There are a million reasons why people lose money Trading Options, but a sure fire way to improve their chances of making money revolves around an understanding of why Options Prices behave the way they do. Understanding relationships is the most important factor in improving your chances of making money. Here are some points to consider and I make the assumption that you thoroughly understand the basics of Options Trading. That includes the definition of Puts and Calls, Delta, Gamma, Implied Volatility and the Black-Scholes Model. Beyond that, understanding Synthetic Positions and numerous Options Trading Strategies are all essential to your success. If you are unfamiliar with these topics that may be a significant reason as to why your trade was an unsuccessful one. If you need an introduction to these topics or a refresher, take a look at the Options Guide which is an excellent resource for reviewing these issues.
Assuming you are past the obstacles in the first paragraph, it’s still quite easy to lose money Trading Options. One major factor, which I have discussed before, which causes losses for traders is the lack of understanding of illiquid markets. Liquidity refers to the ability to get in and out of a trade based on the Bid/Ask Spread. If the liquidity is good, then the difference of the Bid/Ask spread as a percentage of the value of the option is small. For example, an Option with a Bid of 1.00 and an Ask of 1.01 would have a liquidity percentage of 1%. Liquidity should only be measured in terms of the portion of the option that is out-of-the money. If you measured liquidity on the basis of a very deep in-the-money option, the Liquidity Percentage might be very low, but the edge that you would be giving up could be very large. An example of this could be a stock that was trading $120.00. The 90 Calls could be 29.90 Bid, with an Ask Price of 30.05. That’s a liquidity percentage of .5%, but if you Sell the Call for 29.90 you’ve sold it at below intrinsic value and are throwing away 10 Cents. The Option has an intrinsic value of 30.00. Measuring liquidity is essential in all transactions, because the less edge you give up, the more likely you are to make money.
Once you’ve found the liquid market you want to trade, it is essential to evaluate all aspects of volatility. Whether it’s Implied, Historical or the Implied Volatility Skew, this analysis can provide you with the best opportunity to design an Options Trading Strategy to meet your risk/reward requirements. Because it can be difficult to manage risk and it is human nature to be willing to take profits while letting losses run, trading spread positions can build in automatic risk management. Using this method, your potential gains and losses are defined and it is much easier to take the emotion out of trading. Comparing Implied Volatility to Historical and evaluating the Skew enable traders to look at the relationships that exist in their options chains. By analyzing the Skew you can find trades that inherently meet the requirements of your goals. It can be difficult, at times, to get good value with limited risk positions because the Skew is structured to give pricing advantages for only certain types of positions. If you decide to Sell Options Naked to take advantage of a particular strategy, make sure to pick an exit point in order to avoid letting losses run.
Evaluating Implied Volatility is essential. It provides a single number to compare the price of all options in a series. By using the analysis to compare the price of various options, you have a substantially higher likelihood of profitability than if you just evaluate the Bid/Ask Price of an individual Strike Price. The Table below provides a Series of Prices, Implied Volatilities and other information for SPY (SPDR S&P 500 ETF) Options in an attempt to make a little more sense out of what was discussed above. It focuses on numerous factors including a slew of Strike Prices, the Price and Implied Volatility of each individual Option, its distance from the current trading price in both absolute and percentage terms and a few miscellaneous factors.
The first thing to notice in the Table is that the Liquidity Percentage of the higher priced out-of-the money options is relatively low. That makes the SPY (SPDR S&P 500 ETF) an excellent speculative and hedging tool for those trading stock indices. The next thing to notice is the significant Put Skew which has each farther out-of-the money Put having a higher Implied Volatility then the preceding Put. This is nothing new in Stock Indices, but it does present the trader with a multitude of Options Trading Strategies with excellent value. Finally, we can compare the Implied Volatility with the Historical Volatility. It is clear that the Implied Volatility is higher than the Historical Volatility of the last 20 Days (at least in the Puts), unfortunately, if you are a seller, this may not make it a good sale. The current Historical Volatility of the E-minis is at a particularly low level and should the market take a plunge, out-of-the money puts that were sold would not only lose money based on their Delta move, but on a significant increase in Implied Volatility.
Analyzing the Table provides an opportunity to establish either a Long or Short position with good value. All you need is an opinion, a willingness to take some risk and an understanding that for the latter position to be effective you must stick with it for a while. It is not a trade to get in and out of. The first trade is for the Trader interested in getting Long SPY. It involves Buying an out-of-the money Call about equidistant from the current trading price as the out-of-the money Put you are Selling. The value provided by the Skew is obvious. The out-of-the money Call is much cheaper than the out-of-the money Put. The second trade is a limited risk options trade which involves Selling a Call Spread and Buying a Put Spread. This is executed approximately equidistant form the current trading price as well. The Table below shows its pricing advantage. You are able to get Short by Selling the Call Spread and Buying the Put Spread for a Credit.
Analyzing Options Pricing is always much easier for the person not taking the position. While I am able to evaluate trades very easily, that doesn’t always translate into successful trading. The methodology set forth above is an example of how to analyze each and every transaction. There are numerous other factors to consider when trading, but by utilizing these options trading tools you can only increase your level of profitability.
OPTIONS TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. THE INFORMATION IS OBTAINED FROM SOURCES BELIEVED TO BE RELIABLE, BUT IS IN NO WAY GUARANTEED. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.