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Don’t buy into the hype—understand the probabilities behind options SUBSCRIPTION.

READER
By Anton Kulikov | May 13, 2019
SURVEY

Who makes more money in Las Vegas—the gambler or the casino? OK, a gambler might win
once in a while and thus believe it can happen again and again. But over time, the casino
ABOUT
builds wealth while the gambler’s wastes away. Given the choice, wouldn’t it make more sense
LUCKBOX
to be the casino than the gambler? Luckily, exchange-traded options give investors a legal way
to play the role of the casino without the capital that buying a casino requires.

Every trade has a winner and a loser. When it comes to options, the sellers (analogous to the
casino) tend to win over time, making small prof- its consistently. Option buyers (the gambler)
"He Said/She Said" Tour
tend to lose but occasion- ally land a big winner. Orlando, FL - September 7, 2019
The He Said, She Said tour is coming
to Orlando! Tom, Tony, Liz & Jenny
Sure, selling options has been pro table, on average, for the past 14 years, But don’t fall for and a slate of special guests are
bringing tastytrade to your ‘hood.
those ads that say, “Make 800% in 15 minutes with this simple strategy!” They’re a gamble.
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Investors can use options not only for consistent premium selling but also to take a shot on a
hunch once in a while, assuming of course, that the investor knows the risk and odds before
entering the trade.

CME Group & tastytrade: Futures

Suppose one buys the 291-strike call in SPY (the S&P 500 ETF) expiring in seven days for $0.07 per Symposium
New York, NY - August 24, 2019
contract. This trade packs huge potential! If SPY (trading at $285.50 as of April 2, 2019) moves
Tom and Pete are back with a brand
more than $7 dollars in the next seven days, an investor would make $100 for every additional new Futures Symposium for 2019.
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dollar SPY moves higher.

Say that SPY closes at $292 or

higher by expiration. The
$0.07 option is now worth at
The TradersEXPO Chicago
least $1, for a 1,300% Chicago, IL - July 21, 2019

increase! But, what are the Register today to see our tastytrade
hosts speak at the The Chicago
odds? According
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SPY +0.62%  /ES +0.01%  AMZN +1.69%  +2.71% 
NFLX TradersEXPO TSLA -0.15% 
theoretical probabilities, that VIEW MORE 

has roughly a 0.78% chance

of occurring. What about the
probability that the option
will be worth at least $0.01 by
expiration? Theoretically, that Geeks on Parade
Chicago, IL - July 13, 2019
has a 2.15% chance of
Join us for a Geek blowout. 1 show, 6
occurring. The other 97.85% hours, 10 speakers, lots of Chicago
Street Food and your favorite
of the time an investor is tastytrade personalities.

expected to lose the VIEW MORE 

premium invested.

1,300% increase! But, what are the odds? According to theoretical probabilities, that has
roughly a 0.78% chance of occurring. What about the probability that the option will be worth
at least $0.01 by expiration? Theoretically, that has a 2.15% chance of occurring. The other The MoneyShow Seattle
97.85% of the time an investor is expected to lose the premium invested. Seattle, WA - June 15 - 16, 2019
Register today to see tastytrade hosts,
Tom Sosno , Katie McGarrigle, and
Mike Butler speak at the The
“Slim chance,” shows the possible distribution of stock prices by the expiration date of the MoneyShow Seattle.

option. The orange shaded region represents the probability that the option expires worthless. VIEW MORE 

The green area to the right of the red dashed line represents the likelihood that the option
expires in the money. The light green area represents the likelihood that that option is worth at
least $1 by expiration, yielding a return of 1,300%. Orange probability = 97.85%, dark green
probability = 2.15%. Light green probability = 0.78%. Investors who buy options are betting on the
little green area. If they sell options, they’re betting on that orange area.

Now to the historical backtest. “The price is right,” is showing summary statistics for the long call
since 2010, which indicates it has had roughly the same probabilities and duration as the one
trade in the example:

Key points to take away from

this table include the fact
that the theoretical
probabilities listed above the
table nearly equal the
realized historical
probabilities in the table. That
suggests the markets are
priced e ciently, and traders
can use statistical models to
estimate probability of pro t
with decent accuracy.

Second, the “house edge” is the same as the ROI. Those familiar with casinos and gambling
realize casinos use this 54% house edge to determine the payback percentages, or ROI, to
players. The house edge for most casino games ranges between 1% and 10%, meaning that for
every bet gamblers place in the casino, they can expect to lose between 1% and 10% of total
bets over the long run.

It may seem like a casino game like roulette with a house edge of 5.26% represents a better bet
than the long premium example above with a house edge of 54%. However, consider this: in
roulette, a player may have 50 spins per hour, compared to this long premium trade where an
investor buys one contract every 30 hours(roughly /ES
SPY +0.62% ve +0.01%
businessdays). AMZN +1.69%  NFLX +2.71%  TSLA -0.15% 
TOP 10 MARKETS TRADED
 Assume a gambler bets the same amount

Gamblers tend to on roulette as the amount of premium an

investor buys. In other words, $7. That

lose more in a translates to a notional value of $350 per

hour in bets in roulette versus $0.23 per hour

casino than in bets for the long call. Multiply those

gures by their respective house edges and

investors lose by one can expect to lose roughly $18.41 per

hour in roulette versus only $0.12 per hour on

buying options the call. So investors can “play” for longer

with the long call because they lose money
more slowly than in a casino game, even
though the house edge on the call is
astronomically higher.

Below are comparisons of the long call and various casino games wagering $7 per bet.

Takeaways—the far out-of-the-money long call strategy

Expect to pro t at least $1 around 2.15% of the time.

Expect to lose 54% of the total premium invested over the long run.
Markets are e cient because the theoretical probabilities of pro t match the realized
probability of pro t.
Casinos give players better odds per bet, but players lose more at a casino by placing
many more bets per hour there compared with buying a call every week.
Casinos are analogous to option sellers. Gamblers are analogous to option buyers.

Anton Kulikov is a trader, data scientist and research analyst at tastytrade.

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luckbox content is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security,
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a brand of tastytrade, Inc., does not provide investment or nancial advice or make investment recommendations through its content, nancial programming or otherwise.
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investing time horizon or risk tolerance. luckbox magazine and tastytrade are not in the business of transacting securities trades, nor does it direct client commodity accounts
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accuracy, but the publisher disclaims responsibility for opinions and representation of facts contained herein. Active investing is not easy, so be careful out there!

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