The following is an email response by Christopher Ebert to the article “New Reflections on Understanding Options“. Christopher will be joining Zentrader.ca as an options contributor.

Options certainly are strange creatures; but, stranger yet, are the minds of the men who study them.  I give John Douglas credit for attempting to shine light on the world of options, or perhaps more accurately, cast a penumbra on the world of options, at the risk of revealing the unique inner workings of his own mind.  Thankfully, his willingness to publicize these seemingly odd thoughts may result in a benefit to those of us who find ourselves coping with our own strange option-trading minds, by validating our own paradoxical manner of thinking.

Reading this article brought my mind back to a childhood memory from nearly a half-century ago; listening to Judy Collins’ “Both Sides Now” as it played on an AM radio in the family car during a thunderstorm. How times have changed!  Technology has affected everything from popular music to option trading.  Music quality improved greatly with the advent of FM radio, Compact Discs and MP3s.  But, an MP3 of “Both Sides Now”, while devoid of the turntable crackle and punctuating thunderstorm static so common on AM radio just a few decades ago, is still the same song it always was.  The same logic applies to options; no longer are they primarily traded by means of telegram between a farmer and his broker; they are now instantaneously available to anyone with a brokerage account and access to the web; and yet, options are still options. An option contract from the 1960s is virtually the same as one from 2011. True, they may be easier to access these days, speedier to open and close, and more uniform in price structure; but they still work in the same manner.

Not only have the workings of options remained unchanged, but human nature has proved constant as well. How then, can we use the wisdom of John Douglas to make us better option traders?  First, we must heed his warning that the market is full of shadows and illusions. Technology gives the illusion that profiting from options is a task so simple that it is as easy as downloading an MP3 music file.  The constant bombardment of advertising, coupled with a nearly endless supply of “how to” articles, bolsters the illusion.  We need to learn how to recognize illusions for what they are.

Once we are aware of the illusions of the market, we must then attempt to understand the distortion of perception due to our own human nature.  Is our aversion to risk so severe that it would cause us to choose a 100% chance of gaining $3000 rather than an 80% chance of $4000?  As successful traders, we need to be aware that risk aversion is a risk in-and-of itself.  We must seek to avoid allowing our fears to lure us into a risk free world of virtual trading that falsely inflates our confidence by giving us gains of huge amounts of imaginary dollars. Real trading is never the same as the illusion of paper trading.

Who among us would be reassured to learn that the doctor performing our surgery had successfully completed the same operation, dozens of times, every one of them on a simulator? I suspect few of us would; but if we distort our perception of reality, basing our real life trades solely on a fantasy made up of emotionless and risk-free back-testing and paper trading, we are doing the equivalent. Still, simulators can be valuable learning tools, but only if we do not accept the illusion of success as reality.

So, we are left with a dilemma; do we take the easy way out, follow the illusion, and hope for the best; or do we take the time necessary to gain an understanding of options from every possible perspective?  In choosing the latter, many of us may be surprised by the results.  We may find it to be merely an illusion that covered options are safer than naked ones, or that long options are preferable to short ones.  We may see the hurdles our risk-averse minds are placing in our paths, when they cause us to seek the relative safety of owning harmless pets such as butterflies or condors that rarely do anything more than flutter about aimlessly and gobble up commissions.  We may acquire a new affinity for spreads, straddles or strangles. Whatever the outcome, we will have cast away the illusion, focused our attention on the penumbra, and looked at options from a different perspective; and having seen options from both sides, been able to admit to ourselves that as much as we thought we knew about options, we really didn’t know options at all.

 

One Response to “Seeing Options From Both Sides”

  1. Eric Von MarketShot III Says:

    I love this post.

    “…as we thought we knew about options, we really didn’t know options at all.”

    So true my friend, so true.

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