1. Is it possible to make at least 20% expected geometric mean returns per year? With expected returns I mean that you have studied that your strategy in average gives you those returns, considering the expected value of your “play” and the optimal capital management for that strategy. Don't tell me that your strategy can make X% per year, I don't care about that. You also can turn $1 into $1M playing the lottery. I care only about expected value. It seems to me that this forum is full of people fooled by randomness (people that have no idea of the expected value of what they are doing, and have just been lucky while doing something that is less profitable than they think), and then there are some charlatans and some people that seem to know what they are talking about. Some of the latter even have posted incredible screenshots with their annual returns (like rallymode and sellindexvol66). It's because of this group that I have been motivated to keep reading the forum, looking for information in more places and thinking and backtesting different strategies. It seems like there's people capable of consistently getting very high returns per year. Or maybe they are also lying or fooled by randomness, but I “feel” that's not their case. 2. I have been a professional online poker player for several years. I played in many tables simultaneously, playing an enormous amount of hands per year (more than 1 million per year), making a living by exploiting very small edges. To make a living playing poker, you have to make decisions with positive expected value, and manage your bankroll properly so your risk of ruin is as small as possible. You also need to be disciplined enough to play well every hand, don't tilt and just keep working no matter what happens. So I know very well the power of variance fooling people, specially with strategies that have lots of variance (like multitudinous tournaments in the case of poker or OTM options here). You need an enormous sample size before knowing what's the expected return of your strategy by just looking at your realized returns. You can very easily believe that you are “playing” much better or much worse than you really are, just because of luck. I constantly read people here extrapolating from ridiculously small sample sizes. You can't say you "make" 2%-3% per month selling options just because those have been your returns from the last 5 years. You either need to be able to estimate accurately beforehand the expected value of your strategy (and what's the optimal money management to be used) or you need to keep trying it for decades before knowing what's the true expected value of what your are doing. In poker, even after playing 1 million cash game hands your realized return can be different than your expected return. In the case of multitable tournament players (which is a much more volatile modality), you'd need an even bigger sample size. So don't pay attention to minuscule sample sizes. 3. If trading is profitable (understanding “profitable” as more profitable than just buying and holding the underlying), why does that happen? Is it because the behavior of your competitors can be exploited? I'm a quantitative value investor, so I know it's possible to have higher expected returns than just buying the whole market. You profit from being a contrarian, from buying “boring” stocks, or stocks that have recently had a bad perfomance, while you ignore “cool” stocks and stocks with high recent returns. You buy low P/E, P/B, EBITDA/EV stocks and ignore those with high ratios. This works, there are several papers and books that prove it and explain why it happens (behavioural economics). So I wonder if there's also something exploitable when dealing with options. Are there also overvalued and undervalued options? Does the market, in aggregate, overvalue some options? All the time or just sometimes? Why does that happen? Or is the options market efficient? 4. How can you calculate whether an option is over or under valued? Do you compare the current implied volatility with the historical average realized volatility? Do you compare it with the historical average realized volatility of situations like the current one (for example, same month)? How do you calculate the expected value of buying or selling an option?
if you want Answers to questions that have possibly taken experienced people years to discover, you might want to ask with more humility. Remember, you didn't understand some basic concepts of theta yesterday.
I'm sorry if I sounded too harsh. I still have many doubts, that's why I'm just reading and asking. I appreciate your help in that precise thread you are referring to. The biggest doubt I have is whether it's worth trying to keep learning about options. Sometimes I feel like someone trying to beat roulette. Is it really possible to make positive expected value plays that would yield a higher return than just buying and holding the underlying, or the market is efficient enough to make it impossible? Are winners always people that have just experienced a good run, or are some of them really "playing" profitably?
I'll take a stab at no. 4. Options are priced very efficiently nowdays, so looking for mispricings is a waste of time. Being over or under priced is always relative to future conditions, so in general, buy low sell high, implied volatility that is. Expected value? Probability (approximated by delta) times reward to risk ratio, p*(reward/risk). This calculation is actually payoff. Look to maximize payoff, not just probability of winning.
Options are generally used by business insiders, the probability of corporate insiders profiting is determined based on their inside knowledge not just technical execution.
OK, so when deciding whether to buy or sell and option you compare the implied volatility with the historical realized volatility. But with which historical realized volatility do you compare it with? With the average realized volatility of the whole history of that underlying? With the average realized volatility of the last X years? With the average realized volatility of situations similar to the current one (for example, the average realized volatility of December)? To calculate the expected value of a transaction, you need to estimate the probability of each of the possible outcomes and how much you win or lose in each of them. This is very complicated in the case of options, as there are lots of different possible "endings" (lots more if you want to calculate the expected value at each moment that the position is opened). It isn't as easy as for example calculating the expected value of betting for red in a roulette, where only 3 possible outcomes exist.
Yes, it is possible to make 20+% per annum - both expected and realized - using options. There are many methods to do this, however all that I am familiar with involve the same sort of edge available to poker/blackjack players. It's a small edge that must be repeated as often as possible using specific criteria and proper cash mgmt.
Why is it possible to get those returns, why are there over and undervalued options? How can you capture those returns?
- No simple answer to this quandry, but in general if you like to initiate positions with 45 days to expiry, use the 45-day historical realized volatility. - The options delta is a good estimate of probability. At each strike take the delta and multiply by the ratio of how much premium you would collect by selling divided by a theoretical stop-loss value you would take. I say theoretical, because the risk is unlimited when selling options, and you need to have some kind of number in the numerator. Maximize that product, which is known as payoff. I would not recommend you get into the dynamic hedging game if your are a retail trader. Initiate your positions and stick with it until either your profit, stop-loss, or time targets are hit.