Article Highlights:

  • Many individual investors treat options as low-priced speculation on the stock.
  • Several studies show that individuals tend to buy “out of the money” options.
  • On average, those investors lost 91% — even with their big gains included.

When I talk to investors, I’m not surprised how many view options as lottery tickets.

Both options and lottery tickets are cheap. Both can provide instant riches.

You already know most lottery players lose. It’s not surprising that traders who think of options as lottery tickets also lose.

Winning options traders think of the market differently.

Most investors approach financial markets the way they play tennis. That’s based on one expert’s research.

Charles Ellis explained the analogy in The Loser’s Game. His 1975 study still applies.

Tennis, Ellis noted, is two games.

Pros and the best amateurs play a winner’s game. They win points with skill.

The rest of us play a loser’s game. We win points when our opponent makes a mistake. The winner is the player who makes fewer mistakes.

Investing is also divided into winner’s and loser’s games. That’s especially true in options.

Losers Buy Lottery Tickets Instead of Options

Many individual investors treat options as low-priced speculation on the stock.

Remember, losing a loser’s game is the result of mistakes. Many individuals make their first mistake when they open the trade.

They often buy “out of the money” calls.

These calls start out cheap, often less than a dollar. And they often get cheaper.

Over time, they usually become worthless.

An example can make this clear.

How to Play the Game

A call option gives the buyer the right to buy a stock at a predefined price for a certain amount of time.

Options trade with various exercise prices. For a $100 stock, there might be calls with exercise prices of $90, $100 and $110, among others.

The $90 call gives the buyer the right to buy the stock at $90. With the stock at $100, this option is worth at least $10. That’s the difference between the exercise price and the stock price.

Calls with exercise prices below the stock price are “in the money.” They have immediate value. They’re the most expensive options.

The $100 call might trade for $5. Call options with exercise prices near the stock price are called “at the money” options.

The $110 call might trade at $1. The low price reflects the fact the stock must gain 10% before the option is in the money. Calls with exercise prices above the stock price are called “out of the money” options.

“Out of the money” options have little chance of success. Yet they’re popular among individual traders.

One reason is that options are like lottery tickets. Both “out of the money” options and lottery tickets offer a large potential gain for a small risk. That’s appealing to many individuals.

If the stock gains 20% in this example, the $110 option will be worth at least $21, a 900% gain. The $100 option gains 300%. The $90 call gains just 100%.

The $90 call has the highest probability of a gain. But it offers the lowest-percentage return. That makes it less appealing to those playing a loser’s game.

Invest in the Winner’s Game

Several studies show that individuals tend to buy “out of the money” options.

One study looked at more than 700 “out of the money” options investors bought. Three delivered gains of more than 1,000%, and one gained 2,600%.

The rest all expired worthless.

On average, investors lost 91% even with the three big gains.

Another study found that successful options traders avoid “out of the money” calls. They buy at-the-money options with less than three months to expiration.

This simple idea makes options trading a winner’s game.

Winners have an edge. Their edge is a strategy that’s based on hard work (like the one I use in my Precision Profits service).

Winners don’t buy cheap options and hope for the best. They avoid lottery tickets. And that one fact explains part of their success.

Regards,

Michael Carr, CMT, CFTe

Editor, Peak Velocity Trader