What Lies Beneath...

I read this article: '90% of Our Trades Make Money' and Other Expensive Half-Truths by Philip Guziec from Morningstar.com and learn about the thought beneath all the big headlines of the marketing materials that I received and read especially from internet, emails, newspaper, etc. Thinking about the key message of this article again, it is true to certain extent. Hence, I would like to share this article with all my trading buddies and friends. Be careful and think again whether it is the truth or lie beneath the headlines in future...

On my desk is a stack of marketing pitches I've received over the past year hawking option classes, strategies, and systems. These advertisements range from the relatively benign to the borderline criminal, but the key thing to keep in mind is that the objective of the guys making these pitches is to sell courses, newsletters, or systems. That means that the sale needs to be simple and emotionally appealing, but not necessarily that the system will make you money.

I'll walk through a few of these pitches in an attempt to prevent you and your money from parting prematurely.

"90% of our trades make money…"
This is my personal favorite, and it preys on the typical neophyte option user's ignorance of statistics. Anyone can come up with a strategy in seconds where 90% of the trades make money, but the unspoken second half of this sentence is, "…and on the other 10% of trades, you lose your shirt."

There is probably a bunch of fancy option lingo and complexity wrapped around the strategy to disguise the simplicity of this fact, but the bottom line is that any strategy where 90% of the trades make money includes big losses on the other 10% of the trades, and those bring your total return down dramatically. I'll be writing quite a bit about option statistics, but the simple version of the "90% of our trades make money" strategy is to write far-out-of-the-money naked calls. Easily 90% of them will make money if they're far enough out-of-the-money, but a loss on any one of the remaining 10% could bankrupt you.

"We bought xxx calls and made 182%," or "We bought yyy puts and made 367%," etc., etc.
Assuming that these "investments" were even made up front, and not generated by picking the winners after the fact, these are just emotionally gripping numbers that were chosen by selecting from among the winners. What isn't being said is that in the same set of investments, "Our xyz calls expired worthless, losing us 100% of our investment," and "Our pdq puts expired worthless, losing us 100% of our investment." To really evaluate an investment strategy, you need to examine a portfolio return over time.

While we're on the topic of emotionally gripping, let's address this one:

"Joe Schmo was living on the street in a box, but he made $100,000 last year with our secret option strategy." This is just like a casino ad showing the smiling face of a big jackpot winner: "Ed Superlucky won $7,200,000 at the Loseyourshirt casino." In this case, you're hearing from the winner, not the 9,000 other casino "customers" who lost an average of $1,000 apiece. To illustrate further, imagine giving 1,000 vagrants each a credit card with a $1,000 cash advance, and having them all make a 100-to-1 bet at a casino. Ten of them will make $99,000 from nothing, and the rest will wind up defaulting on $1,000 in debt. Joe Schmo, who was living on the street in a box, is the options equivalent of one of those 10 winners.

"Our list of recommended trades last year averaged an 82% return."
These near-lies work in a couple of ways. First, there is the fine-print version, where you'll find something like: "This trading performance assumes that each trade was exited at the high trading price during the period." Think that through for a second. If I buy something, figure I sold it at the same price I paid for it if it goes down in price (the high trading price during the period), and figure I sold it at the highest price it reached if it goes up, of course my calculations will show a huge return!

The second version of the near-lie is slightly more insidious, and it depends on the fact that many options are still relatively illiquid (rarely traded, so a big purchase will move the price of the options). If an options service buys relatively illiquid options, and then pitches the trade to thousands of people, the demand generated will push the price in the service's favor, at which point it will typically sell. The service's portfolio may well make money, but the individual options investors probably won't because they overpaid for the options. When this is done with penny stocks via pitches in e-mails or faxes, it is a little more obvious, and it is rightfully called "pump and dump."

"We've found back-tested strategies that have returned 376% annually, and you can, too, using our back-testing tools."
Back-testing is also called data mining, and it's another way to scam with statistics. In any large set of data, one can statistically find patterns that worked historically, but with no reliable reason the same strategy will work in the future. For example, the Super Bowl Indicator says that most years after the NFC wins are good years for stocks, and most years after the AFC wins are bad years for stocks. The technical term is spurious correlation, and blindly using back-tested strategies should provide a solid, and expensive, education on how schemes that could have worked in the past don't necessarily work in the future.

"Our charting strategy generates signals that blah blah blah… Fibonacci retracement blah blah blah… Candlestick charts blah blah blah…"
Find me one "technical analyst," as they call themselves, among the 500 richest people in the world, and I'll quit my job and read every book ever written on technical analysis.

"XYZ Corp. just got FDA approval for the cure to cancer. We recommend buying the calls on XYZ at…"
Some services seem to add credibility to their analysis by coupling the official release of positive facts with recommendations. This is another strategy for selling services that prey on human psychology. People tend to infer causality when there is none stated. In this case, the sentence adds no value from an investing perspective for two reasons. First, any obvious public news should already have caused the price of the stock and the options to move. Second, even if the news wasn't public, there is no explicit link between the statement and the recommendation. What this service is likely doing is simply linking a news feed to a random generator that suggests the option purchase, knowing full well that human nature will cause many unsuspecting and trusting investors to fall for this strategy, and pay money for the worthless service.

"If you wrote options following our strategy over the past five years, you would have made an average of 22% return on your account."
This is the momentum element of options investing, and the one claim that comes close to an undistorted truth. The securities markets have been in a prolonged period of falling volatility. Another way of putting this is that stock prices have been wiggling around less and less each year since 2001. Because of this, writing options has been a winning game over buying options (technically speaking, realized volatility has been less than implied volatility). Will this continue? Not likely. Volatility has been at historic lows, and the world rarely remains a stable place forever. The one sure thing we know is that volatility won't go to zero. Continuing to blindly follow the strategy of mindlessly writing options is a bit akin to buying tech stocks in 2000. The trend will probably eventually blow up in your face, but you don't know exactly when.

Hopefully these examples will help you better evaluate the marketing materials that show up in your mailboxes, and let you save that money for real investing.

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