Options are popular with retail traders because of the concept of getting huge leverage on a relatively small investment. The prospect of buying an inexpensive out-of-the-money call or put and then having the stock move in the direction you predicted – and producing profits of hundreds or even thousands of percent on the premium you paid is, of course, very enticing.
It’s literally the simplest option trade imaginable – purchase an option based on your prediction for the direction of the stock and then wait until it expires. Collect your cash if you were correct and lose the entire premium if you weren’t.
Tales abound of traders who made a single well-timed purchase of cheap options and then made a fortune on it.
The problem is that those are exactly that – tales. Sure, it happens occasionally, but so do all sorts of unlikely things. That doesn’t make it a good idea.
A recent study of three years’ worth of options on a wide variety of underlying securities traded at the Chicago Mercantile Exchange (CME - Free Report) showed that 76% of options traded expired worthless. Notice that that doesn’t necessarily mean the other 24% of options purchases are profitable. If an option expires in-the-money but by less than the purchaser paid in premium, it would be counted in the “winning” 24% even though the trade was a net loser for the purchaser.
Over the very long-term, index options at the CBOE (CBOE - Free Report) have traded at an implied volatility approximately 2% higher than the actual volatility experienced in the underlying over the life of the option.
Percentage-wise, this would seem to suggest that option sellers have an advantage, but that’s not necessarily true either because it doesn’t take into account the magnitude of the gains for the buyer on the winning trades. Option sellers tend to make a steady stream of money as markets move sideways or rise uniformly, but they’re always at risk of one big move that wipes out those profits and much more.
A quick example:
If you sold 10 out-of-the-money options on 5 different underlying securities for a premium of $2 each and 4 of them expired worthless, you’d be beating the 76% win percentage and you might guess that you’d be counting your profits. Not so fast. If the option you sold ended up more than $10 in-the-money, you’d have a loss on your hands – and that loss could be huge.
Most non-professional traders are not prepared for the emotional roller coaster (or the capital requirements) of selling options and assuming unlimited risk.
So How Can We Make Money Buying Options?
Renowned investor and author Nasim Nicholas Taleb has had incredible success as a buyer of options. Very briefly, his theory is that people tend to underestimate the probability of unlikely events and consequently sell far out of the money options too cheaply. For a long time, Taleb was a net owner of inexpensive options and watched them expire worthless month after month. It’s a hard way to live, posting small losses trade after trade, even year after year.
Then the financial crisis happened.
Taleb made back all the expired premiums and much, much more as options that the market considered practically worthless went deeply in the money.
So how can an individual investor use the same principles to make profits while mitigating the effects of long losing stretches?
Well-placed limit orders.
Play With the Market’s Money
First, we want to identify situations where there is a catalyst present that might make a stock move quickly. Simply buying calls because you’re generally bullish and waiting for a big rally to make you money is not a long-term winning strategy, especially after you factor in commissions and fees.
A good example is a stock that’s the subject of a buyout offer above the current market price and has rallied to close to that price. The more certain the market becomes that the deal will occur, the cheaper the market prices get for out of the money puts. These can be a good opportunity for a wise long-shot purchase as any cracks in the deal can send the shares of the target company plunging to the pre-offer price or below. The most common reasons are a lack of regulatory approval, the revelation of accounting irregularities, or the inability of the acquirer to finance the deal.
If we're long puts, there's also the possibility that an unforeseen negative event in the broad markets takes both of the stocks in the deal down even though noting has fundamentally changed for them ther than market exposure.
On Monday, Pepsi (PEP - Free Report) announced a cash offer to acquire Sodastream (SODA) at $144/share – a 10% premium to SODA’s closing price last Friday – and expects to close the deal to close by January 2019. SODA shares have since rallied to very near the offered price, closing Wednesday at $142.23, and for good reason – there’s no visible anti-trust opposition, there’s no reason to believe SODA has any undisclosed financial issues and Pepsi is planning to finance the deal with cash on hand.
Implied volatilities in Sodastream options have fallen into the single digits as any significant price movement between now and January seems unlikely.
The January 2019 140 puts in SODA were offered at $0.60 on Wednesday and at one point traded as low as $0.45, so the options markets are predicting a very low chance that the deal will not occur. This is an opportunity to make a long-shot options purchase in a situation where there’s still some small chance that the deal won’t go through.
Limit orders are a way to place a smaller wager on the possibility of future uncertainty about the deal. If we buy 2 JAN19 140 puts at $0.60, we will have $120 invested in the trade. There is a very high chance we will lose that entire premium.
If we also put in one resting order to sell one of those puts at $1.20, we have the opportunity to take our money back off of the table and still keep half of the profit opportunity.
The deal doesn’t even have to fail entirely; if at any point between now and January any issues arise and a successful closing becomes uncertain, it’s possible we will get filled on the $1.20 sale simply because the implied volatilities of the options rise and someone else wants to buy that protection. If this were to occur, we’d get back the entire premium and still own one of the puts – for free – in case SODA shares do decline lower than $140.
Th other advantage of placing the resting limit order is that you don’t have to watch the markets constantly between now and expiration. If any other market participant bids that price or higher, you’ll be filled automatically.
So if you tend to agree with Taleb that the markets tend to underprice risk, this type of trade is a way to place a small bet with huge upside potential. Keep in mind this is an extremely speculative trade and likely to lose the entire premium, but if you can accept the risk, it could produce a big payoff.
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