Primer on Options / Feasibility of Options For Retail Investor

[Mister Imperceptible]

I finished Rowland’s PP book and Spitznagel’s Dao of Capital. Rowland was somewhat a disappointment as I had already read much of the information elsewhere, and I was really craving hyperspecificity. Very impressed with Spitznagel. In the end he advocates putting 0.5% of one’s portfolio into far out-of-the-money put options.

Can anyone suggest the best material to start with for buying options? Again, reiterating my desire for hyperspecificity. If you want to do something well, study the Masters. The 23-year-old art teacher might be able to show me a few simple techniques but she won’t be able to teach me to paint like Rembrandt.

And are options truly manageable for the retail investor? Will any advantage inherent in the instrument be arbitraged away by hedge fund managers who move the markets themselves?

[jacob]

The standard book/bible for [the human trading of] options is Natenberg. You want to develop some routine adding the payout diagrams in your head for your portfolio or strategies.

Options are technically manageable/feasible for retail investors. However, the tax-consequences in a taxable account require a lot of book keeping. Qualified dividends can become unqualified if you cover underlying securities with options and it's YOUR job to figure out all the calendar math. 1099 won't tell you. This can be avoided by only dealing with non-dividend payers or trading in a tax-deferred account.

Hedge funds are generally not in the business of arbitraging options, but banks and broker-dealers are. You can pretty much be sure that all options are traded at the Black Scholes price using some GARCH inspired model for the volatility surface. The spreads will be large enough to render this unprofitable if you trade active. You will see some movement to the nearest strike during witching days when people who are short options need to buy underlying securities to cover, but this effect is minor. As a retailer, you'll never see it.

I think for retailers, options are best used in the matter that they were originally intended: Either 1) You have an interest in acquiring the underlying but don't want to commit the money so you buy naked a call or a put option; OR 2) You want downside protection, so use options to cover your position e.g. sell a call or buy a put.

If you want to trade options as such, you need to adopt a medium term speculative strategy, i.e. you need a good idea of where something will be 1-12 months out. So you need have a good idea of both direction, the price target, and when it'll hit that target. That's a lot to ask. (Compare to the standard retailer who only have the idea that the long term direction is up or the value investor who only have the idea that the price target is X dollars away but no idea of the timing. But if you can do that, options will provide for much enhanced ways of making money with surgical precision compared to just going long or short of that something. If not, trading options is a very complicated way to lose money.

[Dream of Freedom]

Jacob is right that option volatility and pricing by Natenberg is one of the best books on it.

It would be hard to make money long term by buying options. There is a technical reason for that. The implied volatility on an option is usually higher than the actual volatility of the underlying stock. So most retail traders make money not by buying options but through selling them. Pro traders will often trade delta neutral meaning that they are relatively unaffected by price movements.

[frommi]

I finished Rowland’s PP book and Spitznagel’s Dao of Capital. Rowland was somewhat a disappointment as I had already read much of the information elsewhere, and I was really craving hyperspecificity. Very impressed with Spitznagel. In the end he advocates putting 0.5% of one’s portfolio into far out-of-the-money put options.

And are options truly manageable for the retail investor? Will any advantage inherent in the instrument be arbitraged away by hedge fund managers who move the markets themselves?

As mentioned already Natenberg`s book is very good. The idea of putting 0.5% into far out of the money options is not that smart, that normally means losing 6% every year, because that makes only sense with short term options, otherwise the payoff will not be large enough. And you need to know when to sell, just buying them is only half of the strategy.
I backtested a strategy of buying a 5% position in 5% out of the money options with 6 months to expiration for the summer period (May->September) and that would have been profitable for DAX and Dow Jones over the last 100 years if you sold them for a 500% profit (after a 20-25% correction) and you were able to pick them up at moderate levels of volatility. But the thing is you have to buy them EVERY summer, if you miss one larger correction you fucked the strategy up. Thats very hard to do after you lost 3-4 times in a row. Now imagine you do this every month.

Nontheless i use options (mostly complex option constructions) to implement a quantitative strategy that shorts stocks. Options can really do wonders here, because normally a naked short has unlimited downside and limited upside and you have to pay borrowing fees, but with options you can turn that around and make the strategy much more profitable.

But options alone don`t provide any edge, you need a strategy for the underlying.

[Mister Imperceptible]

475 pages. I’ve got some reading to do.

Thanks to all for the intel. I may have more questions after further reading.