Divestor

Trading options does not require a full set of knowledge of the highly mathematical aspects of how they are valued (a grounding in statistical distributions coupled with a touch of some multivariate analysis to understand the relationship between price, time and volatility), but it helps. It’s probably the closest cross-section of application of my physics degree (statistical mechanics would be the nearest field that relates to this) to finance.

The language that they use to describe the characteristics of options (e.g. greek lettered-variables such as delta, gamma, rho, theta, etc.) is likely designed to be intimidating and convey some sense of sophistication when they sucker people into trading these products. I find it quite amusing. From a mathematical perspective, it makes complete sense – for example, theta is known as time decay, and it is simply the partial derivative of the function that measures the option value over time. For those that see the words “partial derivative” and are repulsed by it, think instead of your speed (velocity) as being the partial derivative of the function that measures your distance (your GPS at location #1, location #2, #3, etc.) over time (time at location #1, #2, #3, etc.). (People in finance reading this: I know this is completely simplified, please do not correct this loose analogy!).

Every so often, I see posts advocating “generating free income” through selling covered call options or selling put options. Selling call options or put options indiscriminately without regard to paying attention to the underlying financial instrument is giving away money. It’s really bad advice that ends up making option market maker jobs viable. The reason why it sounds so lucrative is because you’ll get your two dollar coin 80% of the time, but 20% of the time you’re giving up a $10 bill.

Instead, one must have a vision about the expected price distribution of the underlying product, over time. The closer one believes that the expected price outcome is normally distributed, the more likely that the trade you place will have a negative expected value. This is with a core assumption that the option pricing is done with a normal distribution assumption (this is not always true).

Inevitably one should always ask themselves whether they could take advantage of an expected price change by simply buying or shorting and taking a more concentrated position. The underlying is nearly always more liquid than trading options. Usually this is cheaper, safer and provides an avenue for plenty of leverage.

I don’t even get into the actual trading costs of options, which are almost always higher for most underlying issuers. This includes both the commission, but the more expensive spread between the bid and ask price. In liquid options (e.g. if you were trading SPY or anything reasonably liquid) this is less of an issue and you are likely to be able to buy at the bid or sell at the ask.

There are a few situations where I would rather buy options than the underlying.

One is that if you are interested in betting on a price decline but have uncertainty about borrowing stock. Unfortunately there is usually a correlation between stocks that are hard to borrow and their implied volatility, resulting in more expensive options.

Also, the deeper out-of-the-money you go, the higher the implied volatility (and thus the higher the price you pay relative to closer-to-the-money strike prices). This is because market makers have evolved well past the Black-Scholes valuation era which assume normal distributions of returns (in reality, there are fat tailed price returns that traditionally have rewarded those betting on “1 in a thousand year” events that actually occur once in ten). Putting this into English, you pay higher for the lottery ticket component of an option predicting an extreme price event even though the absolute price of this is lower.

The other and less intuitive manner that options are useful is if you are expecting a non-normalized distribution of returns. If you find yourself saying “this stock cannot possibly trade lower than X” then there is a good chance that the underlying options will give you the opportunity to sell puts at a strike price near that level (assuming that the stock price is close to X). Using a fictional example, if a stock has a market cap of $500 million and has $450 million of cash on its balance sheet and no debt, and if their operations were cash breakeven in a stable industry and management was not completely incompetent or corrupt, put options at $450 million would be more probable to expire than call options at $550 million.

Some market makers account for this. You see this a lot when biotechnology companies face event risks leading to announcements of pivotal clinical trials. But in certain companies, you don’t see market makers adjust – their computer algorithms don’t account for a probable misshape in the expected distribution of returns. This is one of the rare situations where you can make money trading options at retail levels of dollar volumes. Like everything in finance, it takes time and effort to identify these situations. They will never flash at you on BNN or CNBC. Instead, you’ll just see more advertisements for trading systems that instruct their hapless victims to sell covered calls and naked puts for free income.

There are other situations where using options makes sense, but that’ll be for another post.

Just as a general note, I do not like to trade options. But they are powerful tools that can be used in limited situations to great effect.