When I’m explaining financial markets to someone that is unfamiliar with them, I like to explain difficult concepts using analogies. One of my favorite analogies is comparing financial markets to vehicles. I use cars in particular because everyone knows what a car is and has either driven a car or ridden in one.
Each vehicle has a different level of performance. Some vehicles are fast while others are slower, some require more maintenance, some require constant monitoring, others can be driven everyday with minimal user intervention.
Do You Have A License To Trade That?
To drive a car a license is required, but to trade in the financial markets there is no license required. This leads to millions of people that are trading the markets that have no idea how to control the vehicle that they are using.
Most people will be able to open an account with a brokerage company with little difficulty, and begin trading with out any kind of formal testing or knowledge. This is the equivalent of getting into the drivers seat of a car, and not knowing the difference between the gas petal and the brake pedal.
Driving Fast Cars Without Experience
In the beginning of a trading career many people want to make money really fast, without having to learn how to handle the vehicle they are trading. So they trade penny stocks, and hope and pray that the 80:1 payout will make them money very quickly.
The issue with this approach is it is very similar to giving a 16 year old, with no driving experience driving, a Ferrari 458 Italia. Will it be fast yes, but it will also likely end in a loss of control and an accident. Is it to say that the 16 year old will never be able to drive the Ferrari? Certainly not, it only requires training and experience with the vehicle.
Investing is similar to driving in that it takes practice and education to overcome fear and doubt. Once you have an understanding of how to “Drive” one vehicle, new vehicles will require only minor adjustments for you to become proficient.
2 Types Of Cars You Should Have In The Garage
In general, all investment vehicles can be compared to vehicles. There is a great number of vehicles in the world as there is a great number of investment tools. The two types of vehicles we will focus on are:
- The daily driver (the car we will use to make a living)
- The race car (the car we will use to make a fortune)
Each vehicle requires specific disciplines to be mastered before the vehicle can be fully utilized. If you want to drive a race car, time and money must be spent learning everything about that vehicle. What are the requirement for entry? What are the rules on the race track? Is there specific experience requirements?
Which Vehicle Should You Learn To Drive First?
The Daily Driver is the vehicle that will make you a living. Many traders tend to skip this vehicle because they have a job that makes them a living, they believe the reason they should invest/trade is to make a fortune. Making a fortune is exciting and “when” they find that one hot tip they will be in the money. The issue with this approach is that most people that have a job to make a living, do not have sufficient time or money to learn the vehicle that they want to trade.
My recommendation to most people is to learn how to handle and drive a daily driver. Once the daily driver is creating enough income to financially support a “Race car”, then start learning that new vehicle. With this approach even if the new vehicle is not what you expect, you will still be able to learn another vehicle down the road.
Guest Post by John Pierce
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Leave A Reply (9 Comments )
Omad
107 days ago
So do you consider option trading, naked puts/calls, spreads the daily driver or the race car?
[Reply]
Kirk Reply:
February 2nd, 2012 at 6:16 AM
Personally – I would consider credit spreads more of a daily driver. Naked options have been very good to be but they are more sensitive to volatility which makes them great during high vol (like a race car). Oh yeah and monthly dividend stocks are great “daily drivers” too.
[Reply]
Bill Place
106 days ago
Very well put Kirk
[Reply]
copydog Reply:
February 4th, 2012 at 9:30 AM
@Bill Place,
Will let’s see with naked puts and naked calls. You should not leave your steering wheel.
With spreads you can put on the cruise control once and a while. But most of the time you still have to keep your eyes on the road :-)
[Reply]
M>V
103 days ago
Great article,you couldn’t write it in a more simple way/
[Reply]
John Pierce Reply:
March 14th, 2012 at 11:40 PM
@M>V, Thank you, I try to keep this stuff simple.
[Reply]
Omad
103 days ago
Interesting how everyone feels safer with credit spreads v naked options, I ran some numbers comparing a put credit spread and a naked put on AAPL last month using the same margin and the results were interesting. Here’s what I found:
AAPL trading at $413, I’m comparing the Feb 330 naked put v 330/325 credit spread using $10k of margin. The prices are live prices at around 3pm on 04th Jan.
330 put bid 0.86 ask 0.92
325 put bid 0.73 ask 0.76
IB was showing the spread at bid 0.10 ask 0.20 so lets split the difference and say we sold the spread at 0.15
So with $10k margin we can sell 20 contracts of the spread at 0.15 for $300 total
IB margin required for naked was $3,274 so using $10k margin we can sell 3 contracts at 0.86 for $258 total. Could probably do better then the bid but will use this for the comparison.
Because of the higher commissions on the spread the total dollars you take in will be similar.
Now if on the last day AAPL is at $325, we have a loss of $5 on the spread for a total loss of 2000 * 5 – 300 = $9,700 – our maximum loss.
With the naked there will be at least $5 of intrinsic value in the 330 plus some time value, lets say $1(maybe excessive for 1 day left?), so $6. Total loss of 300 * 6 – 258 = $1,542
So as you can see, for same margin, similar income, massive difference in loss.
Apple could be at $300 at expiry and our loss on the naked put would be 31 * 300 – 258 = $9,042 – still less then the spread. I would never be holding naked puts in the money unless I was happy to be assigned.
Would love to hear others thoughts on this and point out anything I’m missing.
[Reply]
John Pierce
71 days ago
I agree with the comments made here and I will be coming out with a new article in the next week or so.
[Reply]
Omad Reply:
March 10th, 2012 at 12:19 AM
@John Pierce, I’m interested in reading your article John, will you be providing a link?
[Reply]