Buying Options w/High Implied Volatility, Not Good. But What If...

[chrismontez]

"There you go. Now you have the data. Please report back to us after you test it."

No correlation between your links and what I was talking about. If you have a relevant link I'll look at that. I wasn't talking about whether general market volatility was up or down, I was talking about selecting specific stocks to short options on.

I don't recommend shorting calls to people who knows so little about it they would be asking advice on this board. But if that is the way they want to go I think, shorting low IV OTM calls where you are mostly just collecting the time premium has less risk than picking the most volatile stocks in the market and shorting the calls because you get more $ due to the high IV.

 

[chrismontez]

Here is an actual case of retail option trading. When I wanted to learn about the market 5 years ago I talked to a friend who was making a reasonable amount of $ trading. He traded options because he liked the leverage. He trained me using his system of trading on the IV. We were using IB and every couple of minutes we would reset the little balls they used to use on the chart to show the updated IV. When the IV started going up on an option we would buy it, and if it then started to drop we would sell it. Puts or calls, we traded both ways, but he never sold naked calls. He did/ still does very well trading. I never did, mainly because his account was 10 times larger than mine and he had the $ to average down his losers and almost always at least break even. For the 2 years we were in contact he really only lost $ on a few long put positions because it took him awhile to accept the bull was real.

So, this is a small time retail investor making a living buying puts and calls.

 

[spindr0]

Gravestone,

Good, well thought out post providing the pros and cons of buying high and low priced options, It would seem to me that the long option player should be buying options at any IV in an increasing IV environment such as the days and weeks before earnings announcements and closing them right before the EA.

Conversely, the short option player should be selling them right before the EA to capitalize on the higher IV/price. But because of the news driven event, one who is short these options is subject to large losses from a big move, despite the probable IV contraction.

Therefore, one selling before an EA should hedge these over priced cows with cheaper options. What's cheaper? Usually the next month (qualitatively) or more OTM series (quantitatively).

This is just in terms of EA's. On an everyday basis, you have to have an edge. If you have your timing and selection down, if you're lucky enough to avoid the errant news event (pre announcements, etc.), you'll do well. But in the spirit of full disclosure, I have no clue how to do ths :->)

For me, for EA's, the game is to find situations where there's skew, making an educated guess of post earnings IV based on past performance as well as the current pricing of later option months and find some ratio that provides a better chance of capturing that higher IV that being sold. Plan B is to be ready to support with stock in the pre/post market if necessary. Plan C is to be ready to close or adjust during regular hours before losses get out of hand or to take some profits.

Sorry if this is a bit all over the place. I guess that the simple version of what I'm trying to say is to try to sell over/higher priced options that have the potential to contract and buy less over priced options to hedge the possibility of an adverse move.. Find the edge in the distortion of pricing. Hedge!

 

[ig0r]

lol, ok. If you're really that interested my knowledge of options is right up on the level of riskarb's (and I don't use it for trading tiny accounts either).

If you read what I said I clearly stated that if used for hedging it's a perfectly fine instrument. However, transaction costs (spread if you take, adverse selection if you don't, + brokerage/clearing) are higher than the vast majority of stocks, regardless of who your broker is. And no, joining the bid and waiting until you get filled does not reduce transaction costs, market makers (such as myself) aren't stupid. And the fact that they are zero-sum makes a big difference; equities create nominal wealth quite predictably (given inflation). Options do not, they pass wealth around. There is no natural force helping to counteract the money you give up to MM's like me and to your broker, unless you think you've found a mispricing (HA!).

Unless you believe theres easy arbitrage all around you, it doesn't matter one bit whether you understand a security or not - it will not effect the EV (but it can effect volatility of your portfolio if you create more risk unknowingly, I'll give you that... so what?)

Can you make money with options in a retail account? Sure. But I would contend that risk and cost adjusted you will always do better buying equities for long term.

 

[commiebat]

Quote from ig0r:

Retail investors have no edge in derivatives, and derivatives certainly don't have the same investment potential as equity (they are zero-sum).

Retail investors absolutely have an edge in derivatives. Look at an option chain. There are maybe half a dozen strikes in both puts and calls. The retail investor's edge is that he gets to choose which one to buy or sell. That may sound silly, but it's more or less an enhanced version of the same edge he has in buying stocks. You place your bet, based on what one presumes is some research and analysis, and the market maker has no choice but to take the other side. You can even sell premium into your bet, which improves your return versus buying the stock. If that's not an edge relative to trading common shares, I don't know what is.

And that's why market makers hedge. But you knew that already. Here's an interesting angle, though. Market makers don't care that the game is zero-sum, because they're constantly hedging against the stock. Even if they lose money on the actual option, they don't care because they make it back on the underlying. Retail investors aren't fighting for their share of a zero-sum pot, they're making individual bets against people who don't care if they lose. Options may be zero-sum, but they're not the whole game.

EDIT:

Quote from ig0r:

lol, ok. If you're really that interested my knowledge of options is right up on the level of riskarb's (and I don't use it for trading tiny accounts either).

If you have the options knowledge of a market maker, that knowledge is useless in a small account. What retail investors use to profit from options is a basic knowledge of options and half-decent stock picking skills. Not much more than they use for trading equities, really.

However, transaction costs (spread if you take, adverse selection if you don't, + brokerage/clearing) are higher than the vast majority of stocks, regardless of who your broker is. And no, joining the bid and waiting until you get filled does not reduce transaction costs, market makers (such as myself) aren't stupid.

We already knew you were a market maker, from the snobbery.

Bid/ask spreads are narrower than ever, and as more options go penny-traded the added costs compared to equities will become negligible. Broker commissions are already negligible. The added leverage and time premium (if you write) already makes options more profitable than shares for the retail investor, assuming he was picking the right stocks to begin with.

And the fact that they are zero-sum makes a big difference; equities create nominal wealth quite predictably (given inflation). Options do not, they pass wealth around.

As I've explained above, that's not true. The option market is tied to the equity market, and you're the one providing the link. Thanks to you, there is plenty of money to go around for us retail folk.

 

[chrismontez]

From Barron's

"At Goldman Sachs, the options strategists are advising the firm's clients to fight the temptation to sell elevated implied volatility. Normally, traders reflexively enter the market to sell high volatility and buy low volatility.

Why? Because volatility is mean-reverting. When volatility gets too high, it snaps lower, and when volatility gets too low, it tends to snap higher to its mean average. This is a behavior that is almost as predictable as the sun rising and setting -- only not now -- as sometimes the mean reversion does not occur when expected."

 

[ig0r]

Quote from commiebat:

If that's not an edge relative to trading common shares, I don't know what is.

You're right, it's not an edge, and I sure do know what is but it's not accessible on the retail level. I can give you your pick of a thousand contracts from a chain, I don't care which you trade because they're all priced fairly + risk premium for me. It makes no difference how many you have a choice from if they're priced fairly accurately.

 

[commiebat]

Quote from ig0r:

You're right, it's not an edge, and I sure do know what is but it's not accessible on the retail level. I can give you your pick of a thousand contracts from a chain, I don't care which you trade because they're all priced fairly + risk premium for me. It makes no difference how many you have a choice from if they're priced fairly accurately.

Do you contend that common shares are not fairly priced? I would say they're even more fairly priced, particularly the ones that trade billions of dollars in volume every day.

Everything with a liquid market is fairly priced by definition. That doesn't mean it's impossible to profit from trading it.

You think delta hedging is the only way to trade, because as a MM you are forced to trade that way. People trade the equity markets directionally all the time, and you're even advising them to do so. Why shouldn't they trade options directionally, especially since you're generous enough to make it a nonzero-sum game?

 

[ig0r]

Quote from commiebat:

Do you contend that common shares are not fairly priced? I would say they're even more fairly priced, particularly the ones that trade billions of dollars in volume every day.

Everything with a liquid market is fairly priced by definition. That doesn't mean it's impossible to profit from trading it.

You think delta hedging is the only way to trade, because as a MM you are forced to trade that way. People trade the equity markets directionally all the time, and you're even advising them to do so. Why shouldn't they trade options directionally, especially since you're generous enough to make it a nonzero-sum game?

Please scroll up and read my post before last more carefully.

I've done my best to help you guys out, bye

 

[commiebat]

Quote from ig0r:

Please scroll up and read my post before last more carefully.

Oh, this?

"I don't care which you trade because they're all priced fairly + risk premium for me."

There is no + risk premium for you. The options are either fairly priced or not. If you add a risk premium to the price, we can choose to sell to you at that price. If you take off a risk premium, we can choose to buy from you at that price.

Your only risk premium is the bid/ask spread, and they're not 2/8 wide anymore.