"The Unlucky Investor's Guide to Options Trading " by Julia Spina & Tom Sosnoff
Date Finished: March 23, 2025
Pages: 224
How strongly I recommend it: 6/10
Published in 2024 by Wiley
Find it at Amazon
The bible for options traders, though pretty dry and math heavy. I did, however, learn things in this book that I could not get from online videos and tutorials. Worth the read if you are serious about trading derivatives.
My Notes:
An option is a type of financial contract that gives the holder the right to buy or sell an asset on or before some future date.
Unlike casinos, where the odds are fixed against the players, liquid financial markets offer a dynamic, level playing field with more room to strategize. However, similar to casinos, a successful trader does not rely on luck. Rather, traders’ long-term success depends on their ability to obtain a consistent, statistical edge from the tools, strategies, and information available to them. Today’s markets are becoming increasingly accessible to the average person, as online and commission-free trading have basically become industry standards.
In addition to being customizable according to specific risk-reward preferences, options are also tradable with accounts of nearly any size because they are leveraged instruments. In the world of options, leverage refers to the ability to gain or lose more than the initial investment of a trade.
There is no free lunch in the market. A leveraged instrument that has a 70% chance of profiting must come with some trade-off of risk, risk which may even be undefined in some cases. This is why the core principle of sustainable options trading is risk management.
ETFs are typically much cheaper to trade than the individual assets in an ETF portfolio and are inherently diversified. For instance, a share of stock for an energy company is subject to company-specific risk factors, while a share of an energy ETF is diversified over several energy companies.
An option is a type of financial derivative, meaning its price is based on the value of an underlying asset.
The two most common styles of options are American and European options. American options can be exercised at any point prior to expiration, and European options can only be exercised on the expiration date.
The number of underlying shares. One option usually covers 100 shares of the underlying, known as one lot.
The purchaser of the contract pays the option premium (current market price of the option) to adopt the long side of the position. This is also known as a long premium trade. The seller of the contract receives the option premium to adopt the short side of the position, thus placing a short premium trade. The choice of strategy corresponds to the directional assumption of the trader. For calls and puts, the directional assumption is either bullish, assuming the underlying price will increase, or bearish, assuming the underlying price will decrease.
Rather than constructing portfolios according to forecasts of future price trends, the purpose of this text is to demonstrate how trading options according to current market conditions and directional volatility assumptions (rather than price assumptions) has allowed options sellers to consistently outperform the market.
Proponents of the strong Efficient Market Hypothesis (EMH) posit that investors benefit from investing in low-cost passive index funds because the market is unbeatable.
Generally, short premium positions are more likely to yield a profit compared to long premium positions. This is because options are assumed to be priced efficiently and scaled according to the perceived risk in the market, meaning that long positions only profit when the underlying has large directional moves outside of expectation. As these types of events are uncommon, options contracts go unused the majority of the time and short premium positions profit more often than long positions.
Mean (first moment): Also known as the average and represented by the Greek letter μ (mu), this value describes the central tendency of a distribution.
Variance: this is the measure of the spread, or variation, of the data points from the mean of the distribution.
The normal distribution (also known as the Gaussian distribution or the bell curve) is arguably one of the most well-known probability distributions and foundational in quantitative finance. It describes countless different real-world systems because of a result known as the central limit theorem. The theorem says, roughly, that if a random variable is made by adding together many independently random pieces, then, regardless of what those pieces are, the result will be normally distributed.
The Black-Scholes options pricing formalism revolutionized options markets when it was published in 1973. It provided the first popular quantitative framework for estimating the fair price of an option according to the contract parameters and the characteristics of the underlying.
Rather, it is essential to have at least a superficial grasp of the Black-Scholes model to understand (1) the foundational assumptions of financial markets and (2) where implied volatility (a gauge for the market’s perception of risk) comes from.
As stated previously, the Black-Scholes model only gives a theoretical estimate for the fair price of an option. Once the contract is traded on the option market, the price of the contract is often driven up or down depending on speculation and perceived risk.
Implied volatility may be the most important metric in options trading. It is effectively a measure of the sentiment of risk for a given underlying according to the supply and demand for options contracts.
Other than implied volatility, the Greeks are the most relevant metrics derived from the Black-Scholes model.
Conclusion and Key
Successful traders do not rely on luck. Rather, the long-term success
statistical edge from the tools, strategies, and information avail-able. This book introduces the core concepts of options trading and teaches new traders how to capitalize on the versatility and capital efficiency of options in a personalized and responsible way. Options are fairly complicated instruments, but this book aims to lessen the learning curve by focusing on the most essential aspects of applied options trading. The detailed framework laid out in this book can be summarized succinctly in the following key takeaways:
1. Implied volatility (IV) is a proxy for the sentiment of market risk derived from supply and demand for financial insurance. When options prices increase, IV increases; when options prices decrease, IV decreases. IV gives the perceived magnitude of future movements and is not directional. It can also be used to approximate the one standard deviation expected price range of an asset (although this does not take strike skew into account). The CBOE Volatility Index (VIX) is meant to track the IV for the S&P 500 and is used as a proxy for the perceived risk of the broader market. The VIX, like all volatility signals, is assumed to revert down following significant expansions, which indicates some statistical validity in making downward directional assumptions about volatility once it is inflated.
1. Compared to long premium strategies, short premium strategies yield more consistent profits and have the long-term statistical advantage. The trade-off for receiving consistent profits is exposure to large and sometimes undefined losses, which is why the two most important goals of a short premium trader are to profit consistently enough to cover moderate, more likely losses and to construct a portfolio that can survive unlikely extreme losses.
2. The profitability of short options strategies depends on having a large number of occurrences to reach positive statistical averages, a consequence of the law of large numbers and the central limit theorem. At minimum, approximately 200 occurrences are needed for the average profit and loss (P/L) of a strategy to converge to long-term profit targets and more is better.
3. Extreme losses for short premium positions are highly unlikely but typically happen when price swings in the underlying are large while the expected move range is tight (low IV). Because large price movements in low IV are rare and difficult to reliably model, the most effective way to reduce this exposure is to trade short premium once
4. IV is elevated.
5. Although high volatility environments are ideal for short premium positions, short premium positions have high probability of profits (POPs) and some statistical edge in all volatility environments. Additionally, because volatility is low the majority of the time, trading short options strategies in all IV environments allows traders to profit more consistently and increases the number of occurrences. To manage exposure to outlier risk when adopting this strategy, it is essential to maintain small position sizes and limit the amount of capital allocated to short premium positions, especially when IV is low. This strategy can be further improved by scaling the amount of capital allocated to short premium according to the current market.
VIX Range
0-15
15-20
20-30
30-40
40+
Maximum Portfolio Allocation
25%
30%
35%
40%
50%
6. Buying power reduction (BPR) is the amount of portfolio capital required to place and maintain an option trade. The BPR for long options is merely the cost of the contract, and the BPR for short options is meant to encompass at least 95% of the potential losses for exchange-traded fund (ETF) underlyings and 90% of the potential losses for stock underlyings. BPR is used to evaluate short premium risk on a trade-by-trade basis in two ways: BPR is a fairly reliable metric for the worst-case loss of an undefined risk position, and BPR is used to determine if a position is appropriate for a portfolio based on its buying power. A defined risk trade should not occupy more than 5% of portfolio buying power and an undefined risk trade should not occupy more than 7%, with exceptions allowed for small accounts. The formulae for BPR are complicated and specific to the type of strategy, but the BPR for short strangles is approximately 20% of the price of the underlying. BPR can be used to compare the risk for variations of the same strategy (e.g., strangle on underlying A versus strangle on underlying B), but it cannot be used to compare risk for strategies with different risk profiles (e.g., strangle on underlying A versus iron condor on underlying A).
1. Traders trade according to their personal profit goal, risk tolerances, and market beliefs, but it is generally good practice to be aware of
the following:
• Only trade underlyings with liquid options markets to minimize lilliquidity risk.
* The choice of underlying is somewhat arbitrary, but it's important to select an underlying with an appropriate level of risk. Stock underlyings tend to be higher-risk, higher-reward than ETF underlyings. This means stock underlyings present high IV opportunities more frequently, but they have more tail loss exposure and are more expensive to trade.
* Choose a contract duration that is an efficient use of buying power, allows for consistency, offers a reasonable number of occurrences, has manageable P/L swings throughout the duration, and has moderate ending P/L variability. Durations between 30 and 60 days are suitable for most traders.
* Compared to defined risk trades, undefined risk trades have higher POPs, higher profit potentials, unlimited downside risk, and higher BPRs. High-POP defined risk trades, such as wide iron condors, have comparable risk profiles to undefined risk trades while also offering protection from extreme losses. Such trades can be better suited for low IV conditions compared to undefined risk trades and are allowed to occupy undefined risk portfolio capital.
* Contracts with higher deltas are higher-risk, higher-reward than contracts with lower deltas. When trading premium, consider contracts between 104 and 404, which is large enough to achieve a reasonable amount of growth but small enough to have manageable P/L swings and ending P/L variability.
8. When choosing a management strategy, the primary factors to consider are convenience and consistency, capital allocation preferences, desired number of occurrences, per-trade average P/L, and per-trade exposure. Early-managed positions have lower per-trade P/Ls but less tail risk than positions held to expiration. Because managing carly also accommodates more occurrences and averages more P/L per day, closing positions prior to expiration and redeploying capital to new positions is generally a more efficient use of capital compared to extracting more value from an existing position.
• If managing according to days to expiration (DTE), consider closing trades around the contract duration midpoint to achieve a decent amount of long-term profit and justify the tail loss exposure.
* If managing an undefined position according to a profit target, choosing a target between 50% and 75% of the initial credit allows for reasonable profits while also reducing the potential magnitude of outlier losses. Choosing a profit target that is too low reduces average P/L, and choosing a profit target that is too high does little to mitigate outlier risk. Profit targets for defined risk positions can be lower because they are generally less volatile.
* If combining strategies, managing undefined risk contracts at either 50% of the initial credit or halfway through the contract duration generally achieves reasonable, consistent profits and moderates outlier risk.
* If implementing a stop loss, a mid-range stop loss threshold of at least -200% of the initial credit is practical. If the stop loss is too small (-50% for example), losses are more likely since options have significant P/L variance, although they often recover. It's also important to note that stop losses do not guarantee a maximum loss in cases of rapid price movements, so stop losses are typically paired with another management strategy unless trading passively. Stop losses are generally not suitable for defined risk strategies.
9. Maintaining the capital allocation guidelines is crucial for limiting tail exposure and achieving a reasonable amount of long-term growth:
* The amount of portfolio buying power allotted to short premium positions, such as short strangles and short iron condors, should range from 25% to 50% depending on the current market volatil-ity, with the remaining capital either kept in cash or a low-risk passive investment. [refer to Takeaway 5].
* Of the amount allocated to short premium, at least 75% should be reserved for undefined risk trades (with less than 7% of portfolio buying power allocated to a single position) and at most 25% reserved for defined risk strategies (with less than 5% of portfolio. buying power allocated to a single position) [refer to Takeaway 6).
* Generally speaking, at most 25% of the capital allocated to short premium should go toward supplemental positions, or higher-risk, higher-reward trades that are tools for market engagement. The remainder should go toward core positions or trades with high POPs and moderate P/L variation that offer consistent profits and reasonable outlier exposure.
1. Diversifying the underlyings of an options portfolio (i.e., trading a collection of assets with low correlations) is one of the most essential diversification tools for portfolio risk management, particularly outlier risk management. Strategy diversification and duration diversification, though not as essential as underlying diversification, are other straightforward risk management techniques.
2. The Greeks form a set of risk measures that quantify different dimensions of exposure for options. Each contract has its own specific set of Greeks, but some Greeks are additive across positions with different underlyings. Consequently, these metrics can be used to summarize the various sources of risk for a portfolio and guide adjust-ments. Two key Greeks are beta-weighted delta (BA) and theta (0). Beta-weighted delta represents the amount of directional exposure a position has relative to some index rather than the underlying itself. Theta represents the expected decrease in an option's value per day. BA neutral portfolios are attractive to investors because they are relatively insensitive to directional moves in the market and profit from changes in IV and time.
3. Because short-premium traders consistently profit from time decay, the total theta across positions gives a reliable estimate for the expected daily growth of a short options portfolio. The minimum theta ratio (portfolio/net liquidity) for an options portfolio should range from 0.05% to 0.1% and should not exceed 0.2% because this indicates excessive risk. If a portfolio is not meeting these theta ratio guidelines, then the positions should be adjusted as follows:
* If a properly allocated, well-diversified portfolio is BA neutral but does not provide a sufficient amount of theta, then the positions in the portfolio should be reevaluated. In this case, perhaps some defined risk trades should be replaced with undefined risk trades or undefined risk positions be rolled to higher deltas. New delta neutral positions can also be added, such as strangles and iron condors, for example. IV and theta are also highly correlated, meaning that higher IV underlyings could also be considered if theta is too low. These measures can be reversed if the portfolio has too much theta exposure while being BA neutral.
* If the theta ratio is too low (<0.1%) and the portfolio is not BA neutral, then either existing positions should be re-centered or tightened or new short premium positions should be added.
* If the BA is too large and positive (bullish), then add new negative BA positions (e.g., add short calls on positive beta under-lyings or add short puts on negative beta underlyings).
* If the BA is too large and negative (bearish), then add new positive BA positions (e.g., add short puts on positive beta underlyings).
* If the theta ratio is too large (>0.2%) and the portfolio is not BA neutral, then either existing positions should be re-centered or widened or short premium positions should be removed.
* If the BA is too large and positive (bullish), then remove positive BA positions (e.g., remove short puts on positive beta underlyings).
* If the BA is too large and negative (bearish), then remove negative BA positions (e.g., remove short calls on positive beta under-lyings).
* If a properly allocated, well-diversified portfolio provides a sufficient amount of theta but is not fA neutral, then existing positions should be reevaluated. For example, skewed positions could be closed and re-centered or replaced with new delta-neutral positions that offer comparable amounts of theta.
13. Binary event trades, such as trades around quarterly earnings reports, should be traded cautiously, only occupy spare portfolio capital, and their position size should be kept exceptionally small. Binary event trades must be carefully monitored and typically take place over much shorter timescales than more typical trades. They are often opened the day before a binary event and closed the day after.
Options trading is not for everyone. However, for traders who are prepared to understand the complex risk profiles of options, comfortable accepting a certain level of exposure, and willing to commit the time to active trading, short premium strategies can offer a probabilistic edge and the potential to profit in any type of market. There is no "right" way to trade these instruments; all traders have unique profit goals and risk tolerances. It is our hope that this book will guide traders to make informed decisions that best align with their personal objectives.
For more… find it at Amazon.