Buying "Cheap" Options | Skinny on Options Data Science
Mar 11, 2016
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 firstname.lastname@example.org.
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.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.