Here's How to Gain A 3:1 Advantage In The Market

There's only one way to make money in the market - and that's if your investment moves in the right direction, correct?

Well, not necessarily.

As I've written many, many times in this blog, option-selling strategies offer a huge cushion for directional error, where you can still make money even if the stock moves against you.

That's such a comforting position to be in, knowing that more often than not, we all get our timing wrong sometimes when making an investment.

But let's break it down why option-selling can offer a 3:1 advantage against option-buying strategies.

Option Buyers Lose...Big Time

In my experience, most investors who buy options contracts (calls or puts) will focus on cheap, short-term, out-of-the-money (OTM) options that have an extremely thin chance of being profitable.

Why?

Because they don't know any better. Or more aptly put - they just don't know enough about the true inner workings of options.

For instance, say a stock is at $100 per share.

A bullish investor wants to stake a claim but decides to buy call options instead of the stock itself (buying call options is a bullish strategy).

In addition to making that decision, the investor must decide which strike price and expiration month to choose. Lots of choices there, as there are literally hundreds of strike prices and multiple months to choose from. How does one decide which?

A novice investor would typically buy a very cheap, short-term option based on the hunch that the stock is going up. But by how much?

This investor "thinks" the stock will go up to $120 in the next 30 days. Lofty goal.

So he buys a $120 strike 30-day call option for $.50 per contract. The actual dollar cost is $50 since each option contract equates to 100 shares of stock ($.50 x 100).

Now what needs to happen in the next 30 days is for the stock to move above $120.50 in order for the investor to break even. That's a $20.50 per share move.

There's only one way for the investor to win - and that's for the stock to move above $120.50 within 30 days. No other move will help.

Even if the stock moves to $120, the investor won't make a dime. That's sad.

Think about it - if the stock moves to $120 - that's a healthy 20% move in one month. Anyone who owned the stock would participate in that price appreciation.

But the call option buyer would lose 100% of their investment ($50) because the stock needed to move above $120.50 to break even. They ran out of time.

What are the odds of the stock making a move like that in 30 days?

Using our trusty calculator with a typical 25% future volatility, the chance of the stock moving above $120.50 in the next 30 days is less than 1%. Said another way, it has a 99.5% chance of not moving above $120.50. Bad odds!

Option buyers like this have horrible chances of succeeding in the markets. And unfortunately, many of them make the same mistake - thinking they know where a stock will go by a certain date. Too hard!

Option Sellers Win...Big Time!

So if the option buyer has a 99.5% chance of losing, then who's winning?

The option seller!

There's only one way for this option buyer to win - and that's if the stock moves from $100 to above $120.50 within 30 days.

Who wins if the stock moves below $100 in the next 30 days? The option seller!

Who wins if the stock stays flat in the next 30 days? The option seller!

Who wins if the stock moves up from $100 to $120 in the next 30 days? The option seller!

That's three different directional ways in which the option seller can win versus only one way for the option buyer. 3:1 advantage.

The only way the option seller can lose is if the stock moves above $120.50 in the next 30 days. But remember, there's a 99.5% chance that won't happen.

Risk Versus Reward

For the call option buyer, the risk is limited to what the option costs - in this case $50 per contract.

The reward is unlimited to as far as the stock can go above $120.50 in 30 days.

For the call option seller, the maximum reward is the $50, while the maximum risk is unlimited. Although there's a 99.5% chance the call option seller will win, I'm not a big fan of "naked" call option selling.

This is why we stick to put-option selling - which has a finite risk.

If you've been reading many of my blog posts, you know how I love selling put options.

Not only does it offer an upfront cash infusion, but it also offers an opportunity to buy a stock of your choice at a price of your choice.

Using the $100 stock example again, let's say the investor was bearish and thought the stock would drop to $80 in the next 30 days.

That's also a 20% move in a very short period of time.

Our calculator gives the odds the same paltry chance of that happening - less than 1%.

We also know that put-option buyers have a horrible track record and an extremely high rate of failure, as noted in the Chicago Mercantile Exchange study below that I like to show:

Put option buyers lose their entire investment up to 95.2% of the time.

Who's winning then? The put option sellers (us!).

Once again, the put option buyer can only win in one scenario - the stock has to fall to $79.50 just to breakeven.

The put-option seller can win if the stock moves up, if the stock stays flat, and even if the stock drops from $100 down to $80.

Only if it moves below $80 will the put-option seller be forced to buy the stock at the $80 price tag.

But you know what? That's a good thing, because not only was $80 our target buy price, but it's a 20% discount to where it was trading 30 days prior.

My #1 rule when selling put options - only sell put options on stocks that you have a genuine interest in buying at the stated strike price ($80 in this case). This way, if you end up buying the stock, you'll be happy.

Bottom line here is that when selling options, you maintain a 3:1 directional advantage over the option buyer. This offers peace of mind and directional cushion for those of us who might be bad at picking direction and/or the timing. Sure, the reward might be capped compared to the option buyer's unlimited opportunity, but I'd rather have that 99.5% probability of profit on my side.

These are the kinds of trades and odds we put on our side in our Smart Option Seller newsletter.

Come have a look!

Until next time...

- Lee