and Hedging with Agricultural Futures and Options, McGraw-Hill, 2001
Trading options
1. Know the difference between using options to speculate and using options to invest.
Speculators are pure traders, short-term market timers with little interest in the underlying stock, and they often use a high degree of leverage. Investors, however, use options to buy, sell, protect, or increase income from stock positions, and investors do not use leverage.
2. Have a plan.
Will a purchased option be exercised or sold if it is in the money at expiration? Covered writers must know whether or not they are willing to sell the underlying stock; if not, at what price will the call be repurchased or rolled to another option? Put writers must know whether or not they are willing to buy the underlying stock; if not, at what price will a short put be repurchased, even if at a loss?
3. You need a three-part forecast.
In option trading you need a forecast for a specific price change in the underlying, for a specific time period and for a specific change in implied volatility. Developing a forecasting technique is a challenge for all traders, but options trading is unique because of the multi-part forecast required.
4. Be disciplined in taking profits and losses.
Have a profit target and close or reduce the size of your position if it is reached. Have a stop-loss point and close or reduce your position at that price. Have a time limit and close or reduce your position if neither the profit target nor the stop-loss point are reached by the end of the time period.
5. Understand and pay attention to implied volatility.
Implied volatility is the volatility percentage that justifies the market price of an option. Volatility in options corresponds to the risk factor in insurance, and implied volatility reflects the market’s perception of the risk, or potential price range, of the underlying stock.
6. Implied volatility has no absolutes.
Option users must develop a subjective feel for what are ‘high’ and ‘low’ levels of implied volatility.
7. ‘Buying under-valued options’ and ‘selling over-valued options’ are not sufficient strategies.
You must focus on your three-part forecast as much as or more than the ‘value’ of an option.
8. ‘Selling options’ is not a better strategy than ‘buying options’.
It is a myth that 80-90% of options expire worthless. Approximately one third, or 33%, of options expire worthless while 10-15% are exercised, and the rest are closed prior to expiration.
9. Trading means buying and selling.
Trading does not mean buying and holding! The goal of trading is to make a net profit after a series of trades. It is, therefore, essential to accept some losses and to look forward without chastising oneself for making mistakes.
10. Trading options is a learning process.
As a beginner, you should enter trades that have only small potential profits or losses, because this will ensure that objectivity can be maintained. Trades must be initiated and closed so that a ‘trading rhythm’ is developed. You need to develop a market forecasting technique and you should be able to explain your trade selection process in a few sentences. Almost anyone can learn to trade if they spend a few hours every week developing their technique.
John C. Bogle
John C. Bogle is Founder of The Vanguard Group, Inc., and President of the Bogle Financial Markets Research Center.
The Vanguard Group is one of America’s two largest mutual fund organizations, and comprises more than 100 mutual funds with current assets totaling more than $500 billion. Vanguard 500 Index Fund, now the largest mutual fund in the world, was founded by Mr. Bogle in 1975. It was the first index mutual fund.
For his ‘exemplary achievement, excellence of practice, and true leadership’, Mr. Bogle holds the AIMR Award for Professional Excellence, and is also a member of the Hall of Fame of the Fixed Income Analysts Society, Inc.
In 1999, he was named by Fortune magazine as one of the investment industry’s four ‘Giants of the 20th Century.’
Books
Bogle on Mutual Funds, Irwin, 1993
Common Sense Mutual Funds, John Wiley, 1999
John Bogle on Investing: The First 50 Years, McGraw-Hill, 2000
Common sense investing
1. There’s no escaping risk.
Once you decide to put your money to work to build long-term wealth, you have to decide, not whether to take risk, but what kind of risk you wish to take. ‘Do what you will, capital is at hazard,’ just as the Prudent Man Rule assures us.
Yes, money in a savings account is dollar-safe, but those safe dollars are apt to be substantially eroded by inflation, a risk that almost guarantees you will fail to reach your capital accumulation goals.
And yes, money in the stock market is very risky over the short-term, but, if well-diversified, should provide remarkable growth with a high degree of consistency over the long term.
2. Buy right and hold tight.
The most critical decision you face is getting the proper allocation of assets in your investment portfolio - stocks for growth of capital and growth of income, bonds for conservation of capital and current income. Once you get your balance right, then just hold tight, no matter how high a greedy stock market flies, nor how low a frightened market plunges. Change the allocation only as your investment profile changes. Begin by considering a 50/50 stock/bond balance, then raise the stock allocation if:
1. You have many years remaining to accumulate wealth.
2. The amount of capital you have at stake is modest (i.e. your first investment in a corporate savings plan).
3. You have little need for current income.
4. You have the courage to ride out the booms and busts with reasonable equanimity.
As these factors are reversed, reduce the 50 per cent stock allocation accordingly.
3. Time is your friend, impulse your enemy.
Think long term, and don’t allow transitory changes in stock
