By Jim Fink (TMF Hamp)

Thu Oct 13, 5:17 PM ET

I love Las Vegas. Sure, I enjoy the lush hotels, the waterfall pools, the Cirque
du Soleil acrobatics, and the all-you-can-eat buffets, but that is not what I m
ean. I mean I love the casino industry. It is the only industry I know of that h
as a business model based on mathematical certainty (life insurance is a close s
econd). Casinos know that they will make a profit from their gaming operations (
they don't like to use the word gambling) because the odds are always in their f
avor.
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Take American roulette, for example. A bettor has 38 numbers to choose from: 0,
00, and 1 through 36. The odds of the ivory ball falling on the number chosen ar
e 37-to-1 or, put another way, a 1-in-38 chance. Based on the odds, a gambler wh
o bets $1 on a number should receive $38 back if her number comes up on the whee
l. Does a bettor at a casino actually receive $38 for a winning number? Nooooooo
o. She gets only $36. This $2 deficit is what is known as the "house edge" and a
mounts to 5.26% of every dollar bet. In other words, over the long term, a casin
o knows, with mathematical certainty, that it will collect a profit of 5.26 cent
s per dollar wagered. In fact, the decks are so stacked against gamblers that if
they actually start winning, casinos will accuse them of cheating.
What does this casino talk have to do with stocks? Nothing, but it actually does
have quite a bit to do with stock options. Before I explain the connection betw
een casinos and stock options, a quick refresher course in options is called for
. As the Fool has discussed in the past, options are contracts composed of eithe
r puts or calls. Puts give the buyer the right, but not the obligation, to sell
a stock at a certain price. Calls give the buyer the right, but not the obligati
on, to buy a stock at a certain price. Options can also be sold. (And unlike sto
cks, which are physical pieces of paper, options are derivative contracts that c
an be created at will. The Securities and Exchange Commission, which enacted
Regulation SHO to prevent naked short selling of stocks, has no such prohibitio
n regarding naked short selling of options.) Sellers of options, unlike buyers,
have no rights, only obligations, but get paid up front for assuming these oblig
ations. Sellers of call options have the obligation to sell stock to the call ow
ner at a certain price if the owner elects to exercise her call. Similarly, sell
ers of puts have the obligation to buy stock from a put owner at a certain price
if the put owner so elects.
Back to the wheel
Now back to the connection between casinos and stock options. Just as the payout
in roulette is based on the probability of the ball falling on a particular num
ber on the wheel, so too is the price of a stock option based on the probability
of the stock landing on a particular price on the date of the option's expirati
on. Let's say you are bearish to neutral on a stock and want to generate some in
come from this view. You could, for example, sell a November call spread on the
stock. It's best to choose a heavily traded stock with a liquid options market.
Some highly liquid possibilities include Microsoft, Motley Fool Stock Advisor pi
ck Time Warner (NYSE: TWX - News), Google (Nasdaq: GOOG - News), Motley Fool Ins
ide Value pick Pfizer (NYSE: PFE - News), General Motors (NYSE: GM - News), Altr
ia (NYSE: MO - News), Wal-Mart (NYSE: WMT - News), and Stock Advisor pick eBay (
Nasdaq: EBAY - News).
Let's choose, for argument's sake, a $40/$42.50 credit spread on eBay. A credit
spread is the simultaneous sale and purchase of two options -- one sale and one
purchase -- with different strike prices but with the same expiration date. I li
ke to trade spreads because they limit my risk. Let's assume that you sell the $
40 call and buy the $42.50 call. The $40 call is priced at $2.20 and the $42.50
call is priced at $1.20. Your "net credit" (i.e., the amount of cash you will re
ceive after you deduct the cost of the purchased option from the income generate
d by the sold option) will be $1.00 per contract ($2.20 minus $1.20) or $100 ($1
.00 times 100 shares per contract). When they expire, the price at which a selle
r of this call spread breaks even is $41.00 ($40 plus $1.00), meaning that you m
ake at least a penny of profit on the option spread if eBay closes below $41.00
and you lose at least a penny if the stock closes above $41.00 on the date that
November options expire (Nov. 19 for individual stocks).
Is a net credit of $1.00 a fair price to receive for selling the call spread? Th
e short answer is yes. Unlike a casino, the options market doesn't rip you off,
pricing at or very near "fair value," as I'll describe below.
As an aside, I wouldn't recommend placing any credence in those options newslett
ers that claim to have found "undervalued" options to buy or "overvalued" option
s to sell. If such valuation discrepancies actually existed, the institutional m
arket makers in the options pits with their multimillion dollar computer models
would have exploited them in milliseconds, long before a retail investor ever ev
en saw any such discrepancies.
Because the actual math to prove an option's fair value is mind-numbingly comple
x (can anyone say "binomial distribution?"), we need to use a computer and optio
ns valuation software to determine what the probability is that eBay closes belo
w $41.00 on the November options expiration date. And keep in mind that in optio
ns market pricing and valuation, even the best options valuation models are base
d on estimates of future stock volatility (unlike dice in a craps game, which ha
ve definite probabilities) and in turn "fair value," and these estimates could t
urn out to be wrong. Nevertheless, professional traders risk millions of dollars
a day based on these models, so they must be pretty accurate over the long term
.
Rule of thumb
Based on the options valuation software that I use, the probability of eBay clos
ing below $41.00 when November options expire is about 60%. A simple rule of thu
mb can be used to verify that a $1.00 net credit is a fair price for a 60% proba
bility of success. For the price of $1.00 to be fair, the credit received divide
d by the difference in strike prices should equal the probability that the stock
will not close at or below $41.00 ($1.00 divided by $2.50), so the fair value p
robability that eBay closes below $41.00 at November options expiration is 60% (
100% minus 40%).
If you look at this rule-of-thumb concept from a simple risk/reward perspective,
it makes intuitive sense. Buyers and sellers will only enter into a transaction
if they both think they are getting a fair deal. If a seller of the eBay spread
receives $1.00 but is risking $1.50, she will demand that the probability of pr
ofit be at least 60%, because the expectation is the trade will be profitable or
break-even. The back-of-the-envelope formula for the probabilities would look s
omething like this: (60% times $1.00) minus 40% times $1.50) is greater than or
equal to 0. Similarly, on the other side of the transaction, the counterparty to
my spread will accept a probability of profit of only 40% because her potential
reward is greater than her potential loss. Again, the reason this simple rule o
f thumb works is because the options marketplace is very efficient. In conclusio
n, because the rule-of-thumb number of 60% is close to the probability calculate
d by our options valuation software, we have verified that a $1.00 net credit is
a fair price for the eBay credit spread.
I should emphasize that you should never rely on rule-of-thumb calculations when
risking actual capital in the options market. Always rely on probabilities calc
ulated by reliable options analysis software. After all, a rule of thumb is refe
rred to as a rule of thumb because it's generally reliable, though not always.
So there you have the fundamentals of an option spread, the transactions, and as
sociated probabilities. In Part 2 of this options series, I will explain how our
hypothetical eBay credit spread can make you money. Stay tuned.
For other options-related Foolishness:

Options Explained
Considering Stock Options
Get Paid While You Wait
Jim Fink spent many years losing gobs of money buying options and watching his m
oney disappear with time decay. Now he makes a little money selling options and
having time decay work in his favor. May the odds be with you. He has no financi
al interest in any of the companies mentioned, but does hold a brokerage account
with thinkorswim, Inc. Data provided by thinkorswim, Inc. The Motley Fool has a
n ironclad disclosure policy.
By Jim Fink (TMF Hamp)
October 14, 2005
In the first part of my series on "trading with the odds," I explained credit sp
reads and other options basics. I used a November $40/$42.50 credit spread on eB
ay (Nasdaq: EBAY) to show that, since options markets are efficient, the net cre
dit you receive from selling that spread is a fair price. In part two, I'll expl
ain how selling time decay makes you money most of the time.
The beauty of decay
The fairness of options pricing doesn't guarantee you a profit. After all, the e
xpected profit of a fairly valued options trade is zero at the moment the trade
is initiated! (If the expected value were positive, nobody would be willing to s
ell the option. If it were negative, nobody would be willing to buy.)
This is where things get interesting. Options have a unique feature called time
decay. Since options are, in essence, a bet on the future price movement of a st
ock, time is a prime component of an option's extrinsic value. The less time rem
aining until expiration, the less value an "out-of-the-money" call option (an op
tion whose strike price is above the current stock price) has, because it become
s less likely that the stock will rise enough to let the option expire "in the m
oney." With each passing day, the time value of an option inexorably declines.
What does time decay mean for our eBay spread? Assuming that the stock price doe
sn't change, time decay ensures that the spread's expected profit doesn't stay a
t zero. Time works in the position's favor. As each day passes, the probability
that eBay remains under $41 at its November expiration increases, thereby pushin
g the spread's expected value more and more above the zero line.
Options analysis software can help you calculate that this probability increases
from about 60% today to 63% next month. This puts the fair-value price of the s
pread somewhere around 93 cents.
Assuming everything else remains constant, in one month's time the expected prof
it of your spread has moved from zero to $0.07 ($1.00-$0.93) per contract. Becau
se the options market is efficient, it's highly likely that you could buy back t
he spread (i.e., buy to close the $40 call and sell to close the $42.50 call) at
93 cents and pocket the seven cents as profit.
Doesn't sound like much, but on an initial risk of $1.50, a $0.07 return amounts
to 4.7% -- not as good as the casino's more than 5% edge in roulette, but not b
ad either. Especially since that edge continues to grow larger with every passin
g day.
Buyers beware
Just as time decay works for the options seller, it works against the options bu
yer. Thus, after one month, with nothing else changing, an option buyer is 4.7%
in the hole and still sinking. That makes options buyers a lot like casino gambl
ers sure to lose over the long run.
It's also why professional options market makers are almost always short options
rather than long. According to Tom Sosnoff, founder and CEO of the Chicago-base
d thinkorswim brokerage, as well as a former Chicago Board Options Exchange mark
et maker, "The majority of professional traders I know aren't net long option pr
emium on a regular basis. The odds are against you. I think survival depends upo
n collecting time decay."
Of course, it's possible that the day after you sell the eBay call spread, the s
tock will skyrocket. It's not likely -- most of the time, stock prices remain wi
thin a narrow range -- but it could happen. If it does, your options sale could
be big loss.
Remember, however, that if a stock makes a big move in the wrong direction, it w
on't necessarily stay there. It could easily make a round trip by its November e
xpiration and return to a profitable price point. Alternatively, eBay shares cou
ld suddenly plummet, which would help the profitability of the credit spread.
In fact, selling time decay is a high-probability trade precisely because an opt
ions seller has two chances to win and only one chance to lose. In our eBay exam
ple, the seller of the $40 call wins if eBay's stock price stays the same or fal
ls. She loses only if the stock price goes up significantly. The buyer of the $4
0 call wins only if the stock price significantly rises.
Cover your assets
Despite winning in two out of three scenarios, options sellers still risk losses
. I recommend that you never sell an option without buying another one as insura
nce. Simply selling the $40 call would earn you $2.20, improving the breakeven p
rice of your trade to $42.20. For the single short call, that may sound better (
and more profitable) than my spread's breakeven price of $41. But selling the $4
0 call by itself has unlimited risk.
If eBay shoots up to $100 from the current price of about $39, the seller of a $
40 call would need to pay more than $60 to close out her position, a net loss of
nearly $57.80 ($60-$2.20) per contract. Such a huge loss could wipe you out, pr
eventing you from the benefit of having the odds in your favor over the long run
.
In contrast, the maximum loss of my call spread is fixed at $1.50 per contract,
regardless of how high eBay climbs. My $42.50 call will be worth $57.50 if eBay
hits $100, yielding me a net profit of $56.30 ($57.50-$1.20), which offsets all
but $1.50 of the $57.80 loss on my short $40 call. Limiting my risk keeps me in
the game until the long-term odds start working in my favor. That's what I call
peace of mind.
Collecting time decay can be done in many ways, with any view of market directio
n. Besides selling a call spread above the stock's current price, which implies
a bearish market view, you could sell a put spread below the stock's current pri
ce, which implies a bullish market view. Or you could sell both a call spread ab
ove and a put spread below, which implies a neutral market view. Or you could se
ll a near-term put or call in October and buy a farther-out put or call in Novem
ber. The possibilities are virtually endless.
The house (almost) always wins
Does this mean you'll profit every time? Of course not, even if the odds are in
your favor. A 60% chance of profit still means you'll lose 40% of the time. Casi
nos understand that the house edge only applies over tens of thousands of roulet
te-wheel spins. That's why casinos, despite their house edge, limit how much a g
ambler can bet on any one spin. They don't want to be bankrupted by a gambler's
single, gigantic lucky bet.
Options traders need to adopt casinos' mindset. You should limit the amount of c
apital risked on any single option position (2.5% of your capital is a good rule
of thumb), then sell option spreads (i.e., time value) in an endless series of
small trades to capitalize on the small long-term edge options sellers get from
time decay.
Don't limit yourself to a single eBay spread. Supplement it with spreads on Micr
osoft (Nasdaq: MSFT), Time Warner (NYSE: TWX), Google (Nasdaq: GOOG), and Pfizer
(NYSE: PFE), for example. You should diversify not only among stocks, but also
over time -- perhaps by investing a third of your capital each in November, Dece
mber, and January spreads.
Of course, it's still possible that you could lose on your option trades 40 time
s in a row and get wiped out. That scenario's unlikely, though; a 60% probabilit
y means that you'll win more than you lose over the long term. Taking advantage
of time decay is not a get-rich-quick scheme, but it does seem to work. Why shou
ld Las Vegas casinos have all the fun?
Opt for further Foolishness:
Know Your Options, Part 3
Options Explained
Considering Stock Options
Get Paid While You Wait