You might assume that speculating with options and March Madness have very little in common, but you’d be wrong. To start, both have become more mainstream lately — equity options volume surged 40% year-over-year to record high levels to end 2021, according to the Options Clearing Corporation (OCC). Filling out brackets has always been popular, but sports betting popularity in general soared during a pandemic thanks to gambling platforms like DraftKings (DKNG). Wherever you’re working, there’s a good chance there’s a bracket pool set up. Before you stress about that #12 vs. #5 seed, know that the keys to success on options trading and ‘bracketology’ are actually fundamentally similar.
With the 2022 NCAA men’s basketball tournament set to kick off in a few hours, we thought we’d examine the eerily parallel path to both options-trading and bracket victory. So, whether you’re about to embark on your options-trading journey or just now looking at the Field of 68, make sure you obey these 10 Commandments:
Commandment 1: Thou Shalt Not Play If Thou Can’t Pay
Options: Don’t risk precious capital if you can’t afford to lose it. When playing with options, you’re going to have some losing trades along the way — it’s inevitable. As such, it’s not wise to wager bill money or your life savings — no matter what kind of “hot tip” or “good feeling” you have beforehand. As Schaeffer’s founder and CEO Bernie Schaeffer says, “intelligent trading decisions are rarely made when ‘scared money’ is involved.”
Bracketology: Simply filling out a bracket is fun. However, it’s even more fun when you win, obviously. Don’t be that guy dodging your dues — it’s not fair to the winner at payout time, or the bracket manager who has to take a six iron to your knees. If you don’t want to fork over the cash, there are plenty of online leagues that let you join for free.
Commandment 2: Practice Makes Perfect
Options: Before risking precious capital, try paper trading first. Utilizing a virtual trading tool (provided by many online brokers) allows you to test your trading knowledge, theories, and risk tolerance to see which strategies work for you and which don’t. Make sure to take diligent notes in order to analyze each trade’s aftermath, which will help you discover what kind of options trader you are and strive to be.
Bracketology: Before you submit your bracket, try a few brackets first (you can find a plethora of free mock-ups online). Simply running through the bracket a few times will help you encounter matchups you want to analyze later. Fill out a few copies, take a look at them, and see what feels right.
Commandment 3: Thou Shalt Not Play By the Seat of Thine Pants
Options: Research, research, research. It’s crucial to examine a security thoroughly before initiating an option trade. For a multi-dimensional, well-rounded analysis, Schaeffer’s Expectational Analysis® methodology encourages investors to study a stock from fundamental, technical, and sentiment perspectives. Schaeffer’s V.P. of Research Todd Salamone broke down his methodology to us in our Market Mashup Podcast.
Bracketology: Research, research, research. While it’s a rare feat to know the intricacies of every team, it’s not smart to “wing it” without doing your homework. Bracket websites such as ESPN and Yahoo supply you with the stats of each matchup. Run the numbers. And don’t forget to check the injury reports. For example, Baylor, a number one seed, just lost its star player to injury for the first weekend. They will be ripe for an upset.
Commandment 4: Thou Shalt Consider Outside Circumstances
Options: On the same note as No. 3, it’s essential for option traders to be aware of outside circumstances that could be a catalyst higher or lower for the stock. For instance, before implementing an option play on stock XYZ, make sure you check the company’s corporate calendar. A significant event like a date in the earnings confessional, or the release of monthly sales figures, could potentially impact option prices and your strategy.
Bracketology: While a matchup could look good on paper, a team’s performance could be affected by circumstances outside of its control. Consider the team’s travel schedule, where the game is being played, etc. New Mexico State has to fly cross country to face UConn. Wisconsin’s first round game is in nearby Milwaukee. Leave no stone unturned!
Commandment 5: Thou Shalt Do the Math
Options: Before entering a trade, plot the numbers. You should be cognizant of the breakeven levels, profit/loss potential, and any commissions or margin requirements to best understand where your play stands at any given time. For in-depth analyses on a variety of strategies, check out our new and improved Education section.
Bracketology: The odds of picking all upsets is not in your favor. While a few may make you look cool, you want your Elite 8 ponies to be alive after the first weekend. It’s best to sprinkle in some risky upset picks with solid, chalky teams.
Commandment 6: Thou Shalt Raid the Bargain Bin…at your own Risk
Options: It’s basic economics that an item in high demand will command a higher premium. Options are no exception to this rule. By comparing a stock’s historical volatility to an option’s implied volatility, you can gauge whether the option is relatively cheap or expensive at the moment. However, seasoned option speculators can take advantage of inflated premiums by employing strategies like the short put or short call.
Bracketology: “An item in high demand will command a higher premium.” In bracket speak, that means picking a chalky bracket might be safe, but won’t win you money. You win money by nailing a pick amid the chaos. Those teams are ‘in demand.’ There’s cheap value to be had in nailing the #3, #4, or #5 seed that gets hot and demolishes all chalk brackets. Think to last year. It wasn’t just the person who picked UCLA right. It was the person who nailed Houston, a 3 seed. Houston’s ‘implied volatility’ was low, because its probabilities of making the final four were low but in reality the team was a top 25 team all season.
Commandment 7: Thou Shalt Hunt for Sleepers and Busts
Options: As contrarians, we like to find outperforming stocks surrounded by skepticism. If the shares of an equity have powered higher on the charts, but the Street still remains leery, the unwinding of that pessimism — in the form of upgrades, price-target boosts, a short-covering rally, or a reversal in sentiment in the options pits — could all act as catalysts even higher for the stock.
On the flip side, contrarians also enjoy foraging for underperforming stocks surrounded by optimism. If a security is in the midst of a long-term downtrend, but the Street remains bullishly biased, an unwinding of that optimism could pressure the stock even lower as the bulls abandon ship.
Bracketology: Everyone loves a Cinderella. I know I just said don’t get too upset crazy, but if you find a team with good metrics and a favorable matchup, don’t be afraid to ride them far into the tournament. Basketball is a game of runs and momentum, and if you hit on an upset pick, your bracket will look awfully strong in three weeks.
Commandment 8: Thou Shalt Not Be Afraid to Hedge
Options: Unsure about the future of a stock or particular sector? Try hedging your bets pairs trading. By simultaneously opening two related option positions, you allow yourself a safety net to guard against an unanticipated move in a specific sector. For example, to hedge against potential weakness in the pharmaceutical sector, an investor could buy a call on outperforming ZYX, and simultaneously purchase a put on underperforming rival XYZ. As long as the profits from one trade outweigh the losses from the other, your pairs trade is money.
Meanwhile, you can handcuff a long position with a short position, if you want to reduce your risk on a single stock. Shareholders of XYZ can “handcuff” their stake with a protective put, for example, while modestly bullish traders can initiate a relatively conservative play on XYZ by executing a long call spread.
Bracketology: This is a more nuanced strategy. If you think a #13 seed will upset a #4 seed, ‘hedge’ that upset pick by picking the #5 team in the conjoining bracket. If you think a double-digit seed is making a run to the Elite 8 — as one does nearly every year — pick chalky teams around it to compensate.
Commandment 9: Thou Shalt Know Where Thou Stand
Options: Don’t be a passive investor — ignoring your trades could be fatal to your portfolio. Once you’ve initiated your option play, it’s vital that you keep close tabs on the position. If you see that your position is tanking at a rapid-fire pace, simply praying for a miracle often exacerbates the losses. Instead, avoid clinging to losing trades, and consider setting stop-loss levels to prevent a massive deficit in your trading capital.
Bracketology: This is a commandment that should be in effect in November, when the season starts. You don’t have to be Jon Rothstein, watching every game. But tune in to the big games, check out an ESPN clip here and there, and know the landscape. It will help inform your bracket picks come Selection Sunday.
Commandment 10: Thou Shalt Lose With Dignity
Options: As mentioned earlier, all option traders will take a hit every now and again. The trick — besides proper allocation and portfolio management — is to take the losing trades in stride. Have realistic expectations heading into every trade, don’t let fear or greed outweigh common sense, and — most importantly — stay in the game.
Bracketology: As much as it hurts to lose to your Great Aunt Linda, who picked teams based off mascot cuteness, making a bracket is just a game. Just as no one likes a showboat, no one enjoys a poor sport, so stay classy through the tournament and, more importantly, have fun. Good luck!