Options Trading? Fools Gold?

A recent interchange from Scott Burns of The Dallas Morning News and one of his readers offered insight into the get-rich-quick-option-trading-hype seemingly everywhere today.

The question:

What is your opinion about companies that train you to trade in the options markets? I have been to two seminars at local hotels. Both companies stressed that their training is the way to go about $3,000 for two days. Is this a scam, or can Joe Six-Pack pick up on this and make easy money, as both companies portray?

Burns’s answer:

It has been said that if you put enough monkeys at typewriters, one of them would eventually produce Shakespeare. It would, however, require a really, really large number of monkeys. Well, it’s the same with options trading. If you get enough monkeys doing it, you’ll get a success story or two. Unless a person has some unusual talents, however, the odds are that the real name of the course should be “How to Lose Your Money Really Fast.” Options aren’t like stocks or bonds. You don’t own an underlying asset with some intrinsic value. Options are a time-sensitive contract that may, or may not, expire worthless.

That’s a pretty big negative. The quality that makes options attractive massive leverage and volatility is also what makes them dangerous. Small price moves in the optioned asset can multiply the value of your contract or make it worthless. It is possible to reduce risk in this kind of trading by using sophisticated hedging techniques. These techniques require significant mathematical skill. Hedge funds and the trading departments of major investment firms routinely use these techniques. To do it they go to the mathematics and physics departments of major universities. They hire people who were pondering Fermat’s Last Theorem as they went through puberty.

These are the kind of people who get an “A” in college calculus without buying the textbook or attending the lectures. These are the people who take the other side of the trade. Basically, the homegrown options trader is playing against a whole crew of Mensa eligibles. As games go, it would be like either of us suiting up to play professional ice hockey. Helmet and pads notwithstanding, we’d be dead meat.

Scott’s answer is on target, but even if you have the perfect “option formula” (as discussed in the book Trend Following), you can still go belly up like Long Term Capital Management.

More on LTCM.

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