Buying options – how to increase the probability of success
(Last Updated On: 11. January 2021)
In the most cases, options are bought by professional traders for hedging purposes. If you want to make money with options, you should rather sell them than buying them. The reason for this is, that option sellers have statistically a better chance to make money than option buyers. But how does it come? Well, first of all, professional traders usually don’t want to make money buying options. For them, buying options is just a hedging process and they know that they would usually lose money with it. But for them, losing “a bit” of money buying options but get hedged is a much better solution than a total loss. The other ones are private traders hoping to become rich over night buying options by assumption they would insanely increase in their value. But the most private traders have an absolute wrong approach, and that’s why they usually lose money buying options. In this article, I’d like to give you some general information how to increase the probability making profits by buying options. After that, you should get a better understanding whether buying options is a good idea or not.
To understand my explanations in this article, you need to be familiar at least with the basics of options trading. Especially, you need to know about the so-called “Greeks”, the four main key factors are used in options trading. If you never heard about these key factors, you should first delve into this topic, folks. As this article is about how to benefit from buying options, it would go far beyond the scope to explain the “Greeks” in detail. In general, if you never heard about the Greeks, you should first enroll in a basic course about options trading or at least read a book about the basics of options trading. There are tons of free information on the internet available about options trading.
If you would like to have it more structured, I recommend you to enroll in a paid course. In the past, such courses were really expensive, and you had to pay a couple of thousands of Dollars. But luckily, times are changing and nowadays you would get very good online courses about options trading, e.g. on Udemy*, for a real cheap money. And now, let’s dive into it, folks.
First factor – Delta
One of the mistakes option buyers are making is that they tend to buy options far out of the money. Why? Because the higher the Delta the more expensive the option. Therefore, a lot of people are buying options with a low Delta, following this principle: once the underlying would start to move in the direction of their position, it would increase the Delta and consequently, the value of the option which was originally very cheap (thanks to the low Delta). The idea of this principle is, of course, a good one. But their mistake is that they always hope the underlying would move like crazy in their direction and land in the money. The best situation you would have in this situation would be a crash, a black swan event. In this case, you would indeed make a pile of money.
But the problem is that in the long run, you would lose money with this strategy. The reason for this is that Delta is also giving a probability an option would land in the money. So when you are buying an option with a low Delta, you would also have a low probability that your bought option would land in the money. In other words, buying options at a low Delta will work out from time to time. But in total, the most trades will be losers.
Therefore, if you want to make money buying options, you will choose a high delta. Of course, you would need to pay much more money. But on the other hand, you would increase the chance your option would indeed land in the money!
But what is a high delta? Well, this is a subjective definition but for me, a high delta begins at the money. In other words it would usually be a delta of 0.5 and more.
Some traders even buying options in the money, especially option traders of stock options. Of course, doing this they would not only pay for the time value but also for the intrinsic value. But again, doing this, they would significantly increase the probability the option would rise in the value.
Second factor – Vega
As you might have read in my article about implied volatility, this metric influences the price of an option. With Vega, you can determine how would the price of an option change when implied volatility changes 1%. Option sellers are always looking for a high implied volatility. Option buyers should, on the other hand, look for low volatility in expectation of increase of implied volatility in the near future.
The thing is, you cannot predict exactly when the implied volatility would rise (except in case of earnings trading), especially in case you would like to buy options on futures. But with Vega, you can determine a favorable entry point. This is, of course, not a guarantee that the option’s value will indeed increase.
But again, in trading it’s all about probability, folks. And with a low Vega, you would increase the probability that the option would increase in its value and thus, the chance you would make money buying options.
Therefore, never buy an option when the implied volatility is high because this would also mean a high Vega. This mistake is often made by option buyers after a crash. You maybe know that a crash is just a temporary event and if you know how to determine whether a crash is going to its end or not, you would be able to make good money by selling options. But not by buying them! The reason for this is that after a crash or a strong correction Vega is high and even if the security would move into the direction of your bought option, the option would nevertheless lose its value because of a sinking implied volatility (=decreasing Vega).
The question is: when is Vega low and when should you buy options? Well, it’s again a subjective point of view but just to take a look at the Implied Volatility Rank (IVR): A good time to buy options is when the IVR is swaying around a level of 20 or even lower. Then you would know that there is also a low Vega.
Third factor – Theta
With Theta, you see how much an option loses it’s value each day (until the expiration). Loss of value is the best friend of every option seller but the natural enemy of every option buyer. The reason is clear, you would buy something which has a limited lifespan and every day you would lose a bit of money.
Knowing this, a lot of option buyers are making this mistake, nevertheless: they are buying options with a too short expiration. Why? For the same reason they would buy an option with a low Delta – by hoping to pay less and to get a lot. But this does not really work and it’s the same situation like with Delta. In some cases, it would work out. But in total, it would fail.
So which time period should you choose? Well, there is again no objective answer possible.
But whatever you do, you can use a rule of thumb which is: take at least the double amount of time of your usual expectation. In other words: when you expect that, let’s say, something important will happen in the next 40 days which could increase the value of your purchased option, then you should chose an expiration time of at least 80 days. All of this to get a kind of a range of tolerance and to increase the probability that your option will bring you money and not convert into a flop.
Should you sell or buy options?
Finally: Is buying options a good idea? In general, for the most traders buying options is a bad idea. Not because it’s bad in general but because most of the private traders have a wrong approach and a wrong attitude (which is to get rich over night).
But when you follow at least the three advises I’m giving you in this article, you would increase your chances to make money buying options. Of course, you would also need good trading skills to learn how to find entry points buy using indicators or reading chart patterns*. If you are not familiar with the technical analysis, I strongly recommend you to delve into this topic, folks. This would help you a lot to find better entry points for new trades.
Especially, to find the right entry point is crucial (by considering of the other factors) to earn money buying options. The reason for this is that buying options, you would need a strategy which must work out because of the more unfavorable conditions than in selling options. In other words, you need to be a much better trader by buying options than an option seller.
Do I buy options? Yes, I do indeed. But this happens just in 3% (or even less) of all cases. At least at this moment. Maybe there will be a time when I’ll start to buy more options. But maybe not, who knows.
Therefore, it’s all up to you and what you make of it. Just find out the way which works for you. And how to do this? Well, there is just one way to find it out – learn and test, learn and test, and then again, learn and test! Luckily, all brokers offer nowadays paper trading accounts so you can test a lot.
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