Out-of-the-money calls and puts versus Lottery tickets

Trading often appeals to impulsive people, to gamblers, and to those who feel that the world owes them a living. If you trade for excitement, you are liable to take trades with bad odds and accept unnecessary risks. The markets are unforgiving, and emotional trading always results in lossesAlexander Elder in Trading for living.

This above quote of Alexander Elder represents typical retail options trader. Most retail option traders are attracted by the huge volatility in options and buy cheap calls/put with hope of getting rich overnight. The most common strategy that retail option traders prefer is buying out-of-the-money straight calls and puts.

Out-of-the-money straight calls and puts are sold at very cheap rate. These calls and puts require huge move by stock/index to get profit. This is equivalent of buying a lottery ticket.

The distinct between lottery and calls/put is that in former case seller of the ticket pays only a small portion of the overall proceeds in the form of winnings, options are a zero-sum game in the truest sense of the description – winner’s profits are loser’s losses. And the majority of loser’s losses typically come in the form of speculative out of the money plays.

The winners know how to bias the results. Moreover, they know the risk-reward and the probability of success before each trade. In the options world the gambler is defined by a trader who buys a call or put with a low delta. (Keep in mind, delta is the probability that an option will expire in the money.)

Like lottery tickets sold in streets, options with deltas this low have a low probability of success. But because of their low-priced sale and high-profit potential, they attract in retail options traders.

For this reason, I prefer to take the other side in this zero-sum game. I do so by basically taking the other side of the trade – by selling options to the speculative crowd. I prefer to sell options with low delta. The probability of making profit is above 60% and it moves further higher as I sell further out-of-the-money options. The lower delta higher is the probability of success in the trade.

Delta is the first “Greek” that most traders learn about when they get started with options. Most people learn that delta tells us how much the price of an option will change if the underlying stock or ETF changes in rupees

For example, if you own a call option with a delta of 0.50, every 1 rupee increase in the stock or ETF equates to a 50 paise increase in the price of the option. Remember, we make money with a credit spread when the options contracts expire worthless.

Next important consideration is position sizing. Using delta to calculate your probability of success will help you make intelligent choices about your position sizes.

Keeping position sizing in mind along with the probability of success will keep you in the game for the long haul. And that’s the only way you’re going to have sustainable success as an options trader.

Narender Kumar
Option strategist, www.AssuredGain.com

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