Retail options investors, despite years of the options industry's educational efforts, still lack the sophistication of institutional investors. That's understandable: One's a pro, the other isn't. Indeed, you're probably aware that fly-by-night operators have begun exploiting the retail options investor's shortcomings. They are using the flexibility and power of options to lure unsuspecting customers who don't understand the options game.
A Bad Taste
Anyone with a television and a computer can see this. I'm speaking of late-night infomercials, spam emails, bait-and-switch websites and fee-based seminars. These flimflams tout how traders can use options to make money in any market environment.
All one needs to do is buy a software package/trading system/newsletter.
The investor, this moonshine message continues, will then make money regardless of the investment's underlying moves. It couldn't be easier!
Judging by the amount of questions I've fielded, it is a tactic that is targeted beyond retail customers. A surprising number of unscrupulous brokers and investment houses have used variations of the same pitch, luring institutional customers into options, too.
This approach raises two questions: Can options really deliver on these outrageous claims? And are these pitchmen just selling snake oil?
Up, Down, Sideways
What is this magical trading technique that allows traders to profit no matter which way the underlying stock moves? Well, it's actually a very simple strategy that has been a mainstay of the options world for decades. It's called a straddle, and it is the heart and soul of all these late-night moneymaking schemes. Straddles involve buying or selling a call and a put on the same strike. Since most of these strategies involve buying at-the-money straddles, we'll focus on those for now.
Combining a call and a put from the same strike is the basic idea of the straddle. It is also the hook behind all of those spam emails and infomercials. As the ads claim, this position does indeed gain value no matter which way the market moves. It's a powerful concept and one that seems like magic to the options layman. Unfortunately, there are significant downsides to this position that the infomercials neglect.
The Downside
Despite what the hucksters would have you believe, straddles are not a magical path to profitability in options. If these positions performed as touted, there would be little reason to trade anything else. Unfortunately, as with everything in life, the benefits of straddles are balanced against a number of significant drawbacks. The first and most obvious drawback is cost.
Since you are buying two options on the at-the-money strike, you are paying twice the amount of the implied volatility premium when compared to purchasing only a single option. As a result, the trade requires a much larger movement in the underlying instrument just to break even. Since the break-even point is a major consideration in any trading decision, this is a significant drawback.
Another significant downside to trading straddles is theta, also known as time decay. Each option has an expiration date. As it inches toward that date, it loses a little bit of its extrinsic value (volatility premium, interest, etc).
I won't explain all the nuances of theta because it isn't necessary for this example. However, since straddles involve twice the amount of premium as a single option, an investor would also be losing twice the amount of decay every day. To summarize, an investor in this scenario would have a position that loses value at an accelerated rate while also requiring a significant move in the underlying stock just to break even. Suddenly, all of the ads and the infomercials aren't sounding as appealing.
Gamma Scalping
Theta becomes a concern because most of these schemes require buying front-month at-the-money straddles. This is because an option's rate of decay increases as it approaches its expiration date. As a result, the straddle position loses value at an alarming rate that is very difficult to counteract.
Professional option traders fight back against time decay with a technique called gamma scalping. Gamma scalping, when done correctly, allows traders to profit from small daily movements in the underlying stock. This scalping pays for the decay while the investor waits for a large movement in the underlying investment.
Gamma scalping is a time-consuming activity that requires software to calculate your position's "Greeks." It also requires a significant understanding of the options markets as well as the underlying stock. Needless to say, this technique is beyond the ability of most investors who are targets of these moneymaking schemes.
Most customers who fall victim to this pitch simply allow their straddles to decay to zero, all the while hoping for a big movement in the underlying stock that would allow them to make a profit. On the scale of viable investment strategies, this is little better than letting your paycheck ride on the pass line in Vegas.
Strangling Competition
Some programs offer a more sophisticated approach to the straddle method. Most of these programs use strangles instead of straddles. Strangles substitute an out-of-the-money call and an out-of-the-money put for the same strike positions of the straddle.This position is much cheaper than an at-the-money straddle, and it is not as vulnerable to time decay.On the flip side, it also requires a much larger move in the underlying (stock) to generate significant profits. Therefore, while strangles may pose interesting alternative to straddles, they are only practical in stocks in which you expect a massive move in the underlying in a relatively short period of time.
For those with a penchant for risk and sleepless nights, there is an alternative to buying at-the-money straddles. You can sell them.
For decades, selling straddles was one of the most popular strategies in the options world. Its popularity stemmed from the mentality that options are insurance. As everyone knows, you can't make money from buying insurance. Instead, you sell it and collect your premium every day. The more options you sell, the more time decay you collect. Some of the most famous names in the options markets made their fortunes with this method.
As you might expect, this technique works well as long as the underlying doesn't move very much. Not surprisingly, this technique fell out of favor during the late-90s when massive swings in the market bankrupted many of its proponents. Still, it's worth noting that, despite what the ads claim, buying straddles is not the only way to make money in the option markets.
Not All Fun & Games
The moral of the story is that straddles can be profitable. But trading them properly requires a level of sophistication beyond most retail and even some professional customers.
So the next time a friend asks about an infomercial he saw claiming that investors can "make money in any market" using straddles, just smile and tell him to turn the channel.
The views in this column are those of the author and do not necessarily reflect the opinions of Traders Magazine. The columnist can be reached at mark.longo@sourcemedia.com
