Premium Sellers vs. Option Buyers

[sle]

Quote from just21:

So you sell high implied volatility out of the money and hedge it with low at the money implied volatility?

No, that's not what I said. When I say "risk premium" it's a generic term for "little extra" you'd have to pay to protect yourself in the market.

To name a few, just in an index, it could be gamma (straight-forward option convexity), term structure (additional slope of the term structure to compensate for future shocks), short-dated skew (response of realized volatility to market direction), long-dated skew (cost of spot-vega convexity) etc.

The idea is that you find which risk premium is overpriced against another risk premium and what ratio to trade one against the other. Let's take an example - you might want to sell short-dated ATM volatility and buy long-dated skew against it in some sort of ratio (usually, the ratio would be such that spot-vega convexity would protect you from the realized gamma moves). You are actually taking a view (yes, PREDICTING) that short-dated gamma is overpriced against dVega/dSpot convexity and hopefully you'd have some sort of a smart statistical model to tell you so.

Once you develop the relative value thought process, you find that these trades/strategies are fairly easy to construct and evaluate with some simple statistics and some common sense.

 

[RedDuke]

Quote from Maverick74:

Duke, I assure you, whatever ideas you have, whatever thoughts on this are going through your head, whatever clever constructs you can imagine, I have tried them all over 16 years. You can take that for what it's worth or completely disregard it.

Here is your conflict. "When" one needs to hedge, it's never when the VIX is at 12 and the spoos are moving 6 handles a day, just as firemen are never needed at your house during a football game with a BBQ going and Beers in the cooler. Firemen come to your house when someone might die, when there is an emergency. "When" you need to hedge, the VIX will be at 40, spoos will have 60 handle ranges, markets will be gapping up and down in both directions and if you think you have seen whipsaw, wait till you have a leveraged position going in your face and you will truly understand what whipsaw is.

In a perfect world, you will hedge your position when the sun is out, birds are chirping and the market is moving nice and slowly towards your short calls and you hedge away and everything is peaches. The reality is, all hell will break loose, and the amount of money you are going to lose just to get a few nickels in short premium is going to make you seriously rethink your IQ and whether or not you should have drove a taxi for a living.

You want to know what the best hedge is? Just buy em back son. Nice and easy. Take the loss. Grab a beer. Go back to the drawing board. Let me put this another way. If your strategy is so poorly constructed that one losing trade wipes all your profits away, then you need to construct a new strategy. But the simple answer is, if your sell naked calls and the market is gunning for them, lift that offer on them and get flat.

Hi Mav,

I am not trading this way, just exploring it. My bread and butter is totally different kind of trading.

I am trying to find a good "hedge" for selling naked options. Taking a loss obviously works, but I still prefer to have the position protected. Spreads are of not much help. Futures as you and others pointed out, while might be helpful are far from being great, yet they are the only "hedge" that I see so far.

Any other ideas? Your replies are very much appreciated.

Thanks,
redduke

 

[sonoma]

Quote from RedDuke:

...Spreads are of not much help.

Shorter-term short positions, more centrally placed, hedged by longer-dated, lateral long positions, with net long/short neutral or biased net long contracts is the most traditional, options-only hedged situation. You can continually hedge with short options, but you'll soon see that your account needs to be sizable to tolerate a fairly strong trend.

 

[lindq]

Quote from RedDuke:

Hi Mav,

I am trying to find a good "hedge" for selling naked options.

A good hedge for naked options is a wife or partner who doesn't mind living in a car after you blow up your net worth.

 

[Peternam]

Quote from Maverick74:

There have been a lot of threads on this topic over the years. Some good, some not so good. But we might as well talk about religion and politics. We'll have about the same amount of agreement. LOL. I understand where you are in your learning cycle. I was there too at one point. You'll evolve. I'm pretty opinionated about theta. I'm on record as stating it's not really real. But I don't want to re-hash that.

I've been trading for 16 years and my philosophy over the years has ebbed and flowed. I'm heavily influenced by guys like Taleb. But his ideas are just background music in my head. I have formulated my own views based on my 16 years of trading. I personally give little weight to premium selling. In fact, it's the antithesis of my core beliefs about the markets.

As a disclaimer I'll say for the record, there is no wrong or right way to trade. And every trader has to line up their personality with their strategy. Having said that, having traded for several prop firms, having been around 1000's of traders in my life, having studied 100's of some of the greatest traders that ever walked the earth, my conclusion is, you are more likely then not to not be successful if your strategy seeks out small winners. And no I'm not including HFT traders, flow traders, algo traders etc that make 1000's of trades a day eeking out small winners. I'm talking about joe sixpack. I think the only way you stand a chance is to make sizeable gains. In other words, you're going to have to get lucky every now and then. Without big winners, if you are selling premium and collecting pocket change, over time you are likely not going to outperform a broad based index on a risk adjusted basis.

Let me also point out before anyone gets too excited and tells me how much they made the last 4 years, the p&l symmetry of a premium seller is highly correlated to a broad based index. In other words, the market has gone up for 4 years straight and vol has gone down for 4 years straight. You SHOULD be making money in this environment. But don't kid yourself, your basically just long an index. The second this trend changes, you're going to start learning a lot about yourself.

wow, a lot of wisdom in this post :eek:

 

[sonoma]

Quote from lindq:

A good hedge for naked options is a wife or partner who doesn't mind living in a car after you blow up your net worth.

Amen. :eek:

 

[RedDuke]

Quote from lindq:

A good hedge for naked options is a wife or partner who doesn't mind living in a car after you blow up your net worth.

Even if I decide to sell them, it will be a small portion of my capital, so will not be living in a car if you can share your other "hedge" ideas here , it is appreciated.

 

[RedDuke]

Quote from sonoma:

Shorter-term short positions, more centrally placed, hedged by longer-dated, lateral long positions, with net long/short neutral or biased net long contracts is the most traditional, options-only hedged situation. You can continually hedge with short options, but you'll soon see that your account needs to be sizable to tolerate a fairly strong trend.

Thanks. I will look into this and backtest.

 

[sonoma]

Quote from RedDuke:

Thanks. I will look into this and backtest.

Good. Remember that the further away your long options, the more the position acts like a a naked short position. I think that's what you're leaning towards anyway, so be sure to trial different strike distances. No need to have your long positions so tight that your daily mark-to-market is flat in an adverse move. You simply need to be able to ultimately recover. Be patient. Give the position time to come around to your initial estimate of what was supposed to happen. You'll likely have to add other positions during the length of the trade, but with your long strikes, you've got some mitigation working in your favor. You'll also have to be aware that an index will behave differently than an individual ticker.

 

[RedDuke]

Quote from sonoma:

Good. Remember that the further away your long options, the more the position acts like a a naked short position. I think that's what you're leaning towards anyway, so be sure to trial different strike distances. No need to have your long positions so tight that your daily mark-to-market is flat in an adverse move. You simply need to be able to ultimately recover. Be patient. Give the position time to come around to your initial estimate of what was supposed to happen. You'll likely have to add other positions during the length of the trade, but with your long strikes, you've got some mitigation working in your favor. You'll also have to be aware that an index will behave differently than an individual ticker.

Lots of homework that for sure. I am only interested in FOP on ES.

Just curious, are you trading/traded this way?