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I said this a while ago:

Lucky for me, I started my career on an options trading floor out in San Francisco. I have written about it a lot. I’ve met lots of people in my career, even on Wall Street, who only understand stocks and don’t know anything about anything. 

If you don’t understand the convexity that is present in bonds and options, then you aren’t going to understand the convexity that is embedded in stocks, and you certainly aren’t going to understand the convexity in stocks as a result of the existence of the options market. You just have no idea what you are doing.

Back in the ’70s and ’80s when options were first introduced, there was a lot of concern that options would crash the stock market. That hasn’t happened. That isn’t to say that options don’t influence the underlying stocks because they do—some of the wild swings we’ve had intraday in stocks are because of zero days to expiration (0DTE) options, with people loading up on infinite gamma in size.

There are people who do some kind of forensic sleuthing on options, finding the strikes with the largest open interest where stocks will pick up speed. This is not a terrible use of your time. These days, people trade a lot of options. Back when I was on the trading floor, people traded about 2 million contracts a day across exchanges. Now, that number is closer to 12 million. 

There are times when there is more action in the derivatives than there is in the underlying. A lot of this is retail punting—look, I can make 10X my money instead of 1X my money—which is about the worst possible use of options. There is an art to trading plain-vanilla stocks, for sure, but you are really limited as to what you can do.

The options market is liquid enough these days that, in most cases, your execution costs are very low, and you can create payoffs and structures that simply don’t exist in the stock market. These days, about 50% of my trades are options and 50% in the underlying.

Options Masterclass

I recently created a masterclass on trading options. It will be available soon. I should point out that in my Wall Street career (at least at Lehman Brothers), my job was not to trade options. My job was to trade index arbitrage and ETFs, known as “delta one.” I still traded a lot of options in my prop book, and I traded options while managing my own money too. I have been successful at it because of the experience I gained in my time on the P. Coast Options Exchange—a full year immersed in it. And it took about a year to get the hang of it, being exposed to it day in and day out. But that knowledge has stuck with me for life. Options are like riding a bicycle—once you figure it out, it will stick with you forever.

It helped that I had a background in mathematics. If you really want to understand options, you should probably take courses in probability and statistics and differential equations. Many people have been successful without it, though. I worked on the floor with some math PhDs, and I worked on the floor with construction workers—true story. I am assuming that only a small minority of my readers has a math degree, so you will be glad to know that construction workers in 1999 could figure it out.

This class is designed to take an options novice and turn him or her into an options expert. I will tell you everything you need to know. And there is a lot to know! It may break your brain. But if you stick with it, you will be able to manage risk in a way that you couldn’t before, which is the point.

If you want to YOLO call and put options for 1,000% gains, there are other courses for that—you see them on the TV commercials. But if you want to learn how to manage risk, smooth out the volatility of your P&L, and maybe give you some additional leverage for outsized gains, you will learn that in my masterclass.

When It Works

I’ll give you one example, and I’ll give you more next week. Remember when oil prices went negative during the pandemic?

I got the idea that energy stocks were at the lows and could not go any lower. So, I bought some long-dated call options on XLE, the energy ETF. I bought call options instead of the ETF because my risk was limited—if XLE actually did go lower, I would only lose the amount of the premium. I made about $240,000 on that trade, and my execution was not the best—I was a little early. If I had bought the ETF, it would have tied up a lot of capital, and I wouldn’t have made as much. 

I can tell you there is nothing like the feeling of being long an option and watching the stock blow through your strike.

Jared Dillian, MFA