4 Delusions Plaguing Options Buyers

The following is an updated column that originally appeared in the Spring 2012 issue of SENTIMENT magazine, and was reprinted in the market commentary from the June 2016 edition of The Option Advisor, published on May 26. For more information or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- click here.

I thought I'd share my recently developed list of 4 major delusions that can plague option buyers. Readers of SENTIMENT have likely avoided many of these situations, but it always helps to be reminded.

Delusion 1: You are buying volatility and trading multi-directionally by buying a straddle (or strangle) using weekly options -- As time till expiration diminishes, the total dollars you need to purchase a straddle at a particular strike decreases. Note, though, that your cost reduction is not proportional to the reduction in days till expiration (a 5-day at-the-money straddle will cost you half as much as a 20-day). And due to the huge theta of your position, any benefit you may achieve as a "volatility buyer" from rising implied volatility will almost certainly be more than offset by time decay. Perhaps of greatest importance, due to the rapid time decay of the weekly options, a directional move of any significance in the underlying stock will bias your position almost completely in the direction of the in-the-money side.

Delusion 2: You are "playing the fundamentals" of a major stock move by buying a call (or a put) -- Some of the more volatile stocks, with modest share prices and modest market capitalization, can easily double over the course of a year. But the typical higher-priced, large-cap stock to which most call options buyers gravitate, would be very hard-pressed to post a 10% gain in the month or two till expiration they typically buy. Most options buyers are "playing the noise and not the signal" -- they are betting on outlier moves over very short time frames rather than on "the big ones." This is fine, but such bets require a strong understanding of technical and sentiment analysis, as well as a speculator's mentality.

Delusion 3: You are being a "contrarian" -- Almost all investors have a rudimentary sense that "going with the crowd" is not the right way to trade successfully. But they are often not aware of a number of indicators that might be signaling they are taking a crowded trade. For example, many investors do not track the degree that speculators are betting on further upside through call buying, or that heavy short interest (normally considered a bullish contrarian indicator) might be hedged with long call positions.

Delusion 4: You are buying a highly leveraged vehicle -- While most options buyers typically buy too much leverage within the context of also not buying enough time, it is possible by going too far out in time and going too far in the money you are obtaining leverage insufficient to justify the trade. A convenient tool overlooked by most is the "leverage ratio," calculated by multiplying the stock price by the option's delta, and then dividing this product by the option's premium. You'd generally like to see a leverage ratio of at least 5-to-1 in the trades you take.