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

By:

Chief Strategist at Interactive Brokers

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.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers LLC, its affiliates, or its employees.

Any trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations.

In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.

Disclosure: Options Trading

Options involve risk and are not suitable for all investors. For more information read the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or copy and paste this link into your browser:

http://www.optionsclearing.com/about/publications/character-risks.jsp

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