June 21, 2023 | Issue 30

How to Pick Options the Smart Way

Name: Alaric Securities
Brand: Alaric Securities
Rating: 4 (4 reviews)

Nikolay Stoykov

Managing Partner at Alaric Securities

7 Essential Lessons for Success in Picking Options

I am eternally grateful that I began my trading journey as an options market maker on the floor of the American Stock Exchange. In retrospect, learning how to pick options and engaging in derivatives trading is genuinely a scientific endeavor. Professional options traders rarely discuss support, resistance, candlesticks, or breakouts, as they often deem such concepts superstitious. Instead, professionals in the field focus on vega, delta, gamma, theta, etc., treating options trading as a purely scientific pursuit. Many traders widely use the Black-Scholes pricing model, and those who don’t adopt it quickly fall behind. Even novice traders recognize this fact, and it is generally accepted by all.

Unfortunately, most investors and people with strong financial backgrounds go “blank” when options are discussed. We have found that the best way to talk about options is in comprehensive terms. In doing so, we may miss exceptional cases or circumstances where what we discuss may not be entirely accurate. However, it will be too big of a blog to discuss all possibilities one may encounter.

Lesson #1: Option buyers outnumber sellers

Most investors are risk averse, meaning they will take risks only if compensated enough to handle them. Long option payouts are much more attractive than short option payouts. If you are long an option, you can make an unlimited amount of money, while if you lack an opportunity, your payout is limited. Moreover, practically speaking, only professionals can short options; most retail investors can only buy options. In such a scenario, learning how to pick options becomes crucial, as you would expect option prices to be high. Bargains may occur, but in most circumstances, options will be “bid up.”

Lesson #2: Margin requirements differ for buyers and sellers

Imagine that an option is trading around 1 USD. If he wants to buy it, the buyer needs to have 1 USD in his account. However, the seller may be required to post collateral several times higher. In this particular case, the seller may need 3 USD of collateral. We will repeat that: the buyer pays 1 USD for an option with an unlimited or significant upside, while the seller needs 3 USD of margin to make no more than 1 USD. Moreover, the margin required to maintain the short position isn’t fixed; the seller may need to post additional collateral at any time before maturity.

Large and unpredictable margin requirements on options sellers lead to options trading at a large premium compared to their theoretical values. This premium varies across maturities, but options typically cost 50% more than most theoretical models suggest for their valuation.

Lesson #3: Most options expire worthless

Given what we already explained about margining, this should not be a surprise. Most investors fall in love with getting considerable leverage when learning how to pick options. However, options have an expiration date, and while investors can be right in the direction of the underlying instrument, they may lose money. It is a common complaint from inexperienced options traders to say, “I was right about the stock, but I lost money.”

You can make the most money in options by selling short options. Making consistent money by being always long or net long options is challenging. As options traders commonly say – “You can fulfill your dreams only by selling dreams to others.” Most option buyers are dreamers and invariably lose money in the long run.

Lesson #4: Put options can be pricier than call options

An example best illustrates this. With SPY trading at around 435 and 60 days to expiration (August 2023), 410 puts are trading at 2,50 USD, while 460 calls are trading at 1,10 USD. Both options are equally away from the current price, but puts are twice as expensive as calls. This is not uncommon; the difference can be even higher for shorter-dated options.

During periods of significant market volatility, like March of 2020, the media could be full of stories about put buyers making lots of money. The fact is that buying puts regularly is a sure way to lose money. In our experience, buyers do not make money in the long run. As options traders often joke – “The fastest way to lose money is to start buying puts.” This highlights the importance of learning how to pick options wisely, as making informed decisions can significantly impact your trading success.

Lesson #5: Low-priced options are often the most overpriced

Maybe it is hard to believe, but it will make sense once you understand the dynamics of option margining. Options sellers, on average, face very unfavorable margin requirements for low-price options. If an option is trading at 0,20 USD, it is not uncommon for the market maker to sell you the option to post 2 USD in the margin. This example is a comprehensive approximation. There are multiple exceptions when this might not be the case, but we believe it is broadly speaking true.

Most investors rarely ask themselves what an option should be trading at. They are only concerned with how much it costs and how much they can make. In our experience, it is very often to find options trading at 0,20 USD, theoretically 0,05 USD, while options trading at 15 USD are worth around 12 USD. That is true on average. The higher the price of an option, the smaller the premium over theoretical value.

Lesson #6: Long-dated, slightly OTM calls offer the better odds

Longer-dated options typically have higher prices. Margin requirements for sellers of high-priced, long-dated call options are more favorable and stable. Long stock investors can often sell call options without additional requirements (overwriting), increasing the supply of option sellers. As a result, out-of-the-money long-dated call options sometimes trade close to their theoretical values or even lower.

To learn how to pick options for buying, we suggest purchasing call options on large ETFs like SPY or QQQ with a minimum maturity of 12 months, preferably 24 months, and a strike slightly above the current ETF levels. We may adjust the starting point, but the focus should be on buying long-dated, slightly out-of-the-money (OTM) call options on liquid ETFs.

Lesson #7: Convertible bonds and warrants for a successful options career

As an asset class, options are different from stocks or bonds. Companies directly issue stocks and bonds, which trade on the secondary market after issuance. For example, if you want to buy a stock, you are buying from an existing shareholder looking to make a profit or reduce his exposure. If you want to buy an option, the seller is a professional market maker that is SHORTING the option. Let us repeat that you usually buy from an existing shareholder if you want to buy a stock. If you want to buy an option, the seller is typically a professional that is shorting the option. Practically there are no exceptions.

Trading against a professional is a hazardous business. Statistics are difficult to find, but we have yet to see any investors that have had a successful career by only buying listed options. We have heard of many investors making a lot of money being long options, but invariably their long-term performances could be better. However, we do see plenty of successful investment funds that invest in convertible bonds and warrants. Those are derivative instruments (call options) that are issued by companies directly.

If you’re intrigued by this asset class, consider exploring the CWB ETF (SPDR Bloomberg Convertible Securities ETF) as a promising starting point in your investment journey.