The May/June issue of the AARP Magazine featured a financial article titled "Why We Fall for This." Many of our subscribers may already be rolling their eyes, wondering what an article written for seniors has to do with them or with options trading. Quite a lot, it turns out.
I've been trading long enough that I've seen many "Holy Grail" options-trading schemes sweep through the option-trading community. Sometimes I wonder why obviously intelligent, sometimes workaholic traders abandon previously wrought trading plans to concentrate on the latest-and-greatest new options trade. To quote the lead-in to the AARP article, "Money messes with our minds." Research has explored an effect called anchoring. Eric Johnson, codirector of the Center for Decision Sciences at Colombia University, conducted experiments in which study participants were provided with a random number. After they'd heard that random number, they were asked to price a bottle of wine. The higher the random number, the higher they set the price for the bottle of wine. Other experiments by other researchers showed that it's difficult to ignore that anchor, even if we're told to ignore it. The ultimate effect, the article concluded, is that we fear losing money. For options traders, perhaps that fear translates into a fear of losing opportunities to make as much as the next holy-grail options trade promises us.
Still, that premise doesn't totally explain the phenomenon to me. I know from the letters I receive, the forums in which I participate and the trading friends I have that options traders tend to be intelligent people. Many combine intelligence with a willingness to put in lots of work to test out a theory. As a group, they tend to love numbers, and, moreover, the manipulation of numbers. In fact, it may well be that thrill of combining a new set of graphs, charts and results that draws them to the next holy-grail trade, combined with the effect that money has on our brains. The options-trading community comprises many former engineers, software developers and statistics-based professionals who easily set up spreadsheets that automatically import data, manipulate it, and display it in color-coded blocks that blink off and on like the spaceship controls in the 1950-era sci-fi movies. Being somewhat of a clunky person around software (we physics majors back in the dark ages were required to take German so we could read the classical literature in the original, not programming classes), I'm in awe of the hours some options traders spend testing various strategies and the documentations they produce to support their conclusions. I regularly have to remind myself that I once easily understood regression analysis and would have known what a Spearman's rank correlation coefficient was just so I can hold up my head, but that was another lifetime ago.
I do know something, however: these holy-grail trades sweep through the option trading community with many of them only to fade away and be replaced by another, like surfers catching the latest, soon-to-ebb-away trade. Does anchoring completely explain why we are so vulnerable to the excitement of a new trading strategy, and why does that strategy ebb away so quickly to be replaced by another? Perhaps you're familiar with the now-or-later research conducted by some researchers, published in Economics Letters. Study participants were asked if they preferred having a set amount of chocolate now or a slightly larger amount later. "Our guts tend to be impatient," the article concluded. And not just our guts. When the experiment was conducted using money, participants were much more likely to choose the smaller amount now. Economists call this hyperbolic discounting. Another factor described by the AARP article is that we "overweight low probabilities." This leaves us vulnerable to an "urge to gamble." Options traders may be intelligent as a group, but we're still human.
Let's face it: we wouldn't be trading options unless we're willing to take on risk. Before we trade options, we are asked to download and read the standard "Characteristics and Risks of Standardized Options." No matter how much we understand that options were originally created to control risk, most of us put options to a different use. Most of us do not use them to control the risk of lightning striking our fields of corn and burning it to the ground or the interest-rate-related risk to a hedge-fund portfolio. If we don't want to be too vulnerable to the latest holy-grail scheme, we first have to admit our nasty but very human little secret. We're risk takers. Some of us are real cowgirls and cowboys and some of us like our risk taken in smaller, more manageable doses, but we wouldn't do what we do unless we were risk takers.
Many of us love the mathematics behind options trading. We love being immersed in numbers, and conversing with others, online or live, who also love talking our talk. I gravitate toward trading by the Greeks while others enjoy talking about Z-scores, T-scores and standard nines. This interest in mathematics, engineering, architecture or even the statistics related to human behavior explains why we love creating our own spreadsheets or backtesting various ways of managing the Greeks of a trade. How do we explain our willingness to jump on a trade as a result of someone else's exploration? Perhaps our respect for testing, statistics or spreadsheets entices us. Perhaps that willingness harks back to that love of gambling or a fear of loss that the AARP article relates to the anchoring principle. However, from my experience writing for Option Investor for almost a decade, I sadly think something else is afoot. I think some of us want someone else to tell us what to trade.
Option Investor's thrust has always incorporated the "teach a man to fish" approach, one of educating options traders to find their own trades. Trading suggestions for all types of trades are offered, but options education remains important to the writers on the site and should be to the readers, too. One of my most eye-opening experiences as a writer for OIN was when I still wrote for the live portion of the site, the Market Monitor. I had just admitted to making a dumb mistake in one of my trades when I received an email from a subscriber asking if I would trade that subscriber's account.
Now that's a risk I personally wouldn't want to take: choosing someone who had just admitted to a dumb mistake to trade my account. And neither should any of us jump into the next holy grail trade because someone else has produced an impressive spreadsheet to show that it's a terrific trade. I've seen naked puts; ratio backspreads; hybrids of calendars, butterflies and iron condors; adjustment methods to each type of trade, and the latest rage to sweep the options trading community, weeklies, all touted as the next great trading scheme.
There's nothing wrong with any of those trades or trading methods if the situation and risks match up. We should be aware of new developments in the trading community because some may be worthwhile and may match our risk versus reward parameters or trading styles. They don't always. If your account is small, should you be trading SPX butterflies by a methodology that requires you to enter the trade in contract sizes that are multiples of three or six, with adjustments staggered throughout the butterfly's tent shape? Probably not, given the new FINRA-dictated margining rules that will soon run you up short in margin available for your next trade. You might not be able to incorporate some other trader's adjustment guidelines because you just don't have the buying power to do so. Should you be selling naked puts if you're okay with a little risk but find yourself not able to sleep at night, even if you understand intellectually that the risk graph for a naked put is the same as a covered call position? Probably not. Should you be trading bonds if you've never done so but saw a convincing presentation on a bond trade that was tested from October 2010 to January 2011? Definitely not, since you're not familiar with the vehicle and it was in a specific market environment during that period of time. You don't know how the trade would perform under other circumstances. If you've never traded an iron condor, should you jump into AAPL IC's on the weeklies? No, you don't have any idea how iron condors behave one week before expiration.
That's the point. If we acknowledge the risk-taking part of our personalities, we'll perhaps be less susceptible and a bit more skeptic of every claim presented, no matter how alluring the data appears. We must question the circumstances under which the data was tested. Was it tested in all market environments, with at least 30 trades so we have at least a slight assurance that the conclusions are valid? How did the proponent of the new trading method account for slippage and commissions? A trading method that is sans commissions and does not accurately account for slippage may appear profitable on paper, but might experience drastically different results in real life.
Does achieving those profits mean that the trade is likely to experience several big theoretical losses during the life of the trade? If so, is your risk tolerance large enough that you can deal with those big theoretical but as yet unrealized losses? If you're too fearful or if your trading account isn't large enough, you'll be more likely to bail at the wrong time, never accumulating those profits. When I once tested a breakout trade, it was theoretically immensely profitable over the long run, but with far more losing trades than winning trades. I knew my confidence as a trader could not take that kind of battering, and I would be likely to feel so wounded that I would sit out the very trade that produced the big profit right after a string of losses. That trade just didn't fit my personality, as terrific as it would have seemed if someone else had presented it to me.
Before you jump on the next holy-grail trade, be sure you understand how the test was performed and also how it fits into your trading style, your experience level and your account size. Although you may be frustrated seeing others rake in profits, do your own testing. Trade small when you move into live trades. Don't be so afraid of risk that you can't trade at all, but don't be so enamored of risk that you reach for the bigger risk of an unexamined trade, either. Be aware that you're human and we humans sometimes opt for the excitement and risk whether it's good for us or not.