Look at a recent, very obvious example regarding the US election. I can’t tell you how many articles and posts from very successful investors and investor based publications were completely wrong at predicting the market reaction to a Trump victory. In fact, on election night, as the results were tallied and a Trump victory became apparent, the supposed smart money, the futures market, fell so fast that it went “lock limit”. This means trading was temporarily halted to prevent any further declines.
But, as it turned out, when the stock market opened the following morning, the reaction to the news sent the markets in the opposite direction predicted by the so called experts. The dow jones industrial average closed more than 300 points higher the day following the election and then proceeded to close at all time highs by the end of the election week.
The point here is, the professional investor has no better idea than anyone else what the market is going to do next. Yet, many of them are still able to amass enormous wealth from investment or trading in the financial markets.Study of the most successful investors in the world reveals how this is possible. You see, the best of the best when it comes to investing don’t place their success on hunches, or information derived from the headlines. They derive success from consistently applying sound market strategies.
In this week’s Profit Talk we look at volatility and answer why selling options offers a higher probability for success than buying stock outright.
Short Volatility Trading ~ Why Selling Options Works
Short volatility trading is a style of trading that involves selling options. Traders that primarily sell options or use what’s called credit spreads, are often referred to as “premium sellers. My style of trading certainly falls under that category. This means, for me, most of my portfolio is constructed using short premium.
The wonderful and sometimes confusing fact about options is, you can sell them to create a position that is bullish, bearish or neutral the market. The difference is created by how you construct them. So, even though I use a short option strategy to invest or trade, this short premium tactic has no bearing on the price direction I’m betting on. If I have a directional assumption and want to trade it, I’ll do so using a short option or credit style strategy. I’ll do this whether I want to be bullish, bearish or neutral the particular market.
My reason for using this tactic instead of just buying or shorting the market is very simple. Short premium strategies have the highest probability for profit. Compared to buying or shorting stock in the traditional way, or buying or shorting futures or currencies outright, using short options to create the trade offers the highest probability for profit. This is the result of two forces at work, mathematical facts and the free market system. Together, they offer the option seller a higher probability for profit.
Let’s look at the first reason for me which lies in the math facts.
Probabilistic Outcomes ~ Proximity to Current Price
When it comes to probabilities for profit, the numbers don’t lie. In the end, selling out of the money options offers a higher probability for profit then buying or shorting stock does The proof can be found on the option chain. The option chain displays the particulars of the options available for the stock. Here you’ll find information such as the current price of the stock itself, the daily price change and volume. (Figure 1) These are the expiration dates for the option contracts currently being traded.
Opening the option chain reveals the individual contracts traded for that particular expiration date. The information displayed can be customized to fit your personal preference. As arranged here, the individual strike prices are shown along with the associated greeks for each strike price. The strike price designates the stock price the particular options contract is associated with. (Figure 3)
The contracts listed on the right hand side are the Put contracts. (Figure 4) They act as downside insurance on the stock they represent. The buyer of the Put contract has the right to sell the stock at the strike price of the Put contract. This right exists until the contract expires.
The Put contracts below current price are out of the money. Put contracts that are out of the money on expiration expire worthless. In that case the seller of the option realizes full profit from selling the Put. This fact makes selling out of the money Put options a bullish to neutral strategy. That’s because, if you sell an out of the money Put, you’ll realize profit, if on expiration, the price is above the strike price of the put you sold.
The option contracts on the left side are the Call options. (Figure 5) The Call options provide the buyer of the Call the right to participate in the upside movement of the stock. The buyer of the Call has the right to buy the stock at the strike price. The right exists until expiration of the contract. The Call options above current price are out of the money. Calls that are out of the money at the time of expiration expire worthless. In that case the seller of the option realizes full profit from selling the Call.
This fact makes selling out of the money calls a bearish to neutral strategy. That’s because, if you sell an out of the money Call, you’ll realize profit as long as, on expiration, the price is below the strike price of the Call you sold.
The statistical information contained on the option chain is extremely valuable for both stock & option traders. The data is derived from complex math models that have been proven to be incredibly accurate at predicting future prices. This column here depicts the statistical probability the seller of this particular option will be profitable. Simply put, this number is the statistical probability of the option being out of the money on the expiration date.
This number gives us the probability of the stock price being above or below the particular price per share as depicted by the strike price. (Figure 6) These numbers have been proven to be amazingly accurate over time, given enough occurrences. The Put contract side percentages tell you the true statistical probability that the stock price will be above the particular strike. The Call option information displays the probability that price will be below the particular strike or price. Again, given enough occurrences, meaning if done enough times, the numbers fall in line with the probabilities generated by the model, almost perfectly.
Looking at the option chain, you can see the contracts near the current price, called at the money options, have a probability of being above or below the current price at expiration of about 50%. (Figure 7) That tells the whole story right there. Pure & simple, if you buy or sell short a security, you’ve got a 50/50 chance of profiting from doing. That’s it. There’s no sound argument at all against this fact. These option pricing models have been proven to be extremely accurate over time.
On the other hand, looking at a premium selling strategy, or short volatility strategy, meaning, a strategy deriving profit by selling out of the money options, you can clearly see the advantage. Selling out of the money put & call options carries a higher probability for profit then simply buying or shorting stock.
Remember, this column here depicts the statistical probability the seller of this particular option will be profitable. It’s the probability the option will expire out of the money. The Put seller is profitable as long as price is above the strike price at expiration. You can see on the Put side, the further you go below current price the lower the chance of price closing below that price. This makes the probability for profit higher. Conversely, the Call side shows the opposite. The further above current price you go, the lower the chance price has of closing above that price. Therefore the higher the probability for profit.
This is how an option trader can make a statement like “I’ll show you a strategy that has an 90% plus success rate”. That’s easy, sell this put, you’ll have a 92% chance of making a profit. (Figure 8) The law of averages works out, if enough of these high probability trades are placed, the success rate is achieved.
This actuality is the first reason applying strategies based on selling options gives you the best opportunity for success. There is no magic here, just a mathematical reality at work. Your advantage comes simply from the fact you’re profitability window is expanded which enables you to profit from a larger range in price. The advantage is due to your profit point’s proximity to current price.
Think about this, if an investor were to simply buy the stock at the current price, the only way to profit is if price moves up from that point. Relying on this method gives you a 50/50 chance. However, when able to get paid for selling an option that is away from the current price, the possibility for profit exists no matter what direction price moves, at least to a degree. Using this method expands the range price can move and still provide you with a profitable trade. This fact alone increases your probabilities for profit.
Providing a Service
In addition, there is another big reason that option sellers have a higher probability for profit. The reason stems from the fact that the option seller is providing a service. Remember, I mentioned that options are a lot like insurance for stocks. This is true. The availability of equity options provides tremendous benefits to our financial system. The equity option financial instruments furnish the buyer with the ability to define and contain risk. Options make products like annuities possible. They provide a means to deliver guaranteed returns while maintaining protection from loss. Plus, options give the opportunity to hedge risk.
These benefits would not exist without participants willing to sell the option and take on the obligation they require. The incentive to sell the option is created by offering profit to those willing to participate. If there was not an advantage or a profit “baked” into to the price of the option, nobody would sell them. It’s the same for any service and of course insurance is no exception
Look at what companies occupy the tallest skyscrapers in the largest cities across the globe. They are insurance and banking institutions. They are in the business of selling financial products, not buying them. They know how the real money is made. The simple fact is that a free market system must provide a profit incentive in order to attract participants. If no profit advantage existed for those willing to sell the option, no one would sell them and there would be no option market.
Again, no magic or secret tricks going on here, just basic supply & demand economics at work.
Predictive Value of Emotion
There were two reasons that selling options can provide higher probabilities for profit. Now let’s look at another benefit that comes with trading volatility and how to capitalize on opportunities that exist.
As mentioned, options act as insurance on securities. They can be used to insure against loss from falling stock prices or they can provide a means to participate in upward price movement that occurs in high flying markets. This means that options directly address two powerful human emotions, fear & greed.
The price options demand are greatly influenced by the participants level of fear and greed currently experienced in the particular market. This level of emotion and subsequent pricing of the options is depicted by what is called implied volatility. Implied volatility is a function of an option’s price. It shows what the market expects in terms of future price movement in the particular security. A larger expected move will increase the implied volatility.
When it comes to using this measure, our concern is what the current level of volatility is compared to its historical range. The implied volatility level on it’s own does not give us useful information when it comes to aligning the correct option strategy with the given volatility environment. In order to do that we need to compare volatility to itself and give the current state of volatility a relative value when compared to its historical range. This value is often referred as “IV Percentile” or “IV Rank”.
IV Percentile is a function of human emotion and there are two important characteristics that option sellers can exploit when it comes to these emotions. The first important fact about emotions is they normalize over time. This means, that no matter how fearful or greedy people become, this heightened emotion does not last forever. Emotions display a mean reverting quality that greatly surpasses any found among asset prices themselves. The simple fact is they normalize over time.
The second reason is that emotions almost always over state the reality or eventual outcome which trigger the emotion. Think about that statement. Is it not true that our fear about coming events tend to outweigh the eventual outcome itself? This fact is proven over and over in the option market place and offers advantages to the option trader who is aware of this and of ways to capitalize on this fact.
Again, the implied volatility level on it’s own does not give us useful information when it comes to choosing the correct option strategy for the current volatility environment. In order to do that we need to compare volatility to itself and give the current state of volatility a relative value when compared to its historical range. This value measure is called the implied volatility percentile.
It is vital for an option trader to be aware of the current implied volatility percentile value of the particular market they are trading. This value is key to selecting the correct strategy for the given market situation. Based on the volatility characteristics just outlined, the greatest advantages exist when selling option while markets are experiencing elevated IV Percentile values. It is during these periods that the above mentioned attributes of emotion are exaggerated even further. These heightened states of implied volatility provide the option seller with the best chance for success.
Because of this fact, credit style options strategies, which derive profit from selling options, are best placed during high volatility situations. In the end, volatility should be treated like any other asset. When volatility is at the higher end of it’s range it should be sold. Continually doing so allows you to capitalize on emotions rather than being ruled by them.
Okay, so the main takeaways and advantages to selling options are:
Profit opportunities exist due to current price distance from profit generator
Market supply & demand forces create profit to incentify sellers
Emotions tend to overstate the reality and normalize over time
At this point, you might be thinking that sounds great but what’s the catch? That’s a great question. It’s true, there is no such thing as a free lunch. If the market is willing to provide the option seller with all those benefits then there must be a trade off. This is true in all areas of our existence and the financial world is no exception. In the area of investing the trade off is always found in the reward to risk ratio.
This is where all investments are made relevant to one another and must be compared. When it comes to selling options, the disadvantage lies in the reward to risk ratio.
The reward to risk ratio is arguably the most important metric in all of investing and is the subject of next week’s Profit Talk lesson.
I hope this explanation has shed light on some of the advantages these wonderful financial products provide. The advantages are there for both the seller of the option and for our financial system as a whole, making them a win-win product for all of us.
Until next time, keep trading and investing the Profit Effect way, proven, consistent and stress-free, just the way trading supposed to be.