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Understanding Options

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This chapter is from the book

The Bet You Wouldn’t Make

Consider the kind of trade you would not make. Think about the following scenario: Two gamblers are arguing about whether stock XYZ, which is currently priced at $100, is going to go up or down. Gambler A says he thinks it will go up, and Gambler B says he’s crazy. Gambler A bets Gambler B that the stock will go up, and if he is right, Gambler B will have to pay him $1 for every dollar the stock goes over $100. Would you take that bet? Not if you are sane.

There are two problems with this wager. The first problem is that the bet is open-ended. There is no time limit to the wager. Gambler A could come back to Gambler B after a day, week, year, or decade. He only has to wait for the stock to go up and pick the price that most suits him. The other problem is that Gambler B is not getting compensated for putting himself at risk. What does he get if Gambler A is wrong and the price goes down? Merely the satisfaction of being right? He is taking a huge unlimited risk to the upside without getting paid for it and with no cutoff point in time.

If you were Gambler B, what kind of conditions would you put on the bet? First, you’d want a time limit. The open-ended duration exposes you to unlimited risk and an undefined time frame. So you could be right in the short term but wrong over the long term. The other problem is that you are taking on enormous risk without compensation. So how would you define the right compensation for the risk you are taking? You’d use time as your guide. You’d try to figure out how much the stock could possibly move over a given time frame. How much could a stock move in a week? A month? A year? The more time you commit yourself to, the more risk you take of being wrong. The more time, the more risk, the more money you would charge for that risk.

Here is the rub: You want to charge as much as possible, but not so much that Gambler A says the trade is too rich for his blood. Gambler A offers you $2 over the next month to take the bet that he is wrong that the stock will go up. You think to yourself, $2 isn’t enough because the stock regularly moves up and down $5 every month and yet always seems to end up in the same place, which is why you are taking the bet. Even though you think you are right, you realize your timing could be wrong, and you could still lose. So you say you’ll take the bet for $5. This way, even if the price goes all the way to $105, you still don’t lose anything. Gambler A takes the bet because he thinks the price will move at least $6, and he’ll come out ahead. All this is the standard back and forth that goes into any bet, whether on a horse race, a football game, or a prize fight.

In options trading, there is one other piece that also confuses people: the payment method. With just a few exceptions, a seller of an option is paid for giving up some right, but if he loses, he pays in stock and not in dollars. You are not obligated to pay $1 for every dollar the price moves. You as the seller of the bet promise to sell the stock at $100 at any time in the next month, whenever the buyer calls the bet. If the stock is at $110, you have to go out and buy it for $110 and sell it to him for $100 and lose $10 on the trade. However, you still get to keep the $5 you got for taking the bet.

Most people get confused by a put option, which is a bet that a stock will go down. Gambler A bets you $5 that the stock will go down, and you sell him that bet. If the stock goes down to $90, you, as the seller of that bet, have to buy the stock at $100. He gets to buy the stock on the open market for $90 and resell it to you for $100, pocketing the difference.

The seller of the bet always takes on the obligation. If you sell a call, you must sell the stock at the agreed-upon price any time the stock is higher. If you sell a put, you must buy the stock at the agreed-upon price if the market price has moved lower. The risk for the buyer is always limited to the price paid. However, the seller’s risk can be unlimited, such as when the stock price rises substantially.

It is a cliché to say that the stock market is like a casino. But there’s some truth in this statement. Which is more like gambling: stocks or options? Stocks are not a bet because you would never take that bet. When you buy a stock, there is no time limit that determines when you have to sell. Stock traders trade the price of the stock. The trade is about the stock price. Stock trading is not gambling—it is speculating.

Options are not about the stock price by itself, but are about the stock price plus time. What happens within a given time frame gives the trade meaning, structure, and value. Options trading is always about how fast the price will change, how far it will move, or when it will move within a period of time. Options trading is derived from the price action—hence the term derivatives.

“You can’t beat the stock market” is true about stocks, but the options market is not the same. Since options trading is about the stock market, your trading market is less clear. For example, you can trade the aggressivity of a price move. Perhaps you will trade the timing of a price move. Maybe you will trade the actually distance of the price move. Or maybe you will do the opposite and trade the lack of aggressivity, the lack of movement over a given time frame, or the small range of the price movement. In all these cases, you are not trading the market but, rather, trading something about the market. So is it possible to beat the market? It depends on which market.

So if options are closer to gambling than are stocks, does that make options trading worse or better than stock trading? Better. One thing that dominates the world of gambling is the odds. Gamblers are great statisticians. The best gamblers want the odds in their favor when they place a bet. Options trading is also all about the odds. You have to constantly ask yourself when to bet with the house or against it. In both higher and lower prices in the stock, each option will have its own probability. Probabilities are also calculated across different time frames. The pricing in options reveals a plethora of information. Options traders look at pricing models and volatility to determine odds for trading that, when used properly, add a significantly higher level of sophistication than stock trades. Ironically, many options traders feel less like gamblers than do stock traders. A stock trade always has a 50% chance of going up or down. Does a stock trader know what the odds are of going up or down 10% over the next year? An options trader has an idea. The access to greater information is a source of comfort to options traders that stock traders don’t have. Stock trading is more speculation than gambling. If trading stocks were gambling, there would be more sophisticated information about the odds of different price levels over different time frames.

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