113 - Never Buy or Sell Options! (Investing Rules)

Mental Models discussed in this podcast:

• KISS Principle (Keep it Simple Stupid)
• Process vs Outcomes
• Insurance
• Tail Events

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode113

Investing Rules: Never Buy or Sell Options

• Investing rules are simple and short rules that limit mistakes, improving future performance or returns. 
• "You don't need to be smart to make money investing. You just need to be consistently NOT STUPID."

Using Options tends to be stupid

The key idea is that you cannot predict short-term market prices. Ever. Therefore, you shouldn't own options.

There are four cases that I will address independently.

Options are one of the easiest ways to lose a lot of money fast.

In addition, options allow you to turn all of the advantages of investing in the stock market into disadvantages. 

• Long-term investors have time on their side: option holders do not.
• High-frequency traders will always beat you on options. Even retail brokers that don't sell order flow for equities (like Fidelity) still sell order flow for options.
• Normally if you're long you can't be forced to sell. Options can force you to sell when you don't want to do so.

Buying Calls

• Limited Downside, Infinite Upside
• Negative: Time limit on your return
  • Time works against you. You want time to work for you.

Selling Calls

• They limit your upside.
• You should absolutely never sell "naked" call options. This would be where you sell call options on stock you don't own. This is basically shorting a stock. (See the last episode)
• If you sell "covered calls" which means you own the stock, you've now taken away the upside on a stock you have already determined you like. This is terrible.
• You should focus on buying companies with upside optionality. When you sell a covered call you destroy this process. 

Buying Puts

• The limited downside, limited upside.
• These are typically known as insurance.
• You pay a premium, and you get a payoff if something negative happens.
• Insurance is always a net negative on your investment return over time. Unless you market time (bad idea), buying puts will lower your returns if implemented over an investment lifetime.

Selling Puts

• The limited upside, limited downside.
• Selling insurance tends to be more profitable than buying insurance.
• However, you have two options: "naked puts" which means you don't have the cash to buy the stock.
• "Cash covered puts" which means that you lock up your cash for an extended period and lose the optionality of cash.
• I am big on optionality. Never sell your optionality. Never sell your upside. Bet on yourself.

Summary:

You should never buy or sell options because options can cause you to be stupid and lose money.  You don't need to be smart to make money investing. You just need to be consistently not stupid. Investing rules improve your future performance and returns by limiting your mistakes. 

Focus on finding high-quality companies at good prices and harness the advantages of an individual investor. Options destroy these advantages and you should avoid them accordingly.