How to Price and Trade Options - Sherbin Al

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of the trade over time gives her a profit, she can buy it. And if she feels it is too expensive, she can sell it, take on someone else’s risk, and hope to profit from it (just like an insurance company). In essence, you can choose to be the insurance company or the insured, and switch roles at any time, based on your assessment at the time.

Probability of Making Money

      One of the most amazing qualities of options is that you can quantify the probability you have of making money on any given trade before you make it! That sure makes things easier, don’t you think? Although it is definitely a huge advantage, making money trading options is a bit more complicated than that. In fact there are at least three more major moving parts that we need to discuss. We will introduce the concepts here and drill down much deeper later.

      If you are able to make money on 60 percent of your trades, does that guarantee you will make a profit? What if you lose twice as much on your losing trades as you make on your winners? Using a quick example, let’s assume you make 10 trades and you make a profit of $1 on 6 of them, giving you a probability of profit of 60 percent. That gives you a total of $6 in winnings. But on each of the four losing trades, you lose $2. You now have $8 of losses, giving you an overall loss of $2 on your 10 trades. So, we can see it is not just the probability that leads to profitability. It is also the ratio of our average winner to our average loser.

      The first thing you learn in a beginning statistics class is that probabilities have merit only if there is a large sample size. In other words, if I flip a (fair) coin 1,000 times, I can expect to get about 500 heads and 500 tails. I will not be off by much because I have a 50/50 chance of achieving either result. But if I flip the coin twice, I have only a 50 percent chance of achieving one head and one tail. In 25 percent of the cases, I will flip two heads and 25 percent of the time I will flip two tails. In other words, the probabilities have little hold over my results when the number of occurrences is few.

      Probabilities also have something to add to the discussion of how large your trades should be. Trade size, in fact, is one of the most frequently overlooked subjects when learning to trade. Let’s look at an example. Let’s say you have $1,000 and bet $250 on each of four successive flips of a coin. What is the probability that you will lose all four flips and be completely out of money? The math is “px,” where “p” is the probability of the event occurring and “x” is the number of sequential times you are testing for the event to occur. Thus, in a coin flip, where you have a 50 percent probability of losing, the probability of losing four times in a row is .504, or 6.25 percent. If your probability of losing each individual event were 30 percent (you win 70 percent of the time), you would go broke after four occurrences .304, or 0.81 percent of the time. If your probability of losing each event were 70 percent (you win 30 percent of the time), you would go broke after four occurrences .704, or 24 percent of the time. Based on these results, betting $250 is too large a bet for my comfort, especially if my odds are less than 50 percent. Translating this to trading, if 25 percent of my account size is too much to risk on each trade, what size is optimal?

      Once again, the answer is “it depends.” Since there is not a simple answer and because the answer hinges on a number of inputs, we will save that discussion for later also.

Market Efficiency

      You may be asking yourself, “Even if I can learn all this, how can I possibly hope to compete against professional traders?” I have good news for you on that front! Though professional traders and retail traders are “watching the same picture” and trying to profit from the same theoretical edge, the types of strategies employed differ greatly. As such, the retail trader is actually in a better position to profit thanks to the existence of the professional trader. Let me explain.

      We will start by looking at a few of the more common professional trading strategies. First, we look at options market makers. Market makers are traders who get better treatment in several ways due to the fact they provide liquid, two-sided markets in all options for all stocks they are assigned, or choose. There are rules for how far apart the bid and offer can be placed based on the price of the option. So, when a retail trader wants to buy or sell an option, the market maker is out there providing liquidity to facilitate the trade. The market maker can “skew” his quotes so the trader is more likely to buy or sell, based on his opinion. But the market maker has to take whichever trade accepts his market. That is, if someone wants to buy the market maker’s offer or sell his or her bid, the market maker is obligated to make the trade. The retail trader, on the other hand, has the advantage of choosing his trades! We can shop for the best bid or best offer for the exact trade we choose to make. Do not underestimate the advantage that gives us!

      The same liquidity argument can be made for HFT (high-frequency trading) scalpers. HFT scalpers are persons or firms who quote markets at hyperspeed using complex computer algorithms. All you really need to know about them is they make tight, deep markets of which retail traders can take advantage, but trade only in the stocks they choose. This is in sharp contrast to market makers, who have an obligation to always make markets in all their stocks.

      Another professional strategy is that of volatility arbitrage. Proprietary traders, who buy volatility they deem cheap and sell that which they feel is expensive, typically use this strategy. Of course, for “vol arbs,” most stocks’ options are typically cheap or expensive at the same time. For example, if VIX is 12.50, most equity options trade for a relatively low implied volatility (IV). When VIX is 40, most equity options are expensive, as their implied volatilities are rich also. So, the operative word for vol arbs is “relative.” They will always be long option premium they deem cheap compared to the rest and will be short option premium they consider rich compared to the rest. Though they will run a short premium or long premium book (portfolio) based on their opinion of the overall volatility in the market, they will often be on the other side of trades the retail trader wants to make, thus facilitating our trades.

      Though there are many other strategies employed by the professional trader that often finds him on the other side of the retail trade, there are two points I would make about each and every strategy:

      1. This does not mean the professional is right and the retail trader is wrong. In fact, since each trader could be doing something different with a trade, both could be wrong or both correct.

      2. The most important point to be made is that the professional trader supplies liquidity to the marketplace that the retail trader must have in order to be profitable. Without the professionals, the retail traders would be out of business! It is a symbiotic relationship that is to be nurtured, not feared! The professionals keep markets tight and deep. We term this “liquidity” and it means you can buy or sell any liquid option with very little slippage in price. If you think the offer for a particular SPY call is too expensive at $1.78, you can probably sell it for $1.77. This is the sign of an efficient marketplace, without which this book would have been one sentence that stated, “Do not trade options.” Instead, I have yet to figure out why everyone who has the capital and the desire to learn does not trade options. It is perhaps the most efficient, level playing field the financial markets have ever known.

Tired, Worn-Out Metaphors

      It is time for two tired, worn-out metaphors to make their appearance. Why? We will discuss them because they are accurate and illustrative. The first one we just discussed. But I want to reiterate it because it holds the key to successful, profitable options trading. Let’s think about an insurance company and how they price their products. An insurance company takes in (relatively) small amounts of premium from each customer on a regular basis in order to cover large amounts of risk for the customer. They hire a staff of actuaries, highly trained in math and probability theory, to look at the probabilities of disaster occurring, amount of average loss, and so on. They determine the amount of premium they need to charge to give the firm a certain percentage profit in the long run while protecting the firm from catastrophe in the short and long run. They know that a certain number of their customers will make large claims (meaning occasional large costs for the insurer). These are the same things we do as options traders. If we are premium buyers, we are the insured, buying a policy from our insurance company. We generally pay more than the option is worth for the protection or, in the case of options, unlimited profit potential it provides. If we are a premium seller, we are the insurance company. We sell options for more than they are worth, win on

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