Reality Check: Don't Fall Prey to Promises of High Returns in Options Trading

Investors crave the feeling of buying the perfect call or nailing a huge decline via puts. But it is easy to forget all the times these expire worthless.
By Alex Barrow ,

Investors often have the fear of missing out after watching an option play increase 1,000% in a matter of weeks. 

We all crave the feeling of buying the perfect call option on a breakout stock or nailing a down move in the market via puts for a huge gain.

But our mind plays tricks on us. Investors never focus on all the times that an option expires worthless, and they never even imagine blowing out an account by going all in on an option that they thought would appreciate.

The reality of the options market is much different.

It is an ecosystem of sharks and barracudas, taking bites out of each other in an attempt to profit. The players are ruthless and only in it for themselves.

First, there are the highly efficient market makers.

These guys set market prices through their expertise in the Black Scholes Model used to derive an option's price. They win in the long term by controlling risk and collecting the difference in the bid-ask spreads, and in exchange, they provide market liquidity.

The brokerage houses win big, too. They skim their cut off every trade and make out like bandits.

Finally there are the sharps or the professional option traders who squeeze out a profit over time.

Their strategy is the hardest to operate. They aren't rewarded for providing order facilitation services like the other two participants.

Instead, they eat what they kill. Over the long haul, they can get as rich as the other two but only if they size up their strategy and/or attract investor money.

So who is bankrolling these winning players? Suckers.

The complexities of options aren't well understood by most of the retail trading world. Nevertheless, they are highly attractive because of their limited downside, unlimited upside and embedded leverage.

Who hasn't thought about buying that call option on the hot biotechnology stock? Or the way out-of-the money put on the SPDR S&P 500 Trust Exchange-Traded Fund that triples a trading account in a nasty crash?

The lucrativeness of the option market drives retail sheep to the slaughterhouse. They don't know what they are doing, and so they consistently lose, funding the winners.

But don't have to be a sucker like the retail traders.

Options aren't magic, and they can be used to generate attractive returns. But they need to be used in the right way.

The first step to successfully trading options is clearing up common misconceptions surrounding them.

Misconception No. 1: Options can produce 1,000% returns.

It is nothing new: Internet marketers advertising "1,000% returns" in a few weeks on a call option. Or they pitch investors on a trade idea that will make a 500% return if XYZ stock crashes.

This sounds amazing to uninformed investors whose 401(k)'s have been clocking in at a measly 4% a year over the past few years. Their greed emotions start to run wild, but unfortunately, these emotional traders set themselves up for disaster.

It is true that options can offer returns of five, 10 or even 100 times in some situations, but such events are rare. And when they do occur, you need impeccable timing on both your entry and exit to realize gains of that magnitude.

The options that can earn huge returns are the out-of-the-money options. They have a strike price higher than the underlying for calls or lower than the underlying for puts.

Earlier this week, I was looking at the options chain for Apple on my trading terminal.

Apple is a holding inJim Cramer's Action Alerts PLUS Charitable Trust Portfolio. See how Cramerrates the stock here. Want to be alerted before Cramer buys or sellsAAPL?Learn more now.

(Here is an example of an options chain for Apple at Nasdaq.com: nasdaq.com/symbol/aapl/option-chain).

When I was looking at my options chain, Apple stock was trading for $97.14.

On most options chains, the call options are on the left side of the table, and the puts are on the right side.

On my terminal, every option shaded blue is considered in the money. Every option shaded black is considered out of the money.

On the Nasdaq.com page above, the in-the-money options are shaded cream, and the out-of-the money options aren't shaded.

When I was looking at the options this week, I was looking at options that expire on Friday, July 15. If you look at the Nasdaq.com page, it shows options that expired on July 8 and that expire on July 15.

The strike prices are in the middle (the gray area), and the last traded prices of each individual option are listed under the column called "last."

When I was looking at the options, the bid on the 85 puts was 19 cents, and the ask price on them was 21 cents.

Click on "Greeks" at the top of the Nasdaq.com page, and it shows a table that has the implied volatility of the options. This is a prediction of the underlying stock's future volatility.

The delta is also listed. When I was looking at the 85 put on Apple, the delta was listed like this: -.06

The marketer's pitch of 1,000% returns on these options isn't false but unlikely. Yes, it is possible that the 85 put on Apple can go from 20 cents to $2, but the probability is extremely low.

The delta tells us that the options market is only pricing in about a 6% chance of that option making any money at all by expiring in the money. But to get that fat 10-times return the investor not only needs the option to expire in the money but needs it to expire $2 in the money.

That would require Apple to close at $83 by expiration. Apple's price would have to drop $14.14, from $97.14 to $83, a drop of almost 15% and all within just a couple of days, according to these options' expiration dates.

Trying to hit that scenario reduces the investor's chances far lower than 6%.

Now those emotional investors might argue that their guru knows that Apple is going to fall by that much in the next 30 days. The option will definitely finish up 900%, and so they load up their account.

Really?

If a guru could predict a 10 times move in an option with 100% accuracy, he or she wouldn't be sharing that information.

Some quick math should leave investors highly skeptical.

Why? Because even if the guru started with $10,000, that would confer billionaire status in five trades.

And forget 100% accuracy. Even if that guru had 50% accuracy he would be a god among market mortals.

A persistent 5% edge in the markets is big. Anything larger is huge.

Keep in mind that there are billion-dollar casinos that make their nut on a 1% to 2% edge at the gaming tables.

Thinking that some investment guru has an accuracy rate much higher than 10% is foolishness. So don't fall for that.

These far out-of-the-money puts and calls are called "lotto options" for a reason. They seldom win, even with high-quality, cutting-edge analysis from the best in the world.

But let's say our guru is actually pretty good and can hit a 10 times winner about 20% of the time. That marketing still lures the suckers because it is framed in a way that makes investors dream about multiplying their account by 10 times on one trade.

This is a huge trap for newer traders. The only way to 10 times a trading account in one option trade is to go all in.

Even a novice student of risk would adviser never do that. There is a 100% chance of eventually going broke with that strategy.

I play a lot of Texas Hold'em ring games when the markets are closed. 

The stakes are fairly friendly. Most people buy in with five hundred bucks, and some sit down with a grand.

Those who come to play aren't students of the game like myself. They consistently lose.

But it is OK because they are content with paying for the entertainment. They are there for the free food and table talk.

Those with any sense of probability or risk/reward can consistently extract money from this pool of players. It is a fun way to earn a side income. 

The same people who come to the poker tables every night to blow off steam are also the ones going all in on options plays. To them, trading is just another outlet for gambling.

There are many stories of those who have taken their $20,000 trading accounts to $100,000 in a year and then ended up broke. They lose it all.

Over-leveraging and going all in might make for a good story at the poker table in the short term, but it always ends badly. 

Those who plow all their money into one trade will go broke. If it doesn't happen with this trade, it will happen on the next one. It is important to think of trading as a long-term process rather than a single hot tip.

True wealth is made by long-term compounding, not a one-off gain from some option trade.

So when the marketing gurus tout 1,000% returns, keep in mind that it is just a one-off trade that a whole account can't go into, anyway.

Misconception No. 1: Options are more or less risky than stocks.

The financial media will tell you that options are more risky than plain-vanilla stocks. This is true if we define risk as the volatility of returns, but practitioners will tell you that volatility is a crappy measure of risk.

Other market participants will tell you the opposite. They claim options are far less risky than stocks because the loss is defined.

This sounds good on paper, but in practice it isn't too important in an overall risk management system.

Both these viewpoints on option risk are wrong. Options are neither more or less risky than stocks because risk is a function of position sizing, not product type.

Let's break it down.

Investor or traders always want to think of the downside in relation to the account size.

Say an investor wants to buy a call option because he or she thinks that the price of a stock will go up. With a $100,000 account, there is a chance that call option expires worthless and 100% of the invested capital is lost, but the investor gets to choose what that 100% loss means in relation to the account.

If the call costs $1 the investor could bet the whole account and buy 1,000. In that case, if the option expired worthless, the investor would be broke, having lost the $100,000.

Now say that the investor bought just one call option for a total of $100 and the option expired worthless. A loss of $100 on a $100,000 account is just a 0.10% loss in total.

So the option isn't inherently more or less risky than the underlying stock. It just behaves differently.

Rather, what makes it risky is the number of calls bought.

This same argument is also used against sellers of options.

Critics say, "Well if you sell a naked put you have limited upside and unlimited downside. That is a very risky position."

Again, the short put isn't risky in and of itself. Its risk depends on how many sold.

For example, say an investor had the choice between buying shares of SPY or selling a put on the ETF.

Let's say that the stock is trading at $206.44 and a 206 put is selling for $4.45.

If an investor bought 100 shares, he or she would spend a total of $20,644.

Now imagine the market got knee-capped and SPY sold off 50%. The investor would be sitting on a $10,322 loss.

On the other hand, if the investor sold one of those puts struck at 206 with the same 50% decline in the market, things would play out differently.

After the 50% draw down, SPY would be trading for $103.22. The puts are in the money, and the investor owes the buyer (206 - 103.22) times 100 or $10,278.

But don't forget, the investor also received that original $445 credit at the time of sale. So the net loss would only be (10,278 - 445) or $9,833.

The investor actually lost less than if he or she had just bought the plain-vanilla stock.

In this scenario, selling one put option was less risky than buying the plain-vanilla stock.

Now say the investor was feeling greedy and sold two puts instead of one to collect $890 in credit. And imagine the 50% decline still occurred.

Instead of a $10,278 loss, the investor  would have to cover a $20,556 loss. Subtract the credit of $890, and that investor is left with a net loss of $19,666, which is much larger than the $10,322 loss on the 100 shares of plain-vanilla stock.

See the difference? The riskiness of the put has to do with position sizing, not the nature of the instrument.

False beliefs regarding risk can be very limiting to one's development as a trader or investor.

Options can either lead to a trader's demise or victory over the markets. The key is knowing how to use them correctly.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

Loading ...