Why You Should Almost Never Buy Options

Options are low risk, highly leveraged instruments that can 2x, 3x, or 10x your capital in days or weeks.

“Can” is the operative word here. While the above is true, what’s possible is not always probable.

Inexperienced traders often get seduced by the promise of insane profits, perhaps after reading stories from degens on WallStreetBets and other forums, not realizing how difficult it is to be consistently profitable with low probability trades.

In this article we’re going to explore why buying options is usually a losing strategy, how to improve your chances when buying them, and far better alternatives to consider. But first we need to understand how options are priced.

Basics: Buying an option means purchasing a contract that gives you the option to buy or sell 100 shares of a stock at a certain “strike price”. A “call option” for buying, and a “put option” for selling. You pay a premium for that contract, and can pay the agreed upon price of the 100 shares on or before expiration if you wish to own the stock.

e.g. You pay $45 to buy a June $14 call option for Ford (F). In June, the price of Ford is $20. Your option is worth $600 ((20-14) * 100 shares). You could sell it for a profit of $555, or you could buy 100 shares of Ford that are worth $2,000 for only $1,400, which becomes your cost basis. If you do nothing, your broker will automatically exercise the option on expiration and you’ll buy the shares. If you don’t have the funds, you’ll wake up Monday morning to a margin call. NBD, you can just sell the stock you bought and take the $600 profit.

How Options are Priced

Before we can talk profitable strategies, we need to understand how our trading instrument works at a high level. This is important to know.

The price of the option is negotiated on your trading platform between you and the seller and is essentially made up of three parts:

Option Price = Intrinsic Value + Implied Volatility + Days To Expiration

This isn’t a mathematical formula. It’s a high level, actionable understanding of option pricing. Here are usable definitions of each component.

Intrinsic Value – the real inherent value of the option if exercised today: stock price – strike price
Extrinsic Value – the premium you’re paying for the option, which is calculated base on:
- Implied Volatility (IV) – the range of the expected stock price movement in the future
- Days To Expiration (DTE) – the time remaining until the contract expires

From this, we can learn a few things about the options market:

An option will never be priced below its Intrinsic Value; unless someone fat-fingers the price when entering a trade.
Extrinsic Value always goes to zero, as its value is based on the time remaining.
Any of the 3 variables can change the price of the option in sometimes unexpected ways, such as:
- The stock price goes up, yet the option price goes down because IV drops
- The stock price stays flat, but the option price goes up because IV increases
- And most common, the stock price stays flat, the option price drops because time steadily runs out

If you want to trade options successfully, you must understand how to balance all three of these variables and use them in your favor. In most instances when buying options, all three work against you.

Now that we have a pricing foundation, let’s learn about our competitors – our trading partners.

How Option Market Makers Make Money

This is who you’re trading against. You should know how they plan to take your money.

When a Market Maker (MM) sells you an option contract, he wants both Intrinsic Value and Extrinsic Value to go to 0 as soon as possible. According to the Chicago Board of Exchange (CBOE), 30-35% of options expire worthless (complete loss), around 10% of options turn into stock (because they’re profitable), and 55-60% are closed before expiration (a mix of taking profit and cutting losses). It would be a fair, educated extrapolation to say only 1 in 3-4 bought options end up at least marginally profitable. At best, and 1 in 10 at worst.

Let’s look at how the MM thinks about the three elements of option pricing that I’ve highlighted. There are many more factors he considers, but I’ve isolated the most relevant for this discussion:

1. Days To Expiration (DTE), aka Time Decay or Theta Decay – time moves linearly, but price drops faster and faster the closer it gets to expiration. Theta, the rate of value decay due to time, starts picking up speed around 60-45dte and moves rapidly in the last 2-3 weeks. Buying options with less than 60 days means time is working against you.

2. Implied Volatility – IV rises and decreases based on corporate or world news and events. It increases before every anticipated event like an earnings call and drops immediately after (called IV Crush). Startup pharmaceutical companies often have high IV because the FDA could make an announcement at any time approving or rejecting their next phase and dramatically moving the stock price. Politicians, natural disasters, epidemics, war, releasing a new product, or buying another company can all cause IV to move.

Market participants typically measure IV relative to its 12-month range. This is called IV Rank or IV Percentile. Unlike most other measurements in the stock market, IV Rank always reverts to the mean. And since rising IV increases the stock price, you want to buy when IV is relatively low and sell when it’s relatively high. Guess when it’s highest. Right before an event or announcement like an earnings call. That’s the absolute worst time to buy options.

3. Intrinsic Value – The ideal time to sell options is when the stock price is going nowhere. You paid a premium hoping the stock price will move towards and beyond your strike price. The MM sold it to you hoping the stock won’t do that. However, MMs have deep pockets and are motivated to ensure the option goes to zero. They can and will try to move the stock price below your strike price to erase your intrinsic value. They do it every month (see the info box below).

Is the stock market manipulated? Yes. Is it a big deal? No. Jim Cramer famously admitted on the air to manipulating the market when he worked at a hedge fund. He shared stories of using $5-20M in cash to move the market while calling up reporters and suggesting certain information that may or may not have been true, but definitely was in line with his position, in order to move the market where he wanted it. In fact, he encouraged other hedge funds to do it as well.

Yes, big players can and do use their capital to move the market where they want it, especially around Options Expiration (Opex). And we can definitely have a discussion about banning borderline illegal activity like naked shorts, and punishing failures to deliver (FTD), or the SEC failing to investigate our prosecute actual crime.

The stock market is a jungle. Deal with it. You can get mad or you can become wary, savvy, and practice risk management to protect your capital. Most people lose money in the stock market because of their poor choices. I’ve done it. Every trader and investor has done it. The instances of actual theft or fraud are fortunately quite rare.

How To Buy Options Like A Pro (if you must)

Though I can’t recommend buying options at all, I do sometimes. In this section, we’ll discuss how to maximize the probability of success when you do. In the following sections we’ll move on to alternatives where success is much more probable.

We can use what we learned about option pricing and market makers above to avoid the behaviors that are the most destructive to our porfolio.

Let’s start with the Never Dos:

Never go all in on any trade. For every person on reddit who claims they went all in and made 200x on their money, there are 1000 others that did the same with their kid’s college fund or house mortgage loan which led to them getting divorced, committing suicide, or otherwise destroying their lives. Don’t do it. Risk 1-5% of your portfolio per trade; do less the larger your account.
Never buy options before an expected event. Never before earnings. Never before an FDA announcement. IV was high right before because of the anticipation and it will drop once the anticipation is gone. You might get lucky once, but most times, the IV Crush will kill your options. You can’t run a business based on luck.
Never buy an option with less than .30 delta; .40 or higher is better. One rough way to look at delta is “the percentage chance the stock will hit option expiration at that price or better.” So, don’t ever make a trade with a less than 30% chance of making money.

Next, let’s consider more subjective principles:

Buyer beware

Be wary after unanticipated news announcements. e.g., A says they’re buying B. That often results in a one-day pop because “B is going to bring so much value to the company,” then for the next month the stock drags as people realize buying B is a capital expense and a reduction of profit. Yet other times the stock might take off after news.
Be wary about options expiration. You can look on the options chain and see how the MM is positioned and where they are likely to move the market. If they have sold many $100 strike calls expiring in 2-3 days, and the stock price is slightly above $100, it’s very likely it will end the week at $100 or lower so those options expire worthless.

Short term trades

Only buy short term options when expecting a big move very soon due to a chart pattern with confirmation, such as a falling wedge with relative strength. If the move doesn’t happen, or goes in the opposite direction, cut your losses.
If very short term (1-2 weeks) it’s best to buy In the Money (ITM) options where the stock price is beyond the strike (above for calls, below for puts). That will mean delta is above .50, and it has intrinsic value. Theta will be rapidly draining your extrinsic value, and you have a much better chance of not losing all of your money.
If you do buy Out of the Money (OTM) options, buy between .30-.50 delta, and “price for zero”. Meaning you’ve selected a trade where you’re comfortable if the option goes to $0. Perhaps you see a promising chart pattern with confirmed indicators, and you spend $200 on a 14d, .40 delta option. If it pops, you’d sell it right away, possibly making 2-3x. But if the stock doesn’t go anywhere, it’s not a big loss. Or you might sell it early to recover any remaining value.
Buy options on stocks that retain high IV over the course of the options cycle, like TSLA. The options are cheaper to trade than the stock, are leveraged, and they retain their extrinsic value much more so than other stocks.

Long term trades

Buying long term options (6 mo or longer) is a good, cheaper alternative to holding stock. The theta drain will be minimal, especially if the stock is moving in your favor. For example, consider two possible trades for AAPL as price moves from $300 to $320:
1. Buy 100 shares of AAPL at $300 for $30k. If the stock moves up to $320, I now have $32k in stock. That’s a $2k gain on $30k for a 6.67% return on capital (ROC).
2. Buy a 180d $300 strike call for $2400. If the stock moves up to $320, the intrinsic value alone would be $2000 and the whole contract would be around $3800, which is estimated by looking at the current option chain. That’s a $1400 gain on $2400, for a 58.3% ROC. But you need to decide what to do with the option before the 60-45 day mark.

Return On Capital (ROC) is an extremely important measurement for trading. How much is it worth for you to put your capital at risk, and for how long will you wait for that return? 7.5%/year is the market benchmark. If you want to beat the market significantly, aim for an ROC of 20% over 1-2 months on each trade as a fairly conservative rule of thumb. When I sell strangles, I’m looking to start with 20-40% ROC over 2-6 weeks with a high probability of profit and I’ll take somewhere between half to all of that. When I place long, directional trades like those discussed on this page, I’m looking for much higher profit since the probability is lower. The example above buying the long term AAPL option for 58.3% is good if it hits within 3 months, but bad if it takes 6 months or longer.

More Profitable Alternatives To Buying Options

A successful trading career comes from longevity. That means countless small wins from good habits, discipline, risk management, and psychological management. Buying options has many factors working against you. It’s often more profitable to trade with probability on your side. All of these alternatives have better probabilities of success than buying options.

Buy stock

Stock is not sexy like being an “elite options trader”, understanding the arcane nature of the instrument that only gifted individuals can make sense of. But are you in business to look sexy or to make money?

New traders should ignore options and just focus on trading stock. Use stops. Don’t day trade. Learn to read charts. Learn how the market works. Are you in this for the long haul? Build up your account as you build up your habits and skills.

Stocks are better because they move slower, and are safer to learn on. There’s no theta decay. There’s no wild IV movements. If you were wrong and didn’t get out, many stocks will bounce back or even move higher eventually.

You can also use leverage, which is the number one reason people buy options. Cash accounts provide no leverage, but margin accounts provide 2-3x leverage. When you get your account up to ~$130k, and are familiar with selling options, you can get Portfolio Margin from most brokers. They’ll give you 6.67x leverage on stock. Being able to hold on to 100 shares of AAPL worth $30k for only $4500 with no theta decay and the ability to hold for years if need be, is a very good alternative to holding on to a 6 month call for $2400 that is slowly going to zero.

Sell options

It’s much, much easier to control your probabilities and be profitable when selling options. But they are a bit more complicated. They are no more dangerous than buying options when you know what you’re doing. That is, you can blow your account buying or selling options, so both require an education.

To summarize the difference between buying and selling options: the buyer receives a false promise of high leverage with low probability, while the seller receives the high probability of a fixed profit. Probability always wins.

Successful option sellers choose to sell contracts where the mechanics of the market work in their favor. They look to sell options where:

Theta decay is starting to accelerate <= 45dte
Low .16-.20 delta expresses a less than 20% chance of loss
IV rank is high, where it’s likely to drop within the expiration time, taking Extrinsic Value with it
The chart suggests the stock is going no where. e.g. It has already finished a move and is consolidating
They can mirror larger market makers who are motivated to manipulate the stock price

The house always wins. Buying options, you’re betting against the house, and the house always wins. But financial markets are fundamentally different from casinos and sports betting. Here, you can become the house. If you don’t like how a potential trade looks, you can take the other side.

Learning how to sell options does take time and practice, but it’s very worth doing. There are many more choices available to an options seller. You could just sell a naked put, which is a bullish position and one of the highest probable trades. Or you could buy or sell verticals, ratios, strangles, and more complex trades which might give you more advantages that you wouldn’t have had by just buying an option or stock shares.

leveraged vertical Spreads

This is one of my favorite trades because it’s simple, provides high leverage, has a fixed max loss, provides a GREAT return on capital if you hit the direction right, addresses theta decay, requires only level 3 options (spreads), and can dramatically reduce the cost so you can more effectively “price for zero” on expensive stocks. There are so many good benefits.

In this scenario, you want the option to expire relatively soon, say 14-45dte. Too short and there’s not enough value, too long and your capital is doing nothing.

To place the trade, you buy an Out of the Money (OTM) vertical spread; not too far out. Maybe you buy the .40 delta and sell the .35 delta. Buying At the Money (ATM) or ITM Vertical Spreads can also be good trades with even better probability, but you won’t get any leverage on them. This article is about higher leverage trades with better probability than a regular option.

Let’s look at an example comparing buying a regular call versus a leveraged vertical spread. TSLA is currently at $413 and we’re looking at 31dte.

Buy a $432.50 call, .40 delta. The cost is $1430. The stock needs to go to $447.11 in 31 days just to break even. Max profit is “infinite”.
Buy a $430 call and sell a $432.50 call. It’s around the same delta and but only costs $85. The break even is $430. It has a fixed max profit of $165, or 2x.

Now, which is a better play? The smaller cost of $85 per vertical means smaller traders can get involved without coughing up $1430. The break-even point is much lower, meaning the probability of profit is far, far better. The call has theta drain working against us no matter where the stock price is, whereas the vertical theta drain works in our favor, once the price is over $430. And we are exchanging the fantastical, fake idea of infinite profit for a fixed max profit that is realistic and achievable.

Let’s quantify this with return on capital. I could buy 17 of the verticals for $1445, which approximately matches the call at $1430. If TSLA moves to $430 (+4%) by expiration, the call loses $1430, the vertical breaks even.

If TSLA moves to $447 (+8%), the call breaks even, while the vertical gains $2805, for 194% ROC in 30 days. Very, very good.

Tesla does like to move, and if we perfectly capture a 21% move just right and it goes to $500, the call gains $5317 for an ROC of 372%, while the vertical still gains only $2805 / 194% ROC.

The “potential” of hitting the 300+% ROC is seductive, but that’s much, much harder to hit. As we’ll see below, the 8% move is measured at a 20% probability while the 21% move at only 8% probability. The vertical has a much better chance at success, while the regular call is more likely to lose money.

The leveraged vertical spread is a way to get leverage with a higher probability of success over a regular option due to a lower cost basis, and theta decay working in your favor. You can do the same thing on the put side as well.

Zebras

This tool is slightly more complex and difficult to manage, but it’s another great alternative buying options because they have no theta decay, fixed max loss, and allow you to control more shares for less capital than buying stock.

Zebra stands for Zero Extrinsic Back RAtio (Spread). This is a ratio spread, meaning there’s a different number of bought and sold options; whereas a vertical spread has an equal number (buy one call, sell one call).

It acts just like a regular option with a defined risk, fixed max loss, unlimited upside, and an expiration. However it has no theta decay.

To place the trade, you need to turn on the Extrinsic Value calculation on your option chain, or calculate it yourself with:

Extrinsic Value = Option Price – Intrinsic Value

We saw before that Intrinsic Value = stock price – strike price, but it doesn’t go negative.

Next, sell the near ATM option with the highest Extrinsic Value, then buy two ITM options where their combined Extrinsic is nearly the same as the sold option. The two you buy can be from the same or different strikes. All use the same expiration date.

Let’s look at an example. First I’m not considering the option price, only the Extrinsic Value:

1) Finding the highest EV on TSLA 31dte, I sell a 410 call with $21.30 EV
2) Then two calls that combined are near that same EV. I buy a 380 call, $9.90 EV, and a 385 call, $11.30 EV which is $21.20 EV.

Now that I’ve constructed the ratio, I can look at the price. The total cost is $5750. It’s worth about 93 shares or $38k of stock (equivalent delta).

Now let’s compare the Zebra to all of the other trades.

Comparing Long Trades

Let’s compare buying stock, plain calls, leveraged verticals, and a zebra and see which are better to use if we want to get directionally long. We need to increase the numbers of some trades so they all have the around the same stock equivalent (delta) so we can compare apples to apples. The stock price currently sits at $413 and I’m comparing 31dte options.

Position	Share Equiv	Cost	Break Even	Profit from +10%	ROC	Profit from +20%	ROC
Stock (cash)	100	$41,300	$413.00	$4,130	10%	$8,260	20%
Stock (margin)	100	$16,391	$413.00	$4,130	25%	$8,260	50%
3 Calls $432.5	112	$4,290	$447.11	$2,184	51%	$14,670	342%
60 Leveraged Verticals $+430 / -432.50 calls	99	$5,100	$430.00	$9,900	194%	$9,900	194%
Zebra	93	$5,750	$413.00	$4,171	72%	$8,316	145%

The naive trader might look at the calls and say I want the 342% ROC. However, according to the option chain, the probability of the stock moving there is about 8.5%. The probability of moving +10% to $454 is 20%, and to $430 is 33.7%. The call is actually the worst choice because if price doesn’t move up to at least $447, you will lose money.

The Zebra has the same break even as the stock, matching the best probability, but it has a significantly lower capital requirement, much greater ROC, and a fixed max loss whereas the stock can go to 0.

However, the Leveraged Verticals have the best combination of ROC and probability. So, it’s a tossup as to which I would choose. It depends on the chart and where I expect the stock to move, when, and the account size. If I have a small account, I’d go with a fewer number of leveraged verticals because $5750 is too much for one trade until I have about $150k.

Or I would consider selling options, which I’ve excluded from the table above. The intricacies are too much for this article, but that would look like selling a .16 delta naked put to collect premium, about $800. The naked put means a break-even of $369.97 and a probability of profit around 70%. Or selling a .30 delta put spread for slightly worse numbers. In both cases, the stock could go nowhere or drop slightly and I’d still profit.

To be profitable with directional trades, we have to get the direction right and capture some of the move. To be profitable selling options, we don’t have to get the direction right, we have to get the mechanics right. In either case, the smaller gains are much more probable, and more profitable in the long term.

When entering a position, I frequently compare different order configurations to maximize ROC and probability for the timeframe in which I want to place the trade and the move I’m looking for. Having many tools in your toolbox allows you this flexibility.

Trade Smarter, Not Harder

Bought options are useful for hedges and leveraged instruments for experienced traders. They’re just tools, neither good nor bad. And the more you know about those tools the better you can use them to make money.

Know that the odds are stacked against you when buying options. Time decay is relentless. Volatility crushes your extrinsic value. Market Makers have the capital to wipe out your intrinsic value. Don’t let the naive approach to options destroy your account.

Instead learn how to use the tools and strategies to protect your capital and stack the odds in your favor.

At TradeHUD we’re building tools to help you anticipate where the market is moving, and how to best position yourself beforehand. Our dashboards provide insight into the underlying movements of the market, show where institutional money is moving, and identify potential trade ideas.

The path to consistent profits isn’t chasing 10x lottery tickets. It’s building edge through higher probability trades, education, discipline, risk management, and tools that provide institutional-grade insight without the institutional price tag.

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