Questions about credit spreads!!! Help me!

[oldnemesis]

Re Question:

"Did you seriously sell a leap credit spread for .21?"

Just for the record:

I am looking to use option spreads as a substitute for holding stocks and bonds for income.

DD, a classic blue chip, has an annualized dividend yield of 3.1%

The trade I outlined got .21 with a risk of 229 or 9.17% in 216 days.

Annualized that yield is .0917*(365/216) = .0917* 1.689 = 15.5%.

The spread is safer than buying DD by virtue of the lower strike being OTM, and yields 5 times the income.

The loss is a result of a misjudgment on direction. I didn't anticipate they would sell off assets.

(my numbers included commissions.)

 

[Maverick74]

Quote from Strangler:

You are contradicting yourself. In your AAPL hedge example you ARE an option loser. Who cares if you're hedged with the underlying? If you're discussing options then stay in the option universe.

OK, I'm going to break down your points one at a time and go over this. This will hopefully be a good primer for others to learn. Alright let's start with options 101. The first thing you learn if you ever work for a market making firm or any option trading firm is the concept of put to call parity. This is extremely important to learn and understand because it's the foundation by which all option trading is based on. Put to call parity is the principle that there is no material difference between a call, a put and it's corresponding stock. In other words, you can create calls from puts, puts from calls and stock from calls and puts. If anyone needs me to do a 101 on synthetics, I guess I can walk you guys through that but I'm going to skip that in this post.

OK, let deal with this AAPL. First of all, you need to understand that being long stock and long a put in AAPL is the SAME thing as being simply long a call option. It's NOT a hedge, it's an actual position. If I told you right now I was long the AAPL 400 call, you would have no idea if I was really long the call or if I was long the stock and long the put, because they are exactly the same thing. When one buys a call in something and sell it for a profit, no one says to you, sure you made money on that call but you do realize you synthetically lost money on that put. Nobody says that, but technically it's true. You may not have realized it when you bought that call but when you did, you also synthetically bought the put at the same strike along with the stock.

The point I'm trying to make here is, you can call it a hedge but it's not a hedge, it's a call. Unless in your world all call buyers are default hedgers. There is no loser in this transaction. It makes no difference if you are long the actual call or the synthetic call and it makes no difference which specific leg made what. It's immaterial to the position and the outcome is 100% identical. Again, I have to stress that this is vital to understanding options. If you don't understand this, you need to stop and learn it. I assure, any of you guys that have any interest for ever working for a prop firm that trades options, you absolutely HAVE to know this forward and backward. When I traded on the floor, almost 100% of our trading was in synthetics!!!!!!! We never traded direction or vol. We looked at various strikes and compared the actual values bid and offered with their synthetic counterparts. If the Oct 410 calls in AAPL were trading for 7.50 and the synthetic calls were trading for 7.40, then we bought the syn calls and sold the actuals and locked in a risk free .10 profit. We did that all day every day 252 days a year. So if you don't understand the math, you are going to be useless making markets.

OK, on to the next point...

 

[Maverick74]

Quote from Strangler:





I thought all options were fairly priced? Why would this be a bad trade? Just because of the 12/1 risk/reward?

My comment was not referring to the fair value pricing, but rather that a guy would lock up capital for 6 months to "potentially" make 21 cents on a spread. I understand his logic but it seems like an awful waste of opportunity cost. He basically has to sit on this thing forever to capture that 21 cents. The risk/reward is bad sure, but honestly, it's just a poor use of one's capital. It was just an opinion I issued, nothing to do with the value of that spread. I'm not even sure how one would go about discerning value on a 6 month spread like that anyway. Looks more like a punt to me.

OK....next....

 

[Maverick74]

Quote from luckyputanski:

You can't argue with the fact that you lost money on put and the person who sold it - made money. You would be even a bigger winner if you hadn't had bought the put.

OK, so I think we covered this topic on the post on synthetics. Obviously, no one lost money on the put. How did you know I was even long the put? I could simply said I was long the July 390 calls. When in fact I wasn't, it still would have been the same position. As to your comment I would have been a bigger winner had I not bought the put, not exactly. You are assuming it was my intention to simply be long the stock. How do you know that was ever a choice? Maybe buying 100 shares of stock involved too much risk for me, so instead I bought the syn calls. Telling me what I "should" have done after the move is useless commentary. I could you that you should have bought AAPL at $10 a share in 2001, you would be rich now. We have to plan our risk BEFORE we enter the trade, not after. Furthermore, how you do know that the reason I bought the stock and the puts is because I was able to buy the syn calls .20 cheaper then the actual calls putting .20 of money in my pocket on the trade. I'm sure you would agree that was a smart move. I mean if you looked at an ECN and saw the CBOE offering the calls for 9.50 and ISE offering 9.40, I'm sure you would not lift the CBOE at 9.50 right?

Let's move on...

 

[Maverick74]

Quote from luckyputanski:

Also, what about the fact that realized vol is usually lower than implied? There was some research about it, but can be easily calculated. Of course, during crashes selling vol losses money, but it can quickly recover:
http://media.pimco.com/Documents/Vi...eptember 2012.pdf738bfA&bvm=bv.49641647,d.ZG4

Once again, without understand statistics this comment is useless. First of all, when you describe population data like the above it tells us absolutely nothing about what we want to know specifically. For example, yes, many options are overpriced. In fact thousands of them are. Particularly going into earnings, FDA events, court decisions, merger talks, etc. So when you add that data into your population set, the average option might indeed appear to be over priced. But if you remove that data from the population, I think you will find those most ATM options are indeed priced in line with actual stat vol. When you focus exclusively on the put side of things, you have the inevitable put skew to contend with in most risk assets. And again, mixing in the DOTM puts into your population data will skew the entire result. Again, not trying to be obtuse with you, but understanding options is all about understanding data. If you don't understand the data, chances are, all your deductive logic will be incorrect with the options.

 

[Maverick74]

Quote from kinggyppo:

"Two, theta for all practical purposes does not really exist. It's up there with the unicorn and the tooth fairy. The greeks were never created to measure sensitivity on individual issues. They were always meant to understand aggregate risk since aggregate risk is considerably more difficult to manage. But on a single name, theta does not and cannot work for or against you and this can be proven mathematically without any bias. When you buy or sell an option, you are speculating on distribution. That is what an option is after all. It's a measure of distribution. Do I think the average option trader understands this? Of course not. So instead the avg Joe thinks he is earning "theta" or engaging in an "income" strategy. This same guy probably attended a Carton Sheets real estate seminar on "how to buy real estate with no money down". "

Mav can you expand on this when you get a chance not sure I am following you here.

Since you are the King, you go last. I'm going to paste newwurldmn's comments below as a warm up to mine.

Quote from newwurldmn:

You earn theta, but it's not free. You have to earn theta in excess of the costs of gamma, delta, and often other cross greeks. You may not recognize this in your pnl statement but they are there.

Options are statistically overpriced. But the world isn't stupid. There is a very good reason for it: no one can afford to take the blow up risk. Even Warren Buffet.

We all know home insurance is overpriced, but how many of us are in a position to not buy it? And then, how many of us are ready to write a policy on our neighbor's house?

Here is the thing. When one analyzes data we tend to take data and put it into an isolation chamber. In economics we call this marginal analysis. What that means is we want to hold all variables constant while allowing one to change, this is our dependent variable. In this isolation chamber where the world stops and everything is frozen in place we have these greek letters we use to manipulate so we can measure the change in our dependent variable as we play around with our independent variable. We can ONLY do this in our top secret air tight isolation chamber. Because once we make it out into the real world with live changing prices, none of these things exist. They only exist in isolation. As newwrldmn pointed out, when the stock starts moving around and the implied vol oscillates all your variables are changing. It's useless to pretend you know that the call went up because of this or that when in fact you don't know why it went up or went down.

As I said before, analyzing greek risk is best when assessed on the aggregate. The reason for this is because when one has on several positions of all varieties, it's very hard to ascertain risk in a split second simply by observing all your positions. Remember, think back to my comments on the synthetics from earlier. So grouping large amounts of data together and measuring sensitivity to a portfolio is effective for on the fly risk analysis.

Now, let's go deeper and talk about theta. As I stated earlier, an option is an expression of distribution of future prices. It's not a day to forward outlook. For example, if I buy the AAPL Aug 430 calls which expire in 24 days, I'm not making a prediction on where AAPL will be tomorrow or at the end of the week. I'm making a prediction on AAPL's price distribution in 24 days. So for one to look at their theta and say, oh well I just sold those calls and I'll be earning $20 a day in theta is nonsensical. That's not what those calls are. As we stated earlier, your theta exists only in the isolation chamber. Once we put those 430 calls on the open market the option becomes dynamic. If AAPL pops 10 pts on the open tomorrow what does this do for your theta? Does it go up, go down, do nothing? What if implied vol goes up, goes down, stays flat? All these variables are moving. They are not static. You are not "earning" anything. You are expressing an opinion on the forward vol of AAPL over the 24 day period. At expiration those calls will trade at parity. It's as simple as that. You don't get to keep any theta as a dividend payment or a souvenir. What you do get is the realized distribution of the forward vol. If AAPL settles at 450, did you earn any theta? Does it matter?

At the end of the day, we know all the variables that go into option pricing (price, strike, days to expiration, interest rates, dividends and implied vol). That's what you have to sift through on your kitchen table. Not delta, gamma, theta and vega. Those are your second order derivatives. If you don't understand the first, it's pointless to figure out the second.

 

[kinggyppo]

Quote from Maverick74:

Since you are the King, you go last. I'm going to paste newwurldmn's comments below as a warm up to mine.



Here is the thing. When one analyzes data we tend to take data and put it into an isolation chamber. In economics we call this marginal analysis. What that means is we want to hold all variables constant while allowing one to change, this is our dependent variable. In this isolation chamber where the world stops and everything is frozen in place we have these greek letters we use to manipulate so we can measure the change in our dependent variable as we play around with our independent variable. We can ONLY do this in our top secret air tight isolation chamber. Because once we make it out into the real world with live changing prices, none of these things exist. They only exist in isolation. As newwrldmn pointed out, when the stock starts moving around and the implied vol oscillates all your variables are changing. It's useless to pretend you know that the call went up because of this or that when in fact you don't know why it went up or went down.

As I said before, analyzing greek risk is best when assessed on the aggregate. The reason for this is because when one has on several positions of all varieties, it's very hard to ascertain risk in a split second simply by observing all your positions. Remember, think back to my comments on the synthetics from earlier. So grouping large amounts of data together and measuring sensitivity to a portfolio is effective for on the fly risk analysis.

Now, let's go deeper and talk about theta. As I stated earlier, an option is an expression of distribution of future prices. It's not a day to forward outlook. For example, if I buy the AAPL Aug 430 calls which expire in 24 days, I'm not making a prediction on where AAPL will be tomorrow or at the end of the week. I'm making a prediction on AAPL's price distribution in 24 days. So for one to look at their theta and say, oh well I just sold those calls and I'll be earning $20 a day in theta is nonsensical. That's not what those calls are. As we stated earlier, your theta exists only in the isolation chamber. Once we put those 430 calls on the open market the option becomes dynamic. If AAPL pops 10 pts on the open tomorrow what does this do for your theta? Does it go up, go down, do nothing? What if implied vol goes up, goes down, stays flat? All these variables are moving. They are not static. You are not "earning" anything. You are expressing an opinion on the forward vol of AAPL over the 24 day period. At expiration those calls will trade at parity. It's as simple as that. You don't get to keep any theta as a dividend payment or a souvenir. What you do get is the realized distribution of the forward vol. If AAPL settles at 450, did you earn any theta? Does it matter?

At the end of the day, we know all the variables that go into option pricing (price, strike, days to expiration, interest rates, dividends and implied vol). That's what you have to sift through on your kitchen table. Not delta, gamma, theta and vega. Those are your second order derivatives. If you don't understand the first, it's pointless to figure out the second.

ok I think I understand this. You are saying the terminal distribution or price at expiration overrides theta, is that correct?

 

[Maverick74]

Quote from kinggyppo:

ok I think I understand this. You are saying the terminal distribution or price at expiration overrides theta, is that correct?

Think of theta as a hypothetical. In a world where the stock stays frozen in place and doesn't move, that's where our furry little theta friend plays. Theta is an abstract. It has no material meaning to your end result. Even if you close your position tomorrow, it has no material effect.

 

[oldnemesis]

"I understand his logic but it seems like an awful waste of opportunity cost."

Invoking 'opportunity cost' makes the assumption that there are better choices. i.e. positions available that have a better expectation.

Really??

What are they?

Treasuries are earning around 2.8%

The major problem I find with my options portfolio is in finding a way to put all my money to use without incurring excess risk.

It does no good to have several clever positions in place if I have 60% of my portfolio idle. 15% is better than 0%... or doing what a lot of people do... put excess money into the money market which is earning what now .8% ?

The other choice is to concentrate funds in a few positions that I think are clever raising my black swan risk to unacceptable levels.

It's funny how clever positions (with high option prices) have a tendency to become disasters. The option prices are high for a reason.

My overall strategy is to put in place a fairly large number of small positions with distributed expirations and distributed black swan risk.

This produces a portfolio which is like an options based VWINX that is earning 15% instead of the Wellesley's 3% ... and essentially doing it on the same companies. As a matter of fact when I'm looking for a new investment to fill out my dance card I often go through the VWINX holdings for an idea.

http://finance.yahoo.com/q/bc?s=VWINX&t=5y&l=off&z=l&q=l&c=^GSPC

https://personal.vanguard.com/us/Fu...&tableIndex=0&sort=marketValue&sortOrder=desc

 

[4re]

There is another factor to the OP's question. Were you successful trading long calls and puts. If not then you will not be successful trading vertical spreads either. In fact you will most likely lose more than if you keep trying to trade long options. If this is the case I would say to move to something less glamorous like stocks and learn to trade successfully first.

If you were successful with your long options and are just looking at adding some of the spreads to your game that's ok. I don't use credit spreads unless they are part of multi leg strategy I.E. condor or butterfly. I tend to use debit spreads and ratio backspreads mostly. I think it is best to learn several different option strategies that way you can tailor each trade to your comfort zone of R:R, probability of success and even Risk of Ruin ( I like to know what my max loss will be when I set up my trade).

Mav: Thanks for the Option 101 lesson. Great as usual