In fact, many traders get seduced by the lucrative possibilities from options trading; unfortunately, though, nearly 95% of options traders are going to end up on the wrong side of the market. It’s a sad case for many first-timers, too, because the very idea of trading an option would seem straightforward or intuitive.
The sad thing is that when it comes to understanding options, it often is much more involved than just trying to guess whether a stock is going to go up or down. Most traders lack the understanding of some factors which, when not acquired, lead to huge losses. These include timing, strategies, and risk management.
This is not a matter of looking into the crystal ball to forecast futures; it’s much more a matter of statistical probability on your side and, therefore, a chance to mitigate that risk. Too many traders enter options trades with only one possible path to profit: the price goes their way. In contrast, options deliver a changing array of strategies from which, when used properly, can reverse the odds against you to in your favor, and yet so many traders still continue losing.
The secret to trading options and making a profit comes with an understanding of probability, time decay, and risk management. By flipping the odds into a sell position versus buying them, the trader will have two-and-a-half available ways to make money instead of just one. In this article, we will explain why 95 percent of options traders lose money, even when the setup is right and how one can turn the odds around by changing their approach to the market.
Trading Options Problems That Trader Face
The central problem with the majority of options traders is that they view options exactly the same as any other stock trading—they gamble on the direction of the market. Whether you feel that the market is going to rise (buying calls) or that it’s going to fall (buying puts), this binary approach confines you strictly to one way of making money. If you buy a call option, for instance, then the stock price has got to go up for you to make a profit.
However, the market does not always go in the direction you want. It could just as easily stay flat or even go down a little bit, which would mean your option expires worthless. That is why so many traders lose on winning setups: because of this directional thinking. Even if you are right about direction, time decay and volatility can suck most of those profits out before the market moves in your favor.
Why Buying Options is a Losing Game
A person who buys options, in many ways and from the very outset, is at a disadvantage. Here are three reasons for this:
- Limited Time: Every option has a life span. The closer the option gets to its expiration date, the faster it loses value through time decay, also known as “Theta.” Theta decay accelerates at this time, so the stock may move in your favor, but you could still lose money on it if it does not move fast enough.
- Price Premium: Prices for options are dictated by the odds that the stock will close above the strike price prior to expiration. For every option purchased, a premium is paid based on that probability. In addition to needing to move in the correct direction, it has to travel so far that it covers the cost of the option premium to make money.
- Volatility Risk: Another factor in determining changes in option prices is the influence of volatility (measured by Vega). While you are on the right side of a moving stock, dropping volatility leads to falling option prices, especially in the case of out-of-the-money options.
Selling Options: A Smart Strategy with Even Better Chances
Flip it around on them and try selling options instead of buying options. Selling options play to your advantage because, aside from time decay, volatility contraction, and the tendency for markets to move sideways or stick within a range, all the effects that work against the buyers will be working for you.
The Three Ways You Can Profit When Selling Options:
- The Market Moves in Your Favor: Both sellers and buyers are capable of earning a profit from a rising price. A put option, for instance, is sold; it means you want the stock price to stay above the actual strike price. If the stock continues to be bullish, then you get to keep the premium you received from selling the option.
- The Market Goes Flat: One of the best reasons for selling options is that you can make money from the trade even if the market doesn’t move, since sellers get to keep all the premium as long as the stock isn’t drastically below (for puts) or above (for calls) the strike price.
- The Market Moves Slightly Against You: Even if it moves against your position, you are making money by not exceeding the premium of the option. Let me use a concrete example: I sold a call. Now the stock may have gone up by a little bit, but you can still win because the buyer would have to cover that premium cost they paid you.
Now, selling options gives you two-and-a-half ways to make money, while when you buy options, you have only one way. This greatly improves your win rate, especially when combined with a sound risk management plan.
Risk Management in Selling Options
Selling options is considered a high-probability game, but at the same time, it means increased potential risk. You can lose a lot of money in case the market moves adversely against your position. Therefore, risk management is necessary when selling options.
Limit your downside by always using vertical spreads. A vertical spread is when you sell one option and buy another with the same expiration but a different strike price. This limits your potential loss while allowing you to collect a premium. By defining your risk from the start, you prevent catastrophic losses that could wipe out several winning trades.
Why it Works for Sellers
The biggest advantage of selling options is Theta Decay. Time decay favors the option seller because with each passing day, the buyer’s option reduces its value. The closer it is to expiry, the more accelerated the speed of the decay becomes. Selling options puts money into your pocket as you profit from that inevitable decay, even when the markets go against you.
This is especially beneficial when you sell options with only a few weeks to expiration. As time to expiration wears closer, the option price slides very rapidly, meaning one can now profit from a sideways or even a slightly adverse market movement.
Conclusion
That’s why most option traders lose their hard-earned cash, as they tend to focus on the market direction and don’t understand the intricacies of a value calculation of the options, time decay, and volatility. You can turn the tables and make money from lots of different angles by flipping from buying options to selling.
Don’t forget that it’s about finding the right kind of market and using the right kind of strategy that capitalizes on the very natural behaviors of the market itself. Combine this with strict risk management, like vertical spreads, and you will set yourself up to profit from the very factors that make most losers. That is, if you are one of the 95% who lose money on winning setups, it is time to rethink your approach to options trading.
