Comment by Phil

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Phil
January 16th, 2012 at 11:59 am

Verticals/Jomme – It's not very complicated.  Let's say you buy a $40 call for $3 and sell a $45 call for $2 and then you paid net $1 for a $5 spread.  So, if you are wrong, you lose $1 and, if you are right, you win $4 so, if we assume being wrong and being right are random events – you can be wrong 4 out of 5 times and break even.  If you sell the $45 puts for $3 and buy the $40 puts for $2, you get a $1 credit and have made the exact same bet (that the stock will finish over $45) and you are 200% ahead of the game to begin.  Unfortunately though, if we assume your chances of being correct are the same random event, then if you are wrong just one time out of 4 – you blow all of your winnings.  So, buying a vertical – odds 4:1 in your favor, selling a vertical – odds 1:4 against you.  The money you are paid up front is an illusion – it's the payment you get for taking an extreme risk and, like all odds payouts – you are being inadequately compensated for your risk.  That's why we prefer to BE THE HOUSE, and make those inadequate payouts to other fools who think they are smarter than the odds.  This is why the rich get richer – there is always some sucker willing to stick his neck on the chopping block in exchange for a little money up front – try not to be that sucker.  

As anyone who goes to the track hopefully understands, the odds derived in parimutuel betting are not a joke – they pretty accurately reflect the chance of each horse coming in the money.  You can never be certain and, in any given race the long-shot can win but anyone with a long-shot betting "system" doesn't last very long.  In fact, the entire reason the track exists is because the combined wisdom of a few thousand people who attend a race ends up losing more money than they make on a very regular basis.   Both the Mob and the State love the numbers racket – people love to pick random numbers chasing a big payoff.  Again – it's a suckers game, especially when a few percentage points are shaved off the payoff.   Casino games we've discussed in detain and options are no different except for one thing – with options you can BE THE HOUSE – on any options trade you can simply choose to sit on the other side of the table and be the guy who has the money to make the pay-off and, in exchange for that – suckers will line up TO PAY YOU MONEY to gamble and they will happily accept the fact that you are shaving the payouts by charging them a premium. 

There's nothing complicated about this.  I don't think AAPL will fall below $300 this year and there's a man willing to bet me $13.20 that it will, if I run that bet to Jan 2014, I can collect $28.50 as short-term VIX is lower than long-term VIX at the moment.  That's $28.50 I get to put in my pocket today that is out of my put seller's hands today.  And, if I REALLY want to own 100 shares of AAPL for net $271.50, then the $30 of margin would be inconsequential.  $30 is how much risk my broker (TOS) thinks I'm taking selling this put and BELIEVE ME, they are professional odds makers and are very conservative in assessing margin risk.  In fact, if they assume I am a professional in my Portfolio Margin account, my margin charge is a token $3 – a more accurate reflection of the real risk against AAPL's current trend.  

So, if I have $41,981 to buy 100 shares of AAPL and I expect it to go up 10% this year, I can buy the stock and perhaps hedge my investment (which would eat into my potential profits) and I would need AAPL to go up 13.5% in order to make $5,700 against $21,000 in margin tied up.  On the the other hand, if I sell 2 2014 $300 puts for $28.50, I collect $5,700 TODAY and tie up $6,000 in ordinary margin and my worst case is owning 200 shares of AAPL for net $54,300 so my "risk" is spending $12,319 more than I intended but, for that, I get 100 more shares of AAPL at net $123.19 a share.  If you don't REALLY want to buy 100 shares of AAPL for $123.19 then WHY THE HELL would you be buying 100 shares at $419.81?  

This is VERY SIMPLE STUFF folks.  It mainly requires you take a longer-term view of things and develop the BELIEF that the stocks you buy have an actual value.  It requires you to stop chasing idiotic momentum stocks that may not even exist 5 years from now, it requires you to pick stocks based on their own merit and not based on how loudly some monkey on television screams about them.  It requires patiently waiting for a good opportunity to buy and it then requires PATIENTLY riding out fluctuations in the PRICE of your stock.  

You will not get a rush out of investing this way, you won't have fantastic stories to tell people about your 800% gains and your friends will not think you are a genius as you make 10-20% year after year after year – this is the opposite of gambling – this is selling risk to others and letting statistics to the rest and it's also not foolproof because even the best casinos in the World have losing quarters and even losing years (Berkshire Hathaway has had 9 losing years out of 47 – 20%) so you can't over-extend yourself, which makes it even duller the first 5-10 years you pursue this strategy as you stay 50% in cash.

The only way to learn to be the house is practice and patience.  Most casino owners start out as gamblers and wise up later in life and move to the other side of the table.  The same can be said for Investment Bankers and Hedge Fund Managers – they start out as traders and then realize the real money is made collecting fees while others take the risks.   If you could make more money as a trader than a fund manager – why are there no traders in the year's 100 top income producers?  Who's the richest gambler you know?  

These as simple truths that people don't want to accept because it means there is no "system" and no way to "get rich quick."  This is getting rich slowly and it's certainly not as much fun – we're teaching a trading discipline to those who want to learn – if you want to gamble – that's what the other 10,000 stock sites are for…