Putting “Too Good to Be True” to Use

Who hasn’t seen ads promoting a trading strategy that will magically make you rich? Or read an online article about a secret technique to squeeze money out of the market? Here are a couple such “secrets” you may have heard of. But we’ll show you how to turn that too-good-to-be-true strategy into something with more realistic risk and return.

Secret 1: Buy Cheap Out-of-the-Money Options For Giant Profits! Turn Pennies Into Dollars!

What could be better than turning a small investment into a mountain of money in just a few months? Maybe buying that out-of-the-money (OTM) call option for $0.20—that’s a mere $20 investment, not including commissions. And if its price goes to $10, that’s a $980 profit. Do that a few times, and you’ll be driving a golden Bentley around your private island!

Truth be told, if it were that easy, everyone would be a bajillionaire. The story of buying cheap OTM options and selling them for some large multiple of the purchase price as a means to strike it rich is naturally too good to be true.

First off, the prices of OTM options don’t always grow dramatically compared to earlier prices, if at all. Sure, there are some OTM options that can be $0.20 one day, and $2 when the stock moves favorably. If the stock is $100, that $107 strike call might be $0.20, for example. And if the stock goes from $100 to $109—a 9% increase—that 107 call could be worth more than $2. It can happen, but it’s not likely. For that cheap OTM option to be a huge winner, two things need to happen: the stock has to move big, and it has to move in the right direction.

Take a look at some OTM options on the SPX on the thinkorswim^® platform from
TD Ameritrade (figure 1). Yes, the 2845 strike call is less than $2 (affordable, by SPX standards). But with the SPX at $2,704, there’s a theoretical 4.22% probability that the call will be in the money (ITM) at expiration. That suggests a theoretical 95% probability it’ll expire worthless. Not so great.

Further, the SPX price needs to move before the option’s expiration. You may be able to do that one time when you buy a cheap OTM option. But two times? Three times? Can you make a trading career out of that?

That’s your decision. But a more sensible strategy that might also have a small capital requirement and not require perfect market conditions to be potentially profitable is a short OTM vertical—a short put vertical if you’re bullish, or a short call vertical if you’re bearish.

With the stock at $100, a short put vertical might be long the 96 strike put and short the 97 put. If you took in a $0.35 credit, the capital requirement is $65 (the difference between the strikes minus the credit), which is also its max potential loss. If the stock rises 9%, that short put vertical could have a max profit of $35 (the credit received), not including commissions. That’s not as big a profit as you could get on that long OTM call. But that short put vertical can be profitable even if the stock drops a bit, so long as it stays above $97 through expiration. The long OTM call doesn’t have that advantage. So, consider the long OTM option as a potential lottery ticket (high risk, low potential reward), and the short vertical as a kind of plain-vanilla trade.

Secret 2: Gamma Scalp Your Way to Victory! How About a Strategy That Makes Money When a Stock Goes Up or Down, and You Don’t Lose on Time Decay?

What’s not to love about the gamma scalp? Turns out, plenty.

Gamma scalping is a semi-complex strategy that continuously hedges the deltas of a long straddle using—in its simplest form—stock. As a stock price moves up and down, the deltas of a straddle can go from positive to negative. The stock trades become (hopefully) profitable scalps, and they offset the losses from negative time decay.

But let’s look at the numbers. Say the stock is $100, and you buy the 100 strike put and 100 call. Assume the delta of that straddle is close to zero, while gamma is 0.80. If the stock price goes up $1, the delta theoretically increases by 80. If the stock price goes down $1, the delta theoretically drops by 80.

If the stock goes from $100 to $101, the delta of the 100 straddle goes from zero to 80. The gamma scalper sells short 80 shares of stock, and the position (straddle plus short stock) goes back to zero. Say the stock drops from $101 back to $100, and the position’s delta goes from zero to -80. The gamma scalper buys 80 shares of stock to get the position delta back to zero. The gamma scalper is left with the long 100 straddle (the original position). She made $80 selling stock at $101 and buying it back at $100. If the long 100 straddle had theta (time decay) of -20 per day, the $80 scalp more than offset it. The gamma scalper “defended” the long straddle with the scalps, and was able to hold that straddle to wait for the big move. That’s how it’s supposed to work, and what makes gamma scalping sound appealing.

But there are problems. First, commission costs can get high with so many stock trades. Second, if the stock price doesn’t change, and the long gamma doesn’t “manufacture” any deltas to scalp, the time decay still eats away at the straddle’s value. Third, the long straddle has long vega. And if implied vol drops, it can take the straddle’s value down, all else being equal. That means the stock scalps have to offset theta and vega risks. Finally, successful gamma scalping means you’re buying and selling stock at relative tops and bottoms. If the stock went from $100 to $101 and the gamma scalper sold 80 shares, who’s to say it wouldn’t continue higher in the “big move” that would make the original straddle position profitable? You don’t want any short stock in that case.

For gamma scalping to be profitable, too many things have to go just right. Sometimes large institutions do a version of gamma scalping across all the firm’s positions. But that’s a different case.

Consider a long iron condor. It’s an alternative to gamma scalping around a long straddle if you think a stock might have a big move up or down. A long iron condor might be short the 98 strike put, long the 99 strike put, long the 101 strike call, and short the 102 strike call. It’s a long put vertical plus a long call vertical, and you pay a debit for it—which is also the strategy’s max loss (not including commissions). That max profit occurs if the stock is below $98 or above $102 at expiration, and the max loss occurs if the stock is between $99 and $101 at expiration, with breakeven points at $99 (minus the debit paid) and $101 (plus the debit paid). Like a long straddle, the long iron condor is profitable if the stock has a big move up or down, yet loses if it doesn’t.

There are also other alternatives to the long iron condor. And although they also have commissions, they may be less than with gamma scalping. Also, the long iron condor and its cousins may not require constant trade adjustments, as with gamma scalping, and might carry less risk.

So it makes sense to send the snake-oil salesmen packing. Always bring a healthy dose of skepticism to “can’t lose” trading strategies. Consider the basic premise and leverage a smarter strategy.