Read an Excerpt
There are two kinds of successful investors: those who admit to occasionally losing money and those who don’t. Despite claims to the contrary, every investor loses money because risk always scales in proportion to reward. Long-term winners don’t succeed by never losing; they succeed because their trades are well thought out and carefully structured. That said, very few investors recognize the impact of their own trading mistakes.
These mistakes can be subtle. The classic example goes something like this:
- “I bought calls.”
- “The stock went up, but I still lost money!”
This frustrating scenario in which an investor correctly predicts a stock’s direction but loses money is incredibly common in the option trading world. Leverage is almost always the culprit. More precisely, it is the misuse of leverage that stems from a fundamental misunderstanding of risk that so often turns investing into gambling with the simple click of a mouse. Option traders are famous for this mistake. They know, for example, that a sharp rise in the price of a stock can generate tremendous profit from nearly worthless far out-of-the-money calls. But lead is not so easily transmuted into gold. The problem is entangled with complex issues like collapsing volatility, accelerating time decay, and regression toward the mean. Institutional traders understand these issues and they rarely make these mistakes. Thousands of trades have taught them that not losing money is the very best way to generate a profit.
It’s the thousands of trades, winners and losers both, that separate professionals from amateurs.Option trading is just like playing chess: It requires study and practice. The comparison is more valid than you might think. Both chess and option trading are governed by a complex set of rules. Risk analysis is at the center of both games; so is positional judgment and the ability to react quickly. Chess players learn to identify patterns; option traders, in their own way, must learn to do the same.
This book is constructed around these themes. It is designed to let investors explore a vast array of rules and trade structures by solving real-life problems. This approach differs markedly from the catalog of structured trades that seems to have become the contemporary standard for option trading books. Many fine texts have been written on the subject, but most build on this design with slightly different organization or a few novel trading ideas. Collectively they miss the point. Learning to trade options is an active process, best accomplished through doing rather than reading and memorizing. In this regard we have avoided the familiar but bewildering list that includes names like “reverse diagonal calendar spread,” “condor,” and “short strangle.” In their place you will find more descriptive phrases like “sell the near-dated option and buy the far-dated option.” But, more importantly, these descriptions appear in the context of trading situations in which the reader is asked to make a choice, predict an outcome, or design a correction. Moreover, the problems build on each other with each section progressing from basic to advanced.
Our goal was to challenge option traders at all levels. So take your time, work through the problems at a comfortable pace, and, most important of all, make your trading mistakes here instead of in your brokerage account.
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