Danger: Using one trade to finance another

This is a continuation of an ongoing discussion in the comments section. It all refers back to a post from July 2009.

It began with a comment on this post where Mr X (who manages other pepole’s money) proposed the idea of buying a more useful put (i.e., one with a higher strike price) when constructing a collar. Because that ‘better’ put is more expensive that the traditional put (some small number of strikes out of the money) he included the suggestion of financing that more costly collar by selling a put that is farther OTM than the put owned.

In other words, instead of buying a put that affords 100% protection (after paying the deductible) for the other part of the collar (the long stock/short call portion), he proposed buying a put spread. The idea is to buy an ITM put and sell a put that is 20 to 30% out of the money. He provided statistical data that shows that this was sufficient protection more than 99% of the time. That is reassuring evidence for a trader, but the investor who wants the complete protection of a true collar (think Black Swan), this may not be sufficient protection. It is, however, a reasonable choice for someone to consider.

Quoting Mr X:

So you can actually buy a vertical (buy PUT at the money, sell a PUT 20 to 30% lower). This reduces your protection (can still have a major black swan though), but historically it still protects you against 99% of the market drops. And the cost is cheaper (we are saving 20-30% or so on the cost of the protection).

Bottom line: less costly collar, good enough to work 99% of the time (looking back in time does not mean the same results will occur in the future). As I mentioned: a reasonable alternative. The trade is made for a good reason: It costs less, adds to profits (lower cost = higher profit), and is good enough almost all the time. It’s a very attractive idea – for the more aggressive trader.

Summary

The trader has two choices:

  • Own the traditional collar with an (perhaps 5%) OTM put
  • Own a collar with zero deductible (ATM put)
    • This comes with no Black Swan protection

This was my reply at the time:

Overall, I do like the idea of owning the ATM put. But this will not satisfy everyone’s comfort zone. Is it better to avoid the 5% deductible and give up black swan protection? Not an easy decision.

And that was where we left it. An alternative that works better than the collar most of the time, but which leaves the investor facing the possibility of a financial disaster if a true Black Swan event occurs.


That discussion was re-opened recently when a reader commented on the ideas of Mr. X.

One thing led to another and the discussion reached a level where I felt it necessary to post this for other readers.

It is easy to fall into trading traps, and the one discussed by my correspondent is one of those slippery slopes that can lead to blowing up an account. Below is an abbreviated version. The original comment is here

In my mind, this is the progression of a trader:

Step 1: One learns about a put, so they’d like to purchase a put to protect a long position.

[MDW. This trader is off to a very bad start. Learning about puts is not a good reason to buy them. And this really upsets me. One does not BUY or SELL something that is not yet understood. Puts are too expensive for most people to own. It essentially kills any chance to earn profits.

Step 2: To help finance the put, they sell a call, thus they have a collar. They’re willing to part with the stock at the call strike.

MDW: True, it’s a collar. But look what you just did to this poor trader who owned some stock. He ‘learned about’ puts and bought some. Then he sold calls to create a collar. We don’t know that this trader wants to own a collar or even knows what a collar is. This is blind trading for no reason. You are suggesting that this is a ‘step’ in becoming a good trader: Buy a put because the trader learned that they exist (why did he buy and not sell?) and then sell calls just because the trader owns stock and is willing to sell. Two foolish trades. Two steps backwards in an options education. I don’t like being so hard on a loyal reader, but this is not progress.]

Step 3: Like in step 2, they want to help finance the position, so they think of selling a put on the same stock. (this is where you and I agree that this may not be a good idea)

[MDW: I don’t see how this is progress. If the trade is made ONLY to finance the original trade, it is foolish. The discussion you are quoting does not adopt this strategy. Making trades for the sole purpose of raising cash is the (short) path to eventual ruin.]

Step 4: They realize that selling a put on the same stock may not be a good idea because they don’t really want to own it at that strike price.[MDW: Why does the prospect of buying stock at the put strike price occur to you? Not every put seller wants to buy stock. Most traders would cover the put at some future time, rather than take ownership of the shares. There is no indication that the put sale was made for any other purpose than making a trade: Give up the regular collar with its deductible and trade it for a collar with no deductible, but only limited protection. Why is that bad? When I agreed with you originally, I missed the point that Mr X was buying a better put.]

Essentially, they want to sell the put for the wrong reasons and they’re exposed if the stock drops below that lower strike (I think this is where we’re agreeing). [MDW: Not when you explain it this way. In fact, this trader has an excellent reason for selling the put. It lowers costs and leads to profits >99% of the time. What better reason does a trader need, as long as he keeps risk under control by trading the appropriate number of contracts?]

Thus, they try to think of other ways to finance.

[MDW: Why do you believe the trader is seeking other ways to finance? He found a perfectly acceptable method]

Perhaps they could just use existing funds they already have, or they could use the premium from other positions that they would like to own, like by shorting puts on stock B which they are intending to invest in.

[MDW: This trader does not seem to be someone who has any interest in buying any stocks so why would he want to sell puts on stock B? Selling them just to finance another trade is a very poor idea.]

So that’s my thought process of how one gets to this point. The journey doesn’t seem that unreasonable even if individual steps may be ill-advised (i.e. step 3).

[MDW: To me, the journey is dangerous – with each step leading the trader closer to ruin. I do not expect this trader to survive very long]

Thanks.

Tristan,

The big issue for me is that you actively seek ways to ‘finance’ trades. That is a slippery slope that leads to taking far too much risk. If a position is not good enough to own on its own, then it does not belong in the portfolio. It does not have any ‘need’ to be financed.

How does financing the position make it any better to own? Portfolios should be managed by risk and not by how much cash can be collected to finance other positions.

Sure, some trades provide cash that can be used to meet margin requirements of other trades. But making those trades just to generate cash is not smart.

I understand your thinking: If a trader can finance his trades by making other trades that he truly wants as part of the portfolio, that’s a good thing. It keeps the account stocked with cash and eliminates the need to borrow money from the broker.

Look at it from a simplistic point of view. The trader has some positions He seeks to finance them by opening more positions, each of which comes with a net positive cash flow. In other words, the trader sells option premium. Each of those trades involves risk.

It takes a very disciplined trader to recognize when enough premium has been sold. It’s important to prevent over-selling. Once the idea of selling more options to finance other option positions takes hold, it is almost impossible to stop. It will appear to be free money – until the account blows up in one devastating moment.

950

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