Tuesday, May 01, 2007

Ron (Cove3) rant about Options

What follows was written by Ron (Cove3) as a message board post, part of a thread we were talking about. I have inserted my commentary in a different color. My intention is to post a complete rebuttal, but for the time being I want to comment on Ron's ideas.

Chicago, I have read your link many times [Ron refers to "Options Are Cool", where I explain some benefits of options], but as you say, no argument will convince me. As regards personalizing, since you are a spokesman champion of options, I do, IN ONLY THIS INSTANCE, regard you as an adversary, much as I would were you the Tobacco industry proclaming the benefits of smoking or the Narcotics industry proclaiming the benefits of cocaine. Both would say, as would you about options, not harmful in moderation, but of course moderation is never what happens, but primarily abuse.

You, I and other longs on this board have lost money on AMD in part due to hedge funds and speculators having a vast arsenal of weapons with which to manipulate markets [I have lost money, and I was also convinced that some stock price manipulation happened, but today I see that manipulation or not, what I though was a solid company in reality is a very bad business, and that is more than enough to explain the money that I lost. Since this explanation is simpler, by Occam's razor it is better]. The wealthy have pooled their money into unregulated hedge funds giving them an ability to stampede stocks up at down at will (see Cramer [Jim Cramer even confessed that he knew multiple ways of how to manipulate stock prices]). Not being content with that atomic bomb weapon, they pile on more advantage on top of that.... Margin, naked shorting, derivatives, and of course options. [You are putting together very dissimilar things, this makes it harder to understand what is your complaint: Naked shorting is illegal, options are but a particular kind of derivatives, margin is necessary for any kind of short selling. Nevertheless, I will assume the defense of Margin, non-naked (proper) shorting, and options in particular]

The leverage this gives them to create volatility and gain is unimaginable and have turned what should be capital markets for long term investment for the good of all into mere gambling casinos. There's simply no rational for a company's entire outstanding stock to turn over in 3 or 4 days. AMD should never have driven up or driven down to the levels we've seen and wouldn't have been without the arsenal of weapons at their disposal, one of which you're so vigorously defending [Actually, I disagree with this argument for technical reasons that you are not aware of. To write options is a very great deal more complex than to go long on them, that may explain why most discount brokerages have more restrictions and demand more qualifications from option writers than option purchasers. Since to write options is a harder subject, and requires larger commitments of capital to obtain smaller gains, I conjecture that the activity of writing options is more natural for big players than for retail investors; this issue is key, because it contradicts your implication that these instruments are used to increase volatility: Whoever writes options is implicitly taking a stance, that volatility will decrease. Then, if Big Money assumes more often the role of option writer, it is not in its best interest to propitiate increased volatility. I see many good phenomena that explain why market volatility has increased, I will detail below and in my post]

The Fed and SEC could stop all this dead in it's tracks if it weren't controlled by Wall Street.
1. 100% margin [Why 100%? I understand that some people use margin leverage incorrectly, but there are ways to use lots of margin leverage that are even safer ways to invest than simply hold shares, and I will explain how]
2. 3 year holding period for long term capital gains, 3+ yrs being what an investment is all about. [This is ridiculous. Markets are not what they used to be because of many reasons, in particular, in this age a company like YouTube may go at "internet speed" from non-existence to being valued more than one billion dollars in less than the three years you mention. (YouTube in particular was demoed in May 2005 and announced its acquisition by Google in October 2006, less than half three years!. I don't see anything particularly bad with some legislation to be in accordance with the accelerated pace of our times. Your criticism distills strong opposition to liquidity, I can, on the other hand, show how liquidity is an essential positive characteristic of modern financial markets]
3. Tax capital gains and dividends at the same rate as labor, which needs incentive also.
[Allow me to mention some criticism about capital gains taxation that I do not necessarily agree with: If you agree that after the government receives the payments of income taxes, the remainder should be available to be used in any way the contributor chooses, thus, it has weak legitimacy to tax that money again because it multiplied as an investment. I would like to see your refutation of this argument]
4. Add a transaction tax to make it much more expensive to churn stocks. [More opposition to liquidity]
5. Tax inheritances to get at least some of the manipulation/inflation profiteering gains back [Well, this is an entirely different subject: It seems that you think that whoever leaves money in inheritance is guilty of some form of misdeed. This is a political discussion that I will decline to participate in]
6. Use this tax income to reduce the deficit, the burden of which falls primarily on the middle and lower classes who least know how to defend against the inflation which deficits create. [While it is true that the deficit is a middle and low classes killer, the solution is for the citizenry to demand legislation that blocks the government to expend more than its income, this has very little to do with our subject]
7. Ban or regulate hedge funds. [It seems that you hate any mechanism to invest that doesn't require explicit government permission. If you assume that the government is able to decide what ways are good to invest and which are not, then why wouldn't the government, in its infinite financial wisdom doesn't administrate all the money of every individual and company? You can't fire accusations so general, the system of individual liberties is based on the principle that agents can do as they please as long as they don't trample on the liberties of others, that is, government intervention occurs only to protect liberties, it doesn't work as you suggest: "Eliminate these liberties so that there is no abuses"]
6. Eliminate options. Risk can be managed by diversification or selling the investment [Why does it have to be diversification the only mechanism to handle risk? Diversification is very bad at it, risk may keep mountains of money from being invested if it were not for more developed mechanisms to handle it. Your blanket opposition more than anything else reflects ignorance]. Markets functioned before there were such a thing as options. [Many types of derivatives have existed since time immemorial, in recent times, there was ground breaking work that allowed investors to more easily agree about how to price equity options, the Black-Scholes model, and the rise of the options market is the natural consequence of that and other developments. You seem to oppose innovation because it may lead to changes that you don't like. I liked the times when you made a phone call and an actual person took the phone, I loathe and hate the automated voice systems that take your call, but I would not even suggest to outlaw them. Regarding your claim that markets functioned well before there were them, is factually wrong by duplicate: They have existed ever since the market existed, and there is no reason to think that old times were better. What is the difference between your attitude of being opposed to progress and the Fundamentalists who go to the extremes of killing people massively or to impose restrictions on half of the population, women, including denying fundamental rights as the right to be educated; only because they have an idea of how without modernity we would be better?]
All these tortured devices have gotten ownership further and further away from the real thing [yes, they have increased the level of abstraction from the underlying; but this is just a demonstration of the successful development of markets. Just as you have the option to actually buy a business and manage it and nevertheless you choose to take a step of abstraction and own the business indirectly through shares in the stock market, I very much defend my right to take one abstraction step more than you and use derivatives over the share ownership you seem to sanction as morally acceptable] and created massive pyramids which nobody understands [speak for yourself!, but really, don't you see the cognitive dissonance of claiming ignorance about the subject of options and yet being so strongly opposed to them?] Why not have an options market for options? [In a way it actually exists, financial institutions trade "pure" volatility]

It's also increased the disparity in wealth which history shows leads to bad things [This is another political stuff that I don't want to discuss, but it has a side very much pertinent to our discussion: You and I are technologists, that puts us in a very good position to understand the "regressive nature" of our times: Those countries, companies or individuals who get ahead from the pack in the usage of technology use that advantage to further develop technology and get an ever increasing advantage. See it from the point of view of two households, one with Internet, and the other without. This may be a difference as little as a few dollars per month, but which amplifies itself enormously, it is either a virtuous or vicious cycle, what in systems is properly addressed as "a positive feedback loop" meaning a system where a deviation from the equilibrium point leads the system to further deviation. Nevertheless, the argument that technology is to blame for poverty is wrong: although it doesn't benefit all equally, it benefits the whole. The same thing applies to the development of financial markets that allows for margin leverage and options.]. Warren Buffet said there's class warfare going on and his class in winning, [yes, but Warren Buffett's opinion is not that of a Luddite as you seem to imply, the way to correct this problem is not to tax Mr. Buffett up to dissuading him to invest in the stock market] thanks in part to weapons I've mentioned. The Imus uproar is just the tip of the iceberg.

Although I agree with many of your techology evaluations, on this one I'm afraid we will continue to be at loggerheads [being an engineer and/or scientist, I had the luxury of being raised intellectually in disciplines with objective criteria for truth and falsehood, I mean, I learned very early to accept that I made a mistake in a calculation, just the same I leaped to understand that I may be wrong with my opinions. Then, I learned that sometimes you only have approximations to the objective truth, and then that the same thing may be looked at from different models or frameworks that may lead to different conclusions and yet equally "right". Your opposition to even reconsider your opinions on this subject not just give me a higher moral ground, but cause you harm because those opinions are not what I call "operative". If you are concerned about how the options and other financial instruments induce volatility, you should be eager to learn everything about them, because like it or not, they exist. If you ever want to further these opinions into political action, you should be eager to know everything about the opposing arguments, because to "preach to the choir" would lead you nowhere. And finally, there is always the horrible possibility that one is plainly wrong. In that sense, I sincerely thank you, because your arguments provided me with good material to reflect about subjects of my interest and the effort to respond to them led me to improve my understanding].

Regards, Ron