The large moves we have seen recently in the markets may have some thinking about buying cheap options for the very limited risk and the unlimited reward. What's the catch? Dr. Data (Michael Rechenthin, Ph.D.) explains it all.
A table of the results of buying OTM calls and puts at a cost of $0.05 and with 45 days to expiration (DTE) in SPY (S&P 500 ETF) over the last 10 years was displayed. The table included the percentage of profitable trades at expiration, and at anytime during the trade. The table showed that 42% of the calls and 32% of the puts were profitable at some point before expiration, but only 1.1% and 1.2% were profitable at expiration.
A graphic was displayed of a SPY put bought on August 28th, 2008 (shortly before the financial crisis) that was eventually worth $1,255 at one point in time. It was noted that a $0.05 option is up over $100 at anytime before expiration in only 2% of all the occurrences tested.
Some might think that they can beat the odds by waiting until the market experiences a large drop. Dr. Mike explained that it wouldn’t work because the large increase in implied volatility (IV) would result in a call being bought that was much farther OTM. He used two graphs to illustrate his point. Selling cheap options is also a bad bet. Selling premium may be a winning strategy, but the risk/reward ratio of selling cheap options is poor, and more importantly, the return on capital (ROC) is very poor.
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