A Challenge For You Option Specialist...

M

magic423

Are options a "bad bet" long term?

My math indicates they are and I'm truly hoping someone can meet the challenge and PROVE me wrong.

Long term performance can be evaluated in terms of trade return on investment expectation. Here is how trade ROI expectation is calculated:

Expected profit/loss ($$$) per trade divided by investment amount

Let me provide an example to clearly explain the problem I am finding with option positions. I'll use a real life example of selling a SPY Iron Condor (using 2 pt spreads). The trade quote info comes from the Thinkorswim platform 6/12/10.

Relevant Data:
The position - SPY Jul 10 (expiration about 5 wks) sell 114 call, buy 116 call, sell 104 put, buy 102 put
Credit received: .89 or $89 for the 100 shares per 1 contract
Probability of expiring at break even or above: 45.52%
Commission to enter trade: $11.80
Profit Potential: $77.20 (credit received minus entry commissions)
Risk/Margin/Investment: $122.80 ($111 margin requirement + entry commissions)

Ok, that's the position and the data. To see if this (or any) trade is a good bet (profitable long term), one must determine how one would do if the trade were made many, many times. If this trade were made 100 times, one would expect to win the profit potential 45.52 out of the 100 times...

45.52 x $77.20 = $3,514.14 total winnings

And one would lose their investment of $122.80 54.48 times out of the 100 times (100 - 45.52).

54.48 x $122.80 = $6,690.14 total losses

So if this trade were made 100 times, what would be the total EXPECTED PROFIT/LOSS....

$3,514.14
- $6,690.14
___________
- $3,176 total expected loss

Which provides an expected profit/loss per trade of -$31.76 (total loss divided by the number of trades, in this case 100).

This per trade profit/loss is then divided by the investment of each trade ($122.80) to determine the per trade expected return on investment.

-$31.76 divided by $122.80 = -25.86% !!!!

And therein lies the problem. Every credit spread or option position I evaluate produces a NEGATIVE expectation. And that means the position is a bad bet because it will lose money long term.

Closing a position early doesn't solve the problem, it only makes it more complicated to calculate and even compounds the problem.

So here's my challenge...

Where am I wrong? What am I missing? The only way to make money long term is to engage in trades with a positive (not negative) expectation. If there are no option trades with a positive expectation (and I've yet to find one), how does one overcome the negative expectation and make a trade positive??

With all due respect, I'm NOT looking for personal opinions or one's personal trade experiences. If you can't quantify it down to a definable trading situation that can be objectively evaluated, then one can't duplicate it for future benefit. It is all about numbers. It is about gaining an edge (positive expectation) and then profiting from it.

I would greatly appreciate any quality input.
 
You're over-simplifying the probabilities. It's not a 54% chance of max loss (nor ~45% chance of max gain).

For a liquid investment like SPY, the options are fairly priced - neither buying or selling options has no inherent edge.
 
For a liquid investment like SPY, the options are fairly priced - neither buying or selling options has no inherent edge.
More...

You are correct that it doesn't have an inherent edge, it has an inherent DISadvantage. Every option position has a negative EV (effective value) based on the data provided on every trading platform. The issue is not whether the options are priced fairly, that's a factor beyond the control of the trader. In order to obtain a profit long term, one must consistently make trades with a positive EV. So the question is, what turns a position that has a natural negative EV into a position with a positive EV?
 
<b>The Answer To The Problem Revealed...</b>

Yes there is a solution to the problem. I have detailed the answer and provided some additional info in the attached article. Hope you enjoy it and perhaps it may spark some interest and comments.
 

Attachments

Mr. Kevin Butler, is it?

First, the trading position you use as your set up isn't fully explained.

Then, your EV calculation is not accurate. (You use a binary function to determine expected profit/loss, rather than a distribution of future underlying prices.) Even if the formulas were correct, you then add in purely qualitative assumptions into your already flawed EV calculation. ???

Any financial market could be considered to be a negative sum game, after factoring in transaction fees--not just the options market.

Are you a beginner, who is simply trying to discuss ideas? If so, I applaud the effort.

Or are you trying to sell something?

Just curious.
 
Quote from magic423:

<b>The Answer To The Problem Revealed...</b>

Yes there is a solution to the problem. I have detailed the answer and provided some additional info in the attached article. Hope you enjoy it and perhaps it may spark some interest and comments.
More...

The "45.52%" figure is derived, I assume, from delta calcs in the software you're using. It doesn't mean you'll win 45.52% of the time. You may wind up winning 100% of the time for the next 12 expiry cycles. It's just, in a sense, a baseline -- the market's expectation.

As to your PDF, you talk about support/resistance & etc. If those add-ons actually have predictive merit, then you'd as well trade directionally -- lower transaction costs -- and forget about options.
 
You're confusing Implied Volatility (IV) with realized volatility. The probability function in the ToS software utilizes IV to determine the likelihood of a position expiring in or out of the money. Higher volatility expands the range, lower volatility contracts the range.

The reality is that you don't know what future volatility is going to be and that is where the edge in option trading exists.

If IV was always correct, Options would ALWAYS be losing bets because of trading costs. If IV was systematically low, then your calculation would generate profits for every Net Long option trade and losses for every Net short option trade (whether puts or calls). Similarly if IV was systematically high, every Net Short position would indicate profitability and every Net Long position a loss.

The reality is that IV is only an estimation of what realized volatility is going to be at a single instant in time. Trading options is trading volatility.

I would suggest you garner a much deeper understanding of how options are priced, suspect that will aid in the analysis you're doing.

One thing you might also want to do, develop a view of future volatility. When your view is that IV is low relative to what future volatility is going to be, you'll want to be long optionality, conversely, when your view is that realized vol going forward is going to be lower than IV, you will want to be short optionality.

Thats obviously grossly oversimplified, but that should answer your question.

Play with the Volatility adjustment variable on the ToS software, you'll see exactly what I'm talking about.
 
The OP has started the same thread 3 different times now. In each thread the others on ET try to tell him the folly of his logic, but he refuses to listen.

I don't understand his motivation. Does he really think he has found a previously unnoticed flaw in the entire system? Is he a troll? Is he trying to sell something?
 
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