nickle and diming OTM options contracts

[darwin666]

just curious.. do u do indexes. ETFs or stocks.. if so which ones. and which stocks do u think u have mastered the strikes to choose? do u do pre earnings play..

look at the chain for PCLN? do u have IB and Portfolio Margin? are you using up 99% of your margin doing such strangles at all times to keep the cash coming in?

 

[Dolemite]

Another thing, going for a dime seems too small. You might want to up the premium you collect by getting closer and being prepared to close or hedge. It takes a lot longer for an option to go from .10 to .05 than from 1.00 to .50. Which means you are going to have to let that .10 expire to get any real return out of it.

 

[Brighton]

Try stress testing your position by adding a big jump in daily ATM volatility and then make it even worse to account for the skew in OTM options.

The attached image shows a big jump in vol for NG earlier this month. There have been several jumps like this recently; I just happened to have this one handy.

As noted above, if you're trading an index, then maybe a 20% jump in ATM vol is quite unlikely, but I'd look back to at least 2008 to be sure. Also, there is a ton of information about this topic in the Options forum and the 'best of' list. I'd suggest going to the Options forum and sorting the topic by post count - some of the option selling ones are near the top.

Maverick, Atticus, et al may not expound at length about the perils of option selling like they used to, but they did years ago ... and I don't think much has changed.

 

[sle]

It takes a lot longer for an option to go from .10 to .05 than from 1.00 to .50. Which means you are going to have to let that .10 expire to get any real return out of it.

What you mean is that far wings have a lot of vega convexity risk. The question is, are you getting well compensated for that risk?

The point is, as usual, that things are sometimes rich and sometimes not. If you have a proper risk management process, don't get greedy and understand the source of value, you can do ok selling tails too. If you do stupid things, you will blow up, but that has nothing to do with inherent long or short premium bias.

 

[Appleseed]

Yes, if a really big, strong trend forms, you could get hurt very badly. Do you understand why?

worse than strog trends

are the gaps that go against you
as they say
picking up pennies in front of a steamroller
cheers
john

 

[Dolemite]

What you mean is that far wings have a lot of vega convexity risk. The question is, are you getting well compensated for that risk?

The point is, as usual, that things are sometimes rich and sometimes not. If you have a proper risk management process, don't get greedy and understand the source of value, you can do ok selling tails too. If you do stupid things, you will blow up, but that has nothing to do with inherent long or short premium bias.

Actually you will have to dumb it down to get to my level. What I was saying is that if you are literally selling junk at .10 in hopes of collecting theta there will always be a cost to buy it back unless you wait for expiration. It is why the decay of an option (again in my observation), is a lot slower the cheaper the value gets. But if I get the gist of what you are saying, I do track the skew and find that often the option models don't take in account the risk you face if there is a large event. Those .10 options will appreciate a lot faster than your model predicts (from what I have seen).

 

[sle]

What I was saying is that if you are literally selling junk at .10 in hopes of collecting theta there will always be a cost to buy it back unless you wait for expiration. It is why the decay of an option (again in my observation), is a lot slower the cheaper the value gets.

You are making a distributional bet, so unless you are forced to cut your position, holding it to expiration is a given. The decay is pretty discrete given the increment, yes.

But if I get the gist of what you are saying, I do track the skew and find that often the option models don't take in account the risk you face if there is a large event. Those .10 options will appreciate a lot faster than your model predicts (from what I have seen).

What model? If you shock the vol and reprice, these things will fly and simple BS model will show that. For something that wingy, you can't just use first-order greeks, you need to either re-value or use second-order and cross risks.

I am trying to say a few things at once:
(a) There are situations when these options are statistically rich. It could be due to regulatory pressures like the crash puts in indices, it could be due to a large portfolio hedging in single stocks or something else.
(b) If you have a model to evaluate the probability of the payout, a model to evaluate your margin risk, and an insight why these things are rich, you can sell them while controlling your risk.
(c) It is not any different then any other financial risk underwriting trade. When you buy a corporate bond (which people do all the time), you are essentially underwrting a credit default swap on the company yet nobody really talks about it as "selling tail options".
(d) If I were to retire and live in Utah now, this would be one of my primary strategies (in a very specific form, which essentially is "regulatory arb"). You could generate reasonable yields (say 15-20% on the capital) by doing this with fairly low risk of ruin. However, despite apparent simplicity, it is not a good strategy for a beginner - you need to have a good actuarial grasp on the value of these options, good model of what your margin requirements could be and obviously hold extra capital agains possible squeezes.

 

[crayon851]

Try stress testing your position by adding a big jump in daily ATM volatility and then make it even worse to account for the skew in OTM options.

The attached image shows a big jump in vol for NG earlier this month. There have been several jumps like this recently; I just happened to have this one handy.

As noted above, if you're trading an index, then maybe a 20% jump in ATM vol is quite unlikely, but I'd look back to at least 2008 to be sure. Also, there is a ton of information about this topic in the Options forum and the 'best of' list. I'd suggest going to the Options forum and sorting the topic by post count - some of the option selling ones are near the top.

Maverick, Atticus, et al may not expound at length about the perils of option selling like they used to, but they did years ago ... and I don't think much has changed.

Thanks for the input! No thanks to maverick though. Sounds bitter.

What software is this?

I just trade individual stocks.

I understand the risks involved with naked premium being unlimited upside and downside risk.

In terms of unlimited upside, I just carry the belief that a move that is 30-50% over the course of a month is rare for companies that are already considered "economies of scale" (pretty sure I'm using this correctly), and that a move like that in these types of companies would have to have something pretty significant happen in order for that. For instance, Apple would literally have to have half of their market share wiped out in 30 days or something ridiculous.

In terms of unlimited downside, my rationale is this, because you're trading stocks you want to own, you might as well sell a put to collect premium at the strike price you want to own the stock at. For instance, you were going to buy it anyway if your stock dropped 20%, so even if it were to drop another 50%, you're still better off owning the shares at a discounted price from the premium. Its certainly much better than just buying the stock after a 20% drop and then having it drop another 50%.

I haven't tried stress testing my portfolio, but I would like to. I currently don't use any software so I don't know how to do this. I imagine you need some form of graphing software?

What types of strategies do you use? What if you just picked strategies and stuck with those that worked best in either bull or bear markets? i.e just sell puts or calls? with limited risk?

Another question I had was in regards to delta,

Delta is the dollar value that an option will increase/decrease based on a 1$ movement in the underlying? correct?

So, If you trade options that are way OTM that are 0.05 to 0.25 in value that have deltas that are around 0.05. Isn't it viable to trade these contracts for percentage gains, assuming that you expect the stock to move at least $1 in your expected time frame?

Wouldn't you see gains ranging from 10-100% to more? For example, stock abc is expected to move at least $1 in the next 6 months. Buying an option with a delta of 0.05 or even 0.02, for a price of 0.05, can still give you double digit returns.

Or am I missing something?

 

[SIUYA]

T
Another question I had was in regards to delta,

Delta is the dollar value that an option will increase/decrease based on a 1$ movement in the underlying? correct?

So, If you trade options that are way OTM that are 0.05 to 0.25 in value that have deltas that are around 0.05. Isn't it viable to trade these contracts for percentage gains, assuming that you expect the stock to move at least $1 in your expected time frame?

Wouldn't you see gains ranging from 10-100% to more? For example, stock abc is expected to move at least $1 in the next 6 months. Buying an option with a delta of 0.05 or even 0.02, for a price of 0.05, can still give you double digit returns.

Or am I missing something?

You are missing liquidity and having to cross the spread as well as the fact that the move might not be in the direction you want, or the move occurs so slowly that the option you bought at 0.05 stays at 0.05

The real trap people fall into trading these things is that they trade too big in them.
If they are shorting them, they forget they might have to own the stock - which they cant afford to.
If they are going long, they often load into the one that goes no where and hence blow it all quickly.
Sle sums it up well....there are times to do this, and times to not.
You can also do it all the time, but keep the amounts per trade small, aim for small but cumulative returns (like an insurance company, they change premiums based on environment) - and avoid being over levered which is what will get you if you are not careful. This also assumes you have sufficient capital to make it worth while.

 

[crayon851]

So assuming there is liquidity, this is viable?

Of course staying small. I mean if you could find 20 different underlyings all of which you assume will move up or down by x % over the next year, you could essentially leg out of the positions on higher percentage gains right?