Be Careful about New Trend in Trading Options Strategies

Despite some typos an interesting story appeared on Bloomberg recently.  They reported that investors are starting to follow “the smart money” by watching for unusual movement in futures trading options.

If you are not well-versed in trading options you should study the basic concepts carefully and do a little research to see how powerful investors use trading options to make money.

In brief, trading options are contracts where one party agrees to sell shares of a stock (or mutual fund) at a specific price to another party. If the buyer determines when the sales occur these are called Call Options and if the seller determines when the shares change hands then they are called Put Options.

As we noted in a previous article, Warren Buffett makes a lot of money on trading options but he has the financial clout to dictate the terms of his deals. And if market conditions go against Buffett’s plans (as sometimes happens) he still has time to adjust the contracts because he sells 5, 10, 15, even 25 years in advance.

The seller of an options contract collects a fee up front from the buyer. This fee obligates the seller to provide the shares at the agreed-upon price when the contract is closed out. The buyer, however, has the right to walk away from the deal without buying the shares. And this sometimes happens.

What the Bloomberg story notes is that smaller investors are starting to follow in the footsteps of large investors who enact significant options activity. But whereas the large investors like Buffett may be able to renegotiate their contracts (often incurring “kill” fees or providing rebates on the final purchases), smaller investors may not be able to do this.

According to Barron’s, most people lose money on trading options. Options contracts are now written for two different groupings of shares: you can buy/sell 100 shares in a “standard options contract” or you can buy/sell 10 shares in a “mini-options contract”. Experienced traders are somewhat skeptical of the value of the mini-options market, as it will appeal more to small investors because of its lower costs (and lower returns).

It will be more difficult to make money on a mini-options contract and your partner may not be willing to renegotiate if the market conditions change more than you anticipate. Also, small investors don’t have the large cash reserves to work with that major investors have. Warren Buffett’s famed trading deals are powered by the “float” that Berkshire Hathaway derives from its insurance businesses. In this context, “float” is determined as the amount of collected premiums that have not yet been paid back in claims (or used for administrative expenses).

“Float” money acts like a free loan but using “float” as working capital is only feasible if you have a sufficient cash flow to meet all your commitments when the obligations come due. If you as a small investor don’t have any “float” to work with then you are exposing yourself to greater risk of loss than a major investor with a large cash flow and “float”.

Hence, just because smaller options traders are riding the coat-tails of the big guns doesn’t mean all those little guys will make money just like the big guys. If you are buying options that means you are spending money up front which should be added to the cost of your final purchase; if you are selling options that means you may be locked into a selling price that is LOWER than the market price at the time the contract closes. If you don’t already own those shares you have to buy them in order to fulfill your commitment to whomever bought the options from you.