Learn First. Trade Later

I received this very upsetting note yesterday.

Dear Mark,

I read in your book about volatility as one of the important factors of the price of an option

I have a few question about, what you wrote.

Implied Volatility vs. Future Volatility

1) In your book you say that volatility is unknown and different traders can get different values… but I have account with 3 brokers and they show the same (or very similar price) for the volatility…

Future volatility is unknown. However, the market makers must make some volatility estimate or else they would be unable to establish bid and ask quotes.

Your brokers are showing the IMPLIED VOLATILITY (IV) OF THE OPTIONS. They do not make estimates for the future volatility. They use the implied volatility because that is the best current estimate for future volatility. And that estimate changes, depending on many factors, including order flow (supply and demand).

IV is often the best value we can use – unless you want to make your own estimate – and I doubt you want to try that.

By definition IV is the volatility estimate that makes the fair value of any option equal to whatever price it is trading at in the marketplace. I was writing about people who make their own volatility estimates. They are the ones who cannot agree on what the volatility estimate should be and they are the traders who have different opinions on the value of an option. Those are the traders who could believe an option to be over- or under-valued in the marketplace. Not the brokers. They do not have an opinion.

You will probably never make an estimate, but others can and do. You and I usually trade based on the assumption that the current IV and the current option prices represent fair value. But we can decide to go longer short vega, based on the current ‘fair value’ if we believe it is too high or too low. You can trade volatility if you so desire.

Selling Leveraged ETFs Options

2) Since a lot of volatility, means that I can sell “expensive” options, doesn’t it make sense to sell options on Leveraged ETFs, such as FAS or FAZ, that have a lot of volatility?

NO. If the underlying asset is VOLATILE then the underlying asset will undergo big price changes. If you sell options on stocks that make BIG MOVES, there is a good chance that the options will move ITM and that you will lose money. To compensate for the risk of selling options on volatile stocks (or ETFs), the options are priced higher. In other words, you get a higher premium, but that premium is justified.

Your question frightens me.

The pricing of options is a very basic concept. It may not be easy for us to know whether an option’s price is fair, but we have to accept the fact that the option premium that we see is the premium we can trade. If we choose to sell that premium, we do so believing that we have an edge.

Volatile stocks have options with a high premium. Non-volatile stocks have options that carry much smaller premium. Surely you know that is true.

When the stocks are volatile, option buyers are willing to pay higher prices because there is a decent chance the stock will undergo a significant price change that favors the option buyer (assuming he correctly bought puts or calls).

Low-volatile stocks trade with much smaller premium because they are not likely to move far. People do not pay much for options when there is a high probability that the stock price will not vary too much during the lifetime of the option..

You must understand this. There is no way you can survive if this concept is not understood. Selling high-priced options because they are high-priced is foolish. The options carry a higher premium for a reason.

What we want to do – and it is quite difficult – is to sell options when the implied volatility is higher than the future volatility of the stock will be. In other words, option buyers are paying for future volatility of the underlying. If that underlying asset is less volatile than expected, then we collected more premium than our risk deserved. Thus, we stand to profit over the longer term. But we do not know the future and we do not KNOW which options are priced too high. The bottom line is:

It is wrong to believe that you can earn more money by selling options on volatile stocks or a leveraged ETF.

You cannot trade options if you do not understand this principle.

and last question

Should I Use Portfolio Margin?

3) Do you think that a “portfolio margin” account, with more leverage, is a good idea? I would use all the leverage to sell options with 95% or more chance to expire worthless (and with the 5% I either get assigned, or roll out). Is this plan too risky?

Portfolio margin allows traders to take a lot more risk. Reg T margin is far more limiting. I prefer Reg T margin because it removes the temptation for a trader to get in over his head. Yes, a lot more risk.

If you are positive that you can handle the risk; if you are certain that you will NEVER, EVER allow yourself to have too much exposure to a big loss; if you are already a consistently profitable trader; if you are disciplined and will not use all available margin (above, you suggest that you would use all available leverage), or anywhere near all of it; then maybe you can use portfolio margin. But not now. Not if you do not understand the most elementary concept mentioned above.

Let’s examine your question. You want to sell 5-delta options and expect to win 95% of the time. You plan to roll out or accept assignment on the 5% of the trades that end up with your short option being in the money. If that is true, then the plan is to hold all shorts until they expire worthless. All by itself that adds to risk. Some of those short options will be worth covering before they expire – just to minimize risk.

You also must understand that you will not win 95% of the time unless your plan is to hold through expiration and not apply any risk management. But if you plan to roll out some trades that are not working, that already tells you that the 95% success expectation is just too high.

Many times you will get too frightened to hold the trade and be forced to cover because even rolling out will leave you with a dangerous position.

Consider this: You will not like the size of any loss. When you sell an option at a low price, it becomes very difficult for the undisciplined trader to pay 10 times as much to cover the short. Rolling out will not help. If your plan is to roll to a new 5-delta option, that will be a costly roll. If you plan to roll out for even money, then the short option will have a delta much higher than 5, and you will be taking more risk than your plan calls for. Please consider all aspects of your plan before taking action.

So will you do it? Will you have the discipline to cover your shorts and lock in a good-sized loss? If the answer is not ‘ABSOLUTELY, YES’ then you cannot afford to use portfolio margin. Nor can you expect to make money by selling 5-delta options. That strategy is viable only for the disciplined (and experienced) trader. In my opinion, selling those low-delta options is not a good plan.

There will be a day when those 5-delta options KILL you. It will not occur too often, and it will not necessarily come soon, but that day will arrive. There will be a big gap opening with a huge IV increase. There will be a day when those options you sold for 40 cents or one dollar will be trading at $20. At that point, the option’s delta easily could be between 35 and 60. Your account will be in deficit and you will be forced to buy back all of those options and your account will be worthless and you will owe your broker hundreds of thousands of dollars.

If that sounds bad, the reality is even worse. The bid ask spreads would get very wide and your broker will buy those options by entering market orders. They will not ask your permission. You would be blocked from trading and your positions would be closed. Thus, you would not only pay that exorbitant implied volatility, but you would pay the ask price on a wide market. See for yourself. Lower the underlying price by 20%, double IV and see how much those options are worth And doubling IV may not be enough. IV is so are low right now that tripling of IV is a reasonable possibility.

DO NOT DO THIS. No portfolio margin, and more importantly, if you do sell 5-delta options, you MUST watch position size. That is most important. I know that you do not want to believe that these warnings apply to you. But they do.

I wish you well. But you scare me.

Mark

Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.