Odds of Blowing up in Options Selling — 1 in 28 Trillion ?
By: Subham Banka
Tags: Derivatives, Trading, Options, Risk, Finance

Odds of Blowing up in Options Selling — 1 in 28 Trillion ? Subham Banka May 20·5 min read

A bit of background on why I think this needs to be addressed. While discussing the merits of option selling and long-term profitability, a gentleman came up with three thought-provoking counters. He was very logical with his arguments, unlike most Marwari uncles who do not hesitate to inquire to my face as to how my “satta bazaar” is going? Yup those family gatherings are the worst, and I’m thankful to COVID for putting an end to them.

He listed three major areas of concern: -

(1) “High chance of Risk of ruin. Every once in a while, there will be a black swan event that will erode your capital irrevocably”

I would argue that both the frequency of black swan events and their impact on trading capital is grossly dramatized.

(2) “90% of option sellers lose money”

Hey, if Twitter traders were to be believed, Jim Simmons is their kid’s math tutor and Warren Buffet serves Coke and McDonalds to their guests. I’m kidding. More on this later.

(3) “Option selling is a zero-sum game” In the long run, nobody makes money. It’s not as if you guys are producing anything”

PART 1 Risk of Ruin

Risk of ruin is the probability of losing so much money that you can no longer continue trading. It is personal to every individual in the sense that it could be any figure. For some it might be 30–50%, For others it might even be 75% or even 100% of their capital.

There is only so much we can control when it comes to trading. We are going to use two underutilized concepts to illustrate how we can prevent the risk of ruin.

(1) Strategy: Theoretical/mathematical Probability of Profit (PoP) > 55%. We like to initiate trades which that have ~70% PoP.

(2) Size: Risk only ~1–3% of capital per trade.

Note: We are only talking about monthly option contracts with trade entry at 45–20 Days to expiry. Also, we are underlying agnostic, meaning we trade every liquid stock option contract and not just index options.

Learn to Trade Small Trade Often: A coin toss represents a 50% chance of a head or tail. Flip a coin 10 times, you might land heads 8 times out of 10. Flip a coin 10,000 times the results will more accurately reflect the theoretical probability of getting heads, i.e. 50%.

In order to achieve a long-term win rate of ~70–80%, you need to put ‘many small high PoP’ trades and let the probabilities play out over time. Go Big or Go Home Sucks. Period.

Ever wondered why Casinos have table limits? Every game has a maximum amount a player can bet on a particular turn. This prevents someone from betting a million dollars, say, on a roulette number, getting lucky and forcing the casino into a big painful payout. The house always has a mathematical edge. With the help of table limits casinos can exploit their long-term edge over many outcomes by eliminating large lottery payouts.

In the same way you must try to restrict risk on any given trade to 1–3% of trading capital.

Ideally the risk per trade should decrease as the size of your trading capital increases.

In the table given below we calculate the probabilities of seeing consecutive losses given a pre-defined Probability of Profit (PoP) at trade entry: -

Allow me to illustrate how powerful this table is:

(1) Let us assume we put in 70% PoP trades, with 5% risk per trade (higher end) and a total of 20 trades (100% capital utilized).

(2) The chances of us having 20 max loss trades or blowing off 100% of our capital is 1 in 28 TRILLION.

Simple concepts such as Probability of Profit and Table Limits will not guarantee profits, but it will help you stay in the game long enough to identify your strengths and develop your trading style. It isn’t as easy as it seems to go broke in trading.

This is after considering the worst-case scenario. Please note this is not a segment on Risk Management, but rather a segment on Risk of Ruin. I have not included things like strategy diversification, capital allocation levels, notional value per trade per stock and portfolio leverage. More of all that in a separate segment.

Something which worries most traders are Gaps. How many times have you been asked what will happen if Nifty opens 3% or more down? Let’s take a look at how often this has happened: -

Data From 1st October 2007–18th May 2021

2 observations: a) the number of outlier moves (3%+/-) appear to be way lower than expected and, b) ~75% of these moves happened in 2020/21 in a high IV environment. It would be prudent to restrain from jumping to any positive conclusions, but it is thought provoking, to say the least.

PART 2: 90% Option traders lose money

The man has got his stats right. Only 10% of option traders are successful and make a living out of it. Option selling is a business and as such how is this different from any other new business or start-up?

A study conducted by IBM Institute for Business Value (IBV) and Oxford Economics found that 90% of Indian start-ups fail within the first five years due to the lack of innovation and unique business models.

PART 3: Options trading is a Zero-Sum Game

Trading in any product be it stocks, gold, diamonds, oil or any physical commodity is a zero-sum game. Option selling is remarkably similar to poker and casino and insurance businesses. Can we say then that no one can make money out of it simply because of the symmetrical aspect of the business?

It is grossly incorrect to infer that options trading has zero positive expectancy in the long run.

To conclude, take many high probability trades and allocate not more than 1–3% of risk in a single trade. The key is to increase the number of occurrences and let the probabilities play out. Trade Small Trade Often is a motto preached by Tasty Trade, and it works. No single trade should determine the success of your trading career.