Even if the complexity of the options market makes your head hurt and you know that you want no part of it, you should still understand the basics of buying a call or a put when an excellent opportunity arises. Football fans are familiar with the idea of a Hail Mary pass. This is usually a very long, typically unsuccessful pass made in a desperate attempt to score late in the game. The idea is that if it works, you can win the game for your team. If it fails, you have not really lost anything new since your team was going to lose the game anyway.
Once in a great while, an experienced investor (or trader) will realize that something massive is going to happen with a stock, and she becomes nauseated because she doesn’t have enough capital to take advantage of the move that she is entirely sure is about to happen. In absolute terms, a 20% move in a stock’s price (which most investors would consider a good year) doesn’t mean much if you only have $1000 to invest. Sure, making $200 is nice, but the “smart money” made millions on the trade, and that fact is galling.
If you ever find yourself in this boat, then you may want to consider the risks and reward of what I refer to as a “Hail Mary” trade. You make the biggest bet you can afford that your “sure thing” will happen by buying options in your predicted direction as close to the date that the big move will happen as you can get them. By making your biggest bet with options that have very near expiration dates, you have maximized the number of shares of the underlying stock you can control and from which you can profit. The reason that such opportunities are rare is that big profits usually come from contrarian trades where you foresee something that very few other people see, and most of the Street is betting against you.
The Street isn’t stupid (most of the time), and the consensus of the whole is a dominant force. If everyone knows something is going to happen and they have had (just a little) time to process the implications of whatever catalyst is going to happen, then good (or bad) news is already baked into the stock price. The strange and unexpected is what causes price explosions. In days where computer algorithms scour the internet in search of news and execute stock orders in fractions of a second, you cannot compete without some sort of edge that the algorithms cannot duplicate.
Let’s say that you’re sitting at your computer pouring over option chains on Tesla ($TSLA) stock when you get a tweet from Mr. Musk that he has decided to personally lead a mission to Mars. The algorithms may not immediately grasp the implications of that tweet, and human traders will need a few seconds to consider it. You see in a flash of insight that Mr. Musk can’t very well stay on as CEO of Tesla if he is on a mission to Mars, so he must step down. You also believe that the fortunes of Tesla are intricately linked to the charismatic Mr. Musk and that Tesla stock will plummet (at least in the short-term panic) when the Street realizes this fact. In a decisive moment of truth, you place an order for 1 put at a strike price of $342.50 on TSLA for a total cost of $1000 when the stock is trading at $343.14.
As the Street processes the news of Elon’s intrepid expedition, the stock reacts and plummets down to $232.50, losing over 30% of its value in a few minutes. Bottom feeders come in at that level, smelling a deal. This provides some buying pressure, and the stock starts to trend back up a little. You sell the put when it bounces back down to the bottom, which you’ve decided was the $232.50 level. If you had shorted the two shares you could afford to cover with your $1000 investment, you would have made around $200 (because you could only afford a tiny short position consisting of two stocks). Not bad for a few minutes work!
Remember, with a put you are controlling 100 shares of stock. When your $10 put that you paid $1000 for ($10 x 100 shares) sells, the intrinsic value has moved from zero to the difference between the strike price of $342.50 and the price of $232.50 where you sold the contract. You lose $10 per share because of the option premium. This means that your profit from the trade was the $342.50 strike price (it doesn’t matter that the stock was selling for more than that when you purchased the position) minus the $232.50 price where you sold the put.
That comes to $110.00, which doesn’t include the premium you lost (for ease of computations, let’s say that there were mere seconds of trading left before the market closed on expiration day and there was no time value left, so only intrinsic value remained when you sold). That means you made $100 per share off of the trade. That $100, as you will have noticed, is less than the $232.50 you would have made by shorting the two shares of stock. Remember, however, that $100 is your profit per share, and your put gave you the right to the gain from 100 shares. Therefore, that comes to 100 shares times $100 gives you a total profit of $10,000.
If a tenfold increase doesn’t excite you, then you aren’t going to enjoy trading. You may be asking, “Why doesn’t everyone spend all the cash they can come up with on options if it is that easy?” The answer, you probably have guessed, is with the risk. What if the big crash didn’t happen after all? Let’s rewind that scenario and see how it would play out differently under different circumstances. Let’s say that CNBC reports that hackers hijacked Elon’s Twitter account for a few minutes and that he wasn’t responsible for the Tweet.
The stock didn’t have time to react in a big way before the report came out, and $TSLA kept trading as it usually does. You try desperately to sell the “out of the money” put for what you invested in it, but get no takers late on expiration day. You aggressively put in sell orders with lower and lower prices and finally manage to get rid of it at $0.05. After fees, you lost a little more than your $1000 investment when the bell rings.
The takeaway from our two hypothetical scenarios is twofold. The first point is that options trading is attractive to many because the upside is unlimited for call options, and put options are limited only by the fact that stocks cannot go below zero in value. Either way, the profit potential is absolutely enormous when compared with the initial investment if stocks make explosive moves in the direction that you predicted. The second point is that explosive movements that result in tenfold profits are exceedingly rare and can result in you losing everything you invested. This leaves you with two essential questions to ask yourself:
1. How sure am I that this stock will make a massive move in the predicted direction in the allotted amount of time?
2. How am I going to feel if my contract becomes worthless and I lose everything I invested?
What this suggests is that you should make Hail Mary bets only when you are entirely sure that things will go your way. You should also be sure that you can afford to lose the bet and still sleep at night. Making such bets with the rent money is pure folly.
If you want to make money trading in options, you need to make small bets (5% of your total options investment pool is a common strategy) so that when luck goes against you, you aren’t wiped out and can play another hand. You also need to make high probability bets. One of the things I like most about options is that you know the probability of success going into the trade (assuming market conditions remain similar throughout the life of the contract). If you read a book on casino betting, you can learn the “house edge” on nearly every game (that is played according to the rules). Casinos make billions of dollars every year, and they indeed don’t depend on luck. They depend on some brilliant people doing many probability calculations.
When you play blackjack, for example, you are praying for luck and rubbing your lucky rabbit’s foot, but the casino is assured of a profit because it has an edge of one half of one percent (0.5%). The edge is even higher when patrons are making bets based on poor strategies and lubricated with free alcohol. You may have a lucky streak and make a profit by playing 25 hands, but the casino takes advantage of the laws of large numbers and makes its profits on slivers of thousands and thousands of hands. For roulette, the house has a 5% edge. That means that the house is going to keep (on average over many, many bets) $0.05 of every dollar bet.
Casinos get very, very upset when patrons do things to mess up their carefully calculated edges. That is why card counters are identified and banned, and the banned list is shared with other casinos. When you trade in options, you don’t have to beat the dealer. Beating the dealer is a critical concept when dealing with casinos because, rest assured, the casino always has the edge (and why I call casinos and lotteries the Stupid Tax). You can become the casino—you can know your advantage and play only the games that give you the edge you are looking for. Professional options traders don’t make Hail Mary bets. They make high probability bets with relatively small stakes and carefully control their risks. Think you cannot make money like that? Pull the balance sheet for your favorite casino.