Only a Turkey Thinks a Call Option Is Like a Sports Bet

To many Americans, Thanksgiving is about three things: family, turkey dinner, and football – not necessarily in that order.  This year the holiday arrives at a time when legalized sports gambling has been extended into many new states, including mine (Connecticut).  Markets are closed for the holiday on Thursday, and open for only a half-day session on Friday, but an increasing number of Americans can look for action with legal bookmakers amidst the pro and college games on those two days. 

A reference to sports betting in a forum normally devoted to stock and options investing is not as unusual as it may seem at first.  Many market commentators, including yours truly, have asserted that some of the recent popularity of options speculation arose from the sports betting community.  Think back to last spring.  Millions were in lockdown and spectator sports ground to a halt.  After the Fed’s massive intervention caused markets to bottom, and then rally, a number of savvy new investors discovered that their stimulus checks could be put to good use in investment accounts.  Many of them gravitated to options trading because the risk/reward was quite similar to a sports bet.

Superficially, that is quite true.  In both cases, the options buyer/gambler takes a defined monetary risk in the hope of getting a leveraged return.  There are several advantages to options trading over gambling.  The spreads are tighter, commissions are lower, there is far more activity, and it is much easier to exit a trade.  But there is an important disadvantage to options – one that has been easy to overlook during relentless rising markets.

During a radio interview this morning, I was asked what the main mistake is by novice options traders. My response was “focusing on delta and ignoring the other Greeks.” A common and often successful strategy has been to buy out-of-the-money calls in the hope that the underlying share will rise sufficiently to make that call purchase profitable. When stocks are hitting new highs, particularly those that are most popular with options traders, it seems like a fairly straightforward strategy. Furthermore, we have heard about situations when an overwhelming amount of options buyers were able to force the underlying share upward. That is a gambler’s fantasy – being able to influence the outcome of the contest on which they are betting. 

Unfortunately, while the situation described above is common to recent market experience, it is extraordinarily unusual over the longer term.  There is a reason why over time most options expire worthless, meaning that more writers make money than buyers over time.  Too many traders are ignoring decay, especially when they focus on weekly and other short-term options. 

Sports bets don’t decay, but options do.  If I bet on a game, it matters little whether I do so a week or a day in advance.  Options lose some of their value each day, and that loss of value is non-linear.  The closer we get to expiration, the faster they decay.  I’m afraid that far too many speculators fail to understand this pernicious feature.  They are gravitating to short-term options to minimize their initial outlay, but are actually buying the options that are the most likely to decline precipitously if the desired scenario fails to materialize.  This can be overlooked in a raging bull market, but can become very expensive in a two-way or downwards market.

A benefit of options speculation is that the trader’s risk is defined when the trade is initiated.  The loss can be 100%, but it is known in advance.  It means that if markets become less conducive to speculation, speculators could find themselves losing money slowly but continually.   That is certainly better than blowing up spectacularly, but not a pleasant prospect either.  If you speculate, please do so responsibly.