Derivatives, according to billionaire investor Warren Buffett, are “weapons of financial destruction”. That’s a very clever expression but let’s be honest: Mr. Buffett makes hundreds of millions of dollars for his company (Berkshire Hathaway) by selling derivatives.
Options contracts (promises to buy or sell shares of stock or commodities at a fixed price in the future) are the most well-known form of derivative contracts used in the financial world. Unlike you and me, Warren Buffett gets to use the float from his insurance companies to finance his big stock options deals. But another of Warren Buffett’s secrets is that he trades really far ahead of the curve, up to 25 years.
There are probably thousands of articles that explain how trading stock options works. I have read a lot of them. But I was pretty impressed with this article from OptionsHouse. It covers the basics with a very well-written, no-nonsense style. I think one reason they do such a fine job is that, as a brokerage, they have to be very careful about what they say. That article was probably reviewed by several people or written by someone very senior in the organization.
You can’t let just any old schmo write an article about investing, much less teach the basics to people who have no idea of what it is all about. So when it comes time to pick a good article that explains the basics, how do you know which one is good? Truth be told, you can’t and you won’t until you have learned enough to go back and say, “Well, that article was pretty good.”
But one thing you can do is see what other people have to say about whoever wrote the article. OptionsHouse is a service vendor. They process online trades for you. You can easily find reviews of OptionsHouse on the Web because they are such a major player. The good things people say about OptionsHouse may be motivated by personal interest but they may also be speaking from personal experience.
In addition to the private reviews, you can also look for any third-party recognition of their expertise. For example, OptionsHouse was recently awarded a very high rating from financial rating service Barron’s. This is a testimony to their service, software, and customer satisfaction. But you have to translate that recognition into a confirmation of their knowing what they are doing, too. So we have some pretty good ideas of what people think of a company like OptionsHouse.
But at the end of the day you still have to decide if derivatives, options contracts, are a thing for you. You can sign up with the best brokerage in the business and still use their system to make bad investments. Personally, I think there are two basic strategies that pay off.
First, you can try to jump the market. If you do a lot of research on a sector and whatever company you want to trade in, you may be able to identify a positive (or negative, if you like shorting stocks) trend before other people spot it. But this really, really hard to do. Taking advantage of market ignorance of oversight is not a great goal, in my opinion. Most investors fail to do this consistently.
The other strategy is to share the growth in equity. That mean hitting a strike price that looks attractive with moderate growth over time. You may also have to ask for (if you are buying) or offer some guarantees (if you are selling). These costs should be factored into the deal because what you want to do is make enough of a profit from the transaction that ultimately you can go out and do it again and again and again and hit often enough to build your wealth.
Sharing the growth in equity means being a little less aggressive on your strike pricing. Besides, if you are selling the options you get the contract fees up front. You can take that money and invest it again, long before the deal matures. If you can move 10,000 shares of a stock three years out, and you and your buyer agree there will probably be a 10% growth in share price between now and then, your best bet is to set a strike price that looks attractive enough to give the buyer an edge on the market at that time.
If you’re off by 5% in your estimate then a strike price set 4% above current price gives you a tidy profit over what you paid for the stock today (to be combined with the options contract fee). Your buyer is betting that the fair market price at time of maturity will be more than 4% above today’s price. Of course, he needs a better margin to recoup his contract fee as well as his cost for the stock.
If your strike price is too aggressive no one will buy. If it’s “just aggressive enough” then someone may buy but they will walk away from the contract. That may seem great to you but if you consistently set your strike prices too high your pool of potential customers will dry up. Quite simply, if there is little to no hope of profit for them other investors will pass on your deals.
You are not going to charge into the world of options trading and turn it upside down. There are plenty smart people who are looking at all the angles. And, frankly, the money is played pretty tight in these marketers because the margins are so tight. When two people have to share the growth in equity the realized change in equity for either person is less than whatever the market sees.
Despite these reservations, I think you’ll find that the world of options trading is well worth looking into. After all, if it’s good enough for Warren Buffett then it’s probably good enough for you, provided you are willing and able to take a few hits until you get the swing of things.
