Taking a much-needed quasi-vacation in Las Vegas, I couldn’t help but offer a couple words on strategy, risk, and probability. Walking through the casino last night, I couldn’t help but observe the throngs of tourists … some sober, but many partaking in the free alcoholic beverages offered by the house.
What a bighearted gesture by the casino, right? Anyone (over the age of 21) can sit down, bet a couple bucks, and get what would normally be a $12.00 drink for free. As many of you know, there is no such thing as a free lunch or in this case, a free drink.
What the casino is hoping is that you partake in as many of those as you can handle (without passing out of course) because as you imbibe those libations, your ability to manage your money (control your risk) is being depleted. Even though you may have started with a rational plan, you are now out of control and the result is usually not positive.
What’s worse is that in EVERY game on the casino floor, the odds and probability are generally NOT in your favor. For example, the version of roulette that has a zero and double zero gives the house an advantage of 5.26%. Basically, they take about five cents of every dollar played as their “edge.” This actually decreases a roulette player’s probability of winning to less than 50%.
Unfortunately – whether at the gaming tables or in the markets – you can lower your own probability all on your own, without even having a drink. Frustration, lack of experience, minimal familiarity with a strategy, and emotional strains can all cause a reduction in the probability of success. Improper strategy selection and poor planning are typically the causes of a reduction in the probability of success.
In options trading, however, you can actually increase your probability of success through the use of some spreads. (Remember that generally, when you improve your probability, you decrease potential profit).
For most new options traders, the long call and the long put are the first strategies they employ. While both these strategies offer benefits – such as reduced costs and leverage – they both put a trader at a statistical disadvantage.
Let me clarify this; just because you have a statistical disadvantage, you are not doomed to lose money. Plenty of traders are able to invest successfully in long calls and puts. Both calls and puts typically have a higher profit potential than a vertical spread, for example.
The reason I say they have a statistical disadvantage (compared to stock or some vertical spreads) is because when you purchase an option outright, you are paying for the “optionality,” or time value, of that option. That theta (time decay) continually works against your profitability as well as your statistical probability of success.
Deep in-the-money options have less “time value,” proportionally speaking, which means you will pay less theta. At-the-money options generally have the most dollar amount of time value, which means have the highest-dollar theta. Finally, out-of-the-money (OOTM) options, though cheaper with generally lower thetas, will have the highest percentage of their value being paid as theta (remember OOTM options have NO intrinsic value).
Risk
With any trade – whether it is an individual option or spread –