Option Trading & The Protection of Capital


            With option trading, most if not all investors don’t understand the house rules. Most investors incur substantial losses on their option investments which amount to be larger than losses in equity investments. This is often attributed to poor market timing and a result of overreaction in regards to past performance.


            What appears most in option investors is the motivation of gambling and entertainment rather than following rules that lead to profit. Option traders are indeed persistent traders and among the most persistent losers. Michael and I were a little perplexed in how a housewife by the name of Karen was able to make $105 million in option trading. Are the rules based on technical analysis, candlesticks, P/E ratios, institutional market makers, or just plain luck?


            How can a normal educated investor achieve or duplicate these results if at all possible? There are certain hypotheses that come close to arriving at the truth, but at times they are vague. However, the attributes that are imperative require discipline and the knowledge of how orderly markets behave.


            We all know in China that the retail investors dominate the landscape in terms of their stock market. Even now the government of China has an army of funds to raise stock prices in order to attract retail investors back into the market after their combined losses of $1.1 trillion. The American market is dominated by institutions that benefit retailers with orderly markets. Elite option firms do exhibit a rate of 95% return, so what are their attributes?


            One attribute is based on large profitable firms who possess higher institutional concentration, higher analysis coverage, higher trading volume, media coverage, and immediate news releases of certain securities that are widely held and establish a certain degree of confidence in their moat. Earnings surprises are risky because they’re based on selling on news until revisions from analysts are received by the public. Institutional market makers do have an edge on that, they have the information beforehand to determine liquidity risk in how low or high the stock must go for them to purchase it. For them, small-cap stocks are extremely risky as any shock results in large price swings.


            Robert J. Schiller, an American Nobel Laureate, provided us with a glimpse in how the markets work. In his financial singularity thesis he mentions a hypothetical state in which powerful computers direct all investment decisions. He further mentions that financial markets becoming perfect would never become a reality because people will continue to influence the market. He pointed out the situation in China with their retail investors as a support to his thesis.


            Our published article ‘Janet Yellen’s Stock Crash Party with the Chinese’ comes out with a different conclusion. We argue that the use of sophisticated computers have allowed the ‘smart money’ held by institutions and the ‘dumb money’ held by retailers to converge towards each other. The two co-exist in a narrow range and smart money can not unload their shares without the dumb money finding out about it. The stealth and sophisticated investor has accumulated all these shares without realizing that dumb money holds the potential trigger. What it means to the option trader and the tools they use in determining value through Delta, Gamma, Theta, Vega and Rho is that they have become irrelevant.


            The housewife who allegedly made $105 million in option trading refused to disclose her secrets. She only indicated that technical analysis, candlesticks, and all the myriad of tools are not part of her strategy. However, she does use certain tools as an anticipatory reaction in allowing market engines such as the Dow, NASDAQ, and S&P 500 to lower the value of a security that has a wide legitimate following. The wide legitimacy of value is based on human condition that analysts are compelled to be right with their price targets on securities. She allowed the financial market makers to do their job by raising and lowering the value of the security. She’s cognizant of the economic cycle that acts as a trigger between the bulls and the bears. Both bulls and bears co-exist and both need to profit.


            The bulls turn to bears as fast as bears turn into bulls. The monetary policy of expansion and contraction correlates perfectly with the symphony that plays between the bulls and bears. The trend becomes your friend until it reaches the overvalued stage and follows with a reversal. Reversals are based on profit, no different than the accumulation of securities to profit from. It is the sequential weakness and strength of a security that determines profit taking on both sides. It is also focusing on the bigger, macro picture with respect to timing, accumulation, and reversal of a security that is paramount for option traders.


            Today, Vice Chair of the US Federal Reserve Stanley Fischer stated that he would be happier if he saw “more physical investment than financial investment given the monetary accommodation.” This housewife should be commended in understanding macroeconomics. She established the real attribute in how markets behave: animal instinct, patience, stalking, streamlined volatility, and the human condition that drives all markets. 


            The jobless rate in the US has successfully gone below 5% and now stands at 4.9%. A macroeconomic view that utilizes the Phillips Curve will now require an interest rate hike in order to keep inflation/price growth in check. Fischer argues, “A persistent large overshot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession.” He continued, “Monetary policy should aim to avoid such risks and keep the expansion on a sustainable track.”


            Fischer’s implication to the economy is that in order to contain inflation it is absolutely necessary that interest rates are increased early and slowly. There are way too many variables in the global economy that could act as a contagion. There’s a competitive aspect to economic statistics, especially from emerging economies. It may be called one-upmanship that follows the trend that emerging countries should have the lion’s share of foreign capital. If China nudges their economic statistics, you can be sure India follows suit. India is facing the worst drought in 50 years, how can it not affect their economy? The only way out of droughts is for these countries to join the game with the ideological myth that liquidity serves the poor.


            The global economic conundrum may have its own trigger which is directly related to the self-fulfilling prophecy that the Dow can never profit. Now, the word profit can’t even exist in the mind frame of Wall Street. I congratulate the woman who made $105 million trading options, but is she prepared to protect her capital? Everyone is in the same boat, or should it be called a herd?

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