Options are cool — dedicated to Ron (Cove3)

Someone from the AMD message board whom I have learned to respect, Ron (Cove3) has criticized the existence of options and other ways to leverage investments, such as margin, because that infuses volatility on markets and become instruments of stock price manipulation. Since he is opposed to options in general, he also dislikes discussions in the message board about their usage. This friend is the one I have quoted most often in "the best message board posts" thread I (somewhat) maintain thanks to his excellent analysis.

But it happens that I strongly disagree with such negative notions about options and this post is an explanation of my reasons. This is very long, but one of my best essays ever as far as content is concerned... about the language... well, I also wrote in a rush.

To begin, let us not talk about equity options, let us talk about real estate investments.

Would you buy a house and not have it insured against a disaster? Perhaps you would prefer not to insure it, but I guess that you agree that insurance is a justifiable idea for investments that took probably decades for a family to acquire. Well, put options (options to sell) are precisely that: insurance for equity investments. Having insurance facilitates to some investors to put their money in those stocks, because through the combination of the shares and puts in the same amount (so called "married puts"), the investor guarantees a risk exposure of his choosing. Just like insurance, the higher the risks of a tragedy to happen, the higher the premiums. It is only reasonable.

On the other hand, is there a way to motivate employees, and especially upper management to collaborate with the well being of the company in a way that shareholders benefit? It may be not effective to stimulate them with plain shares, the relationship of capital to returns is too small, there is the need for leverage. On the other hand, the time frame at which share price appreciates may be too long as to make it impractical. Again, leverage is needed. For upstart and technology companies, which require top human resources and move in a very volatile environment, probably the only way to align the employees with the interests of the shareholders are the options packages. I have worked in companies that got my services because they offered me a participation in the success of the company itself through options: If I accepted the risks of the projects I was working on because I believed in those projects, and the projects actually worked, then I would receive significant benefits, despite the fact that I wasn't someone who had money to financially support the company. And there frequently are rules such as that to be eligible for an options package, you must work for some months/years, effective factors to reduce the very high turnover rates in technology companies, which produces economic inefficiency at large scales.

Thus, both kinds of options, to sell and to buy, have benefits.

Have you ever learned about the history of maritime empires such as Holland and England? Think about the times when, let's say, England ships navigated to China to commerce and bring back important products, in voyages that took upwards of a year fraught with all kind of perils: One factor that helped make them practically viable, for the benefit of those economies, was the existence of insurance. I am not good at analyzing the finances of a company, but I claim to be a good technologist. I love the idea of investing in the companies that have technology leadership because I think that the leadership ends up showing up all over the market. But AMD in particular is very volatile because of intrinsic reasons (at the same time it has huge possibilities, but equally huge uncertainties about succeeding). Perhaps I wouldn't have the stomach to commit the savings of all my life to investing in this company. Diversification may not work for me either, because all I would be prepared to invest in are technology companies with the same volatility problem, and I would be vulnerable to problems in the sector. No, for people like me the insurance that put options provide may be the difference between investing or not.

Just like insurance was born out of necessity and as a consequence of the development of markets, financial derivative instruments such as options and futures were born.

Some people may object that they complicate things for everyone, but nobody has ever said that we have to refuse the benefits of the modern world because it is very complicated.

The same thing happens with options (and other financial derivatives, for that matter). To radically oppose them is more or less the same thing as banishing modern technology because it can be mis-used to catastrophic consequences.

More to the point, some people may argue that day trading should be prohibited because it (supposedly) doesn't benefit anybody, that short selling is prejudicial, in general, that speculation is negative.

Well, I disagree, let me explain each point separately:

All markets are less than perfect, and the distortions only create economic inefficiency, therefore, it is justified for an economy to expend some resources addressing this problem.

Let me tell you an anecdote:

While I was learning about options, I noticed that there were cases in which some options for some stocks were mispriced; for example, a call was unusually high priced (and/or the puts were too cheap), as if the investors were anticipating a jump in the stock price and were speculating with the options rather than the shares, which created an imbalance. Knowing that options are derivatives, and that there are equivalences between the shares, the puts, and the calls; if the calls were "expensive" I synthesized them with puts and shares and wrote the expensive calls keeping the difference in a risk free business. There wasn't much money to be made that way, because the distortions were minimal, and the companies small, thus by the mere fact of buying puts to synthesize calls I produced an effect of raising/lowering the prices of those options. Those opportunities existed because the big firms wouldn't care to commit their resources for such peanuts, but for me it was perfect to make a dime while learning. I actually made money that way. Was I contributing to the companies whose stock I was working on?: no. But I was contributing to this economy: I was devoting resources (entrepreneurial abilities, labor and capital) to make the stock market less imperfect.

By the same token, those who day trade help the markets to become more efficient.

What is the right price for, let's say, shares of AMD? Nobody knows. How do you get to a price, then? -- through the participation of traders. Ah!, but wait a minute, how reliable is the price that the market is assigning to AMD shares? again, nobody knows, but the standard deviation of the annualized lognormal variation (obtained through the market) gives you a good idea. If you want to have a developed market, for the economy's sake, you must understand that you have to pay for it. That is, you must allow people to benefit from their work coming up with an assessment of what the right prices are and what the right volatilities are. The best thing of the current state of affairs is that the risks of that activity are assumed by those working on it.

I expended years upon years studying sciences, including very sophisticated mathematics. Even though I currently am not doing something so called "productive" with all of that accumulated knowledge and skill, I don't see the efforts I am expending at trading the way I can and works for me as a waste of those "resources" under my control (my time, knowledge, skill and capital), quite the contrary, I have a very high concept of how they contribute.

Also, a necessary positive spillover of that activity (an economic "externality") is the creation and maintenance of this blog, which has an educational component, like our participation in the message board: You don't have to agree with me about my opinions, but perhaps our efforts in the intellectual exchange of ideas is productive, that is a net positive.

Going back about leveraging investments, although I have actually lost money so far, I still think I am capable of appropriately using margin to leverage my investments, especially in the recent months that I have been accelerating my gains. As a matter of fact, the margin leverage is what is making it worth for me to dedicate increasing efforts to the stock market, and increasing capital through informal agreements in my network of acquaintances.

Short selling? The only way to make it worth for people to "say" that a security is overvalued is to allow market participants to bet against a security (allowing them to benefit from detecting overpricing). According to Sharikou, the demise of Enron, which was arguably a good thing that if anything should have happened much sooner, began once investors who took bearish positions on Enron kept asking though questions and demanding answers. Of course, those who were under the delusion and had vested interests (quite literally) didn't want to uncover an scandal of this magnitude.

What I have been talking about doesn't mean that there is no chance for manipulation.

I said that just like technology, these financial instruments give the bad guys the power to do more harm. But it is difficult to qualify anybody in a stock market as a bad guy. I mean, let's say that you want to probe the degree of conviction that the market participants have about a given price level, then you use your money to try to induce movement in a determined direction. Is that illegal or immoral?

If the recent sell-off of AMD was provoked by "market manipulators" using God knows what kind of non-obvious mechanisms to induce panic selling, then the manipulators made me an important favor: They separated the shaft from the wheat. I mean it, because although I am "down" due to the sell-off, assuming the hypothesis of the manipulators, then my shares could be safely acquired at these price levels now that the manipulators got rid of the speculators looking for a quick profit, because I think that what separates an investor from mere speculators is that when the investor sees his investment at a lower price he would tend to buy because the same thing can be acquired for less, while the speculator will sell because the underlying is not moving according to his prediction.

In this whole quarter I bought at three occasions: 1) After there was panic selling regarding the ATI acquisition/bad quarter results, although a modest quantity, 2) After ATI warned, another small quantity, and 3) After the excellent quarterly reports last week (at least, they are still much better than what *I* expected, which is what counts), a very large amount this time. Do I expect the price to go up short term? No, not really. I didn't abstain to buy simply because I didn't have guarantees that these good prices were going to happen again, and these major shake-ups got rid of weak investors, diminishing volatility, thus I had enough protection already to enlarge my holdings.

But it may be the case that there are no manipulators, that the quarter results, in the form of the gross margin decline, reveals the tragedy of AMD that now has production capacity but is forced to sell at steep discounts because it no longer has competitive products.

About the manipulators, the case must yet be constructed: a) To indicate exactly what is the conspiracy, b) to explain why that conspiracy is immoral/illegal or harmful to the economy, c) to demonstrate that the manipulation mechanism works, d) to demonstrate that the market doesn't have preventive/corrective strategies against those manipulation mechanisms. So far, all I see is a bunch of disgruntled investors angry that their investments are "down".

I advised repeatedly about not being a "low hanging fruit" for those who were "shaking the tree" (I still think that this was Wall Street shaking the tree), perhaps the major firms had a tacit agreement that if there was any weakness in AMD's report it would be pointless to hold, that it would be easier and safer to just sell and buy back lower, especially if the players had the (correct) appreciation that the others were going to feel alike.

Going back to gambling with options, well, it is arguably something stupid and bad. Like drinking alcohol or playing the lottery. But it happens that some people actually like those activities, thus I don't have moral grounds to make them illicit. In the case of options gambling, it is more sort of gambling in the hippodrome, there are those who have so much dedication at horses that they can consistently beat the odds against them to make little gains, thus it is even harder to condemn the activity.

But that doesn't mean that we shouldn't try to educate our fellows, especially the newbies, that derivatives are dauntingly complex, and that they should be used with extreme care. That suggests that we most participate in constructive discussion about this subject.

My friend Asatru Skald, whom I feel honored to be qualified by him as his friend, and I have been working in a protective way to diminish the risk of investing in AMD. As a matter of fact, I am extremely enthusiastic because I think the mechanism works great (and has been working great indeed), it seems to pour money without real risks, thus it is natural to use the message board as forum; especially because our versions of the mechanism are full of interesting questions, such as: "Should I protect with far out of the money leaps puts, or ATM, or far in the money?", "Should I allow my written calls to be exercised?", "Should I make counter-momentum trades, or momentum-neutral?", "does it work unmodified in higher than normal volatility scenarios such as earnings reports?". I could expend the whole day interchanging ideas about these questions, and I think that my pretension would be entirely legitimate.

There are many factors coinciding to make the stock market more volatile, not just that since there are margin and options investors can do many more crazy gambles and introduce more noise to the environment: Time is compressing in this civilization, transformations happen much faster than ever before. It is not only a matter of having zillions of discount brokerage firms with zillions upon zillions of "investors" connected to the internet and chasing their securities in real time rather than the paucity of the old process of calling the broker to do the trades and get financial advise. A closer example: It took a mere few years, one could say months, for a company such as Youtube to go from being valued zero to more than a 1 G$, without it needing to even post a single dollar in profits, think about it, such quick "rags to riches" stories can only happen if the markets are very dynamic -- that is, volatile!. I find it only natural that the stock market is so developed that has a "meta market" of derivatives that works an order of magnitude faster to what returns on investments is concerned.

My advise to you, highly regarded friend, is to come to terms with the reality that the complexity of all of these financial instruments and devices are here for the duration, because I am sure that you are so smart that you will be able to complement your skills in classical investments with the new possibilities to increase your gains; just like I assume you were able to complement your prior knowledge about finance and investment with the possibilities of the internet that allows you to communicate with us, for the net mutual benefit.