybody is a trader.

I’ve encountered many people who believe that since they own stock to get dividends, which are also taxed at 15%, for now, that they are investors. Dividends are a touchy subject but let’s be clear about one thing, dividends are generally a bribe by the company to get people to buy their stock. That sounds harsh but unless the company is debt free and has more cash than it needs for future investments it probably shouldn’t be giving out a dividend. Some companies will actually go into more debt and borrow money to pay dividends it can’t afford to keep stockholders happy. This sounds like a terrible investment strategy. At best a dividend is a hedge. If a company offers a 5% annual dividend and the stock drops 8% then you have hedged your losses to -3%. We’ll look at a number of option strategies that can do much better than this.

Many people consider “investing” in the stock market as a safe bet because over time, the market goes up; so buy-and-hold is a proven long-term strategy, right? There are a number of problems with this reasoning. The first is the selection effect, as pointed out in the book The Anthropic Bias: A proper analysis of the market requires continuous records of trading of which we only have about a century’s worth from the American and British stock exchanges.

But is it an accident that the best data comes from these exchanges? Both America and Britain have benefited during this period from stable political systems and steady economic growth. Other countries have not been so lucky. Wars, revolutions, and currency collapses have at times obliterated entire stock exchanges, which is precisely why continuous trading records are not available elsewhere. By looking at only the two greatest success stories, one would risk overestimating the historical performance of stocks. A careful investor would be wise to factor in this consideration when designing her portfolio.1

Very few look at the stock market 100 years in the past. We’ve had one depression and a few recessions. Statistically, there are too few data points to draw any kind of conclusions going forward. In addition, variables—such as the demographic boom since World War II or the inflationary policies of going off the gold standard—could have more to do with the rise in asset prices than the presumption that markets will go up eventually. This is not to say that buy-and-hold is wrong, but considering yourself an investor and assuming that it is true might be a poor conclusion.

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