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Am I overlooking the risk?


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Am I overlooking the risk?

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  #1 (permalink)
trader0303
phoenix
 
 
Posts: 2 since May 2011
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I've been doing a very simple options strategy for a few months and have had success, and it seems too "low risk" that I must be overlooking something.

I sell a call above the stock price, and sell a put below stock price betting that the stock will stay in the range, and both will expire worthless.

I manage it by if the stock reaches my call price I buy the stock, and sell it if it goes back into my "range" . Inversely if it falls to my put price I short the stock, and cover my short when it rises back above my put price.

So, even if the options expire out of my "range", my risk is covered. I do this when I have the cash in the account to cover buying or shorting the stock to manage position. What am I missing besides overnight gaps?

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  #3 (permalink)
 Fat Tails 
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trader0303 View Post
I've been doing a very simple options strategy for a few months and have had success, and it seems too "low risk" that I must be overlooking something.

I sell a call above the stock price, and sell a put below stock price betting that the stock will stay in the range, and both will expire worthless.

I manage it by if the stock reaches my call price I buy the stock, and sell it if it goes back into my "range" . Inversely if it falls to my put price I short the stock, and cover my short when it rises back above my put price.

So, even if the options expire out of my "range", my risk is covered. I do this when I have the cash in the account to cover buying or shorting the stock to manage position. What am I missing besides overnight gaps?


First of all, I am not an options trader, I just love any sort of puzzles and respond for fun.

Your question is about a free lunch. You know that there is no free lunch offered by the financial markets, because if there was, somebody had already eaten it up and digested it before you arrived. If there is a free lunch, it is hidden as well as the holy grail, which has never been found to my knowledge. So there must be a potential downside to your options strategy.


Black Swans

You identify a range and sell a put below and a call above the current price of the stock. If I understand you correctly, you are selling an uncovered strangle. This is a strategy, which typically generates a monthly income, as you are basically selling insurance to long stock and short stock holders. There is risk involved in doing this, as you have no protection, when the underlying suddenly moves up or down. For example if a takeover bid is announced, the stock of the underlying may easily double, and you will be sitting on a huge loss. This means that there is a substantial tail risk, as occasional black swans are coming out of nothing and reap all the little profits that you have accumulated. What are the alternatives?


Buy Protection to Cover Tail Risk: Iron Condor

An alternative to an uncovered strangle would be selling two vertical spreads, a bear call spread and a bull put spread. This limits your risk, as you buy protection against black swan events. However, the regular income generated by this strategy, which is called the Iron Condor, is much lower compared to the uncovered strangle. Another downside of the Iron Condor is the higher cost, associated with commissions and slippage (as you are selling spreads, this would be double the cost produced by uncovered strangles).


Coming Back to Your Way of Managing the Short Strangle

Your way of managing the short strangle does not allow you to manage tail risk. The tail risk is enormous, as the option markets are only open from 9:30 AM EST to 4:00 PM EST. This means that you are fully exposed during 17 hours and 30 minutes during each day and cannot react to any announcements. The Iron Condor would protect you. If the stock reaches the lower strike price, and if by chance the option market is open, when this happens, you sell the underlying. This will leave you with the following position
- short put & short stock = synthetic short call
- short call

You have now sold two short calls! This means that you have now exchanged your downside risk for an additional upside risk. You are still selling the same amount of insurance, but you have transformed your non-directional position into a directional bet. Same applies in case that the stock reaches the upper border of the range. In that case you have sold two puts, the original put and the synthetic put created from the long stock and short call position.


Cost Associated with Managing the position

You buy the stock, if it moves past the strike price of the call and sell it again, if it moves below. Practically this is not feasible, because you would buy and sell it many times back and forth. So in practice you buy, if it exceeds strike + x, and you sell it back if it moves back below strike – x. Every passage will cost you 2x + commissions + slippage. The narrower the range is the more passages you will have to pay for. In practice some of the passages occur outside the trading hours of the options exchange, and that is where additional risk drops in.


Summary

In my opinion you are selling insurance with no appropriate risk management. It is much about the same as AIG selling credit default swaps. You know what happened to AIG. Everything went well until the tail risk manifested itself.
I do not see any edge, unless you have a proven method to select stocks which will show a lower volatility than the implied volatility priced into the options that you are selling. In that case, and if you have access to the options market at a competitive price (spreads on stock options can be huge), your approach is valid. In any case I would prefer Iron Condor Spreads to selling uncovered Strangles, as this will considerably reduce your risk of ruin.

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  #4 (permalink)
trader0303
phoenix
 
 
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Fat Tails View Post
First of all, I am not an options trader, I just love any sort of puzzles and respond for fun.

Your question is about a free lunch. You know that there is no free lunch offered by the financial markets, because if there was, somebody had already eaten it up and digested it before you arrived. If there is a free lunch, it is hidden as well as the holy grail, which has never been found to my knowledge. So there must be a potential downside to your options strategy.


Black Swans

You identify a range and sell a put below and a call above the current price of the stock. If I understand you correctly, you are selling an uncovered strangle. This is a strategy, which typically generates a monthly income, as you are basically selling insurance to long stock and short stock holders. There is risk involved in doing this, as you have no protection, when the underlying suddenly moves up or down. For example if a takeover bid is announced, the stock of the underlying may easily double, and you will be sitting on a huge loss. This means that there is a substantial tail risk, as occasional black swans are coming out of nothing and reap all the little profits that you have accumulated. What are the alternatives?


Buy Protection to Cover Tail Risk: Iron Condor

An alternative to an uncovered strangle would be selling two vertical spreads, a bear call spread and a bull put spread. This limits your risk, as you buy protection against black swan events. However, the regular income generated by this strategy, which is called the Iron Condor, is much lower compared to the uncovered strangle. Another downside of the Iron Condor is the higher cost, associated with commissions and slippage (as you are selling spreads, this would be double the cost produced by uncovered strangles).


Coming Back to Your Way of Managing the Short Strangle

Your way of managing the short strangle does not allow you to manage tail risk. The tail risk is enormous, as the option markets are only open from 9:30 AM EST to 4:00 PM EST. This means that you are fully exposed during 17 hours and 30 minutes during each day and cannot react to any announcements. The Iron Condor would protect you. If the stock reaches the lower strike price, and if by chance the option market is open, when this happens, you sell the underlying. This will leave you with the following position
- short put & short stock = synthetic short call
- short call

You have now sold two short calls! This means that you have now exchanged your downside risk for an additional upside risk. You are still selling the same amount of insurance, but you have transformed your non-directional position into a directional bet. Same applies in case that the stock reaches the upper border of the range. In that case you have sold two puts, the original put and the synthetic put created from the long stock and short call position.


Cost Associated with Managing the position

You buy the stock, if it moves past the strike price of the call and sell it again, if it moves below. Practically this is not feasible, because you would buy and sell it many times back and forth. So in practice you buy, if it exceeds strike + x, and you sell it back if it moves back below strike – x. Every passage will cost you 2x + commissions + slippage. The narrower the range is the more passages you will have to pay for. In practice some of the passages occur outside the trading hours of the options exchange, and that is where additional risk drops in.


Summary

In my opinion you are selling insurance with no appropriate risk management. It is much about the same as AIG selling credit default swaps. You know what happened to AIG. Everything went well until the tail risk manifested itself.
I do not see any edge, unless you have a proven method to select stocks which will show a lower volatility than the implied volatility priced into the options that you are selling. In that case, and if you have access to the options market at a competitive price (spreads on stock options can be huge), your approach is valid. In any case I would prefer Iron Condor Spreads to selling uncovered Strangles, as this will considerably reduce your risk of ruin.

Fat Tails --- thank you so much for taking the time to put that reply together. I'm going to take some time now to learn more about Iron Condor Spreads. The approach I've been taking is certainly risky....it's a high probability play, but the one time it goes wrong, it would wipe away all my winnings and more.

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  #5 (permalink)
 Fat Tails 
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trader0303 View Post
Fat Tails --- thank you so much for taking the time to put that reply together. I'm going to take some time now to learn more about Iron Condor Spreads. The approach I've been taking is certainly risky....it's a high probability play, but the one time it goes wrong, it would wipe away all my winnings and more.

Fully agree with your summary.

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  #6 (permalink)
 Delta_Panther 
Switzerland
 
 
Posts: 112 since Aug 2009

Hi

This sentence from Fat Tails points out the most important thing: "I do not see any edge, unless you have a proven method to select stocks which will show a lower volatility than the implied volatility priced into the options that you are selling.

Now how to improve the way it is presented from trader0303 ?

Just flip the coin and go long the options and short the stock. Leg in first with the options to have better BE on both sides and use stop loss for the sold stocks.

Delta_Panther

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  #7 (permalink)
vinoth
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I too fully agree with your summary. Just a naked call or put cant bring a edge to live in this market

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  #8 (permalink)
 bartokInD 
Toronto Canada
 
 
Posts: 10 since Nov 2012

the risk is a little bit more that what was described. if the stock moves towards either the call strike or the put strike, then you have to hedge by buying or selling the stock. how much stock do you buy or sell? that depends on the delta of the option. as the stock moves closer to the strike, the delta gets bigger and you have to hedge more stock.

so it's not a matter of simply buying the stock if it goes above the call strike and selling it if it goes bellow. you need to dynamically hedge your position. as you can imagine, this can be costly in terms of commissions. it can be even costlier if the stock moved towards the put option which would require you to short stock. this brings about 1 additional risk, and 1 additional cost.

1.) is there stock loan available? if not, then you won't be able to short.
2.) the stock loan rates that brokers charge can be substantial.

what you want to do is look at the volatility that you're selling, and if the options are expensive enough to cover the hedging costs.

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 Bermudan Option 
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This is referred to as "picking up pennies in front of a steam roller." The one time you are wrong can wipe out your entire account. Good thread!

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Bermudan Option View Post
This is referred to as "picking up pennies in front of a steam roller." The one time you are wrong can wipe out your entire account. Good thread!

+1

You can go for quite a while making 10% a month until you have a bad month that wipes your account. You can only make the 10% in the first place by having 100% of your account on the line & 10% is a GOOD month.

Seen a few people on various forums doing it & they won't listen. Then one day, then blow up & disappear.

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  #11 (permalink)
mwtzzz
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As a general rule of thumb, selling premium works well, until one day when something unexpected happens and it works so totally against you as to wipe out all profits you were able to achieve to that point.

In your particular example, any big move against either short put or call, will wipe out any premium you made and put you in the hole. Let's say you sold the put for $1300 and the call for $1170. Let's say one day a piece of news causes price of the underlying instrument to jump so that call is now worth $5000 and because the price jumped you were unable to get a fill on your stop order to buy the stock. you're now sitting on a $2530 loss in the options and you still need to buy the stock in case it continues to move against you.

Or, instead of any big moves happening, prices could bounce around between the strike prices and the middle point, causing you to excecute your strategy of buying and selling shares a bunch of times. Do that enough times and any profit you have from selling the options is erased by losses incurred on the stock.

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