A lot of emphasis is placed on selection of one strategy over another. Are you conservative or a speculator? Are you trying to make fast money or hedging equity positions? In fact, this is a primary concern among traders. The strategy should match the risk profile, of course. But there is much more to how and why you trade options.
I’m a fan of index funds and diversification. Low costs, low turnover, and passively managed exposure to thousands of stocks make Total Stock Market (TSM) index funds great starting points for stock market exposure. In fact, most investor portfolios I see are insufficiently diversified to a point where a TSM index fund would be a material improvement.
To those of us involved in the Steady Options community, options trading is almost second nature. But most investors, and even most traders, don’t trade options. There may be a variety of reasons why this is the case, but I believe it’s mostly related to the learning curve of understanding a completely new concept.
Can you rely on the net return calculations most options traders use? No. When you figure out the basic probability of outcomes, you probably use the additive method. This calculation of profit or loss gives you a false read on the likelihood of success.
A lot is said about probability of profitable outcomes in option trades, but do we truly understand what probability is or how it works? Options traders can become better informed and even wiser by looking a step beyond the well-known conclusions.
The purpose of the below piece is to demonstrate how Lorntine Capital uses ORATS (Options Research and Technology Services) in our own backtesting.Note: ORATS does not pay me for writing this but has requested that if we like the software, we assist in promoting it.
A calculation of “breakeven” as well as maximum profit or loss, sets up a single system for modeling and comparing one option to another. But it might also require traders to adopt an unrealistic assumption about outcomes based on best-case or worst-care scenario.
One of the biggest challenges I come across with the typical investor is maintaining realistic expectations and being able to properly understand the tradeoffs between risk and return. We all want high returns with low risk and there’s no limit to the efforts we’ll make to find it.
Options traders endlessly debate the merits of the Black-Scholes pricing model. Some swear by it and others don’t even try to use it. Given the many profound flaws in the model, it is not an accurate tool for developing a sense of where price is likely to move in the future. But there are alternatives.
Options traders must, naturally, be concerned with the likelihood of payoff for a strategy. Ironically, one of the most often cited statistics about profit and loss is simply incorrect. That statistic is captured in the headline of a story posted online “Trading Options: Data Shows That 75% or More of Options Expire Worthless.”
Financial planners can usually give generic advice that will be appropriate for the majority of Americans, and that’s the goal of this article. If we can get the fundamentals of cash-flow planning right (where to put your money after you earn it and pay your taxes and bills), we’re 80% of the way towards maximizing our financial situation.
Among the good reasons to trade options is the need to meet or surpass your breakeven yield. This is the yield you need just to preserve your purchasing power; and it higher than most people think. In fact, most people relying on moderate to conservative yields from stocks, mutual funds, real estate and savings accounts might be earning well below this breakeven level.