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Asher's Letters to Samech - Part 2 BS"D Dear Samech, Whoa! Too many questions. We can't possibly discuss all those things at once! Most of what has set you dithering was just jargon tradingese ...(One of the famous trading gurus liked to call it, "macho stuff - good for making an impression at cocktail parties"). As long as you got the gist and importance of what I wrote you, that's plenty for now. Osmosis will do the rest. Since we haven't even touched on Options proper, it seems pre-emptive to discuss nuances and details. Cart before the horse sort of thing. But since you're so antsy, here's the basic definition: An Option is a contract giving the holder the right but not the obligation to buy (Call Option) or sell (Put Option) a stock or commodity (underlying instrument a.k.a. underlying) at a given price (the strike price) by a given date (expiration date). An Options trader can either buy or sell either a Put or a Call. That's four possibilities:
Confused? Good, serves you right! Just kidding. The definition I've given is packed with information. Think on it. As we discuss Options more, I'm sure it will become clear. For perspective, let's take a look at some interesting statistics. BTW, most of these stats are "accepted in the industry" statistics rather than substantiated statistics. Comparison Set A
GAMES OF CHANCE:
In Las Vegas, in every game, in every casino, the house has a statistical
edge. The size of this edge for the mechanical games is actually
controlled by legislation, in Nevada anyhow. COMMODITY TRADING: 90% of all new commodity traders loose their investment capital. Frightening odds! Instant, starry-eyed, millionaire market wizard newbies jump in with the sharks, underfunded, trade an assortment of 50 kinds of trades, using 50 indicators, and 50 methods - too much too fast without proper regard for Risk and Money Management. Usually they leave the fray after shooting themselves in the foot. Comparison Set B
BUSINESS: Eighty percent of all new businesses do not survive the first 3 years. As a CPA and business consultant, I often quoted this government statistic to cool down short funded clients who were burning to quit their jobs, sell their houses, and go deep into hock, to invest (gamble?) on their own personal "TWMPM" or "Money Tree". (No offense, Misters Roberts and Williams.) VENTURE CAPITAL: The VC firms that contracted me to work up their Venture Capital Plans usually assumed a 2 out of 10 win ratio. They were prepared to risk $1,000,000, ten times, (We're not talking about the short funded here!), while accepting "probability" of only 20% return. Careful, that's 20% of the TIME, with up to a ten thousand percent (10,000%) Risk:Reward Ratio return target of $100,000,000 - twice out of ten! (You'll hear a lot about Risk:Reward Ratio and Risk Management as we go along.) These were hard nosed, savvy businessmen who all subscribed to the "Never trade with money you can't afford to lose" school of thought. And believe me, they rigorously did their homework and what-if scenarios before they plunked down their money. OPTIONS: "Percent that die worthless" is a very misleading concept. Unlike with most other kinds of trading instruments, people use Options for all sorts of reasons, for example, Risk Control. Well-funded commodities traders anticipating a substantial move might hedge or protect their commodity purchase with an Option or two. Buying a Put when you own a long commodity position reduces (not to be read "eliminates") the risk of a powerful adverse move against the position. If the market unexpectedly dives (never underestimate this - Drawdown IS the silent killer. Remember?), the Put will increase in value, offsetting some of the loss on the long position (more on this when we get to "The Magical Powers of Delta"). Such prudent traders are quite content to pay the premium on these insurance policy Options, and to never have a "claim" to collect against them. In fact, they actually bought the Puts with the express desire that they should die worthless. BTW, as long as we've sidetracked already, using Options as a tool (as opposed to as a primary trading instrument) can also save your account when the silent killer attacks in the form of a limit move. When your trade is suddenly locked, say limit down, you can't even get out of your position. Worse than that, you can find yourself locked limit for several days running. The market repeatedly limits down in the opening few minutes of trading, while you can only sit on your hands, impotent, watching your funds leak away. At the same time, the Option market in that very commodity normally will continue trading as usual. You may have to pay a premium price, but buying a Put or two will have almost the same effect as exiting your limit-locked, long commodity position. Fast action can recoup and repair much of the damage as the value of the Put(s) increase(s) while the value of the underlying continues to plunge. When the market starts trading again, you gracefully exit your position and, if the market starts to turn back around, leg out of your Puts. This is a very nice survival tool to have ready in your bag of trading tricks. You're probably about to ask me, "Is trading gambling?" It all depends on your definitions. (Sorry, I'm not gonna get trapped into this circular debate. If forced, I usually argue for "Trading is a Business" because it gets my mother off my back.) Let me simply counter, "Is crossing the street gambling?" Trading Commodities is the riskiest form of trading. Losses come fast and can be much larger than expected. Some trading systems and methods help control risk better than others do. They wisely keep you out of the market until or unless the expected move proves itself, instead of encouraging you to greedily chase bottoms and tops as some other approaches teach. Trading Stocks is a bit less risky than Trading Commodities, mainly because they are less highly leveraged and don't have a contract expiration date. Options are more complex, but offer the trader much more control. Well-considered Options strategies can definitely increase the trader's edge, or as I prefer to say, decrease the "house edge". Commodity Traders ultimately consider two main variables, Time and Price (Really, that's only one variable, Price action. When talking about Time, they actually are referring to Timing.) plus Open Interest and Volume; whereas, Options Traders additionally study and build their strategies based on Time Decay, Price (of the underlying), Implied Volatility, and a whole variety or rates-of-change associated with the Price of the Option vs. the Price of the underlying commodity (the Greeks). Crossing the street is more complex to evaluate in terms of Risk : Reward. Even an underfunded street crosser can greatly decrease risk by simply looking both ways, crossing with the light, crossing in the crosswalk, and not running. The crosser's "at risk" in case of sudden "Drawdown", however, is substantial; whereas, the reward, getting to the other side of the street, is rather mundane! Whew, that's a lotta words at one shot. I'm too pooped to pop! 'Fraid that's all for tonight. Be well. Regards to E., Asher P.S. FYI, next letter I'm
considering outlining a few things about "Your Trading Business Plan
and Funding". Depending on how long that letter runs on, I hope to do
some sample juggling using the Trading Target Calculator. If you haven't
done so already, please go to my site and get the
Asher's Letters to Samech, Part 3 Back to Asher's Letters to Samech, Part 1
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