Hey Traders,
More people than ever are active in today’s markets …
And we’re seeing more and more active retail traders in the options pits than ever before!
Now, I really love the fact that so many people are finding ways to get in on the massive profit potential that Wall Street insiders have used to build their fortunes for decades …
But …
Options trading isn’t simple, and that means there’s lots of room for error among retail traders who maybe aren’t aware of some of the finer points of trading.
In fact, a paper published by the MIT Sloan School of Management zeroed in on three specific, costly mistakes retail traders are making.
Note that many of these mistakes are made in the context of trading around earnings announcements – which I personally advise against, in most cases, largely in part because of the potential for these mistakes!
Are you making any of these costly retail rookie mistakes?
- Buying Into The Hype
Who would have thought … retail traders love a trend.
Well, more specifically, the analysis found that retail traders bid up options prices on companies who were expected to see more post-earnings volatility … which usually happened to be the ones making headlines, and getting ample media attention.
Hello, AAPL … TWTR … TSLA … GME …
But how are retail traders responsible for the bid-up options prices?!
Put simply – overpaying for volatility.
Implied volatility (IV) is expected future movement.
But, of course, none of us know the future … so IV can change based on a number of factors, like demand.
One of the big factors in how cheap or expensive an option is is the implied volatility being priced in. When implied volatility is higher, you end up paying more for options, because the market expects a higher likelihood that a stock will make a big move.
But what makes an option “too” expensive?
Well, you need to look at implied volatility and compare it to realized volatility (RV) – how much the stock has actually moved in the past.
We know what a stock’s realized volatility is, because it has already happened. We don’t have to guess.
Typically, if you’re making a trade, you’d like to see the implied volatility to be as close the realized volatility as possible. That way you know you aren’t paying a premium for “expected volatility” on a stock that historically, has not moved very much.
But what has been happening with retail traders is everyone is piling on to these “hot names” …
This increases the demand for options, which in turn results in a higher implied volatility, because if people are buying more of these options, they must be expecting more movement, right?
Usually, yes, but in this case, it’s more of everyone just piling onto the bandwagon and driving the prices up.
Take a look at this comparison of 30-day HV and 30-day IV below. Note how IV (the red line) spikes ahead of earnings, then drops sharply in the days after.
So retail traders are essentially driving up IV, while the actual movement, RV, has not changed.
Think of it like this …
In 1996, Tickle Me Elmo was the toy every kid wanted for Christmas.
The retail price on a Tickle Me Elmo was about $29 …
But the demand for the toy was massive, and it sold out everywhere.
As a result, people were paying a premium to get their hands on one – up to $1,500!
Did this change the actual value of the Tickle Me Elmo toy, once all the hype had died down?
No! The doll was still only worth $29 (although, I’d like to argue it isn’t even worth that!).
The $1,500 price tag was created by demand … and that’s basically what retail traders are doing to options prices by piling onto the “trendy” names.
- Paying Enormous Bid-Ask Spreads
The “bid-ask” spread of an option is how much market makers are willing to pay for an option (the “bid”) versus how much they are willing to sell the option for (the “ask”).
The “bid-ask” spread is one way that brokers and market makers make their money – buying low and selling high.
One factor that affects the bid-ask spread is liquidity – more liquid options tend to have lower spreads, while less liquidity usually means a larger bid-ask spread.
Another factor is perceived risk or volatility.
If a trade is more volatile, the person taking the “other end” of your trade (for example, the market maker selling you the option) will charge a higher premium because they are taking on more risk.
The MIT study noted that retail traders are incurring “enormous” bid-ask spreads ahead of earnings.
Admittedly, Lowe’s (Ticker: LOW) might not be the “hottest” name to trade, but look at the different bid-ask spread from the August expiration – with LOW set to report on the 17th – versus the September expiration.
The bid-ask spread for the 200-strike call in August is $0.40, while the bid-ask spread for the September 200-strike call is $0.15.
While a few extra cents may not “feel” like a lot when you’re making your trade, when you really do the math, it may be costing you more than you think!
An extra 5% or 10% trade cost eats into your profits … and done repeatedly, it can really make a difference in your bottom line.
- Never Letting Go
Another mistake retail traders make is holding onto their options too long after earnings.
After earnings, implied volatility tends to nosedive – a “vol crush” if you will.
So you pay a premium for a high IV option, only to hold onto the trade too long, while you watch the value of your option plummet!
In some cases, you can actually be RIGHT about which way a stock will move …
But the vol crush will be so bad, your option will still LOSE value!
Again … this is why I almost never hold a trade through earnings.
But retail traders make this mistake all the time!
This isn’t to say retail traders are stupid, or that every retail trader makes these blunders.
Not at all.
But … all three of these errors are preventable, especially if you know what to watch out for.
And here at Option Pit … we’ve always got your back!
So I encourage you to keep trading …
But just make sure you aren’t throwing your potential profits out the window!
Your Only Option,
Mark Sebastian