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

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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

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4 Responses to Buying fair valued options

  1. Dmitry 02/09/2011 at 7:54 AM #

    Hi Mark.

    What is your opinion on strikes with low open interest? Could there be liquidity problems with them? Bad fills?

  2. Mark D Wolfinger 02/09/2011 at 8:09 AM #

    Hello Dmitry,

    Most people advise avoiding options with low open interest for just the reason you state.

    However, I disagree. First newly listed options always begin with zero open interest, and I often trade options the first or second day they are listed.

    Next, the width of the bid/ask spread is far more important than OI. If the trading volume of other options in that underlying are sufficient to indicate trading interest, I ignore OI. When the bid/ask spread seems reasonable, I’m never afraid to trade the options.

    I know I’m in the minority, bit I believe that if the market makers show decent bid/ask spreads that you will always be able to trade with no difficulty.

    As we saw during the flash crash, any option, no matter how actively traded, can become 100% illiquid.

    BUT – and it’s a big but – when there is high trading activity, you have an increased chance to get a good fill because you may end up trading with another individual investor – and that’s going to be at a better price than you get when trading with the market makers. So higher OI does give you that possibility.

  3. Jeff 02/09/2011 at 12:16 PM #

    Mark,
    I agree fully with your comments about options being overpriced. As you further indicate, it is therefore normally more advantageous to be the seller rather than the buyer of options. So why your personal preference for iron condors instead of sticking with option selling strategies (such as covered calls and selling puts)?
    Jeff

  4. Mark D Wolfinger 02/09/2011 at 1:06 PM #

    Hi Jeff,

    Good question.

    There are three reasons why I prefer to sell call and put spreads, rather than just selling calls and/or puts:

    1) Risk.
    2) Risk
    3) Risk

    It’s a personal preference, but I’d rather seek a smaller profit and own a position with limited profit potential.

    When selling naked options, losses can be significantly larger. Sure, most of the time selling the naked options works out better. But it’s the times when it’s not better that concern me. Avoiding ruin is my primary consideration.

    As you already know, the strategies that you mention are equivalent. Each is selling naked put options. And that’s fine if you like the strategy. And it’s even better when you are using stocks that you would like to be part of your portfolio.

    For my comfort zone, I don’t want to own any stocks and prefer limited risk. Even when that means I am sacrificing much of the options overvaluation.

    Regards