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Bullish Short Strangles
Jesse posted a article in SteadyOptions Trading BlogMy investment philosophy is built upon harvesting risk premiums with positive expected returns. Examples of risk premiums that meet my personal criteria for inclusion in a portfolio include the equity, size, value, and volatility risk premiums. The volatility premium is the persistent tendency in the options markets for implied volatility to exceed realized volatility. This should not be perceived as market mispricing, but instead, rational compensation for risk to the seller of option contracts.This is similar to how insurance companies are profitable over the long term by collecting more in premiums than paying out in claims and other expenses. Buyers of insurance are willing to lose a relatively small amount of money in the form of recurring premiums in order to transfer the risk of a large loss. Sellers of insurance need a profit incentive in order to take on this risk. A bullish strangle is a way to gain some exposure to the equity premium with reduced downside risk. Every option strategy includes tradeoffs, and the bullish strangle tradeoff is less upside capture in a rising market…and even potential losses. I’ve used the ORATS Wheel to complete backtests from 2007-current on 3 different equity index ETF’s…SPY, IWM, and EFA. The trading parameters used were: DTE: 30 Short Put Delta: 40 Short Call Delta: 16 Exit: 80% of credit received, or 5 DTE, whichever occurs first Collateral yield: None Results: This is impressive considering that no collateral yield is included. For example, US Treasury Bills are conventionally used as a risk-free form of collateral for option selling, and would have added just under 1% per year to the total returns during this period. Adding some term risk to the equation with 5 Year Treasuries, similar to what we do in Steady PutWrite, would have added almost 4% per year during this period along with diversification benefits that would have increased the overall Sharpe Ratio. Conclusion Options are a great addition to a portfolio for the disciplined and well-informed trader/investor. They don’t have to be used as a speculative tool, nor do they have to be used in a high-risk manner. The bullish strangle is potentially a great strategy for an investor with a more guarded outlook on the equity markets or who simply lacks the courage to buy traditional index funds. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady PutWrite service, and regularly incorporates options into client portfolios. Related articles: Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work?
Does “Managing Winners” Add Value to Short Strangles?
Jesse posted a article in SteadyOptions Trading BlogThanks to the help of a Steady Options member who deserves the credit for co-creating a web based backtesting tool with me, I can quickly test varying short strangle techniques on SPX options from 2001 to May 2020. Management at 50% credit My first test will use the aforementioned parameters. Specifically: Symbol: SPX Time Period: 2001-May 2020 Strategy: 16 Delta Short Strangle, excess returns only Entries: Expiration closest to 45 DTE Exits: At least 50% of the credit received or a 21 DTE time stop, whichever occurs first Slippage and Commissions: None Position Sizing Rule: 1x notional compounded growth of $1 million Trade reentry: Next trade entered immediately after closing current trade Data frequency: End of day Results… CAGR: 4.44% Annualized Volatility: 8.62% Sharpe Ratio: 0.52 No management My second test will use more conventional parameters. I’ll list only variables that differ: Entries: Expiration closest to 30 DTE Exits: 5 DTE time stop Results… CAGR: 5.46% Annualized Volatility: 8.19% Sharpe Ratio: 0.67 The results favor the second approach in this sample period, which is passively managed with just an entry and DTE exit. Note that holding until expiration produces similar relative performance results from additional tests I’ve completed using ORATS. So why do many option educators confidently promote active management as a source of additional expected return? The devil seems to be in the data, as the results from my backtesting differs from that which I’ve seen in the articles and videos from others. Do your own homework and form your own opinions, as option backtesting is time consuming, expensive, and difficult to replicate the results of others due to the number of variables involved. Slightly Bullish I do find that setting up a short strangle with a modest long bias improves results, which is also counter to what many suggest by recommending either a delta neutral or slightly short delta trade launch. Although a short delta setup “leans into the pain” of a short vega trade, it ignores the equity risk premium (upward drift of equity market prices over time). A slight long bias adjusts for this well documented factor. We can see this in my final test where all variables are held constant as in test number two with the exception of increasing the short put delta from 16 to 25. Strategy: 25/16 Delta Short Strangle Results… CAGR: 6.30% Annualized Volatility: 9.93% Sharpe Ratio: 0.63 Conclusion Short strangles on the S&P 500 appear to have been a winning trade for decades. They experience occasional large drawdowns, which would be expected from a strategy that resembles an insurance like risk profile. To continue your own strangle trading research, CBOE has a direct link to an excellent paper from Parametric that I recommend for further reading, “Volatility Risk Premium and Financial Distress”. The author of the paper concludes “The conclusion of the study is unambiguous. Investors may benefit significantly by taking advantage of the Volatility Risk Premium at all times.” A key consideration to any trade strategy is the fundamental rationale for why a strategy naturally has a positive expected return. If it requires skillful active management of when to get in and out, I’d advise caution as it’s difficult to differentiate luck from skill in financial markets. Like passively owning index funds, market participants efficiently set option prices in a manner that creates positive expected returns for strangle sellers, and it’s unclear whether active management adds or subtracts from expected returns. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Related articles Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work? Building a Short Strangles Portfolio Bullish Short Strangles Iron Condors or Short Strangles?
Selling Naked Strangles: The Math
Kim posted a article in SteadyOptions Trading BlogAssumptions: $100,000 account. Sell SPY 10 delta calls and 10 delta puts. Use options expiring in 30 days. Base the number of contracts on "notional exposure", not margin. Hold till expiration, then open the next trade. Notional value speaks to how much total value a security theoretically controls. For example, with SPY around $290, that means selling 1 SPY strangle per ~$29,000 of capital. With SPY around $288 on August 12, 2019, we will be selling the following strangle: Sell 4 Sep.11 2019 264 put Sell 4 Sep.11 2019 302 call Those strikes are the closest to 10 delta. 4 contracts give us notional exposure of $115,200 ($288*100*4), which means 1.15 leverage. This is fairly conservative exposure. This is how the P/L chart looks like: Please note that our total credit is $676 (assuming we can get filled at the midpoint). Now lets do the math. If ALL trades expire worthless and we keep all credits, we will collect $676*12=$8,112. This is 8.1% on $100,000 account. But this is the best case scenario. This is probably not going to happen. Based on the deltas of the options, this trade has around 80% probability of winning. Which means that statistically, 2-3 trades per year will be losers. Now, lets be conservative and assume that 2 trades per year will be losers, and the losing trades will lose the same amount as winners ($676 per trade). In reality, when the markets move against you, even with the best risk management, your losers are usually larger than your winners when you trade a high probability strategy. But again lets be conservative. Note: The theoretical probability of winning is based on deltas and implied volatility, while the actual win rate is slightly higher because of the volatility risk premium (IV exceeding RV over time). But it doesn't have material impact on the results. This assumption gives us total P/L of $676*10-$676*2=$5,408. That's total annual return of 5.4%. You can use T-bills as a collateral, which might add 2-4% to the annual return. In no way this single example can represent the whole strategy, and this calculation might not be very "scientific". Different dates or parameters might provide slightly different results, but this is a ballpark number. We estimate the range to be around 5-7% per annum. Of course fund managers like Karen Supertrader who use similar strategies realize that those returns probably would not attract too many investors, and also would not get her a spot in tastytrade show. What's their solution to get to the 25-30% annual return they advertise? The answer is: leverage. To get from 5% return to 25%, you need 5x leverage, or 20 contracts. To see how the leveraged trade would perform during market meltdown, lets assume it was initiated on Dec.3, 2018, with SPY at 280. Three weeks later, SPY was around 234, 16% down. This is how the trade would look like: That's right, the $100k portfolio would be down 50%. This is how you blow up your account. In this case, the 16% market decline took 3 weeks. What if it was 25% decline happening in one week? You can only imagine the results. Of course we could change the parameters, use 20 delta options, different time to expiration etc. This would not change the results dramatically. With 20 delta options, you would get more credit, but also higher number of losers per year. Does it mean the selling naked strangles is a bad strategy? Not necessarily. In fact, according to CBOE Volatility Risk Premium and Financial Distress, 1x notional strangle on SPX has historically returned about the same as SPX with 3x the Sharpe Ratio: But the strangle itself produced around 6% annualized return, which is pretty close to the performance we calculated. Rest of the return came from the collateral. The bottom line is: selling naked strangles on indexes is a good strategy if used with a sensible amount of leverage. But you should set your expectations correctly. I suspect that most traders would probably base their position sizing on margin, not notional exposure, which is like driving a Ferrari 190 MPH down a busy street...just because you can. This would increase the return, but also the risk. If you base your position sizing on notional exposure, the risk is pretty low, but so is the potential return. Naked options by themselves are not necessarily a bad thing. The problem is leverage and position sizing. If implemented correctly, naked options can make money in the long term. But if you overleverage, you just cannot recover from the inevitable big losses. We warned our readers about the dangers of naked options and leverage on several occasions. It's not the strategy that killed Karen Supertrader, James Cordier, Victor Niederhoffer and others. It's the leverage and lack of risk management. What about selling naked strangles on individual stocks? Personally, I would never do it, especially not before earnings. The risk is just too high. But lets leave something for the next article.. “The problem with experts is that they do not know what they do not know.” ― Nassim Nicholas Taleb. Related article: Do 80% Of Options Expire Worthless? Selling Options Premium: Myths Vs. Reality Karen The Supertrader: Myth Or Reality? Karen Supertrader: Too Good To Be True? How Victor Niederhoffer Blew Up - Twice The Spectacular Fall Of LJM Preservation And Growth James Cordier: Another Options Selling Firm Goes Bust
Put Selling: Strike Selection Considerations
Jesse posted a article in SteadyOptions Trading BlogShould I place all my contracts at one strike and expiration, or split it up for diversification? Should I wait until expiration as my natural exit, or roll early? Should I handle winning trades the same way as losing trades? Should I only sell enough contracts to be fully cash secured, or use leverage? In this article, I’m going to address the question of choosing strikes based on delta, while keeping the other variables constant, in order to show some historical performance comparisons of SPX put options from 2001-2018. Whenever I make trading decisions, I always remind myself of a couple quotes from W.E. Deming… “In God we trust, all others must bring data.” “Without data you’re just another person with an opinion.” Assumptions held constant for the following backtests… Product: SPX Period: 2001-2018 Entry: 30 DTE Exit: 80% of credit received, or 5 DTE, whichever comes first Position Sizing: 100% notional/cash secured (no leverage) Collateral yield: 0% Commissions and slippage: Not included Based on those assumptions, here’s the data for trades placed at different deltas. Key observations: Higher risk has historically resulted in higher reward…As strikes move away from at the money (ATM), volatility and annualized returns both decline. This is what we would have expected to see in a world of not perfectly, but highly efficient markets. Sharpe Ratio’s increased with out-of-the-money (OTM) options. This is what I find most interesting and worthy of further discussion. Why would there be higher Sharpe Ratio’s with OTM options, and is there any opportunity based on this data? Research from AQR has come to similar conclusions that Sharpe Ratios tend to increase the further out of the money an option is sold. This might be for the same reason that we see a linear decrease in historical Sharpe Ratios for US treasuries the further out on the yield curve you go (i.e., comparing Sharpe Ratios of 1/2/5/10/30-year treasuries): Aversion to and/or constraints against the use of leverage. If you’re an investor who is unwilling or unable to use leverage, your only choice to maximize expected returns is to sell the riskiest option (ATM) and buy the riskiest treasury bond (30-year). This being a common theme among market participants can create market forces that impact prices. But if you are willing and/or able to use leverage, you could simply lever up OTM put options or shorter-term treasury futures to your desired risk level, and get paid more per dollar risked. Isn’t that the objective…the most gain with the least pain? Of course, risk cannot be eliminated…only transformed, and leverage creates risks of its own and should be used responsibly. Unfortunately, it too often isn’t. As I wrote in a recent article, excessive leverage is the number one mistake I see retail and even occasionally “professional” investors make. In our Steady Momentum strategy, we sell OTM puts and lever up to around 125% notional to give us a similar expected return as ATM puts with slightly less volatility. We also collateralize our contracts with short and intermediate term bonds instead of cash, as collateral ends up being a significant portion of total returns with put selling strategies. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.
James Cordier: Another Options Selling Firm Goes Bust
Kim posted a article in SteadyOptions Trading BlogIt's All About Leverage and Margin The author is mentioning some low priced gold options: "So, you're recommending the August $1,100 puts. That gets us out there far enough, decent premium, $500. The margin is less than 2 to 1. So, you're taking in about $500-600 for each one you sell. The margin requirement is about $800-900. It's a quite small margin requirement to hold this position, and it makes it quite easy to put in a portfolio. Once you put it on, if that value does start decaying, the margin requirement goes away with it. So, your margin requirement drops" What Mt. Cordier forgets to mention is that if the position goes against you, the margin actually increases. It can double, or triple, in a very short time period. Also, one contract gives you control on $120,000+ of gold futures. Based on margin requirements, that's over 1:100 leverage. The article implies that those strategies are almost free money. And then there is no mentioning of risks at all. ZERO. Anyone who was reading the article could see this coming. The writing was on the wall. But the really scary part came about two weeks later. Catastrophic Loss Event On November 15, 2018, OptionSellers.com notified its investors in an email entitled “Catastrophic Loss Event” that it not only lost all their money, but that they would also owe money to Intl FC Stone for margin calls. According to OptionSellers.com, they lost a substantial portion of their investors’ assets due to a short call position in natural gas that, according to Optionsellers.com “was so fast and intense that it overwhelmed all risk measures in place.” Mr. Cordier then informed investors that they have a debit balance in their accounts which they need to bring back to zero by paying INTL FC Stone the difference. So, in addition to trying to process the news all their money is gone, they also have INTL FC Stone breathing down their necks demanding they pay the money they owe for its margin calls. According to Investors Watchdog,Tampa-based OptionsSellers.com touts itself as premier and highly experienced commodities options trading firm. The firm’s president and head trader, James Cordier, explained in a recent interview: “Our goal is to take an aggressive vehicle and manage it conservatively.” Unfortunately, Mr. Cordier did not trade options conservatively. It traded “naked” rather than “covered” options, leaving investors subject to unlimited exposure. This unlimited exposure is what caused to lose all their money and more in the last few days. Thus, OptionSellers.com and its principals negligently engaged in a risky trading strategy that was unsuitable for its clients and breached its fiduciary duties to them by putting its interests ahead of its clients. What Happened? This is a pretty good explanation from Palisade Research: James Cordier blew himself up by selling naked call options on Natural Gas. . . Mr. Cordier with his expert financial opinion thought it was wise to sell naked call options on Natural Gas. The thesis was that the 2018 winter was expected warmer than previously thought. And with the over-supplies of Nat Gas coming in from higher prices – Nat Gas would weaken over the next few months. So Mr. Cordier made a bearish bet on Nat Gas by writing naked call options. Remember – a naked call option is when a speculator writes (sells) a call option on a security without ownership of that security. It is one of the riskiest options strategies because it carries unlimited risk. . . He thought that he could take advantage of the ‘peak’ natural gas price two ways. First – since Nat Gas prices were up recently, he could sell options for higher premiums as bullish investors came in. Giving him more upfront profits. And Second – he believed that Nat Gas prices peaked. And would soon turn south. Which meant the options he sold would expire – and he would be off the hook. And at the very least – he didn’t think Nat Gas prices were set to go that much higher. But they did. . . Nat Gas shot up nearly 20% in a single afternoon last week – to its highest price since 2014. Some say that the added buying sparked a ‘short-squeeze’ – when a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions. Soon after the smoke cleared he had to break the news to investors and clients. He sent a letter – and made a video apology – telling everyone about the unfortunate “catastrophic” situation. The Numbers Our contributor Chris Welsh provided some real numbers how those catastrophic losses were possible: Traditionally you can get about 16x leverage trading oil futures contracts, based on the margin requirements (though with oils recent major drop offs those margin requirements are now higher). Using some actual older prices, this means to open a $90,000 oil and gas position, each account would have to only invest $5,610. So if an account had $56,100 in it, he could purchase a position worth $900,000. Then if the price of oil goes up 1% (and he's long) then his investment would go up close to 16%. This is not abnormal, and exists in the normal option trading we do too. However, that is just really, really, really poor risk management to use that much leverage. Which gets us back to those pesky margin requirements. Margin is NOT static. So If I bought that $90,000 position for $5,610 of margin, when the price starts moving against me, I have to put up more margin, because the risk to the position increases. It's not uncommon to see margin requirements double, or triple, in a very short time period. Well his margin requirements went THROUGH THE ROOF. That $100,000 account now had a margin requirement of over $100,000. This means he's now subject to a margin call and has to either liquidate positions or put more cash up. He did neither, which means all those accounts got forcible liquidated....but after the prices had moved even more. Now that $100,000 account has a value of -$50,000, of which the owner is responsible for putting up. And since these are separately managed accounts, that means each separate "investor" is responsible for their share. These things only happen to people that don't understand risk or don't care or are idiots or are greedy idiots....or fill in your superlative here. One of OptionSeller.com clients shared his statement for 1mln portfolio where you can see all his positions. The level of leverage is just scary. Is Selling Options Really Superior? In his interview from couple years ago, James Cordier said: "Once I realized that 80% of them expire worthless I started selling commodity options instead of buying them." Not only this is factually not true (according to CBOE, approximately 30%-35% of options expire worthless), but this is also completely irrelevant, as we demonstrated in our article Do 80% Of Options Expire Worthless? This is an argument used by many amateur traders, and also by some options trading "gurus" to attract new subscribers. Even if the "80% expire worthless" myth was true, it doesn't matter - if you gain little when options expire worthless but lose big when they go in the money, your bottom line is still negative. But the most important thing is that most options are not held till expiration. Selling options has its advantages and disadvantages, so is buying options. It's not about the strategy, it's how you use it. Saying that 80% of the options expire worthless is like saying that 100% of the people eventually die. "Experts" like James Cordier should know better. And maybe he does - but those claims definitely helped him to attract new money from people who don't know any better. The fact that those people are considered gurus and are featured on CNBC, WSJ, Bloomberg and MarketWatch is scary. The Lessons James Cordier is obviously not the first money manager who blew up his clients accounts (or experienced catastrophic losses). Victor Niederhoffer, Karen Supertrader, LJM Preservation And Growth Fund.. there are probably many others less famous. Naked options by themselves are not necessarily a bad thing. The problem is leverage and position sizing. If implemented correctly, naked options can make money in the long term. But if you overleverage, you just cannot recover from the inevitable occasional losses. We warned our readers about the dangers of naked options and leverage on several occasions. As our contributor Jesse Blom mentioned: All 3 of these examples, and the newest one, share the common element of leverage. Excessive leverage, and also lack of diversification. Strategies like naked option selling work fine if you ignore margin requirement and view risk based on notional exposure. Parametric's VRP paper shows how a SPX naked strangle has been less risky than owning the underlying index when sized based on notional exposure. For example, that means selling 1 SPX strangle per ~$265,000 of capital today. But in this case, James Cordier took commodity futures (NG) which is itself a leveraged instrument, and applied even more leverage using naked options. Here are the elements that contributed to the failure: Using highly leveraged instrument like Natural Gas futures. Writing naked options that have theoretically unlimited risk. Using leverage on already leveraged instrument. No diversification. Using no hedging or risk management. The result was disastrous and inevitable. It always is when someone is using extreme leverage like this one. As one of our members wrote: "People see these crazy returns and think these personalities are doing something magical when really most are just levered to the hilt and taking dumb risk when there are several reasonable ways to hedge". One macro hedge fund founder faulted both Cordier and his investors for the outcome. “The nature of the strategy is that you make a little bit of money until you blow up. The probability of losing it all is fairly significant. With derivative contracts — if you don’t understand them — you really need to give money to someone you trust, and to couple of them. Have some checks and balances.” OptionSellers.com “basically took advantage of guys who didn’t know any better. I instantly thought of my grandmother, my grandfather. I honestly was thrown when I heard about it.” Conclusion To add insult on injury, it turns out that James Cordier enrolled his clients into managed accounts and not a fund. This was the reason why his clients not only have lost all their money, but that they also owe money to their broker for margin calls. As Chris explained: The media keeps referring to this as a "hedge fund." But that is NOT what it was. It was 290 separately managed accounts, all trading the same strategy. Whereas a hedge fund is an actual "company," typically a limited partnership or limited liability company, that insulates investors from losing more than they invest (unless specifically structured to make investors liable, which is VERY rarely done). The wheels started coming off here. Since these are block accounts, that means EACH client owns their own accounts and is responsible for them. So if he loses MORE than is available in the account, the account owner gets the bill....not the fund "manager." Should we feel sorry for the Mr. Cordier? There is no sympathy from Josh Brown, the Reformed Broker: Some people made me aware of how he was marketing this fund. He called it a retirement strategy. It’s not a retirement strategy, it’s speculation. I don’t feel bad for James Cordier, or his “clients.” Taking in premiums from selling calls – picking up nickels – and having no idea of the potential for a blow-up is the most childish thing I’ve ever heard. No, the laws of risk and reward are not repealed just because someone sounds sophisticated when discussing derivatives. Risk cannot be eliminated, only transformed. This man sold investors a lie. And now he compounds it with a new lie – “a rogue wave came along and capsized us!” GMAFB. Google this guy’s sales pitch when you get a chance. If your strategy bets on the movement of commodities and it isn’t durable enough to survive the movement of commodities, perhaps you have no business managing money in the first place. So no, no sympathy. Fuck you and your cufflinks too. “The problem with experts is that they do not know what they do not know.” ― Nassim Nicholas Taleb. Related articles: How To Blow Up Your Account Karen The Supertrader: Myth Or Reality? Karen Supertrader: Too Good To Be True? The Spectacular Fall Of LJM Preservation And Growth
Who Wants The Last Nickel?
Mark Wolfinger posted a article in SteadyOptions Trading BlogWhen you sell options, or option spreads, it's prudent not to wait for expiration. Let someone else have the last few nickels At some point, the remaining profit potential (and that's all it is: potential) is just too small for the risk involved One of my difficult experiences as a CBOE market maker was suffering through losses that were the result of not buying back my short option positions when they were available at a ‘teeny.’ A teeny is 1/16, or $6.25 per option. Options did not always trade in decimals (decimalization began in 2000 and was complete by 2001), and for many years traded in fractions, with 1/16 being the smallest fraction. It seems to be a true waste of money to pay $6.25 for an option that is ‘obviously’ worthless. And it is a lot of money. In fact, I used to joke about it on some Friday afternoons when I’d make a point of selling one option at 1/16, announcing that this was paying for my dinner tonight. *In the late 1970’s that price bought a decent dinner.] Today, I’m horrified that this was my standard operating procedure. When an option reached a ‘teeny’ it was hopelessly out of the money and it seemed so foolish to buy it back. I clearly remember making a bunch of money when Jan 1978 expiration passed. I was short options that expired worthless. In those days, our account balances (net liquidating value) did not reflect that the options were worthless until Wednesday morning. Today, efficiency and powerful computers make that data available Sunday, or barely one day after the options officially expire on Saturday morning. Thus, Wednesday after expiration was always a pleasant day. We may have earned the money earlier, but we did not have it to spend until the third business day following expiration. But I digress. In February, I recognized a powerful income source when I saw one and had an even larger expiration day, collecting those residual teenies. March was better yet. I decided I was being foolish and went for a larger payday in April. Alas, April 1978 was not a good time to be short call options. That was my first significant loss. Getting clobbered should have made it a simple no-brainer to cover those cheap options forever after. But life is not a fairy tale and it didn’t happen. I was caught again. More than once. Today, I no longer play that game. I’m a firm believer in making my profits and letting someone else have the last few nickels on any trade. Some people prefer to sell options and spreads that are very far out of the money. Yes, the premium collected is small, but those premium sellers believe the profit is guaranteed. It’s not. There’s always a chance of a major stock market event. Oct 1987 anyone? If you are a seller who collects a $0.25 premium, then I’m not suggesting that you pay $0.05 to close. I don’t know how to deal with positions that are sold for so little. I know when I sell call or puts spreads at prices near $1.50, I’m pleased to pay as much as 25 cents to get them back – depending on how much time remains. Today I’m always bidding something to bring those home. A waste of money? Yes it is. But not always. Every once in awhile those small buy-backs have saved me a bundle. This is a difficult lesson to learn. Especially from someone else’s experiences. I had risk managers, trading friends, and clearing house presidents tell me how foolish I was. But I knew better. I scoffed, to my everlasting regret. Today, risk management is at the center of my trading and education methods. Near the top of must-do strategies is the idea that there’s just too much risk involved to go after the last nickel or dime. I’m happy to allow someone else to earn that profit. I truly hope that you never suffer through the experience of having very low priced short positions explode in value. And when I say explode, I’m not thinking that the price may move from $0.05 to $1.00. I’m thinking of 10 x that number. This post was presented by Mark Wolfinger and is an extract from his book Lessons of a Lifetime. You can buy the book at Amazon. Mark has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Mark has published seven 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. Added by @Kim Thank you Mark. Excellent example. If something thinks this is "theoretical", consider our JNJ hedged straddle from July 1, 2019: On July 11 we closed the short calls for 2 cents. On the morning of July 12 (expiration date of the short options), the stock was trading at $139, and we closed the short 137 puts at 3 cents: Some members questioned why we are closing puts that are $2 Out Of The Money and not letting them to expire. Couple hours later, they got the answer: news about criminal probe broke, and the stock nose-dived below $133. Those 137 puts that we closed earlier for 3 cents were suddenly worth around $5! After getting rid of the "hedge", we were able to close the 140 straddle for 73.6% gain. This is of course an extreme example, but you get the point. Trying to save the last few cents of the short options can backfire, big time. To many members, it was an eye opening experience.
Selling Options Premium: Myths Vs. Reality
Kim posted a article in SteadyOptions Trading BlogWhat is Selling Options Premium? Selling Options Premium is a general term that refers to Options Selling strategies (as opposite to Options Buying strategies). Options Selling strategies usually have a positive theta and negative gamma, while Options Buying strategies usually have a negative theta and positive gamma. Some examples of Options Selling strategies include: Iron Condor Butterfly Spread Short Straddle Short Strangle Calendar Spread Some examples of Options Buying strategies include: Long Call Long Put Long Straddle Long Strangle Reverse Iron Condor Please note that getting a credit or paying a debit is not what defines a strategy. A butterfly spread can be done with credit (Iron Butterfly) or debit (regular Butterfly). What is typical for Options Selling strategies is the fact that they are usually theta positive, gamma negative, vega negative (there are exceptions). Myths vs. Reality Myth 80% of the options expire worthless, so selling them gives you an edge. Reality According to CBOE, approximately 30%-35% of options expire worthless. But more importantly, percentage of options expiring worthless is irrelevant as we demonstrated in our article Do 80% Of Options Expire Worthless? This is an argument used by many amateur traders, and also by some options trading "gurus" to attract new subscribers. ---------------------------------- Myth Options Selling has high probability of success (80-90% winning ratio). Reality First, not all options selling strategies have high probability of success and high winning ratio. For example, butterfly spreads have much lower probability (but better risk/reward). When referring to 80%+ winning ratio, it usually implies selling low delta credit spreads or iron condors. But what is important is not that you win 80% of the time, but what happens when you lose? If you make 5% on winning trades but lose 60% on losing trades, you are still losing money, right? ---------------------------------- Myth Options selling has a lousy risk/reward. It's like picking up pennies in front of a steamroller. Reality This myth is an opposite of the previous one, used by options selling opponents. And again, risk/reward has inverse correlation to probability of success. Good risk/reward = low probability of success, and vice versa. ---------------------------------- Myth Options selling allows you to have extra income (they are sometimes called "income producing strategies"). Reality A BIG FALSE. The fact that you are getting cash upfront doesn't mean that cash will necessarily stay in your account. If the position goes against you, you will need to pay more to close it. If you want stable and reliable income, buy T-bills, dividend paying stocks etc. Options are NOT for income. ---------------------------------- Myth If I sell options with 10 deltas, I have 90% probability of success. Reality This claim completely ignores Implied Volatility changes. This is especially true when selling puts. If the underlying starts to tank, IV will start to increase and the delta will start to increase at much higher pace, amplifying the losses. ---------------------------------- Myth Selling weekly options will produce the best results due to higher positive theta. Reality Higher positive theta comes with higher negative gamma. Those strategies are much more sensitive to underlying move, and the losses are much harder to control. ---------------------------------- Myth When selling premium, we can win in three scenarios: if the stock price stays the same, moves against us slightly or moves in our favor. Reality While this is true, it ignores the size of the winners in those three scenarios vs. the size of the losers if the stock moves sharply against you. ---------------------------------- Myth One of the most important aspects of selling premium is the positive theta. Reality Yes, but those positions usually also have negative gamma and negative vega. In case of a big move (especially down move) the negative gamma and negative vega will play much bigger role than positive theta. It is very misleading to look at one Greek and ignore the others. ---------------------------------- Myth: A good way to capitalize on volatility crushing after earnings is to sell premium. Reality: It is true that Implied Volatility increases before earnings and crashes after earnings. However, if the stock moves more than "expected" after earnings, selling premium will be a losing strategy because the gamma losses will outpace the vega gains. How NOT To Trade NFLX Earnings explains the concept. Does Selling Options Premium Work Or Not? The short answer is: it works most of the time - till it doesn't. And when it stops working, the losses can be devastating. Just ask Victor Niederhoffer, Karen Supertrader, James Cordier and many others. The main reason Selling Options works in the long term has nothing to do with 80% of options expire worthless, 90% winning ratio or other myths. The main reason it works is that Implied Volatility (IV) tend to be higher on average than Historical Volatility (HV), especially on indexes. When using a strategy, please make sure you understand why it works or doesn't work in the long term. Some options "gurus" insist that selling options is the only way to be profitable. They are trying to prove that options buying doesn't work - and we prove them wrong time after time for the last seven years. Selling options has its advantages and disadvantages, so is buying options. It's not about the strategy, it's how you use it. Risk management and positions sizing are the key. Not surprisingly, none of those options selling gurus is willing to provide their track record. If you do insist to sell options, here are few simple rules that might help you to reduce the risk: Always look at risk/reward. Don't be attracted to high probability low delta options. Those trades might work well for many months (or even years), but inevitable will eventually happen. They are a true definition of "picking up pennies in front of a steamroller". Never underestimate the risks of leverage, especially when you sell naked options. This sounds obvious, but even experienced money managers with decades of experience often ignore this simple advice in pursuit of high returns. Victor Niederhoffer had one of the best track records in the hedge fund industry, compounding 30% gains for 20 years. Yet, he blew up spectacularly in 1997 and 2007. Not once but twice. Be very careful with selling weekly options due to high negative gamma. Be aware that earnings are a binary event if you decide to sell options before earnings and hold them through the event. Never sell naked options on individual stocks. The risk of unexpected event like acquisition, earnings warning, analyst upgrade/downgrade is too high. Conclusion Selling Options Premium can work, and it should be part of well diversified options portfolio. However, in my opinion, you should always have other strategies to balance your portfolio and control risk. Having only options selling trades in your options portfolio is a certain path to ruin - especially if you are using excessive leverage. Just imagine what will happen if you have a portfolio full of gamma negative vega negative trades and S&P 500 goes down 5-10% (not to mention a sharper correction). Years of small gains will be gone. Related articles: Karen The Supertrader: Myth Or Reality? Karen Supertrader: Too Good To Be True? How To Blow Up Your Account The Spectacular Fall Of LJM Preservation And Growth James Cordier: Another Options Selling Firm Goes Bust How NOT To Trade NFLX Earnings
Building a Short Strangles Portfolio
Stephan Haller posted a article in SteadyOptions Trading BlogLately we experienced a 7% down move in the S&P 500. image source: TOS trading platform We have also seen an explosion in the VIX. image source: TOS trading platform All in all a pretty shitty situation if you have a delta neutral short premium portfolio. So let's have a look how a portfolio consisting of 30 delta short strangles and/or atm short straddles in IWM, FXE, TLT, GLD, XLE, which was started before this wild ride in the markets happened, would have performed. Set up As shown in my books, IWM, FXE, TLT, GLD, XLE are the most uncorrelated ETFs. With these underlyings you have exposure to the Russell 2000, the Euro Currency, Bonds, Gold and the Oil Sector. Rules $100k portfolio capital allocation based on the VIX (20-25% allocation in very low VIX environment, 40-50% in a high VIX environment) equal buying power in all underlyings never go above 3x leverage in notional value 30 delta short strangles or atm straddles about 45 DTE profit target = 16 delta strangle credit at trade entry close all positions at 21 DTE if profit target is not hit before if short strike in strangles gets hit, roll untested side into a short straddle (original profit target doesn't change) if break even in a short straddle gets hit, roll untested side to the new atm strike (going inverted) if IVR in IWM goes above 50% and/or VIX makes a big up move, add aggressive short delta strangle to balance deltas Portfolio Performance As a starting date I picked July 30th 2019, probably the worst day in this expiration cycle to start this kind of portfolio. Since the VIX and IVR was pretty low at this moment, I committed only a little bit above 25% of my net liq. IWM image source: TOS trading platform FXE image source: TOS trading platform TLT image source: TOS trading platform GLD image source: TOS trading platform XLE image source: TOS trading platform Portfolio So far in dollar terms a $1,571.50 loss or 1.571% loss on the whole portfolio. Not too bad considering the IV explosion and the big moves, especially in TLT. As you can see, even in a tough market with big outside the expected moves and IV explosion, short strangles/straddles are not a recipe for disaster. The key is to trade small when IV is low and mechanically adjust your positions/deltas. Of course the expiration cycle is not over yet and we can still have more big moves and much higher implied volatility in the coming days, but you should have seen now, when you have the right set of rules and religiously stick to these rules and when you trade small enough when IV is low, you are not going to blow up your portfolio. Stephan Haller is an author, teacher, options trader and public speaker with over 20 years of experience in the financial markets. Check out his trilogy on options trading here. This article is used here with permission and originally appeared here. Related articles Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work? James Cordier: Another Options Selling Firm Goes Bust How Victor Niederhoffer Blew Up - Twice
Selling Short Strangles and Straddles - Does it Work?
Stephan Haller posted a article in SteadyOptions Trading BlogBut with undefined risk strategies comes theoretical unlimited risk. Therefore it is crucial that you follow the rules I pointed out in my books and which are mentioned about almost every day on tastytrade Rules: do not use more than 40 - 50% of your available capital on your overall portfolio do not use more leverage than 3x notional of your net liq (if you have a $100k account, don't go over $300k notional) manage at 21 DTE to avoid gamma risk manage your strangles at 50% of max profit and your straddles at 25% of max profit. spread your risk among lots of uncorrelated underlyings commit capital based on IVR or the VIX (high VIX risk up to 50% on your overall portfolio, if VIX is low, risk less) Now let's have a look at what you can expect in profit if you sell different type of strangles/straddles: 16 Delta Short Strangles: tastytrade has shown in a study that you can expect to keep 25% of the daily theta if you sell 16 delta short strangles in SPY, IWM and TLT. Image source: tastytrade Let's have a look at how much contracts you could sell, until you exceed 50% of your capital in margin requirement and/or 3x notional leverage and how much money you would make in a full year. For the study I was using August 13th 2019 closing prices. Although the percentage of theta you can expect to keep is higher than 25% in SPY and IWM, I was using the 25% number, to be more conservative. SPY 16 Delta Strangles As you can see, if you just sell 16 delta short strangles in SPY, you can expect to make 9.11% in profit, if you go up to 3x notional leverage. IWM 16 Delta Short Strangles As you can see, if you just sell 16 delta short strangles in IWM, you can expect to make 10.93% in profit, if you commit 50% of your buying power. Now let's have a look at short straddles. tastytrade has shown in a study that you can expect to keep 40-50 % of the daily theta if you sell atm short straddles in SPY. Image source: tastytrade Let's have a look at how much contracts you could sell, until you exceed 50% of your capital in margin requirement and/or 3x notional leverage and how much money you would make in a full year. For the study I was using August 13th 2019 closing prices. For the daily theta you can expect to keep, I was using 45% as the tastytrade suggested. SPY Short Straddles As you can see, if you just sell atm short straddles in SPY, you can expect to make 18.13% in profit, if you commit 46.83% of your buying power. IWM Short Straddles As you can see, if you just sell atm short straddles in SPY, you can expect to make 25.25% in profit, if you commit 48.12% of your buying power. Since we want to diversify our portfolio, let's have a look at the 5 most uncorrelated underlyings, which I showed in my first book. For these examples I was using today's (August 14 2019) prices right at the open. GLD Short Straddles TLT Short Straddles FXE Short Straddles IWM Short Straddles XLE Short Straddles In the next article I will show you how to build a portfolio with these five underlyings and how to commit your capital based on the VIX, so that you don't get wiped out in a move we experience at the moment. Stephan Haller is an author, teacher, options trader and public speaker with over 20 years of experience in the financial markets. Check out his trilogy on options trading here. This article is used here with permission and originally appeared here.
Debunking the "Trading Options for Income" Myth
Kim posted a article in SteadyOptions Trading BlogSearch for "Trading Options for Income", and you will get a bunch of results: Learn how to generate consistent stream of income trading options and earn high profits. How to Earn Consistent Income Trading Weekly Options. Make Money Selling Naked Puts - How I Make An Extra $3k - $5k Per Month In The Stock Market. How to Sell Naked Puts for Big Income. And many more. So how does it work? You would implement an options trading strategy where you can get a credit, and your account would be credited with the money you got. Some of those strategies include: Iron condor Short straddle Short strangle Iron butterfly Example You decided to follow an advice from an options guru who aims to provide you with consistent income of 5% per week. That would translate to 260% per year, not compounded. They would recommend entering weekly credit spreads, getting a credit and allowing them to expire worthless, so you keep the credit. Lets say you follow their advice and enter 2435/2440 call credit spread on June 1, 2017. You get $0.30 credit, and the short calls have delta of 11 which gives the trade 89% probability of success. This is how the P/L chart looked like: All you need is for SPX to stay below your 2435 short strike for one day - and you keep the whole credit. ~90% of the time, you will achieve that goal. The next day, something "unexpected" happens. SPX rises to 2440, and the trade is losing 80%. Now you need to buy back the credit spread for the full $5.00, resulting a $470 loss. Congratulations! You just gave back a year worth of previous months "income". The track record of this "guru" looks something like this: You might say that this example is a bit extreme, but it was a real trade recommended by a real subscription service. Of course you can select a different expiration or strikes, but the principle remains the same. The fact that your trade resulted a credit doesn't mean that the money will stay in your account. This is NOT an income. If the trade goes against you, you will need to close it for a debit which might be higher than the credit you got. Sometimes MUCH HIGHER. In some cases, one bad month can eat the "income" of a whole year. Conclusion As our contributor Mark Wolfinger mentions: "If you trade the options “income” strategies (iron condor, credit spread, naked put, covered call, etc), the credit collected has NOTHING to do with how much loss you should be willing to accept." But isn't it just semantics? Well, the biggest risk of "trading options for income" is if that income is needed or expected to be used as current income. That is, if it's needed to cover your current expenses. If you start depending on income from "income generating strategies", you must recognize that there will be months that you lose. Not only do losing months eliminate that month's income, many times the losses will be equivalent to having to "pay back" income from previous months. There's just no way that the Market is so predictable that you can target and achieve a predefined amount of income month in and month out. Options trading is NOT an income producing strategy. If you want a consistent stream of income, buy dividend stocks, rental properties, bonds etc. When you are trading options (or any other instrument), there will be losing weeks, losing months and sometimes even losing years, no matter how good you are. If you see someone promising you a consistent stream of income from trading or investing, they are probably doing something similar to Bernie Madoff. Does it mean you should not be selling options for credit? Not at all. Options selling strategies should be part of any well diversified portfolio. Just stop treating it as "income" and start treating it as regular trading, that will have its ups and downs. Related articles 10 Options Trading Myths Debunked Do 80% Of Options Expire Worthless? Selling Options Premium: Myths Vs. Reality The Use And The Abuse Of The Weekly Options The Risks Of Weekly Credit Spreads Make 10% Per Week With Weeklys?
Do 80% of Options Expire Worthless?
Kim posted a article in SteadyOptions Trading BlogWhat is the Truth? Is it true? Do 80% of all options REALLY expire worthless? Are 80% of all options buyers automatically losers which makes 80% of all options writers automatically winners in the options market without any risk? According to The Chicago Board Options Exchange (CBOE) here are the facts: Approximately 10% of options are exercised (The trader takes advantage of their right to buy or sell the stock). Around 55%-60% of option positions are closed prior to expiration. Approximately 30%-35% of options expire worthless. The CBOE goes on to point out that having an option expire worthless says nothing about the profitability of the strategy that it may have been part of: Multi-legged strategies can often require that one leg or more expire worthless although the strategy as a whole is profitable. Option positions closed prior to expiration may be profitable or unprofitable. Options that expire worthless may not be unprofitable if they were part of a strategy that involved other securities such as covered call writing. Only About 30% of Options Expire Worthless? What does it mean? ABSOLUTELY NOTHING! It doesn't mean that when you buy options, you automatically have 70% chance of winning, it also doesn't mean that if you write options, you only have 30% chance of winning. Here are some of the arguments used by different options gurus in order to separate you from your hard earned money: BE THE HOUSE – Not the Gambler! Be the insurance company and win 90% of the time! Get stable and consistent monthly income! Get 90% winning ratio with our strategy! Those arguments have no basis in reality. Insurance companies can lose significant amounts of money during periods of national disasters. Monthly income can become monthly loss during periods of high volatility. And so on.. If you are not a member yet, you can join our forum discussions for answers to all your options questions. Advantages of Options Selling Opportunity for monthly cash flow with high annualized returns. Opportunity to buy stocks at lower prices via naked puts strategy. Over the long term, Implied Volatility tends to be higher than Historical Volatility. Downside protection for put sellers or covered calls sellers. Options sellers tend to have a higher win rate (but a lower rate of return). Covered call writers may also capture dividends. Opportunities to trade in self-directed IRA accounts, especially covered call writing. Disadvantages of Options Selling Money can be lost is stock price dips below the breakeven. Profit potential is limited by the strike price. Assignment risk (may have to buy or sell shares). There is a learning curve and time commitment. In many cases, risk/reward is not favorable (you risk much more than you can gain). When using strategies like Iron Condors, one bad month can wipe out months of good gains. Why it doesn't matter Those who suggest that 80% of options expire worthless assume that if an option expires in the money, it automatically means a win for options buyers, which isn't true. If you buy a deep in the money option and the underlying stock moves against you, your options would still end up losing money even if it is still in the money by expiration! Ultimately, it is the direction of the underlying stock that determines if you end up profitable. How about hedging? If you bought options as part of overall portfolio using strategy like Protective Put, and your options expired worthless, is it necessarily a bad thing? Not if you stock doubled in value while you held those protective puts. And one final example: consider a strangle seller who sells options (both puts and calls) on high volatility stocks before earnings. He can gain $100 four times in a raw when the stock doesn't move in the money, but lose $1,000 during a cycle when the stock moved big time and one of the options became deep in the money. In this case, 9 out of 10 of the options expired worthless, but he still lost money. Even if the "80% expire worthless" myth was true, it doesn't matter - if you gain little when options expire worthless but lose big when they go in the money, your bottom line is still negative. But the most important thing is that most options are not held till expiration. Conclusion Percentage of options expiring worthless is completely useless to options traders. This is NOT what should impact your decision to become an options buyer or options seller. The only way to determine which options strategy suits you is by really learning about them, their reward risk ratios, practicing them and understanding which approach best conforms to your investment objectives, trading style and risk appetite. Options is risky no matter if you are an options buyer or seller, don't let anyone tell you otherwise. There is no such thing as becoming "banker" in the options market. Understand the risks of options trading and you will be profitable. Related Articles: Are Debit Spreads Better Than Credit Spreads? Selling Naked Put Options What Is The Best Options Strategy? The Road Not Taken Are You Ready For The Learning Curve? Can you double your account every six months? If you are ready to start your journey AND make a long term commitment to be a student of the markets: Start Your Free Trial