out of the money strangles

[scorpioncapital]

Anybody use a short strangle strategy where you sell a deep out of the money put and call, and collect a premium at expiry if the stock is range bound within a very large range for a very short time say 1-6 months?

 

It would seem this strategy is quite conservative and many brokers will reduce collateral of one side to zero while the return could be potentially double. Likewise, it mitigates somewhat the loss of making a directional bet.

[frommi]

You just sell volatility that way, can make sense, but all in all you have probably no alpha in this game. And when you want to profit from contango you can just buy XIV. But be ready to lose a lot from time to time. :)

[Ross812]

Wouldn't you have to sell spreads to reduce cap your risk and limit your losses?

 

Ex.  APPL @ 100 - Sell $115 Call and $85 Put - you need to keep $8500 in cash or margin, and you are selling a naked $115 call.

 

or

 

Sell spreads $115 - 130 Call Spread and a $85 - $70 put spread. 3k in cash or margin and you liability is covered on both ends.

 

[frommi]

Of course you can limit your risk that way. But you will make money 90% of the time and lose all of what you made in the rest 10%. :)

You have to bring in something else (alpha), otherwise you won`t make any money in the long run.

[scorpioncapital]

Well, you can resist the lure of the near the money call.

 

I look for these criteria

 

1. Stock has dropped alot recently - but not due to some bankruptcy risk, more like earnings miss or regulatory.

 

2. Company pays no dividend and aggressive buyer of its stock - this creates a strong corporate put (like the Fed put)

 

3. I don't go for the fat option premium. Instead I prefer the farthest out strike at the closest time that yields 1/2 of the leg. E.g. if my target is 20% return on collateral, the put leg should yield 10% and the call leg should yield 10%. Sometimes the put yield can be very juicy even without the call insurance especially int he case of #1-#2 above, in which case selling the call is mostly insurance.

 

[ccap]

I spent 8 years running one of the largest equity option market makers. 

 

1) The US equity market systematically overprices volatility.  It is possible to make money by being short vol.

2) Over the short term (~3 months), the underlying is pretty much random.

3) Being short options is just about the riskiest trade you can put on.  Imagine the worst story you've heard about being short stock and multiply it by 100x.  You can become insolvent in a day.  I'm not exaggerating.

 

Anyone that decides to sell options must figure out how much money they could possibly lose on their position and use that to risk manage.  I had some extremely competent friends with a very advanced system almost go broke with the last vol spike.

 

Those that believe they have an edge in terms of valuing a stock can make money selling options while taking on less risk.  This is done by selling out of the money puts on a stock that you would like to own at a lower price.  If the stock gets below your buy price, you buy the stock.  If it doesn't, you pocket the option premium.  Buffett does this. 

 

The siren song of making money 9 out of 10 years and losing it all in the other year has tempted many to their doom.  Keep in mind that vol has gone straight down from 2009 until 2014.  Anyone that was short vol for that time looks like (and thinks) they are a genius.  Those that were short vol 2007-2009 look like (broke) idiots.  I've noticed that Interactive Brokers is now offering courses on how to short vol.  This may be an indicator that the smart money is done and the uninformed are getting in.  A 9/11 attack, nuclear detonation, Russian war, etc. will put those that are short of vol into a very difficult position.  Anyone thinking about shorting options should know exactly what they are doing, why they are doing it, and how bad it can possibly get before dipping their toes into this pool.

 

 

[Kraven]

I spent 8 years running one of the largest equity option market makers. 

 

1) The US equity market systematically overprices volatility.  It is possible to make money by being short vol.

2) Over the short term (~3 months), the underlying is pretty much random.

3) Being short options is just about the riskiest trade you can put on.  Imagine the worst story you've heard about being short stock and multiply it by 100x.  You can become insolvent in a day.  I'm not exaggerating.

 

Anyone that decides to sell options must figure out how much money they could possibly lose on their position and use that to risk manage.  I had some extremely competent friends with a very advanced system almost go broke with the last vol spike.

 

Those that believe they have an edge in terms of valuing a stock can make money selling options while taking on less risk.  This is done by selling out of the money puts on a stock that you would like to own at a lower price.  If the stock gets below your buy price, you buy the stock.  If it doesn't, you pocket the option premium.  Buffett does this. 

 

The siren song of making money 9 out of 10 years and losing it all in the other year has tempted many to their doom.  Keep in mind that vol has gone straight down from 2009 until 2014.  Anyone that was short vol for that time looks like (and thinks) they are a genius.  Those that were short vol 2007-2009 look like (broke) idiots.  I've noticed that Interactive Brokers is now offering courses on how to short vol.  This may be an indicator that the smart money is done and the uninformed are getting in.  A 9/11 attack, nuclear detonation, Russian war, etc. will put those that are short of vol into a very difficult position.  Anyone thinking about shorting options should know exactly what they are doing, why they are doing it, and how bad it can possibly get before dipping their toes into this pool.

 

Good post.

[thepupil]

I spent 8 years running one of the largest equity option market makers. 

 

1) The US equity market systematically overprices volatility.  It is possible to make money by being short vol.

2) Over the short term (~3 months), the underlying is pretty much random.

3) Being short options is just about the riskiest trade you can put on.  Imagine the worst story you've heard about being short stock and multiply it by 100x.  You can become insolvent in a day.  I'm not exaggerating.

 

Anyone that decides to sell options must figure out how much money they could possibly lose on their position and use that to risk manage.  I had some extremely competent friends with a very advanced system almost go broke with the last vol spike.

 

Those that believe they have an edge in terms of valuing a stock can make money selling options while taking on less risk.  This is done by selling out of the money puts on a stock that you would like to own at a lower price.  If the stock gets below your buy price, you buy the stock.  If it doesn't, you pocket the option premium.  Buffett does this. 

 

The siren song of making money 9 out of 10 years and losing it all in the other year has tempted many to their doom.  Keep in mind that vol has gone straight down from 2009 until 2014.  Anyone that was short vol for that time looks like (and thinks) they are a genius.  Those that were short vol 2007-2009 look like (broke) idiots.  I've noticed that Interactive Brokers is now offering courses on how to short vol.  This may be an indicator that the smart money is done and the uninformed are getting in.  A 9/11 attack, nuclear detonation, Russian war, etc. will put those that are short of vol into a very difficult position.  Anyone thinking about shorting options should know exactly what they are doing, why they are doing it, and how bad it can possibly get before dipping their toes into this pool.

 

CoBF sure has attracted some well qualified and distinguished lurkers!

[Andy Dufresne]

I spent 8 years running one of the largest equity option market makers. 

 

1) The US equity market systematically overprices volatility.  It is possible to make money by being short vol.

2) Over the short term (~3 months), the underlying is pretty much random.

3) Being short options is just about the riskiest trade you can put on.  Imagine the worst story you've heard about being short stock and multiply it by 100x.  You can become insolvent in a day.  I'm not exaggerating.

 

Anyone that decides to sell options must figure out how much money they could possibly lose on their position and use that to risk manage.  I had some extremely competent friends with a very advanced system almost go broke with the last vol spike.

 

Those that believe they have an edge in terms of valuing a stock can make money selling options while taking on less risk.  This is done by selling out of the money puts on a stock that you would like to own at a lower price.  If the stock gets below your buy price, you buy the stock.  If it doesn't, you pocket the option premium.  Buffett does this. 

 

The siren song of making money 9 out of 10 years and losing it all in the other year has tempted many to their doom.  Keep in mind that vol has gone straight down from 2009 until 2014.  Anyone that was short vol for that time looks like (and thinks) they are a genius.  Those that were short vol 2007-2009 look like (broke) idiots.  I've noticed that Interactive Brokers is now offering courses on how to short vol.  This may be an indicator that the smart money is done and the uninformed are getting in.  A 9/11 attack, nuclear detonation, Russian war, etc. will put those that are short of vol into a very difficult position.  Anyone thinking about shorting options should know exactly what they are doing, why they are doing it, and how bad it can possibly get before dipping their toes into this pool.

 

+1 and welcome!

 

Out of sheer curiosity, how do you feel about the flip side of the coin so to speak? i.e. a long strangle or long straddle - with both short term and longer term options ... e.g. BAC LEAPS - the underlying has oscillated +/- ~10% in the past 6 months but the ATM and OTM LEAPS have gyrated significantly, both the calls and the puts. Since the risk is defined upfront, might this also be a viable strategy with shorter dated options?

 

TIA,

 

Andy

[scorpioncapital]

I would add one other point - don't go crazy and don't be tempted by a slightly higher premium. Instead always be tempted by the farthest out strike price. It's easy to put in an order for some premium 5% of the stock price but if it comes time to collect, you have to figure out a way to unwind. You could unwind and roll down into another position. This sometimes works out well even considering the loss of the first position - if you do it at the right time - before things get to an extreme state. Nibble first, and pounce when the odds look really good - and the odds almost always look better at some point later on.

[ccap]

I spent 8 years running one of the largest equity option market makers. 

 

1) The US equity market systematically overprices volatility.  It is possible to make money by being short vol.

2) Over the short term (~3 months), the underlying is pretty much random.

3) Being short options is just about the riskiest trade you can put on.  Imagine the worst story you've heard about being short stock and multiply it by 100x.  You can become insolvent in a day.  I'm not exaggerating.

 

Anyone that decides to sell options must figure out how much money they could possibly lose on their position and use that to risk manage.  I had some extremely competent friends with a very advanced system almost go broke with the last vol spike.

 

Those that believe they have an edge in terms of valuing a stock can make money selling options while taking on less risk.  This is done by selling out of the money puts on a stock that you would like to own at a lower price.  If the stock gets below your buy price, you buy the stock.  If it doesn't, you pocket the option premium.  Buffett does this. 

 

The siren song of making money 9 out of 10 years and losing it all in the other year has tempted many to their doom.  Keep in mind that vol has gone straight down from 2009 until 2014.  Anyone that was short vol for that time looks like (and thinks) they are a genius.  Those that were short vol 2007-2009 look like (broke) idiots.  I've noticed that Interactive Brokers is now offering courses on how to short vol.  This may be an indicator that the smart money is done and the uninformed are getting in.  A 9/11 attack, nuclear detonation, Russian war, etc. will put those that are short of vol into a very difficult position.  Anyone thinking about shorting options should know exactly what they are doing, why they are doing it, and how bad it can possibly get before dipping their toes into this pool.

 

+1 and welcome!

 

Out of sheer curiosity, how do you feel about the flip side of the coin so to speak? i.e. a long strangle or long straddle - with both short term and longer term options ... e.g. BAC LEAPS - the underlying has oscillated +/- ~10% in the past 6 months but the ATM and OTM LEAPS have gyrated significantly, both the calls and the puts. Since the risk is defined upfront, might this also be a viable strategy with shorter dated options?

 

TIA,

 

Andy

 

Andy,

 

Being long equity options (volatility) while being delta neutral (e.g. straddles and strangles) is a losing trade on average.  The customers on the equity option exchanges are almost all buying options.  As a result, market makers are typically left holding a short position.  As a result, the market makers have to raise the prices to compensate themselves for the risk they are forced to hold.  This is just like a sports bookie getting all of the bets for the home team.  He has to adjust the spread on the game so that he gets two sided betting and makes money.

 

I don't have great feelings about being long short dated options unless you have very specific event knowledge.  In the short term, the underlying stock behaves more or less like a fat-tailed lognormal distribution (aka random).  Unless you know something that has a larger magnitude than the randomness, you're just gambling on short dated options, and the house takes a large cut.

 

LEAPs are a different animal, and I do think it is possible to have an edge.  Because the market makers are running a delta flat book, their forward prices are typically based on risk free interest rates and stock borrow rates.  They are not doing fundamental valuation to come up with the forwards.  If someone has done careful valuation of a business, they may come up with an intrinsic value that is very different from what the market makers are using for their forward price.  My portfolio has a decent amount of LEAPs & warrants, but I have no short dated options.  I am considering selling a small amount short dated puts on stocks I'd like to buy at lower prices. 

 

Here is a quote from the Buffett FAQ:

[CM: Black-Scholes is a know-nothing system. If you know nothing about value -- only price -- then Black-Scholes is a pretty good guess at what a 90-day option might be worth. But the minute you get into longer periods of time, it's crazy to get into Black-Scholes. For example, at Costco we issued stock options with strike prices of $30 and $60, and Black-Scholes valued the $60 ones higher. This is insane.]

 

We like this kind of insanity. We will pay you real money if you deliver someone to our office who is willing to offer us three-year options that we can pick and choose from.

 

If you're interested in LEAPs, I suggest you read Greenblatt's terribly titled "Stock Market Genius" book.  Also, the Jamie Mai chapter of "Hedge Fund Market Wizards" has a good coverage of instances of inconsistencies in option pricing.

 

Your observation about the BAC LEAPs jumping all over the place is right on.  You can approximate the price of an ATM option as 0.4*stock*vol*sqrt(t).  If you assume that vol and time to expiration stay constant, a $1 change in the underlying will make the option price move by about $0.40.  This will cause a lot of bouncing around.  Furthermore, volatility is very volatile.  If the market sells off, vol may spike by 2x, which will cause the price of the option to double.  Similarly, if you bought during a vol spike, the option may drop a lot as vol comes down.  Because LEAPs are so volatile in the short term, Greenblatt recommends you have no more than 10-15% LEAPs.  I can't even stomach that much.