Why Most Retail Option Traders Lose

Whether they admit it or not, the truth is that most retail investors lose money trading options.  The professionals will tell them that it's because they're not savvy enough or they don't understand options well enough.  We don't really believe any of that is true.

Yes, maybe the professionals have a deeper understanding of the math behind options pricing, but we don't believe that prevents retail traders from winning.  And these days, the technology available to individuals is absolutely good enough for anyone to win with.  Choices like LiveVol and ThinkorSwim are cheap enough (or free) for anyone to afford, so that is not a valid reason for losing, either.

The truth is much simpler than that.  The real reason most people lose is because they're almost always buying options.  That's it.  That's the whole answer.  And it's not even their fault.  Brokerages won't allow most people to sell options and will almost always tell you that selling options carries a huge amount of risk and should be avoided.  They scare people away from it.  While it's true that selling options is riskier than buying them, we believe that anyone can easily be taught that risk, and that selling spreads can alleviate almost all of that extra risk.

Not believing us yet?  Ok, here's a little bit of research to back up our claim.  We took 11 different high-volume stocks and back-tested 2 years worth of data.  For each day, we looked at the IV30 (taken from LiveVol) and then looked ahead 30 days at the HV30 (also from LiveVol) to see how they compared to each other.  The results will amaze you.

1. AAPL - total of 471 days checked.
       IV30 was higher than HV30 - 62.00%
       HV30 was higher than IV30 - 38.00%

       This means that if you picked any day in the last 471 trading days, there's a 62% chance that the 30 day         implied vol on that day predicted bigger moves than actually happened.  And keep in mind this time               period included AAPL dropping from 700 down to 500!!

2. GOOG - 471 days checked.
    IV30 was higher than HV30 - 82.38%
    HV30 was higher than IV30 - 17.62%

3. PCLN - 471 days.
    IV30 was higher than HV30 - 73.891%
    HV30 was higher than IV30 - 26.11%

4. SPY - 471 days
     IV30 was higher than HV30 - 78.77%
     HV30 was higher than IV30 - 21.23%

5. GLD - 471 days
    IV30 was higher than HV30 - 62.21%
    HV30 was higher than IV30 - 37.79%

6. FB - 326 days
    IV30 was higher than HV30 - 44.65%
    HV30 was higher than IV30 - 55.35%

    This was the only stock in the study that had HV30 at a higher percentage, almost definitely because of         the disaster of an IPO that they had, followed by a huge drop in the stock, and has recently had a huge         rally.  And with all that it still didn't win by much.

7. TSLA - 471 days
    IV30 was higher than HV30 - 58.39%
    HV30 was higher than IV30 - 41.61%

    Amazing.  This stock has had a furious rally, and still IV30 was consistently too high.

8. EEM - 471 days
    IV30 was higher than HV30 - 79.41%
    HV30 was higher than IV30 - 20.59%

9. QQQ - 471 days
    IV30 was higher than HV30 - 77.49%
    HV30 was higher than IV30 - 22.51%

10. IWM - 471 days
      IV30 was higher than HV30 - 88.75%
      HV30 was higher than IV30 - 11.25%

      Yeah, good luck buying options in this thing.

11. GS - 471 days
      IV30 was higher than HV30 - 71.34%
      HV30 was higher than IV30 - 28.66%

There's not really much else to say here.  The results are very clear.

Does this mean that you should just start selling options in everything?  Of course not.  Keep in mind that in the end the only thing that matters is whether you win or lose money, and our study here did NOT measure whether those times that HV30 outperformed IV30 would have caused option sellers to lose more than their gains.  A more extensive study involving looking at the PNL of actually trading options each day would be needed to determine that, but considering how far most of these are away from being 50/50 we think its pretty safe to assume that selling options is the more profitable strategy.

Does this mean we never buy options?  Once again, of course not.  We buy options all the time.  But we only do it when we believe they're under-priced, and we have our own pricing models that we use for that.

Even after looking at this, we still don't want to tell you to just go out and sell a bunch of options, especially in smaller accounts.  But selling out-of-the-money verticals or selling Iron Condors is certainly a good strategy.  The risk is limited to the width of the strikes, and it won't eat up most of your capital.  The real trick is determining when is the right time to do it.

Our newest idea is to put about $50,000 in a separate account (we figure that's a good estimate of the average account size), and trade it the way we would most like a retail investor to trade it.  We'll tweet every trade we make, both opening and closing, and keep a spreadsheet on the PNL.  You can play along if you want, or just observe for a while to see if what we're doing is working.  Given the limited amount of risk this account will be allowed to put on (we won't have portfolio margin), this will be quite different from our current strategies.  We're incredibly excited to see how this goes.

A Basic Example On Gambling, And How It Relates To Options

From what we've seen, the majority of retail traders, and even the tv anchors and guests, all approach option trading from a different point of view than we do.  They mostly do their analysis of which direction they think a stock will go, and then they create an option strategy around that.  While that is a perfectly reasonable strategy, it is something we almost never do.  We approach our trading from a purely gambling perspective and usually have no opinion whatsoever on the direction of the stock.  In fact, a good portion of the trades we make are in stocks that we have no idea what the company even does, and some of them we don't even know the name of the company.

Let's start with a very basic gambling example (no intricate math here), and then we'll relate it to option trading.  Consider a game played with 1 die.  If you roll a 6 then you win $10, if you roll a 1,2,3,4, or 5 then you lose $1.  Sounds like a great game for you, right?  1 out of 6 times you win $10, and 5 times out of 6 you lose $1.  So on average, every 6 rolls you make $5 (your $10 win minus five $1 losses).  You make about 83 cents a roll (on average).  I'd play this game all day every day if I could.
One important thing to note, however, is that on each individual roll you are expected to lose.  A 6 is much less common than a 1,2,3,4, or 5.  But the big win on those occasions where you get your 6 makes up for the more common losses.  That is how we look at trading options (and life, for that matter).

For our option trading, all we are concerned with is getting to buy something for less than it is worth (or sell for more than it is worth).  In our gambling example, anything less than 83 cents is a price we would definitely pay to roll.  Any price over 83 cents and we'll pass and move on to something else.  So for options,  if we see something offered at 25 cents and we think its worth 31 cents then we'll buy them.  And we won't care what the company does, or what some chart says.  All we care about is buying for less than fair value.
Remember, just like before, each buy of out-of-the-money options is one you are probably going to lose to. And also just like before, the profit on the times you win will outweigh your more common losses.  If you are winning every bet you make, that means that you are only betting on the sure things, and you are simply not betting often enough.

Unfortunately, especially for retail traders, while our dice game is very simple to find the fair value of, options are not.

Feel free to leave any questions in the comments section.  We'll try to answer anything you ask.

P.S. One thing that really drives us crazy are all the options "professionals" seen on tv who almost never recommend an option or a spread because it was offered too cheap, or it was bid too high.  Are they not concerned with price?  Does the implied volatility not matter to them at all?  All we ever hear from them is why they think the stock will move in a certain direction, and that is why they made the trade.  They're more like analysts who trade options than professional option traders.

Life cycle of large option trades

A lot of people aren't familiar with the process of how large option trades get done so I thought I'd lay it out for everyone here.
The first step is the order itself.  A customer (could be anything from a hedge fund to a rich individual investor) contacts either his bank or his broker and gives them the order.  If it's a bank they may decide that they like the order and are willing to trade with the customer themselves (a huge conflict of interest in my opinion but it happens all the time).  If they don't want the trade or only want part of it, they then shop it out (if it was a broker getting the order they shop it out as well).  The banks and brokers have a large list of contacts of professional traders.  Usually its a big list of market-makers and banks and trading firms.  They either call or instant message their list of contacts with the order the customer gave them and see if anyone wants to trade against it.  They may have one person wanting the whole thing or a bunch of people wanting small pieces.  When they get enough interest to cover the entire trade then it's time to execute it.

Every trade needs to print on an exchange, so the next step is getting it down to one of the floors.  Each floor has different broker firms who execute orders.  The upstairs broker holding this large trade will then call down to one of the floor brokers and tell them the order and ask them to cross it.  This means that they have both sides of the trade and do not need help from the floor traders.  The floor broker then walks into the option pit in which this stock trades and announces the trade.  The specialist and floor traders then get to look at it and decide if they want to trade it.  If they don't, then the broker crosses it and it gets on the tape.  If they do, then the broker has to find out if the people that were shopped the trade are willing to cut back a little to let the floor traders get some.  The floor traders cannot be bypassed if they want to participate on the trade.  If the upstairs people are willing to cut back, then the floor guys get their piece and the trade gets on the tape.  If they're not willing to cut back, then the upstairs broker will cancel the order on the floor and send it down to a different exchange in hopes of avoiding those floor guys.  Eventually they either find an exchange where the floor guys don't care, or they cut back the least that they can.

One last thing to discuss is if the option trade was tied to stock.  Most of the really big trades are tied to stock.  In this case, the last thing to do is cross the stock.  Once the trade is executed on the option floor, the broker must then call up a different broker to execute the stock portion (i.e. Cheevers or Libucki).  They then print the stock at the agreed upon price, and each person on the trade will get their portion of the stock.

That is the entire life cycle of a large option trade.  I hope it shed some light on the process.

P.S. Just in case anyone was wondering, the professional traders (market-makers and such) that get the phone calls and instant messages about the large trade are NOT allowed to act on it until the trade is announced on a floor.  If someone were to get shown a big trade that was buying a large number of calls, they might be tempted to go out and buy other calls on the board knowing that the big customer is doing that. This is called frontrunning and is against the law.