From Barron's
From Hunted to Hunter
By STEVEN M. SEARS
UNTIL RECENTLY, THE OPTIONS MARKET'S reputation was like the Wild West's. It was thought to be ruled by shoot-from-the-hip traders who were fast with numbers and could predict stock prices by reading incoming orders. A widely quoted statistic was that 80% of options traders lost money.
But this mythology is now starting to be replaced by rigorous analysis and academic research like that which has long shaped how investors perceive the stock and bond markets. The results are surprising, and probably won't be considered good news for market makers.
Everyone knows that speculators reflexively buy calls before corporate earnings reports and to bet on takeovers. But no one really knows if the trades are profitable, or if picking the right options contract is more important than, say, understanding a stock's fundamentals.
By analyzing buying and selling options strategies for more than 350 stocks over more than 10 years, Goldman Sachs options strategists Maria Grant and John Marshall found that investors who correctly anticipated a stock's reaction to earnings news had options-trading returns of 46% to 64%, depending on the strategy. "Getting direction right makes all the difference, which is good news for fundamental investors," the strategists write.
Profits were also significantly affected by whether speculators chose to buy calls, which is how most investors speculate on earnings, or sell puts, which also increase in value should the underlying stock advance. The study found that call buyers made more money than put sellers, but that put sellers made money more consistently. The issue: Do you want to hit singles and doubles consistently or strike out sometimes while going for triples and home runs?
Indeed, call buyers made money 54% of the time, with an average profit of 64%. Put sellers made money 86% of the time, but the average profit was 46%.
Volatility is the key component of options prices. And while most institutional investors believe that market makers boost volatility to offset the risk of known events, the study found "no evidence of meaningful systematic options mispricing around earnings." Investors must determine how much of a stock move is already reflected in the options price, but the bid-ask spread may be even more influential.
As a result of the increased efficiency with which options are now priced in a competitive market, establishing a position a day, or even hours in advance of an earnings report, as most everyone now does to avoid losing money to "time decay," may not offer a material advantage. The study found the loss in value due to time decay was offset by tighter spreads.
The strategists offer these guidelines for earnings speculators: 1. Investors confident about a stock's direction, but not the size of its move, may do better selling options. 2. Investors more confident about the magnitude of the stock's move, and less so about its direction, may do better buying options, given the higher average profit. 3. As a rule, stocks must advance an average of 5% to 7% for long trades to beat short trades.
By following these rules, investors who were once hunted by market makers increasingly may become the hunters. |
