Many novice traders think that options are a great idea: You buy unlimited potential to profit and a guaranteed stop-loss which you can quantify right from the very beginning. What’s not to like? But as my daughter found out on a recent trip to London, buying health insurance isn’t always the whizz-bang idea it’s cracked up to be. In theory one should stash the equivalent monthly premiums into a savings account, which will then provide cash payment for the occasional consultant’s fee – assuming a fit young person’s profile. You see, ‘the house’, in this case the insurer, always wins.
But what if one isn’t willing to take on that risk? I would suggest that in this case making a living out of trading financial products may not be for you. However, the bigger threat is that it often leads to complacency. Rather than carefully monitor the market for signs of impending change, one has fixed in one’s mind take profit and pre-determined cut out levels and everything else in the middle becomes irrelevant; this makes for sloppy technical analysis.
The next pitfall is overpaying for the convenience. We all know that M&S meal deals for 2 carry a massive mark-up – but oh, how handy they are on a Friday evening after a hard days’ work week.
The chart I am showing you plots the price and volatility of sterling against the US dollar – cable as it’s known in professional circles (because it was the first FX exchange rate to be quoted over a transatlantic telegraph line). In the top half are weekly candles, where I’ve drawn in the most rudimentary of long term lines and retracements. What I’m looking for is signs when volatility might increase or decrease.
The lower half plots observed, often known as historical, volatility – the brown line. It is based on the difference between one closing level to the next, as compared to previous readings. You can see that early this year, and again this summer, it is quite a bit lower than the bars.
The bars plot the implied volatility of a generic put on the pound (red candles) or call on cable (green ones). This generic vanilla structure is a one-month, at-the-money, 10 delta option. The salient feature here is just how often puts are more expensive than calls – with or without Brexit; the massive surge, to really desperate highs, was around the referendum on the subject. Are you really prepared to pay that much for protection and peace of mind?
Also worth noting is how very often all options can become expensive to the underlying price moves, but how they can also be cheap at times too. That’s when buying insurance might be worth it.