Every March since I was a kid, I enthusiastically filled out a NCAA Tournament bracket. Way before the Internet, I would submit my picks to the local newspaper with the hope of getting my picture in the paper. I was eight.
It was easy…I picked a few of my favorite teams from my most-beloved conference at the time and allowed the chips to fall where they may. There was no process behind my selections. Other than the obvious mismatches, I simply guessed. While this simplistic strategy occasionally works for gamblers (and eight year-olds) it’s not the tactical approach most savvy bracketeers would employ.
Serious bracketeers gather as many statistics as they can to make the most informed decision possible. Factoids such as the 12th seed has beaten the 5th seed 24 out of the last 27 years or two teams seeded 10 or lower have gone to the Sweet Sixteen 14 out of the last 16 years can only increase the probability of accurately predicting a winner.
Unfortunately (or fortunately, for those of us in know), most approach their picks with a gambler’s mentality…randomly placing a bet and hoping for the best.
And the ignorance of the gambler carries over into the investment arena, particularly in the world of options.
In the spirit of March Madness I hope to teach you, the self-directed investor, how to approach the market with a statistical advantage using options. Options make intuitive sense if they can be viewed in an easily understood framework, such as basketball.
There is no denying that options can befuddle even the most sophisticated investor.
Professionals and retail investors alike struggle to understand the core fundamentals of options and it shows in the ongoing ignorance of how most investors choose to use them.
Take for instance the most basic and frequently observed characteristic of an option – delta. Delta is the probability of an option finishing in-the-money. In basketball terms, it’s the probability that one of the teams will win.
For example, let’s take my beloved Oregon Ducks.
On the surface the 12th-seeded Ducks look like underdogs versus the 5th-seeded Oklahoma State Cowboys. However, the professional odds makers have a different prediction…they view the game as a toss-up, a coin flip. Before the game begins Thursday, each team has an equal chance of winning or, as I like to say, success.
With options, 50% is a typical delta for an at-the-money option (i.e., the underlying asset’s price is equal to the option’s strike price) with a relatively short term to options expiration… let’s say one expiration cycle, or roughly one month.
In basketball terms, the tip-off hasn’t occurred. The Ducks and Cowboys are tied. Each team is neither ahead nor behind, just like the option isn’t in or out-of-the-money.
Now suppose the Ducks are heavily favored. They might have a delta of, say, 80%. And since the game has yet to begin they would be considered in-the-money. Vice versa, if the Ducks were the underdogs they would have a delta less than 50%, say 20%. An option with a delta of 20% would have a very difficult time closing in-the-money or above 50% by the time it reached expiration day.
So, if we can predict a winner with 80% accuracy, why do we insist on guessing, thereby decreasing our odds to a lowly coin-flip? Again, gamblers and investors insist on taking this approach even though we have resources that enable us to increase our odds significantly.
If you are interested in how I make trades with an 80% chance of success don’t miss Sunday’s edition of The Strike Price (sign-up here).
I will be discussing, in great length, my favorite way to trade options. It's an extremely simple strategy to learn and arguably the most powerful strategy in the professional options traders' tool belt.