Yesterday evening, I attended an options trading seminar at the Gaylord National Hotel at National Harbor. It’s an impressive new convention center on the banks of the Potomac in Maryland, right across the water from Old Town in Alexandria, Virginia. The sunset over the water was beautiful.

The seminar was taught by my friend Tom Sosnoff, Senior Vice President of the Trader Group at TD Ameritrade (NasdaqGS: AMTD). I’ve known Tom for about a decade, the same length of time I have been a client of thinkorswim, the Chicago-based options brokerage firm he co-founded in 1999. TD Ameritrade bought the firm for $606 million in June 2009, making Tom a very rich man in the process. I have asked Tom at least a couple times how he came up with the silly name thinkorswim and haven’t gotten a satisfactory answer either time. I’m not sure he even remembers anymore.

Memories of Chicago

Tom and other traders at thinkorswim used to teach in-house classes every Monday evening at the firm, first when it was located on Lincoln Avenue and even for a time after it moved to its current offices on Chicago Avenue. I think it fair to give Tom, co-founder Scott Sheridan, Director of Quantitative Strategies Tom “TP” Preston, and head trader Steve Rashis all the credit for teaching me how to trade options in a high-probability, defined-risk manner. Nicest guys you’ll ever want to meet, and even answer their own email. Having weekly access to these options gurus was definitely one of the best of the many perks I enjoyed by living in Chicago.

Anyway, back to the present.

Cat Fight!

When Tom started the seminar, I expected him to start by discussing his view of the current market selloff. Instead, I was surprised to hear him talking about Whitney Tilson, a value fund manager and Warren Buffett devotee. It turns out that Mr. Tilson had been quoted in a Bloomberg article that very morning badmouthing option trading:

Trading options is one of the all-time suckers’ bets. Most experienced professionals lose money doing it. It’s virtually certain that inexperienced, individual retail investors will lose money doing this.

It was shocking to hear that such an ignorant statement had come out of the mouth of an allegedly intelligent human being. Tilson obviously knows nothing about options. As I have written recently, selling put options and selling covered calls actually reduce the risk of stock ownership, while the judicious purchase of long-term call options as a stock replacement strategy can significantly enhance investment returns by minimizing your actual capital at risk.

Knowing Tom, who was a Chicago Board Options Exchange (CBOE) market maker for 20 years and has devoted his life to educating retail investors about option trading, he wasn’t going to take this ignorant insult sitting down. And he didn’t. He told us that Tilson, as a stock investor, could benefit by employing options in conjunction with his stock trades. Sure, options can be used recklessly, such as buying significant amounts of short-term out-of-the-money calls that are likely to expire worthless, but such speculative activity is only a very small part of the options world and one that smart traders avoid. Smearing all options traders for the behavior of a stupid few just isn’t fair.

Those Living in Glass Houses Shouldn’t Throw Stones

Tom then provided some examples of Tilson’s trading mistakes, showing that value investors can make stupid money-losing trades just as easily as anyone else. On October 6, 2008, Tilson was quoted as saying: “This is a great opportunity to invest in the market. We are putting money in hand over fist.” He also said his favorite individual stock was the satellite technology and digital set-top box manufacturer EchoStar Corp. (NasdaqGS: SATS).

What happened next?

Echostar fell 43% in the next six weeks. To this day, Echostar has never closed at a price as high as it did on October 6, 2008. Who’s the sucker now, Whitney?

Tom then gave another example. On January 22, 2010 Tilson said on CNBC: “I’m shorting the Hell out of homebuilders because America won’t need any homes for years.”

What happened next?

Homebuilders — as measured by the SPDR Homebuilder ETF (NYSE: XHB) — skyrocketed 34% over the next three months. To this day, XHB has never closed at a price as low as it did on January 22, 2010. Who’s your daddy, Tilson?

If Tilson had sold covered calls on Echostar or sold puts on his homebuilder short, he would have lost less money than he actually did.

Game, set, and match Tom Sosnoff! The point is that any type of risk-taking investment, whether it be purchasing stocks or trading options, can lose money. What’s important is how intelligently you trade; that is what determines your long-term profitability. Looking at the mediocre performance of the mutual fund Tilson manages, I’d say Tilson should shut up and stop casting stones at option traders smarter than him. Even his idol Warren Buffett sells put options to lower the cost of stock purchases, for heaven’s sake!

Bearish on Bonds

Enough about Tilson. The rest of Tom’s talk was very informative. His favorite bullish trades are natural gas (NYSE:UNL) and the Euro (NYSE: FXE). But what really seemed to pique his interest was his favorite bearish trade right now: long-term U.S. treasury bonds (NYSE: TLT). Interestingly, he thinks the current bond laddering actions of brokers to enhance the yield on customer cash deposits will make the ultimate interest rate rise worse. About a month ago, I wrote how TD Ameritrade was getting hurt by the Fed’s zero interest rate policy (ZIRP).

According to Tom, brokers are taking the cash deposited by customers and investing it in bond ladders in order to earn higher rates of return. I spoke a little about ladders in Part 4 of my asset allocation series. In essence, brokers are lending long term and borrowing short-term. Whenever you have different fixed-income durations for your assets and liabilities, you are asking for trouble. Just ask Thailand about 1997. (then again, don’t; they have enough problems right now). When short-term rates rise, Tom predicts that brokers will unwind their bond ladders and bring their assets and liabilities back in synch duration-wise. This unwinding will cause them to sell these longer-term bonds, which will result in long-term interest rates rising faster than they otherwise would have.

Trading Wisdom

Tom provided some valuable insights into options trading that I may revisit down the road, but it is too complicated to rehash right now for this article. What I will share, however, are some short quips of trading wisdom he made along the way of his presentation:

• The trend is your friend, but the “fade” (i.e., the contrarian reversal trade) is the ultimate wealth builder. Expecting the unexpected yields the biggest profits. Just ask John Paulson and Michael Burry, who shorted subprime mortgage debt before anyone else figured out the real estate crisis.
• Good traders sometimes lose money, but they never make bad trades.
• Risk is just a measure of education. If you know what you’re doing – trading only liquid products with tight bid/ask spreads and employing defined-risk options strategies — you can significantly reduce risk and sleepless nights.
• Leverage your existing capital by using your open positions to generate additional capital through overlays. For example, if you already own stock, sell call options against it to bring in more income.
• The only certainties in life are death, taxes, and options time decay, so always sell options to take advantage of their time decay.
• Don’t trade too large a position size. Otherwise, you will panic at the worst possible moment and not allow your trade the time it needs to turn profitable.
• Always know the odds (i.e., risk/reward) before you put on a trade.
• Irrational markets have deep pockets (i.e., last longer than you expect), so avoid making short-term trades betting on a reversal.
• Reversion to the mean will occur eventually, however, so take advantage of extreme market conditions by making long-term trades going the other way.
• Stop with the stops. The reason Accenture (NYSE: ACN) traded for one penny on May 6^th is because someone placed a stop loss market order (i.e., sell at any price once stock falls below a certain price). If you are going to place stops, make sure they are stop loss limit orders (i.e., sell order is activated if stock falls below a certain price, but sale will only occur if stock trades at a minimum price level).
• Think about your next trade, not your last trade.
• The most liquid markets lead other markets. Use them as “tells” for what is about to happen in the stock market. The smart money is the big money and big institutions need to use the most liquid markets in order to initiate their trade biases fastest and with a minimum of price dislocation. Since the currency market and the stock index futures market are more liquid than the stock market, these markets will make their move prior to the stock market.
• Realize that prayer is not a viable trading strategy.

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Elliott Gue, editor of The Energy Strategist investment service, has written a wonderful primer on low-risk options strategies entitled “The ABCs of Options to Hedge Risk.” This special options report and four others are yours free if you sign up for a two-year subscription to The Energy Strategist. No-risk guarantee: For the first three full months if you’re not completely satisfied simply call us for a 100% refund – no questions asked.