Modern Option Trading – An Introduction
At Quartzite Risk Management LLC (Quartzite), we think options are an essential part of almost every hedging strategy. Though, if you hang around a retail brokerage office long enough, you’re likely to hear one of the following, maybe you’ve even said one of these yourself:
“Ninety-percent of options expire worth nothing. Why would anyone ever buy options?”
“I’m never buying another put, even when the market goes down, they don’t work.”
I’ve heard dozens of variations on the first statement. The percentages bounce around, and I’m never quite sure where to find the data that supports the claim. Or, for that matter, how anyone could calculate the percentage with any accuracy. First, in-the-money options are frequently exercised/assigned or otherwise closed before expiration. So, if traders often close in-the-money positions before expiration, wouldn’t the data about expiring options be biased to show mostly out-of-the-money options? Second, what if a trader buys an option to protect a market position, and the option expires worthless, but the trader’s market position profits more than the premium of the option? Did the option expire “worthless” in the purest sense? In this case, the option position allowed the trader to hold the winning market position comfortably, so it created value for the trader above-and-beyond its expiring value, right? Third, the statement itself is flawed in its understanding of how professional traders approach options trading. Options market-makers, the people who buy and sell options for a living, tend to think of options as part of a broader portfolio. This collection of options is actively managed as a whole – not as standalone or buy-and-hold investments. Suffice it to say, without diving into the very deep rabbit-hole of modern option trading practices; the statement misses the point almost entirely. At Quartzite, we believe options can play a valuable part in the ongoing process of risk management. To do so, they need to be managed appropriately as part of a more extensive risk management portfolio – not purchased and forgotten.
I’ve heard the second statement more times than I care to remember as well. In my experience, it is usually uttered by someone who was “advised” that “something is better than nothing.” It’s true; something is often better than nothing. Though, if a producer buys an out-of-the-money put to protect his crop, and holds that put to expiration without making any adjustments, it can be worse than nothing. If the market falls, but not beyond the put’s break-even price, the producer faces losses on both the crop and the put. At Quartzite, we firmly believe risk management shouldn’t compound problems. That’s why we work hard to implement modern option strategies that protect against - not compound - adverse market moves. And this is why we generally insist on viewing options as part of a broader risk management strategy.
It’s no wonder many hedgers (and even their brokers) don’t possess the information they need to make sound choices when using options. Modern option trading is complex, and useful information, at least in our opinion, is generally tucked-away in dense, boring books filled with complex mathematical equations. Or that information is passed down from trader-to-trader inside the walls of proprietary trading and options market-making firms – far away from the sight of the typical end-user. At Quartzite, we hope to use our knowledge and experience in modern option trading to help producers find practical solutions for managing their risk.
