Buying options instead of buying equities can seem very attractive on the surface to novice traders because of the low cost of entry compared to buying shares of stock. But there is a hidden fallacy in thinking in this way. In this video, Seth Freudberg, Head Options Trader of SMB Capital’s options trading desk, breaks down the details of this fallacy and how to avoid falling into it.
View Video Transcriptadobe is trading for 572 dollars a share
so
if you wanted to buy a hundred shares
you’d have to pony up fifty seven
thousand two hundred dollars but what if
there was a way to control one hundred
shares of adobe
for only ninety six dollars i’m seth
freubert the head trader of smb capitals
options trading desk here in manhattan
and the traders on our desk here
have a full understanding of how options
work how to trade them
and more importantly how not to trade
them so while the idea of controlling
100
shares of adobe for 96 dollars may sound
like an
awesome idea in this video we’ll show
you the
fallacy in that concept and hopefully
save you a lot of money in the process
so stick around so that you can be a
smarter trader and not get suckered into
dopey concepts that have hidden flaws
[Music]
hi i’m seth freuberg and i’m the head
trader of smb capital’s options trading
desk
smb capital is a proprietary trading
firm located in midtown manhattan
and we provide capital for options and
equity traders from all over the world
trading both remotely
and in our offices here in new york city
now i’d like to suggest that you click
on our subscribe button right now
so that you don’t miss any of our free
trading videos that we produce
for traders and investors all over the
world they’re really
very valuable okay so this is going to
be a pretty blunt video today because
there are certain
frankly dopey concepts floating around
in the trading world and i feel an
obligation
now and then to debunk them because we
try to keep it real here at smb capital
and
it annoys me to honestly see people get
sucked into new and different ways to
lose your money
and i think that it’s important to be
educated as to how to stay away from
these
get rich quick schemes in the options
world because
short of just hitting the lottery in the
real world of trading you have to
actually
work to become competent and
consistently profitable
and you just can’t get around that you
see a lot of people are attracted to
options trading
because they don’t really have enough
money to buy 100 shares of a stock like
adobe which i understand completely
because everyone has to start trading
with whatever capital they have but they
have heard
options are really cheap and you can
somehow control
100 shares of a stock way cheaper with
options than you can
outright buying the shares so they want
to know more
about options now in order to explain
why there’s a huge
flaw in thinking this way i need to make
sure that you understand how
call options on stocks work for those of
you familiar with call options just hang
in there
this is going to be really quick and
then we’ll jump back into the lesson of
this video really fast
okay so what’s known as a call option on
a stock entitles the buyer
of that option to purchase 100 shares of
a stock
that at a certain price called the
strike price of that option
regardless of what price the stock’s
trading at the buyer of a call option
pays what’s called a
premium to the seller of the option
because the seller of the option is
taking the risk
that the stock will go way above the
strike price of his call option
in which case the buyer can exercise his
option and the seller could lose money
on the transaction
because he’ll have to sell the shares to
you for far less than the value they’re
showing
in his account but it’s important to
realize
that if the stock on the expiration date
if the call option
is not above the strike price of the
call then the seller of that call just
pockets the premium that he was given by
the buyer he walks away completely free
of any obligations because no one would
exercise the right to buy
a stock at a price higher than is
trading in the open market
and so in a nutshell that’s how call
options work
so you’ll very often hear individual
traders say gee i love trading options
because the most i can lose
is the cost of the option which i’ve
heard are really cheap
whereas with shares of stock i can lose
way more than that because i’m putting
so much more
money up and they say to themselves just
think about the leverage i’m employing
here
how smart i am because if i spend a
little bit of money on the option
and the stock goes above my call strike
price by expiration day then i could get
a return of
a thousand percent or more and that’s
theoretically true
for instance let’s say that we thought
adobe stock was going to go up
over 600 by mid-july for whatever reason
but suppose with the stock trading at
572
we don’t have a spare 57 200
to spend on 100 shares but we do have 96
well then we could spend 96 by buying
a 635 adobe call expiring on july 16th
and what that means is that on july 16th
if adobe has rallied to above 635 to say
646 that call would be worth a lot of
money because
we could buy those shares at 635 and
immediately turn around and sell them
for 646 in the market making eleven
dollars per share
as you can see from the calculation
because you’d be buying the shares for
6.35
the sprite strike price of your call but
you could sell them for 646
immediately and so you’d make 11 on each
share
times 100 shares because each options
contract
represents 100 shares of stock cashing
it in
for a total of eleven hundred dollars
and then if you deduct the original cost
of the option
you’ll see that the net profit on the
trade is one thousand and four dollars
which when compared
to the original ninety six dollars does
indeed produce a return of over
one thousand percent in a very short
period of time
less than a month before we get into why
there’s a
giant fallacy in this whole discussion
of buying cheap options to make huge
returns
i’d like to let you know that there
really are real and effective option
strategies
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getting back to our adobe example
you may be wondering hey this sounds
great i mean i put up 96 bucks
and i make over a thousand percent
return on that small investment in a
very short period of time
so what could be wrong with this i’m
living the dream right
but there’s a problem with that thinking
and the problem goes like this
you see when somebody says to you the
most i can lose is the cost of the
option
what they’re really saying to you is the
most i can lose is
100 of my investment because the cost of
the option
is your investment so somebody said to
you the most i can lose is 100 of my
investment
that wouldn’t sound so great but that in
fact is exactly
what you’re being told when someone says
the most you can lose is the cost of the
option
as though it’s not a big deal to lose
100
of what you put into the trade but the
fact is that most people who buy
cheap options are exposing themselves to
losing 100 of their investment and to
make matters
worse the probability of this happening
losing 100 of his investment is
extremely high
over 90 in most cases when you’re
referring to
cheap options so let’s take a look back
at this
adobe example that we were just
discussing but this time
we’re going to focus on something else
not the cheap
price of the option but rather the
crucial issue of the probability
of that cheap 96 dollar option having
any value at all on the day that it
expires
which is july 16th in this case so if
you look at the column called
delta on this options chain you’ll see
that the option has what is known as a
delta of 6.09
now an options delta is arrived at
through a mathematical formula
which projects how much the option’s
value will change
with a one-point move in the stock from
which it’s derived
but a delta has also been shown to
approximate
the probability that an option will have
a value on the day it expires
in other words the probability that
adobe will get past
that call 635 strike price by the time
these options expire
and so what this means is that as a rule
of thumb there is a
6.04 likelihood that the option will
have
any value at all on the day it expires
and so
putting it more realistically it has a
94
chance of expiring completely and
utterly
worthless on the day it expires because
the chances
of adobe closing below 635 on that day
are actually super high meaning you just
burned up
96 dollars in a game that you should
have known going in
had a 94 chance of being a losing
proposition and so if you do the math if
you do that exact same trade
over and over again you will lose 15 out
of 16 times
and that’s because the probability is so
high of that call expiring worthless
so what this means is that if you do
this trade 16 times in a row
the overwhelming likelihood is that you
will lose almost every single one of
those times
and so therefore if you made this
equivalent trade
16 times the losses on those 15 trades
would be 1440
meaning that just to break even and make
no money
but at least not lose anything you’d
need to make 1440
on that one winning trade meaning the
stock price would have to go
way past the strike price of the call on
that one out of 16 times
and that’s only to break even mind you
and if you do the math on that you need
a to have a fifteen hundred percent
return
on that one winning trade just to break
even
that’s the hurdle that you have to
overcome on that one
trade just to break even otherwise the
whole thing has been a fiasco
doesn’t sound so great now does it under
the light of honest
scrutiny in other words what this means
is that even if
right out of the blocks i make a
thousand percent return
on a long way out of the money cheap
call trade like this
the likelihood is i’ll give it all back
and more
if i continuously make an equivalent
trade the next 15 times
because there’s such a high probability
that i’ll lose the trade
in the first place so next time that
someone brags to you about a thousand
percent gain
on an out of the money call option the
next question should be well tell me
how many times have you lost money
making that same trade and at that point
they’re pretty likely to change the
subject so remember
when someone says to you all i can lose
is the cost of the option
that’s like saying all i can lose is
everything
and to make the experience even more
pleasurable you’ll lose
100 of your investment 94 of the time
that’s what these guys are bragging
about and it makes no sense
and that’s because they leave out the
probabilities
when they’re telling you they’re one
anecdotal big win
so to me it’s pretty much a losing
proposition now
selling those same options where you
would win
94 of the time that sounds like
something a little more interesting to
me
and that approach being net sellers of
what is known as options time premium
is the kind of trading that we practice
on our desk and that’s a completely
different sort of story for another day
now just to remind you if you’re serious
about your trading
you’ll need to check out the free
intensive options class
that we’re currently running where
you’ll learn three real world option
strategies that our professional options
traders use
all the time so just click the link that
should be appearing now at the top
right corner of your screen or you can
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to optionsclass.com to register for this
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and investors to learn
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before you miss it
* no relevant positions