Buying fair valued options

I have a question, another options book I just read talked heavily about the theory of options pricing in the context of Black Scholes. If options are priced “fairly” based upon expected value (log normal distribution of expected price range based on volatility, etc), why do most call buyers lose money and the option writers are generally more successful?

Thanks,

Terry

***

You make the reasonable qualification: “if options are priced fairly”…But, that is not reality.

Options tend to be overpriced

When we calculate a ‘fair value’- it is based on the prediction that the stock will be as volatile as the estimate used in the calculation. We are forced to make an estimate or else we cannot use the formula to crank out option values.

Looking back, history tells us that index options have been priced higher than actual realized volatility, and options traded above ‘fair value.’ This is true for indexes – I am not as certain about individual stocks. Nevertheless, when buyers pay too much, they are not likely to win.

When buying options it is so difficult to earn money on a consistent basis. Besides worrying about overpaying for the options, the buyer must get the timing correct. With options being a wasting asset, if it takes too long for the move to occur, there may be no profits to be earned.

The direction must be correctly predicted. Obviously buying calls is not going to be a winning strategy if the stock moves to the downside.

The move must be large enough to overcome time decay and the premium paid. Many times the stock moves in the correct direction – and moves quickly. However, if the move is not large enough, the option price may barely budge.

Buying options with the expectation of making money is a game that must be left to those traders who have a strong track record that proves they can predict both direction and timing. They must win often enough to overcome the many times when one or both of those predictions fails to come true. It’s my opinion, not a proven fact, that the vast majority of traders would be making a smart move by not buying individual options.

Option sellers have so much less that can go wrong, so they WIN far more often. The problem is that losses can be enormous and it’s up to the trader to prevent big losses. The best method for managing risk and limiting losses is to sell an appropriate quantity – and not look for a huge win on a single trade.

The 2nd best method is to avoid naked selling. Sell spreads instead.

In other words: manage risk and don’t get cocky as a premium seller. Premium sellers win often, but not often enough for many to walk away as winners. Failure to manage risk properly dooms them to failure. Why? It’s the size of the losses that determines their overall success/failure. And I can assure you that no matter how long your winning streak, it will come to an end when something unexpected happens.

Coming April 1, 2011

896

, , , ,

4 Responses to Buying fair valued options


  1. Fatal error: Uncaught Error: Call to undefined function ereg() in /home/mdwoptio/www/blog/wp-content/themes/canvas/includes/theme-comments.php:63 Stack trace: #0 /home/mdwoptio/www/blog/wp-content/themes/canvas/includes/theme-comments.php(19): the_commenter_link() #1 /home/mdwoptio/www/blog/wp-includes/class-walker-comment.php(179): custom_comment(Object(WP_Comment), Array, 1) #2 /home/mdwoptio/www/blog/wp-includes/class-wp-walker.php(144): Walker_Comment->start_el('', Object(WP_Comment), 1, Array) #3 /home/mdwoptio/www/blog/wp-includes/class-walker-comment.php(139): Walker->display_element(Object(WP_Comment), Array, '5', 0, Array, '') #4 /home/mdwoptio/www/blog/wp-includes/class-wp-walker.php(387): Walker_Comment->display_element(Object(WP_Comment), Array, '5', 0, Array, '') #5 /home/mdwoptio/www/blog/wp-includes/comment-template.php(2225): Walker->paged_walk(Array, '5', 0, 0, Array) #6 /home/mdwoptio/www/blog/wp-content/themes/canvas/comments.php(43): wp_list_comments(Array) #7 /home/mdwoptio/www/blog/wp-includes/commen in /home/mdwoptio/www/blog/wp-content/themes/canvas/includes/theme-comments.php on line 63