# Strategies with Options - Discussion



## hhse (4 January 2015)

Hi,

Thought it would be useful to have a discussion of certain strategies with options.

To kick it off...

I was watching Closing The Gap 30/05/2014 Episode on Tastytrades whereby they discussed Covered Strangles. This involves selling a put, alongside a covered call. However, wouldn't it have been easier then to sell one OTM Put and one ITM Put as opposed to buying a stock, and then selling a call & put against that stock (latter having a higher commission). Liquidity for ITM options are not an issue, because we only work with liquid products.

I must be missing something... but I can't seem to figure it out. Help?

Thanks.


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## CanOz (4 January 2015)

hhse said:


> Hi,
> 
> Thought it would be useful to have a discussion of certain strategies with options.
> 
> ...




well, from the little i know, selling an ITM put or call is suicide, the loss is unlimited.


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## hhse (4 January 2015)

CanOz said:


> well, from the little i know, selling an ITM put or call is suicide, the loss is unlimited.




Not the case.


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## CanOz (5 January 2015)

hhse said:


> Not the case.




How so? the option is in play completely, any movement regardless of the time to expiry should be reflected in the price? To draw on an analogy, selling premium is like selling insurance. Selling ITM options is like selling flood insurance on the riverbank, selling far OTM options is like selling insurance on the grassy rise.

What am i missing HHSe.

BTW, glad you started the thread, really keen on learning options, only put it off for 5 years


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## hhse (5 January 2015)

Because an option is made up of intrinsic value and time value(time/vol). If you are selling ITM options, you'd be selling it at intrinsic + time. i.e stock is at $20, Put of $21 will be intrinsic value + time value, it will easily be above $1.

You risk is lower when you sell a put option, than it is when being long a stock. Worst case scenario, stock drops to $0, you have have loss 100% if you owned the stock outright, however with a put, you would have only loss Strike less premium collected.


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## CanOz (5 January 2015)

hhse said:


> Because an option is made up of intrinsic value and time value(time/vol). If you are selling ITM options, you'd be selling it at intrinsic + time. i.e stock is at $20, Put of $21 will be intrinsic value + time value, it will easily be above $1.
> 
> You risk is lower when you sell a put option, than it is when being long a stock. Worst case scenario, stock drops to $0, you have have loss 100% if you owned the stock outright, however with a put, you would have only loss Strike less premium collected.




What if the stock increases in price to 25?


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## cynic (5 January 2015)

hhse said:


> Hi,
> 
> Thought it would be useful to have a discussion of certain strategies with options.
> 
> ...




If one were to consider the scenario where the SP explodes upwards, the difference between long stock and short puts should become apparent. The "covered" call would no longer be covered once the SP is trading above the strike of the sold ITM put.

Another issue that may merit consideration is the increased exposure to volatility from the additional sold put.


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## hhse (5 January 2015)

CanOz said:


> What if the stock increases in price to 25?




You make the same amount of money under both strategies. $1 + time value collected on put/call.


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## minwa (5 January 2015)

CanOz said:


> To draw on an analogy, selling premium is like selling insurance. Selling ITM options is like selling flood insurance on the riverbank, selling far OTM options is like selling insurance on the grassy rise.




So do insurance companies reject insurances on riverbank properties ? No. Just like car insurance do not reject the application of a 18 year old male in a sports car. Why ? They markup the premium to compensate for the risk. 

So selling ITM options you get to sell at a marked up price, and if you are correct in your pick, the premium will evaporate faster (as there is more sold initially) making you more money than a OTM option. Think do car insurance companies make more on the 18 year old than the 40 year old mum IF THEY ARE CORRECT (that they dont have an accident) in their prediction much like your correct prediction of price & implied volatility will make you more on the short ITM than the short OTM


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## DeepState (5 January 2015)

hhse said:


> Hi,
> 
> Thought it would be useful to have a discussion of certain strategies with options.
> 
> ...




If options are European then same diff before micro structure details unless you value voting rights, have cap gains issues etc. In Aust, you may value franking which can be priced into skew, but usually not fully.

I think the mentality might also be arising from how to add value to a basic long position.  Some people write calls thinking it is some form of free money you get just for turning up.  Some people write strangles because they are convinced they are on a winner with the stock and are happy to load up if it falls and sell out if it rises.  So, whilst you are basically correct in terms of arbitrge relationships, at least some of the non-delta hedged and non-Greek speakers consider options from a starting point of a basic long.  That may be why many strategies, often portrayed exclusively in terms of final payoff profiles only, are expressed from that viewpoint.  As you have pointed out....often something else makes more sense straight up....that's life, and part of the reason that it is clear you are above the pack already.


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## hhse (5 January 2015)

DeepState said:


> If options are European then same diff before micro structure details unless you value voting rights, have cap gains issues etc. In Aust, you may value franking which can be priced into skew, but usually not fully.
> 
> I think the mentality might also be arising from how to add value to a basic long position.  Some people write calls thinking it is some form of free money you get just for turning up.  Some people write strangles because they are convinced they are on a winner with the stock and are happy to load up if it falls and sell out if it rises.  So, whilst you are basically correct in terms of arbitrge relationships, at least some of the non-delta hedged and non-Greek speakers consider options from a starting point of a basic long.  That may be why many strategies, often portrayed exclusively in terms of final payoff profiles only, are expressed from that viewpoint.  As you have pointed out....often something else makes more sense straight up....that's life, and part of the reason that it is clear you are above the pack already.




Thank you. This was answered really well. Appreciate it, I did not think about benefits that come with the long stock component.


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## hhse (17 January 2015)

Strategy 2:

I'm bullish oil and expecting a rise within the medium term, just not sure when it will rise - this is just an opinion only, as I like to trade things near its lows or highs. Volatility on a lot of oil products has recently been high. To take a bullish position in oil, I have selected USO ETF as it has over 95% correlation to oil price.

Strategy taken as follows: sold a July $17 put at $1.88 and purchased a $4 wide debit call spread at $17/$21 for $1.52. Net $0.36 credit, cost basis of USO $16.64, Estimated max loss: $5.64 (estimated at a 2 standard deviation move, but technically, max loss is $16.64 if oil goes to zero and stays there), Max profit: $4.36. Essentially, I'm going out 6 months, and selling a naked put spread to fund a debit call spread while taking in some credit and reducing my entry cost basis.

What medium term strategy would you have adopted?


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## Sharkman (18 January 2015)

hhse said:


> Strategy 2:
> 
> I'm bullish oil and expecting a rise within the medium term, just not sure when it will rise - this is just an opinion only, as I like to trade things near its lows or highs. Volatility on a lot of oil products has recently been high. To take a bullish position in oil, I have selected USO ETF as it has over 95% correlation to oil price.
> 
> ...




that's a risk reversal call spread - selling naked puts to fund a long call vertical. but typically you'd sell the put at a lower strike than the long call - since you're doing both at a 17 strike you might as well have just sold the 21 puts instead and saved yourself a couple of commissions and spreads to cross.

short 17 put + long 17 call = synthetic long
long underlying + short 21 call = short 21 put

unless the spreads are ridiculously wide (i don't trade the USO ETF so i don't know how it behaves), you should have been able to sell the 21 puts for something in the vicinity of 4.36, which would net you the same risk profile.

other than that i think what you've said makes sense. if you think IV is high then trading spreads (or even selling premium) rather than outright buying options is probably what you want to do.

what was your reasoning behind selecting those strikes?


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## hhse (18 January 2015)

Sharkman said:


> that's a risk reversal call spread - selling naked puts to fund a long call vertical. but typically you'd sell the put at a lower strike than the long call - since you're doing both at a 17 strike you might as well have just sold the 21 puts instead and saved yourself a couple of commissions and spreads to cross.
> 
> short 17 put + long 17 call = synthetic long
> long underlying + short 21 call = short 21 put
> ...




Good feedback. Now, in hindsight, I would have done what you suggested. No particular reason, I just feel that oil between $55-$60/barrel is reasonable in medium term.


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## hhse (10 February 2015)

Strategy 3: Credit Put Spread

Bullish Euro (EUR v USD) - at an extreme point. Volatility in regards to itself is high (when volatility is high for an underlying in regards to its historical volatility, you want to sell options, as the premiums collected would be higher). No other reason needed really, I don't over think it...

Sold $110 Mar 20 Put and Bought $107 Mar 20 Put for total credit of $0.74 - if my trade costs were smaller, I'd consider only doing one strike wide. Also, days to expiration should be around 40-55 days as this offers optimal time decay and directional risk (too short of a time frame, and you will be significantly exposed to the latter).

Assumption: Bullish
Max Loss - $226
Max Profit - $74
Probability of success - 85% (calculated as premium collected divided by width of strike)

The reasons for the credit spread are: low margin requirement, limited loss. However, you are trading off getting further away from the money and a higher premium when compared to a naked put.


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## hhse (10 February 2015)

hhse said:


> Strategy 3: Credit Put Spread
> 
> Bullish Euro (EUR v USD) - at an extreme point. Volatility in regards to itself is high (when volatility is high for an underlying in regards to its historical volatility, you want to sell options, as the premiums collected would be higher). No other reason needed really, I don't over think it...
> 
> ...




Ha ha ha... I was referring to the ETF FXE!!! Ha Ha... Can't believe I missed that.


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## Sharkman (10 February 2015)

hhse said:


> Strategy 3: Credit Put Spread
> 
> Bullish Euro (EUR v USD) - at an extreme point. Volatility in regards to itself is high (when volatility is high for an underlying in regards to its historical volatility, you want to sell options, as the premiums collected would be higher). No other reason needed really, I don't over think it...
> 
> ...




Vol being high wrt the historical vol for the underlying doesn't automatically mean sell premium. It is when vol is high wrt the *future realised volatility* (which nobody knows for sure) that one can definitely say it is time to sell premium. IV may be high wrt the HV for the instrument, but that might be because a company is about to report earnings - it's a risky (but also potentially profitable) game selling premium into a profit announcement!

I only trade equity options, not FX, but similarly IV in FX would tend to spike when there are potential macro events expected in the lifespan of the option (I would imagine AUD/USD IV would have been crushed last week after the RBA announcement for eg). In terms of the EUR/USD I would have thought vols are being jacked up due to the whole Greece situation. So the future RV could well end up being higher than the current IV.

Secondly I tend to think of credit spreads as more of a low conviction trade. So I'd lean towards a put credit spread if I don't think the stock is going to drop below a certain level, but I'm not really sure if it will rally or if it will just stagnate during the lifespan of the option.

If I'm bullish on something and the IV is a bit too high for me to consider outright call buying, I'd be more inclined to go for a call debit spread over a put credit spread - if I have enough conviction that it's going to rally, I want to be paid at 3 to 1 odds if I'm right, not paid 1 to 3. It also gives you a bit more flexibility - if it does move in your direction sooner than expected, you can always take the spread off, then continue the directional bet with house money by buying outright ATM options with the cash left over after recouping your original premium. Harder to do that with a credit spread as you can't get enough house money to play with until the decay has set in.

In other words - I view credit spreads as a strategy to use when I want to bet on where the underlying *won't* go, rather than where it will go. It's akin to taking an "Australia or Draw" bet in a test match, whilst a debit spread is akin to betting on Australia outright. In exchange for covering a wider range of outcomes, you get a worse payout ratio. If you're confident enough in your view of where it *will* go, you might as well go for a debit spread and get paid at better odds if you're right.

Just my own thoughts, not gospel, so treat with skepticism


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## hhse (11 February 2015)

Sharkman said:


> Vol being high wrt the historical vol for the underlying doesn't automatically mean sell premium. It is when vol is high wrt the *future realised volatility* (which nobody knows for sure) that one can definitely say it is time to sell premium. IV may be high wrt the HV for the instrument, but that might be because a company is about to report earnings - it's a risky (but also potentially profitable) game selling premium into a profit announcement!
> 
> I only trade equity options, not FX, but similarly IV in FX would tend to spike when there are potential macro events expected in the lifespan of the option (I would imagine AUD/USD IV would have been crushed last week after the RBA announcement for eg). In terms of the EUR/USD I would have thought vols are being jacked up due to the whole Greece situation. So the future RV could well end up being higher than the current IV.
> 
> ...




FXE is an ETF, earnings is irrelevant. FXE is liquid, so in most part, greek crisis/macroeconomic events should already be factored into the price. So by default, you can go further out.

A spread isn't necessarily about conviction. I use it to limit capital.

Agreed, I meant high implied volatility vs IV in last year.

Numerous studies done by Tasty trades show that credit spreads dominate debit spreads in stocks with high IV products relative to itself. I don't do my own studies, so I stick to their rule of thumb.


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## Sharkman (12 February 2015)

hhse said:


> FXE is an ETF, earnings is irrelevant. FXE is liquid, so in most part, greek crisis/macroeconomic events should already be factored into the price. So by default, you can go further out.




I was using company earnings in the context of equity options to bring up the point that when IV is high compared to HV, it's high for a reason - the market is expecting the underlying to be more volatile than it has been historically. Upcoming earnings numbers for a stock, or macro events for an FX based instrument are factored into the IV - but they may not be fully factored into the IV, because unless time travel has been invented, nobody knows what the future realised volatility is going to be. Even if the IV is high relative to the IV over some historic observation period such as over the last 12 months, it doesn't always mean it's an expensive option - the future RV could end up being even higher than the current elevated IV.



hhse said:


> A spread isn't necessarily about conviction. I use it to limit capital.




Yes, a spread is good for limiting risk and collateral requirements relative to being outright short options, absolutely. What I was saying is that I view debit spreads as high conviction, and credit spreads as low conviction, I wasn't saying I view outright buying premium as high conviction and both types of spreads as low conviction.

In the case of your typical put credit spread where you sell an ATM or slightly OTM put and buy a further OTM put, you win if the underlying rallies or stays flat, but you only win 30c or so for every $1 you risk. It's an appropriate strategy if you're pretty sure that it won't collapse, but you're not completely sure whether it will rally or not go anywhere - ie. low conviction.

If you're confident that the underlying is going to rally (which I assumed was your view on EUR/USD, since you said "Bullish"), then you don't need to take a lower odds bet covering the "if it doesn't go anywhere" outcome to express your view, so instead of risking $1 to win 30c, you can risk $1 to win maybe $3 by buying a call debit spread. Unless the risky on the delta skew is very high and it's against the direction of your intended spread (eg. puts heavily favour calls and you want to buy a call debit spread), high IV should not be a deterrent to buying a debit spread vs selling a credit spread, because even in a debit spread you're still selling some gamma to help mitigate the decay.


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## hhse (13 February 2015)

Sharkman said:


> I was using company earnings in the context of equity options to bring up the point that when IV is high compared to HV, it's high for a reason - the market is expecting the underlying to be more volatile than it has been historically. Upcoming earnings numbers for a stock, or macro events for an FX based instrument are factored into the IV - but they may not be fully factored into the IV, because unless time travel has been invented, nobody knows what the future realised volatility is going to be. Even if the IV is high relative to the IV over some historic observation period such as over the last 12 months, it doesn't always mean it's an expensive option - the future RV could end up being even higher than the current elevated IV.




When implied IV is high vs history, the fact is, probability of success increases for credit spreads, and in these environments credit spreads dominate debit spreads. Reason? Well IV reversion to the mean.



Sharkman said:


> Yes, a spread is good for limiting risk and collateral requirements relative to being outright short options, absolutely. What I was saying is that I view debit spreads as high conviction, and credit spreads as low conviction, I wasn't saying I view outright buying premium as high conviction and both types of spreads as low conviction.




Debit spread vs Credit spread does not have anything to do with 'conviction' - strike selection does. I could have easily moved my strikes to take in more credit and trade off my probability of success. Why would I do this? Sure I'm bullish, but it's okay to choose a higher probability of success trade (85%) to decrease variance vs a 30% of success trade that is being suggested.

My point is, I don't understand how IV has nothing to do with choosing strategy, i.e Debit vs Credit spread, and how 'conviction' should be the determinant in choosing the strategy - when clearly by adjusting your strikes under either strategy you can tweak your max profit/loss and your probability of success.


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## robusta (1 March 2015)

Listened to this guy on a podcast last night.

http://www.amazon.com/The-Intelligent-Option-Investor-Investing/dp/007183365X

http://www.intelligentoptioninvestor.com/

http://intelligentoptioninvestor.co...e-Essence-of-Intelligent-Option-Investing.pdf

I think it might be worth a read.


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## DeepState (8 April 2015)

Do options prices (equity index/stock or currency) embed certain reasonably permanent biases to fair values? 
If so, where? Why?
If where is known, what strategies are perceived to be most suitable to exploit these for a risk neutral investor?

TIA


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## wayneL (8 April 2015)

DeepState said:


> Do options prices (equity index/stock or currency) embed certain reasonably permanent biases to fair values?
> If so, where? Why?
> If where is known, what strategies are perceived to be most suitable to exploit these for a risk neutral investor?
> 
> TIA




There used to be a fairly consistent and reliable overvalue of option on indicies and certain stocks of megalithic capitalizations (eg JP Morgen).... on face value. In reality they were pricing in fat tailed distributions... IOW black swans.

Not very common these days with the preponderance of retail traders believing that short option strategies are a wealth panacea, aided by the seminar industry.

BY the way, "fair value" is such a nebulous and fleeting concept as to be worthless. Realized values henceforth can deviate wildly from any notion of fair value today.... which can only be speculated on.


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## DeepState (8 April 2015)

wayneL said:


> 1. There used to be a fairly consistent and reliable overvalue of option on indicies and certain stocks of megalithic capitalizations (eg JP Morgen).... on face value. In reality they were pricing in fat tailed distributions... IOW black swans.
> 
> 2. Not very common these days with the preponderance of retail traders believing that short option strategies are a wealth panacea, aided by the seminar industry.
> 
> 3. BY the way, "fair value" is such a nebulous and fleeting concept as to be worthless. Realized values henceforth can deviate wildly from any notion of fair value today.... which can only be speculated on.




Glad you are back.

1. Was that pricing ultimately too high on a risk neutral basis?

2. Is that at both wings?

3. Almost all security pricing involves risk and uncertainty.  It would be a total freak if IV matched outcome.  Yet, are you of the belief that assessment of any fair value is impossible?  That there is no figure for IV, no shape in the smirk, no fold in the IV surface... that would make an investor think that there is a probabilistic gain to be had? 

Essentially, if I take this literally, the argument seems to be that the outcomes are so uncertain that no pricing can be ascertained as reasonable or not (fully uncertain), or that current pricing is efficient (can't make money from the market, it's too accurately priced on average through time).  You were a heavy and highly informed poster on options threads previously.  This suggests you once saw things differently (assuming knowledge was gained for purposes of profit/risk-management rather than pure curiosity), so I am curious for your experiences that led you to this point - but only if you care to expand. 

In any case, thanks.


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## wayneL (9 April 2015)

You still get the smirk of course, just not as much fat in it as there used to be. 

In my opinion the nature of stock markets have changed due to covert manipulation via bot trading and manipulation of money supply such as QE and mass access to "information" via the Internet. Not a conspiracy theory just a fact as I see it. Therefore the nature of risk and its pricing is different.

That said, we (usually) take a bet on volatility when when play with options. Fair value is our individual perception of future realized volatility and cannot be objectively measured. I one believes an option is not trading at fair value and forms a strategy on that basis, you are betting that the market is wrong.

It often is, but it's a bet not an objective measure. You are also betting on the magnitude of directional movement or lack thereof. You can get your vola bet right or wrong, but a grinding unidirectional market will make things more interesting.

These days I have more success betting of direction/non-direction with vola the deal maker or breaker.... with robust defense mechanisms. But... my circumstances are different now that I don't ride the screen all day.

Just my $0.02


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## DeepState (12 April 2015)

wayneL said:


> In my opinion the nature of stock markets have changed due to covert manipulation via bot trading and manipulation of money supply such as QE and mass access to "information" via the Internet. Not a conspiracy theory just a fact as I see it. Therefore the nature of risk and its pricing is different.




Thanks again.

What changes have you observed in the market dynamics as it pertains to options?


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