Options 101.3

Welcome to the third post of the Options 101 series. In this post we’ll be looking at the ‘Circle of Competence’ idea and why this is extremely important for options in particular.

First of all let me start by referring you to the previous two posts:

Options 101.1: General Option Information

Options 101.2: Why Selling Options Is So Great

What is a Circle of Competence?

The CoC is a term used a lot by Warren Buffett and Charlie Munger, the legendary investors. It applies to all ways of investing, but in my opinion its especially crucial when working with derivatives and leverage.

The CoC basically says that you cannot understand everything in this world and one of the most important rules for investing is: invest in what you understand. The CoC is a circle of your knowledge, certain companies and business models simply fit into that circle and some don’t.

If you cannot explain how a business makes its money, what its risks are, how can you make a decent investment into this company? Understanding where earnings come from, and foreseeing problems due to Trade Wars, macro economic headwinds are crucial factors in becoming a successful investor or trader.

How to put this into practice?

Ask yourself, do I know this company? Can I explain a five year old what this company does? Do I know where their earnings and risks come from? Do I know the market sentiment (for traders)?

Read articles, and choose the articles carefully, don’t just read from certain authors that confirm your opinions. Try to avoid ‘Confirmation Bias’ and read opposing pieces to get a deeper understanding of the company, management and stock.

Stick to a certain group of stocks. You cannot follow the entire S&P500 all day long. Check companies that you like, follow CEO’s that you like, make it easy for yourself to stay interested in the company and its news and earnings. This way you develop a chain of information, going back years, that provide you with guidelines to how a stock might trade, or how a stock might perform in the long term.

Understanding a business model and an entire company also helps you stay calm in tough times. Trumps Trade War might or might not affect a company that you’re invested in. If it doesn’t affect your company, great! It does? Well is the company solid and does it have diverse income streams, or should you really be worried about the situation because Chinese money makes up a big piece of the pie?

The Circle of Competence for General Information

This theory expands into many aspects of life. Aside from companies, you’ll also need a Circle of Competence for the products that you use to trade, or invest in, these companies. Buying and selling stocks is fairly straightforward, but then it’s more about finding the right broker that provides the right prices for your investment style.

Using derivatives like turbo’s/sprinters/speeders, options and futures is an absolute no no if you don’t understand the products themselves. These leveraged products can often lose you more money than you put into the trade or more money than you even have in your brokerage account.

Before you start using options, make sure you understand the material and you could try and explain the material to someone else for example, to make sure you really understand it yourself.

Once you mastered the material, dip your toes in slowly at first, don’t go in ‘all guns blazing’ and blow up your motivation and money.

An example

I started reading about, and making investments halfway through 2016. I started because a friend of mine showed me a crowdfunding platform and explained me how it works. After that I got interested and bought books on investing and I got hooked. I bought my first set of stocks at the end of 2016 and kept investing since then.

I kept reading, I got hooked on SeekingAlpha’s community and the Yahoo Finance newsfeed. I expanded my knowledge on companies that I found interesting, cool or simply superbly profitable.

After started working at a brokers office in Amsterdam I got even more information and opinions about stocks and the general economy. I had to do some tests about financial products (to prove I could inform clients in the correct way) and I noticed I nailed the test for Options, I really liked the subject. This happened in November of 2018.

So after building up a database about certain stocks for two years, I started trading options on these companies. Without complimenting myself too much, but the trades have been going quite well.

The funny thing is that most of my trades involve the same names over and over again, you guessed it; those names are the ones I have gotten a lot of information about in the past.

Trading outside of my Circle of Competence has been profitable as well. But these trades often include the ones that I have to hold way longer, or go through hell the turn a profit (Beyond Meat).

Conclusion

Stick to what you know. This is especially important when you work with derivatives and leverage! Trading outside of your strategy and outside of your Circle of Competence is a recipe for disaster, and we don’t want that to happen, do we?

I hope I provided some useful information for you. Any feedback will be hugely appreciated, thanks for reading!

Feel free to ask me anything, there are no stupid questions!
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