letting your losers run and limiting winners

[Magic]

Philosophically, the idea is that, if you're selling options, you're *mostly* selling for time decay. (Idea being: of time, and market movement, and volatility, the only thing you have *guaranteed* is the burn of time.) With that, imagine that each sale of an option/spread is the roll of a die -- it bounces up and down, it's about to land on one corner, but it's *mostly* going to land Theta-side up, but there might yet be enough inertia in the kinetics of the cube, to allow a half-bounce to Delta-side up.... "Yipes!"

Sorry to drag this earlier replay back from a few days ago, but I'm just learning about options and this post stood out to me. Options provide additional value besides exposure to underlying... i.e. ATM options have no intrinsic value; but they still have value because of the other things they provide like leverage, risk reduction, etc..

So there's... not edge per se... but consistent premium offered to option writers for providing this service, sort of akin to how liquidity providers more or less collect the spread? So some strategies are built around this premise; we just need to model all likely scenarios well enough to remain solvent and cover our tail risk adequately so we can keep collecting the premium over the long haul. Also to find a way to do this effectively enough that you get enough returns to make it a worthwhile use of capital while not over-leveraging or absorbing too much risk.

Are those mostly accurate statements/assumptions?

 

[tommcginnis]

Options provide additional value besides exposure to underlying... i.e. ATM options have no intrinsic value; but they still have value because of the other things they provide like leverage, risk reduction, etc..

Or more particularly, a probabilisticly-weighted "time value." (...Which puts 'leverage, risk reduction, etc.' into a nice package.) AND, let's remember, that that time value goes to the other side of the market, such that ITM options carry it, too. (And *lose* it, too! Right now, the ES 2715 put for Mar09 is ~$19.00 with the market at 2714. It's going to lose a whopping $18 through theta-burn over the next 3 market days.)

So there's... not edge per se... but consistent premium offered to option writers for providing this service, sort of akin to how liquidity providers more or less collect the spread?

"Exactly!" (With the proviso that the service is Risk Acceptance for the option writer, versus Liquidity Provision for the bid-ask arbitrageur.)

...to remain solvent and cover our tail risk adequately so we can keep collecting the premium over the long haul. Also to find a way to do this effectively enough that you get enough returns to make it a worthwhile use of capital while not over-leveraging or absorbing too much risk.

Very well put. (IMO.) Very, very well put.

 

[Magic]

@tommcginnis , thanks! Just want to make sure I'm on the right track.

At the moment I'm trying to conceive of a way to understand how much of the time value premium is collected by the option writer purely for the service of holding risk and offering convexity... vs. how much is a simply a fair value payment upfront for the risk itself being taken, if that makes sense.

On a theoretically neutral instrument, say Option Writing Strategy XYZ collects an average of $10 per instance over 100,000 instances, and the total losses add up to $800,000. Per instance; $8 out of the $10 received is essentially the fair value of the risk absorbed and $2 is for the service rendered.

I've read a few people who contend that options are priced in such a way that premium is priced extremely efficiently to equal the risk being traded---i.e. the guy writing a bull put spread collecting premium the guy buying the same spread with a debit will be equal after an infinite number of iterations... less commission costs and slippage.

I've read papers that show over decades writing put spreads on SPY is net positive [with caveats, not compounding returns etc.]; but then I wonder how much of that is from time value collected vs. just running a bullish strategy on an instrument that has consistent upward drift.

You guys have any thoughts on this? It seems rational to me to believe that that option writers are providing things and taking on dispersion of returns which should be compensated monetarily but finding a lot of conflicting schools of thought out there.