# The idiots way to options riches



## Hopeful (2 September 2006)

What's wrong with this simple plan. I'm new at this so be gentle.

Buy stock XYZ for $20 and write a call option with a strike of say $22 (a 10% move will get you exercised). Then, set your stop loss at the current price minus the premium you recieved. So, if the stock drops past BE you exit the whole position without a loss, but if it goes up then you win. It's a "can't lose" trade! 

Of course, if the stock opens with a huge gap then you get your arze handed to you. And then there are brokerage fees as well. 

What else am I missing? This is a kind of "dorathy dixer" question to elicit some responses, don't panic I'm not going to do this just yet. Cheers. Humor me.


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## wayneL (2 September 2006)

Hopeful said:
			
		

> What's wrong with this simple plan. I'm new at this so be gentle.
> 
> Buy stock XYZ for $20 and write a call option with a strike of say $22 (a 10% move will get you exercised). Then, set your stop loss at the current price minus the premium you recieved. So, if the stock drops past BE you exit the whole position without a loss, but if it goes up then you win. It's a "can't lose" trade!
> 
> ...




Firstly, you will get SFA for the call that far OTM... probably only a few cents, depending on volatility

Secondly, it doesn't work that way anyway. If the stock starts moving down well before expiry, theta will not have had time to deliver you any advantage.

http://www.hoadley.net/options/strategymodel.htm


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## Hopeful (2 September 2006)

wayneL said:
			
		

> Firstly, you will get SFA for the call that far OTM... probably only a few cents, depending on volatility
> 
> Secondly, it doesn't work that way anyway. If the stock starts moving down well before expiry, theta will not have had time to deliver you any advantage.
> 
> http://www.hoadley.net/options/strategymodel.htm




If it goes down I want to be out anyway. The call premium gives you a little bit of room before BE. So that's the downside - getting stopped out. If the figures were a little more realistic:

RIG (a US stock) is currently trading at 70.45 , Oct calls with a 75 strike are selling for 1.90. So then I hit the bid and short the call then go buy the stock. If it goes down to 70.45 minus 1.90 = 68.55 then I exit with a small loss (brokerage). On the other hand if it ends up anywhere above 68.55 at expiry then I'm laughing (yes, American style means I can get assigned...). 

I'm afraid I think I missed your point. I can see two likely results, one positive and one even (I can also see disaster as well, but that would be so without writing a call anyway).


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## wayneL (2 September 2006)

Hopeful said:
			
		

> If it goes down I want to be out anyway. The call premium gives you a little bit of room before BE. So that's the downside - getting stopped out. If the figures were a little more realistic:
> 
> RIG (a US stock) is currently trading at 70.45 , Oct calls with a 75 strike are selling for 1.90. So then I hit the bid and short the call then go buy the stock. If it goes down to 70.45 minus 1.90 = 68.55 then I exit with a small loss (brokerage). On the other hand if it ends up anywhere above 68.55 at expiry then I'm laughing (yes, American style means I can get assigned...).
> 
> I'm afraid I think I missed your point. I can see two likely results, one positive and one even (I can also see disaster as well, but that would be so without writing a call anyway).




OK This is why I bang on and on and on about greeks.

You are analyzing this as if you keep the premium of the short call when you are stopped out.

The only way this is possible is if you stay short the call till expirey *after* you are stopped out on the stock. You can do that, but suddenly you have unlimited risk to the upside and possibly greater than a month to go befor expirey... a very dangerous game.

Firstly, I advise you get a grasp of synthetic positions to understand what you in fact have. What you have with the above position is a synthetic written $75 put.

Secondly, understand that until expiry, your position risk is measured via the greeks. You simply cannot say that if the stock goes down by a 1.90 I'll close out at break even. That is only possible if this happens at expiry. 

I think the error comes from looking at the hockey stick graph without understanding that that is the profit/loss AT EXPIRY. Before expiry, the graph is different, and changes every day.

This is why I posted the link to the strategy modeller. This piece of free software will enable you to analyse if-then scenarios before expirey of the option.

Good luck


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## wayneL (2 September 2006)

Viz


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## dutchie (2 September 2006)

G'day Hopeful

WayneL is of course spot on and continually keeps reminding us to learn the "greeks" before thinking about using options.

Don't forget when you sell the shares you still have an open call position that needs to be closed - you need to pay more brokerage plus premium (could be anything - depending on the "greeks").

If you don't close it, thinking it will expire worthless then: 
1. Will your broker let you have a naked call open.
2. There will be margin required if he does.
3.  You are open to unlimited losses if the stock changes direction (especially if it gaps up the next day!).

Keep plugging away though as you will learn more about options (they can be very versatile).

But I don't think there are too many positions that you are gauranteed to win or break even at the worst (unless of course you have a very good handle on the "greeks") - if there were then everybody would be doing them.



Cheers

Dutchie


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## bunyip (2 September 2006)

Wayne

I know very little about options.
Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing  trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
For the style of trading I've outlined, do options really offer any significant advantage over simply buying or shorting CFD's?

Bunyip


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## swingstar (2 September 2006)

bunyip said:
			
		

> Wayne
> 
> I know very little about options.
> Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing  trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
> ...




wayneL will go into specifics as far as better profit potential (volatility increasing etc.), but I think you have a similar style to me (i.e. hold for a few days to weeks), which on the ASX, if you get a lot of opportunities it's probably best to trade CFDs. CFDs usually have much smaller spreads and you don't have to wait half hour into open for a market.


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## bunyip (2 September 2006)

swingstar said:
			
		

> wayneL will go into specifics as far as better profit potential (volatility increasing etc.), but I think you have a similar style to me (i.e. hold for a few days to weeks), which on the ASX, if you get a lot of opportunities it's probably best to trade CFDs. CFDs usually have much smaller spreads and you don't have to wait half hour into open for a market.




I aim to enter from the first entry signal that presents itself after a new trend has become established. I'll stick with the trade as long as the trend continues moving in my favour. This could be weeks, months, or even years in some cases.......depends on the behaviour of the stock.

Bunyip


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## wayneL (2 September 2006)

bunyip said:
			
		

> Wayne
> 
> I know very little about options.
> Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing  trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
> ...




It depends on the situation. There are times when I'll just take the straight out stock/future (or CFD in your case)

<add> With more medium/long term trend trades, you can enhance these significantly by using options. But it is a far more pro-active approach. Each position will need to be analysed and a view formed for so-as a strategy can be customized to that view. It won't simpley be a choice of either the option or the share. You will be legging in, legging out, morphing, hedging to get the best advantage.

In the US there are long term options you can use called LEAPS (I don't know if there is an equivalent here) that you can use to simply replace shares, but these still add a layer of analysis to decide if they give you any advantage, because of vega risk for eg.

For instance, if the trade is a day trade or certain other circumstanes, I won't even look at options.

For swing trading, there are advantages and disadvantages of using options. Options will add substantially to the compexity of the trade, because now you have to consider IV, SV, which strategy, which strike(s), which expiry(s) and so on.

In return, you never have to worry about an ELNesque gap that I often post here, wiping out your account.

If you are a busy trader and do several a day, options analysis can become overwhelming in terms of compexity, intensity and time.

So it does depend on a few factors as to whether there is an advantage in options for swing traders. But it also opens up possible new dimensions to your trading.

Cheers


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## bunyip (2 September 2006)

Wayne

Thanks for your reply.
In view of my "THE SIMPLER THE BETTER" approach to trading, I doubt if options and I could ever become friends.
Each to his own I guess.
Thanks for getting back to me.

Cheers
Bunyip


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## Magdoran (4 September 2006)

bunyip said:
			
		

> Wayne
> 
> I know very little about options.
> Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing  trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
> ...




I would argue that at their best, options should outperform CFDs hands down when it comes to risk to reward, but to do this, that the options environment needs to satisfy specific conditions, and where these conditions are not met, that other instruments including CFDs may be more appropriate, but not the other way around.  What I’m saying is, given a general choice, options should be considered above CFDs.

One key variable though is the capacity and actual knowledge of the individual trader/investor.  If you can’t develop a sufficient understanding of options to a level to trade them, then this effectively rules this instrument out of contention.  However, in my view, if you can’t figure options out, I would have serious doubt about such a person using any kind of derivative product period.  I’d tend to think they’d be better off getting someone else to manage their investments such as considering using a managed fund.  

This may sound harsh, but if you don’t have the intellectual capacity to understand derivatives to this level, trying to use related leveraged instruments just doesn’t add up to me – either you’ve got the ability to learn or you don’t.  So, I tend to agree with Wayne regarding which instrument to use, it all depends on the situation.  

The problem I have is that many CFD traders are not aware of their full exposure to risk, and often are not capable of evaluating the best instrument available to them based on their market view of a potential trade.

I’ve sat down with CFD traders and compared notes looking at the real risk to reward involved with a range of trades comparing CFDs and options and how they performed.

While sometimes good options trades are not available for a stock/index/commodity future/Forex (in which case perhaps using a CFD may be the better alternative in some cases), generally I have found that if you have sufficient options knowledge, options can significantly outperform CFDs in terms of risk to reward, if the appropriate strategy is available (sometimes appropriate options aren’t available maybe due to volatility problems, or liquidity/open interest, etc).

I went through one example with a trader (which was representative of the general findings overall) where the option slightly outperformed the CFD in terms of reward, but was about 5% the exposure - yes, that’s 20 times less exposed - than the CFD position.  But each underlying and options market may differ significantly depending on a host of variables, so this comparison can vary widely.

So, I would argue that it is essential to fully understand all the instruments you are considering, and that the trader/investor develops the ability to assess the risk to reward proposition they are considering entering.  That’s what using derivatives should be all about, minimising risk in context with maximising reward.

Sometimes a CFD will be the better alternative, but it is having the ability to assess which instrument is best based on the trader/investor’s style that ultimately separates the amateurs from the professionals.

Another issue is that many people using CFDs don’t understand their real exposure.  If you’re using a 5% margin for collateral, that means that you are borrowing 95% of the full amount the position is worth.

So, for example, let’s say you enter long $50,000 worth of XYZ stock in CFDs while it is trading around $10, so your margin requirement is $2,500.  Let’s say that overnight a major negative news event happens, and the next morning the stock opens at $5.00. 

You’ve just lost around $25,000 if your position is closed (which will happen if your account is not big enough to put up the margin required), but thought you were risking $2,500 if you didn’t understand the real nature of the exposure which was $50,000.

Just think about how many people may load up several positions like this thinking all they need to do is leverage $2,500 at a time.  What if the market moved significantly against them?  It is very easy to be exposed to over $100,000 of risk if you don’t know what you’re doing.  

Even though strong moves like this are uncommon, they do happen, and they are a real risk.  I know a trader who lost over $100,000 in this way in under a month because he didn’t manage his positions, and didn’t realise his real exposure.  All you need is one major loss to wipe out months of good trading… think about it.

Ok, so there are guaranteed stop losses (GSL) available for CFDs which can be used to limit risk, but this is usually set at a maximum 5% loss in the underlying, and often has a fee to establish one, and for some providers a fee to move the stop loss as the underlying moves.  This is certainly preferable to being totally exposed, but can still leave the trader/investor exposed to considerable risk. 5% for each large position can add up very quickly.

Another issue about CFDs is the exposure to having your account cleaned out.  This happens if a position moves against you, and there are not sufficient funds available to cover the growing margin requirement.  I’ve heard of CFD traders having their account cleaned out on an intra day spike, only to see the stock rally up past where it opened and continue on in their direction.  But if the account can’t meet the margin requirements at any time, the position is automatically exited at a maximum loss to the account.  This is a real problem if it is not managed, and in my view a major disadvantage compared to options.

With options, there are a myriad of ways to control risk that are not available with CFDs.  Firstly, even using a simple long call or put, the risk is limited to the initial premium (plus OCH fees and brokerage).  You can’t lose more than you paid.  Then there are a range of spreads available to cap risk, each with application depending on the market conditions.

Secondly, there are no interest payments required on a long position (or a short one for that matter – although you can receive interest from CFDs for short positions) like there is with CFDs.  Certainly, there is time decay, but this can be managed, and ameliorated, or even utilised using various options approaches (sold options suffering time decay are helpful to the seller).

Thirdly, if you buy a put for a bearish position, you don’t owe the dividend at ex div like you would if you were short the underlying with CFDs (Of course if you were short a call that is assigned before ex div, you would owe the dividend).

In addition, options are regulated instruments with significant underwriting, where CFDs are essentially an OTC (over the counter) instrument, and there is a risk that the CFD provider could become insolvent, and part or all of the trader/investors’ funds may be lost in this event. 

So, some key issues are based on your view of the market, how long you intend to be in the position, and what the best risk to reward strategy is available balanced against the probability of success.

Add another dimension of a range of other instruments available such as futures, warrants, forwards, swaps, bonds and debt notes, and other instruments such as convertible notes, and you have a smorgasbord of choice.  The challenge though is developing the capacity to evaluate all these instruments, and then effectively evaluating the best risk to reward approach with the best probability for success.

While I understand when I hear the response that CFDS are ostensibly simpler than options, I would argue that in the broadest perspective that this is a misconception. CFDs are actually more complex than they seem.  Sure they are perhaps less complex than options, but they’re quite dangerous in the wrong hands, and certainly less flexible, and arguably can be much more exposed to risk.  Sure, it’s harder to work out an options strategy at first, but if you don’t do the due diligence, you’re really leaving yourself open to potential ruin.

Now, in the particular style of swing trading bunyip is outlining, in my view using liquid options in tradable markets should outperform CFDs significantly because the risk is capped, and can be as good as 20 times less the exposure.  This can make a huge difference to the bottom line, but requires a full understanding of the instrument.


Regards


Magdoran


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## swingstar (5 September 2006)

Hi Mag

I've had quite a few 'aha' moments thanks to your posts recently. Wow, was I thinking 'mechanically'... 

I am reconsidering CFDs. As I mentioned above, the main advantages for me are smaller spreads and being able to close a position in the morning at open, without having to wait for MMs (it might be different using a full service broker, since I've seen it mentioned that they can contact MMs directly?). I've been stuck with options a few times when there has been no market and hence no way to offload a losing position. 

My experience is limited to the ASX though... markets are more liquid in the US and I think I've seen Wayne mention that MMs have to provide a market at open. 

Nevertheless I agree (or rather am enlightened, lol) that it obviously depends on the situation. With my style, it would probably be beneficial buying liquid options, and CFDs for stocks with no or thin options. Obviously the more knowledge I gain of options the more uh options I have and strategies I can utilise (and not just relying on directional movement). 

Cheers


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## wayneL (5 September 2006)

Magdoran said:
			
		

> I went through one example with a trader (which was representative of the general findings overall) where the option slightly outperformed the CFD in terms of reward, but was about 5% the exposure - yes, that’s 20 times less exposed - than the CFD position.  But each underlying and options market may differ significantly depending on a host of variables, so this comparison can vary widely.




Great post Mag,

I just wanted to pick up on this point and emphasize it.

I have often made the point that options are an instrument primarily created for the transferance of risk. In the case above, that risk has been primarily tranferred to someone else   Combined with a good general trading edge, the other *smaller* risks assumed by taking on an option position (theta, vega) become de-accentuated.

Superfluous comment I know, but I'm bored ####less on this holiday (in the US) monday.  

Cheers


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## dubiousinfo (5 September 2006)

Magdoran said:
			
		

> While sometimes good options trades are not available for a stock/index/commodity future/Forex (in which case perhaps using a CFD may be the better alternative in some cases), generally I have found that if you have sufficient options knowledge, options can significantly outperform CFDs in terms of risk to reward, if the appropriate strategy is available (sometimes appropriate options aren’t available maybe due to volatility problems, or liquidity/open interest, etc).
> 
> I went through one example with a trader (which was representative of the general findings overall) where the option slightly outperformed the CFD in terms of reward, but was about 5% the exposure - yes, that’s 20 times less exposed - than the CFD position.  But each underlying and options market may differ significantly depending on a host of variables, so this comparison can vary widely.
> 
> ...





In cases where the option was not the best alternative, would there be any reason you could'nt use the CFD & look to reduce the risk by using some options as well. I don't have a particular stratergy in mind, just considering possibilities.


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## bunyip (5 September 2006)

Magdoran

There's a lot of good information in your post. 
Thanks for going to so much trouble.
I agree that traders can come unstuck very quickly if they use leverage recklessly.
Thanks again.

Bunyip


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## ducati916 (5 September 2006)

*et al* 

While I would certainly concur with the post from *Magdoran* the following is worthy of a little further discussion;



> While I understand when I hear the response that CFDS are ostensibly simpler than options, I would argue that in the broadest perspective that this is a misconception. CFDs are actually more complex than they seem. Sure they are perhaps less complex than options, but they’re quite dangerous in the wrong hands, and certainly less flexible, and arguably can be much more exposed to risk. Sure, it’s harder to work out an options strategy at first, but if you don’t do the due diligence, you’re really leaving yourself open to potential ruin.




The popularity of CFD's undoubtably lies within their constituency of providing enhanced exposure to the market ar very small capital funding requirements.
Their popularity is further enhanced by the direct correlation to the underlying securities price fluctuations.

Options by contrast, are priced on a myriad of *contingencies* 
It is these variables within the pricing, exemplified via the *greeks* that complicates the true measure of risk being priced.

The outcome, is, the preferrence of novice investor/traders to the more transparent [seemingly] pricing of risk via the CFD. As has already been illustrated by *Magdoran* this risk is not quite as clear cut as it first appears.

The recognition of risk, the pricing of risk, the assumption of correctly priced risk, the management of assumed risk are the mandatory steps required, and if performed correctly, will result in a positive expectancy of risk adjusted reward.

CFD's are of course in the first instance designed for the gamblers that populate the financial markets, providing the big leveraged moves that get the adreneline flowing for generally small capital.

If your strategy revolves around directional plays, there is no excuse for leverage, prior to consistent returns with common stocks over at least two market cycles [Bull/Bear]

If your strategy is non-directional, then Options would be the preferred instrument, [as Convertible Arbitrage requires large capital to implement successfully for example] but, would require the theoretical knowledge to be in place prior to practical implementation.

jog on
d998


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## Magdoran (5 September 2006)

swingstar said:
			
		

> Hi Mag
> 
> I've had quite a few 'aha' moments thanks to your posts recently. Wow, was I thinking 'mechanically'...
> 
> ...



Hello Swingstar,


Glad to hear the comments were helpful!

What you’re saying I concur with…

As for which instrument to choose, this gets down to your trading style, including risk profile, and wether you can actually trade illiquid options with your approach or not.  To do so though requires a lot of knowledge of the Greeks, particularly volatility, delta and theta.  

If you’re trading way OTM positions, you have to accept that heavy losses will occur when you get it wrong, and be comfortable with this (hence considering small positions for single options series).

The alternative is to use CFDs in these situations if you prefer, and it is up to the individual to evaluate which approach to choose based on their style and risk profile.  And as you say, you don’t always have to trade directional strategies.

Spreads for any instrument certainly are a factor to be considered as well as the nature of the market maker in any market, I fully agree here, and this is probably where the art comes into trading.

As for the US market, it trades very differently from the ASX, so do be aware of the differences by trading cautiously in new markets to get the hang of them…

Great to hear from you, and hope all is going well!


Regards


Magdoran


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## Magdoran (5 September 2006)

wayneL said:
			
		

> Great post Mag,
> 
> I just wanted to pick up on this point and emphasize it.
> 
> ...



Hello Wayne,


So you’re on holidays huh?  How is the US – are you back in California? (if so say “hi” to Arnie for me, won’t you – especially since you don’t have to be in your crypt! Hahaha!).

Fully agree with your comment!


Mag


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## Magdoran (5 September 2006)

bunyip said:
			
		

> Magdoran
> 
> There's a lot of good information in your post.
> Thanks for going to so much trouble.
> ...



Hello Bunyip,


You’re most welcome, I hope the information is of value.

What I have found is that the precision of T/A styles starts to become important when using options because of the time element involved.  You have to take into account the expiry of an option to suit your timeframe, and if you’re swing trading, being able to project support/resistance in time and price starts to become really important – especially if trading OTM single options unhedged along the lines of your current approach.

Being able to read the bar chart and volume, combined with wave structure and understanding how the underlying trends (especially understanding counter trends) I think makes a significant difference when trading options since time is a critical factor in selection of strategy.

Hope this helps!


Warm Regards


Magdoran


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## Magdoran (5 September 2006)

ducati916 said:
			
		

> *et al*
> 
> While I would certainly concur with the post from *Magdoran* the following is worthy of a little further discussion;
> 
> ...



Hello Ducati,


You raise some really interesting points here, very elegantly.  

Thanks for that, you covered some very relevant ground I didn’t have space to cover in my post.  Together, both posts present a very full coverage of the issue at hand.


Regards


Magdoran


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## ducati916 (6 September 2006)

*Magdoran* 

We have an excellent example already posted, that we can use.



> I wanted to show you one way you can trade options using volatility.
> 
> The stock I want to show you is Forrest Laboratories FRX. FRX has suffered a bit of a decline from a high of over $48 in February down to about $36 in June and is currently trading at circa $39. The reason for this decline, apart from a general market decline in the same time period, is that FRX is involved in a court case regarding one of its pharmeceutical lines. The exact details are not important to us.




Now this as you will recognise, is, *enzo's* FRX trade.



> The trouble is, we don’t know which way this baby is going to jump, that’s in the hands of the judge. So, delta neutral? Long straddle is out of the question due to the low gamma and vega risk. Short strangle? This could miss the goalposts by a mile, too much uncovered risk. Butterfly/Condor? This would put a bit of a lid on risk, but we could still miss the goalposts with no chance of morphing the position if it gaps.




In the first instance, is the choice of instrument, common stock, CFD, Option contract the best choice?. The choice, as it turns out would have had a rather dramatic impact on the resulting outcome, as the common gapped overnight by some $5.00 or 16% on the underlying http://finance.yahoo.com/q/ta?s=FRX&t=3m&l=on&z=m&q=c&p=&a=&c=

Now assuming the wrong play, Options without a doubt provided the best of a bad outcome, as to some degree the position is hedged.

My query, and related to the topic under discussion is this;
How was the risk of an adverse outcome within the legal liability priced?
Was the useage of Historical/Implied Volatilities the correct measure of risk?
*Sails* identified the greek *vega* as being underpriced.



> I had a good look at the trade over the weekend and also came up with $46 as being the worst level for August expiration. I only took IV down to 25% and found about $5,000 loss at this level.
> 
> Assuming 19th August expiration and FRX closing at $46 with 25% IV, the Jan07 $50 calls would be worth about $1.86 and the $40 Aug calls would cost $6.00 to close:
> 
> ...




The vega pricing model assumes a change in the Option price caused by a change in volatility, which, of course with the legal liability pending decision, was the fly in the ointment.



> Margaret was correct here in pointing out that there was more vega risk than I had calculated. I had one incorrect input into the software which messed up the if/then scenario.
> 
> I could change the structure of this trade to accomodate this risk, however the reason I put this trade on in the first place is that my volatility projection for the back month is for no change. This stocks options don't get much cheaper as I pointed out. So I will leave it as it is.
> 
> ...




I'm not sure I agree that the mistake, even if rectified from the inputs would have provided the correct pricing for an adverse decision in the legal liability on the position, as historic volatility does not look to be high enough;
http://finance.yahoo.com/q/ta?s=FRX&t=my&l=on&z=m&q=c&p=&a=&c=

However be that as it may, in a CFD, the adverse move could well have on a 5% margin position ended the traders game............... permanently.

Therefore, the question really becomes, in regards to the following;
*Recognition of Risk
*Pricing of Risk
*Assumption of Risk
*Management of Risk

How successful was the preceeding example within the decision tree?
Which instrument was the best *risk adjusted for reward ?* 
What is the key component to have in place?

jog on
d998


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## ducati916 (6 September 2006)

And another example;



> Hey all,
> I went to put on an options trade but they wouldnt let me, because they were saying that the margins would have been to much for my account. Anyway here are the details:
> 
> CBA Febuary options
> ...






> To my understanding, it is fairly easy to summarize: it is the dividends that are causing the disparity you have found and you can usually only win on a trade like this IF the underlying falls below the sold call strike by the day before ex-dividend.




Again, the initial step in the process was missed.
**Recognition of Risk*
*Pricing of Risk
*Assumption of Risk
*Management of Risk

There are no free lunches in the market.

jog on
d998


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## Magdoran (6 September 2006)

ducati916 said:
			
		

> *Magdoran*
> 
> We have an excellent example already posted, that we can use.
> 
> ...



Interesting approach Ducati.  

This is where having knowledge and experience in evaluating derivatives is critical. The FRX example is quite unique since the volatility conditions offered a range of opportunities to employ major skews, but the approach ventured by Wayne was quite complex.  Comparing this kind of approach to CFDs, Futures, or common stock would require a detailed understanding of each instrument, and the capacity to evaluate the probabilities of a very volatile market.

The FRX trade was an unusual approach because it was a diagonal ratio back spread which had the sold strikes expiring before the bought strikes.  Part of the problem with this kind of approach is that it is difficult to calculate the effects when volatility changes at different rates for the bought and the sold strikes.

The risks are that the sold leg moves deep ITM and that there is a prospect of being assigned especially the closer the sold leg moves towards expiry.

The other risk is that the volatility in the bought leg falls significantly hurting the value of the longer term strike.

The objective is for the volatility to drop harder for the sold strike, and for the underlying to really move up sufficiently to put the bought strikes deep enough in the money to outweigh the increase in value for the short strike.

The problem with conventional graphs is that it is difficult to simulate the divergent effects of volatility, and also to take into account the earlier expiry of the sold position.

Ratio back spreads have an area of risk with break evens slightly above and below the bought strike price level (which is where the maximum risk is located), and it is in this area that the diagonal version is even more exposed since all the underlying has to do to incur a loss nearing expiry of the sold strike is to stay within the break evens.

Essentially this strategy needs the underlying to break up or down away from the bought strike as far as possible, preferably below the sold strike, or as far as possible above the bought strike (certainly above the upper break even).  And it needs to do this before the sold position gets too close to expiry, or moves too much in the money too close to expiry.


*Comparing Strategies:*

Now, how do we compare this approach to CFDs, stock and futures?  

This is a process of assessing the probability of where and when the stock may move, and looking at the relative leverage in each case, assessing the net profit or loss both in probable outcomes (including time frames), and also taking into account less probable extremes, again assessing probable profit and loss models (specifically for CFDs, Futures, and option strategies, and common stock).

Using a range of modelling packages would allow an examination of the areas and magnitudes of risk for options strategies, and a manual calculation based on futures and CFD margins could then be compared looking at:

•	Maximum profit and loss in the worst case scenario to determine position size and risk mitigation approaches.
•	Estimated profit and loss based on the more probable outcomes to assist in selecting the best balanced strategy in line with the individuals trading approach. 

This is where the devil is in the detail.  Talk to 10 different derivative traders and you’ll get 10 different answers.  A lot is determined by ability, preference, and risk profile.  Some people opt to use very risky strategies in order to make large profits (which may result in losses), and some opt to make small but probable profits with capped risks…  Some use a mix of the two, and employ one approach or another depending on their view of the market.

In essence Ari Kiev in “Trading in the Zone”  talks about getting bigger (or increasing risk) in specific situations that the trader views as being high probability, and reducing risk or position size in situation where the probability is lower (but within tradeable parameters).  This is perhaps an approach to consider, but again depends on the individual.

Also, it is possible to use a mix of instruments if the individual has the capacity to determine an effective approach using a co-ordinated strategy using different instruments.

So, as you can see, a lot will depend in the individual psychology of the trader as much as their market analysis capability and their capacity to evaluation derivative strategies.  Certainly not for the inexperienced, hence my earlier comment about people contemplating using any kind of derivative should be fully aware of a range of instruments, and fully conversant with the risks involved.


Regards


Magdoran


----------



## wayneL (6 September 2006)

Bear in mind the FRX trade was ####ed up from the beginning. Sans the mistake in analysing vega risk, it would have been done completely differently, or possibly not at all.

As I pointed out in the thread, I have given myself a very low score for the implementation. So sure, use it as an example, but only for an example sake.

Cheers


----------



## Magdoran (6 September 2006)

wayneL said:
			
		

> Bear in mind the FRX trade was ####ed up from the beginning. Sans the mistake in analysing vega risk, it would have been done completely differently, or possibly not at all.
> 
> As I pointed out in the thread, I have given myself a very low score for the implementation. So sure, use it as an example, but only for an example sake.
> 
> Cheers



Hello Wayne,


I actually thought the FRX trade looked good too (certainly on my graph), and I suspect that it yielded a guaranteed profit at one point (albeit a small one).

It was also a great working example highlighting all sorts of Greeks all at once, and all sorts of aspects such as using diagonal approaches and using ratios.

I thought it was great stuff and a really good exercise.  I think we all learned a lot from it, so I congratulate you on posting it.

Even now it is a powerful model for this discussion.


Regards


Magdoran


----------



## ducati916 (6 September 2006)

*enzo* 



> Bear in mind the FRX trade was ####ed up from the beginning. Sans the mistake in analysing vega risk, it would have been done completely differently, or possibly not at all.
> 
> As I pointed out in the thread, I have given myself a very low score for the implementation. So sure, use it as an example, but only for an example sake.




As it happens it is only being used as an example.
It is a useful example, as I have a variation on standard Options to run by you guy's [Options traders]

I am not particularly interested in whether it failed or succeeded, more in the way that it is initially constructed.

The bolluxed vega input while definitely changing the pricing, was not the most important initial consideration, rather, the *legal liability, or lack thereof, was the critical component* 

Therefore, initial risk assessment should have had this parametre in the mix.
That it was ignored, placed the trade on a non-risk adjusted basis immediately, and thus *all the price calculations were understated.* 

Thus due to a failure in;
*Recognition of Risk
*Pricing of Risk was incorrect. This is the stage that I would look at. The *greeks......if you like are equivalent to TECHNICAL PRICING of risk* 
I would introduce the concept of a double check on price risk by, calculating shall we call it *FUNDAMENTAL PRICING* of the Option.

Therefore we end up with two calculations of fair value for the Option.
The first calculated via a standard Technical methodology;
The second as a cross-check utilizing a Fundamental methodology.
The Fundamental methodology pays more attention to *contingent risks.......or, the Recognition of Risks* and places a price on them, cross-referenced with the standard greeks, or Technical pricing model.

*Magdoran* 



> Essentially this strategy needs the underlying to break up or down away from the bought strike as far as possible, preferably below the sold strike, or as far as possible above the bought strike (certainly above the upper break even). And it needs to do this before the sold position gets too close to expiry, or moves too much in the money too close to expiry.




Correct.
The fly in the ointment was the realization of an incorrectly priced risk.
One that had not been contingently priced into the Option.
When that risk eventuated, the model collapsed.
It was only the strength of the;
*initial strategy
*rational management........that saved the trade deteriorating into a total debacle. Had a pure directional strategy been utilized with CFD's, untold mischief could have been the result.

jog on
d998


----------



## Magdoran (6 September 2006)

dubiousinfo said:
			
		

> In cases where the option was not the best alternative, would there be any reason you could'nt use the CFD & look to reduce the risk by using some options as well. I don't have a particular stratergy in mind, just considering possibilities.



Hello Dubiousinfo,


Apologies for not answering your question sooner – you have a remarkable talent of asking what at first appears to be a straight forward question, that is actually quite tricky when you think about it!

Ok, so let’s look at this logically.  In a condition where there is not a viable option to suit a specific market view, in what cases should we also NOT use CFDs, even with the prospect of reducing risk by using supporting options.

Simple answer – you need to assess each situation and consider firstly all the possibilities (determine maximum risk to maximum reward), then secondly assess the probability of what is likely to happen based on your analysis, and consider the likely outcome of the strategy you are considering.

Complex answer:  a lot depends on your capacity to analyse the nature of the trend, and how effective your forecasting ability is. 

From here you then need to determine your view of the market – is it bullish, bearish, trading sideways, is it in a blow off trend, or is it creeping up/down, or is it trending in an orderly way.  This will in part determine the time frame and type of strategy you will consider using based on this market view. 

Then you would need to assess the available instruments and the associated strengths and weaknesses of each, and evaluate the potential risk to reward within a framework of probabilities.

Now to answer your specific question given that you have considered the above variables, you could use options to mitigate risk in a CFD if anyone transacts with your order.  But, this may not be to your advantage depending on your overall approach.

Problems may be wide spreads, liquidity -in that if you enter some options series, it may be so illiquid that there is a real risk that the position may work adversely – whether short or long the option, or a strategy.  

For example, you may well deem it reasonable to sacrifice capital on buying a put for protection for a heavily leveraged long CFD position, and commit to purchasing these understanding that the capital outlaid is like a 100% paid insurance premium.

If the CFD position size is too large, interest alone can hurt your position, and a long option may just lose value through theta decay.

Maybe the available strikes in the options may not be suitable.  Maybe the volatility is too high.

These are just some examples off the top of my head, but I’m attempting to give some examples of what you need to consider.  I’m sure others may be able to give lots of other examples, but the key here is having the requisite knowledge of derivatives to make these assessments.


Hope that helps!  Phew!


Regards


Magdoran


----------



## ducati916 (7 September 2006)

*Magdoran* 

Prior to running a second [cross-check] valuation, it might be of interest to examine some of the thinking process involved.

There would seem to be a fairly loose general agreement, on this and other forums, that, *emotions* within a trading, or investment methodology are negatives to be eliminated.

I would disagree that in the first instance that emotions are a negative, and in the second, that they can be somehow switched off.

It is this initial error in attempting an emotionless state, that the first rule is violated; viz. *Recognition of Risk* 

Again using psychological experiments, what has been demonstrated are;
the physiological responses to negative stimuli are correlated to;
*the *expectation* about the *intensity* 
*not the *probability * of receiving the noxious stimuli.

The result, is thus that we as humans cannot weigh decisions without emotional filters. Pure cognition [emotionless] cannot trigger a decision in humans. These emotional markers that accompany every decision, are responsible for the mobilization of *motivational states* that preceed action.

The capacity to plan cognitively, evaluate the merits and consequences of a decision and construct imaginable outcomes are inseparable. When they are separated via surgical techniques [frontal lobotomy] the results generated in exclusion of anticipatory emotional filters are uniformly poor.
In games of probabilities & uncertainity, the inability results in bankruptcy every time.

Emotions therefore are necessary and highly important. What however is also important is the weighting of a decision based on cognitive & emotional inputs. This brings us directly back to the original point;

**Recognition of Risk* and finding the balance between the facts, as knowable, and uncertainity, or possible future outcomes.

jog on
d998


----------



## ducati916 (7 September 2006)

As a direct example, we can again utilize the FRX trade.
First, we have the trade identified, and some of the surrounding circumstances;



> The stock I want to show you is Forrest Laboratories FRX. FRX has suffered a bit of a decline from a high of over $48 in February down to about $36 in June and is currently trading at circa $39. *The reason for this decline, apart from a general market decline in the same time period, is that FRX is involved in a court case regarding one of its pharmeceutical lines. The exact details are not important to us*.




The relevent area to this example lies within the highlighted sentence.
That it is identified, and then categorically dismissed, immediately struck me as odd, and why I followed the trade through the time-period.
This is the area of the *emotional filter* that must be balanced with an analysis based on quantifiable criteria;

The *numbers* are summarized in the last paragraph;



> Now I want you to notice something. The bottom blue line is the payoff today, the top blue line is the payoff at expiry of the Aug calls. So what do you notice? huh huh?
> 
> No risk!
> 
> ...




The Risk was recognised, and dismissed, therefore in actuality, never recognised, as it was not recognised, it could not be comparatively priced.
The contingent risk would have needed to be priced on an emotional pricing methodology, as, we have imperfect knowledge of an unknowable future outcome, and when compared with *market pricing, via a technical pricing model* we see the risk in terms of a price based on *intangible elements*

jog on
d998


----------



## Magdoran (7 September 2006)

ducati916 said:
			
		

> *Magdoran*
> 
> Prior to running a second [cross-check] valuation, it might be of interest to examine some of the thinking process involved.
> 
> ...



Hello Ducati,

Great post Duc, I think you’re onto something here, but in part it is something that I think Mark Douglas has made a concerted effort to address in both “The Disciplined Trader” and in “Trading in the Zone”.

Interestingly I have been considering the conclusion that a key element in the process of effectively exercising judgement is learning how to compensate for your own bias.  

Firstly recognising emotions on several levels (conscious/subconscious) – in effect recognising your own “matrix” of bias and preferences, and then working out how to effectively filter these potentially disruptive emotions in a specific way to enhance decision making capability, while simultaneously focusing the individual on freeing their mind to react to what is actually happening – for instance not having to be right all the time, thinking in probabilities, recognising when the reason they first took an earlier decision has changed in a way that requires a reappraisal or (corrective) action to be taken.

This is not easy.  Soros talks about not being worried about making mistakes, but focuses on first recognising them, then working out how to correct them.  He actively looks for flaws in his thinking (from “Soros on Soros). I think this is the crux of the problem – how to become as objective as possible, but without impairing the key emotional capabilities that empower individuals to be decisive.

I think you have made an excellent point, we need feelings to invest and trade – we use emotions to make decisions, that’s how we’re wired.  The trick is to have the right mindset, on two levels.  One is a methodical decision making process at a strategic level, where we develop detailed knowledge over time, and reflect on this away “from the action”.  The other level is not unlike panic management in fluid situations (not unlike making command decisions under pressure in a combat zone).

So I agree, it’s not about turning off emotions, it’s more about filtering the potentially disruptive ones out and focusing on fluid decision making capabilities when required in tandem with the cooler more strategic thinking.  Fully agree with your point that the cognitive and emotional aspects are inseparable (and if they are they impair the individual).  I think Douglas really addressed this well in “Trading in the Zone”, which I think can help people to pull the trigger, and exit when the situation requires it.


Regards


Magdoran


----------



## ducati916 (8 September 2006)

*Magdoran* 



> Interestingly I have been considering the conclusion that a key element in the process of effectively exercising judgement is learning how to compensate for your own bias.




Agreed.
This again is an example of the evolutionary process that has modified our neural functionality. These are the *heuristics* that tend to be mentioned in psychological texts and are examined within Behavioural Finance studies. They are simply the result of the requirement of reaching fast and instinctive decisions. However, in the post-industrial world, they are less of a positive factor in the decision making process.

Heuristics circumvent the solving and studying of problems through a long-hand and labour intensive process that makes a significant call upon the available processing power of the cognitive apparatus.



> Firstly recognising emotions on several levels (conscious/subconscious) – in effect recognising your own “matrix” of bias and preferences, *and then working out how to effectively filter these potentially disruptive emotions in a specific way to enhance decision making capability, * while simultaneously focusing the individual on freeing their mind to react to what is actually happening – for instance not having to be right all the time, thinking in probabilities, recognising when the reason they first took an earlier decision has changed in a way that requires a reappraisal or (corrective) action to be taken.




Absolutely agree.
I have highlighted the area that relates to the topic under discussion; viz. 
*Recognition of Risk

Within the FRX trade, the assessment of risk, was completed in two stages.
The first was via a heuristic, which resulted in the ignoring of the litigation in process, and that was to have a material effect, and second, within the technical method of an analysis of [some] all of the greeks.

As the Black, Scholes model [for example] assumes;
*an efficient market
*due to information flow
*rationality
This model, is an example of, albeit, elegant heuristic.
The premises are all open to serious questions however as regards the validity and accuracy of their valuations in a non-linear outcome.
Hence the advantage to be found in adding a further layer [where applicable] to an Options pricing model such as B/S.



> This is not easy. Soros talks about not being worried about making mistakes, but focuses on first recognising them, then working out how to correct them. He actively looks for flaws in his thinking (from “Soros on Soros). I think this is the crux of the problem – how to become as objective as possible, but without impairing the key emotional capabilities that empower individuals to be decisive.




Again agreed.
Cognitive bias + emotions = problem.
Remove cognitive bias by eliminating the heuristic evolution and returning to a longer more quantitative based analysis [for example] will almost automatically result in a modification of the emotional input to helpful, as opposed to detrimental.



> So I agree, it’s not about turning off emotions, it’s more about filtering the potentially disruptive ones out and focusing on fluid decision making capabilities when required in tandem with the cooler more strategic thinking. Fully agree with your point that the cognitive and emotional aspects are inseparable (and if they are they impair the individual). I think Douglas really addressed this well in “Trading in the Zone”, which I think can help people to pull the trigger, and exit when the situation requires it.




Again agreed.
Therefore, what actually remains is to build an analytical model for Options traders that accomplishes the requirements discussed.

jog on
d998


----------



## wayneL (8 September 2006)

ducati916 said:
			
		

> Within the FRX trade, the assessment of risk, was completed in two stages.
> The first was via a heuristic, which resulted in the ignoring of the litigation in process, and that was to have a material effect, and second, within the technical method of an analysis of [some] all of the greeks.




Duc

Notwithstanding that the analysis was heuristic, (whatever that is, I'm yet to look it up) that the litigation was ignored is not quite correct. The litigation was material in analysizing the IV's and IV skews, and in projecting change in same (vega)

The issue with the vega was that there was a mistake in the calculation due to a misunderstanding in the workings of the software. Had this not been the case, the strategy would have looked quite different and perhaps even non-existent. If there was no way to mitigate the above risk within the goal of the trade (i.e. to tade the difference in theta) I wouldn't have put it on, full stop.




			
				ducati916 said:
			
		

> Therefore, what actually remains is to build an analytical model for Options traders that accomplishes the requirements discussed.
> 
> jog on
> d998




Therefore the analytical models are contained within works of BS/CRR  et al, but one had better get the sums right.

Of course, further exploration is always welcome.

Cheers


----------



## ducati916 (8 September 2006)

*enzo* 



> Duc
> 
> Notwithstanding that the analysis was heuristic, (whatever that is, I'm yet to look it up) that the litigation was ignored is not quite correct. The litigation was material in analysizing the IV's and IV skews, and in projecting change in same (vega)




Well we can agree to disagree. The reason that I am arguing for the materiality of the litigation being ignored is as follows;



> *The reason for this decline, apart from a general market decline in the same time period, is that FRX is involved in a court case regarding one of its pharmeceutical lines. The exact details are not important to us*.




I would argue that the details in this example should be important, and that ignoring even a rudimentary analysis caused risk to be underpriced.



> Generally, we want to be buying low volatility and selling high volatility.
> 
> Now there was 31% at the $50 Jan 07 calls and there was 85% at the $35 Aug calls. There was also 65% at the $40 ATM Aug call which I ekected to take because the extrinsic value is still highest ATM.
> 
> So I sell the Aug $40calls and buy the Jan $50calls? Well yes! But that would give me a bearish diagonal spread, and seeing as I want to be market neutral, thats not what I want




This seems to be the crux of the analysis.
That the *selling of high volatility and purchase of low volatility* is the basis of the trade being placed.

I previously addressed the point of the incorrectly inputed vega.
I felt, from the historical volatility both from a visual inspection, and from additional calculations performed by *sails* that the vega would not have caused a material difference in the analysis;



> Hi Wayne,
> 
> I had a good look at the trade over the weekend and also came up with $46 as being the worst level for August expiration. I only took IV down to 25% and found about $5,000 loss at this level.
> 
> ...




In response to this calculation, and based on the previous post;



> The issue with the vega was that there was a mistake in the calculation due to a misunderstanding in the workings of the software. Had this not been the case, the strategy would have looked quite different and perhaps even non-existent. If there was no way to mitigate the above risk within the goal of the trade (i.e. to tade the difference in theta) I wouldn't have put it on, full stop.




And in response to *sails * on the previous discussion we see the dichotomy of retroactive analysis, these are the very real difficulties in attribution of past events; viz. the contradiction in post trade analysis.




> Just an update on this trade... but first:
> 
> Margaret was correct here in pointing out that there was more vega risk than I had calculated. I had one incorrect input into the software which messed up the if/then scenario.
> 
> ...




The combination of the various points presented suggests that the initial *cognitive bias..........or heuristic* was so embedded, that even on acknowledged evidence to the contrary, the evidence was rationalised away.
This is common, and a major finding within any number of the better quality studies. The point of pursuing the point is......how to avoid it in the first place?



> Have back tested diagonals (with and without ratios) on the Aussie market but just can't get them to look right - usually too much risk. But then we don't get a lot of IV skew between months either. Magdoran, if you have time, would still be interested in looking at some past examples?
> 
> Agree Wayne, that it is still a high probability trade with only a small area of risk (and unlikely) near August expiration. Good to hear it is moving favourably for you.




This is the area under discission with *Magdoran* 
As can be seen from the later comment; how is this *high probability ascertained?* 
We have just identified a mistake in the original analysis.....and.....it is still a high probability trade?

This is pure cognitive bias in action.
A heuristic decision is reached, and irrespective of contrary evidence, the initial decision far from being questioned is *reinforced* 

The first step in a cure, is a correct diagnosis.
With a correct diagnosis, we can create a patient management plan
We can then monitor the patient, adjusting as we go, based on objective, quantitative criteria.
The result, should then be positive, if it is not.........
Back to step #1

jog on
d998


----------



## happytrader (8 September 2006)

Any beginner reading this thread for education purposes might actually get the idea that one has to be extremely intelligent to trade options successfully. However, the most successful traders I know personally get to the point where they only trade up to a handful of stocks or patterns continuously and at key times. Decisions and trades are made and executed rapidly. From my own experiences and observations of colleagues, limited selection, key times and quick decisions seem to be defining characteristics.

Cheers
Happytrader


----------



## Magdoran (8 September 2006)

happytrader said:
			
		

> Any beginner reading this thread for education purposes might actually get the idea that one has to be extremely intelligent to trade options successfully. However, the most successful traders I know personally get to the point where they only trade up to a handful of stocks or patterns continuously and at key times. Decisions and trades are made and executed rapidly. From my own experiences and observations of colleagues, limited selection, key times and quick decisions seem to be defining characteristics.
> 
> Cheers
> Happytrader



Hello happytrader,


You raise a really good point – and that is to try to keep everything simple (this thread for example too, point taken).  I certainly agree that you don’t need a degree to be a successful options trader, but you do need the right knowledge and attributes.

Unfortunately to try to explain all the known attributes on a written forum like this for others to understand is actually really difficult to get the message over.  I know that we get tied up in beginner unfriendly terms sometimes, sorry… but to try to explain the aspects that have been recognised is quite involved and not easy to put simply.  

Interestingly your description of traders who trade selected stocks or patterns that they know continuously and at key times about sums up my core “position trading” style.  I’m not sure that the decisions in all aspects are rapid – certainly the quick “command” style decision to enter and exit is, but as described in my earlier post, this is done in the context of broader strategic thinking, and within a system where there are a series of steps in the decision making tree.

So this is what the recent discussion was about – how do you assess risk using different options strategies, and even though experienced options traders make this look easy (because they do it all the time), it is actually not as easy as it looks.

In a trending market, it becomes much easier to just enter single series at the money directional trades, and if volatility is fairly consistent, some people can have a great run in options, even for months.  It is when these conditions change that can catch a lot of traders out, especially when volatility has rapid significant changes.

But the style described is mainly swing/position trading, usually directional, often using single series options (some will use slightly ITM, many ATM, and some OTM) where this ability to make quick decisions is used.  But behind this process there needs to be the ability in knowing when to enter and exit, and which options to use.

Personally, I actually do the hard yards away from the market, looking for potential opportunities and considering the volatility, and think through which strategies may work best.  Then I do the due diligence rapidly when the opportunity arrives, and that decision making is certainly executed rapidly when looking to get set.

The discussion above was really getting to the core of how to assess risks.  Experienced traders either consciously think this process through, while others develop the ability to do this intuitively.  The message here is to identify that risk assessment however you do it is a cornerstone of options trading.


Regards


Magdoran


----------



## ducati916 (8 September 2006)

*Magdoran & enzo* 



> The discussion above was really getting to the core of how to assess risks. Experienced traders either consciously think this process through, while others develop the ability to do this intuitively. The message here is to identify that risk assessment however you do it is a cornerstone of options trading.




Agreed.
To progress the model we need to;
*ask *enzo* to reconstruct the initial valuation model [with amended vega]
*or, take a new, real time example, and provide a dual analysis & valuation.

If option #2 is undertaken, we will need an example that includes a non-linear event that will provide a similar scenario for valuation as the previous litigation in the FRX example.

Anyone interested?

jog on
d998


----------



## Magdoran (8 September 2006)

ducati916 said:
			
		

> *Magdoran & enzo*
> 
> 
> 
> ...



Hello Ducati,


While I understand where you are coming from, and while the issue you raise is certainly of interest at the fine tuning end of options trading approaches, it maybe getting to the level where the majority will see this as splitting hairs, and will not really benefit from the discussion.

Certainly not beginners, or for that matter even at the intermediate level.

The FRX example is great for those wanting to play around with complex spreads, and to see the impact of ratio and diagonal variations, and it certainly highlights just how involved the Greeks can get.

But I wouldn’t see this as the “pin up” idol to interest new options traders.  I can almost hear happytrader thinking, what’s this Frankenstein’s monster of an options position got to do with straight calls and puts?  And if he is, he’d have a valid point at that level.

In fact, I suspect that the majority are either snoring or “changing the channel” (clicking on to another thread).

The original topic was about the pros and cons of a strategy, then briefly raised the notion of options vs CFDs, then the mental state behind assessing risk came to the fore.  While all this is relevant, aren’t we losing track of the basic option mechanics at the start?

Perhaps you could start a new thread Duc and frame a discussion there?  What do you think?


Regards


Magdoran


----------



## ducati916 (8 September 2006)

*Magdoran* 



> While I understand where you are coming from, and while the issue you raise is certainly of interest at the fine tuning end of options trading approaches, it maybe getting to the level where the majority will see this as splitting hairs, and will not really benefit from the discussion.
> 
> Certainly not beginners, or for that matter even at the intermediate level.
> 
> The FRX example is great for those wanting to play around with complex spreads, and to see the impact of ratio and diagonal variations, and it certainly highlights just how involved the Greeks can get.




Oh,Oh!
The model that I was proposing is a completely different model that is utilized to value non-linear events. That Options, in essence, provide a very similar framework, this model could be used as a cross-reference to the standard greeks in a valuation.




> But I wouldn’t see this as the “pin up” idol to interest new options traders. I can almost hear happytrader thinking, what’s this Frankenstein’s monster of an options position got to do with straight calls and puts? And if he is, he’d have a valid point at that level.
> 
> In fact, I suspect that the majority are either snoring or “changing the channel” (clicking on to another thread).
> 
> ...




I think that in the light of the lowest common denominator, I'll just drop the subject. 

jog on
d998


----------



## Magdoran (8 September 2006)

ducati916 said:
			
		

> The model that I was proposing is a completely different model that is utilized to value non-linear events. That Options, in essence, provide a very similar framework, this model could be used as a cross-reference to the standard greeks in a valuation.



Oh, Ducati,


I think I missed something then, can you expand on what you mean the term "non-linear events" please - I may have a different interpretation...

Also how would the model (can you please summarise this in simple terms please?) be used as a “cross-reference” to the “Greeks” we’re currently using?

Don’t forget if this approach is to have value, it needs to be compatible with actual options traders and their style, and I know Ducati that you are still studying options in theory (hence you may have more of an objective viewpoint in theory, but then there’s nothing like experiencing the “real thing” either!).

I still think setting up a separate thread for this would be worthwhile for the advanced options traders if you’d care to do it.  I’d also be interested in Wayne and Margaret’s perspectives here too.


Regards


Magdoran


----------



## wayneL (8 September 2006)

I'll separate the rocket science into a different thread later on. Missus has me doing some confounded chores for the moment


----------



## wayneL (8 September 2006)

wayneL said:
			
		

> I'll separate the rocket science into a different thread later on. Missus has me doing some confounded chores for the moment




I can't think of an elegant way to separate this into two threads without messing up the conversation flow. Perhaps rename the thread... Joe?


----------



## wayneL (8 September 2006)

happytrader said:
			
		

> Any beginner reading this thread for education purposes might actually get the idea that one has to be extremely intelligent to trade options successfully. However, the most successful traders I know personally get to the point where they only trade up to a handful of stocks or patterns continuously and at key times. Decisions and trades are made and executed rapidly. From my own experiences and observations of colleagues, limited selection, key times and quick decisions seem to be defining characteristics.
> 
> Cheers
> Happytrader




Hi HT,

There are of course a myriad of approaches in trading options, each as defined by the greeks.

From the sounds of it your (and friends) style is primarily trading delta, both long and short, with long gamma and vega, negative theta.

There is nothing wrong with that, but folks should understand that that is but one approach. 

By far my most profitable approach has been delta neutral, short gamma and vega, with positive theta... almost the direct opposite to you. There are others of course.

Which is best?

Neither! There is no best appraach to options, and I contend that ALL approaches are the best... in the right circumstances.

For instance in this current expiry cycle, I haven't put on my favourite strategy on the SP (the one above) because the IV conditions did not offer an edge in that strategy. As it is shaping up, it looks as though it will have been profitable anyway (sans any big move next week) but risk/reward was just not to my liking.

In fact I have been long delta, gamma, vega, theta negative (in other word I bought calls) on the grains because there was a bit of an edge I thought from being long vega. I also did the same with hogs last month, but also was able to enhance that position by doing a couple of morphs along the way.

Re having to be intellegent. hmmmm not a prerequisite but, I certainly recommend the struggle to learn all this stuff...and though of only average intellegence I must admit to enjoy the challenge of getting as far as I can with this. 

In the end, horses for courses, and certainly there is no room for looking down the nose at simple approaches, so long as risk is known.

Cheers


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## wayneL (8 September 2006)

ducati916 said:
			
		

> *Magdoran & enzo*
> 
> 
> 
> ...




I'm not sure we could reconstruct the FRX trade faithfully without live data. Also, as the result is now known, surely this would taint said reconstruction.

I will try to find a new scenario... so what we want is some pending unknown known. e.g. litigation, FDA announcement or similar, right? This is what will give us the enourmous IVs and time skews we are looking for.


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## happytrader (8 September 2006)

Hi Wayne

I absolutely agree with you that there is more than one approach.
However, whatever the strategy successful trading is dependent on making decisions one can commit to and manage the outcome of. 

I have known many ' trading course junkies' who have paid dearly for all the best info from some very successful people and yet they can't bring themselves to take a trade. The library and the internet abound with great free info. 

But the fact remains most people can't make decisions and as with the majority are comfortable as employees.

Managers are the goal oriented thinkers and the employees are generally the feelers. Two totally different views and accompanying behaviours along with results are observeable. This appears to have its roots in experience e.g the family unit, mum, dad and the kids.

Traders, like good parents and managers are foremost decision makers and the easiest way to build this ability is to narrow down the field to timeframes, necessary information and limited choices to reduce being overwhelmed. 

Cheers
Happytrader


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## Bobby (8 September 2006)

wayneL said:
			
		

> ...and though of only average intellegence I must admit to enjoy the challenge of getting as far as I can with this.




Wayne if you think your of only average intelligence then may I say  :bs:

I think your on the way to have savoirfaire characteristics   

You already possess certain savant powers!

Take care.
Bob.


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## ducati916 (9 September 2006)

*enzo* 



> I'm not sure we could reconstruct the FRX trade faithfully without live data. Also, as the result is now known, surely this would taint said reconstruction.
> 
> I will try to find a new scenario... so what we want is some pending unknown known. e.g. litigation, FDA announcement or similar, right? This is what will give us the enourmous IVs and time skews we are looking for.




As to tainting, or biasing, the result, certainly, but this of course is a problem with analysis in hindsight unless allowed for. However as an initial experiment, it has certain characteristics that are helpful when building a new model.

Irrespective, in essence as to what we are looking for.......correct.

We want a trade that the greeks have priced as attractive for strategy XYZ
But that has a;
*known event
*unknown timeframe
*unknown magnitude
*unknown result

These, [and possibly some I haven't thought of] types of risk are not accurately, or even adequately priced via the greeks.
I am looking for a quick, easy, methodology, to use as a pricing mechanism as a cross-check on the price generated via the greeks.

I would hazard a guess that 99% of options traders on this site utilize an online calculator, or software to do the calculations in a Black/Scholes, or Cox/Rubenstein calculation.

Nothing wrong with that *after you have done them long-hand for a year or so* as you will then fully understand your greeks, and you will notice that certain elements of risk are ignored, or not built into the models [in specific scenarios].

jog on
d998


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## happytrader (9 September 2006)

Hi Ducati

Quote:
I would hazard a guess that 99% of options traders on this site utilize an online calculator, or software to do the calculations in a Black/Scholes, or Cox/Rubenstein calculation.

I don't know or have ever known of any trader that actually uses these models to trade. Many do however, take a peak at the days trade history of a particular option and most definitely assess open interest. The usual method is actually to identify a key time, make a trading decision and commit to an entry. This is made by several methods: 

1. make an offer at the last price (might get a bargain)
2. make an offer halfway between the spread (high chance of success) 
3. buy at market (entry assured)

Models are all very good for theoretical pricing but things can move very quickly and the pricings can be way off the mark.  This is after all an auction and the market is always right.

Also there is absolutely no reason why you can't get accurate pricing by free trialling option software and using the above methods to test your models. In fact thats how we of the same school and teacher were all taught to paper trade for a period of 6 weeks on low volatility stocks.

Cheers
Happytrader


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## ducati916 (9 September 2006)

*happytrader* 



> Quote:
> I would hazard a guess that 99% of options traders on this site utilize an online calculator, or software to do the calculations in a Black/Scholes, or Cox/Rubenstein calculation.




Actually, this is just my sense of humour.
The above is an example of an *heuristic* viz. a generalization, made without any quantifiable methodology. 



> I don't know or have ever known of any trader that actually uses these models to trade. Many do however, take a peak at the days trade history of a particular option and most definitely assess open interest. The usual method is actually to identify a key time, make a trading decision and commit to an entry. This is made by several methods:




Oh Oh.
While I would not say that I know a lot of Options traders, all of the ones I do know, utilize the greeks in some shape or form. Without doing the necessary work, you are at the mercy of market makers, who of course have your best interests at heart.



> 1. make an offer at the last price (might get a bargain)
> 2. make an offer halfway between the spread (high chance of success)
> 3. buy at market (entry assured)




I real hit/miss, amateur hour methodology.



> Models are all very good for theoretical pricing but things can move very quickly and the pricings can be way off the mark. This is after all an auction and the market is always right.




*The market is a peanut.
*The market can move quickly, thus providing better, or increasingly prohibitive pricing in regards to the valuation ascertained via modelling.
*Without a price/value calculated in any shape or form, you have no bench-mark by which to calculate your risk/reward assumed.



> Also there is absolutely no reason why you can't get accurate pricing by free trialling option software and using the above methods to test your models. In fact thats how we of the same school and teacher were all taught to paper trade for a period of 6 weeks on low volatility stocks.




And then the total contradiction.
Of course volatility is a constant.......................

In the final analysis, there are only two variables that count.
*Direction
*Volatility

If you can predict these with 100% accuracy, you can make money trading anything that you choose to. If however you can't, then, like the rest of the capital markets you need a methodology to;
*Recognise
*Price
*Assume
*Manage
*RISK
*REWARD

jog on
d998


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## ducati916 (9 September 2006)

If you are trading ASX Options, in the manner previously described, then you had better think again.

http://lightning.he.net/cgi-bin/suid/~reefcap/ultimatebb.cgi?ubb=get_topic;f=6;t=000171;p=1#000001

Unless *you * have a pretty good idea of what risk you are assuming, you could be the patsy.

jog on
d998


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## happytrader (9 September 2006)

Thanks for your reply Ducati

Quote
I would hazard a guess that 99% of options traders on this site utilize an online calculator, or software to do the calculations in a Black/Scholes, or Cox/Rubenstein calculation.

Its like you said, you are indeed a 'guesser'
and a searcher of the holy grail too.
Good luck with that.

Just my sense of humour

Cheers
Happytrader


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## wayneL (14 September 2006)

ducati916 said:
			
		

> *enzo*
> 
> 
> 
> ...





NRPH?

http://finance.yahoo.com/q?s=NRPH&d=t

http://cboe.ivolatility.com/nchart....,R*1,period*12,all*4,schema*options_big&2=x:1


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## ducati916 (14 September 2006)

*enzo* 

Yes, this will work just fine.
Does your modelling, or whatever methodology you employ, provide a value or price? [if so make a note of it, and the two values can be compared later]

Possibly Magdoran & Sails might calculate their price or value, and we would have further values as a comparison.

We know *happy's* value, I've just removed the dart from the value selected.

jog on
d998


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## happytrader (16 September 2006)

Hi All

Actually I thought I would have a peak at NRPH when Wayne mentioned it and
paper trade it. However, the prices are taken from real trades.

'the idiot way'

Buy write strategy

Time frame 2 days

13 Sept 06 - Buy NRPH at 3.35pm for $24.85 and at the same time Sell to open option code QNCIE with Strike price 25.00 @ 80c expiring on 15 Sept 06 Open interest over 1000

Possible scenarios

Option expires worthless - Keep premium and shares pay brokerage one way.
Stock goes up and you are exercised - you keep the premium and make a small profit of 15c on the share and pay brokerage both ways. 
Stock goes down - risk subsidised in part or entirely by receipt of 80c premium. Actual loss depends on you.

We here find you very entertaining Ducati. Its just like being home in NZ.

Cheers
Happytrader


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## wayneL (19 September 2006)

ducati916 said:
			
		

> *enzo*
> 
> Yes, this will work just fine.
> Does your modelling, or whatever methodology you employ, provide a value or price? [if so make a note of it, and the two values can be compared later]
> ...




Duc,

I don't think I can assign a "value" to these options.

1/ The OPM (whichever one is in use) requires a trader (or the market collectively) to make a projection of volatility likely for the term of the option. Due to the pending news, this is an impossibility. An educated guess at the best of times, this becomes an outright gamble in the current circumstances.

2/ The problem with all OPM's is the presumption of continuous markets... exactly what is virtually guaranteed NOT to be the case when the decision is ultimately released. A contraindication to the fundamental philosophy behind oprion pricing IMO

In other words, I wouldn't be game to try to actually value them. These sorts of situations I try to play on what certainties there are. i.e.

1/ IV skews, both time and price

2/ vega/volatility crush

The certainty is that there will be a significant shift in IV. What is not certain is where the underlying will move to, if anywhere.

If I can remove enough vega risk while spreading the theta as well as being positive gamma, or, have a favourable risk/reward (again a guess)  jumbo jet spread (a very wide condor), then I have a trade. Otherwise I pass. I am looking for 90% probabilty of success with little risk.

Not many of these actually measure up. I can't get this one to work because of the spreads in the back month series.

Thats all I can really add at this stage unless a better candidate turns up.


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## Magdoran (19 September 2006)

Hello Ducati and Wayne,


Can I ask a dumb question here?  What exactly are we trying to do here?  Valuation of options is problematic in volatile market conditions because the market is trying to estimate the probability of a given option finishing in the money by expiry (although some players are estimating that the actual value of an option will move favourably within whatever strategy they determine to enter).

When market players try to factor in unknowns like important news events, volatility can rise significantly because the option sellers build more risk into the price of the options.

The strategy of using volatility and the resulting mispricing between different strikes to their advantage is an effective way to both reduce risk, and ameliorate adverse effects of volatility in the option prices.

I had a play around with various spreads with ratios and diagonals to name a few, but the volatility skews were odd.  

Part of the problem was the potential behaviour of the stock:  The chart is bearish in the daily, bullish in the weekly, but looks like it could retrace more, unless we get a good pattern higher low in place, or it may move strongly on the expected news...

So, when it comes to valuing the options, a lot would depend on what you would expect the stock to do, the time frame you expected it to take, and what your volatility expectations were.

A real problem with many of the positions I was looking at for interest for this thread, was that a volatility crush would adversely effect the long leg (bought option), and if using a diagonalised ratio back spread, the danger of an adverse exercise, or the negative prospects of the sold leg expiring at an unfavourable time were reasonably high.

This is assuming selling the front month, so to use the volatility skew (best buy in volatility was around 80, best sell was around 200), the danger was the stock did nothing, or moved to a price that would result in a loss if the volatility fell sufficiently.

Of course the loss was fairly small, and the potential gains unlimited (if using a call version), but the stock would have to move significantly for this to happen, and before the sold position got too near expiry.

I found the volatility sometimes was not favourable to a spread buying a later dated strike.  In fact straight directional spreads could be constructed that had better risk to reward ratios, but were subject to getting the direction and magnitude right.

Unless you have very good forecasting approaches, trying to select a viable position here would be fraught with difficulty since the volatility is so high and has been increasing heavily.  If the stock then didn’t deliver any kind of move, or the news item the market was expecting either doesn’t eventuate or is revealed and priced in, the volatility may well fall significantly.

So, in my view the options are way overvalued from a nominal model, but this is because of an unknown news item, and the market pricing this into the premium.  We’d expect a volatility crush once the news is known, but this may coincide with a strong move in the underlying on the expected announcement (of course we may not too).  

Personally I just wouldn’t trade this kind of stock at all.  I have no edge to tell me which way the stock might move, up down or sideways, or how far.  My weekly gives me the feeling it is bullish but retracing some more, the daily shows a bearish drive, with an exhaustive bar down, and a few days of unclear inside days (maybe suggesting the downward momentum has halted).

With conflicting information like this, the wildly high volatility, and the uncertainly this represents I just don’t see a trade that is viable that suits my risk to reward profile, or within any measurable probabilities (not to say this can’t be done, just that I’m not geared for this kind of trade – there may well be an arbitrage in the static numbers, but during actual market conditions these may disappear quickly).  

If I had to trade, I’d probably pick a direction, and look to sell ATM or slightly ITM and hedge with a bought position with a favourable skew.  My directional guess would be going bullish with a bit of time probably the December strikes, or go out even further.  Perhaps a bull put or bull call, but prefer to get a really good skew to protect the position from adverse price movements, or from volatility crush.


Regards


Magdoran


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## wayneL (19 September 2006)

Magdoran said:
			
		

> Hello Ducati and Wayne,
> 
> 
> Can I ask a dumb question here?  What exactly are we trying to do here?




Mag,

The Duc was suggesting that the OPM's were missing a component of risk assessment and therefore flawed pricing in situations "Rumsfeldian" (known unknowns etc)

I agree. And not having delved into the actual mathematics of BS, BM, CR&R etc, I wanted to see where Duc was going with this.

Cheers


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## ducati916 (19 September 2006)

*enzo & Mags* 

I haven't really had time to look at the current example in respect to some of the numbers involved, but this is the basic gist;

You own an Option on a gold producer [medical company] exerciseable at $50 million, or $1.00/share. The mine has a value of $100 million if the price of gold = $600+ or $40 million if the price of gold = $400 or less.

You have no firm knowledge of whether the price will be high or low, but based on your calculations of [volatility, beta, Black/Scholes, charts, etc]
You have the odds at 75% high, 25% low

The mine will be depreciated [depleted] at the rate of $10 million/annum.
So what is the value of your Option?

Value of hold = [0.75*($100 - $10 - $50)] + (0.25*$0.0) = $30 million
Value of exercise = [-$50 + (0.75*$100) + (0.25*$40) = $35 million

Therefore, the value of exercising the option is greater than waiting.
If this quick cross-reference reinforces your existing analysis, then you would have further confirmation for the trade. If the value were lower, you may look at your values.

Obviously you need an estimate, or reasonably solid figures to work with.
If FRX wins the case, it is worth $X per share, if lose, $Y per share.
Still working through this area at the moment.

jog on
d998


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## Hopeful (31 October 2006)

Hopeful said:
			
		

> RIG (a US stock) is currently trading at 70.45 , Oct calls with a 75 strike are selling for 1.90. So then I hit the bid and short the call then go buy the stock. If it goes down to 70.45 minus 1.90 = 68.55 then I exit with a small loss (brokerage). On the other hand if it ends up anywhere above 68.55 at expiry then I'm laughing (yes, American style means I can get assigned...).
> .




The Octobers expired on the 20th with the stock finishing at 70.28. If I had held it until expiry I would have kept the premium (it never reached 75) of $190  . I would have sold the stock on the 20th for 70.28 to completely exit the position.

Entry:

Buy 100 RIG for          -7045
Sell 1 Oct 75 call for   +0190
Net                          -6855

Exit:

Sell RIG for                +7028
Call expires                  0000
Net                          +7028

NET PROFIT $173 ($165 after commissions with IB)

165/6855 is a 2.4% return in about 7 weeks. Annualised is about 50% return.

I like options    . Of course, in this example I ignored the greeks / risk factors. But it's better not to think about risk because that leads to hesitation and hesitation leads to doing nothing *insert tongue-in-cheek here*.


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## Hopeful (31 October 2006)

_
165/6855 is a 2.4% return in about 7 weeks. Annualised is about 50% return.
_

No, 18% return - not so hot eh. (well, I did say "idiots guide" didn't I).

Anyho, continuing with this...

(Oct 30 at the close) I think with the market going so well there's a good chance RIG will start to follow along soon. Targetting $83 in about 2 months I propose to sell JAN 80 Calls for 2.20 covered by the stock at 71. See you again in January!


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## Hopeful (16 February 2007)

Hopeful said:
			
		

> _
> 165/6855 is a 2.4% return in about 7 weeks. Annualised is about 50% return.
> _
> 
> ...




At January expiry (19th) RIG closed at 75.80 , would have kept the premium of 2.20 and would have kept the stock too. Would have written another one (say an $80 Feb call for say $2.00) at Jan expiry , which would also have expired worthless.

So simply selling covered calls has worked really well so far. Let's do another one:

Sell May $85 calls for $1.80. See you in May.


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## wayneL (16 February 2007)

Hopeful said:
			
		

> At January expiry (19th) RIG closed at 75.80 , would have kept the premium of 2.20 and would have kept the stock too. Would have written another one (say an $80 Feb call for say $2.00) at Jan expiry , which would also have expired worthless.
> 
> So simply selling covered calls has worked really well so far. Let's do another one:
> 
> Sell May $85 calls for $1.80. See you in May.



Why are you writing them so far out in time?


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## Hopeful (18 February 2007)

wayneL said:
			
		

> Why are you writing them so far out in time?




The shorter term ones are cheap as chips, very unappealing.

BTW, this is just imaginary trading to see what I might do if I were inclined to do CCs in the future. But it's worked well so far, in theory!


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## Mofra (18 February 2007)

Hopeful said:
			
		

> The shorter term ones are cheap as chips, very unappealing.



Howdy Hopeful,

"Cheap" can often be a subjective term when it comes to options; remember the acceleration of time decay is greatest (as a rule of thumb) in the final 3 weeks until expiry. If your spread is net credit, this is a bonus. Of course, the inverse is true as well.

Cheers


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## wayneL (19 February 2007)

Hopeful said:
			
		

> The shorter term ones are cheap as chips, very unappealing.
> 
> BTW, this is just imaginary trading to see what I might do if I were inclined to do CCs in the future. But it's worked well so far, in theory!



OK lets extrapolate this thinking to it's logical conclusion.

If 90 day premium is better than 30 day premium, then 180 day premium must be better than 90 day premium. So why not write the August calls?

Why not write the 2008 LEAP? Why not the 2009 LEAP and get > $10?

Well part of the reason is that you are writing quite a long way out of the money. 

It is often stated that theta accelerates as we get closer to expiry so options with 30 days or less till expiry should be written. This is not quite accurate.

It is of course accurate for AT THE MONEY options. However as we go further IN or OUT of the money, theta actually DEcelerates as we get very close to expiry.

For the strike Hopeful is writing, it is actually better to write further out.. 2 - 3 months. It is only when writing AT (or close to) the money that is is better to write with 30 days or less.

Happy brainstorms


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## Hopeful (28 May 2007)

> At January expiry (19th) RIG closed at 75.80 , would have kept the premium of 2.20 and would have kept the stock too. Would have written another one (say an $80 Feb call for say $2.00) at Jan expiry , which would also have expired worthless.
> 
> So simply selling covered calls has worked really well so far. Let's do another one:
> 
> Sell May $85 calls for $1.80. See you in May.




Finally, would have gotten called out. Would have sold RIG at $85 for a nice gain, and would have got the premium out of it too, $1.80. ei 9.20 + 1.80 $11 gain on this trade. I'm starting to wish I had actually done this now... 

Now for the summary of this:

Bought stock in Oct at 70.45
Sold Oct 75 call for 1.90 (not called out)
Sold Jan 80 call for 2.20 (not called out)
Sold Feb 80 call for _about_ 1.00 (not called out)
Sold May 85 call for 1.80 (premiums were not good so went for a longer term call, but got called out)

Buy stock 70.45 sold stock 85 = +14.55
Sold options for total premium of +7.00
Profit for 8 months is 21.55 ie $2155 for an investment of $7045, this is 30% for 8 mths or 45% for a year annualised. 

Had you bought and held the stock only, 7045 , 9552 (at May exp) that would be 36% or 53% annualised.

Conclusion, just buy the stock, worked out better not to mention commissions. Even better when the mkt is flying options are cheap so just buy calls or do a bull call spread. It was the low premiums which tripped me up forcing me to go out further in time, but then sacraficing the potential upside.

Conclusion, when options are good value (low volitility, market moving up smoothly) just buy them. When options are volitile and expensive sell them! Valid conclusions (all other things being equal)?


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