We all know that 90% of traders lose money, but when it comes to options, the statistic is even more daunting: 99% of traders end up in the red. Most people who enter the world of options trading do not achieve long-term profitability. When asked why these traders fail, the usual answers are poor mentality, greed, emotional trading, or a lack of market experience.
While these factors do play a role, they are really not the differentiating factor a lot of the time. Often, these “poor mentality” things are symptoms of poor trading, not the cause.
So we need to ask: What is it that the 1% of profitable option traders do differently?
Key Takeaways
- Mindset and Value Perception:
- Profitable option traders see the market through the lens of value, always asking whether an option is fairly priced. They focus on the concept of “buy cheap, sell expensive” by leveraging their deep understanding of the trading products.
- Price Sensitivity and Fair Value:
- Successful traders are highly sensitive to price and constantly evaluate if an option’s market price reflects its true value. Identifying and exploiting discrepancies between market price and fair value is crucial to their strategy.
- Expected Value (EV):
- The difference between an option’s market price and its fair value represents the expected value. Consistently finding mispriced options ensures a positive average expected return, which is a cornerstone of long-term profitability.
The Mindset of Profitable Traders
The key difference between the successful 1% and the rest lies in their fundamental approach to the market. It’s not just about having a stronger mentality or mastering emotions. It’s about having a fundamentally different perspective on how to evaluate and seize opportunities. Successful traders see the market through the lens of value. They play a game of “buy cheap, sell expensive,” grounded in a deep understanding of how options work, what drives their value, why someone is willing to buy them, and especially under what circumstances someone is willing to overpay for them.
Understanding How Options Work
One of the first things you’ll learn about options is that they are complex financial instruments. Unlike stocks, which simply go up or down in value, options involve multiple factors that influence their price. This complexity can be daunting, but it also offers lucrative opportunities for those who truly understand the product. Profitable option traders know the ins and outs of options. They know what causes them to change in value. They know how to structure trades to express different views in the market. They know how to manage their trades.
The Importance of Price Sensitivity
The most crucial trait of profitable option traders is their sensitivity to price. When they see an option priced at $5, they don’t just consider its potential payoff; they ask, “Is this option really worth $5?” Understanding the fair value of an option compared to its market price is the cornerstone of their strategy. In option speak, they can identify the difference between the amount they can collect in premium from selling options and the amount they will have to pay out due to realized volatility.
An example of price sensitivity explained through a simple arbitrage
Imagine finding a $5 bill that someone is willing to sell you for $3. It’s an obvious profit opportunity. Similarly, if you find an option worth $3 that the market values at $5, you can sell it now and buy it back later for $3, securing a $2 profit. This is a simple concept, but the challenge lies in accurately determining the true value of an option.
Evaluating Options for Fair Value
Most traders think of options in terms of the leverage they provide. They predict that a stock will go up, so they buy a call option to maximize their gains. However, they often overlook a critical question: “Is the price I’m paying for this option justified?” This lack of price consideration is a fundamental reason why most traders basically donate their money to other market participants. Profitable option traders always evaluate whether the price of an option reflects its true value.
In our approach, we focus on finding these price discrepancies. By identifying options that are mispriced by the market, we can consistently generate profits. For instance, if an option is priced at $5 but we determine its fair value is $3, we can sell it for $5 and buy it back later at $3, securing a $2 profit. Finding a repeatable process that finds options trading for $5 that are really worth $3 is what we call a strategy.
The Role of Expected Value
Tying this back to the concept of expected value (EV), the difference between the market price and the fair value of an option represents our EV. If we consistently find options that are mispriced, our average expected return will be positive. This is the mentality that separates professional, profitable option traders from everyone else. While most traders focus on managing emotions and maintaining a strong mentality, the pros concentrate on evaluating the true value of their trades and capitalizing on the market’s price insensitivity.
Conclusion
Understanding the complexities of options and being sensitive to their pricing are the two key traits that distinguish the 1% of profitable option traders from the rest. Focus on these two things and you’ll eventually be able to consistently identify and exploit opportunities in the market.
