Options trading has always been a specialist profession. However, over the past few years, fintech companies have pounced on the options trading market. As a result, it's now cheaper and easier than ever to trade options with lots of leverage.
This is not necessarily a bad thing. Lower trading costs and easier access to financing could be hugely beneficial for traders that know what they're doing. However, it could also be catastrophic for traders who don't understand what they're doing.
Buffett on option trading
Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), who are not only some of the best investors in the world but also some of the most experienced, have discussed this topic several times in the past.
For example, at the 2003 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders, the duo labeled the Black-Scholes models for options pricing as "insane." The Black-Scholes options pricing model is used to determine the fair price, or theoretical value, for an option based on six variables such as volatility, type of option, underlying stock price, time, strike price and the risk-free rate.
Buffett criticized this model as part of a broader discussion on the problems with options in general. Specifically, he noted:
"Black-Scholes is an attempt to measure the market value of options, and it cranks in certain variables. But the most important variable it cranks in that might be subject — well, might be a case where if you had differing views you could make some money — but it's based upon the past volatility of the asset involved. And past volatilities are not the best judge of value."
As Buffett explained, this "mechanical system" for pricing options, which fails to consider some essential variables, can lead to some "silly results," especially over long periods. This can give some great opportunities for those investors who're prepared to wait:
"We made one — as I mentioned last year — we made one large commitment that basically was — had somebody on the other side of it using Black-Scholes and using market prices — took the other side of it and we made $120 million last year. And we love the idea of other people using mechanistic formulas to price things, because they may be right 99 times out of 100 but we don't have to play those 99 times. We just play the one time when we have a differing view."
The main takeaway for investors from this is that making money in the options market is far from certain. As Buffett explained, most of the time, there are no opportunities in the options market. However, there are some occasions where the reward justifies the risk.
The issue traders face is patience. It requires lots of patience to wait for the right opportunity and act with conviction when the opportunity emerges.
As Munger explained in 2003, the Black-Sholes model is a "know nothing value system." It's designed for people that know nothing, which can lead to inefficiencies. Buffett explained:
"Because, as Charlie says, it's a know-nothing affair. And we are know-nothing guys, in respect to an awful lot of things, but every now and then we find something where we think we know something, and anybody that's using a mechanistic formula is going to get in trouble in that situation."
So, if you know something about the market and can take advantage of the "know nothing" system, it may be possible to make money in the options market. If you don't, it might be better to stay away from this complex and fast-moving market entirely. Buying something you don't understand can be a fast way to lose money quickly.
Disclosure: The author owns shares in Berkshire Hathaway.
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