Options: What Your Broker Doesn't Want You to Know
Right off the bat, I want to say this isn't about "that dirty rotten stinkin' bad old broker." Brokers and money managers, please know, I'm just going to slowly make our readers understand the things that motivate your actions -- other than just making the client money.
One of those things includes making yourself money. Yes, you have a right to do what you can to get paid, too! It's a free market and a free country and I won't hate the players -- but I will hate the game. ...
Options Can Buy Your Freedom
Ever since I started trading options, my life got a lot easier. And that's not only because I've been making all kinds of money doing it, but because I don't have to deal with all the stress.
It really comes down to living the lifestyle I 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, and what I'm going to tell you is not my opinion; it's fact. They will usually try to discourage you by saying options are risky or that you don't qualify to trade them.
Investment professionals who know options, trade options -- not stock. And they want you to trade stock, not options.
1. Your investment professionals, as individuals and as corporations, are running a business and want high profit margins.
This means they want to get the best bang for their buck by spending as little time as possible explaining things to you, or having someone explain it to them so they don't sound foolish or make mistakes.
Options trading is just one of those things where you keep finding out more and more -- at every corner you turn, it blows you away and you want to know more. Ask anyone who took the initial steps of learning about options; they will probably say the exact same thing.
This puts a burden on the investment professional because you might be a Level-II options trader (i.e., you can use more-advanced strategies in your account), and given what you realized you can do so far, you start to ask lots of questions about additional strategies.
Why open that can of worms as an investment professional?
2. Options trading requires you to commit less capital to an investment even though you can make the same profit, dollar-wise, as you would make on the stock, index or Exchange-Traded Fund you're trading.
In fact, you can make a lot more when you're right about what you think a stock or ETF will do, while risking a lot less. I'll show you how in a minute (as I promised to last week).
But why does this cause an investment professional to discourage you from trading options?
They want to have as much money under their management as possible. Their goal is to manage every penny they can get their hands on because:
b) They are often rewarded by their superiors for having larger assets under management.
c) They are afraid of letting money sit in cash for too long because, quite often, their customers see that there is money sitting in cash and consider it available capital.The customer calls the investment professional when they want to pay off a debt, buy a new car, go to Las Vegas, or put that cash in a high-interest account that their banker just sold them on. One way or another, the idea is that investment professionals are trained to not let cash sit on the sidelines for too long, or else the customer might pull it out of the account.
There are seminars that investment managers go to, or meetings that the top brokers have, where they share strategies to keep the customer from asking for the money back. They are so paranoid that the customer will ask for the money back, that it's one of the top things a broker will learn about as a sales technique.
The funny thing is, the broker is right. The customers are just humans. Think about the fact that savings was at an all-time low while personal debt was at an all-time high, year after year for nearly a decade leading up to the recent crash. Humans, especially Americans, have a very hard time sitting in cash.
The problem is the broker is motivated to keep moving and moving (if it's a commission-based broker) or to keep the money invested in a stock, whether it's working or not, if it's a fee-based investment adviser.
That's not good for you, the customer.
3. 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 these days, but it is still possible. It's pretty easy to do when it comes to trading bonds. You'll see one commission, and then there will often be a hidden commission. Also, the brokerage firm often can get kickbacks one way or another when giving another "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 people trade smaller dollar amounts of options than they would trade in a stock or ETF.
Last week, in my article titled "Read This, and Never Trade Stocks/ETFs Again!" I told you, if you think Apple (AAPL) will trade higher, you could either be a stock trader and buy 1,000 shares at $160 for $160,000 (all of which is at risk) or you could buy 10 call options (of a particular series) representing 1,000 shares and only commit $28,000.
Stock trader makes $30,000
Options trader makes $25,000
SIDE NOTE: (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 1 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 you are only risking (worst-case scenario) a fraction of what you can 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 to that...
Remember, I told you the option had a delta of 0.75. That means with a 1-point move in the stock, the option, theoretically, would 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 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 made $32,500 when the stock advanced by 30 points ($2,500 more than the stock trader).
What if the stock declined 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, why are you trading stocks and ETFs again?