Any Horse from the Barn

Options have been widely defamed as being “wasting assets”. Another well known statement is that 90% of the time option buyers lose money. Many “option experts” have said that option buying is the sucker’s game and most professionals are option writers. Such, motherhood statements are difficult justify objectively.

But there is other side to this story as well. Logically, if 90% of the time option buyers lose money does it mean they recover all that money in rest 10% of the time when they gain. However, with all these half cooked stories around option buying is something that has been widely avoided by many people. But, subjectively, yes they are true to an extent. Lot of attempts by option buyers go in vain, due to lack of underlying moves or delayed moves.

Partly, the reason behind it is the way strikes are selected by option buyers before initiating their trades. It is done like picking “any horse from the barn”. Probably, the stress of selecting a stock post rigorous analysis is so high that very minimal focus is given to the selection of strike/s. So, while many times the underlying moves as anticipated but the strike premium does not move. Options are slightly different instruments in terms of risk – rewards and one should understand the picture well before entering a position.

The beauty with options is that you can mathematically measure what an option is worth and what your probability of profit will be. The pointers that you need to know as you compare options in order to select the best one to buy are:

1. The fair price of an option
   2. The delta
   3. The theta

If these three items do not look good, look for another option or create a strategy that has a good risk-reward picture.

The other big strength for option buyers is the “surprise volatility”. Options are priced assuming a log normal curve. The problem is that the markets do not always move in accordance with a log normal curve. Chaos theory throws a wrench in the bell curve theory. Stocks can make moves that are much larger than what a log normal curve prescribes.

Therefore, surprise events prescribed in chaos theory can create instant home runs for option buyers and provide the option buyer with a secret edge in the game. For instance a negative news item comes out about a stock and market participants—like a herd of elephants trying to exit through a small door—try to exit the stock at the same time and cause the stock to show a dramatic drop in price.

Net – net, when you are buying options, buy options on stocks that have the greatest potential for surprise volatility, but for that you need to be rightly placed. So, next time analyse well before you “strike”.

Happy Trading.

Cheers!!!