I’m not a fan of dogma when it comes to trading.
My own trading style is a mix of income trades and swing trades, both option longs and option shorts.
And I’ve witnessed profitable traders in stocks, futures, forex, and bonds. And I’ve seen many other make money with every kind of option strategy under the sun.
I don’t have a problem if all you do is short options. You do what works for you.
I do have a problem if you think that only shorting options is the only way to make money and you make sure to tell everyone you know about it.
The US markets have been range bound for over 6 months, and some of you out there are getting cocky, so it’s time to take some of the air out of option selling strategies.
The Opex Myth
One of the most overused and probably made up statistics in the options world is the fact that nearly all options expire worthless.
Think about the nature of the options market. Very rarely do investors use options for assignment, nor do they exercise contracts. It’s too margin intensive and it’s just easier to trade based off the value of the contract.
Think about it… let’s say you have a short option that’s in the money going into expiration.
What are you going to do? Take assignment and end up with a sizeable stock position going into the next week?
That’s no fun. It’s easier to either roll the contracts out in time, or just buy to close the option.
This happens on a massive scale as we head into opex. If an option trader has short options that are in the money, they’ll get closed or rolled.
That doesn’t mean every single option that was bought didn’t make money. If a trader sees enough movement, they will close or reduce risk in a long option position.
The Fat Premium Myth
Way too many traders get sucked into the idea that if the premiums are so high on options, it makes it an obvious sale.
And then it doesn’t matter what the overall market does because you have such a high premium and your odds are so high, that it’s a sure bet.
Back in late 2014, the oil markets were collapsing. Not just the commodity but also oil companies.
And because of this big selloff, investors were hedging through options. That helped to drive option premiums through the roof.
Many traders then started to sell that premium because, hey, the IVRank was at 100% so it’s a layup…
… except you forgot to think about the ACTUAL volatility in the market. As well as the trend, which was down.
So many got smoked on this specific short premium trade.
The “I’ll Make It Back Up With Theta” Myth
Here’s the thing… if we want to really dive down into the option greeks, you’ll see that market timing matters so much more than what the implied volatility is or how much theta you can expect to pull out of a trade.
Let’s consider a short put in AAPL right now:
This short put can be sold for around 2.15 and has a delta of 0.30. That means the odds priced into the market that this will be a profitable trade is right around 70%. We can figure that out by subtracting the delta from 1.
Assuming AAPL stays above the strike price of this short option, you look to collect $215 per contract. Not bad right?
Well think about this. The option delta is .30, which means for every $1 move in the stock, the option value will change $30.
That’s nearly a 14% swing in the value of the option. Just from a one point move.
And AAPL right now is swinging right around 2.25 points in a day, which means that this option can move around $65 per day.
What if you get two down days in a row? Then you’re sitting at a much worse spot.
This means that even if you do want to believe that the theta will catch up, it’s still a much better idea to have some form of market timing working for you instead of blindly selling options because you think the odds are in your favor.
The Option Odds Myth
Since we’re talking about odds, let’s talk about how just looking at the odds of success is a terrible idea.
Some traders call this “probability of profit.” Abbreviated as PoP.
It means if you look at a 50 delta option, it has about a 50% chance of expiring out of the money.
A 30 delta option will have a 30% chance, and so on.
There’s a few flaws in using this as your only source of trading information.
These probabilities are based off the current option values. The extrinsic value of an option drives the implied volatility, which does some fancy voodoo that gives us these PoP numbers.
The problem here is that the pricing assumes lognormal distribution. It assumes Brownian motion, which means that the change in stock price movement resembles a bell curve.
Any experience in the markets tells you otherwise. Stocks and markets trend much more than you think. The introduction of external catalysts drive levy flight, which is really, really hard to price in.
Option pricing ignores trends, and we can’t afford to do that.
The Random Walk Myth
Efficient markets require one thing to be true: infinite liquidity.
We don’t have that, so markets aren’t efficient.
On a long enough timeframe and in a super liquid market, behavior will approach full efficiency.
But on individual stocks that’s nowhere near the case.
This is important to understand because many option sellers out there think that since you can’t beat the market that you have no choice but to sell premium.
Except we just determined that selling one-sided premium can be a very aggressive directional trade. And that option pricing can be hilariously bad at predicting price movement.
It’s not that it’s impossible to time the market, it’s that it is really hard to do. And you just might not be good at it.
It can, however, be slightly easier to time individual stocks, especially those that just had catalysts. Post earnings announcement drift (PEAD) is one of the most well documented phenomenon in the markets and is exploitable using options.
What’s The Solution?
This doesn’t make option selling in and of itself a terrible idea. Many of the trades we take at IWO Premium are net short options.
But you can’t view it in a vacuum. You MUST take into account what the underlying stock is doing, and you gotta have another kind of risk management strategy other than “I’ll make it back when the premium gets sucked out.”
At IWO Premium, we run a combination of statistical trades and directional trades– they tend to complement each other very well and it leads my clients and me to be profitable option traders. Want to learn more? Go here.