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Options University’s Options 101 - Part 25

Filed Under Beginner Options Trading 

Options 101
Part 25
 
Comparing Returns Amoung Funds and Managers
You will be persuaded by different types of investments or individual stock pickers to put your money with them because they “beat” the Dow or some other index. While their returns may be higher, it does not mean that they necessarily beat it on a risk-adjusted scale. As an example, assume the Dow increases 10% over the year but a money manager tells you to put your money with him since he earned 20%. On the surface, it seems like he did much better. However, we haven’t considered the risk. What if this manager invested all his clients’ money into lottery tickets to get the 20% gain? Now it doesn’t appear too impressive. If he is taking that much risk, you’d certainly want better than a 20% increase on your money. We’d say that, on a risk-adjusted scale, this manager didn’t perform as well as the Dow even though his return is higher.
 
Traders and money managers who place their money in high-risk investments will do better than the Dow or S&P 500 or other broad-based index from time to time. But the chances that they will sustain that record are very low. People who place their money with a fund or manager just because they posted the highest numbers are mistakenly assuming that all of them took the same amount of risk. Before you place your money with them, find out what they are investing in before you get too impressed with the numbers. At any given time, there are thousands of speculators and hedge fund managers who speculate with high-risk investments. It shouldn’t be a surprise that a great number of them will beat the Dow or S&P 500 during the course of a year. This doesn’t mean that they are more skilled than the manager who consistently returns a smaller number.
 
Make sure you understand the risk-reward relationship before you start investing. Risk and reward never separate. They are joined together by a rational force – the same force that caused you to price the earlier games in the order you did. If you always seek the investments that have the highest potential for return, you are by default, seeking the ones with the highest risk. We have tried to give you many examples of how to use the risk-reward relationship so that you do not forget it, which is easy to do. For example, we just received an email promotion from an options trader with the following advice:
 
Quote in Promotional Email:
“Cheaper options are usually the best plays. They give you the most leverage, the percentage returns are better, and if the market or stock goes against you, you are risking less.”
 
You can see that even this professional got it wrong. You are not “risking less” by purchasing cheap options – you are taking on more risk. It is true that if you buy a cheap option there is less money to lose, but that is because you have a higher chance of losing it. And why are the percentage returns better? Because there is more risk. Why do cheap options give you the most leverage? Because there is more risk. But if you look at the quote, he is making it sound as if you’re getting all the positive attributes (high leverage and higher percent returns) without any negative consequence since you are “risking less” for all of these benefits. That is simply not true. All of those positive attributes are a direct result of the higher risk in cheap options.
 
Understandably, it is easy to make this mistake with financial investments since we do not have little pictures (such as the coin and cards) off to the side like we did with the pricing game reminding us of the risk in each game. When you start trading options remember this one thing: Cheap options are priced that way for a reason. That reason is risk.
 
Key Concepts
 
1)       The time value of an option is determined by the volatility of the underlying stock.
2)       The time value is purely determined by what traders are willing to pay for additional time.
3)       The higher the risk, the cheaper the price (and the higher the reward).
4)       Higher strike calls (and lower strike puts) are riskier.
5)       There is no inherent advantage in trading options on high-volatility stocks because they will be priced correspondingly higher. Price is the equalizer.
 

Option Price Behavior
One of the biggest mysteries to new (and experienced) traders is the way in which option prices move with changes in the underlying stock. For example, let’s assume you buy a $50 call for $3 with the underlying stock trading for $50. Within a few minutes, the stock climbs up $1 to $51. What would you expect to happen to the price of your option? Would it climb $1 too? The answer is, unfortunately, no. Although it seems like it should be trading for $4 at that point, the option will rise by something less than $1. Why is that?
 
This is a very difficult concept to explain to new traders, and the explanation belongs in a more advanced book, but it’s important that you at least understand that options will generally not move dollar-for-dollar with the underlying stock. Please understand that the following details are not really necessary to understand in order to trade options. We’re just showing you this to explain why options will usually not move dollar-for-dollar with the stock and so you are not alarmed when you see it occur. Let’s see if we can make some sense of why this might happen by going back to our pizza coupons.
 
Assume that pizzas are selling for $10 and you have a coupon that allows you to buy it for $7. If these coupons were actually traded in a market, we know that it must be worth at least $3. Why? Just as with our call options – arbitrage. Let’s say the coupons were missing $1 of intrinsic value and trading for $2. Arbitrageurs could buy a coupon for $2 and then pay $7 for the pizza thus spending only $9 for the pizza. They could then sell it in the street for $10 thus making a free dollar. The buying pressure on the coupons will raise the price, and the arbitrage opportunity will stop once the coupon is trading for at least $3.
 
Now let’s assume that the storeowner announces that tomorrow the price of pizzas will go up for certain by one dollar to $11. Upon hearing the news, the market will immediately raise the price of the coupon from $3 to $4. If not, arbitrage is possible again for the same reasons as in the previous paragraph. In other words, if pizzas are now worth $11 then the $7 coupon must fully reflect the $4 intrinsic value. In this case, the pizza price rose one dollar and so did the coupon.
 
But now let’s go back to the beginning when pizzas were $10 and change the situation a bit. Let’s say that, instead, the storeowner announces that he will flip a coin tomorrow to decide whether or not to increase his prices by $1. If the coin lands heads, he will raise prices to $11. If it lands tails, they stay the same at $10.
 
We know that when the storeowner announced that pizzas would definitely rise by one dollar that the coupons also rose by the same amount. In other words, because prices were guaranteed to rise, the market immediately priced that $1 increase into the coupons. With the coin flip though, the owner introduces some risk and we’re now only 50% sure that pizza prices will rise. What should we pay for the coupon now?
 
To be continued….

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