5 Ways Not to Be a ‘Dumb Money’ Options Investor

The options market is Wall Street’s Rodney Dangerfield.

It gets no respect, even though the financial markets couldn’t function without puts and calls. Even Bitcoin, invented in 2009 by the still-pseudonymous Satoshi Nakamoto, has found greater acceptance. Many on Wall Street now consider crypto to be a full-fledged asset class, unlike options and other derivatives.

Incredibly, many investors say 70% to 90% of all options trades end in a loss. The figures have been cited for decades, and reinforced by academic studies, although failure rates probably aren’t that high. If they were, daily trading volumes would never have grown to about 45 million contracts, up from one million around 2000.

We thought options market leaders would welcome the opportunity to dispel persistent misperceptions—but we were wrong. OCC, previously known as the Options Clearing Corp., issues and settles all options contracts, but doesn’t have profit and loss percentage data on trades. That’s surprising. OCC also manages market risk. OCC is so important to market stability that the federal government declared it a “systemically important financial market utility” after the 2008-09 financial crisis.

OCC says some 22% of trades expire worthless. But that stand-alone fact isn’t useful; many investors want options to expire worthless to keep premiums. Other options market leaders noted the many complexities in defining success and failure in a complicated market. The point is reasonable, but can you imagine major companies in other key industries tolerating persistent perceptions that raise doubts about their products?

It’s easy to conclude that the options market needs losers like people need oxygen. Dumb investors—and they are a hallmark of every market—create reliable profits for options dealers, who historically have had many colorful sayings about them.

Before options traded on computer systems that are prohibitively expensive to operate, floor traders joked that the difference between Las Vegas and Wall Street was that casinos bought drinks for losers. No one worried about investors losing interest. Losers always come back to Vegas.

To improve the odds of success, we offer some simple rules to help anyone who wants to be a better options investor.

1) Stocks first; options second. Only trade options on stocks you own or want to buy. You’ll never consistently outsmart major dealers like Citadel, Susquehanna, and Wolverine. They are engaged in global, multidecade analysis of everything that moves markets. Use options to better manage your stocks, not for speculation.

2) Ignore high-volatility options, which basically pay dealers to make markets in risky options. Average investors rarely make loads of money trading hot options. Focus on enhancing stock returns by gaining mastery of covered-call and cash-secured put selling strategies.

3) Sophisticated investors usually sell options, as dealers often overprice them. Stocks must make extraordinary moves for long options to be profitable—which happens less than you might think.

4) Embrace contrarianism and guard against overconfidence. Try disproving your thesis rather than celebrating it.

5) Practice the “good investor” rule: Bad investors think of ways to make money; good investors think of ways to not lose money. Top options traders put risk before reward, process before profit, and thinking of probabilities over possibilities.

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Originally Posted October 4, 2023 – 5 Ways Not to Be a ‘Dumb Money’ Options Investor – Barrons

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.