Options Trading: A Little Knowledge Is A Very Dangerous Thing

Includes: GOOG
by: Ted Barac

When people first become familiar with options strategies, I believe that there's a tendency to both oversimplify the rationale for the trades and overlook the risks/downside. Not only are there hidden transaction costs (wide bid/ask spreads) and liquidity issues that are often ignored, but other underlying problems are also overlooked. In the following article, I will examine a few of these issues with respect to some of the most commonly discussed option strategies.


I recently read an article from someone touting straddles (concurrently selling puts and calls of a security in the expectation that the stock will remain range-bound and the options will expire unexercised) for Google (NASDAQ:GOOG). This is certainly a reasonable strategy, but only if the options are priced attractively. Therein lies the problem. There was absolutely no analysis of the intrinsic value of the call and put options and why they may be considered too expensive (i.e., overstating expected volatility), and thus good candidates for selling.

As mentioned, for a straddle to be a good investment, the option prices must overstate expected volatility. Very simplistically, even if you think that the stock will be very stable and there's only a 10% probability that the straddle options will be exercised, selling them is not wise unless the options price reflects a greater than 10% chance (and, thus, the option premium more than compensates you for the call/put exercise risk).

If you see the exercise risk as 10% and the options imply a 5% probability, it's a bad trade even though the likelihood that the options are exercised is small. In this scenario, you will still make money on the trade most of the time, but the downside of the one lost trade will likely more than wipe out all of those gains (because the options premiums are so low and the exercise loss potential is so high). In poker parlance, the "pot odds" are negative and the trade is not worth the risk.

In other words, it's not the absolute volatility expectations for the stock, but those expectations relative to what's embedded within the option price that counts. While the justification for implementing straddles is often just a belief that the stock will remain stable, that's just a small part of the necessary analysis.

Selling Covered Calls

Another popular options strategy is to sell covered calls. Again, there is usually no discussion about the intrinsic value of the options recommended for sale. The strategy is generally simplified to state that you can enhance your income by selling calls on stocks that you own. If the stock goes up, you collect the option premium and get some limited upside (between the price where you bought the stock and the price where it was called away) and, if the stock goes down, your losses on the underlying stock are mitigated by the premium you collected on the call that you sold. A win-win, right?

Wrong. Be aware that this trade removes substantial upside potential from the stocks you own, but leaves most of the downside. When you own a large portfolio of stocks there will inevitably be some big losers, and you generally need some big winners to offset those losses. Selling this upside potential away by selling calls may be justified, if the call premiums more than compensate you for the lost upside potential. But, again, this is only the case if the options you are selling are priced attractively (i.e., they are too expensive).

What's counterintuitive about this trade is that it reflects conflicting views (a bullish stock position and a bearish option position), which is difficult to reconcile. When you believe that the underlying stock is cheap (the price understates the stock's upside potential), and assuming that the options markets are relatively efficient, then you should also find the call options to be cheap (i.e., also understating the stock's upside).

As such, you are implicitly either wrong on your long stock position or your short option position. Over time, if these covered call options you're selling are cheap (as would be implied by your view that the stocks are cheap), the lost upside from the options being exercised should more than offset the premium you receive by selling those calls and you are on the wrong side of those trades.

Selling Puts to Enter Positions at Lower Costs

The rationale behind this trade is to sell puts on stocks that you like, so that you can collect option premiums or get an attractive entry price into the stock. If the stock goes up, you collect the premium and the option expires unexercised. If the share price goes down, the stock price is put to you and you get the stock at a lower price than where you originally liked it. Again, a win-win, right?

Wrong. You can like the stock at $30 and then hate it when it's put to you at $20. That's because stock prices tend to move not in a vacuum, but as a result of incremental information flow. The same stock you loved at $30 may be unattractive at $20 in light of the profit warning/accounting probe/lawsuit/name-your-own-disaster-here that moved the stock to the level where it was put to you.

Again, as with the other examples, the attractiveness of this trade all comes down to the pricing of the options. I will say, however, that this trade is at least consistent (i.e., your bullish view on the stock is consistent with your bullish position with the option), as opposed to the covered call strategy where you are expressing conflicting bullish and bearish views.


In summary, don't get fooled into believing that there are simple options trading strategies and/or formulas that systematically work. As Warren Buffett famously said, "Beware of geeks bearing formulas." I would expand that to say, "Beware of geeks bearing option strategies." The systematic trading of covered calls, straddles, etc. only make sense if the options are priced attractively and determining intrinsic value for options is extremely complicated. I laid out very simplistic scenarios (the chance of the options exercising) to make my points, but the real extent of the outcome variables to consider is immense and the formulas and systems used to price options have historically proved questionable at best.

For that reason, there's really no reason for retail or institutional investors to get too caught up in complicated options strategies. The simple buying of puts and calls can be an effective means to leverage your views with well-defined downside. Beyond that, I would leave complicated options strategies to the hedge funds that dupe their clients into believing they are the ones that have finally discovered that one magic options formula that systematically works.

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