“Anyone, Anyone?…” – Ben Stein from Ferris Bueller’s Day Off
Last week I had the opportunity to be a guest speaker for the undergrad finance derivatives class at the University of Calgary. I like to do this every semester at U of C and SMU in Dallas. I highly recommend it to other traders out there. The idea is simple. Give the students a “real world” perspective about what it is like to trade. In such a classroom setting, I like to start off by saying that what they are learning can be tossed out the window when it comes to making money in the market on a consistent basis. That’s when you usually start to see the finance prof squirming in their seats. Take that as a good sign. Try it. Don’t worry, your fellow traders “got your back”. Overall, I find it fun and quite rewarding to speak to such a group. If that sounds like something that may interest you, just contact the finance chair at your local university. Be prepared, though. These whippersnappers are sharp and bright even the students in the back row.
How did it go? I gave them the secret sauce to trading then we called it a day. You know, buy low, sell high. Case closed. Ok. That’s not true, but I can say that no one fell asleep and I was able to get through the presentation even without using the old trust worthy overhead projector. That’s a positive. The other positive is that I was able to not look like the guy on Broadcast News during his first t.v. anchor segment…check out the movie, you’ll get it.
There were two takeaways from this last presentation that stood out:
First, finance at the university level is too theoretical, less practical. That needs to change and it’s the main reason I like to do this as I, too, was once a finance student.
Second, if you find yourself in front of such a crowd, don’t answer any questions from anyone in the front row. I warned you! If you do, be prepared. This one front row student asked a great question, which I commend him on asking. It takes a lot of courage to stand up for yourself in front of your classmates especially in front of a sweating middle age guest speaker who once placed his first trade by calling his broker. “That’s like…old, you know?”
The front row student’s comments (paraphrased):
I get it that you can do better with selling options, but I disagree completely. Buy and hold in solid companies that are fundamentally sound (ie. the Motley Fool, Warren Buffett, Benjamin Graham approach) can generate high returns while carrying less risk than doing your options thing over the long haul.
You little punk! Who invited you to this party!? Ok, thoughts are one thing, but I was on a roll and then to get upended by this front row student? Don’t worry, I recovered quickly.
My real response:
Thanks for that astute observation. (I should go into politics). Taking a fundamental approach to stock picking is fine and can be quite profitable over the long run, but you might be better off using options on that stock instead of buying stock out right. Let’s break my response down into the following four categories. By doing so, you’ll see that options can outperform buy and hold, which might come as a surprise. At the same time, I’m not saying put your whole nest egg in the options world. Diversification of asset types is key, but let’s just address buy & hold as you are advocating.
So, why do options work? Let’s take the simple example of selling an ATM (At The Money) Put mechanically month after month versus buy & hold on a fundamentally sound stock.
1. Assuming “no leverage”, selling a cash secured ATM Put will outperform buy and hold. See the following link. It’s on the S&P500 but it can also be applied to individual underlyings as well. You will see in the video that the returns are higher, risk is lower and to top it off with a cherry on top the sharpe ratio is higher for the ATM Put versus buy & hold.
2. Assuming “leverage”, selling a put and buying a call ATM is 100% the same as owning the stock; it’s called a “synthetic long”. The difference is capital required. Thus, options allow the investor to take on the same position as buying stock out right while costing less. This leaves more cash available for other investments or hedging strategies.
3. Assuming a market crash, let’s compare the two. The ATM Put has a delta of 0.5, while the stock carries a 1.0 delta. That means the long stock portfolio is already more exposed to downside risk even if the market falls by one tiny point. I am not even mentioning the breakeven for the trade using the ATM Put, which is the strike price less the premium received. In addition, most options traders place at least 50% of their portfolio in cash while the long-term portfolio will have a small cash position. All of this helps to reduce the pain during a market drop.
4. Assuming a market melt up, the long stock portfolio will do better (hey, I had to help the kid). However, we all know that stocks normally do not move up and up and up without catching a breathe every now and then. Refer to the video in the first point above.
Verdict….he wasn’t impressed, but I was and that’s what counts! I didn’t even have to pull out the old trust worthy trump card of the M3 or Bearish Butterfly, but so how I wanted to. However, I did mention how the Bull trade has beaten Warren Buffett two-fold from the period of 2002 – 2014.
So, whenever any of you fellow traders think you need a break from trading, head on down to your local derivatives class and let them know how it is. It really is fun and rewarding. Also, please feel free to shoot me an email and I’ll forward you my presentation as a kick-starter. Don’t worry, it’s in Powerpoint not on one of those old plastic sheets used for overhead projectors.
How did the class session end? Well, I can say that front row boy and I are now Linkedin buddies! One step at a time and we’ll win them over. Until the next finance class….
Written and contributed by John Wilson