Capítulo IV. La tierra ejidal y las trasformaciones sociales del pueblo de Ixtayopan
4.1. Los Ejidos de San Juan Ixtayopan
This is one of the most important secrets in the book. Many option experts have said that option buying is the sucker’s game and most professionals are option writers. This is partially true. I love to write options, but option buyers have one secret advan- tage. That advantage is surprise volatility. You see, when you buy options, you are betting on one thing—volatility, movement of the underlying stock or futures price. If the stock does not move, you lose!
Volatility is usually pretty predictable and moves in accor- dance with a log normal curve (i.e. bell curve). In fact, the Black and Scholes Pricing Model for measuring the fair value of an op- tion, which won a Nobel Prize, is based on this curve.
The problem is that the markets do not always move in ac- cordance with a log normal curve. Chaos theory throws a wrench in the bell curve theory. Stocks and even futures can make moves that are much larger than what a log normal curve prescribes.
For example, over the past few years, many stocks have made 5 to 10 point moves, sometimes more overnight, and on some occasions dropping over 50% in value, based on unexpected news, earnings reports or takeover action.
On a log normal curve, there are 3 standard deviations on each side of the curve, but some stocks move as much as 10 stan- dard deviations, way beyond the bounds of the curve. Hence, the pricing model is undervaluing the options, especially the out-of- the-money ones at the ends of the curve. In statistical terms, the tails of the curve are fat.
Therefore, surprise events prescribed in chaos theory can create instant home runs for option buyers and provide the op- tion buyer with a secret edge in the game.
One reason for the gigantic moves in stock prices, usually overnight, is the institutional influence. There are over 4000 mu- tual funds, and the institutions truly dominate the stock market. Hence, when a negative news item comes out about a stock, the institutions—like a herd of elephants trying to exit through a small door—try to exit the stock at the same time and cause the
O P T I O N B U Y I N G
stock to show a dramatic drop in price; for institutional man- agers do not want to show a losing stock in their portfolio.
In conclusion, when you are buying options, buy options on stocks that have the greatest potential for surprise volatility. That would mean tech stocks, overvalued stocks with a lot of hype, single drug pharmacy stocks up for FDA review, stocks in indus- tries that are in flux, stocks where you cannot pronounce the name, and the list goes on, any stock or futures that is vulnerable to surprise news or events.
T H E O P T I O N B U Y E R ’ S S E C R E T W E A P O N
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THE STOCK
ADVANTAGE
As you search for the best options to buy, you have a choice of stocks, indexes or futures, both financial and commodities. Which one has the greatest potential for surprise volatility? The winner is stocks!
Stocks by far have the potential for surprise price action. If you review and compare the historical volatility of stocks, indexes and futures, you will see the difference. In fact, some stocks have natural volatility of over 100%. Never will you see that with other instruments. Stocks are much more prone to explosive gains and losses.
Therefore, there is a big advantage to buying options on stocks rather than other instruments, such as futures. Also, again remember, when you buy options, you are betting on volatility, so buy options on those instruments that have the greatest poten- tial for surprise movements.
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THE PUT
ADVANTAGE
When you buy options, you should always buy both puts and calls. However, based on our research and track record over sev- enteen years—even though we recommended the same number of puts and calls for stocks—the put investments by far provided the best return with the most home runs.
Therefore, I would bias my options portfolio with more puts than calls. Puts provide more home runs for stocks, not only due to surprise volatility, but also to the fact that when stocks fall, panic can set in and enhance the decline. And, of course, there is the institutional influence.
Many years ago Joe Granville and I were discussing our love for put options, and he made a good analogy. When stocks rise in price, it is like climbing the steps of the Empire State Building, but when they fall, it is like jumping off the Empire State Build- ing. Stock prices fall much more sharply than they rise, and that
is what you are betting on—violent price action. Consequently, puts give you more bang for your buck.
There is also another advantage; puts are usually cheaper than calls. This is due to the fact that puts and calls are priced based on the cost of holding the underlying position and a call is a surrogate for the stock. Owning a stock is more expensive than shorting a stock, the purpose of a put.
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Secret
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DIVERSIFY
Diversification, important in all investments, is critical when it comes to option buying. Since many of your positions will be losers, the more positions you have increases your odds of hitting a home run. With only a few positions, you could easily wipe out your portfolio very quickly.
When we talk about diversification, we generally mean you should own both puts and calls and a variety of each, but there is another type of diversification that also applies here—DIVER- SIFY OVER TIME!
Don’t buy a lot of option positions at one time. You are bet- ting on market volatility. If the market goes to sleep (and it can sometimes for a year or so), you are dead. Your options will melt away and expire. If all your money is in options at one time, your portfolio will vanish.
time, patiently waiting for the market or a stock to explode. Once you see the market waking up, you can increase your option buy- ing activity.
A good game tactic is to plan to spend a set amount of dol- lars each year and gradually to invest that capital over that pe- riod, possibly using seasonal tendencies to maximize your opportunities and gains.
Time diversity is also important, for you are sure to en- counter losing streaks, and when you do, you will have enough money in reserve to return and play another day.
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