Podcast – Episode 008 – Why Options Were Really Created
Resources mentioned in this episode
Welcome Genius Nation. Welcome to another edition of The Option Genius Podcast. So glad to have you here. You know, I gotta tell you. Today I’m going to be talking about something that is near and dear to my heart, because, well, I love options. If you can’t tell. The guy behind OptionGenius.com, having traded options for years and years now, and really getting out there, and evangelizing options, and telling people, “Hey, you know what? You need to be trading options.” I do it because, they have literally changed my life for the better, and I really feel that they are great for all types of investors. And they’re just like … They’re another, if you’re going into retirement, if you’re going to try to create your financial future, and be financially free, and talk about the different types of freedoms that we really aim for at Option Genius, they are … If you’re going after those with a gun, right? Well then options are a bullet in your gun.
Or maybe it’s a type of gun, maybe you have different guns, and options is one of those guns. The stocks are another gun that you have in your arsenal, that you can use to blow through any kind of resistance that you have, to get to where you’re going, and to get to what you want in life. I really think that everybody should be out there, they should at least know about options, and if they have a stock portfolio. If they have an IRA, if they have trading accounts, they should be familiar with options in some degree. They should understand what they are, and they should understand how they use them, even if they’re only doing a covered call once in a while. That extra few percentage points can really, really add up over the long term. Over 10, 20, 30 years, to grow into something really substantial.
The problem is, that most people out there are being told myths about options. They’re being told, or they’re getting erroneous information. Most people lose money with options, and most people are afraid of options because they’re told, “Hey, those things are risky. You better stay away from them. People lose money on those.” Why? Why is that out there? It’s because there’s so much false information.
Well, maybe not false exactly to say, but it’s been told by people who don’t really know the whole story. I mean, you could read any kind of article in most of these magazines that talk about finance, you know? There’s so many of them out there now. But, when they talk about alternative investments, or they talk about ways to make passive income option selling, selling options, selling premium, none of that is ever discussed. Because, it’s taboo in a sense, or it’s too complicated, or too advanced, you know? It’s a shame that people, common, every day normal people are not told this stuff.
I mean the rich people, they know about it, okay? You ask anybody whose very wealthy. I guarantee you that they already know about options. Maybe they don’t trade them, but they’ve heard about them, and they probably have dabbled in them in the past. It’s crazy. Even brokers are like this. This is what drives me nuts. Let’s say you’re a new guy, right? You’re a new trader, or you’ve been trading in the stocks, or you have an investment account, and you go to your broker, and you call up your broker and say, “Hey broker guy, I’ve heard this thing. It’s a really cool strategy. It’s called, ‘The naked put.’ I want to do that. It sounds interesting, it sounds really cool. I think I can make some money doing that. Can you please go ahead and setup my account so I could do these naked puts?”
The broker will be like, “Well, you know. No, I can’t let you do that.” They’re like, “Well, why not? You know?” That’s what you’re asking. Say, “Hey, Mr. Broker guy, that’s your job, right? It’s my money, I want to do what I want to do with my money. Why are you not letting me do this particular trade?” The broker will be like, “Well sir, I’m looking at your account application that you’ve filled in with us when you first opened your account. It says here that you consider yourself a conservative investor. If you are a conservative investor, then by our rules, I cannot let you trade this option strategy because it’s a more advanced option strategy, and it’s very risky, and you could lose your money.”
“Well Mr. Broker guy, it’s my money, and if I want to do it, I should be able to do it. If that’s the only thing that’s holding us back, well then you go ahead and change my form from conservative, to speculative, okay? Put me down as a speculator, that’s fine, if that’s all it takes.” “Okay sir, I can change that for you. But then it also says here that you have no experience in options sir. For that reason, I’m going to still have to deny you your request.” “Okay well Mr. Broker guy. Fine, I don’t have experience, that’s true. I want to learn. You’re not letting me learn. I can’t learn unless you let me do it on my account. What can I do Mr. Broker guy?” On a side note, there are ways to get around this as well.
But so, “Mr. Broker guy, tell me. What can I do?” “Well sir, you can do what’s called a covered call. The covered call is an option strategy. We will let you go ahead and do that. In fact, we let everybody do that. It’s a very safe, and a very conservative strategy sir. You can do that, let me go ahead and turn that on for you, and you can go ahead and start that sir. Have fun with that one.” “Okay Mr. Broker guy. You’re not going to let me do the naked put?” “No sir, that’s correct. But you could do the covered call.” “Okay, so I can do the covered call Mr. Broker guy, but I can’t do the naked put? Even though, if you look at the risk graph, they both have an almost identical risk graph. Where, the upside is capped, and the downside slopes down, goes down to zero. Is that correct Mr. Broker guy? Is that what you’re telling me? That these both strategies have the exact same risk graph, but I could do one, but the other one is too complicated?”
“I don’t understand the question sir, I am just a broker. I’ll have to turn it over to my manager sir. Please hold.” That’s normally the way it goes with these brokers, right?
If your broker is confused, no wonder the whole general population is confused about this stuff, right? Especially when you have people like Warren Buffett, whose, even though he uses this stuff, he uses options, he uses naked puts a lot, and I’ll save that story for another episode. But, he tells people, “Hey, you know what people? You should stay away from derivatives. Derivatives are …” I don’t know the exact quote, but, “Derivatives are evil,” or something like that. That’s what he says.
When people hear Warren Buffett, Warren Buffett, he’s a rich guy, right? He made all this money trading stocks. He’s like the only guy on the … I don’t know, I read this somewhere. He’s the only guy on the fortune rich list, whose done it by actually trading stocks, which is also not true. But, that’s what they say. If he’s saying it, then it’s probably true, right? Even look at the word derivative. What the heck is that, right? What is a derivative? Even the word sounds scary, right?
I mean if I ask you, “Hey, what is the definition of a stock? What is a stock?” It’s pretty simple, you know? A stock is, well, it’s a piece of a company. You buy a stock, you own part of a company. Boom. Simple, simple understanding. Easy, easy, easy. Anybody else’s trade, you tell them that definition, they’ll get it in two seconds, right?
But then, let me ask you, “What is the definition of an option?” If I asked you, “Hey, you know what? You know what a stock is. What’s an option?” I get that question a lot, you know? “Hey Allen, what do you do?” “Well I trade options. “Oh options, what is that?” “Well sir, the definition, if you pull it up for an option, is that it is a right, not an obligation, to blah, blah, blah, blah, blah. In the future, at a set price, blah, blah, blah, blah, blah, blah, blah, blah, blah, blah.”
I mean it goes on for like a paragraph. That is the definition of an option. There’s no easy, quick two or three word explanation. That’s another reason why people don’t understand it, because if it’s … The definition is so long, then it must be scary, and it must be risky, and it must be something bad, right? Now, it’s safe to say, options are a complicated topic. They’re made more complicated by the myths that are told about it. One of the big myths that are told about options is one that I want to cover today. Basically it says that, “Options were created to make money.” That is completely untrue.
What? Allen? What are you saying Allen? You tell us to trade options to make money. That’s the whole podcast, that’s the whole Option Genius thing, right? You’re supposed to make money from options. Exactly. But I’m telling you to sell options, not to buy options, okay? That’s the difference. The reason to sell options, is that options were created as a way to lose money. Now, let me give you a little background here, so stick with me.
Most amateur traders don’t realize this, but options were actually created as a way to hedge a position. They were created to act as insurance. That’s part of the reason the stock market was created as well. Options were first introduced in the commodity space, okay? Imagine you are a farmer, okay? Let’s say you’re a wheat farmer and you have to spend all this money to get the feed, and to get the supplies, and to get the horses or whatever, the donkeys and stuff that they use to plant all the wheat. Then you have to let it grow, make sure you get enough rain, make sure there are no locusts or anything that eat your crop. Then, when the wheat is grown, then you have to go, and you have to cut it all down, or chaff it, or whatever it’s called. I’m not a wheat guy, I’m sorry. But you have to harvest it, right?
Then you have to take it all down, then you have to take it all the way to the market, or get it to the market somehow. Then, at that time, then they tell you, “Hey, you know what? We’re going to pay you five dollars per bushel of wheat.” Then you look at your cost and you’re like, “Wait a minute, I just … It cost me seven dollars …”
You look at your cost, and you’re like, wait a minute! It costs me seven dollars a bushel to grow this wheat, and you’re only gonna give me five? Last year the price was nine. And you’re saying, “Well, Mr. Farmer, that’s the market price. We had a lot of farmers this year who grew a lot of wheat, so we’re over-supplied. There’s not enough demand. Everybody’s buying corn this year, you grew wheat, I’m sorry, the prices are not just there.” And so, as a farmer you lose two dollars a bushel because you didn’t know in advance what the prices were going to be. Right? So that’s why they have futures, exchanges, that’s why they have options. So basically, what you can do is, when you are getting ready to do the planting season, you can go out and buy put options on wheat as a hedge against falling prices.
So you want to make sure that you get a certain price for your wheat, and you want to make sure that you have protection as an insurance in cases the prices drop. So this way, even if the price of wheat goes to zero, and your crop is totally worthless, it doesn’t matter, you still have your put options there, and they will make money and make up for the loss.
Now, let me give you another example. Let’s take a toy manufacturer. You manufacturer toys, and most toys are made out of plastic, so you make plastic toys. And, as you know, plastic uses oil and gasoline, a lot of oil is used in making plastic. So that is one your input costs, is what it is called. It is one of the costs that goes into the toy. So, in order for you to be able to make your toy and sell it at a proper price, you have to know how much the toy is going to cost you in advance. So, you need to know what the oil and the gasoline are gonna cost you in the future. If they go up too much, your toys will cost you too much money to produce and then if you try to sell them for too much, then nobody’s gonna buy them. So what do you do? You buy call options on oil and gasoline. So that way, even if the prices go up, your options will make money, and you can use that money to offset the higher cost of materials.
Now in both of these scenarios, what do you want? You want to lose money on your options. You only wanted them as insurance. Nobody every wants to collect on their insurance. Right? Because that means something bad happened. I mean, we have insurance on our houses, we have insurance on our lives, we have insurance of our health, and we pay, every month we pay the premiums, and we hate paying ’em. Right? I hate paying the premiums. But, you don’t want to collect. Right? You never want to call the insurance company and say, “Hey, insurance company, I’ve been paying my premiums on my car, but my car just got wrecked, so I want some money back.” You don’t want that, ’cause you want to keep the car. You don’t want to get into a wreck. You never want to claim on your premiums.
It’s the same things here. Options were created as a way to be insurance as a hedge, and nobody want to collect on them. If you’re buying them as a hedge that means something went wrong, and you just don’t want that. So, market makers and other traders are happy to sell these options because they know that the odds are on their side and that the options will most likely expire worthless. So you see, both sides know that the options are gonna expire; the buyer knows it and the seller knows it. But it’s part of business. It’s one of the expenses of running a business that you have to have insurance. And both sides are happy with it. The companies, the farmers, all these people are happy that the option is there because they can buy insurance so they can make their life easier; they have peace of mind knowing that they have insurance. And the guy selling the insurance is happy because he is making money, and he has a very, very, almost a sure thing kind of bet. So, both sides are happy.
But then something happened that kind of turned the whole option market on it’s head. Options were then introduced on stocks in the hopes of increasing trading and commissions. I don’t know who first came out with them, but they were something that is another tradable vehicle. And so, did that pay off for the stock exchanges? Oh, you bet they did! I mean, options, volume, and commissions generated by options, and fees generated by options. You look at a chart, and the popularity of options just keeps going up and up and up and up. And the money that is being made by brokers, by stock exchanges, by the commissions, it’s crazy. And so, they don’t mind when people trade. They want trade, they want more trading. The more and more trading the better, the more liquidity the better. Right?
So that’s when speculators jumped in. Speculators tried to, you know, if you can buy a stock and it goes from 1 to 100, that’s a lot of money. But if you can buy an option and the stock goes from 1 to 100, that’s like zillionare type money. And so, people started promoting this as a way to get rich, and get rich really, really quickly. So if you ever see an advertisement for a course or a system or a book that’s telling you to buy options, they’re always gonna have that example where they compare it to stocks. And say, “Well, you know, if a stock goes up 10% you make 10%, but if the stock goes up 10% and you bought an option, you’re gonna make like 100 to 200 percent.”
They always have that example in there, because that’s what they’re trying to do. They’re trying to sell to your greed to try to get you to understand, “Wow, I can make so much more money, I gotta do this thing.” And while it is possible, it is possible once in a while to hit a home run, over the long term buying options is a losing game. I hope that I’m preaching to the choir here. That’s just the way it is. Does that make any sense? Right? ‘Cause, I mean, you have this instrument, this derivative, that costs money, but it is super, super hard to use it to get a payoff. That’s why most traders with options lose money. This definitely sounds to me like something that an insurance company would come up with. Right?
When you go for, I’ve been in accidents before where the insurance company would say, “You now what? You’re covered for this, but you’re not covered for this.” Recently, we just had hurricane Harvey and there was the hurricane in Florida, and then the hurricane in Puerto Rico. But the one with Harvey here in Houston is that most of the damage was done by flooding, almost 90% of the damage was done by flooding. Very little was done y wind and hail and rain. All the water came in from the flooding and that’s why all the homes were ruined. But, your home insurance does not cover flooding. For that, you need a separate flood insurance. Oh great, wonderful, you know? And that’s definitely something an insurance would come up with. Right? That they could weasel out of paying. Because that’s their business model, they want money from you but they don’t want to pay it out.
Okay, fine. That’s something like an option. To me that’s what it sounds like. You gotta be right on the direction, you gotta be right on the movement, how much is gonna move, and they you have to be right on the time of the movement. It’s so incredibly hard to make money over the long-term with options that’s not even really worth it and that’s why we should be selling options. And that’s what I use it for. Right? In most cases I sell options that are very, very far away from the money. Now, because of that, most likely the options that I’m selling are probably not being bought by speculators. They’re probably being bought by hedgers, people who are protecting their positions. So I’m acting as the insurance company for these folds. I don’t know who they are; they might be a hedge fund, it might be a large manufacturer. It might be whoever it is, you know, a mutual fund. But I’m acting as their insurance company.
And do you know who owns the largest buildings in most cities? You go to downtown, go to the biggest city, if you live in one go look at downtown, if you live near one, take a drive to your biggest city. Take a look at the biggest buildings in downtown? Who owns the largest buildings, or who has the names on them? It’s gonna be the banks and it’s gonna be the insurance companies. Okay? There’s a reason why that is. Even if you take a look at San Francisco, take a look at any picture of San Francisco where you see the skyline of San Francisco, and you’ll notice that there is just one building that is shaped like a pyramid. I mean, it stands out, it’s there, it’s a tourist attraction. Everybody sees that pyramid building. That is an insurance company building. Okay? It’s iconic, it stands out. And it’s very, very real estate and it’s a very expensive building, but the insurance company can afford it. Why? Because of heir business model.
So, that’s the business model I want to have. And since option were created as a way to make money and the odds are in my favor when I’m trading options, that’s what I want to be doing. Got it”? I hope that makes sense.
Here’s another piece of information that is kept secret. Do you know how Warren Buffett made most of his money. Trading stocks. Right? That’ what everybody says, that’s the general story. Yes, and no. There’s a lot more to the story than that. He actually got really rich and he did that by buying an insurance company-
He did that by buying an insurance company. That is what propelled into stardom I guess. That is what gave him the big war chest to go out and buy stocks and start buying companies whole. Until then, all he was, was a small time money manager. A handful of people had given him his money and he had decent returns, but there’s no way he was gonna turn into the second richest man in the world. For a while, I think he was the richest man in the world. If had kept up that pace, there was no way he was gonna get that big.
It wasn’t until he bought the insurance company did he have all the excess funds of the insurance company available so that he could go out and start buying other companies. When he bought the insurance company, this insurance company had millions and millions of dollars just sitting there in its accounts. This is premiums that they had collected and they had to hold on to it. They couldn’t use it. That’s what they use to invest. That’s how an insurance company makes money. Let’s say you go and you buy some life insurance. You give money every month to the insurance company and the insurance company is hoping that you don’t die for a long time. Basically, when you buy life insurance you’re essentially betting the insurance company that you’re gonna die and they’re betting against you saying, “No, sir. You’re not gonna die. We don’t think you’re gonna die. We’ll sell you insurance.” Because if they thought you were gonna die soon, they wouldn’t take your money. Crazy business model.
The insurance company has all this money that’s collecting and then they invest it. Warren Buffet saw this and was like, “Wow, man. I could make more money than the insurance company makes so let me go ahead and buy this distressed insurance company.” He got all the funds and then he started investing those and that’s how he got really, really big really fast. He did it not using his own money. That’s not how he got rich. He used other people’s money to get rich. If you don’t believe me, that’s fine. Go ahead, look it up for yourselves. Go read his biography. You’ll see for yourself that’s how he got started really, really big. That’s how he grew. I mean that’s just another myth out there that we are not told. The general population doesn’t know about this stuff until you investigate, until you go further into the details.
Let’s go ahead and wrap this up, folks. Number one, don’t believe everything you hear without investigating for yourself. I think that should be a general rule of life. Unfortunately, it’s not always possible because everybody’s busy. We listen to the news media and we listen to the articles in the magazines and everything. Some of this stuff we hope that they’re telling us the truth. We hope that they’ve done their homeowner, they’ve investigated it. We believe it. A lot of the times, the people who are reporting it are the people who are writing the articles in the magazines, whatever, they have their own biases. They have their own opinions. Those get interjected in that anyway, but we should always look at both sides of the story.
Number two, options were made to lose money. If you look at the history of options, that’s why they were created. That’s why they’re there. Insurance companies are a great business model. That’s number three. If that is the case, if you believe in all those three things, then why would you trade in any other way? Why would you have the odds against you? Once in a while, if you see an opportunity, use an option to buy it and to make some money. If you think it’s gonna work out for you, go for it, but over the long term, the long term strategy, the long term income generation plan that you have, should be doing with selling options. Trade with the odds in your favor as an option seller.
That’s it for this episode, folks. I’ll have more coming up for you in future episodes and if there is a topic you’d like to hear about, just let me know at firstname.lastname@example.org. Just email me, email@example.com. Happy trading folks. Take it easy.
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