Celibacy Vs Condoms: The Answer To Whether You Should Trade Options
Options are surgical tools. They are priced for specificity. What to consider before bothering with them.
The point of dashboards is to help you make better decisions. Decisions that accord with your objectives.
I’m underwhelmed by the standard of dashboards in the investing world. They are not designed to help you make better decisions. They are designed to make you stick a quarter in a slot machine. The focus is on returns not risks. Returns are less predictable than risk and risk itself doesn’t exactly lay down quietly on the operating table for examination. Jason Zweig called attention to Robinhood’s brazen options GUI near the height of call option yolo’ing:
Robinhood’s emails and other communications were prompting me to trade options, another risky strategy I’d signed up to try. I didn’t trade any, largely because the way Robinhood displays options prices confused me. Other brokers show your potential gain and loss equally prominently. When you look into buying a call option on Robinhood, however, the app shows you a measure called “To break even,” with no indication of potential loss.
Interested in selling the same option? Now Robinhood will show you something called “Chance of profit,” again with no measure of possible loss. But if there is (say) a 65% chance of profit if you sell an option, then there must be a 65% chance of loss if you buy it. By instead highlighting “To break even,” Robinhood draws your attention to how little a stock has to rise for you to begin making money by buying an option—even though you could lose as much as 100% of your investment if the stock goes up less than you anticipated (or goes down).
“Chance of profit,” meanwhile, focuses you on the high likelihood of earning at least a small amount when you sell a call option. If the underlying stock goes up more than you expected, though, that could cost you far more in forgone upside than you earned selling the option. Other major brokers, including ETrade, Fidelity Investments and Charles Schwab, don’t pull this sort of switcheroo. They use the same format whether you want to buy an option or sell it—and they don’t use the term “Chance of Profit.”
“How a brokerage firm displays risk and reward shouldn’t hinge upon whether you’re buying or selling an option,” says Roy Haya, head of options strategies at Fort Point Capital Partners LLC, a San Francisco-based investment firm. “Changing the optics like this could encourage activity on both sides of the same trade, and that seems like a suspect way to entice inexperienced options traders.”
“Each [options-quote] display,” says a Robinhood spokeswoman, “seeks to elevate the information that we have found to be most relevant to a seller or a buyer, who have asymmetric opportunities and risks—certainly not to encourage any particular investment strategy.”
Robinhood’s business relies on churn because active trading in options ensures your customers will either blow up or bleed out. Options trading is high margin for the brokerage. A mirror of what it looks like for the client.
Consider this:
1% slippage in a $50 stock means losing 50 cents on your fill. Now think of options. If you pay 51 cents for an option worth 50 cents you are incinerating 2% in expectancy. And that’s without fees. The absolute smallness of the numbers is insidious. Optically tight bid-ask spreads lure you into trading more. If the markets were really wide and you had to pay $1.00 for that option worth $.50 you’re almost guaranteed to lose. It’s like borrowing money from the mob. You’d know it’s a bad deal. But when the market is tight, your negative edge is obscured just like it is in blackjack. You actually get to win fairly frequently. And that is the hook. You don’t realize you are playing a losing game.
The danger of options is not unlike the danger of risky sex. It’s exciting. If you sell options irresponsibly your win frequency is still high. It feels niiiice. But if you get burned, the outcomes range from an uncomfortable coyote morning all the way to, well, ending up on whatever the Jerry Springer show of today is disavowing your baby, I mean, account. (I was a 90s teen and my references are frozen in the original Jurassic Park amber).
If you buy options irresponsibly, it’s only a matter of time before you end up with a disease. Hep-B. B for “broke”.
Think Before You Even Get Aroused
When it comes to options, I’m a prude. I preach celibacy. I don’t do it in my personal account (my only account these days). No blanket advice is perfect. But I think it errs in the right direction. There are more people who think they should trade options but shouldn’t than there are people who aren’t trading options who should. I can never keep type I and type II errors straight. Even with this “on-the-nose-for-this-post” graphic:
Taking the other side of your trades is such a consistently good business, I’m picturing every customer opening an options account as Tobias:
From my perspective, I just eased into options as a job. It was simply a subset of trading which is what I more broadly signed up for. I wasn’t inherently interested in options, but as I started learning about them I was as vulnerable to the same nerd snipe that many readers of this blog find themselves mired. I just had the advantage of being on the house side. So if my plea for celibacy has any hope of working I should at least offer a sound rationale that is more than “you’ll go to [financial] hell”. You need to understand the purpose of options in the first place.
Why Anyone Would Trade An Option?
Let’s address reasons to trade an option.
Directional speculation on the underlying
This is a common and intuitive use of options. You’re bullish so you buy some calls. You’re bearish and sell calls or buy puts. Pretty straightforward. The dominant rationale here is using the options for their “delta” and inherent non-recourse leverage. If this is you then my paternal reminder:
This is really a fundamental trade more so than a trade born of some opinion of the option’s price. In other words, 90% of the work is actually upstream of the options trade. That last 10% involves choosing the exact expiry and strike but if you have an explicit forecast for the stock, a forecast that is presumably fueling the burning desire to go through 2FA into your brokerage account, possibly fill out an “Intent To Trade” compliance form, and then the commitment to follow the thing you bought (and follow it you will — you didn’t trade an option because you’re “in it for the long haul”), then the actual option selection is rather trivial. The best bang for your buck easily falls out from a well-fleshed-out forecast.
If the options part is hard, then it’s inheriting the wishy-washy nature of your upstream fundamental analysis.
Hedging
Buying an option can act like an insurance policy. Puts can protect a long position, calls can protect a short position. As opposed to a stop order which is exposed to gaps, an option is a “hard” stop. You always maintain the right to exercise at the strike price. This hard optionality is presumably baked into the price because it’s valuable (one of my conjectures is that various flavors of option selling strategies that have rules for covering options when they start hemorrhaging are, at their core, attempting to arbitrage this hard-to-pin-down concept. This starts to rhyme with “vol trading” which we’ll get to because, when you get to the nucleus of the logic, these strategies are premised on the idea that the replication is cheaper than the hard option.)
In any case, when hedging, most people buy options. Like speculation, 90% of the work is done upstream of the option’s decision. The rationale for whether you should hedge versus simply use less leverage or run smaller position sizes is complicated. If your core position is X then is that better or worse than a bigger hedged position? That’s a hard question. Consider the logic I’m recycling from Finance As A Laboratory For Decision-Making:
People understand that even though insurance has negative expectancy it can still improve a portfolio that is focused on compounded returns. It makes no sense to look at the line-item of insurance divorced from the optionality it gives you in the rest of your portfolio.
(I could pull lots of links on this idea, but let’s be brief).
This concept is fractal. Let’s zoom in on the smallest portfolio — a spread. You don’t necessarily care about the p/l of any individual leg of a spread trade but the performance of the spread overall.
Before we consider a spread, let’s just look at the single position. Suppose you buy something for $4 when it’s worth $5 but then sell it for $4.50. You made both a:
- +$1 expected value trade
- $.50 EV trade.
If you knew it was worth $5 you negated half a good trade with a bad trade.
In real life, you often might like the price of a spread but it’s hard to tell which leg is the “good side”. That’s one of the reasons you trade the spread. Once you do the spread you don’t care about the individual p/ls.
Another reason you may do a spread is that you might like a trade (ie maybe vol is cheap in X) but can do it bigger if you spread it. This is one of those questions that comes up a lot on real trading desks. Do I like the outright, or do I like the trade better paired against something else (and assuming I can do the trade bigger if I spread it)? Do I like being long z units of X exposure, or do I prefer 5z units of (X-Y)? The answer depends on understanding the distribution of the outright vs the spread and the relative price of each within those distributions.
Again, the decision of whether to mitigate the risk requires more brain damage than actually picking the hedge. You can learn more about the logic of hedging in If You Make Money Every Day, You’re Not Maximizing.
If you are rigorous and clear in your decision to hedge, then once again, most of the work is upstream from the options trade.
Some kinky thing called “vol trading”
“Volatility trading” is another reason to trade options. This is a niche reason because it’s actually the inversion of the first 2 reasons. Those reasons originate from very natural impulses — to speculate or cut risk. Vol trading is the business of supplying liquidity to all those normie investors. It’s a strategy that starts with the idea that the options themselves carry their own reason to be traded — they are mispriced. I use the word strategy as if it’s a form of risk premium like “value stocks”, and maybe that argument can be made, but I think it’s more adaptive to understand it as a subset of trading in general. It’s not an investment strategy, it’s a business (see Trading Vs Investing).
The semantic distinction between investing strategy and business is useful. You wouldn’t open a restaurant as a side hustle or hobby. Despite the ease of “larping as a vol trader” by picking up some language and opening an IB account, you are not vol trading as an investment strategy. Vol trading is a low-margin business, that requires institutional cost structure and infrastructure. The breadth of diversification and sheer transaction quantity demands economies of scale. Core strategies such as dispersion require those economic synergies making it more efficient as an overlay instead of a clinically administered stand-alone strategy. Knock yourself out with An Example “Options Relative Value Trading Framework”.
For the retail masochists
If you insist you want to “vol trade” from home these interviews are the best guides. I warned you.
Both interviews include Darrin Johnson who is the closest I’ve seen to a person grinding options day-in, day-out who came from a pure retail background. The second interview includes Noel smith, SIG alum, who now backs traders and has seen a gamut of independent traders. I think that episode stands out as the best reality check. It debunks lots of misinformation and frames the entire endeavor of trading brilliantly in the context of “this is a business”. There’s also this one line that reminds us that this is not a good career choice for those who prefer a bit more determinism in their vocation:
You do your best and at some point, you put your finger in the air and if you don’t think that everyone does that at some level you don’t understand how the business works. Everybody has to make some kind of a judgment because if you are only looking at the data you have the same data everybody else has and you have a totally in-consensus opinion. You have to make some judgments.
For the aspiring professional masochists
The 99th percentile vol PM probably makes similar money to the 90th percentile investing PM. The competition to be a top vol trader is likely higher simply because its puzzle-like similarities attract nerds with very specific forms of aptitude. But even worse from a “these are the people you’ll be competing with” point of view is that the specific intellectual nature of the job means it’s fun for them. The net result when combined with the relative smallness of the market (vol trading is to investing as “math rock” is to music) — more competition per unit of pay. If you want to just make money, almost any other avenue is better if you are in any way ambivalent about the work.¹
Addressing covered calls and cash-secured put selling
I claim there are 3 reasons to trade options.
- Speculation
- Hedging
- “Vol trade”
The most popular form of retail option trading doesn’t seem to fit in one of these buckets: covered call selling (and its close cousin cash-secured put selling). What gives?
It actually does fit. It’s hedging.
I know that’s not the intent but if you sell a call against a long position, you are hedging.
Repeated game thinking is a useful lens here and one of the most important mental models you should derive from the world of trading. Here’s the logic: if you sell a 25 delta call against your long, your underlying position gets called away 25% of the time². In fact, any software that aggregates risk would show your net exposure to the stock dropping to 75% after you sold the call option. Whether you sell 25% of your stock outright or sell a call option that theoretically gets assigned every 4th time you make the trade, your net exposure is the same in the long-run. The option expression changes the shape and timing of the exposure, but it is the same exposure. Any large sample will prove it out.
Now there’s the argument that maybe you get called away less than 25% of the time and therefore that 25 delta call is overpriced. If you want to make that argument, fine. Just own it. You are now making a vol bet.
“Selling calls for income” is in the marketing euphemism hall of fame right next to “re-education camp” and “adult entertainment”. It’s a motte-and-bailey argument where the motte is “cash flow is income”. That’s only superficially similar to the credit you receive for the option. The problem is the bailey — you can’t then conclude that the credit is income. It’s not income. It’s the probability-weighted expectation of the stock being above its strike before expiration.
A stock price itself is the discounted sum of future paths. You simply sold a set of those paths, that appears to be income if the stock does not expire above the strike. If there was an accounting ledger the credit is the option premium, but the debit would be the risk. The risk part is conveniently swept under the rug by assurances that “you’ll be happy if the stock gets there”.
If I benchmark to the counterfactual world where I sold 25% of the stock, then the scenarios where the stock goes up by a lot OR goes down, then the call selling strategy was expensive. Do you see course/book promotor’s sleight of hand?
I don’t want to belabor this anymore. I’ve covered it multiple times:
I’m at the point of invoking Brandolini’s Law and moving on.
Wear a Condom
If you preach celibacy while ostriching any discussion of condoms, you are laying irresponsible odds against pubescent urges. When it comes to options, many of you are insatiably horny. If you insist on using options, take the following concepts to heart:
Specificity
You are paying for specificity via options because they are priced with a particular vol to a specified expiry. The offsetting benefit is you are highly levered to being right.
From If You Make Money Every Day, You’re Not Maximizing:
The beauty of options is how they allow you to make extremely narrow bets about timing, the size of possible moves, and the shape of a distribution. A stock price is a blunt summary of a proposition, collapsing the expected value of changing distributions into a single number. A boring utility stock might trade for $100. Now imagine a biotech stock that is 90% to be worth 0 and 10% to be worth $1000. Both of these stocks will trade for $100, but the option prices will be vastly different. If you have a differentiated opinion about a catalyst, the most efficient way to express it will be through options. They have the most urgent function to a reaction. If you think a $100 stock can move $10, but the straddle implies $5 you can make 100% on your money in a short window of time. Annualize that! Go a step further. Suppose you have an even finer view — you can handicap the direction. Now you can score a 5 or 10 bagger allocating the same capital to call options only. Conversely, if you do not have a specific view, then options can be an expensive, low-resolution solution. You pay for specificity just like parlay bets. The timing and distance of a stock’s move must collaborate to pay you off.
Since you pay for specificity, you need a well-formed understanding of your edge. If you’re going to trade options directionally I would want to see the specificity in your fundamental analysis that suggests these particular options are the right options to buy or sell.
It’s so easy to lose on timing or changes in vol even if you get the direction right. See:
Destination vs Path
I've posed the following:
If you have a view about the expected return of an asset in 5 years should you care about the path? Depends who you ask. Anyone marked-to-market (HFs, market-makers, futures traders) will say yes especially if they are managing money for others. PE, RE, and bond investors are more likely to say no…I’m biased by my path-or-die experience in trading. Mark-to-market is the goddess of tomorrow, you can’t afford to piss her off.
Options offer you the chance to isolate bets on either path or terminal value if you want.
A few examples:
- Market prices are clever. In What The Widowmaker Can Teach Us About Trade Prospecting And Fool’s Gold, I show how market prices are clever. They can balance the wagers of path vs terminal value investors simultaneously! The calendar spread options are priced so that the path of the gas price is highly respected, even if there’s strong consensus about the terminal value of the spread (ie the March-April futures spread which is a pure bet on in winter gas being in short supply).
The OTM calls are jacked, because if we see H gas trade $10, the straddle will go nuclear. Why? Because it has to balance 2 opposing forces: Let me repeat how gnarly this is. The price has an unbounded upside, but it will most likely end up in the $3-$4 range. Try to think of a strategy to trade that. Good luck.
Wanna trade verticals? You will find they all point right back to the $3 to $4 range.
Upside butterflies which are the spread of call spreads (that’s not a typo…that’s what a fly is…a spread of spreads. Prove it to yourself with a pencil and paper) are zeros.
The market places very little probability density at high prices but this is very jarring to people who see the jacked call premiums. That’s not an opportunity. It’s a sucker bet.- It’s not clear how high the price can go in a true squeeze or shortage
- The MOST likely scenario is the price collapses back to $3 or $4.
- In options land, many investors like to buy 1×2 ratio spreads because the payoffs look amazing for low-probability events. For example, if a stock is $100 and you can buy the $115 call and sell 2 of the $120 calls for zero premium, you think to yourself:
a) “If the stock does nothing or goes down I break even”
b) “If the stock goes to $120, I make $5” (or $1 if the stock goes to $116)
c) “I don’t start losing money until the stock goes over $125. That’s 25% away! This is risk-free return”
Nah dog. That’s first-time-at-the-rodeo thinking.
The reason the 1×2 is so cheap is the call skew on the $120 strike is pumped up because someone has been buying them like crazy. That’s where the bodies are hidden. The question you need to ask yourself is “conditional on the stock going to $120 did it get there fast and sloppy, or slow and grindy.” If it goes there in a fast way, the market-maker community will be short beaucoup gamma and be scrambling to buy the $120 calls back. You sold some teenies and went to Santorini and are now getting a margin call on the beach because the 120s you’re short are blowing the f out.
The path-aware trader is plotting how to be long the scenario where your vacation abruptly ends. - If path is so important, how can you manage to it?
a) Avoid excessive leverage
b) Pre-determine when you will cut losses (beware this can be a big topic with lots of room for disaster)
c) If you insist on betting on terminal value, do it in fixed premium ways where your max loss is bounded. Now you don’t have to worry about mark-to-market risk.
In There’s Gold In Them Thar Tails: Part 2, I cover the topic of path, how to exploit investors’ lack of appreciation for it, and how Jon Corzine became a symbol for path-blindness.
Conclusion
You probably shouldn’t trade options. But I get it. Everyone gets a little curious.
I hope this post offered some protection.
Footnotes
- It might sound self-serving to argue that options traders are somehow more talented than their counterparts in broader asset management. They are likely more “pointy” or (ie less-well rounded). I’m not too comfortable making that claim necessarily but perhaps it’s better to refer to my friend Agustin Lebron who has interviewed an impressive sample of candidates at Jane Street, one of the most selective employers in finance and technology. An attractive candidate in their eyes is not just someone with a lot of horsepower and a sterling CV. That’s table stakes. They want to see a demonstrated history of competitive excellence. Like finding that 20-year-old who became the second-best player in the world in some weird variant of poker or a world-class bullet chess player. It’s not that these skills are necessarily transferrable, it’s the process behind those skills that offers a promising clue to the candidate’s trading aptitude.
Also, an astute reader will notice that when I write “the 99th percentile vol PM probably makes similar money to the 90th percentile investing PM”, it’s actually a self-own even if you think I was being brash. Bad table selection on my part. So much for strong decision-making skills.
The 21-year-old version of myself would not be hireable today. It’s far too competitive because these jobs are now the equivalent of winning the lotto. Make no mistake. There is an all-out war for talent because the power law nature of technological leverage on elite problem-solvers and speed is winner-take-all. The top companies are looking for Avengers. - This is not perfectly true because the probability of a stock finishing in the money and its delta are not exactly the same. See Lessons From The .50 Delta Option. But for the options investors use to overwrite they are close enough to not quibble about.