2 Common Misconceptions That Will Ruin Your Options Strategy by Alex Barrow, Macro Ops

Options.

They’re supposed to deliver you 1000% 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 come out like bandits.

And finally you have the “sharps” or the professional option traders that 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 strategy 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 1000%? Or the way out-of-the money put on the 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 #1: Options Can Produce 1000% Returns For Your Account

We’ve seen it all before. And I’m sure you have too. Internet marketers advertising “1000% 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 401k’s 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 1000% 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 stock below:

Common Misconceptions Options Strategy

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 shade black is considered “out of the money”. The expiration date for all these options is July 15, 2016. 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:

Common Misconceptions Options Strategy

You can see the bid is $.19 and the ask is $.21. 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 1000% 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 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 guru KNOWS 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 account.

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 $10k, he would be a billionaire in just 5 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 amongst 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 1-2% 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 1 dollar 9 times and on the 10th time win 9 dollars. (9*1)-(1*9)= 0 ) This means a 10% hit rate would give you a 0% edge.

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

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