a bit extra (or a lot extra) as profit? Or are you content to pay those premiums so you do not have to worry about things, even if it proves to be a bad financial decision? Once again, as we have discussed, every trade is about transference of risk. When you buy an option, someone is taking on your risk and collecting a fee for their trouble (much like you buying insurance). More often than not, that seller will be the one profiting from the transaction (much like an insurance company). And that profit maxes out at the premium you paid (and they collected). But at times, you get to cash in on your policy in a big way. So, over time, who comes out ahead? The answer is a definite, unqualified “It depends!” Wouldn’t it be nice if you could figure out the probabilities of an event occurring and its cost beforehand? Just like an insurance company utilizes actuaries to calculate the probabilities and costs of losses and sets premiums accordingly, option sellers do the same thing! But you may feel like you will never be able to figure that out. The math is daunting and the concepts beyond reach. Thanks to some incredibly powerful and easy-to-use software provided free of charge by a good broker, it is actually pretty easy! Thus, if a trader feels the option is too cheap and that the expected value of the trade over time gives her a profit, she can buy it. And if she feels it is too expensive, she can sell it, take on someone else’s risk, and hope to profit from it (just like an insurance company). In essence, you can choose to be the insurance company or the insured, and switch roles at any time, based on your assessment at the time.
One of the most amazing qualities of options is that you can quantify the probability you have of making money on any given trade before you make it! That sure makes things easier, don’t you think? Although it is definitely a huge advantage, making money trading options is a bit more complicated than that. In fact there are at least three more major moving parts that we need to discuss. We will introduce the concepts here and drill down much deeper later.
If you are able to make money on 60 percent of your trades, does that guarantee you will make a profit? What if you lose twice as much on your losing trades as you make on your winners? Using a quick example, let’s assume you make 10 trades and you make a profit of $1 on 6 of them, giving you a probability of profit of 60 percent. That gives you a total of $6 in winnings. But on each of the four losing trades, you lose $2. You now have $8 of losses, giving you an overall loss of $2 on your 10 trades. So, we can see it is not just the probability that leads to profitability. It is also the ratio of our average winner to our average loser.
The first thing you learn in a beginning statistics class is that probabilities have merit only if there is a large sample size. In other words, if I flip a (fair) coin 1,000 times, I can expect to get about 500 heads and 500 tails. I will not be off by much because I have a 50/50 chance of achieving either result. But if I flip the coin twice, I have only a 50 percent chance of achieving one head and one tail. In 25 percent of the cases, I will flip two heads and 25 percent of the time I will flip two tails. In other words, the probabilities have little hold over my results when the number of occurrences is few.
Probabilities also have something to add to the discussion of how large your trades should be. Trade size, in fact, is one of the most frequently overlooked subjects when learning to trade. Let’s look at an example. Let’s say you have $1,000 and bet $250 on each of four successive flips of a coin. What is the probability that you will lose all four flips and be completely out of money? The math is “px,” where “p” is the probability of the event occurring and “x” is the number of sequential times you are testing for the event to occur. Thus, in a coin flip, where you have a 50 percent probability of losing, the probability of losing four times in a row is .504, or 6.25 percent. If your probability of losing each individual event were 30 percent (you win 70 percent of the time), you would go broke after four occurrences .304, or 0.81 percent of the time. If your probability of losing each event were 70 percent (you win 30 percent of the time), you would go broke after four occurrences .704, or 24 percent of the time. Based on these results, betting $250 is too large a bet for my comfort, especially if my odds are less than 50 percent. Translating this to trading, if 25 percent of my account size is too much to risk on each trade, what size is optimal?
Once again, the answer is “it depends.” Since there is not a simple answer and because the answer hinges on a number of inputs, we will save that discussion for later also.
You may be asking yourself, “Even if I can learn all this, how can I possibly hope to compete against professional traders?” I have good news for you on that front! Though professional traders and retail traders are “watching the same picture” and trying to profit from the same theoretical edge, the types of strategies employed differ greatly. As such, the retail trader is actually in a better position to profit thanks to the existence of the professional trader. Let me explain.
We will start by looking at a few of the more common professional trading strategies. First, we look at options market makers. Market makers are traders who get better treatment in several ways due to the fact they provide liquid, two-sided markets in all options for all stocks they are assigned, or choose. There are rules for how far apart the bid and offer can be placed based on the price of the option. So, when a retail trader wants to buy or sell an option, the market maker is out there providing liquidity to facilitate the trade. The market maker can “skew” his quotes so the trader is more likely to buy or sell, based on his opinion. But the market maker has to take whichever trade accepts his market. That is, if someone wants to buy the market maker’s offer or sell his or her bid, the market maker is obligated to make the trade. The retail trader, on the other hand, has the advantage of choosing his trades! We can shop for the best bid or best offer for the exact trade we choose to make. Do not underestimate the advantage that gives us!
The same liquidity argument can be made for HFT (high-frequency trading) scalpers. HFT scalpers are persons or firms who quote markets at hyperspeed using complex computer algorithms. All you really need to know about them is they make tight, deep markets of which retail traders can take advantage, but trade only in the stocks they choose. This is in sharp contrast to market makers, who have an obligation to always make markets in all their stocks.
Another professional strategy is that of volatility arbitrage. Proprietary traders, who buy volatility they deem cheap and sell that which they feel is expensive, typically use this strategy. Of course, for “vol arbs,” most stocks’ options are typically cheap or expensive at the same time. For example, if VIX is 12.50, most equity options trade for a relatively low implied volatility (IV). When VIX is 40, most equity options are expensive, as their implied volatilities are rich also. So, the operative word for vol arbs is “relative.” They will always be long option premium they deem cheap compared to the rest and will be short option premium they consider rich compared to the rest. Though they will run a short premium or long premium book (portfolio) based on their opinion of the overall volatility in the market, they will often be on the other side of trades the retail trader wants to make, thus facilitating our trades.
Though there are many other strategies employed by the professional trader that often finds him on the other side of the retail trade, there are two points I would make about each and every strategy:
1. This does not mean the professional is right and the retail trader is wrong. In fact, since each trader could be doing something different with a trade, both could be wrong or both correct.
2. The most important point to be made is that the professional trader supplies liquidity to the marketplace that the retail trader must have in order to be profitable. Without the professionals, the retail traders would be out of business! It is a symbiotic relationship that is to be nurtured, not feared! The professionals keep markets tight and deep. We term this “liquidity” and it means you can buy or sell any liquid option with very little slippage in price. If you think the offer for a particular SPY call is too expensive at $1.78, you can probably sell it for $1.77. This is the sign of an efficient marketplace, without which this book would have been one sentence that stated, “Do not trade options.” Instead, I have yet to figure out why everyone who has the capital
