Someone contacted me as to why I am writing my caveat now and I told him that I felt concerned that too many traders are being lured into this market with premium selling. The ease with which money has been made using this strategy in past memory (in the major indexes) is both spurious and specious in nature. It is truly a Goldilocks situation for anyone short volatility for an extended period of time. I shared that when I employed premium selling in my past, I did so with relatively deep pockets. Even then, it was extraordinarily difficult during market turmoil. The problem with such funds is that the fee structure benefits often excessive risk taking. I exhort that smaller self directed accounts highly leveraged and having a dearth of capital relates an image of a family of plump chickens taking an evening stroll past a starving family of foxes. I simply wish to convey the warning from a rather mature vantage point that I can see the proverbial icebergs, and most may lack the proper lifeboats on deck. Please be careful.
Premium Sellers vs. Option Buyers
- Thread starter Squilly_D
- Start date
Best exemplified by the infamous Karen the Supetrader. It all started with a $22k seminar. wtf.
http://www.youtube.com/watch?v=cXy9HoWX0es
Quote from RichardRimes:
YES..I know I have experienced it and its paralyzing because at the time I just didn't have a clue how to balance my trading to minimize the effects...finally giving up and taking a huge loss
You could have simply closed your position no? I don't understand why so many retail option traders have such an aversion to taking a loss. LOL. It doesn't matter if you are long or short premium, the first knee jerk reaction to most people here is roll, hedge, spread, layer, buy more, sell more, double up, close your eyes, open your eyes, roll again, roll some more, keep rolling, add 7 more legs, neutralize, scalp, don't answer phone from broker trying to call you, look up one way airfares to Brazil, pack bags, roll some options, drive to the airport, do some more hedging from your smartphone, board plane, check quotes before takeoff one more time, land in Brazil, check quotes, realize your smart phone doesn't work there, throw phone in trash, go to beach, never look at another option again.
I don't understand this logic. If one is long premium, you can ONLY lose your premium, yes that is 100%. When you are short premium, you can lose "multiples" of your premium and your account value. They are NOT the same thing. Yes I understand trading is risky. One who is long anything can lose money just as easily as one who is short anything. But the magnitude of risk is VERY different.
OK, so here is my story. There is a thread here buried deep in the archives, but it's here, about a poster who had this unique strategy of selling DOTM puts in SPX options. Now, I know what you guys are thinking. Hey Maver, that ain't original, I've been doin that fur years. Not like this you have. This guy had the idea to sell shit so deep out of the money, there really wasn't even a market on these strikes. You see, he did very extensive research and back testing going back oh I don't know, years he says, that shows the market never made such a large move over the time to expiration he would be exposed to. As an example, say SPX was trading at 1600, he might sell the Oct 900 puts. But Maver you say, there ain't no market down there. How he gonna do it? Well, he would put offers out up and down the strikes at .05 offer waiting to get lifted. Then once filled, he would wait till expiration and deposit profits in the bank.
Well this guy walked into my prop firm. Now I debated this guy, on this very message board, in this very forum, just like I am now. I explained to this guy why he was wrong and told him he was going to blow out. I walked him through step by step EXACTLY how it was going to happen. It's in the archives!
But he insisted on doing this. I let him come into our firm with 50k. I told him day one, EXACTLY what we were going to do to his positions should his haircut get out of control. I walked him through it a dozen times. That's just how I roll. He understood. So the trading begins. He did exactly what he said he would do, he put out offers up and down the SPX chain for a .05 so so so so so far out of the money. It would take Elon Musk years to reach these strikes using his new hyperloop travel. That's how far away they were.
So sure enough, this guy starts getting filled on these orders and after a few months, the guy is banking some coin. He sells the puts, waits, collects the money and repeats month after month. Keep in mind during this whole process I reiterate just how badly we are going to lube him up and pluck his rear when the time comes. He understood.
Well one day, an event happens. You can call it, a rare event, an unexpected event, a fat tail, black swan, whatever you like. But it happened. History gave it the name of the flash crash. After some riots broke out in Greece on a down day in the market, something random happened. A fat finger error triggered some sell orders in an already weak tape coupled with some serious technology issues. The market went into free fall. Not even the hyper loop could move this fast. Well, what this guy was not anticipating, despite the fact I laid out in detail, on this very message board (it's in the archives) exactly what would happen IF there was such an event. Those nickel puts went 20.00 offered. Yes, as in 20 pts. And yes, the ones that were a million points out of the money. These options actually had real bids on them as well. Well, this guy with a 50k account was showing an unrealized loss of close to 10 million dollars. And no I'm not making that number up. I had the risk desk in my ear the whole time speaking some language I was not familiar with. Now, we all knew that the prices in the market were not indicative of any real value, but as the old saying goes, price is truth. We had to buy these puts back. This trader did not like that idea. It wasn't his choice though. I explained that to him before he sold his first contract. Now, we weren't about to lift the 20.00 offers. But we were bidding for him. Some at 5.00, 7.00, 10.00. It actually took several days to even get filled at these outrageous prices. I explained to him we had no choice, as no broker does because had we not bought them back as a firm, our clearing firm would have paid 20.00 and closed our shop.
You see, I tried to explain to him, that in the market, what you think does not matter, nor what your spreadsheet or your backtest told you. What matters are the rules you have to play by. When you are short options with any kind of leverage, there is not a broker in the world that will not hesitate to blow you out, even if there is next to zero chance that these options would ever get remotely close to your short strike. That's just how margin works. Believe it or not, we were actually able to work the orders so the guy only lost 100% of his account. That was an act of God. We sent the trader his U-5, and this guy probably never traded another option again ever.
Of course afterwards he was still angry why we would buy back his options at such inflated prices. And my response to that is, what inflated prices. We actually paid far less then what the market was offering. We got them cheap. Let me repeat this one more time, this guy laid out this entire strategy on ET. I responded on that thread in detail exactly what would happen if he did that strategy. This trader did it anyway. And what I said would happen DID happen and exactly in the fashion in which I described it.
Moral of the story...listen to those with more experience. And remember, whatever you think you know is not even close to what you probably should know. So account for that error in your future decision making process.
Well this guy walked into my prop firm. Now I debated this guy, on this very message board, in this very forum, just like I am now. I explained to this guy why he was wrong and told him he was going to blow out. I walked him through step by step EXACTLY how it was going to happen. It's in the archives!
But he insisted on doing this. I let him come into our firm with 50k. I told him day one, EXACTLY what we were going to do to his positions should his haircut get out of control. I walked him through it a dozen times. That's just how I roll. He understood. So the trading begins. He did exactly what he said he would do, he put out offers up and down the SPX chain for a .05 so so so so so far out of the money. It would take Elon Musk years to reach these strikes using his new hyperloop travel. That's how far away they were.
So sure enough, this guy starts getting filled on these orders and after a few months, the guy is banking some coin. He sells the puts, waits, collects the money and repeats month after month. Keep in mind during this whole process I reiterate just how badly we are going to lube him up and pluck his rear when the time comes. He understood.
Well one day, an event happens. You can call it, a rare event, an unexpected event, a fat tail, black swan, whatever you like. But it happened. History gave it the name of the flash crash. After some riots broke out in Greece on a down day in the market, something random happened. A fat finger error triggered some sell orders in an already weak tape coupled with some serious technology issues. The market went into free fall. Not even the hyper loop could move this fast. Well, what this guy was not anticipating, despite the fact I laid out in detail, on this very message board (it's in the archives) exactly what would happen IF there was such an event. Those nickel puts went 20.00 offered. Yes, as in 20 pts. And yes, the ones that were a million points out of the money. These options actually had real bids on them as well. Well, this guy with a 50k account was showing an unrealized loss of close to 10 million dollars. And no I'm not making that number up. I had the risk desk in my ear the whole time speaking some language I was not familiar with. Now, we all knew that the prices in the market were not indicative of any real value, but as the old saying goes, price is truth. We had to buy these puts back. This trader did not like that idea. It wasn't his choice though. I explained that to him before he sold his first contract. Now, we weren't about to lift the 20.00 offers. But we were bidding for him. Some at 5.00, 7.00, 10.00. It actually took several days to even get filled at these outrageous prices. I explained to him we had no choice, as no broker does because had we not bought them back as a firm, our clearing firm would have paid 20.00 and closed our shop.
You see, I tried to explain to him, that in the market, what you think does not matter, nor what your spreadsheet or your backtest told you. What matters are the rules you have to play by. When you are short options with any kind of leverage, there is not a broker in the world that will not hesitate to blow you out, even if there is next to zero chance that these options would ever get remotely close to your short strike. That's just how margin works. Believe it or not, we were actually able to work the orders so the guy only lost 100% of his account. That was an act of God. We sent the trader his U-5, and this guy probably never traded another option again ever.
Of course afterwards he was still angry why we would buy back his options at such inflated prices. And my response to that is, what inflated prices. We actually paid far less then what the market was offering. We got them cheap. Let me repeat this one more time, this guy laid out this entire strategy on ET. I responded on that thread in detail exactly what would happen if he did that strategy. This trader did it anyway. And what I said would happen DID happen and exactly in the fashion in which I described it.
Moral of the story...listen to those with more experience. And remember, whatever you think you know is not even close to what you probably should know. So account for that error in your future decision making process.
You kinda answered your own question. History is ripe with people who thought their risk was capped, but still managed to blow up in a spectacular fashion. Blowouts are certainly not exclusive to short sellers in any way.
In reality any strategy can blow out. It's not really as simple as "short vol is bad, long vol is good", because there are many ways to be short vol and long vol respectively, and short vol is not mutually inclusive with unlimited risk either.
Also since we are sharing stories, I actually know a guy (expiration trader) who managed to blow his entire account on these trades. And his trades were long vol. It happens more often than you think.
Hey Maverick,
thanks for the quality posts. I have a question for you. Earlier you mentioned that you have to have big winners. From your experience at a firm, do the guys that had big winners do it with risk/reward ratio or leveraging up? Or a combination?
i.e. When the opportunity is there do they trade at their usual 1x but aim for 5:1 risk reward?
Or do they leverage up, say, 2x or 3x and aim for their usual, say, 2:1 risk reward ratio?
thanks for the quality posts. I have a question for you. Earlier you mentioned that you have to have big winners. From your experience at a firm, do the guys that had big winners do it with risk/reward ratio or leveraging up? Or a combination?
i.e. When the opportunity is there do they trade at their usual 1x but aim for 5:1 risk reward?
Or do they leverage up, say, 2x or 3x and aim for their usual, say, 2:1 risk reward ratio?
This discussion is as old as time...
One can blow up being long optionality, as well as being short. However, the thing that blows you up is leverage, always and everywhere. And it's a lot easier to be misled and get oneself properly leveraged by selling options. Hence, Maverick's story is highly instructive.
One thing I will say that is definitely a lesson I have learned over the years. There are all sorts of arguments that can be used to sell options. The WORST reason and the one that should NEVER be used is "it will never get there".
One can blow up being long optionality, as well as being short. However, the thing that blows you up is leverage, always and everywhere. And it's a lot easier to be misled and get oneself properly leveraged by selling options. Hence, Maverick's story is highly instructive.
One thing I will say that is definitely a lesson I have learned over the years. There are all sorts of arguments that can be used to sell options. The WORST reason and the one that should NEVER be used is "it will never get there".