Knowing the Real Odds of Successful Options Trading
Options trading is one of the greatest games on earth, and one reason it’s so great is flexibility. You can be a long investor and bet on the action of stocks, the markets, futures and/or commodities, or you can act as the “casino” and take the bets instead of making them.
In the options game, you can pick your role. You can either be the “house” (i.e., you can sell puts and calls) or you can be the guest at the table (i.e., you can buy puts and calls). But unlike a real Las Vegas casino, with options you can be equally rewarded as either the house or the guest.
Now, anyone who has used options knows they are an excellent tool to have in your trading arsenal, as they provide the aforementioned flexibility. However, options can also be used to reduce risk and increase your income in the markets. Once you properly learn how to use options, I think you’ll find them to be invaluable investment tools that you’ll continue using for the rest of your life.
Notice, however, that I say once you “properly learn” how to use options.
Luck Be a Lady
Many novice option traders go into this game ill-equipped to make sound decisions. After encountering multiple disappointments, they come to the conclusion that the game is rigged. These ill-prepared investors then leave the casino with a bitter taste for the game, and usually with a lot of lost capital.
I have been trading options since the options exchanges first opened in 1973, and that means I’ve seen pretty much everything. As an options newsletter writer since 1983, I have spoken with thousands and thousands of traders from all walks of life. One thing I have learned unequivocally in that time is that to be successful, you can’t dismiss the role of Lady Luck.
I’ve observed that most investors seem to trade by the seat of their pants. When they are successful, they believe they have the power to predict the markets. But in many cases, their success is simply a matter of Lady Luck’s benevolent touch.
Of course, Lady Luck can be a fickle handmaiden. She runs in streaks, and she runs both hot and cold. The solution to dealing with Lady Luck is to have a solid game plan in place that minimizes the role of luck and puts the odds of success in your favor.
When you buy options, your odds of winning on any particular play are much lower than most people think. In fact, I’ve come to learn that when you trade options, your probability of winning will almost always be less than 50%.
That virtual coin flip in terms of winning any particular trade does not mean that you can’t make big money in this game. For example, over a two-year timeframe in the 1980s, I had an overall return of more than 1,500%. But, surprisingly, during that incredible period I only came out on the winning side of the trade 20% of the time.
That 20% winning record may not seem like a good one, but it actually is when you compare your odds of winning in the options game with games of chance.
In Las Vegas casinos there is an ancient game called Keno, where players pick 20 numbers from 1 to 80 to win the pot. Fifteen-point Keno, where you try to pick 15 out of 20 numbers, pays $100,000 for a $1 ticket.
What are your odds of winning?
Well, your true odds are over 430 billion-to-1! Hey, I’ll take the options game over those odds any day.
Taking Your Best Shot
Let’s look at an example of odds and Lady Luck in the world of sports.
During the 2001 NBA playoffs, the Sacramento Kings missed 22 consecutive three-point shots in one game, and they were one of the highest-scoring teams in the league!
Now, an NBA player should be able to hit a three-point shot about 35%-40% of the time, so even if your odds of winning approach 50%, you still can have long losing streaks. It’s the same with options trading, because even if you are doing everything right, you could still encounter a long losing streak.
Sometimes a stock you are bearish on can be unexpectedly lifted by good headlines, or a stock you are bullish on might drop because the broader market is plummeting. That’s just the way the ball bounces.
Such streaks are, in large part, Lady Luck at work, and these streaks tend to really discourage the novice option trader. Many novices either quit or haphazardly change their trading strategy and start making all the wrong moves. This tends to extend their losing streaks, and eventually they get frustrated and give up the game entirely.
Don’t let Lady Luck discourage you. If you have what you think are sound-and-proven trading strategies in place, you have to realize that Lady Luck can be cruel. Of course, she can also be one of your biggest benefactors.
If you plan to trade options, remember that Lady Luck has a tendency to make us look very brilliant, or very stupid. Consequently, as you trade options, beware of her allure. Be prepared to encounter the occasional losing streak, and don’t get too boastful — or too greedy — when she places that winning touch on your shoulder.
Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron’s.