Finding the ideal trade strategy

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Mark,

A follow-up question.

I guess the reason I was looking at this comparison (buying collars, buying call spreads and selling put spreads) this morning, is because I was looking at various limited risk bullish positions.

I concede that the following thoughts may not be well directed, nonetheless …

I noticed that in a typical bullish spread, the position has a break-even point that is roughly equivalent to the position’s extrinsic cost above the base strike. For example, to buy a 35/36 call spread (as of last Wed), with DBA at 34.90 would give a break-even around $35.50, which is about the same as the extrinsic cost of the position. So, to profit, the underlying has to move by more than .60 by expiration.

I also note that when one buys stock, there is no extrinsic cost and the break-even is the same as the price paid for stock. For example, if it goes up a penny by expiration, the buyer profits a penny.

Basically, the question I want to ask you is: Are there any option positions that can act like something in between these 2 examples?

For psychological comfort reason, I’m interested in a break-even trade – like buying stock – and limiting maximum loss to that of buying an OTM call spread. I’d trade-off something else in exchange for that.

One idea to accomplish this is with a collar. Instead of buying 100 shares only use 90,80,70,60,or 50 shares. I’d lose delta and compromise the upside protection, but I would meet my objectives. Plus, I could buy cheap FOTM put options as black swan insurance. Maybe this approach just makes sense for low $ stocks.

Crazy? Is there a better way to achieve objectives? Are objectives misguided?

Dave

***

Hello Dave,

The simple answer is no, there is no such animal. The reason is that you want the very low cost of an OTM option spread, but you want to buy it by paying no premium. That’s why the collar looks so attractive. You can buy puts and sell calls for little, if any cash out of pocket.

People choose to buy call options as a replacement for owning stock for two basic reasons. The first is leverage, allowing a small amount of money to be used to control stock and benefit if and when the stock moves in the right direction – before the option expires. The other, and more important reason in my mind, is to gain the benefits of reduced risk (after all, the stock may undergo a steep decline – even when you are bullish). The trader must pay for that protection (it’s the same as buying a put: long call is equivalent to long stock plus long put). You want it for no cost.

However, if you are willing to come along as we think outside the box, I believe I have a workable idea.

Thinking differently

It’s good that you are willing to trade something in return for what you seek. You want so much, that the only thing you have left to ‘trade’ is the sum you can earn.

To begin, consider selling an OTM put spread. We both recognize that it is the equivalent of a collar, but this time you are using lower strike prices than that of the ‘traditional’ collar (often both the put and call are OTM).

First, this trade can provide a profit, even if the stock declines (at expiration) down to the first OTM put strike price. So you are already better off than your first requirement that a profit be available if the stock moves higher.

Second, this trade limits losses. The problem is that the potential loss is greater than you could lose by buying an OTM call spread. However, here’s that trade-off you were willing to make:

  • Instead of selling (for example, 10-lots and collecting $1 for a 5-point spread)
  • Sell only 3 or 4
  • The maximum gain is reduced from $1,000 to $300 or $400
  • The probability of earning a profit is much higher than when buying stock
    • The stock does not have to move higher to earn money.
  • Loss is limited to $1,200 or $1,600
    • You control that maximum loss by the limiting size of the trade
    • You control that maximum loss by exercising sound risk management
    • Just as you would (I hope) sell the stock to limit losses at some point, so too do you limit losses by adjusting or closing the position, when necessary

You make that trade-off, which is reduced profits. Your losses are limited. You may earn money when the stock declines. What’s not to like for the bullish trader who is willing to accept limited profits in exchange for the specified benefits?

If you prefer, you can be more bullishly aggressive and sell a put spread that is ATM or even a point or two ITM. That reduces the chances of winning, but the maximum loss per spread is reduced and you can sell more than 3 or 4 of them.

No your objectives are not misguided – they suit the specific investor. However, not all objectives can be sought because it is not always possible to find a strategy that meets all of your requirements.

3 Responses to Finding the ideal trade strategy

  1. Mauro 02/07/2011 at 7:18 AM #

    Hey Mark,

    The recent months i’ve learned more about the B&S formula.
    The price of an option is derived from his probability and his reward (which is based on the normal distribution). So with an ATM option we will make money on 50% of the time and lose money on the other half. With an OTM option we will lose (for example) 75% of the time and win 25%. On the long run we will make no money or loss money.

    This starting point is of course only correct if we agree that the market moves randomly and the options prices are fairly priced. And we must believe this, otherwise we can’t rely on the calculations of the B&S formula. The theory behind the efficient market hypothesis as well as the B&S formula depends on markets being unbiased an unknowably random.

    So then any option or combinations of options will break even over the long haul.

    If we cannot predict the future, there is not any one strategy that is preordained to make money. Is it correct to say that the only manner we can make money is if we can forecast the futures volatility and buy of sell mispriced options?

    *English is not my mother tongue, so perhaps i’ve made some mistakes.*

    • Mark D Wolfinger 02/07/2011 at 8:44 AM #

      Mauro,

      If, in the long run, in you make the identical trade, under the identical conditions an infinite number of times, then the buyer and seller each break-even. Each trader will be behind by the cost of making the trades.

      However, that requires that the options be trading at fair value and that the volatility estimate used to determine the fair value of an option proves to be accurate. It also requires that the buyer/seller can get that fair value when making the trade.

      But that’s impossible. You cannot get fair value. If we knew fair value, the market makers would bid a bit less and offer a bit higher and no one would be able to trade at fair value.

      However, you are not going to live long enough to face the identical situation an infinite number of times. In fact, it’s likely this next trade will never be duplicated, with everything else being identical. When buying options, you must still get direction, timing, size of move correct. And you must not overpay for the options. To me that means buying options is a poor strategy choice.

      Mauro – we do not agree that options are fairly priced. They are not fairly priced, but the calculations made by using the Black-Scholes formula are ‘accurate’ as far as they go. Enter data, get calculated results. No errors there.

      However, this is not the best formula, nor the most accurate. Refinements have been made and other models are preferred.

      The point is that we cannot rely on these simple models unless we have complete confidence that the volatility estimate will prove to be accurate. History on index options tells us that volatility estimates have proven to be too high.

      Trading mis-priced options is to our advantage. If we are willing to wager that they are indeed mis-priced. But no, there are other ways to generate a trading edge.

  2. Mauro 02/07/2011 at 9:10 AM #

    Thanks for the reply, it is very useful !