Truth about trading options & returns

Options.

They’re supposed to deliver you 1,000% returns overnight, week after week, right? That’s what a lot of these Internet trading “gurus” will tell you, anyway.

But the reality is far different.

Options are a zero-sum game. When one person wins, another loses.

The winners are few.

First you have the highly efficient market makers. These guys set market prices through their expertise in the Black-Scholes model used to derive an option’s price. They win in the long-term by controlling risk and collecting the difference in the bid-ask spreads. In exchange, they provide market liquidity.

The brokerage houses win big, too. They skim their cut off every trade and make out like bandits.

And finally you have the “sharps” or the professional option traders who squeeze out a profit over time. Their strategy is the hardest to operate. They aren’t rewarded for providing order facilitation services like the other two participants. Instead, they eat what they kill. Over the long haul they can get as rich as the other two, but only if they size up their strategies and/or attract investor money.

So who’s bankrolling these winning players?The suckers.

The complexities of options are not well understood by most of the retail trading world. Nevertheless, they’re highly attractive because of their limited downside, unlimited upside and embedded leverage. Who hasn’t thought about buying that call option on the hot biotech stock that returns 1,000%? Or the way out-of-the money put on the SPDR S&P 500 (SPY) that triples a trading account in a nasty crash? We all visualize that outcome and crave it.

The lucrativeness of the option market drives retail sheep to the slaughterhouse. They don’t know what they’re doing, and so they consistently lose, funding the winners.

But you don’t have to be a sucker like the retail traders. Options aren’t magic, and they can be used to generate attractive returns. But they need to be used in the right way.

The first step to successfully trading options is clearing up common misconceptions surrounding them.

Misconception No. 1: Options can produce 1,000% returns for your account

We’ve seen it all before. And I’m sure you have, too. Internet marketers advertising “1,000% returns” in a few weeks on a call option. Or they pitch you on some trade idea that will make a 500% return if XYZ stock crashes.

This sounds amazing to uninformed investors whose 401ks have been clocking in at a measly 4% the last few years. Their greed emotions start to run wild. They tell themselves things like:

“Imagine what 500% or even 1,000% returns could do to my portfolio! If I bet $ 10,000, that could turn into $ 50,000 or even $ 100,000!”

Unfortunately these emotional traders set themselves up for disaster.

It’s true that options can 5x, 10x or even 100x in extreme situations, but these events are rare. And when they do occur, you need impeccable timing on both your entry and exit to realize gains of that magnitude.

The options that can earn huge returns are the “out-of-the-money” options. They have a strike price higher than the underlying for calls, or lower than the underlying for puts. Refer to the option chain for Apple (NASDAQ:AAPL) stock below:

At the time of this screenshot, Apple was trading for $ 97.14. The calls are on the left side of the table and the puts are on the right side. Every option shaded blue is considered “in the money.” Every option shaded black is considered “out of the money.” The expiration date for all these options is July 15. The strike prices are in the middle (the gray area) and to the sides are the prices of each individual option.

Now let’s zoom in a bit and focus on one of these out-of-the-money options.

Check out the 85 puts:

You can see the bid is 19 cents and the ask is 21 cents. To the right of that is the implied volatility (IV) — the option market’s prediction of the underlying’s future volatility. And the next column is the probability that the option will expire in the money. The last column is the delta of the option (the Greeks are a discussion we’ll save for another time).

The marketer’s pitch of 1,000% returns on these options isn’t false, it’s just unlikely. The options that 10x, like the 85 put in Apple, can go from 20 cents to $ 2.00, but the probability is extremely low. The option market is only pricing in about a 6% chance of that option making any money at all by expiring in the money. But to get that fat 10x return you not only need the option to expire in the money, you need it to expire $ 2.00 in the money. That would require Apple to close at $ 83 by expiration. Apple’s price would have to drop $ 14.14, from $ 97.14 to $ 83. That’s a drop of almost 15%! And all within the next 30 days according to these options’ expiration dates. Trying to hit that scenario reduces your chances far lower than 6%.

Now those emotional investors might argue that their gurus know Apple is going to fall by that much in the next 30 days. The option will definitely finish up 900%. And so they load up their accounts.

Really???

If a guru could predict a 10x move in an option with 100% accuracy, he would not be telling you about it. Some quick math should leave you highly skeptical. Why? Because even if he started with $ 10,000, he would be a billionaire in just five trades.

• $ 10,000 (x 10).
• $ 100,000 (x 10).
• $ 1,000,000 (x 10).
• $ 10,000,000 (x 10).
• $ 100,000,000 (x 10).
• $ 1,000,000,000.

And forget 100% accuracy. Even if he had 50% accuracy he would be a god among market mortals.

A persistent 5% edge in the markets is big. Anything larger is huge. Remember, there are billion-dollar casinos that make their nut on a 1% to 2% edge at the gaming tables.

If you’re playing for a 10x, you would need to be right 10% of the time to break even. (You lose a dollar nine times and on the 10th time win $ 9. (9*1)-(1*9)= 0 ) This means a 10% hit rate would give you a 0% edge.

Professional traders would love to get 5% to 10% edge on an options play over time. To achieve that level of edge you would only need a 15% to 20% hit rate on options going 10x.

Thinking some investment guru has an accuracy rate much higher than 10% is just fooling yourself. So don’t fall for that. These far out-of-the-money puts and calls are called “lotto options” for a reason. They seldom win, even with high quality cutting edge analysis from the best in the world.

But let’s say our guru is actually pretty good and can hit a 10x winner about 20% of the time. His marketing still lures in the suckers because it’s framed in a way that makes you dream about 10x-ing your account on one trade.

This is a huge trap newer traders fall for. The only way to 10x a trading account in one option trade is to go all in. Even a novice student of risk would tell you to never do that. There is a 100% chance of eventually going broke with that strategy.

I play a lot of Texas hold ’em ring games when the markets are closed. (Got to feed the risk addiction somehow.)

The stakes are fairly friendly. Most people buy in with 500 bucks. Some sit down with a grand.

The people who come to play aren’t students of the game like myself. They consistently lose. But it’s OK because they’re content with “paying” for the entertainment. They’re there for the free food, table talk and massages from the game girls. If you have any sense of probability or risk/reward, you can consistently extract money from this pool of players. It’s a fun way to earn a side income. (The cross-training between trading and poker is also incredible, but that’s a topic for another day.)

Anyway, the same guys who come to the poker tables every night to blow off steam are also the ones going all in on options plays. To them, trading is just another outlet for gambling.

I can’t tell you how many stories I’ve heard at the poker table of guys who took their $ 20,000 trading account to $ 100,000 in a year and then wound up broke. They lose it all. Every single penny.

But this never surprises me. Overleveraging and going all in might make for a good story at the poker table in the short term, but it always ends badly. You can’t fight the probabilities no matter how hard you try.

If you plow all your money into one trade, you will go broke. If it doesn’t happen this trade, it’ll happen the next one. It’s important to think of trading as a long-term process rather than a single hot tip. True wealth is made by long-term compounding, not a one-off gain from some option trade.

So when the marketing gurus tout 1,000% returns, keep in mind that it’s just a one-off trade that you can’t put your whole account into anyway.

At Macro Ops we’ll usually bet 0.5% to 2.5% of our account on any one trade. A lot of hedge funds will even bet as low as 0.10% per trade.

If you follow sound position-sizing mechanics and put 1% of your account into the guru’s pick and get your 10x, your total account would be up 10%. Now don’t get me wrong; that’s a great return since you only took 1% risk to get it. But it’s a far cry from a 10x on the whole wad.

Misconception No. 2: Options are more/less secure than stocks

The financial media will tell you that options are riskier than plain vanilla stocks. This is true if we define risk as the volatility of returns. But practitioners will tell you that volatility is a crappy measure of risk.

Other market participants will tell you the opposite. They claim options are far less risky than stocks because your loss is defined. This sounds good on paper, but in practice it’s not too important in an overall risk management system.

Both these viewpoints on option risk are wrong.

Options are neither more nor less risky than stocks.

Risk is a function of position sizing, not product type.

Let’s break it down.

As an investor or trader you always want to think of your downside in relation to your account size.

Say you want to buy a call option because you think the price of a stock will go up. You have a $ 100,000 account. There’s a chance that call option expires worthless and 100% of your invested capital is lost. But you get to choose what that 100% loss means in relation to your account.

If the call costs $ 1.00 you could bet your whole account and buy 1,000 of them. In that case if the option expired worthless, you’d be broke, having lost the 100 grand. Now say you bought only 1 call option for a total of $ 100, and the option expired worthless. A loss of $ 100 on a $ 100,000 account is only a 0.10% loss in total.

So you see the option is not inherently more or less risky than the underlying stock. It just behaves differently. Rather, what makes it risky is the number of calls you buy.

This same argument is also used against sellers of options. Critics say, “Well if you sell a naked put you have limited upside and unlimited downside. That’s a very risky position.”

Again, the short put is not risky in and of itself. Its risk depends on how many you sell.

For example, say you had the choice between buying shares of SPY the S&P 500 ETF and selling a put on the ETF.

Let’s say the stock is trading at $ 206.44 and a 206 put is selling for $ 4.45.

If you bought 100 shares of the stock, you would spend a total of $ 20,644. Now imagine the market got kneecapped and SPY sold off 50%. You would be sitting on a $ 10,322 loss.

On the other hand, if you sold one of those puts struck at 206, with the same 50% decline in the market, things would play out differently.

After the 50% drawdown SPY would be trading for $ 103.22. The puts are in the money and you owe the buyer (206 – 103.22) * 100 or $ 10,278. But don’t forget, you also received that original $ 445 credit at the time of sale. So the net loss would only be (10,278 – 445) or $ 9,833. You actually lost less than if you had just bought the plain vanilla stock!

In this scenario selling one put option was less risky than buying plain vanilla stock.

Now say you were feeling greedy and sold two puts instead of one to collect $ 890 in credit. And imagine the 50% decline still occurred. Instead of a $ 10,278 loss, you would have to cover a $ 20,556 loss. Subtract the credit of $ 890 and you’re left with a net loss of $ 19,666. This is much larger than the $ 10,322 loss on the 100 shares of plain vanilla stock.

See the difference? The riskiness of the put has to do with position sizing, not the nature of the instrument.

False beliefs regarding risk can be very limiting to your development as a trader or investor.

Remember: Position size determines risk, not product type.

Options can either lead to a trader’s demise or to his victory over the markets. The key is knowing how to use them correctly.