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Friday, November 21, 2008

Think Before He Trades

You gotta love YouTube... Here's one that was posted on our message board and I thought you might enjoy it.



Sunday, November 9, 2008

Radioactive Trading Review Redux

A few moments ago I commented on the Radioactive Trading blog to a post addressing the relationship between a long call and a married put. I am re-posting my commentary below, just to keep the record clean.

Before I do that, I want to re-visit the reasons why TheOptionClub.com came into being. I, and a small group of other people, were studying the subject of options and trying to discover how best to trade them. One problem we encountered was that there were a lot of folks out there selling what they said was the best way to trade. Some of the information was really great. So of it was nonsense.

My friends and I formed a group for the purpose of separating the hype from reality, fact from fiction, and simply drill down to the truth about options and trading. That's what TheOptionClub.com is about...learning about how options really work and how they can be used for legitimate trading and investment purposes.

So, my commentary about married puts, call options, and the Radioactive Trading Blueprint are offered in exactly that spirit. I encourage you to learn as much as you can about trading, investing, how options work, and how you can benefit from their use.

Kurt,

It is interesting that this debate about whether a married put and a call option are synthetic equivalents persists. For what it's worth, it's not just Chris Smith that says so...

"This position [the married put] is also called a synthetic long call, because the profit graph is the same shape as a long call's." McMillan, Options As A Strategic Investment, (4th Ed., 2002, New York Institute of Finance), p. 271.

"Many conservative investors purchase stock and then add a protective put to their position to hedge their risk. What they fail to realize is that this position has the same exact risk/reward profile as a long call but at a significantly higher cost." Jabbour and Budwick, The Option Trader Handbook, (2004 Wiley & Sons), p. 45.

I could quote more, but is it even necessary? The point is that it's not Chris Smith who is saying that the positions are equivalent. It's Myron Scholes. It's Fischer Black. ...to argue otherwise means that you have found the Black-Scholes option pricing formula defective.

Come on...

The point to understand about the risk free rate of return is that a call option allows you to adopt an identical risk/reward position as a married put, but with significantly less capital. The market, and the Black-Scholes formula, recognize this and price the positions accordingly.

Is a call option better than a married put?

No. It provides a risk/reward ratio equivalent to owning a married put.

A call option is more efficient, however. Less capital is required for the trade. You have one commission to get in and one to get out, compared with the married put's two. It's also easier to set up a "stop" for automatic execution.

You argue that married puts are better for those who cannot, or will not, apply risk management. I guess we could go with that, but if someone is that lacking in discipline I doubt that they would do the homework necessary to trade any option position.

My guess is that your successful students are diligent and dedicated. If they were not, they would not be successful. At least not in the long term.

Your position adjustments are not simple. They are quite sophisticated, in fact. Those adjustments move your students into some pretty complex multi-legged positions, which is another reason not to create confusion about what position they're actually holding. It's demanding work and requires discipline. If they can handle that, I'm thinking they can handle position sizing.

By the way, the counter argument to the "automatic position sizing" is that the lower capital requirement of the call option provides the investor / trader the choice of whether to accept a risk free rate of return or seek higher returns. Could that lead to over leveraging? Absolutely. But as you and I have discussed there are also good investment opportunities out there that return better than the risk free rate.

The call's low capital requirements also make your core strategies tradeable in a small account. Why not provide the alternative?

So, what about the guy who buys company stock in his retirement account? Does it make sense for him to trade a married put? Quite possibly... It would also make sense for him to sell a portion of the position as soon as he is able to diversify his holdings.

It just seems to me that the married put is being portrayed as more than it really is. It is a legitimate option strategy with real purpose in today's market. It is not always the best tool for any given job, however.

As I said in my review, I agree that The Blueprint has quite a bit to offer. It's greatest contribution, in my opinion, is the tireless focus upon risk management and trade planning.

Where I think it does a disservice is in its mislabeling of option positions and the portrayal of the married put as the ultimate option strategy. This only leads to later confusion as Radioactive Trading students begin expanding their knowledge. Your indication that this will be resolved in future editions is a positive step towards making The Blueprint more valuable.

I would encourage those same folks who were "burned by the snake oil gurus," as you say, to learn the true facts about options and how to use them responsibly. This may very well mean taking advantage of the benefits that The Blueprint offers, but it would also include expanding their knowledge and understanding so as to fully appreciate how options work.

Christopher Smith
TheOptionClub.com

If you're interested to read my review, it remains available on our website.


I do think that Kurt Frankenberg has done a very nice job of putting together a trading plan for married puts. The reality is that sometimes a married put will make a lot of good sense, but that often you will have better choices available to you. Sometimes that choice will be the purpose of a long call option.

The best lesson Kurt offers is on risk management. We could discuss trade planning as there are many adjustments choices offered