efficient, level playing field the financial markets have ever known.
It is time for two tired, worn-out metaphors to make their appearance. Why? We will discuss them because they are accurate and illustrative. The first one we just discussed. But I want to reiterate it because it holds the key to successful, profitable options trading. Let’s think about an insurance company and how they price their products. An insurance company takes in (relatively) small amounts of premium from each customer on a regular basis in order to cover large amounts of risk for the customer. They hire a staff of actuaries, highly trained in math and probability theory, to look at the probabilities of disaster occurring, amount of average loss, and so on. They determine the amount of premium they need to charge to give the firm a certain percentage profit in the long run while protecting the firm from catastrophe in the short and long run. They know that a certain number of their customers will make large claims (meaning occasional large costs for the insurer). These are the same things we do as options traders. If we are premium buyers, we are the insured, buying a policy from our insurance company. We generally pay more than the option is worth for the protection or, in the case of options, unlimited profit potential it provides. If we are a premium seller, we are the insurance company. We sell options for more than they are worth, win on a high percentage of trades, but have an occasional larger loss as part of our trading life. In general, short premium is the winning strategy for options trading, just as most insurance companies make money. The small amounts of premium consistently collected more than make up for the occasional large loss.
The other metaphor is one I hesitate to use as it can easily be misconstrued. I will try to make it clear. If you go to the casino every month for the next 10 years and play craps, roulette, or the slots, you will almost certainly come up a loser. The term “gambler” in my mind points to a person who is playing “against the odds.” That is, they do not have the odds in their favor but are nevertheless hoping to overcome them. Though this can be done in the short run, it is highly unlikely you will do so in the long run. Using this definition, casinos do not gamble. Rather, they have the probabilities working for them and they know if they do one thing correctly, they will be profitable. What is that one thing? Sizing bets made in their casino properly. My guess is if you were to walk into a casino and slap $1 billion on the pass line of a craps table, the casino would not take the bet. If they have the odds on their side, why wouldn’t they take the bet? Odds work only if you have a high enough number of occurrences. So, for a single bet, the casino would not risk losing that amount of money. Now, if the same gambler came in and wanted to bet that same $1 billion in $100,000 chunks, that would be a different story entirely. The casino would take all 10,000 $100,000 bets. In fact, the pit boss would probably be looking at a nice bonus if he got you to split up your bets that way and stay at his casino. Why the difference? He is not gambling. He is going to win because the odds are in his favor and the number of occurrences facilitates the odds getting to work their magic. Also, the casino is now able to withstand the maximum drawdown it might incur while the odds have time to “do their thing.”
CHAPTER 2
What to Look for in a Broker
Before you trade any financial instrument, you must open a brokerage account. Yes, more paperwork! But for many, that is not the worst part. There are many terms and concepts embedded in the paperwork that are foreign to most new investors. And there are many warnings as to the risks of various types of investments. In fact, there are additional risk disclosures specific to options you must read and sign when you open an account that allows options trading. But what brokers do not warn you about are the risks that are inherent in choosing the right brokerage firm. What do I mean by that? Let’s explore the topic in more depth.
Most people are comfortable putting their money into banks. They are sure that when they drive to their local branch and ask for $300 to do some shopping, the bank will comply. They are also comfortable that when they choose to withdraw large percentages of their accounts, the bank will not have a problem coming up with the funds. This is particularly true for larger banks. Despite some times of distress, such as our most recent financial crisis of 2008–2009, the fact that the government-run FDIC (Federal Deposit Insurance Corporation) insures accounts for up to a total of $250,000 for each deposit ownership category in each insured bank lends further security to the depositor. But what do banks do with your money when you deposit it? If you are to be truly comfortable, shouldn’t you know what happens with it when you drop it off? Well, very soon after you drop your money off, the bank is out loaning it to someone else or to some other business. Of course, everyone who has heard George Bailey in It’s a Wonderful Life proclaim, “I don’t have your money. It’s in Tom’s house … and Fred’s house” knows that! It is what banks do. That is their business. And it is for this exact reason that 2008 and 2009 were such terrible years to be a bank. The real estate crisis put tremendous stress on banks’ balance sheets as many loans became uncollectable. And it is for this reason that the government insures bank accounts. So, why am I convincing you of the safety of your bank account when we are talking about brokerages? Well, in my opinion, if you choose the proper brokerage, your money is even safer there. When you deposit funds in a brokerage account, your financial institution has a legal obligation to segregate your funds into a separate account for your benefit. In other words, your funds will not be at risk if Tom or Fred loses his job and cannot pay back his loans. Furthermore, though the FDIC does not cover your account, it is in fact covered by SIPC (Securities Investor Protection Corporation). And it is covered for $500,000, $250,000 of which can be in cash. In total, it is covered for twice that of your bank account. Of course, this protection does not extend to trading losses or fraud. (We will get back to this point.) Rather, it covers you against your brokerage firm going bankrupt due to less nefarious reasons. But SIPC is not a government-run (or funded) corporation. It is funded by the member firms that are covered by SIPC. So, though SIPC is there to protect you, just as when you choose a bank, there is no reason to tempt fate. You do not want to rely on the “safety net” under your account. So, let’s look at further steps you should explore to protect your money.
Just as the small, local bank down the street is enticing, but fails to have as much “room for error” as the large bank in town, a large brokerage firm is generally a safer bet with less risk of losing your funds. Though I suppose that statement can be subject to debate, let me explain my reasoning. First, large brokerages, by definition, have deeper pockets. Thus, just as JP Morgan Chase was able to easily withstand losses from the “London Whale’s” trading as a result of its deep pockets, a large brokerage can likewise withstand losses caused by errors. Furthermore, large brokerages do not start out as large institutions. They have paid their dues and are usually run by experienced industry professionals with expertise far beyond those of most small firms. They have generally also “vetted” their policies and procedures to be sure they are proper and safe and work in all (or virtually all) market conditions. Larger firms also generally have instituted what we call “enterprise risk management policies and procedures.” These are designed to add safety against all known risks to the firm. But the risks that I pay closest attention to and that I have the most exposure to are those related to trading.
If you have been around floor traders for any length of time, one comment you might have heard is, “My clearing firm’s risk managers are pains in my behind!” I cleaned up the language (more than a little), but you get the point. This is one area in which I believe professional traders are misguided. For me, I am happy when the risk manager calls. In fact, before I open an account, most of my questions for the sales team center around their trading risk management policies and procedures. And once my account is open at a firm that I have little experience with or knowledge of, the first thing I do is run up my risk just beyond my limit. Why? I want to be sure the trading risk managers are on the ball. If they do not call me, I do not consider it a courtesy or a blessing. Quite the opposite! If they are not calling me concerning my risk, they are not calling others about their risk either. A market breakdown could then put the firm at risk of losses beyond their ability to cover, thereby putting everyone’s
