Why Simple Put Options Buying Fail in Volatile Markets

The recent stock market crisis (2008) took the stock market down by more than 30% in less than a year. This has a lot of traders thinking that big money can be made simply by buying put options on stocks that will move down with the market, especially high beta ones. Nothing can be further from the truth. Most amateur options traders who did that either failed to make any money, make very little money or outright lose money even though the stock moved down a lot as predicted. Why is that so?

Volatile market conditions are especially bad for buying stock options due to 2 reasons. Firstly, the extreme volatility resulted in extremely high implied volatility which increases the extrinsic value of options dramatically, depressing its profitability. Secondly, extreme volatility leads to extreme speculation which encourages market makers to open up the bid ask spread to an unreasonably wide level in order to fill their own pockets.

Extrinsic value is the price one pays to the seller of stock options in order to justify the risk undertaken by the seller for giving such a right to the buyer. This price is arrived at in theory by options pricing models such as the Black-Scholes model. Extrinsic value directly affects the profitability of the options as the higher the extrinsic value of an option, the more the underlying stock needs to move in order to breakeven or profit. For example, if two options based on the same underlying stock, the same strike price and expiration month have different extrinsic values (of course this cannot be the case in reality), the option with the higher extrinsic value will make lesser money in profit than the option with the lower extrinsic value when the underlying stock moves by the same amount when held to expiration.

Extrinsic value is affected mainly by the level of implied volatility of the underlying stock. If the underlying stock is expected to make big moves, implied volatility goes up and the extrinsic values of its options go up as well. In times of extreme market volatility, extrinsic values go up dramatically across the board, depressing the profitability of options. In fact, one could end up losing more money than usual if the stock does not move according to expectations due to the higher extrinsic value paid. This is why a lot of amateur options traders who simply bought put options recently failed to make much money or any at all. This situation is made even worse by the wide bid ask spreads provided by the market makers.

Market makers are whom options traders really trade options with. When you buy an option, you are really buying directly from market makers who hold an inventory of those options and when you sell options, you are really selling back to these market makers who want to maintain an inventory of those options. Market makers buy and sell options in the exchange, ensuring the liquidity of all options contracts and profit primarily from the bid ask spread that they provide, buying at the bid and selling at the ask. They function exactly like used car dealers, buying at lower prices and selling at higher prices. Typically, the more actively traded the options are, the closer the bid ask spread tend to be due to competition between market makers, however, in times of extreme volatility where there are a lot more buying and selling on panic and more than enough business to go around for all market makers, they usually open up the bid ask spread in order to make even more profits. That is why we saw unusually wide bid ask spreads in this recent crisis. Wider bid ask spreads result in larger upfront losses which again depress the already depressed profitability of stock options due to the higher extrinsic values.

The higher extrinsic value and wider bid ask spread makes profiting from simple stock options buying extremely difficult and are the main reasons why amateur options traders fail to make money buying put options during the recent stock market crisis. Conversely, writing options are an extremely profitable way to trade options during a volatile market where extrinsic values are high. Naked writes and Credit Spreads are really the way to go in a volatile market condition and are what most beginner options traders do not know about. Selling options instead of buying them turns the table around and creates an extremely profitable position during times of high extrinsic value. Learn more about credit spreads now.