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Mar 11, 2016

Buying "Cheap" Options | Skinny on Options Data Science

By:Sage Anderson

If you've followed tastytrade programming in the past, then you are well aware that probabilities tend to favor sellers in options markets.

Much like the human condition, there's a tendency for market participants to overbid the price of insurance because the fear of negative events is such a compelling force.

After the sell-off in global equity markets, some low-dollar premium opportunities may have started to look attractive as a play on a quick market rebound.

Before you spend your hard-earned cash on those nickels and dimes, or “cheap options”, you might consider some findings that Dr. Data recently presented for The Skinny on Options Data Science.

In an episode titled "Buying Cheap Options," Dr. Data builds a compelling argument as to why chasing low-dollar options can be such a low-probability strategy.

Looking back through 10 years of data on SPY, Dr. Mike Rechenthin (aka Dr. Data) ran a back-test that revealed the likelihood of low-dollar options finishing in the money when trading in a window of 45 days-to-expiration.

As you can see below, $0.05 options (calls or puts) purchased on the SPY during the last 10 years had roughly a 1% success rate in terms of finishing in the money by expiration:

While the numbers get more attractive when one considers how frequently a low-dollar option ($0.05) goes positive at some point during the life of the contract, this strategy is still on the wrong side of the probability tracks.

Dr. Data also explains why buying calls expecting a bounce after a big market sell off doesn’t work, either. It’s because volatility (price of insurance) increases during market sell-offs, making the calls more expensive. Basically, sellers of risk adjust for market conditions and charge more for these low-dollar (“cheap”) options.

Still convinced that buying nickels and dimes is a low-probability endeavor? Dr. Data explains that while the probability of success is out of whack on the long side, the risk-reward equation is what complicates the short side.

Absolute income from sales of nickels and dimes is fairly insignificant and even worse, it's extremely capital intensive.

Selling options with more "meat on the bone" puts traders in the sweet spot with both high-probability positions and a far more sensible return on capital. So look at the probabilities. And don’t get nickled and dimed by the lower option prices into making a low probability trade.

Please don't hesitate to contact us with any feedback or questions at support@tastytrade.com.

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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