Betting means taking a look at the odds... let's use horse racing as an example.
The following horses have these odds. Which one is your best bet? (1/10 means bet $1, receive $10 upon win)
Hoof Hearted............1/10
Seabiscuit.................1/3
Dapper Dan..............1/99
Kentucky Pride........1/36
Mr Ed.......................1/7
It's obvious that Seabiscuit has the best odds of winning. In response, his payout is substantially lower than the other horses. A risk-on better would put $20 on Hoof Hearted, a gambler would put $20 on Kentucky Pride (Dapper Dan ain't gonna win), and a betting man would put $10 on Seabiscuit. The house always wins, so this is still gambling, per say, but it's an analogy.
(I would personally bet Seabiscuit and Mr Ed in a perfecta box)
The same thing goes for options trading. Options are priced based on their probability of retaining intrinsic value upon expiration, meaning they can be profitably traded for shares at that time. What many retail traders fail to understand is this fundamental point. That, and they don't understand the other mathematical variables at play, aka the Greeks.
The Bad Trader
A bad trader will take a look at the following:
The bad trader will determine that the 100 strike call is a good trade. What is his analysis?
The Bad Trader thinks paying 3.50 x 100 = $350 is cheaper than paying $97 per share. He's right; in order to make the same gains he would need to buy 100 shares, $9700 compared to $350 He thinks that this is a "cheap" trade, and that he can only lose $350, right?
The fact is, GPRO must advance from 97 to 100 PLUS the price he paid for the call, 3.50. GPRO then must rise 6.7% by expiration to BREAK EVEN on the trade. It must rise far higher and faster than 103.50 in order to make any money. That certainly could happen, but everyday that it doesn't, the extrinsic value of his call option will diminish, no matter where GPRO goes. He only has 11 days for that to happen, 9 of which are trading days. Yes, even over the weekend, his call option loses value. This is called theta decay, elaborated here.
The Bad Trader also does not ask why the heck a call option so far out-of-the-money with such little time to expiration is priced so high. This is due to the underlying stock's implied volatility. The more a stock moves, the higher the IV, the higher the option price. To compare, here's an option chain of a low IV, similar price stock:
Notice how the strike call that is equidistant OTM as 100 is to 97 (3%) is 106. The 106 call is trading at 0.30! less than 1/10 of the GPRO strike. And the irony is the Bad Trader would make the same mistake, thinking the 106 call is cheap and buying it.
These kinds of trades happen all too often in retail trader world. After all, only 1 in 10 people who try their hand at trading will ever make money. What happens to the Bad Trader's GPRO 100 call? It will probably lose a lot of value this week, especially if GPRO doesn't move all that much.
A bad trade can still make money; the 100 call can still rise from 3.50 to 4.00, 4.50, 5.00, but that's GAMBLING. The chances of that happening are against him, heavily. This trade will most likely lose money.... a lot of money.
The Good Trader
The Good Trader knows all the inputs of an option price, and how to trade around them. He has studied the markets, and has probably lost money falling for the gambling mentality. But he has learned from that mistake. The good trader trades based upon PROBABILITY.
The Good Trader doesn't look as cool; he doesn't make huge profits like a gambler, but makes small profits consistently. In the long run, the Good Trader will win out. These are the 1 in 10.
The Good Trader will use statistical analysis when making his bet. He looks at a high IV stock like GPRO with a keen eye. He notices premiums are very high given the days to expiration (DTE) and decides to capitalize.
The Good Trader firsts tests his trade by pulling up a risk profile:
He observes the standard deviation lines (yellow) and the mean price line (blue), and then calculates the percentage chance that this trade expires OTM. This is done using Z-score.
Z = (x-µ)/Ϭ
where x is the strike price of the sold option, µ is the mean price, and Ϭ is the value of 1 standard deviation. From the above model, he can estimate that µ = 97 and Ϭ = 11. This gives him
Z = (115 - 97)/11 = 1.63
With this Z = 1.63 he can look at a bell curve and analyze the percent chance of the stock being at a price above or below our sold strikes (115 and 77.5). Thankfully we have the internet, and do not need to calculate this by hand.
The chance of the price rising or falling below or above our sold strikes upon expiration is 10.31%, and the chance of the price being somewhere in between the sold strikes is 89.69%.
Those are very good odds! The Good Trader places the trade, selling the 77.5 puts and 115 calls for 1.25 credit, meaning his maximum profit is $125 per spread. He does this 10 times, so his max profit is $1250.
If GPRO stays in between 77.5 and 115 for the next 5 or 6 days, he will profit immensely. If GPRO's IV percentile declines between now and expiration, he will profit even more.
Conclusion
The Bad Trader is essentially gambling that GPRO will rise even more, even though it has already risen substantially in recent weeks. The Good Trader is playing the odds heavily in his favor, and has a higher chance of making more money. Can the Bad Trader make money and the Good Trader lose money? Absolutely. But, the Good Trader had the better odds, and as long as he managed his loss and didn't bet more than he could handle, he will be fine. The Bad Trader, however, will fail to learn from the mistake since his trade made money, and will go on to continue recklessly gambling until his account goes to $0.
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