Options trading - the system to lose
Options have a different pricing behavior than stocks or commodities that are traded in the future markets. It is impossible that the price of a physical commodity like copper or wheat falls to zero. Stocks can vanish after a substantial loss in value reflecting the deteriorating business of the underlying company. Markets of both have a long lifetime, which is infinite for commodities -we will still need to eat for foreseeable times- and hopefully long for a company.
On the contrary, options have a duration, which is definitive and short. At the expiration date options out of the money become worthless and before that all options are gravitating lower towards their intrinsic value in expectation of that date. That and the leverage of options gives their prices the potential to soar to a multiple or to fall almost to zero in a matter of days.
Trading options is like buying lottery tickets
The options market is a zero sum game. Option contracts are sold by their creators, traded during their lifetime and exercised by their final holders. What one gains must be lost by someone else. Prices go up and down, the arithmetic balance of gains and losses is zero and the media tell us mostly about winners and only sometimes about losers. All this leads many to think of a game with chances of at least 50:50 for their personal success vs. failure.
But many options expire worthless, all others have their premium stripped and only few are gaining hugely. This distribution leads directly to the idea that it is very likely that the average trader is a loser at the end of the game. Trading options is like buying tickets in a lottery, few people win big prizes and get onto TV, some win smaller prizes and most people get nothing.
The winner takes it all
Let's assume 10000 people are playing this zero sum game in an option market set up only for them. No one can outsmart the other, all have the same information and skills, so effectively everything is driven by random. Adding all their losses and gains together will always show a balance of zero. But, the longer this game is played, the more the capital is concentrated on very few of the 10000 people. Who the lucky ones are that had more big gains than all others may change, but the concentration increases all the time, statistically.
In other words, the probability that a single individual is a loser steadily moves towards 100 percent. This effect works the stronger, the more speculative one operates. So, buying options out of the money makes you very quickly poor, but trading them or buying options in the money and even the opposite, creating and selling them, is also ruled by this effect.
The right trade size
Overtrading is also common in the futures markets and even in the stock market. But in the options markets it is the rule and not the exception. The small option prices probably make people think that they are their bet size. Wrong! In the stock market it is clear that the stock price times the share number is the trade size, at least for long trades. In the futures market it should be clear to everyone, but it isn't, that something in the magnitude of the contract price is the sum at risk and not the margin deposit.
Interestingly the same holds true for options, not the option's price but the strike price or the price of the underlying contract should be eyed. Still, if you don't have an advantage as in the example of the random market, you will end up losing. Sound money management can only withstand the effect of concentration in conjunction with an edge. Optimally sized bets in the option markets have to be much smaller for realistic advantages than most people think. Imagine that you are buying or selling something with the price of the underlying contract or stock. That in turn suggests to trade these directly without using option leverage.
Beyond the financial markets
In fact, in many other areas of life the simple arithmetic of relative increases or decreases favors failure rather than success, whereas the success gets the attention. The option market is a good example for this fallacy. Whenever there is a jackpot to win, you can be sure that chances are good, that you walk home from the casino as a loser. If you start playing with a given capital, it is likely that you end up with nothing. The mere effect of concentration will cause this and it is not necessary that the game or system itself is unfair, which it nonetheless mostly is.
But not only the world of roulette, lotteries and trading is affected - the effect of concentration is universal. Life itself is sort of a game, some become rich during playing it. Earning interest and leaving the inheritance to the heirs, would make in a few generations most people poor as a church mouse and very few super rich if there were no taxes.
Our daily struggle to make a living presents itself quite similar. Most people get only a fraction of the huge salaries few others earn, which extends from individual employees to whole countries. Growth processes happen on logarithmic scales. If a manager gets a salary increase, the difference could be alternatively used to pay ten new employees. In the third world a whole village could probably be employed with the money. Will the manager work equivalently harder after the salary increase?
Evolution is another example. Small advantages of a species over other ones in the same niche, are considered to cause the others to die out after several generations. This is an increase to the maximal possible concentration of the winner, the best adapted species, as biologists would put it.
Mixing up maximum, mean and median
Whenever a system is closed and no resources can flow in from the outside, and the law of logarithmic growth rules, there will be an uneven distribution of the outcome, some sort of jackpot, a cake with few big and many small pieces. Be careful, don't be too speculative, or you won't get even one of the small pieces. Moreover, it is unwise to rely on such a system as a substantial investment.
It doesn't help you that you theoretically could win the big prize, when you realistically get next to nothing. We need an absolute amount of energy and resources to live and not a theoretical chance for something so big that we can't make use of it fully. Look at what most people in that system get -the median- and keep in mind that not only the biggest piece of the cake, but also the arithmetic mean -the zero sum in the options market- may be an illusion.
The best system for trading options - don't do it
In theory the option markets, be it stock or future options, are a zero sum game, but reality is far from that. The modern hunter of our financial world is the market maker, and he will assure with all sorts of tricks that the zero is greatly negative. Characteristic of the options market is a very high spread, the difference between buy and sell price at a given time, which the market maker cashes in.
Really outstanding is the ability of the options market maker to raise the price of an option more than proportionally, when everyone wants to buy it, i.e. when the underlying stock gives a trade signal. You think you will work with a stop-loss? In the moment of an adverse price swing of the stock, when you want to sell your option, these legal criminals now exaggerate the option's price drop!
Perhaps traders should do the opposite, have an anticyclical system with regard to the underlying market to get a good price in the options market? First, the market maker still earns the spread and second, he will still let the price of the option slip away in the direction of the balance of all orders at a given market situation. So he still expands the visible spread virtually.
Depending on the exchange there are ridiculous rules like that traders are not allowed to enter smaller orders incrementally. No, they have to show at once what they want, so that the market maker can see that he has someone on the hook. Participants are not granted what every market maker demands for himself as a matter of course, namely to be able to hide the position he holds or has to trade.
Another common practice of option market makers is to delay or not execute at all trades at offered quotes. They like to trade only with the customer when it is advantageous for them. There have been even cases that someone gained hugely after, say, a stock takeover and the market maker then cried foul, alleged insider knowledge and tried to reverse the trade.
All in all these market maker tricks are the second reason to keep your money and mind away from this hunting ground of the sharks. Trading directly the underlying market will almost always put you in a better position. Whether that is sufficient or not is another question.
Below are some articles for those who are active in other markets and may want to reassess the idea to switch to stock trading: