Trading Psychology: Playing the 'Lottery' With Premiums

Analyzing the risks and rewards of premium buying and selling

May 19, 2015 at 8:15 AM
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So, is buying options premium a bad idea? The team at tastytrade seems to think so, judging by this piece from six weeks ago, titled "4 Studies Proving That Option Traders Should Not Buy Premium."

The studies are really just back-tests, so I'm not sure they really "prove" that you shouldn't buy premium, but I believe the gist is valid. Let me try to 'splain as I see it.

Options are zero-sum games. In a vacuum (i.e., not counting offsetting stock positions), there's a winner and a loser. But the risk/reward experience is not analogous. The buyer can only lose the premium he/she paid. Conversely, the buyer has essentially boundless profit potential (yes, a stock can only go to zero, so a put has a cap on it, but depending on the specifics it's a huge percentage return, potentially), while the seller can only earn the premium.

As such, the seller necessarily demands a premium above and beyond some sort of "mean" expectation, in order to compensate himself for assuming the tail risk. And the buyer is willing to pay the premium for that same boundless-upside, lottery-ticket potential.

Thus it stands to reason that options-premium sales "work" more often than not. Consider a pure delta-neutral options-volatility play like a straddle or strangle. If it's priced correctly, the seller should "win" on the trade about 68% of the time (1 standard deviation). But if it's priced perfectly, the actual profit expectation of the straddle/strangle sale should be zero. That's because of the open-ended risk potential of the short side (or, if you prefer, the open-ended reward potential of the long side).

So, in theoretical world, there's no edge in either side; the expectations should be equal and you pick your side on personal preference. In the real world, though? I suspect that tastytrade has it right.

We're humans. We're more attracted to the lottery-ticket side of the trade. We love the concept of turning a small amount of money into a large amount of money. Exactly the same dynamics play out in sports.

Consider a somewhat uneven matchup -- let's call it Rockets vs. Warriors. The current market is Rockets +600, Warriors -900. The middle is 750 -- for argument's sake, let's say that's the market price for the fair odds of the series. And let's also say we tighten that spread to zero and assume the sports books exist to simply provide a public service.

That is, you would have to risk $750 on the Warriors to win $100 if they win the series. That sounds unattractive, right? Contrast that with the other side. You can win $750 if the Rockets win, while only risking $100!

Guess where the public money will go on this one? Most likely on the Rockets. But in reality, the odds are probably tilted too far that way, as the casinos know that's the side the public will play. The midpoint implies an 88% chance the Warriors win; the reality is they're probably a bigger favorite than that.

Trading psychology works exactly the same way. And that suggests that over time, options will overprice risk.

None of this is to say that premium buying never works, and premium selling always works. Of course, that's far from the case. It does suggest that premium selling works better over time, and with that I agree.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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