Expectancy is the probability of profit less the probability of loss. If you make $1.00 on ten trades and lose $2.00 on 5 trades you have zero expectancy. $1*10/15- $2*5/15 = 0. Increase your average win to $1.01 and you have achieved positive expectancy. 1.01*10/15-2*5/15 = .007 and so on. In any trading environment the actions of buyers and sellers drive the price of an asset to "fair value" at any and every point in time. Fair value = mid-point between the bid/ask spread = zero expectancy. Why are options a negative expectancy game for any retail trader? Because of slippage (the difference between bid/ask spreads) and commissions. How much is this negative expectancy? Let's assume that the average option price is $4.00. The market for that option is likely to be 3.90 bid/4.10 asked. For a retail customer to buy that "$4.00 option" he has to pay some market maker for the privilege of ownership. Let's say that on average you can shave a nickel off the B/A so that means on a round turn your cost is $0.10 in addition to the fair value. Add another penny in commissions and your net cost is $0.12. That leaves (4.00-.12)/4.00 as the probable payback on the trade. Or 97% payback. That's about the same odds offered by casino blackjack. Every option trade is therefore a negative expectancy event. So how does anyone facing these odds make any money?
A skilled trader has the ability to "alter the odds" so to speak by bringing individual options into combinations that, while on their own offer only negative expectancy, in combination they provide positive expectancy. It is in essence the TRADER'S skill that creates positive expectancy.
One way to maybe get a handle on how this operates is to "reverse engineer" a trade. When you buy a simple call and if you track the life of the value of that call from the moment you bought or sold it you can see in retrospect that there would have been several times that the trade would have been profitable or at worst a situation where it would have shown the least loss. Blindly or randomly entering and exiting trades will always result in the negative expectancy outlined above. But the skilled trader - through deep experience - learns to select those ripples in an option's history that either result in reduced losses or better than average gains. There are so many permutations and ways for these momentary positive expectancy events to occur. The bottom line though is that options, while at any moment are offered as zero or negative expectancy events, when you are in a position, the continuous changes to value mark opportunities to overcome the original negative expectancy. It's as if you have heads on a coin flip but somewhere just before it lands you can see that it is very likely to land tails. If this observation leads you to quickly withdraw most of your at-risk bet, then you have skewed the odds in your favor.
A skilled trader has the ability to "alter the odds" so to speak by bringing individual options into combinations that, while on their own offer only negative expectancy, in combination they provide positive expectancy. It is in essence the TRADER'S skill that creates positive expectancy.
One way to maybe get a handle on how this operates is to "reverse engineer" a trade. When you buy a simple call and if you track the life of the value of that call from the moment you bought or sold it you can see in retrospect that there would have been several times that the trade would have been profitable or at worst a situation where it would have shown the least loss. Blindly or randomly entering and exiting trades will always result in the negative expectancy outlined above. But the skilled trader - through deep experience - learns to select those ripples in an option's history that either result in reduced losses or better than average gains. There are so many permutations and ways for these momentary positive expectancy events to occur. The bottom line though is that options, while at any moment are offered as zero or negative expectancy events, when you are in a position, the continuous changes to value mark opportunities to overcome the original negative expectancy. It's as if you have heads on a coin flip but somewhere just before it lands you can see that it is very likely to land tails. If this observation leads you to quickly withdraw most of your at-risk bet, then you have skewed the odds in your favor.