Trading Options II: Guiding principles (CODE)

March 2, 2021

Let me give you an interesting example. The investment world involves an enormous amount of high IQ people trying to be more skillful than normal. You can hardly imagine another activity that gets so much attention. And weird things have happened. Years ago one of our local investment counseling shops, a very big one, they were looking for a way to get an advantage over other investment counseling shops. And they reasoned as follows. We’ve got all these brilliant young people from Wharton and Harvard and so forth and they work so hard trying to understand business and market trends and everything else. And if we just ask each one of our most brilliant men for their single best idea then created a formula with this collection of best ideas, we would outperform averages by a big amount... So they tried it out, and of course it failed utterly.

The interesting thing about this situation is that this is a very intelligent group of people that’s come from all over the world. You’ve got a lot of bright people from China where people tend to average out a little smarter. And the issue is very simple. It’s a simple question. Why did that plausible idea fail? Just think about it for a minute. You’ve all been to fancy educational institutions. I’ll bet you there’s hardly one in the audience who knows why that thing failed. That’s a pretty ridiculous demonstration I’m making. How could you not know that?

Now at a place like Berkshire Hathaway or even the Daily Journal, we’ve done better than average. And now there’s a question, why has that happened? Why has that happened? And the answer is pretty simple. We tried to do less.

We never had the illusion we could just hire a bunch of bright young people and they would know more than anybody about canned soup and aerospace and utilities and so on and so on and so on. We never had that dream.

- Charlie Munger (March 3, 2019)

We continue our series on trading options. In this post, we discuss four principles of options trading which everyone under-implements:

  1. Capital efficiency,
  2. Opportunism,
  3. Diversification,
  4. Extrinsic value.

CODE for short. The unifying recommendation from all four principles is to trade lightly and defensively.

This is part of a series discussing our intended options trading strategies.

Capital efficiency

If you think you have a winning strategy - and you should, otherwise, stop trading now - you should use all of your capital to implement it.

Naively, this sounds like we are pressuring you to seek greater returns at the cost of adopting extra risk. However, it’s almost the opposite, or at the very least, not that simple. Capital should be viewed as a tool for not only earning returns, but managing risk while preserving the same (absolute) returns.

For example, in the context of selling puts, using all of your capital is the difference between

  1. selling a single at-the-money put while holding a lot of free cash, and
  2. selling several deep out-of-the-money puts on a diverse collection of underlying stocks.

One has almost a 50% chance of ending poorly, while the other has a vanishingly small chance of ending poorly.

Opportunism

There are many different stocks, most of which remain listed for many years, and each has a wealth of options contracts. You are not compelled to trade any one of them, at any particular time. You should use this freedom to your advantage: Save your aggressive trading for when you see blatant inefficiencies.

Food for thought: Stock pickers should research; options traders should explore. Stock picking profits from private information and knowledge. Options trading profits from public fear and exuberance.

Diversification

Diversify. Keep in mind that there are many ways to diversify, and you should use all of them. Here is a sample list:

  1. Trade in many different stocks.
  2. Trade in both small caps and large caps.
  3. Open both bullish and bearish trades.
  4. Sell options with many different expirations.
  5. Place your orders at different times, rather than all at once.

Extrinsic value

Options sellers profit from extrinsic value. It’s great if you can predict stock prices (and the flexibility of options helps mollify the correctness of your attempts), but the thesis for trading options does not require it.

The more controversial half of this principle is its contrapositive: Do not buy extrinsic value. The implications are surprising in the sense that many options sellers do not abide by them. Here are a few:

  1. Do not buy-to-close a contract unless it is justified by either capital efficiency or opportunism.
  2. Do not sell (narrow) spreads, due to the high extrinsic cost of the defensive leg.
  3. Do not roll an option early, unless it is deep in-the-money. Wait until it is near expiration or carrying little extrinsic value.