Writers & Readers have Responsibilities

One of the frustrating aspects of teaching via the written word is the difficulty in holding a meaningful real-time conversation with readers.  I receive email with well-reasoned questions, however, sometimes an email message demonstrates a complete distortion of my words. 

I want to know how certain conclusions were reached, but additional correspondence seldom clarifies the issue.

From a recent email: "when I really understood the PUT CREDIT SPREAD, I had difficulty sleeping at night."  That spells trouble.

He concluded the following from my words:

  • "It seems too good to be true" 

  • "Earning 4 to 5% a month is almost certain"

  • "It's 'safe' to say that AAPL (last: $241) will not reach $200 in one month"

  • "If I play the APPL 190/200 or 200/210 range for next
    month expiry, it seems quite safe"

I don't understand the source of any of those conclusions.  I always mention that these trades are not safe.  They may be safer than selling naked puts, but that hardly translates into 'safe.'

I looked at the option prices for Sep expiration, currently three weeks away (when the email arrived).  APPL Sep 190/200 put spread can be sold @ ~$0.15 and has  a 95% chance of expiring worthless.  This is safe to sell?  Not in my world?

How does he expect to earn 4-5% from this trade?  No mention of that.

Next, I looked at the October 190/200 put spread.  This spread is in the correct price range and a seller should be able to collect $55.  If it expires worthless, the gain will be ~5.5%.  This is a two-month play, and does not meet the 4-5% 'safe' return.

This trade has a 92% probability of expiring worthless. Remember: that ignores  the trader exiting early due to risk.  That is not 'safe.'  Make this trade 6 times in one year, and the chances of winning all 6 times is: 60% – for a gain of $55*6, or $330.  That means the  trader will lose money at least once (and possibly twice) in four years out of 10. And those losses could be as much as $945 each.

That is not safe. It's not even profitable.

If this is the trade he wants to make in an attempt to earn 5+% from now through October, that's his business.  What he does not understand is the potential loss, coupled with the likelihood of taking that loss, makes this a poor trade. 

For the record: I never suggest selling credit spreads for small premiums and always tell readers that front-month trades are too risky for me. Thus, he did not get any of his conclusions from me.

I've come to like this man, and truly want to help him get over his blind spot, but I cannot successfully communicate with him. It's my responsibility to present information in an easy to understand manner (and other readers tell me that I do that very well), but it is his responsibility to read carefully and not jump to conclusions. 

Each person has his own adjustment point (but it's never in a panic for the trader who has emotions under control), but beginners panic too quickly and overconfident experienced traders often adjust too late.  Risk management and trading skills must be learned.  They are not inborn.

ADDENDUM:  I heard from him again, and he tells me he is thinking of taking out a home equity loan to make this play in large size, and that he plans to use his IRA to do the same.  I must conclude that this is someone pulling my leg.

He states that these spreads have "zero possibility of losing."  In other words, 'free money.'  And why do they have zero chance to lose money? Because one broker (using bad data) told him that the puts he plans to sell have zero delta.  

I feel so sorry for my correspondent and have no idea how to help. 


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8 Responses to Writers & Readers have Responsibilities

  1. rick forno 09/01/2010 at 6:20 AM #

    “when I really understood the PUT CREDIT SPREAD, I had difficulty sleeping at night.”
    This person put on a trade w/o understanding how it worked? *facepalm*
    But yes, based on your addendum, I think this person is being funny. Or else is in a world of their own and beyond your ability to help steer them right.

  2. Vince H 09/01/2010 at 7:09 AM #

    I agree it does sound like the guy is pulling your leg, but the truth is if he isn’t, well then this just may be one more example of evolution at work. Taking our IRA and home equity and rolling it into any investment you’ve just heard about strikes me as Mother Nature’s way of telling you that you’re just not bright enough to have extra money.
    As my father used to say, sometimes “stupid” is terminal.

  3. Marty 09/01/2010 at 8:54 AM #

    Hi Mark,
    I don’t want this to sound nit-picky, but when you mention the probabilities of playing a vertical (or any spread) repeatedly it brings up something I’ve wondered about before. If the spread in question has a P of 92% and you repeat the same spread (same P value) 5 additional times, how would that result in a 60% probability of success long-term?
    It’s sort of a rhetorical question…I understand the formula you used is 0.92^6 = 60%, but that’s the Gambler’s fallacy/Hot-Hand fallacy is it not? In other words if I were to flip a coin (which has a single event probability of 50% heads) 9 times and get all heads, the 10th flip still has a single event probability of 50% heads. Whereas the gambler’s fallacy says I have only a 0.5^10 = 0.098% chance! And if someone was watching the first 9 flips and offered me 1000:1 odds (or even 10:1) that I couldn’t flip heads again, I’d take that bet all day long. The coin has no memory.
    Perhaps options are different somehow since I see nearly everyone use the same logic to argue against placing this kind of low-return, high-probability trade as an income strategy? Do options have “memory”?

  4. Mark Wolfinger 09/01/2010 at 9:38 AM #

    His messages did NOT have the feel of someone who has already placed the trade. Just anxious.
    Trying to convince him that paper-trading come before mortgaging the house!

  5. Mark Wolfinger 09/01/2010 at 9:50 AM #

    I like your dad’s slogan.
    Evolution at work. The Darwin Effect.
    I hope he is just thinking about trading and has not yet pulled the trigger.
    Thanks for sharing

  6. Mark Wolfinger 09/01/2010 at 10:10 AM #

    Good discussion.
    Will post a reply as soon as possible. Today

  7. rluser 09/01/2010 at 10:44 AM #

    Perhaps the “at least once” is overstating the case, but the 60% to win “all 6 times” is dead on. Natural language is poor for discussing statistics, but I read this as saying for unmanaged (set and forget) trades this has an expected value of $180 loss per year.

  8. Mark Wolfinger 09/01/2010 at 10:55 AM #

    I have made no effort to quantify the size of the losses, but you reached the heart of the matter: There is a negative expectation when playing this game.
    And that is something my correspondent cannot yet visualize.