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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9 Responses to Danger: Using one trade to finance another

  1. Tristan Grayson 04/18/2011 at 7:47 PM #

    Hi Mark,

    Thanks again for your time and energy on this thread. I will attempt to clarify.

    In Step 1, I am not suggesting that a trader actually buy a put or buy something that is not understood. I am walking through the thinking and learning process, not suggesting actual trades.

    In Step 2, again, I am not suggesting actually trading without understanding, but I’m describing the learning process.

    Regarding Step 3, when I read Mr. X’s quote, it seems like he is describing selling the lower put to finance the original trade. I am agreeing with you that it may perhaps be foolish because it removes the Black Swan protection as you describe. The reason I call this ‘progress’ is because understanding ideas sometimes requires intermediate states that are not true / not good ideas, but just stepping stones to better understanding.

    In Step 4, you are right that selling a put doesn’t necessarily mean that you’ll definitely buy stock at that price, but that is possible if you get assigned if you’re unable to cover the put for some reason (i.e. coma risk). What I’m trying to point out in Step 4 is that selling the lower put removes the Black Swan protection (as you mention) and if the trader actually wants the Black Swan protection, they should not get funding by selling this lower put, but perhaps they could think about funding via some other method, like perhaps selling a put on another instrument that they’re already considering.

    You mention “this trader does not seem to be someone who has any interest in buying any stocks…” — I wasn’t talking about any specific trader. I’m just saying that if the trader was already intending to sell puts on other stocks, that could help fund. I didn’t even know that we were talking about a specific trader with a profile as specific as you’re describing.

    Mark, I am very confused by your deeply personal assumptions/accusations when I read your end section. I am the most conservative trader I know, with small position sizes, no use of margin/borrowing, and only selling options and you’re telling me that I’m going to start using margin and blow up? I don’t even do the financing strategy described, but I thought it would be beneficial to discuss the idea to further my understanding of whether it was a good or bad idea, or under what circumstances, etc.

    Thanks.

    • Mark D Wolfinger 04/19/2011 at 7:08 AM #

      Tristan,

      If you believe that I thought that you were the trader described by your 4 steps, then I humbly apologize for ‘personal assumptions.’

      I don’t understand how it is even a remote possibility that you believe I made that connection. These trades appear to be randomly chosen and they have nothing to do with you. It was clear (to me) that this was an imaginary trader

      I’m sorry you were hurt.

  2. Kamal 04/20/2011 at 8:49 AM #

    Mark,

    Just a thought on a tangential.

    Rather than getting into these combinations like Collars, Spreads, etc., is it not simpler to go in for naked selling ?

    (Simpler meaning easier to monitor & to get out accordingly in case the trade doesn’t progress as we estimated)

    When I believe, after proper analysis, that the market is going to move up (Or down), then what if I sell reasonably far OTM Puts (Or Calls) ? All these, with full acceptance of the fact that, inspite of our analysis market can go anywhere it likes (Or doesn’t go) and accordingly I get out of my trades in case they don’t move in the direction of my profits.

    Is that too radical & risky? Because most of the stuff I read caution me against naked selling. But I am not sure this has to be that way, for someone who is ready to jump out, the moment the trade doesn’t progress as expected.

    Kamal

    • Mark D Wolfinger 04/20/2011 at 9:51 AM #

      Hello Kamal,

      Yes, it is much simpler to sell naked options. It is also much simpler to jump off a tall building without bothering to set up the bungee equipment.

      It is not too radical. As far as ‘too risky’ is concerned,surely you know that is a person opinion. It is too risky for me. However, if you allow for a large loss – and especially if you do not get greedy and sell an appropriate quantity of options – just so that you do not get destroyed if the inevitable, but still unlikely to happen in an given time period – occurs, you will survive with an acceptable loss. That’s the tricky part. This strategy is so profitable when it works that it is difficult to trade smaller size.

      The problem with being ready to ‘jump out’ is that it is an essential, but not sufficient, ingredient. What about the bad/good news event that results in a 30% gap change in the stock price? This is the risk that should concern you. Not so much your discipline in exiting.

      I’m not saying: don’t do it. I am saying size the trade carefully.

      Regards

  3. Kamal 04/20/2011 at 10:38 AM #

    Thanks Mark.

    This nails your point very effectively: “It is also much simpler to jump off a tall building without bothering to set up the bungee equipment.” That scares me !

    Not in the context of an explanation, rather recalling what I missed out in my mail:
    1. I trade single lots
    2. I trade only Index Options. Not into individual stocks ever so far. I guess this doesn’t make any difference in the context my original question and your subsequent answer. May be, can I say the cases of gap opening might be reduced ?

    Although I am able to understand, but have difficulty digesting this: “This strategy is so profitable when it works that it is difficult to trade smaller size.” Though it is too early about the ‘profitable’ part of it in my case, because I am about to enter into my fourth year of trading without breaking even because my efforts were not focussed and methodical in my initial year (s), but of late I am able to see an appreciable difference in my ‘profitablity’. Its only when I don’t ‘jump out’ of a trade, due to HOPE (Its a four lettered word), then my profitability part of it goes for a spin. Hence, I do frequently ‘jump out’ too early, thereby have quite a lot of trades with small losses, but occasional ones with good profit.

    Kamal

    • Mark D Wolfinger 04/20/2011 at 10:56 AM #

      Kamal,

      Yes, gaps are less frequent for indexes than individual stocks, so that adds a bit of safety.
      However you can trade one-lots for two reasons
      a) That’s the right size for your comfort zone
      b) That’s all you can afford when trading a small account.

      If b) obtains, then you must be careful. You may (I cannot answer this for you) feel safer trading 6-9 lots of the corresponding ETF instead of the big index. I don’t like that for two reasons: Higher commissions and expiration occurs almost one whole trading day later.

      Regarding exit points: You must find a way to manage risk effectively. If getting out early is what you have to do, then so be it. I would never tell you to hold out a little longer becasue that is the start of a very slippery slope.

      I do have two suggestion that may work for you:

      a) The obvious (and not my true suggestion) is to try selling spreads. It will give you more staying power and limited losses.

      b) But this idea may work for you:

      When selling a naked option, you collect a nice pile of cash. I don’t know when you exit, but you may want to consider setting a profit target. If you sell an option and collect $400, $800, or perhaps $1,500 – you don’t need much time to pass before you get some good decay (I would not be trading 90-day options if I were using this strategy.) Perhaps a target profit of 25 to 50% is sufficient.

      I say that because it would mean that you are out of the market at least 25% of the time. [In general, all else being equal, you can expect to collect half the time premium when 75% of the original time has elapsed]. You cannot get safer than not holding any positions. Enter 4-5 weeks prior to expiration and be ready to take a’ nice’ profit when it becomes available.

      That is not how most people trade, but it does combine more safety with a risky trade strategy.

  4. Kamal 04/20/2011 at 12:16 PM #

    Thanks for your inputs Mark.

    Since I happen to be in India, we don’t have the option of trading Options on ETF. Though we can buy and sell ETF directly, there are no Futures or Options based on those Index ETFs.

    When you say, “Perhaps a target profit of 25 to 50% is sufficient.”, do you mean 25 to 50 % of the money collected by selling those options? Or did you mean something else ? May be time?

    I don’t set a profit target; rather I exit, when there is either a loss that begins to hurt (This can happen in the immediate week of my entry, if market & my analysis don’t align) or when the market begins to move against my position (This normally happens, sometime after my entry. I continue to hold, as long as the market moves in my favur or as long as it stalls somewhere; I exit only when it moves against) Please note I trade Options that expire in the near month ( 1 – 30 calendar days) or next month ( 30 – 60 days).

    Kamal

    • Mark D Wolfinger 04/20/2011 at 2:05 PM #

      Kamal,

      My pleasure.

      I was referring to the premium collected. Rather than seeking 80 to 90% and holding for a long time, seek perhaps 50% and you can exit more quickly. It’s just one way to reduce the amount of time that you are exposed to market risk.

      Each of your exit decisions is reasonable and should keep you out of big trouble (barring that gap).
      However, I suggest you consider setting an additional exit point: I would not be happy (for you) to learn that you sold an option, collected $1,000 and refused to buy it back @ $20 just becasue the market was moving your way. There should be some point at which the additional profit potential is just too small to take any risk. You have to define where that point is.

      You seem to have things under control.

  5. Kamal 04/20/2011 at 2:24 PM #

    Thanks a lot, Mark, that was really motivating & inspiring.