By: Chris Rowe — August 30, 2017
What Your Broker Doesn’t Want You to Know
Right off the bat, I want to say this isn’t any kind of “dirty rotten stinkin’ bad old broker” tirade.
Today I only want to give you a richer sense of what motivates your broker's actions by examining a few motives that go beyond just making money for their clients.
Obviously the things that motivate a broker include the broker's making money for himself. They have a right to get paid, too! It’s a free market and a free country and we shouldn’t hate the players. But that doesn't mean we have to love every single aspect of the game.
Let's begin our discussion by stating a simple fact about... options. And that fact is: most brokers do not want you trading them.
I on the other hand do want you trading them. One reason is that options can buy you your freedom. Since I started trading options, my life has gotten a lot easier. And not just because I’ve made a lot of money doing it, but because they've spared me having to deal with a lot of stress.
Money is great, of course. But the deeper meaning of money is that it lets you live the lifestyle you want to live. If your broker, your money manager, or whatever professional you rely on is keeping you from doing that, then it’s time for me to step in here and “pull some cards,” so to speak.
I worked on Wall Street from 1995 to 2004. So what I’m going to tell you is not more than my opinion. It’s a fact.
Brokers will usually try to discourage you from using options by telling you that options are "risky." Or that you don’t qualify to trade them.
Investment professionals who know options, trade options — not stock. And yet... they want you to trade stock -- not options. Something's fishy.
Here's what's going on here.
Your investment professionals, as individuals and as corporations, are running a business and want high profit margins.
They want to earn the biggest bang for their buck. That means spending as little time as possible explaining things to you, or having someone explain things to them so they don’t sound foolish or make mistakes.
This puts a burden on the investment professional, because his or her client might be a Level-II options trader (that is, one able to deploy advanced strategies). That client could start asking lots of questions about those additional strategies. No professional is eager to open that can of worms.
Options trading allows you to commit much less capital to an investment even though you can make the same profit -- or even more profit -- then you'd make on the stock or ETF you’re trading.
That's great for you! But investment professionals want to have as much money under their management as possible. Their goal is to manage every penny they can get their hands on.
Maybe they're paid a certain percentage of the assets managed. If so, every dollar in cash helps. Perhaps they're rewarded by their superiors for having larger assets under management. Or maybe they're simply afraid of letting money sit in cash for too long.
They don'e want that idle cash burning any holes in their client's pocket. The client could decide that spare cash is better used paying off a debt... or buying a new car... or financing a nice trip to Paris or Palm Springs.
Heck, the customer might even decide to plunk that cash into the very same high-interest account their banker just sold them on!
Whatever the case, investment professionals are trained to keep cash off the sidelines, lest the customer pull it from the account. Brokers and managers attend seminars where they share strategies designed to keep the customer from asking for their money back.
The funny thing is, the broker is right! Customers are only human. And humans, especially Americans, have a very hard time sitting in cash. Savings are dangerously low while personal debt is dangerously high, year after year, more often than not.
The bottom line is: the broker is motivated to keep capital moving and moving (if he earns commissions)... or, if he earns fees) to keep that money parked in a stock, whether that stock is working or not. That’s not good for you, the customer.
Here's something else that motivates brokers: It’s hard to hide commissions in options.
Sometimes brokers trade stocks and are able to pick up extra commission on the trade desk by risking your capital. It’s not easy to do that these days, but it is still possible. It’s pretty easy to do when it comes to trading bonds. The client will see one commission, but then there will often be a hidden commission. Also, the brokerage firm will can receive kickbacks (of one form or another) by giving another brokerage “party lots” of order flow.
With options, it’s an agency-based trade, and there are no hidden commissions. The broker can’t hide them. On top of that, the commission isn’t a lot of money to the broker or money manager because typically an option trade typically involves a smaller dollar amount than a stock or ETF trade.
Let's add some meat to that bone. (I think we've said enough about brokers for now...)
In a past article (titled “Read This, and Never Trade Stocks/ETFs Again!”) I said that, if you think Apple (AAPL) will trade higher, you could either be a stock trader and buy 1,000 shares at $160 for a $160,000 outlay (all of which is at risk)...
...or you could buy 10 call options representing in total 1,000 shares and only commit (and risk) $28,000.
If Apple trades 30 points higher, the stock trader makes $30,000. The options trader makes $25,000. If the stock declines by $30, the option trader only loses $20,000.
But the maximum risk for the options trader is $28,000. The stock trader loses $1,000 every time Apple loses one point of value, and the stock was at $161! So the maximum risk in the option was only 17.4% of the value of Apple’s stock ($28 is 17.4% of $161).
It’s great to be able to sleep at night knowing that, at worst, you're only risking a fraction of what you could lose in the stock. But when it trades up 30 points, we only make $25,000 on the option.
Something You Might Want to Teach Your Broker
Here’s the easy fix for that…
In that previous article, I assumed the option had a "delta of 0.75." That means with a 1-point move in the stock, the option would theoretically move 75 cents.
We want to make $1,000 for a 1-point move in Apple’s stock. So, what do we do? With 10 call option contracts (remember, there are 100 shares represented in a contract), we bought 750 deltas. (Each call gives us 75 deltas.)
So let’s just buy something closer to 1,000 deltas. How? My hypothetical call option has 75 deltas. Knowing that, I consider buying 13 call options to get me 975 deltas. That means with a $1 gain in the stock, my option would likely gain 97.5 cents.
However, the delta of the option increases as the stock moves higher (with call options, but the reverse is true with puts). So what does that mean?
Well, I still make 25 points because I still own the same option as before. But since I own 13 call options instead of 10, I make $32,500 when the stock advances by 30 points ($2,500 more than the stock trader).
What if the stock declines by 30 points?
The owner of the call option would lose 20 points of value (not 25) and since we own 13 call options that means a $26,800 loss compared to the stock owner who lost $30,000.
So remind me... Why aren't you trading options again?
Talk to you soon.