Let’s talk about options for a few minutes.
I am convinced that short-term trading of stock options to take advantage of directional moves in individual stocks or indexes is financial suicide.
We have all heard the disastrous statistics that 90% of all traders lose money.
I am pretty sure that that number is low for short-term options traders.
While we have all heard the story of folks who made 1000% on an option trade, I can tell you that based on my thirty-plus years of experience that’s the exception and not the rule.
My option-trading friends here at Money Map Press, like Chris Johnson and Tom Gentile, look at options a bit differently – and to some success.
They are among the very few elite traders who actually know and stick to a proven method that has made them fortunes as they’ve done here.
There’s much more to the story than what most people know, and I’ll tell you about it so you don’t end up as a broke investor on Wall Street.
Why It’s So Easy to Lose When Trading Like the Rest
When I was a broker, we used to joke that the worst thing that can happen to a new option trade is to have a winning trade the first time out.
Making a big percentage win can be addicting, and the newbie wants to keep the adrenaline and cash flowing and based on the recent success he is now an options expert.
Very shortly he will be a broke options expert most of the time.
I know a lot of professional options traders.
Some trade based on the value of the option relative to the underlying security or other options on the same security.
Some make profits taking advantage of all the other options traders with the lack of knowledge about how the contracts are truly valued.
All of the muse computers and math that would make a physicist blush and collectively they are an incredibly risk-averse group of individuals.
Everything is hedged.
The first rule of making money in options is never lose big money.
When you trade options think about who is on the other side of that order.
Odds are its an options specialist who has a pricing system running on a supercomputer using an algorithm designed by someone who is overqualified to work for NASA.
Your chance of winning against that are roughly the same as me knocking out Muhammed Ali in his prime.
I could get lucky, but odds are I will be taking a little nap pretty quick.
Based on that it would be safe to assume I never trade options, right?
I trade them occasionally.
I do not, however, ever trade them on a short-term basis, and I only use what I consider to be my play money.
It is the same stack of cash that I set aside each year for poker and horseracing when I was single.
If I lost my stake, I am out of the game for the rest of the year.
That tended to make me a very cautious gambler which made me a much better gambler with a slavish devotion to the math of the bet.
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It has also made me a much better options trader, also with a slavish devotion to the math of the trade.
I approach options much differently than most individual options traders.
What I Do Differently is Exactly How I Invest in Everything
First, I start with valuations.
I want to execute bullish strategies on stocks or sectors that my work shows to be grossly undervalued with enormous potential upside.
I want to implement bearish strategies on stocks that I think are grossly undervalued, and a catalyst exists that could cause prices to tumble dramatically.
I start with valuations, not chart patterns, stories, tips or systems.
Now I bring the math to the party.
I am going to use the work folks like Fischer Black, Myron Scholes, Nassim Taleb, and other options and math giants use to calculate the probability of a particular option trade’s success rate.
I then compare the probability of the payoff to decide if it is sensible math with a positive expectation over time.
Speaking of time, I am going to buy as much of it as possible.
I have seen no evidence anywhere that the short-term trading of options is game with a positive mathematical expectation.
The more time I buy, the higher the probability of the trade working becomes.
Once I have a trade that looks like it has a positive expectation, I use an options calculator to determine the actual value of the option.
If I am using the spread, as is usually the case when I make a bearish bet, I price out both side of the trade.
Overpaying for options is one of the biggest sins individual traders can make, and I don’t want to do that.
Now I take the expected probability and payoff calculation and plug them in my Kell Criterion Calculator.
This formula was developed by two professors from MIT.
The formula was used by Ed Thorp, another mathematician, to make enormous amounts of money in the casinos and the markets.
The Kelly Formula tells me how much of my bankroll I can bet on each trade and not go broke.
Being something of a chicken, I then cut that number in half and bet that percentage of my total stake.
What we end up with is a bunch of long-term bets with low probabilities and high payoffs.
I don’t expect to win them all or even most of them.
Because of the probability/payoff calculations I just need to win a few over times, and I will be a net winner.
At the end of the year, any winnings are deposited into my long-term accounts to compound along with the rest of my money in a long-term private equity replication strategy featuring lots of small banks, takeover targets, and REITs.
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John Templeton once said that you couldn’t beat the market if you do what everyone else is doing.
I think that applies to options trading as well.
Short term directional trading has been historically a losing game, so I am going to make my bets on a valuation-driven model that uses probability theory and payoff potential to make money over time.
There is one other option trading approach I use do not consider speculative at all.
In fact, I think it is about as close to win-win trading as you can get.
I am out of space and time today, so we can talk about that next week.
To the Max,