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A kind reader rebuts

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A kind reader has commented on my previous posting regarding options and sent me an email for clarification. I do not know everything and I can be wrong. Hence, I appreciate readers who bother to tell me that. Although we all want recognition to feel good but no one is perfect and it takes more courage and effort to point out my mistakes. I take things objectively. It is unnecessary to react negatively and be defensive about it. I would rather be open and see the other person’s perspective before judging.

Below is the original email which the reader has gladly allow me to post it.

Alvin,

I appreciate that you are pretty open minded about taking in comments. As such, please take down my comment from your website – my purpose was not to publicise my thoughts or to discredit your blog but just to get the message across to you that some statements need more clarification.

I have not read Dave’s book but I think anything written down as a commentary should be pertinent and accurate on a standalone basis. Please note that I am not an options expert but certain things can be easily misunderstood (in my opinion). You are more than welcome to solicit and defer to experts rather than mine – it is entirely your own choice.

I write down some points below for your consideration:

a) “Options selling as non-directional trading. Simply because you do not need to get the direction of the price to win. The price can move up a little, move down a little or stay stagnant, and you can still win as an Options seller. This further increased your probability of winning.”

Selling options is not strictly speaking a non-directional trade. When you sell an option, you are short theta (as you said, which is correct), and depending on whether a call or put, long/short delta, short gamma and short vega. If you have a net positive or negative delta, it is to me, hard to justify your trade as being non-directional, i.e. You will lose money if the underlying moves against you since as you correctly stated, option value comprises time value & intrinsic value (underlying price – strike, or strike – underlying, if either a call or put respectively). What are “non-directional”, are option pair trades where the net delta position is neutral, not strictly “options selling”. This can be achieved by putting on a put and call position (in the same direction, as you said, like straddles and strangles) BUT the net position will have a net gamma and vega that exposes the position to other effects that a trader may lose money if the position is hedged and/or have to put up huge amounts of margin.

As a personal comment, I have yet to encounter a brave soul who is willing to enter such a risky strategy unhedged. Naked short strangles and straddles are possibly the worst strategies to try gain limited upside while exposing yourself to unlimited downside. You may recall that Nick Leeson brought down Barrings with such trades. http://www.optionetics.com/forums/topic.asp?fid=1&id=22466&page=3 I am hard pressed to find anyone who would want to expose themselves to bankruptcy, no matter how “remote” the risk is. Remember, a stock can go up infinitely in price, theoretically. A naked short call position could be asking for serious trouble.

b) “You can only buy call and put Warrants but you cannot sell them. Why are the banks doing this? There is only one reason – they continue to earn money from the retail investors by taking the other side of the trade.”

Traditional warrants by definition can only be sold by the issuing company (of the underlying equity). Also, banks earn money by taking both sides of the trade – whether you buy or sell an option with a bank counterparty, is irrelevant, the bank will always charge a spread off you. Because market makers are expected to hedge their positions, in practice, their premium over the “fair price” will depend on their perception of their ability to hedge themselves. However, in general, it is easier to hedge a long gamma position than a short gamma position, so in fact, a bank should be more willing to buy an option from an investor in such strangles/straddles, (however this would increase the bank’s credit exposure to you as your liability is to the bank who has paid you a premium upfront and therefore if your credit profile is terrible, no bank is likely to have appetite for this) than to sell an option position to an investor (particularly in large sizes).

c) “Unlike directional trading, especially at a longer time frame, your account fluctuates up and down with the market. There is no consistency. Selling Options would allow you to earn cash flow slowly. You would not get fantastic results in one trade, like 100% in one trade. You probably can make 5% consistently. But that is how casinos win money. They take your $1 bets consistently to build their empire.”

This is confusing since most brokers will insist you pay margin on any short option positions nowadays. This means your option position is going to be marked to market daily. Short straddles/strangles in particular are so risky that alot of brokers will not even allow you to net the margins on the positions. Unless you have very deep pockets, your margins could run so high that you go insolvent.

Also, a side point but in my opinion very, very important: there is a fundamental difference in how casinos make their money versus investing: In casinos, there are a fixed number of outcomes and each game is independent from each other and therefore statistically speaking, the odds are in the casino’s favour as the house. On the other hand, in the stock/option markets, there are many variables, like delta, gamma, vega (as opposed to just one in most casino games), and almost every single “game” is correlated and mutually dependent on each other, in the current state of finance. There is no such thing as a statistical guarantee that anyone will win consistently in the stock markets because simply put, the rules don’t apply.

Well, I hope this was useful in some way or other.

Best Wishes and good luck

CMY

PS: It means that you care when you rebut. Thank you.

8 thoughts on “A kind reader rebuts”

  1. I am quite curious on the risk level as I am new to options trading. I also saw the author writing about this at http://www.optiontradingpedia.com/articles/bookie_trading_strategy.htm

    He mentioned “”To protect yourself from unlimited loss you would place a protective buy stop at 550 and a protective sell stop at 475. If the future price reached those levels you would immediately liquidate the entire position. You would take a loss on one option and a profit on the other option as well as a small profit on the futures. There is less than a 20% chance of this happening.””

    So if one uses protective stop losses and liquidate a position if the trade does not goes well, will it still be consider “unlimited downside? or how does one become a bankrupt if he uses stop losses? any comments?

    Reply
    • Stop losses can indeed limit losses. But stop loss orders are not entirely fool proof. There will be times where prices may gap and your orders would be filled at a further price than you desire. Such things may happen why there are sudden bad news affecting the underlying asset of your options.

      Reply
  2. Thanks for the quick reply.

    I am a newbie to options trading, so there are much that I am unclear with regards to option trading.

    I agree that there are possibilities for gaps down. I remember that he mentioned that he steer away from stocks options because of that and prefer other assets such as ETFs where the gaps are not so apparent.

    Anyway, I just want to clarified whether one can really go bankrupt or suffer unlimited losses if they sell options. [So I guess the risk of losing money is always there when one trades, but proper risk management can prevent that from happening.]

    Reply
    • I have just attended Dave’s course and he has risk management methods to limit his losses. Like what you pointed out, he prefers to trade options on futures contracts as commodities are not possible to go to zero. Secondly, he does not let his options get in-the-money by either closing his trade or roll the contracts further out-of-the-money.

      Reply
      • Hi Alvin,

        can I know what is your honest opinion on the course? And have you benefited from it? Will appreciate your kind sharing.

        Thank you.

        Reply
        • I have just started trading the strategy and hence it is too early to evaluate. Selling options is susceptible to black swan events and blowups are possible if risk management is not done properly. I will discuss about the strategy in due course.

          Reply

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