Tag Archives | risk management

ITM Calls as a Stock Substitute

I found this series of questions to be quite valuable. Here we have a relatively new options trader who finds an excellent method for reducing risk, but who gets caught up in a mistake that makes him question his methods.

Mark,

I’ve been using DITM options for swing trades, while utilizing the leverage to potentially increase the return of buying stock outright.

Plus much less downside risk, unless you decide to buy extra options with the cash not used to buy stock. To be clear, I’m hoping that you do not decide to buy 10 calls, paying $8 each, Instead of $100 shares at $80/share. That’s a very bad idea. You must determine your correct position size by the number of shares you would have bought, and buy only one call for each of those 100 shares. Careful position sizing is essential to risk management.

I usually pick the first strike showing a 1.00 delta. My question is whether this is actually a good risk to return strategy based on the changing delta.

You adopted an excellent strategy, but your focus seems to be misguided.

100 delta options are too far in the money – unless it’s expiration week. The major benefit of using this trading method (buying calls instead of stocks) is to gain a large amount of downside protection. As you know, a market tumble can be quite costly for stockholders.

If you chose ‘high delta’ options instead of 100 delta options, you would gain that protection at a very modest cost. I urge you to consider the idea of paying a few dimes over parity for a call option that has a 75-85 delta instead of paying closer to parity for that 100 delta option. This is a personal decision and if you refuse to pay that time premium for protection, so be it.

Example

With the stock trading at $76, don’t buy the 65 calls (price = $11.20). Instead, buy the 70 calls (price $6.50). That extra $30 reduces the potential loss. Consider it to be an insurance policy.

Next, I understand neither your reference to changing delta nor “risk to return strategy”.

1) The risk to return is outstanding. You cut the dollars at risk from a gigantic number (when owning stock) to a much smaller number (by owning a call option). Surely you understand that.

2) Changing delta? If you are unfortunate enough to see the stock decline by enough for the option delta to become < 100, that's GOOD for you. You seem to believe it's costing money. All it means is that you would lose LESS money per point of decline that you would lose if owning stock. I have one question for you: If you are a swing trader, why would be holding a long position in this stock when it declines by so much? That is not how swing traders operate. They are quick to cut losses. Remember, until the stock falls enough to cut delta, you lose $100 per point. 'Changing delta' doesn't mean much in your scenario because 100 delta options don't change delta very quickly.

Say I pay $10 for a call with a 1.00 delta, and based on this, expect about a 10% move in option price for a $1 stock move (give or take some). The stocks drops. At this point the option price and delta will also drop,
which could very easily cause the percentage option loss per dollar to go up based on higher volatility.
.

You are off on several wrong paths here, and that’s the reason for posting this discussion. This is a good learning opportunity for rookie option traders:

a) You should expect the ‘give or take’ to be essentially zero for a 100 delta option

b) You are thinking in percentages, and that is confusing you. As a swing trader, concentrate on what you are doing. You are buying (or selling short) stocks, looking to make a few dollars per share. Using call options changes nothing in your basic plan – except that it reduces risk. Concentrate on dollars and forget those percentages.

c) You do NOT KNOW that the option delta will be less than 100 when the stock declines by one point. You did say these are deep in the money options.

d) If there is a change in implied volatility, you WILL NEVER lose ore than $1 per point in the price of an option when the stock declines. Why? You own the option. You own the vega. You BENEFIT when the implied volatility increases. Thus, any losses would be reduce by that change in volatility. Couple that with your anticipation that the delta becomes less than 100 and you benefit again by losing less than $100 per point decline (in the sock price).

Here’s where you miss the big picture: If the volatility increase is large enough – due to a general market scare – you can MAKE money on the decline when oping calls! Did you know that? Get out your option calculator and see what happens to the value of a call with a 70 strike price when implied volatility goes from 30 to 60 and the stock declines from 75 to 70. Assume options have 30 days before they expire. [Your calls would lose less than $1 in value. If they were longer-term options, they would increase in value]

Should the stock move higher, the volatility may decrease and the delta is maxed out at 1.00. Thus, my option price increases, thereby lowering my percentage gain.

No. Delta may be maxed at 100, but so is the delta of the stock. The long call and the long stock move in tandem. The percentage return is totally unimportant – and in fact, it does snot change. You paid $10, so every one point gain is another 10% return on your investment. Plus, your return is far better than that of the stockholder. I’ll say it again. Forget those percentages.

So I’m wondering if this approach actually causes a disadvantage as the reward potential for say a $2 increase may be lower than the risk potential of a $2 drop because the percentage gain decreases for every dollar going up while increasing for every dollar going down. So I may make 18% on a $2 upside but in exchange for a 30% drop for a $2 drop … again give or take.

No. You illustrated why your idea is good. The bad things you found in the strategy are imaginary. They are contrary to fact. You earn as much on the upside (you may earn a little less if you take my advice to buy options with a small amount of time premium). To compensate, you have an excellent chance to lose less than $1 per one point drop in the stock price.

Sit down. Think about this carefully.

One additional point: These DITM calls don’t do the job for stocks that pay decent dividends because you may have to exercsie for the dividend to prevent losing money.

925
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Managing Iron Condors with Imagination

This post is based on the very thoughtful comment/questions posed by Chris O.



Dear Mark,

I have been thinking lately, If one always exits an IC early, say one month before expiry on an IC that was opened three months before expiry, is it useful to do the following:

As the short legs of the IC ought to be closed one month early and I want to discipline my self to do so, why don’t I select my protection, the long legs of the IC, at one month earlier expiration.

Such wings of the Condor are cheaper to buy. The wings of an IC chosen the normal way, extending to the same expiration, are mostly worthless when I sell them one month before expiration, together with buying back the short legs of the IC.

So using shorter duration long legs on the IC takes away any hapless covering of the entire IC, and allows me to make more money?
Looks like Free lunch = I must be overlooking something.

Not so free lunch

This is not a free lunch, and there is likely to be significant margin problems. However, the strategy has a great deal to recommend it.

You envision an iron condor similar to the following:

Buy X INDX Jul 1050 calls
Sell X INDX Aug 1040 calls

Buy X INDX Jul 880 puts
Sell X INDX Aug 890 puts

Your long options expire before the short options. This has a lot going for it, per your description above. However, the margin gods don’t like such positions. When the long option expires after the short, they are considered to be naked short. That uses up a ton of margin for the average investor.

Portfolio margin

However, if your account uses portfolio margin, you are granted many special advantages regarding margin. Such accounts are margined by looking at the overall risk associated with the portfolio – and not by looking at each individual position. The bad news for many is that the account must be at least $100,000 to qualify. But readers should ask their broker about portfolio margin, just in case they do something different. [IB follows the rules mentioned here]

Forced exit

If you want to ‘discipline yourself’ to exit one month early, this is certainly a good way to do it. However, do keep in mind that when INDX is near 880 or 1050 (the strikes of your long options), the longs are going to expire worthless and it is going to cost a lot of money to buy back your shorts.

Nevertheless, that specific result will not occur very often and over the longer-term this may well be a winning play. This trade allows the position to be opened for a large cash credit, and there are obvious benefits in doing that.

1) one spread, put or call, might be too close to the money and have to be bought back at a loss or a additional wing must be bought for that side to cover a short position during this last month. Does not make sense as an argument, I want to stick to the rule of closing the short legs on month before expiration, so closing at a loss is “biting the bullet”. I definitely don’t want to stick around in a high gamma last month environment with a short option close to the money, even when it has a long option covering to the final month.

Yes, it makes sense to me. However, I urge you to take the worst case scenario, estimate an implied volatility for the August calls, and get yourself a good estimate of how much can be lost. If you size this trade properly (that loss is acceptable, not devastating), then you will be in good shape when using strategy.

It’s easy to back-test, if you have the data. Or you can accumulate data in a paper trading account. To gain data quickly, do three different indexes simultaneously.

2) IV might have jumped on the underlying, and both short options may have higher value than I collected – even with one month to go. Does not matter? If IV is so high I don’t want to remain in the last month when gamma is also high. Wild swings can happen. So again, why bother buying wings on an IC when the plan is to carry the IC to the final expiration?

Are long legs of an IC carrying to to the last expiration date worth anything, one month before expiration at a high IV?

Yes, it matters. Yes, IV may become a problem. And yes, those one-month options would have a very high value in your high IV scenario.

However, a low IV offers an occasional extra profit. The key to survival here is being very careful about position size.

There is a point you are missing. If you own the traditional iron condor in a high IV environment, one month prior to expiration, your remaining long call would significantly cut the loss when exiting. But, as you say, your plan is to earn extra profit all those times when IV is not extra costly and your long option is not near the stock price. Probability is important for a good analysis of this play, and having he ability to back-test this method for a bunch of years would be helpful.

3) I am trying with a small position, now running until final expiration in May, at Interactive Brokers and see little effect on margin requirements. No argument either.

Can you shed some light?

Thanks a lot for your efforts

I don’t understand why there is no problem with margin. Please let me know if you are using portfolio margin.

Do keep in mind that there is little to be learned from a single example. You can develop some novel adjustment ideas, but this study requires a good deal of data.

Chris-O
Holland.

P.S. On Options for Rookies Premium, is the planned content difficult to organize for people in a very different time-zone than yours?

[Visit the link above for a short video that describes live meetings (and the problem of time zones), one of the important features for Gold Members. You must become a free member (Bronze) to gain access to the video]

Yes, different time zones present a problem when planning live meetings. We already have members from Hong Kong, Singapore, and the Netherlands. Therefore, I am requesting that members suggest times that are best for them and I’ll do what I can to make it convenient for as many as possible. If necessary, I’ll add extra sessions. For now, I’m promising four live sessions per month, but I suspect it will have to be more than that.

922
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Adjusting with the Greeks

Mark,

I have been spending a great deal of time lately looking into making adjustments and all the various methods people use as part of developing my overall plan. I understand and subscribe to your idea that first and foremost you MUST want to own the adjusted position as a new position not just to save yourself from a "loss".

I have gone back and read some of your old posts about the three stages of adjusting and about your kite strategies. I am wondering if now would be a good time to post a refresher and maybe some new examples of the various ways one could consider adjusting positions and how to focus on Greeks when making different adjustments.

Thanks again for the great Blog and book. 

Scott

 Thanks for the suggestion.

My business is doing my best to help others learn about options – especially those in the earlier stages of their learning or trading careers.

Option trading is not mathematics. It is not an exact science. One problem I face is that when I express an opinion, some readers accept that as THE TRUTH. While that may be flattering, it's not my purpose. I believe in offering ideas that I'd like readers to consider. Obviously I believe each idea is sound, and is a reasonable alternative for the given situation.

When making such comments, I never know my audience on a personal level. Some readers are more sophisticated and can tackle more complicated ideas. Others are in position to seek higher gains and are willing to take greater risk to achieve their goals. Still others are very conservative traders who abhor risk.

The point is that it's difficult to give general advice that is appropriate for everyone. With that in mind, I'll tackle Scott's request.

Focusing on Greeks

is an intelligent method for reducing/eliminating specific risk. Good idea. The one aspect of option trading that separates it from all other forms of investing is that it allows specific risks to be measured.; You can measure delta (ok, so can any stockholder), but you also have the ability to measure the rate at which delta changes (gamma). You can determine the effect of time passage on the value of your positions, etc.

It's not so much a matter of focusing on the greeks and making specific trades related to the greeks that's important. Scott, if you look at your vega (or any greek) and let’s say you find that you are short 600 vega and that a 5-point jump in implied volatility will theoretically (the greeks provide an estimate of how the option prices will change; they do not provide a guarantee) make your position lose $3,000.

You can decide:

a) That's ok. The position can stand that much swing or perhaps, ouch. If the former describes how you feel, no vega adjustment is needed. If the latter holds true, then you want to buy some vega. It's not complicated. You could cover some short options, or perhaps buy a new positive vega spread.

b) Such a move is likely, so if 'ouch' is how you feel, you should take some risk-reducing action.  Or, you may feel that although it would hurt, it's so unlikely that you won't adjust.

You measure risk; then decide whether you want to take that risk or reduce it.  That's how to use the greeks.  It's not more complicated than that. When you have a good handle on risk, you are in position to take appropriate action.

Kites are too complicated for a review. At least not right now. I never finished all I had to say about them – because so much detail is needed.

I will say this about kite spreads. Any time you can own a naked long option at a cost that you deem acceptable, it does take a lot of risk out of a major market move.  But, it's not for everyone.

Examples

My basic premise on adjusting is that any one trade can illustrate what's possible. Almost any trade that reduces risk is helpful. For iron condor traders, that means reducing delta exposure, and perhaps reducing negative gamma and vega as well.

Examples are just that. There are always alternatives. Your individual needs and comfort zone boundaries often define how to adjust.

Let's say you traded 10-lots of a credit spread (or a whole iron condor) and the call portion is in trouble. With stock trading near 200, 15 points higher than when you opened the trade, you are short a 210/220 call spread that expires in 45 days.

If we take this as the given situation, some traders will object that they would never own this position unadjusted. They would have done something earlier, or say that 10-lots is too many (or too few). Others would say 'what's the problem?' The fact that such positions can be looked at as very risky by some while getting no more than a shrug of the shoulders by others already tells us that any 'examples' may be considered as unrealistic by the majority.

If adjusting a credit spread, iron condor, butterfly – any limited loss trade that has changed the position into one you are no longer willing to own, something must be done. The two obvious choices are to close or reduce. However, if you see something that turns the position into something desirable, then go for it. I don't know how to provide a list of possibilities that may appeal to any trader or group of traders.

A trader could buy calls or puts, buy debit spreads for delta, sell credit spreads for delta – but get even shorter gamma and vega. He/she could own calendars that widen where risk is now greatest. There is truly a large list of potential trades to help any position – depending on how you want to 'help' it. I use a limited number of adjustment trades in my repertoire, but each of us is limited only by our imaginations.

918
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Trader’s Mindset Series: Oblivious to risks

Here’s one of the most perplexing risk evaluations I ever heard (read) from a seller of naked options:

I was never in any danger. The stock was always higher than the strike price of the puts I am short.

This person was convinced that the only time risk must be considered occurs when short options move into the money. If the options were out of the money, and remained OTM, then the options would expire worthless and the seller would have a tidy profit.

I can’t argue with the 2nd sentence. Options that are OTM once expiration day has come and gone are worthless.

However, that mind-boggling first sentence is believed by more people than common senses would suggest.

Once of the basic truths about investing (even when it would be more truthful to refer to it as gambling) is that some people with little experience believe that it’s easy to make lots of money in a hurry. I don’t know why that’s true, but the fact that skills must be developed over time is a foreign concept to such believers.

photo:scopeformoney.com

Confidence that a current investment will eventually work out is common. Stocks decline and many investors like to add to their positions, increasing their risk in a losing trade. The mindset is that the stock only has to rally so far to reach the break-even point. For example, buy 1,000 shares at $50, then buy 1,000 shares at $40 and the beak-even is ‘only’ 45. Add another 1,000 shares at $30 and the trader’s mindset is that this stock will easily get back to $40, the new break-even price.

There is no consideration for the possibility that this company will soon be out of business. This investing newcomer just knows that his original analysis must be correct. This is the mindset of overconfidence. In a situation such as this, it’s also being oblivious to the real world.

The naked put seller

The put seller described above believes that being short an out of the money option is of no concern, as long as it remains OTM. He just doesn’t get it. The possibility of losing a significant sum is staring him in the face and he truly doesn’t recognize the danger.

I’m not suggesting that this oblivious mindset is common. However, as option traders we must be careful to avoid that mindset. I’m sure that every reader here understands the risk of being short naked options. However, being oblivious to other risks can result in a disaster. How large of a disaster? That depends on just how blind the trader is to the true risk of a position.

The spread seller

As an example, let’s look at a trader’s whose preferred strategy is to sell OTM put spreads, rather than selling naked puts. This is a common strategy for bullish investors.

Let’s assume that one trader correctly decides that selling 10 puts with a strike price of $50 is the proper size for his/her account. Even oblivious traders understand that the maximum loss is $50,000. They also recognize that the chance of losing that amount is almost zero, and that it is difficult to know just how large the maximum loss is. Sure, a stop loss order can establish that limit, but stocks have been known to gap through a stop loss, leaving the trader with a much larger loss than anticipated. The ‘flash crash’ was an extreme example of how bad things can get.

What happens when this trader decides that selling naked puts is no longer the best idea and opts to sell 5-point put spreads. Each spread can lose no more than $500 (less the premium collected). The problem arises if the trader, not understanding risk, decides that selling 100 of these spreads – with a maximum loss of (less than) the same $50,000 – is a trade with essentially the same risk.

When a trader is not paying attention, he/she can become blind when the total money at risk is similar for two different trades. It’s easy to incorrectly believe that risk must be similar. In this example, two positions have vastly different risk.

Position size and probability

The trader whose mindset includes being oblivious to reality, is either unaware of statistics or ignores them. The big factor here is probability. There is a reasonable probability of incurring the maximum possible loss when selling 100 (or any other number) of 5-point credit spreads. Depending on the strike prices and the volatility of the underlying, the chances of losing it all can be near near zero to almost 50%, depending on the strikes chosen. Let’s ignore the ‘near zero’ examples because the premium available when selling such spreads is tiny and no one should be trading those on a regular basis.

However, when the chances are one in five, or even one in 10, you know that such results are going to occur (on average) every five or ten months. It takes some good sized wins to be able to withstand those losses. But the truth is that the trader who is not aware of the difference between the chance of losing $50,000 no more than once in a lifetime vs. losing that amount at least once every year has no chance to find success.

One important aspect of risk management is understanding how likely it is to collect he profit or incur the loss. The size of that profit or loss is not enough to tell the whole story.

Please do not be an oblivious investor. Please understand risk and reward for every trade, as well as for your entire portfolio.

914
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Why Trade Options. Part II

Excerpts from an excellent post from Sean (the minimalist trader)

Breaking News: Markets are risky.

Ok, you knew that. You wouldn’t be here if you weren’t already permanently scarred by a bad beat at least once in your career.

Today, a new element of risk has been introduced via market structure. The May 6th flash crash was the first headline advertisement for what surely has become a topic on every active traders’ mind. Stories proliferated around that time of traders who got blown out on that day, and investors who’s way-out-of-the-money stops were triggered, only to watch their stocks swiftly rebound to a more normal price. And even to this day, it seems at least once a week some random stock has its own mini flash crash as a result of some computer gone haywire or a cascade of triggering stop orders.

Traders and Investors are rightly concerned about this, and some are downright scared. It puts many of us in awkward positions. We all know we should trade with stops firmly in place, but in this new marketplace it seems putting a resting stop order on the books is practically an invitation for some HFT [High Frequency Trading] stop-sniffing algo to hunt it down and force its execution. So do we then just put in mental stops? Seems like a logical jump, but that method is fraught with all kinds of its own headaches: What if I’m not at my desk when the trigger is hit? How do I exit? What if I’m frozen in a panic-stricken trance? It happens. Believe me.

For all these reasons and more, this is why I trade options and why I think options trading should become a bigger part of your trading arsenal.

Options trading has always been a useful tool to express a market opinion.

I utilize them because I can define risk. This is especially important when taking speculative, risky, or news-driven positions. This is simplicity in managing risk. And this is why I like options and feel that options are an essential tool for any Minimalist Trader.

Sean’s fears are very realistic. We’ve seen the system break down, and although I’m more confident than he about it the severity – the next time it happens, there is no way to be certain.

Just one more reason for using options.

Stop orders

Continue Reading →

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The Stretched Collar, Again

Thanks Mark for your prompt reply. After reading two of your books and this blog, I must say that options trading is becoming less scary and more appealing to me, so thank you.

Amir, “Less scary” is very good. But please do not become overconfident.

I’ll explain my logic regarding my second question – buying longer term put option (6 month for example) and selling monthly call option against it in a collar strategy.

I trade index futures, Emini S&P (symbol: ES) and Emini Nasdaq (NQ). The CME provides margin discounts for Inter Commodity Spreads

I believe that the Nasdaq will outperform S&P – so I’m long 2 NQ and short 1 ES (that’s my “portfolio”). Now lets add the options to the soup as follows:
Sell 2 OTM CALL (NQ)
Buy 1 OTM PUT (NQ)

The credit from selling 2 calls will cover the cost of the put.

I need a bit of clarification. I assume you mean that after selling the calls every month for for six months, you will collect more than the cost of the put. Or, are you telling me that you will collect that much the first month?

Does the basic risk as you explained (the very expensive put loses so much money, that it kills my whole play) apply to this situation too?

If the market drops, 1 Emini Nasdaq contract is protected by the put option and the second Nasdaq contract is hedged via the short Emini S&P contract (value of 1 point NQ is $20; value of 1 point ES is $50).

What do you think? can it work?

Thanks again

Amir

***

Hello Amir,

When replying to reader questions, I don’t know anything about the trader. Sometimes I receive very sophisticated questions from someone who doesn’t understand what he is asking. At other times, I must be careful not to provide a rookie answer to a more sophisticated trader. It makes it difficult.

How long have you been trading? Have you been using options for a few years, or are you in the very early stages of learning? I ask because you are not using an ordinary strategy.

This question is difficult to answer. Many factors are in play. If you are a rookie, I would tell you that this is too complex and that you should get your experience with a simpler approach. On the other hand, if you are an experienced trader with experience trading this setup, then I’d be encouraging you to continue.

***

Almost anything ‘can’ work

The question is whether this (or any other) play has an appealing (to you) risk/reward profile.

I’ll offer comments. Use anything that’s appropriate and discard any ideas that don’t apply to you.

This position feels delta short and would not do well in a rally. The collar trade that you appear to be emulating performs much better (than this trade) when the market rallies.

1) I assume you understand the vega risk of this position. You own lots of vega from that long-term put. If the market rallies you would be in trouble. Let’s look more closely.

a) This position is naked short 1 ES contract. Yes, it appears that you own 2 NQ minis, but by writing covered calls, the upside is limited. There is nothing worse than being naked short calls (or stock or futures) in a big rally.

b) You are short 2 NQ ITM puts (equivalent to the two covered calls). Those will make good money on the upside, but the profit potential is limited. It is not enough to offset the naked ES short – on a big up move.

c) Owning an OTM, longer-term put would not only lose money on that rally, but the likely IV crush translates into an even larger loss. True you sold two shorter term options (you may look at them as either the covered call, or the naked put) – but that single, long-term put option has more vega that these two options combined. That is not good on the upside (and it’s not so good on the downside either)

The upside is risky

I understand that the delta of this position depends on which specific options that you traded, but this feels short. If it is neutral, it would become short quickly due to negative gamma.

2) What I do not like about that play is that you do not know where the market will be when it’s time to sell the next round of calls. I know that it should not matter because once expiration has passed, wherever the market is as that time, you are long 2 NQ and short 1 ES and that you can afford to write to call options. But that put option makes a big difference.

What if the market moved higher, that put is now farther OTM and offers less protection. In fact, it may soon become nothing more than disaster insurance.

That’s not a realistic collar – because the put is supposed to provide good protection because it is not far OTM. In your trade, that long put is a play on volatility. You are depending on a big IV increase to protect the value of the portfolio. Most collar buyers rely on gamma – or the fact that their long options gain delta very quickly when they move ITM.

It’s acceptable to trade vega for gamma, but it is far from riskless. I get the fact that theta is on your side and everyone loves positive theta. however, its buddy, negative gamma is where the risk lies. This position requires careful handling and adjusting if the market continues to move higher.

How far OTM is too far OTM for you? At some point you may be forced to roll that put to a higher strike? When would you make this trade? How much cash are you willing to invest? Whatever you decide, write that sum into your trade plan so you can remember to do it when the time comes.

It’s difficult to gauge such costs when you would must estimate a market level and an IV level to estimate the cost.

3) Yes: In this play the 6-month put loss could make this whole play a loser. As already mentioned, you have upside risk outside that put.

Use ‘what if’ software to examine the value of the portfolio at different prices, IV, and dates. There is no need to make this into a guessing game. You can gauge risk/reward and see where your risk lies much better if you take a look at some possibilities.

4) The downside appears to be better.

a) 2 NQ vs 1 ES ought to be a reasonable hedge – when we look at the $20 per point vs. $50 per point comparison. If NQ does not decline by more than 50% as much as ES, you are in good shape. Please remember that NQ is far more volatile than ES, and I don’t know whether 2:1 is the right, market neutral hedge. If you get the hedge right, then you will prosper if NQ outperforms.

b) You own a naked put option. That’s good in a decline.

c) You are long vega and that should be good, but not always. When IV explodes during a violent market, it’s the near-term options that explode the most. In other words, the big IV increase provides a good bonus for the price of your long put, but it’s possible – depending on time to expiration and just how much the IV jump in the front-month options exceeds that of the longer-term option – that you can lose money from the IV surge.

I recognize that you are short front month calls, and not puts, but they may not decrease in value (as the market falls) by enough to do contribute to the portfolio value. Against that naked put, you own 2 NQ vs being short 1 ES, and this is a bearish play.

One more point. This is a convoluted trade and I may not be correct in my analysis. If you want a collar, I think you should trade a collar equivalent (sell a put spread).

I am not comfortable enough with my analysis to give you advice. It just feels to be a bearish trade. You must run the risk graphs, and your broker may offer suitable software. Ask. The computer will give you a much better picture of risk than I can.

If you do that, I’d like to see one of those risk graphs.

902
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Buying fair valued options

I have a question, another options book I just read talked heavily about the theory of options pricing in the context of Black Scholes. If options are priced “fairly” based upon expected value (log normal distribution of expected price range based on volatility, etc), why do most call buyers lose money and the option writers are generally more successful?

Thanks,

Terry

***

You make the reasonable qualification: “if options are priced fairly”…But, that is not reality.

Options tend to be overpriced

When we calculate a ‘fair value’- it is based on the prediction that the stock will be as volatile as the estimate used in the calculation. We are forced to make an estimate or else we cannot use the formula to crank out option values.

Looking back, history tells us that index options have been priced higher than actual realized volatility, and options traded above ‘fair value.’ This is true for indexes – I am not as certain about individual stocks. Nevertheless, when buyers pay too much, they are not likely to win.

When buying options it is so difficult to earn money on a consistent basis. Besides worrying about overpaying for the options, the buyer must get the timing correct. With options being a wasting asset, if it takes too long for the move to occur, there may be no profits to be earned.

The direction must be correctly predicted. Obviously buying calls is not going to be a winning strategy if the stock moves to the downside.

The move must be large enough to overcome time decay and the premium paid. Many times the stock moves in the correct direction – and moves quickly. However, if the move is not large enough, the option price may barely budge.

Buying options with the expectation of making money is a game that must be left to those traders who have a strong track record that proves they can predict both direction and timing. They must win often enough to overcome the many times when one or both of those predictions fails to come true. It’s my opinion, not a proven fact, that the vast majority of traders would be making a smart move by not buying individual options.

Option sellers have so much less that can go wrong, so they WIN far more often. The problem is that losses can be enormous and it’s up to the trader to prevent big losses. The best method for managing risk and limiting losses is to sell an appropriate quantity – and not look for a huge win on a single trade.

The 2nd best method is to avoid naked selling. Sell spreads instead.

In other words: manage risk and don’t get cocky as a premium seller. Premium sellers win often, but not often enough for many to walk away as winners. Failure to manage risk properly dooms them to failure. Why? It’s the size of the losses that determines their overall success/failure. And I can assure you that no matter how long your winning streak, it will come to an end when something unexpected happens.

Coming April 1, 2011

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