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A Few Notes on The Options Trading Body of Knowledge

| | Posted in: Equity Options

In his 2009 book The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry, author Michael Thomsett “provides a market overview and discussion of risks, in addition to a comprehensive listing of strategies.” He states that the “…book is designed for the options trader, whether a novice or skilled pro, who understands and appreciates the market issues.” He states that the book “provides a very comprehensive explanation of how option premium develops based on various elements of value; calculation of returns from options and stock trading; federal taxation works in the options market; how stocks are picked for options trading; online and print resources; and a very complete glossary of terms that options traders will find valuable.” Some notable points about the book are:

The book might best be characterized as a reasonably robust how-it-works description of stock options. It offers hardly any discussion of options on indexes and futures, the rules for which differ from those for stocks and funds (for example, with respect to early exercise and tax treatment).

The book offers judgments on the profitability and risk of strategies for stock options and the value of specific technical and fundamental indicators, but does not press conventional wisdom by performing backtests on historical data or by citing confirming formal research. For example:

Page 23: “On the highly conservative side, the covered call is the safest and most profitable of all option strategies. A study of possible outcomes reveals that a properly structured covered call is going to yield double-digit returns even in the worst-case scenario, when return is calculated on an annualized basis.” The author does not substantiate by test or reference the superlatives or the double-digit annualized returns in this assertion. It is, for example, not obvious that selling covered calls is safer or more profitable than selling cash-covered puts.

Page 25: “High-risk strategies include naked options, especially when positions involve multiple contracts.” As noted, selling naked puts is arguably no riskier than selling covered calls.

Page 40: “When prices fall considerably in a very rapid move, long call entry is signaled and may easily produce immediate profits when implied volatility is high. …This over-reaction invariably corrects over the following two to three sessions. The same swing trading approach can take advantage of implied volatility using puts. For example, when a stock’s price spikes upward in a single session on momentary news or even a rumor, it is likely to correct within two to three sessions following…” The author supplies no tests or citations of research to substantiate consistent profitability from trading stock options based on such signals.

Page 68: “A sensible fundamental rule: Invest in stock of companies that pay better than average dividend yield and that have increased their dividend per share every year for at least the last 10 years. …A sensible fundamental rule: Limit investment candidates to those companies whose P/E has been consistent through the past decade and whose P/E is not excessively high (above the 20-25 range).” The author supplies no tests or citations of other research to substantiate the outperformance of stocks based on the recommended criteria.

Page 70: “A sensible technical rule: Look for strong signals of important changes in price movement and trading range. Especially important are tests of resistance or support and breakouts, followed by price retreat or by continued movement.” Again, the author supplies no tests or citations of other research to substantiate the outperformance of stocks based on the recommended criteria.

Analysis of the outcomes for actual options trading is complex and bounded by a paucity of historical trading data compared to that available for stocks and bonds. However, there are some formal studies (see those referenced in Blog Synthesis: Equity Options) that attempt to model expectations for some options strategies based on available historical data. A shortcoming of the book is that it does not describe or reference such research.

The book is loose in a few places with respect to predictability. For example, from page 21: “Both intrinsic value and time value are very predictable, but the unknown portion of the premium extrinsic value [derived from implied volatility] is where all the unknown elements come into play.” The author surely means “specified” rather than “predictable” for variation of option intrinsic value (moneyness) over time.

In summary, investors may find The Options Trading Body of Knowledge useful as a broad source of information on how strategies for stock options work, but they should be skeptical of any judgments it offers on strategy profitability/risk and recognize that rules for other kinds of options may be different.

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