Why I Wouldn't Buy Options Like Lottery Tickets

by: John R. Conway

Whenever I go to the gas station to fill up my truck there always seems to be someone in line buying a lottery ticket with the hopes that they will hit it big. While a dollar quick pick lotto ticket doesn't seem to be a lot of money to spend to win millions, the odds of you winning are slim to none due to the millions of different combinations of all the total possible numbers. With earnings season approaching for many high flying names such as Google (GOOG), Apple (AAPL) and Priceline (PCLN), just to name a few, traders may be tempted to make their next option trade similar to buying a lotto ticket with the hopes of winning big.

In my opinion, an options lotto ticket is where an individual makes an out of the money call or put purchase based on an event that can drive up shares of the underlining stock higher or lower. These events usually include earnings, conference calls and media related events. The lottery part of the equation usually stems from a trader making a directional bet, with the anticipation that the news goes their way. If the news doesn't go their way, the contract will most likely expire worthless and one will most likely have little premium left since option traders are limited by the amount of time till expiration.

When one plays their state's lottery, tickets that are bought are also defined by time. It would be great if one's lottery ticket did not expire for six months or even a year, since one will have greater odds of winning. In options, trading the weekly or front month calls or puts leading up to a big event can seem cheap at times. Much like a lottery ticket, the probability of one's out of the money call or put getting in the money is less than a contract that is in the money. There is nothing wrong with making speculative out of the money call or put bets in the option market, but investors should avoid making casino style bets, unless they have the discretionary income to do so.

When I am not investing, I work at a casino and have the opportunity to meet many different kinds of people on a daily basis. These people include college students, retirees, business owners and even the occasional celebrity from time-to-time. The people I meet on a weekly basis usually have the discretionary income to lose, so for them this is pure entertainment.

I sometimes wonder in the back of my mind if the people I meet in the casino could trade options better than they gamble? Trading a short expiration out of the money call or put can be like playing the game of roulette. The odds of the out of the money call or put bet going an investors way can be similar to a gambler hitting their lucky number at roulette. These are both risky bets, but both could have high payouts.

If you are a newer investor to the game of options, I would recommend avoiding the allure of cheap out of the money calls or puts and I would only recommend non-directional option strategies (strangle, straddle and reverse iron condor for example) for trading around a stock event. Here are some reasons I avoid trading out of the money calls based on an event:

1) Time: The closer to expiration, the greater the probability that the out of the money call or put will expire worthless. If you have the discretionary income and don't care about a loss, at least give yourself a time horizon that has a greater probability of getting to your destined target rather than trying to achieve your target in a short time frame (weekly or front month options for example). Also, the closer you get to expiration with out the money options and your target is not reached, the greater you will have little option premium left. Therefore, you will join the ranks of the thousands of option contracts that expire worthless every month. The short amount of time investors have with out of the money calls or puts will increase the probability of time decay. On high flying names like Google, Apple and Priceline, investors can bet on way out of the money call or put contracts (over/under 200 dollars the actual share price). But with a short time frame, and if the stock moves up or down slowly, time decay will eat your premium away very quickly.

2) Define Your Risk: Cheap out of the money options are cheap for a reason. Sometimes it can be tempting to purchase large amounts of out of the money contracts, but just because you are purchasing more doesn't mean you're going to make more. The more option contracts investors buy; this will not increase the odds or probability that your bet will go your way.

3) Speculation: Remember that out of the money is a speculative trade since the odds of you succeeding are further away from happening than an in the money contract or deep in the money contract. In making a speculative bet, you should prepare yourself for losses and have an exit plan. There is nothing wrong with speculating, but give yourself time, the best odds possible and money set aside for speculative purposes, rather than making bets as if you were at a casino.

4) Greeks: Option traders should always be familiar with the Greeks and how they affect option contracts. If you still feel tempted to buy your options lottery ticket, then keeping a close eye on implied volatility, theta and delta can help investors realize how much they could possibly gain or lose.

Sometimes earnings can present frustration when investors are making a directional bet since the event could go positive, but since the stock didn't reach its destination, investors' bets will erode very quickly due to little time left. Apple, Google and Priceline all have options that are that extend over $150 above their shares prices. I believe that all three of them could possibly be over $1000 a share before the end of the year. However, this is more than likely to happen over a period of time and not in a day or a week.

Generally, I'd rather be a buyer of options when implied volatility is low and play the run-up in the stock and then exit out of the trade before earnings. If one is a buyer when implied volatility is high, investors will be paying a higher price per contract. In my opinion, if you're going to speculate at least be smart about it and remember that the price of an option contract is important, but is only one factor out of the many to consider when using options.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.