Friday, October 5, 2007

Options Education : Opinion versus Fact!

The most basic aspect of trading is learning to differentiate between what is FACTUAL and what is OPINION. If you stay interested in the financial markets long enough you will discover that there are a lot of sharks out there who have become expert at making that task very difficult.

Several subscribers of this newsletter have contacted me over the last few weeks asking for my opinion of certain promoters who also advocate Options Trading Strategies. I make it a point to not comment on other services. However, without mentioning any names I feel that it is necessary to inform you of some of the most common and deceptive practices used by some promoters.

One of the great appeals to Options trading is that there are so many possibilities and trading strategies that can be used to manage risk. However, most services when promoting options like to demonstrate the tremendous REWARDS that are achievable. Although tremendous gain is possible, options are considered speculative instruments and potentially very risky in untrained hands. Since an Option gives the owner the right to buy or sell something for a specific period of time the OPTION is considered to be a deteriorating asset. Since all options have an expiration date, if all things are considered equal, the closer you get to that expiration date the less that the option will be worth.

There is an abundance of literature available on OPTIONS written primarily for locating and marketing to the GREEDY INVESTOR. One promoter who charges over $3,500 for his seminars on Options Education touts that investors in his seminars earn returns in excess of several thousand percent per year! He provides and documents several real time examples and shows how some traders made a 12,000% annualized return. (Just in case you thought that was a typo that is twelve thousand percent!)

My statistics teacher in college used to say that "The figures don't lie, but liars figure." Listen Up....because if you don't learn how to read the fine print that these deceitful promoters espouse you too will make those types of returns but probably won't be able to pay your rent!

Most traders enter into the financial markets seeking that ONE home run trade that will permit them to check out of the rat race. Knowing this FACT deceitful promoters arm themselves with examples that will lead you right into their arms. Here is a common example of their con in action:

Let's say that you purchased an OPTION at $1 per share. On that very same day the market moved in your direction and you were capable of selling that option at $1.50 per share. Since Option contracts are all standardized sizes of 100 shares your net profit before commissions would be $50. You also would have established a profit of 50%. This is a great return considering that most money managers earn 15% a year!

To determine your Return on Investment you only need to divide your net profit by your initial investment. In this instance you had a 50 cent profit per share on an initial investment of $1 per share.

Now the promoters bait the hook....... Even though your profit was $50, your return on investment was 50%. This is indeed factual. Think of how EASY it was to earn that return, after all you did it in only one day! So since there are 365 days in a year, to calculate an annualized return we would multiply 50% times 365. The result is a staggering return of 18,250%. (Now if your stomach is turning by this type of deceit, GOOD!)

I offer you the MATH below:

Buy Price 1

Sell Price 1.5

Profit $0.5000

Gross Profit $50.00

% Return 50%

# of Days 1

# of periods in a year (365 days) 365

Initial $ Investment $100.00

Net Profit $50.00

Annualized Return 18,250%

Now what infuriates me about these promoters is how successful they are at providing the public with this type of "financial snake oil!" One promoter in particular has actually written a best-selling book on options that is filled with these types of misleading and deceitful computations. Hard to believe but an 18,250% return will barely pay for the price of the book!

Although this is a technical point. many of you have probably realized that the above example is further complicated by the fact that the financial markets are not open 365 days a year. If you take weekends and holidays into account you literally only have 252 days to play with. So the more mathematically oriented con men would offer you the following calculation:

Buy 1

Sell 1.5

Profit $0.5000

Gross Profit $50.00

% Return 50%

# of Days 1

# of periods in a year (252 days) 252

Net Profit $50.00

Annualized Return 12,600%

Hey 12,600% annualized return...sure beats those low yielding MUTUAL FUNDS!

Now, I wish I was making this stuff up, but my mailbox is filled everyday with variations of these examples. No mention is ever made of the fact that your profit BEFORE commissions was $50 bucks which is not bad and might pay for DINNER out on the town.

This may seem extremely elementary and basic to many of you. However, I have seen many extremely successful individuals taken in by this type of deceit. I think you'll agree that although the numbers are accurate they are completely unrealistic and the INTENTIONS of the promoters are what is in question. Nonetheless, you'd be surprised how many $3,500 seminars the above example will SELL.

The financial markets only require one thing of you if you are to be successful and that is that you manage your risk on each and every trade. THERE IS NO OTHER SECRET. In my own trading I must admit that it took me years to learn how to TAKE a LOSS. Once I learned how to lose and accept it as part of doing business my trading dramatically improved. Although I consider this to be among the most profound truths that I have learned regarding trading I readily recognize that it is nowhere near as marketable as promoting 18,250% returns. Or was that 12,600%? After all 50 bucks IS 50 bucks!

Sometimes it is difficult to differentiate between FACT and OPINION. In those instances I heed the words of the great Yogi Berra, "You can observe a lot by just looking." Nuff said.

Next article I'll get back to LOW RISK trading ideas in these high risk markets.

Study away.....and remember, let's be careful out there!

-Harald Anderson

Harald Anderson is the founder and Chief Analyst of a leading online resource of Options Trading Information. He writes regularly for financial publications on Risk Management and Trading Strategies. His goal in life is to become the kind of person that his dog already thinks he is.