# Options Not So Risky!



## wayneL (28 June 2006)

It is often stated that options are high risk investments, and it is true that options in the hands of a certifiable idiot, can cause deleterious damage to said idiots account. However in actual fact, options are no more risky than stocks.

People believe they are risky because of a fundamental misunderstanding of what an option actually does. An option merely transfers risk from one trader to another in exchange for risk in another form.

Lets consider the six possible one legged positions that a trader can undertake.

Long  stock
Long Put
Short Call

Short Stock
Long Call
Short Put

Lets assume that all the option strikes are the same and ATM and traded at fair value. If all six positions are initiated at the same time (ignoring cost of carry and  brokerage) by one trader there would be no possible profit or loss.

Said another way, if six separate traders each entered one of the above positions, each trader would either end up with either a profit or a loss, of varying magnitutes. However, if the profit or loss of all six traders were added together, the result would be 0, NO MATTER WHAT THE STOCK PRICE DOES.

Now in reality, the contest risk (spread + commish) would ensure a slight loss overall.

So what we can see here is that options have not introduced any additional risk whatsoever (apart from additional brokerage perhaps)

More to come……


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## wayneL (28 June 2006)

It is not by accident that I have separated the 6 positions into two groups. The first group:

Long stock
Long Put
Short Call

…If traded concurrently, also will always add up to zero, no matter what the underlying does. As a matter of fact, the above three positions, when traded together is called a locked position, because no profit or loss is possible from the point the trade is placed. This particular locked trade is called a “conversion”, and is the most likely position you friendly market maker will be in if you are on the other side of one of the other option positions.

Also, if we take any two components of a conversion, it will be the synthetic opposite the remaining component.

For example if we take the long stock and the short call and put them together, what do we have? Well we have a covered call, but we also have a synthetic short put… which is the exact opposite of the remaining component, the long put. Put a short put and a long put together and they cancel each other out… SHAZAM! A locked position.

Likewise;

Long Stock + Long Put = Synthetic Long Call   
Locked by the Short Call

Long Put + Short Call = Synthetic Short Stock
Locked by Long Stock

The exact Same scenario applies to the second group, only in reverse. Those three as one position is known as a “reversal”.  That is , short stock + long call + short put

More….


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## wayneL (28 June 2006)

So where am I going with this? It is to demonstrate that options are NOT more risky than stocks, they are not LESS risky than stocks, and that they merely transfer risk from one aspect to another, and one trader to another.

Lets look an extreme example to illustrate. Lets say we have a stock trading at 30 dollars and the options are trading at 25% volatility (with sixty days till expiry). We have six traders who each enter 100 shares (or one contract) on one of the above positions.  (we are excluding cost of carry for the sake of simplicity)

Trader 1 buys 100 x stock @ $30
Trader 2 shorts 100 x stock @ $30
Trader 3 long 1 x 30call - @ $1.20 * 100
Trader 4 writes 1 x 30call - @ $1.20 * 100
Trader 5 buys 1 x 30put - @ $1.20 * 100
Trader 6 writes 1 x 30put - @ $1.20 * 100

OK! Disaster! The stock gaps down to $5.00 overnight due to bad news. Lets tally up the winners and losers in order, biggest winner, down to biggest loser.

Trader 2 (short stock) makes $2,500
Trader 5 (long put) makes $2,380
Trader 4 (short call) makes $120
Trader 3 (long call) loses $120
Trader 6 (short put) loses $2,380
Trader 1 (long stock) loses $2,500

Two things to notice here:

1/ The stock positions lost the most and made the most.
2/ The Profit and loss of all positions add up to zero

So in this particular instance the long stock ended up being the most risky position of all. It lost more than all of the option positions.

More….


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## wayneL (28 June 2006)

So am I trying to say that stock is the riskiest position? No, not at all.

I am merely saying that long stock has the most downside risk.

Other positions have risk in other areas. By removing risk in one area, you will be taking on risk in another area. The decision the trader must make is whether that trade off, of one type of risk for another, is both acceptable and/or advantageous according to your precise view of the stocks potential movements within a given time frame. (even if your view is precisely imprecise)

By buying a call (or synthetic equivalent thereof), you are removing a great deal of downside risk. However it comes at a price, you must pay a premium and the potential upside is reduced absolutely by that amount of premium at expiry. There is also time risk; the stock must make it move before the expiry date.

…and so on down through the strategies, trading one risk for another.

All of these risks are quantified by the outputs of the various option pricing models, and are known as the greeks. It is the greeks that tell you where these risks are, and how much.

The important thing to remember, and the intent of this thread, is to dispel the myth of options being "risky". 

Any questions are welcome.

Cheers


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## MichaelD (28 June 2006)

wayneL said:
			
		

> Any questions are welcome.



Aren't options risky?

     


(just couldn't resist)


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## cuttlefish (28 June 2006)

The only thorn in the side of this argument is liquidity (contest risk as you call it?), which I don't think can be dismissed (and you've of course mentioned it as well in the first post but glossed over it). 

It means you aren't guaranteed to get the 'theoretical price', all you get is a spread unless its a highly liquid options series - this unfortunately typically means no more than a couple of months out and pretty close to the money.

But if you trade in underlying stock you do get the liquidity and don't have to worry about this.

This is a concern if taking large options positions - similar to the concerns someone would have taking large positions in an illiquid stock. If you want to get out in a hurry you will pay a price - maybe a big price.

Are there any strategies for dealing with contest risk (assuming I've understood this term correctly)?  Also has this cost been quantified?


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## wayneL (28 June 2006)

Cuttlefish,

You've brought up some interesting points



			
				cuttlefish said:
			
		

> The only thorn in the side of this argument is liquidity (contest risk as you call it?), which I don't think can be dismissed (and you've of course mentioned it as well in the first post but glossed over it).
> 
> It means you aren't guaranteed to get the 'theoretical price', all you get is a spread unless its a highly liquid options series - this unfortunately typically means no more than a couple of months out and pretty close to the money.
> 
> But if you trade in underlying stock you do get the liquidity and don't have to worry about this.




Firstly, I am not advocating the trading of options over stocks, just trying to help people understand them better. If people want to trade them or not trade them, let that be from a position of understanding, and not heresay, misinformation and half truths.

However this liquidity risk is real, and one must assess any instrument as to the suitability to their trading style. If the trading style is entering for short term speculation and exiting on some type of stop, then stay right away from illiquid series. Exactly the same, as you say, for illiquid stocks. 

But contrary to popular opinion, this is not the only use of options. If you want to trade this way, then stick with those series you've mentioned above.

But regarding this liquidity issue; this only applies in VERY small option markets like OZ. US options have masses of liquidity right out away from the money and right out in the back months. If people insist on trading illiquid markets, then it will be a problem



			
				cuttlefish said:
			
		

> This is a concern if taking large options positions - similar to the concerns someone would have taking large positions in an illiquid stock. If you want to get out in a hurry you will pay a price - maybe a big price.




*"Large Option Positions":* This is a very important point. People tend to over use leverage when presented with the opportunity. I've seen people who wouldn't dream of taking a 1000 delta position in a stock, happily take on 5000-10000 deltas in an option position... absolute friggin' insanity.

This is in actual fact where the great bulk of additional contest risk is incured in option positions. people are taking on enourmous position sizes... way way too big for their account size... and this is precisely where option traders crash and burn. 

Instead of merely transfering risk, they are assuming whopping great gobs of additional risk as well... deta risk, vega risk, theta risk and contest risk. This is almost always underestimated by noob (and not so noob) traders, because they don't understand the greeks (read haven't bothered to learn them) and how they quantify risk.

Contest risk is only *slightly* larger in an option position of equivalent underlying size, than on the underlying itself.



			
				cuttlefish said:
			
		

> Are there any strategies for dealing with contest risk (assuming I've understood this term correctly)?  Also has this cost been quantified?




Well I think I've answered that indirectly. Determine your position delta, and don't violate sound money management principles.... and don't trade illiquid series if your trade management includes the use of emergency exits.

Cheers


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## cuttlefish (28 June 2006)

thanks for the reply.  I guess something I've found in my experimenting with options is that the reality is that contest risk (or the cost of the spread) is real - you might be able to negate it on one side of the trade (e.g. only enter when you're not paying it - effectively means only entering when you're buying from another trader rather than an MM) but you can't guarantee it on exit. (and yes you can increase your chances of not paying it on either side if you pick a liquid option).

To me in the illiquid Australian market this limits the variety of choices available in using options - almost to short term trading rather than taking longer term positions.    I'm still experimenting at using long ATM calls (or near atm calls) for long term investing types of positions but am aware that I'm paying a contest premium when doing it, and also don't have the ease of exit I would with a long term position by directly buying the stock - so if I need/want to exit in a hurry I might have to give away a fair bit of theta and delta (and if it wasn't for the arbitrage traders I'd be giving away a lot more.). 

For this reason I'm not that confident about using them to synthesise the equivalent of a large investment in the underlying.

I guess the other way of doing it is to use reasonably deep ITM's to synthesise the long position in which case there isn't as much theta and vega built into the price - but to some extent that defeats the purpose - it would be possible to achieve similar by directly buying more of the underlying using margin and I'd probably pay less carry cost overall.

I know I can also short puts to take long term positions, but I'm talking about low volatility stocks and my understanding so far is it is probably better to short options when you think volatility is going to reduce and long them when you think it will rise.

I'm at the very early stages of learning this stuff, so finding it interesting to talk and think about it and also by trying it am learning a lot that you can't learn via the reading etc. 

I've found a lot of the comments on here helpful, particularly discussions on the greeks etc. in the options mentoring thread, and am pretty sure they've resulted in an increased success rate so far.


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## wayneL (29 June 2006)

cuttlefish said:
			
		

> thanks for the reply.  I guess something I've found in my experimenting with options is that the reality is that contest risk (or the cost of the spread) is real - you might be able to negate it on one side of the trade (e.g. only enter when you're not paying it - effectively means only entering when you're buying from another trader rather than an MM) but you can't guarantee it on exit. (and yes you can increase your chances of not paying it on either side if you pick a liquid option).
> 
> To me in the illiquid Australian market this limits the variety of choices available in using options - almost to short term trading rather than taking longer term positions.    I'm still experimenting at using long ATM calls (or near atm calls) for long term investing types of positions but am aware that I'm paying a contest premium when doing it, and also don't have the ease of exit I would with a long term position by directly buying the stock - so if I need/want to exit in a hurry I might have to give away a fair bit of theta and delta (and if it wasn't for the arbitrage traders I'd be giving away a lot more.).
> 
> ...




Well you've got a pretty damned good grasp of the concepts if you are in the early stages. Good stuff.

A couple of comments on long term positions and ATM vs ITM.

Remember, there is always a trade off of risk.

ATM: Theta and Vega is maximum when atm the money, and also gamma is reduced the further out in time you go. Therefore you must be careful "when"  you put the trade on in terms of the stocks Implied Volatility cycle.

Even low IV stocks cycle from relative lows to relative highs. The lower quartile in the IV range is the time to put this on. 

ITM: Reduces the above considerations markedly, but once again there is a trade off. You will have more absolute downside risk. 

In comparing it to a margined stock position, once again, trade offs. You effectively have NO downside protection in this position if the stock is subject to a large gap down.

The decision comes in when you decide "where" you would prefer your risk to be. If you consider there is little downside risk because of excellent fundamentals, and not expecting any real volatility, then unquestionably the best position is straight stock.

But if your outlook varies from that, then an option strategy could suit.

Also, there is the flexibility to metamorphosise the long term position for short term advantage, using options. This can be achieved whether the underlying position is stock or a long term call. As your view evolves, transfer risk to where you want it to be.

Cheers


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## hissho (29 June 2006)

wayneL said:
			
		

> Said another way, if six separate traders each entered one of the above positions, each trader would either end up with either a profit or a loss, of varying magnitutes. However, if the profit or loss of all six traders were added together, the result would be 0, NO MATTER WHAT THE STOCK PRICE DOES.




hi Wayne
Glad to see another good thread on options!

here's my question: sometimes you can find arbitage opportunities in conversion, box spread and reversion etc.....

1) how does that happen? because of a mistake made by MMs?

2) how would you capture such a risk-free opportunity? sitting in front of your computer all day and search? or you set up your software in some way so that you'll get a pop-up window when the opportunity presents itself?

thanks


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## sails (29 June 2006)

Hissho, while you are waiting for Wayne to reply, I will add that there is usually a reason apparent mispricings and an upcoming dividend is the most usual one.


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## cuttlefish (29 June 2006)

Wayne, 

Thanks again for the reply.



			
				wayneL said:
			
		

> Even low IV stocks cycle from relative lows to relative highs. The lower quartile in the IV range is the time to put this on.




thanks - useful advice.



> In comparing it to a margined stock position, once again, trade offs. You effectively have NO downside protection in this position if the stock is subject to a large gap down.




I think thats a good point as well - and a valid counterpoint to the liquidity argument in favour of direct stock.


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## wayneL (29 June 2006)

hissho said:
			
		

> hi Wayne
> Glad to see another good thread on options!
> 
> here's my question: sometimes you can find arbitage opportunities in conversion, box spread and reversion etc.....
> ...




Hi Hissho

Margaret is spot on there, make sure to account for the dividend in apparent persistant arb opportunities. (A big factor in Oz options)

Notwithstanding, these arb opps do exist. However they are "usually" closed pretty quicksmart by the instos. I heard of one Japanese firm who specialises in arbitration, recently spending USD28 *MILLION* uprading their computer system.. ie the speed at finding these opportunities. The gain in speed achieved? *1 SECOND*!

So in reality, for the retail trader, by the time you investigate to see if this a true arbitrage, its gone!

It's not really realistic to go looking for them and even if you do find them, margin rules + cost of carry + commish may destroy the profit for us retail traders. Those locked positions are still useful though in determining whether a strategy is fairly priced, sometimes they will show up some vol skew that might be worth a few cents more doing a spread one way over the other, even if the arb is not viable, so still worth looking at.

Also look at the opposite lock/synthetics for an advantage in this regard.

Cheers


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## wayneL (29 June 2006)

OK, So I've bsically demonstrated that options do not introduce risk, but merely transfer risk.

But unquestionably, people crash and burn, sometimes spectacularly, trading options, and this is where this perception of high risk comes from. 

Basically the question is; if options are so safe, how do so many people blow up?

Here's one way:

Quite some time ago I posed a question to the board; I asked how, given the present condition, would people trade this particular stock I mentioned, that was trading at $26.76.

Anyway, someone sent me a PM and said "write 100 $25 puts, it will never get that low"

Anyway the puts were selling for $1.20, so that strategy would have *initially* collected $12,000.

Can you guess what happened next?

To avoid unnecessary anticipation, I submit exhibit A, the stock in question:

more...


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## wayneL (29 June 2006)

Anyone who actually wrote 100 $25put option contracts would be staring a ~$175,000 loss in the face.

Now I will point out right here that anyone who bought 10,000 shares at the same time would have lost even MORE. But I submit that the same person who sold the 100 contracts, would NEVER have bought 10,000 shares because of the risk!!

Can you see where I'm going with this? Can you see the shear lunacy of what this person suggested? This is precisely what people do every day with options.

By not understanding the greeks people expose themselves to absolutely insane levels of risk.

And that ain't all! But I won't bore with more stories, I'm sure you get the gist.

Cheers


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## GreatPig (29 June 2006)

_<Makes mental note>_ Must remember not to do that...


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## Hopeful (26 September 2006)

Blimey and crikey! A drop like that is one of the reason options were invented - to protect you against financial ruin.

A few others that that chart reminds me of are HIH Insurance, Pasminco, NAB (about 2 years ago), Enron, Repco, hmm anymore?

I'd like to get some opinions on writing a covered call on RMBS. It has been one of the highest yielding calls in recent weeks (or longer I guess) as it has extreme volitility. An ideal collar candidate? Would you consider it?


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## wayneL (26 September 2006)

Hopeful said:
			
		

> I'd like to get some opinions on writing a covered call on RMBS. It has been one of the highest yielding calls in recent weeks (or longer I guess) as it has extreme volitility. An ideal collar candidate? Would you consider it?




Below is RMBS, with the arrows pointing to the spots where you would have written calls, expiry from the previous cycle having been the previous friday; since April.

The September expiry is the only one where you would have made a profit. The previous 4 months would have been a blood-bath. You would have written the 12.50 call for sept and had them called... the current price being $17.50
*
Selecting stocks to do CCs based solely on high IV is a loser!!!!*

Cheers


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## wayneL (26 September 2006)

Hopeful said:
			
		

> I'd like to get some opinions on writing a covered call on RMBS. It has been one of the highest yielding calls in recent weeks (or longer I guess) as it has extreme volitility. An ideal collar candidate? Would you consider it?




Just noticed it was *collars* you are suggesting and not CC's (Jumped to conclusions when I saw the extreme vol)

1/ IV is not really relevant at expiry of a collar unless the written call is ITM and the put OTM.

2/ A collar is a synthetic vertical spread. Why chew up capital buying stock when you can use a pure option strategy for much cheaper (and keep the bulk of your capital earning interest) You also have much more versatility... for instance you can do a bear vertical much easier without the long stock, which would have been nicely profitable in the above chart

3/ A collar is NOT a safe CC. It is a synthetic vertical and your greeks will be different.

That said, on a high IV stock such as RMBS, a vertical spread is quite a sensible choice in that it does much to neutralise some of the unsavoury negative aspects of high IV when picking direction.

Cheers


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## Hopeful (27 September 2006)

Thanks for the reply, WayneL. One would be foolish to do bullish strategies in a bear market. But as it appears that RMBS may have found a bottom. 

I haven't traded Options yet, but working up to it - still got lot's to read. But I would have liked to write a RMBS naked call on the 15th of Sept (my indicators told me it would likely fall from there) for about $1.30. I would now be looking to buy the stock to cover and a protective put as well.

What are your top income earning strategies? A little bird tells me that these are one person's top four:

1.BWB
2.Collars
3.Gamma Scalping
4.Time spreads

I only know what a collar is though... (must read more must read more).


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## wayneL (27 September 2006)

Hopeful said:
			
		

> 1.BWB
> 2.Collars
> 3.Gamma Scalping
> 4.Time spreads
> ...




1. BWB ?????? Buy/Write? Nah, unless holding stock long term

2. Collars? Verticals are better

Lets say you bought stock at 50, sold a 50 call (or higher), and bought a 45 put... thats a collar.

The exact same payoff diagram gan be contructed buy simply buying the 45 call and selling the 50 call... thats a bull call spread.

Exactly the same as each other synthetically. Why would you do a collar, unless you already own the stock?

3. Gamma scalping? If the planets line up.

4. Time spreads. Yes

Plus, but not limited to:

5. Butterflies/Condors

6. Ratio spreads( indicies only IMO)

7. naked option writes and strangles (futures only imo)

Cheers


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## wayneL (27 September 2006)

Hopeful said:
			
		

> Thanks for the reply, WayneL. One would be foolish to do bullish strategies in a bear market. But as it appears that RMBS may have found a bottom.




The May cycle on RMBS was in a raging bull... pull up a chart for the period immediately preceding


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## Hopeful (27 September 2006)

wayneL said:
			
		

> 2. Collars? Verticals are better
> 
> Lets say you bought stock at 50, sold a 50 call (or higher), and bought a 45 put... thats a collar.
> 
> ...




What software do you use to create your payoff/risk diagrams? Can I do it with Excel formulae?


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## wayneL (27 September 2006)

Hopeful said:
			
		

> What software do you use to create your payoff/risk diagrams? Can I do it with Excel formulae?




http://www.hoadley.net/options/strategymodel.htm is excel based and the base version is free.


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## sails (27 September 2006)

Hopeful said:
			
		

> Thanks for the reply, WayneL. One would be foolish to do bullish strategies in a bear market. But as it appears that RMBS may have found a bottom.
> 
> I haven't traded Options yet, but working up to it - still got lot's to read. But I would have liked to write a RMBS naked call on the 15th of Sept (my indicators told me it would likely fall from there) for about $1.30. I would now be looking to buy the stock to cover and a protective put as well.
> 
> ...



*Hopeful,*  I think your little birdie might have been reading Scott Kramer's board at Optionetics recently!  Scott has actually written some articles on both collars and BWB's - might be worth searching the Optionetics article archives - they are free   .

*Wayne*, a BWB is "Broken Wing Butterfly" which typically is described as an unbalanced fly or a ratio spread with a further out long for some protection.  For example, BHP:
+1 $26.00 put
-2 $25.00 put
+1 $23.00 put

Good when IV's are high and likely to fall plus a gentle movement towards to sold strikes as one would want with a ratio spread.

The other thing I have done is start off with a butterfly and then adjust it into a BWB by expanding either the debit or credit side of the fly at support or resistance levels.  It can usually be done cheaper when the market moves beyond the outer strikes of the fly than just putting it all to begin with - but still experimenting!


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## wayneL (27 September 2006)

sails said:
			
		

> *Hopeful,*  I think your little birdie might have been reading Scott Kramer's board at Optionetics recently!  Scott has actually written some articles on both collars and BWB's - might be worth searching the Optionetics article archives - they are free   .
> 
> *Wayne*, a BWB is "Broken Wing Butterfly" which typically is described as an unbalanced fly or a ratio spread with a further out long for some protection.  For example, BHP:
> +1 $26.00 put
> ...




Ahso! It's funny how different circles can use different terminology. I know a BWB as a (rather convolutely) "butterfly with embedded vertical". LOL

Which is in fact the precice way to convert the fly to the BWB.

Another topic I noticed on Kramers board which arises here:



> The risk graph of a collar and bull call spread are the same, but that is where the similarities end.
> You have a much better chance of making money over the long run with collars than bull call spreads because you are always in the position and the stock acts as a flotation device by which you remain at equilibrium.
> 
> The problem with a call spread (which is not like the collar) is that if you purchase an OTM call spread the stock can go up and you still lose money if the stock does not appreciate beyond the b/e point. Then when the options expire, you have to put on a new vertical call spread. Because of the run up in the stock which you may not have capitalized on, you will likely have to pay much more for the same vertical spread out the next month or move up a strike. If this keeps happening on a slowly drifting higher stock you could be chasing profits all the time without actualizing any. It is a non-fluid trade because of the starting and stopping effect of moving options around every month.
> ...




To me, he appears to be on crack here. It seems complete nonsense. Am I missing something?


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## sails (27 September 2006)

wayneL said:
			
		

> Ahso! It's funny how different circles can use different terminology. I know a BWB as a (rather convolutely) "butterfly with embedded vertical". LOL
> 
> Which is in fact the precice way to convert the fly to the BWB.



Totally agree - and that is exactly how I stretch out the regular fly to the "BWB" - (BWB is easier to type)!!



> Another topic I noticed on Kramers board which arises here:
> 
> To me, he appears to be on crack here. It seems complete nonsense. Am I missing something?



Now that you mention it, I do remember reading that and thought at the time  he couldn't have been comparing collars and verticals at the same strikes.  Agree, I think he's a bit off with the fairies there.  That sort of thing is the reason I have learned to never put real money on anything I read until I have tested and proved it for myself - and understand the implications of the greeks.  But on the same token, try not to throw the baby out with the bathwater and I've found Scott to have some thought provoking ideas.

One possible, interesting difference between the two (collar and vertical) is that interest is technically paid upfront when purchasing the long call where this is not so when purchasing the stock.  The cost of carry on the stock is not pre-paid. 

Suppose the long call is a couple of months out and we know the interest component is factored into that call - then the stock tanks (now don't get excited and put that bear suit back on yet!).  If the position is closed out, much of the pre-paid interest component in the call is likely to be lost whereas cost of carry is only to the time of exiting the position.  Any thoughts???


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## wayneL (28 September 2006)

sails said:
			
		

> Totally agree - and that is exactly how I stretch out the regular fly to the "BWB" - (BWB is easier to type)!!



Agree, forevermore known as BWB  



			
				sails said:
			
		

> Now that you mention it, I do remember reading that and thought at the time  he couldn't have been comparing collars and verticals at the same strikes.  Agree, I think he's a bit *off with the fairies* there.  That sort of thing is the reason I have learned to never put real money on anything I read until I have tested and proved it for myself - and understand the implications of the greeks.  But on the same token, try not to throw the baby out with the bathwater and I've found Scott to have some thought provoking ideas.
> 
> One possible, interesting difference between the two (collar and vertical) is that interest is technically paid upfront when purchasing the long call where this is not so when purchasing the stock.  The cost of carry on the stock is not pre-paid.
> 
> Suppose the long call is a couple of months out and we know the interest component is factored into that call - then the stock tanks (now don't get excited and put that bear suit back on yet!).  If the position is closed out, much of the pre-paid interest component in the call is likely to be lost whereas cost of carry is only to the time of exiting the position.  Any thoughts???




LOL @ off with fairies comment  

Re the cost of carry issue. It is true that if you put the two strategies into hoadley, there will be a difference in the diagrams, particularly with longer expiries. But this is because the cost of carrying long stock is not factored in. With the cost of carry factored into carrying the long stock, the payoff once again becomes identical.

To prove this, simply substitute a synthetic long (long call, short put, for the benefit of noobs) for the long stock whereby these carrying costs are taken into account by hoadley. This difference is then corrected, and the diagrams identical.

Cheers


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## sails (28 September 2006)

wayneL said:
			
		

> ... Re the cost of carry issue. It is true that if you put the two strategies into hoadley, there will be a difference in the diagrams, particularly with longer expiries. But this is because the cost of carrying long stock is not factored in. With the cost of carry factored into carrying the long stock, the payoff once again becomes identical.
> 
> To prove this, simply substitute a synthetic long (long call, short put, for the benefit of noobs) for the long stock whereby these carrying costs are taken into account by hoadley. This difference is then corrected, and the diagrams identical.
> 
> Cheers



I agree if you put both strategies into Hoadley and take them both right through to the expiry of the long call - the result should be identical.

However, I can't have explained it sufficiently in my last post, so will try another way.

I'll break it down - the short calls will be identical on both strategies, so won't even discuss them.  We are really comparing the long call vs. stock plus long put at the same strike.

Let's say the long call (long put) is three months out.  We pay more for the call vs. the put due to the interest component in the calls.  Then one month later XYZ goes into a trading halt and the news is really, really bad.  XYZ drops 50% when the stock trades again.

Now our previously ITM long call is extremely far OTM and the long put will now be equally deep ITM.  Most, if not all extrinsic value has gone in both positions including the interest component in the calls.

So, for the purpose of this illustration, we decide to exit the position.  We have probably lost most of the *remaining* 2 months of pre-paid interest on the calls, however, we have no further cost of carry on the stock - in other words, we have only paid for 1 month cost of carry on the stock.  

Not advocating it as a better strategy by any means, but just an interesting concept that I had never thought of until recently when reading about this elsewhere.


----------



## wayneL (3 October 2006)

sails said:
			
		

> I agree if you put both strategies into Hoadley and take them both right through to the expiry of the long call - the result should be identical.
> 
> However, I can't have explained it sufficiently in my last post, so will try another way.
> 
> ...




Been putting some thought into this. I'm not a natural mathematician, and options do force one to resort to maths sometimes. This is such an occasion.

It seem seems intuitive that what you are saying is correct. The problem I am having with this is:

1/ It is not born out synthetically via bought call/sold put synthetic long, and 

2/ Cost of carry is also accounted for in the bought put leg of the collar, so in this way we are also being paid in advance for carrying costs as well....self cancelling?

To prove my contention is going to require equations  so still working on this to settle the matter.

Any mathemeticians out there?


----------



## Hopeful (15 October 2006)

I have been watching webinars from 888 and ioe, plus reading some other stuff and the picture I'm getting is that credit/debit spreads are the way to go for consistent income. Debit spreads are slightly better due to getting a better fill when putting it on in one single transactions (because the MM is on the other side and it suits him better somehow).

What do you fellas think of credit/debit spreads, have you done well out of them? 

BTW, simply selling puts has been the most profitable strategy overall over the last 5 years, however it is also the one with the highest risk/reward ratio.


----------



## bingk6 (15 October 2006)

Hopeful said:
			
		

> BTW, simply selling puts has been the most profitable strategy overall over the last 5 years, however it is also the one with the highest risk/reward ratio.




Hi Hopeful,

You will find a lot of people who would NOT recommend a short put strategy for very good reasons, however, I am not one of them, a I believe that it can be a very good strategy if used appropriately.

IMHO, 3 things need to be in place for this strategy to work
1) TA shows price having reached a a support level and is showing signs of rebounding
2) You must be able to absorb the consequences of being assigned stock. In other words, use this strategy only if the stock has reached an attractive level for you and that, all things being equal, you would be quite happy to purhcase the stock outright.
3) The IV for the stock should be in the upper quardrant

The reational is as follows:

If you find the stock at attrractive levels, and you are bullish, you can either buy the stock outright , or to write a put (either ATM - where extrinsic value is maximum or slightly OTM) in order to get a reasonable premium. From there, two things can happen

1) The stock continues to rebound and ultimately finish OTM, in which case, you pocket the premium, or
2) The option finishes ITM and you are assigned the stock.

For me, either of those options is superior to buying the stock outright at the start. If you are assigned the stock, you would be purchasing the stock at a level below the market price at the time if writing the option.

Now, heres the key, if the IV of the stock is high (say >35%) and you have been assigned the stock, then you do a covered call (CC) on your stock.If you really want to keep the stock, then write a OTM call. If holding the stock is not that important to you, then write ATM or ITM options to gain more premium. If CC expires OTM, then write another CC and on and on it goes. If CC is exercised, then issue another Short Put and once again on and on again.

I have found this strategy to be a very useful strategy for generating a great deal of premium. But off course, if you are using the Short Put to gamble away hugh amounts of money (as per the Wayne's example above), that is really bad news. IMHO you need to have the financial resources to cover all possibilities in order to use this strategy


----------



## Hopeful (16 October 2006)

bingk6 said:
			
		

> Hi Hopeful,
> 
> You will find a lot of people who would NOT recommend a short put strategy for very good reasons, however, I am not one of them, a I believe that it can be a very good strategy if used appropriately.
> 
> ...




Thanks for your post, it sounds like a great strategy (sounds very much like the often touted "renting stocks and selling insurance" strategy that I keep running into on the net). Do you also buy a protective further OTM put when shorting puts to cover yourself against these kinds of disasters (adlr.us nbix.us opwv.us pas.ax hih.ax etc)? How long have you been able to trade consistently profitable before facing a disaster? 

Interestingly, selling puts naked is actually less risky than just plain buying the stock because the stock can only go as far as zero and the premium you take in at least partially offsets the huge loss. In any case a naked put trader might want to avoid the high IV stocks as they are the ones most likely to make you homeless.


----------



## Hopeful (16 October 2006)

Hopeful said:
			
		

> Thanks for your post, it sounds like a great strategy (sounds very much like the often touted "renting stocks and selling insurance" strategy that I keep running into on the net). Do you also buy a protective further OTM put when shorting puts to cover yourself against these kinds of disasters (adlr.us nbix.us opwv.us pas.ax hih.ax etc)? How long have you been able to trade consistently profitable before facing a disaster?
> 
> Interestingly, selling puts naked is actually less risky than just plain buying the stock because the stock can only go as far as zero and the premium you take in at least partially offsets the huge loss. In any case a naked put trader might want to avoid the high IV stocks as they are the ones most likely to make you homeless.




Woops! The above should have read "protective call"   .


----------



## Mofra (16 October 2006)

Hopeful said:
			
		

> Do you also buy a protective further OTM put when shorting puts to cover yourself against these kinds of disasters (adlr.us nbix.us opwv.us pas.ax hih.ax etc)?



Hopeful,

I tend to concentrate the majority of my trades on net credit options trades, what you are describing by taking a long position in a put further out of the money than your short put position is a vertical, specifically a bull put spread (eg short BHP $26 put, long $25 put to limit downside). 

This is assuming your long/short ratio is 1/1 (which it doesn't need to be, if you'd prefer more/less downside protection based on you risk profile). In simple terms, you can at the very least calculate your maximum risk so as to determine your position size before you place a trade, which is a much overlooked piece of the trading plan IMO. 

Having an idea of your maximum loss doesn't absolve you from the responsibility (to your account balance!) of examining the greeks and understanding just what you are getting into - for a start, you don't want the MMs gouging you - and if you get caught holding one leg only your delta position will be miles away for your intended exposure (if you regularly calculate your aggregate delta position to determine your overall market exposure). A couple of cents outside your plan on both legs can also scew your plan to a higher risk/reward than you anticipated as well.

There are some very experienced options professionals here who can offer better advice than I can (still a wage slave personally) but we all have to start somewhere, and you never stop learning.

Hopefully (bad pun) you keep us posted updates and best of luck on your trading journey.

Regards,

Mofra


----------



## bingk6 (17 October 2006)

Hopeful said:
			
		

> Thanks for your post, it sounds like a great strategy (sounds very much like the often touted "renting stocks and selling insurance" strategy that I keep running into on the net). Do you also buy a protective further OTM put when shorting puts to cover yourself against these kinds of disasters (adlr.us nbix.us opwv.us pas.ax hih.ax etc)? How long have you been able to trade consistently profitable before facing a disaster?
> 
> Interestingly, selling puts naked is actually less risky than just plain buying the stock because the stock can only go as far as zero and the premium you take in at least partially offsets the huge loss. In any case a naked put trader might want to avoid the high IV stocks as they are the ones most likely to make you homeless.




Hi hopeful,

For me, the IV of a particular stock is the KEY consideration here. Having re-read my initial post, I realize that I did not explain it as thoroughly as I would have like, so will try again.

With the Short Puts that I issue, I am in essence, offering insurance to another shareholder who may have seen his/her shares plummet in value over a period of time and who may no longer have the stomach to watch their shares fall any further and is therefore looking to buy some insurance against further falls. Having said that, it would have to be a stock that I am happy to own and whose price level has reached a level whereby its starting to look attractive to me.

With regards to the IV for the stock, I would still prefer it to have a high IV. Why? Because it offers a higher premium, relative to a lower IV stock. This means that you can write the PUT at 2 or more strikes OTM and still receive a reasonable premium, if that’s what you want. A low IV stock forces you to go closer to the action to get a reasonable premium if you know what I mean.

Secondly, my interpretation of IV in this context of selling insurance for stock is very similar to how a normal insurance company would operate, with an important difference. Say we have an insurance company offering insurance for motor vehicles. A vehicle that is parked in a “good” suburb will attract a lower insurance premium than a vehicle from a “not so good” suburb. Why ? Because of the insurance company’s perceived difference in “IV” between the two suburbs. The “not so good” suburb is perceived to be more volatile and it makes sense for the insurance company to charge a higher premium for the “not so good” suburb, because statistically it has more claims, and more likely than not, is a trend that will continue to be the case in the future.

Similarly, in the case of options, IV is dependent on the volatility of the stock. However, if I initiate a short put (say ATM, right on a support level), having a high IV does not mean that it is likely that the stock will plunge through my support and incur a big loss for me. Indeed, it is just as likely to rebound strongly off the support. A high IV should theoretically move more (in absolute value terms) in EITHER direction, relative to a lower IV stock. It does not indicate an inclination to move more in one direction than the other. The odds of a high IV stock working in my favour is comparable to the odds of a high IV stock working against me. 

Compare this to the “IV” for the insurance company. With the “not so good” suburb, the insurance premium has to be higher because the odds are in favour of there being more claims in future. It is therefore only natural and prudent for the insurance company to price their premiums accordingly. With options, IMHO, receiving a larger premium (via high IV stocks) without necessarily having any more odds stacked against me one way or another, makes good sense to me.       

In any case, lets just assume that that your short put is assigned and you end up with the stock. With a high IV stock, your covered calls will also bring in more premium than for a low IV stock etc etc etc . 

Therefore to summarise this rather long discussion, I see no sense in issuing a short put to a low IV stock, and getting peanuts for a premium when the odds of the stock finishing in your favour are NO better than if you had issued a short put for a high IV stock. For mine, receiving a lower premium MUST imply lower risk. Otherwise, who is going to put up with receiving a low premium when they can receive a higher premium without having any further odds stacked against them. All things being equal, I will grab the larger premium anyday.

As you have probably noticed, I am not in favour of buying options, only selling them. I can’t really say why that is the case because in the scenario that I have described above (with a stock hitting a support), a vanilla long call is close to perfect, with unlimited upside and limited downside. One single leg, lower transaction costs etc etc. Perhaps the extrinsic value associated with purchasing a call is putting me off ?? I guess it has more to do with an individual’s own psychological makeup.  

I trust that this answers all your questions.

Please note that these thoughts are purely my own views. I know that these views would run contrary to what some of the more seasoned options players like Wayne, Sails and Mag think. They must be thinking that after having posted all this valuable information on options trading on this forum, that this is all that this F…… M…. can come up. However, I am being truthful in that this is what I think. Now I must seek help..


----------



## mumtrader (23 November 2006)

WayneL, with respect to the quote from Kramer's board regarding collars vs. verticals, you are definitely missing the point.  Of all the traders I know of, when it comes to trading this guy is certainly not on crack.  He is one of the best trained floor traders in the world.  Literally a guru on real options trading.  The guy he mentions, Peter Achs, took US$30K and turned it into US$1.2M in 3.5 years, using dynamic collaring techniques on BBBY.  I've never met a trader who did that with straight out vertical spreads.  Never met a trader who could manage the volume of trades it would take to do it, employing proper money management techniques & dealing with liquidity issues.

If it hasn't happened before I'll point you in the direction of J.L Lord's books @ Random Walk Trading.  This is where trading gets much less like gambling.


----------



## wayneL (23 November 2006)

mumtrader said:
			
		

> WayneL, with respect to the quote from Kramer's board regarding collars vs. verticals, you are definitely missing the point.  Of all the traders I know of, when it comes to trading this guy is certainly not on crack.  He is one of the best trained floor traders in the world.  Literally a guru on real options trading.  The guy he mentions, Peter Achs, took US$30K and turned it into US$1.2M in 3.5 years, using dynamic collaring techniques on BBBY.  I've never met a trader who did that with straight out vertical spreads.  Never met a trader who could manage the volume of trades it would take to do it, employing proper money management techniques & dealing with liquidity issues.
> 
> If it hasn't happened before I'll point you in the direction of J.L Lord's books @ Random Walk Trading.  This is where trading gets much less like gambling.




OK

Explain to me then, using collars would have differed from using the equivalent vertical spread... i.e. same strikes, and therefore almost exactly the same greeks.

Then tell me which point I am missing.

As a point of order, I can take 30k into the casino and do the same thing in 10 minutes if I'm lucky. One ocurrance does not prove anything.

That sounds ruder than it's meant to be, (and it's not meant to be  ) but no-one has been able to demonstrate to me, the superiority of collars over verticals.

Cheers


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## wayneL (24 November 2006)

mumtrader said:
			
		

> I've never met a trader who did that with straight out vertical spreads.  Never met a trader who could manage the volume of trades it would take to do it, employing proper money management techniques & dealing with liquidity issues.




I'm sticking to my crack hypothesis...

How many traders have you met?

Have you actually met Achs?

Have you actually met Kramer?

Why would the transaction volume differ between the two strategies?

How would MM issues be affected?



			
				mumtrader said:
			
		

> If it hasn't happened before I'll point you in the direction of J.L Lord's books @ Random Walk Trading.  This is where trading gets much less like gambling.




I'm wondering if the insult implicit in this comment was intentional.

I'm sorry, so far semingly the ranting of a starstruck sycophant...

Lets have some maths please


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## money tree (24 November 2006)

Naked puts are OK from a risk perspective, but your broker will demand HUGE margin payments to cover the positions! It just does not give bang for the buck over the long term.


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## ducati916 (24 November 2006)

money tree said:
			
		

> Naked puts are OK from a risk perspective, but your broker will demand HUGE margin payments to cover the positions! It just does not give bang for the buck over the long term.




Some accuracy in your statement is required, are you referring to;
*Naked a LONG Put
*Naked a SHORT Put

The differences in risk are material.
jog on
d998


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## wayneL (24 November 2006)

mumtrader said:
			
		

> If it hasn't happened before I'll point you in the direction of J.L Lord's books @ Random Walk Trading.  This is where trading gets much less like gambling.



Oh My!!!    LOL

800USD for three "pamphlets"... or $400 for the one to find out what a BWB is.

I like reading option texts... but I'll pass on that one thanks.


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## money tree (24 November 2006)

ducati916 said:
			
		

> Some accuracy in your statement is required, are you referring to;
> *Naked a LONG Put
> *Naked a SHORT Put
> 
> ...




Some common sense in your response is required. The conversation thus far was referring to writing puts. Also, Ive never heard anyone refer to a long put as "naked" because it does not have the risk profile of a short put. Furthermore, it would be blatantly obvious that margins are paid on written positions only. There was never any confusion...


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## ducati916 (24 November 2006)

*moneytree*



> Some common sense in your response is required. The conversation thus far was referring to writing puts. Also, Ive never heard anyone refer to a long put as "naked" *because it does not have the risk profile of a short put.*
> 
> Naked puts are OK from a risk perspective,




I just wanted you to clarify your position, as your assertion to risk, is just nonsense


jog on
d998


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## Hopeful (24 November 2006)

Bingk6, thanks for your post.

Regarding IV, when it's high you get more premium for your sold options. I get that. But if we are talking about collars it involves one long and one short option with the same expiry, same with spreads. So although you'll pull more in you'll also pay more out so doesn't it balance out? So therefore IV doesn't have to be a major consideration with collars. But also consider that collars are for neutral to mildly bullish scenarios, high IV would imply that a big move is relatively likely and as such high IV stocks are by definition not stocks suitable to the collar strategy.

If on the other hand you are talking about writing nakeds then high IV means higher risk to the writer (and buyer). If XYZ did break below your support level and has high IV then the move is likely to be a big one - your loss on the written option would be severe. So by only sticking to high IV stocks for writing nakeds you are taking on more risk but also more reward. Same as doing it on a sluggish heavyweight stock but with a larger number of lots, but with less outlay. Therefore it's a good idea to use high IV stock from the point of view of total outlay versus total possible % ROI. I guess.

How am I doing?


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## wayneL (24 November 2006)

There is something I am not getting with these optionetics bozo's and their whole BWB and collar setup.

I have nothing against the underlying logic of these two strategies. They are allied to each other in that they are limited risk/limited reward directional strategies with mixed greeks.

The only difference from a P/L standpoint is that the BWB has a bit more profit potential in the middle of the distribution curve (depending on the strikes used)

Yet these clowns insist on the synthetic version of a vertical spread, in the form of the high capital requirement collar, yet they use the "true" version of the BWB.

Indeed the BWB can be constructed using long stock... so why don't they, when they do so with the synthetic vertical?

I concede there may be an answer to this, but where is it? Why can nobody explain, if indeed there is one?

Cheers


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## professor_frink (24 November 2006)

some guy Wayne says is on crack said:
			
		

> The risk graph of a collar and bull call spread are the same, but that is where the similarities end.
> You have a much better chance of making money over the long run with collars than bull call spreads because you are always in the position and the stock acts as a flotation device by which you remain at equilibrium.
> 
> The problem with a call spread (which is not like the collar) is that if you purchase an OTM call spread the stock can go up and you still lose money if the stock does not appreciate beyond the b/e point. Then when the options expire, you have to put on a new vertical call spread. Because of the run up in the stock which you may not have capitalized on, you will likely have to pay much more for the same vertical spread out the next month or move up a strike. If this keeps happening on a slowly drifting higher stock you could be chasing profits all the time without actualizing any. It is a non-fluid trade because of the starting and stopping effect of moving options around every month.
> ...



I've been staring at this quote for ages and I just can't figure it out.
How on Earth is someone that is poor at picking direction going to make any money on ANY kind of strategy that involves the underlying moving a certain way?


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## wayneL (24 November 2006)

professor_frink said:
			
		

> I've been staring at this quote for ages and I just can't figure it out.
> How on Earth is someone that is poor at picking direction going to make any money on ANY kind of strategy that involves the underlying moving a certain way?




My crack hypothesis only gains strength with that one.

The difference is purely psychological...

...and fails to mention the ramifications of assignment in the "equilibrium" argument; which will take the position out


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## mumtrader (24 November 2006)

Geez Wayne, doesn't take much to rattle your cage does it?  I wasn't insinuating anything insulting in my post, just trying not to assume too much. . . but if it is insults you wish to 'trade' well:

I don't have to prove anything to you.  All I can say is you are all looking at this from the wrong angle, based upon a tiny snipit of a conversation that has been running for a year.  It works & they are right.

Anyway, prove it to yourself, you're the one with the bone to pick apparently.  If you're all so clever & these guys are so drug addicted, go over to the Optionetics board and kill them with your superior knowledge.  It's been ages since anyone was foolhardy enough to debate options strategy with either of them (let alone think they can win).  It'll be good for a laugh.  

Or are you guys all so in awe of eachother over here (speaking of sycophants), trying to show how much Cottle you've memorised, to bother continuing your trading education?


----------



## wayneL (24 November 2006)

mumtrader said:
			
		

> Geez Wayne, doesn't take much to rattle your cage does it?  I wasn't insinuating anything insulting in my post, just trying not to assume too much. . . but if it is insults you wish to 'trade' well:
> 
> I don't have to prove anything to you.  All I can say is you are all looking at this from the wrong angle, based upon a tiny snipit of a conversation that has been running for a year.  It works & they are right.
> 
> ...




As expected, no mathematics anywhere to be seen, just _ad hominem_ attacks... weak ones at that.

As far as challenging the optionetics bozos on their own site? That would be the height of bad manners, and I can imagine the howls from the rest of the starstruck sycophants there... if you are anything to go by. No thanks.

All I want is a mathematical presentation as to how a collar achieves superior results to a vertical spread. All that has happened so far is a nasty bout of hyperbole... no facts.

I am genuinely interested if there is a difference based in fact rather than psychology.. please someone enlighten me.

Sorry mumtrader, your credibilty = 0... and the only way to repair that is to start talking proper option theory instead of bulldust.


----------



## Hopeful (26 November 2006)

Disclaimer: Options beginner with training wheels firmly attached;

Base on Friday's last-traded prices

RMBS Collar , RMBS last price 23.10

Buy RMBS @ 23.10
Buy ATM 22.50 Jan put @ -2.15
Sell OTM 25.00 Jan call @ +1.95
Net debit -0.20 - 23.10 = 23.30

Max Loss is -0.80
Max Rew is 1.70
BE is 23.30

RMBS Bull Call Spread / Bull Put Spread (perfect parity)

Buy ITM 22.50 Jan call @ -2.90
Sell OTM 25.00 Jan call @ +1.95
Net Debit 1.95-2.90 = -0.95

Max Loss is -0.95
Max Rew is 2.50-0.95=+1.55
BE is 23.45

Conclusion

In this case the collar works out slightly better as the max reward is slightly better as is the risk and BE. However, what about the risk free interest you would have earned on funds not commited to the trade as in the collar vs spread? Well, the difference in max reward is about 10% better for the collar and that's for only two months, so yea interest lost is negligable. 

Let's try it with a less volitile stock, hmm say IBM:

Collar IBM last 93.35

Buy stock at 93.35
Buy  put 95 Jan  -2.75
Sell OTM call 100 Jan  +0.45
Net -93.35-2.75+0.45= -95.65

Max loss is -0.65
Max rew is +4.35
BE is 95.65

Bull Call Spread IBM

Buy Jan 95 Call -1.85
Sell Jan 100 Call +0.45
Net Debit -1.40

Max Loss is -1.40
Max Rew is +5.00-1.40 = +3.60
BE 96.40

Once again the collar seems better with a better risk/rew profile and lower BE. Actually, the IBM collar looks quite good doesn't it? With IV at a rel. low 18% looks like a good deal. Am I missing something? I prolly messed up somewhere.


----------



## wayneL (26 November 2006)

Hopeful said:
			
		

> Disclaimer: Options beginner with training wheels firmly attached;
> 
> *Base on Friday's last-traded prices*
> 
> ...




There's your problem Hopeful (in Red). You cannot use last traded prices. You must use live bid/ask quotes if you are to have any hope of a true comparison.

Monday night I'll have a look on live bid/ask and we'll see how we fare.

Cheers


----------



## wayneL (26 November 2006)

Hopeful... just noticed this with regards to RMBS



			
				http://finance.yahoo.com/q?s=rmbs said:
			
		

> RMBS is delinquent in its regulatory filings




Be careful with regards to this... it might get pink sheeted (which I have no idea of the ramifications)


----------



## wayneL (26 November 2006)

Hopeful

A couple more mistakes. You have used the ask in each case. You need to use the bid price when selling option.

The actual difference in P&L is accounted for in the cost of carry on the long stock.

It will cost you ~$200 to carry 1000 stock till January expiry, which is the difference in the payoff diagrams.

This is a nuance of that need to be remembered when using option software, it does not account for stock carrying costs. This can give erroneous results when comparing strategies when stock is involved.

However, you are going well. It just takes time to get the head around all this stuff.  

Cheers


----------



## Mofra (26 November 2006)

money tree said:
			
		

> Naked puts are OK from a risk perspective, but your broker will demand HUGE margin payments to cover the positions! It just does not give bang for the buck over the long term.



Sounds like one of the very reasons I focus on verticals, the net exposure margin requirments are much lower. 

However, as a simple little trader who doesn't moniter positions 24/7, I am uncomfortable with the potential loss of naked puts in that 1/1000 chance of major news decimating price.


----------



## Hopeful (26 November 2006)

WayneL, it shouldn't matter if I used last-traded prices or bid/ask prices because it's the comparison we're interested in, as long as the calculations are consistently applied between the items being compared. In any case I have re-done the calculations using the bids for sells and the asks for buys and this is what I've come up with:

RMBS 23.10 Collar , 22.50 and 25 strikes for Jan

Risk 0.85
Rew 1.65
BE 23.35

RMBS BCS using same strikes

Risk 1.00
Rew 1.50
BE 23.50

The spread has a 17% higher risk , a 9% lower reward , and an unfavourable BE. The cost of carry (0.05x23.10/6) would be worth about 0.20 for the two months. Ah ha, that explains the difference as you said! So much for the free lunch.

IBM Collar 93.35 , 95 and 100 strikes for Jan

Risk 0.75
Rew 5.20
BE 95.75

BCS 

Risk 1.45
Rew 3.55
BE 96.45

Wow, big difference here. Risk is 93% higher, reward is 32% lower, and BE is worse as well. But now consider cost of carry (.05x93.35/6) at 0.78 and we are almost square! So there you go, they are the same. But you already knew that, didn't you  . 

In practice, for a small account holder like myself, getting peanuts for interest in my account from my broker (IB doesn't pay for the first $10,000 in USD and same for AUD), I would be much better off with a collar.



> Originally Posted by http://finance.yahoo.com/q?s=rmbs
> RMBS is delinquent in its regulatory filings




This is a worry, but the market doesn't seem to be concerned given the run up in RMBS since I sold a covered call  .Apparently RMBS has not reported earnings for six years according to some yahoo on the Yahoo RMBS message board - but there is obviously more to it than that or else how would they be allowed to continue on the exchange for so long? I'll be bidding on a 20 put come Monday. Thanks for the warning!



> However, you are going well. It just takes time to get the head around all this stuff




Thanks for the encouragement, long way to go.


----------



## bingk6 (27 November 2006)

Hopeful said:
			
		

> WayneL, it shouldn't matter if I used last-traded prices or bid/ask prices because it's the comparison we're interested in, as long as the calculations are consistently applied between the items being compared.




Hi Hopeful,

It depends on the liquidity of the options involved. Don't know anything about RBMS, so cannot comment specifically in this case. However, if the options are illiquid, then the last traded prices for each leg might have been traded at vastly different periods during the day. In other words, the share price applicable to when each of the legs were executed could be significantly different, which would render your comparison invalid.

However, if the options are very liquid, then you are half a chance. In any case, using live option prices against the same spot price at underlying share price is the only basis for a valid comparison.


----------



## Magdoran (28 November 2006)

*Naked Puts*


Determining the viability of options positions is an involved process.  There are a range of different perspectives and approaches to consider.

On one level there is straight risk to reward, which is the maximum risk compared to the maximum reward.  Just looking at this aspect independently however is of limited use because we also should consider putting this in a probabilistic context.

Essentially we also have to weigh the chances of events occurring, and consider the long term ramifications of adoption a particular strategy.  This in part can form the basis for determining expectancy, and feeds into the longer term trading equation of overall profit and loss.

Now, if someone argues that there are ways to limit this risk, then we are talking about a very different scenario than naked puts.  I’m specifically focussing on simply selling puts for premium as a strategy without any refinements. 

The reality about naked puts – you have a capped reward, and a significant risk.  The delta increases against you the further into the money it moves which is not what you want on the sold side of the transaction.

The potential risk, and to some extent problem with naked puts, is that since the reward is capped, and the possible losses can be quite significant (yes, that means selling a put, or being short a put, hence owing the obligation to buy a specific amount of stock at a specific price), you have to have more wins, and try to minimise losses, especially large losses.

Let me illustrate the point in addition to Wayne’s excellent example in post 14 and 15 of this thread.  Theoretically a sold put could at some point reach it’s theoretical maximum loss if the stock is liquidated and moves to $0.  This is a deliberately extreme example to illustrate a point.  For instance, if you sold 20 Australian $80 put contracts on a stock currently trading at $80, and the stock dropped down to $2, the intrinsic exposure would be $78 per share, multiplied by 20,000 which equals $1,560,000.  Selling naked puts as described in this instance has a possibility if a stock went to $2 overnight of 1.56 million Dollars.

Think about playing roulette at a casino.  One of the reasons the house wins overall in the long run is having 0 and in some cases 00 where the house wins all bets other than any bets on 0 or 00.  Sure, 0 doesn’t come up often, but when it does, it clears the table.  It is the low probability events that in the long run claim many a victim who sells naked puts.  All you need is a black swan (+4 standard deviations) move against you, and you can wipe out a host of sustained gains.

So, you could have a string of wins and be well ahead, and then you get a black swan against that position, and end up losing all your gains, and may even end up in a loss or even a significant loss position.  All you need is one big loser to put a significant dent in your bank account.

Sure, some people have the capital to buy the stock and are willing to hold it (especially institutions and the larger private investors), but many don’t have the means to do this.  Also, there are some who can employ this tactic at specific times quite successfully, and have worked out ways to measure the risk and determine times to use naked puts.  These are professionals who have spent a lot of time doing this.

There was a case I heard about a guy who lost his retirement funds on short puts, so my comment is that if you are new to options, please be aware of the risks.  You really should be well versed in the market and options to effectively use this approach.  Personally I have never sold a naked put, I just don’t like the risk to reward parameters, and don’t want to invite a black swan to land on my doorstep.  I figure it’s too much like tempting fate!


Regards


Magdoran


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## Hopeful (29 November 2006)

And from what I understand everything you've said about naked puts also applies to covered calls because the risk graphs are identical when costs of carry are accounted for. Although the psychology of trading them may be different. I am long RMBS and short a RMBS Jan $20 call. Doh. RMBS looks like it could go either way right now.


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## Magdoran (29 November 2006)

Hopeful said:
			
		

> And from what I understand everything you've said about naked puts also applies to covered calls because the risk graphs are identical when costs of carry are accounted for. Although the psychology of trading them may be different. I am long RMBS and short a RMBS Jan $20 call. Doh. RMBS looks like it could go either way right now.



Hello Hopeful,


In answer to your statement:  Yes and no.

The difference is that the volatility equation in the put tends to move up against you if you’re trying to wind out a short put while a stock is in free fall, where the sold call isn’t so much of a problem in a covered call, and the stock doesn’t have implied volatility effects.

Also, the stock is unlikely to be as leveraged as a put (depending on wether you are using margin, and if so at what level of leverage).

Sure the risk graphs look similar, but this is at expiry, and it really depends on your timing and volatility conditions if you’re going to buy back a sold put to close the position.

Hence the two perform very differently.  It still boils down to how much money you have to put up compared with how much you make, and what the long term probabilities are based on the chosen strategy.  

There are two ways to look at this.  One is to consider the overall history and probability in all conditions, and the other is to look at probabilities in bullish markets with certain pre selected parameters.  Essentially look to trade in specific market conditions with a lower probability of adverse price movements.  Of course “every moment in the market is unique” (ala Douglas), and “anything can happen.”

For comparative approaches, consider if you could bought an OTM call and have it either expire workless (maximum risk) as opposed to exiting at a target price in the money (say around 300%-500% profit), this equation may outperform a range of other strategies depending on the market conditions for example.  

In my view, match the strategy to your capability and the market conditions.  If you think selling a naked put or using a covered call strategy will outperform any other strategy, and you are confident it will succeed, and are prepared to accept the risk, then that is your decision.  Each trader and investor is the captain of their own ship…

Personally I agree with Wayne on this issue, the numbers just aren’t attractive, and I think that the limited reward which is usually available doesn’t offset the significant risks undertaken to justify the strategy.  Also, I have found strategies that are more effective for me to use that in my view significantly outperform the high risk strategies.


Regards


Magdoran


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## wayneL (29 December 2006)

wayneL said:
			
		

> Another topic I noticed on Kramers board which arises here:





			
				Scott Kramer said:
			
		

> The risk graph of a collar and bull call spread are the same, but that is where the similarities end.
> You have a much better chance of making money over the long run with collars than bull call spreads because you are always in the position and the stock acts as a flotation device by which you remain at equilibrium.
> 
> The problem with a call spread (which is not like the collar) is that if you purchase an OTM call spread the stock can go up and you still lose money if the stock does not appreciate beyond the b/e point. Then when the options expire, you have to put on a new vertical call spread. Because of the run up in the stock which you may not have capitalized on, you will likely have to pay much more for the same vertical spread out the next month or move up a strike. If this keeps happening on a slowly drifting higher stock you could be chasing profits all the time without actualizing any. It is a non-fluid trade because of the starting and stopping effect of moving options around every month.
> ...





			
				wayneL said:
			
		

> To me, he appears to be on crack here. It seems complete nonsense. Am I missing something?



I have been doing some agitating on this topic on another board. I will report developments as they occur  

So far, we have this:



			
				Maverick74 said:
			
		

> This guy is on crack. He is 100% wrong and I can prove it mathematically. Bring that guy over here so I can go one on one with him in the octagon. I will rip that guy to shreds. Seriously man, where is the SEC on this ****? Hopefully by now, all you realize that a synthetic is EXACTLY the same position as it's actual. It does not matter what the stock does or how much you have to roll the position, it is 100% the same. There is NO difference. Please, someone invite that kind gentleman over here and post a link to where he is and I will pay him a kind visit.




LOL


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## sails (1 January 2007)

These are the potential circumstances that I think could make a difference between a collar and a bull call spread and have listed my reasons below:

1. Wayne summed up nicely on another forum what I was trying to get across in Post #29 (albeit an unlikely event) which is quoted below:


> So the only difference here is that we pay the cost of carry up front when we buy the natural, whereas the cost carry is "pay as you go" for the synthetic.
> 
> So if the underlying takes a big hit early in the life of the strategy, we cop the additional loss of the cost of carry on the natural. However, as this is a black swan type event, the probability of this is quite low. Under "normal" circumstances, this is just not a factor.



2.  Hopeful raised an interesting situation where funds are held with a broker that doesn't pay interest.  In this case, a collar is probably superior as it would make no sense to be paying the interest component (cost of carry) in a long call in addition to having the funds sitting idle in a bank account.

3.  As the interest component is usually around the risk free rate and margin lending is well above the risk free rate, I believe a bull call spread could probably be a better strategy, taking advantage of the opportunity to leverage at a lower interest rate.

4.  However, dividends, capital returns and these types of situations can be detrimental with a bull call spread where the short call is at risk of assignment.  The long call will not hedge the div if one is assigned on the short call the day before x-div, so that in itself can create a big difference in the profit/loss between the two strategies if the bull call is not managed properly under these types of conditions.

Any thoughts?


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## wayneL (1 January 2007)

sails said:
			
		

> These are the potential circumstances that I think could make a difference between a collar and a bull call spread and have listed my reasons below:
> 
> 1. Wayne summed up nicely on another forum what I was trying to get across in Post #29 (albeit an unlikely event) which is quoted below:
> 
> ...




OMG!!!!! Those other places bring out the absolute worst in people. The behaviour of those traders is absolutely atrocious.... errr, pot calling the kettle black here ROFLMAO.

Some interesting things though, Margaret has mentioned a few great points. I'll try and collate the main points for the Lazarus blog and here.

Interesting stuff.


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## wayneL (2 January 2007)

sails said:
			
		

> These are the potential circumstances that I think could make a difference between a collar and a bull call spread and have listed my reasons below:
> 
> 1. Wayne summed up nicely on another forum what I was trying to get across in Post #29 (albeit an unlikely event) which is quoted below:
> 
> ...




Margaret, I think that sums it all up pretty well. About 500 posts all boiled down to 4 points. Well done.

It's amazing that WW3 was very close to being declared, to get to that LOL

The other point to come out is that SK's explanation (posted above) is still nonsense. It took Alex M to clarify the real difference... but it is something you pointed out months ago in this thread.  

Thanks

Cheers


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## wayneL (6 January 2007)

US margin rules to change in april.... NOT BEFORE TIME  

http://sigmaoptions.blogspot.com/2007/01/new-margin-rules-for-option-positions.html



> This was released in the middle of last month, and while trumpeted by a few option education firms, seems to have slipped by largely unnoticed by a lot of the retail trading community.
> 
> SEC APPROVES CBOE'S NEW PORTFOLIO MARGINING RULES TO BENEFIT CUSTOMER ACCOUNTS
> 
> ...


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