Finding the edge in options

For us to have an edge in option trading, some other group of traders or investors must be systematically making a mistake (making the same mistake over and over again). So who really trades options?

  • Market makers – professional traders that use mathematical models to calculate profitable buy and sell prices for multiple options on multiple companies
  • Informed investors – investors who have conducted enough research to gain an information advantage over the competition, or perhaps company insiders, who want to gain maximum directional exposure up until option expiry
  • Underlying asset owners – investors in the underlying asset might use options to reduce or increase exposure depending on transaction costs, tax implications, stock borrow availability, funding costs, or cash utilization reasons
  • Uninformed option traders – traders who trade somewhat randomly

Let’s start at the bottom of the food chain.

Uninformed option traders, whose behavior mimics flipping a coin, will on average break-even before trading fees and the cost of crossing spreads. The mistake they make is placing trades and they lose money to commissions and bid-ask spreads. Brokers and market-makers profit from uninformed option traders.

Underlying asset owners could be informed investors looking for a cheaper way to trade or just uninformed traders. They are happy to pay bid-ask spreads if its cheaper than some other fee that they’re facing.

Informed investors have price sensitive information that most other market participants haven’t found yet. They make money off market makers who provide liquidity and make prices without taking into account this extra information.

Market makers are usually winners on average. They use mathematical models to calculate what they think is the correct price. Their weakness is that the models are designed to win on average, but not necessarily profit on every individual stock. Their vulnerability is stock-specific events and abnormal stock-specific volatility.

Without a professional setup and large support team its difficult to compete in the market making game. The best source of edge is therefore to become an informed investor in some sense and make money off market makers.


But if you’re an informed investor, why trade options instead of just buying or selling the underlying asset?


Buying options fixes the downside of trading at the expense of introducing a time constraint to the trade (if you hold an option forever it eventually expires). This can be invaluable before big announcements that can move stocks +/- 20% overnight.

Selling options provides you with a fixed return (the option premium) but you give up the ability to make bigger profits in the event of excessive volatility. This is valuable if you want to make a relatively smaller amount money even if a stock doesn’t move at all.

 

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