The Shorting of Frauds, Overhyped and Bankrupt Stocks Journal

[atticus]

Quote from Daal:

What about the idea of playing the market maker?Shorting the options then delta hedging. The MM might have some advantages over retail but it could be that during times of high panic the IV edge can help cover that

This strategy could be combined with a small directional bias in order to generate an extra return if you know the stock well

During panics you best be able to withstand the haircut to expiration. The idea that you can hold to expiration under a flash crash scenario.

You can be somewhat sloppy with the hedge. Short 50 of the 20D SPX puts at 32-vol and short 25 ES. The initial delta req is to short 20 ES, but you over-hedge. If the mkt rallies you wait out the decay (synth vol) and the strip-vols will drop (lower VIX) will counter the heavy-hedge. The vol-slope may increase as you trade away from the strike, but the lower strip offsets.

If you're good at direction you can trade in and out of the hedge.

Short two puts + short one futures is a synthetic straddle at whatever strike you choose. Say you're mildly bearish from 1350 cash. Short the SPX 1330P at 20.00; short ES at 1347. The synthetic straddle was sold at 70.00. Cash touches the strike, your 1330 synthetic straddle is trading at 62.00 and you buy the 1280P/1380C wings at 20.00.... you know have converted to an iron fly at 0 forward risk. Now you have a riskless fly and you can reload another overwrite.

The fly is riskless only in the sense that the MTM gains are embedded. You can't lose on the fly and it has no variation/maint. req.

 

[Ghost of Cutten]

Quote from Daal:

I was reading the 1st chapter of this book
http://www.amazon.com/gp/product/04...=1789&creative=390957&creativeASIN=0470452544

and I came across what I believe is golden advice that might help me short these type of fraud/bankrupt stocks

1-Do put backspreads in order to build a bearish position while being vol neutral. Its so obvious I don't know why I didn't do it before. You short an ATM put and use the money to buy many OTM puts. If the stock rises you break even, if it crashes you profit. If it just goes down a bit you lose. But the whole idea behind these stocks is that they will crash big. This helps me finance the position without overpaying for the options by a huge amount

The problem here is what if the short spends 18 months steadily grinding lower? You could lose a fortune as each month the price drifts down enough to hit you on the ATM puts but not enough to put the OTM puts into the green.

This just seems like another classic example of someone thinking they can magically create 'free money' in options by fiddling around with spreads. Generally this is not true - whatever you gain in one scenario, you give up in another. With back spreads, you can be right on direction and do even worse if the stock falls gradually than if the stock soars massively - how is that aligned with your expectation (that the stock will fall?).

Rule of thumb: if a trading position is such that you could be totally right and yet lose money, it's not a good position.

There is no getting around the risk of being short. Either you pay a hefty premium to cap that risk via puts, or you accept the risk by being naked short. Any attempt to lower the market price of being bearish, for example by trying to 'finance' the puts, comes at a cost of losing more money if some other scenario occurs. Backspreads can cause you to lose big if the stock drifts steadily down. Writing call spreads causes you to lose moderately if the stock drifts up. There's no free lunch.

However, I would say that writing call spreads seems a much more rational way to 'finance' puts than doing back spreads. In reality they don't 'finance' anything, they just alter the structure of your payouts under different scenarios. Being long some OTM puts, and short some call spreads, means you make more if it goes down a lot (your expected scenario), lose less or zero if it goes down a bit (2nd most likely scenario if you are right), and lose more if it goes up (least likely scenario if you are right). That looks like a superior structure to back spreads, where your biggest loss comes in your 2nd most likely scenario of a mild decline.

Finally, if the stock is really going to collapse, why do you want to be short a put? Just load the boat on OTM puts and finance them the conventional way - by paying for the premium! Why put on a spread that will reduce your profit - or even hand you a loss - if you are right?

 

[Ghost of Cutten]

Quote from Daal:

What about the idea of playing the market maker?Shorting the options then delta hedging. The MM might have some advantages over retail but it could be that during times of high panic the IV edge can help cover that

This strategy could be combined with a small directional bias in order to generate an extra return if you know the stock well

Why would you be able to out-market make a market maker? Stick to your edge, picking stocks that are going to blow up in 1-3 years. Then bet as purely as you can on that happening. Don't bet on other shit you know little about, like trading volatility, or short-term swings, or market-making options.

The best bearish bets I made were when I had a lot of conviction, and either bought a lot of long-dated (1-2 year LEAP) puts and held them through thick and thin; or when I had some kind of timing edge and caught a big downswing with 1-3 month puts. I can't remember ever doing good, let alone making home runs, trying to finesse with option spreads or any fancy stuff.

 

[Ghost of Cutten]

Quote from Daal:

Let me ask you this, do you think that IV are consistently too high during single stock panics?For instance, if someone consistently shorted puts everytime IV had a really big spike, assuming they had good fills, would that make money on avg?No delta hedging would be made

I ask this because sometimes I look at put prices and I just can't buy them as they don't offer good odds, but that puts me in a contradiction because if I can't buy them its illogical not to be selling them(assuming you can get filled at that price or close to it)

Questionable. Ask how shorting puts 1 or 2 days before the bottom (i.e. near perfect timing) in October 87, or Q4 2008, would have done. You would have soiled your underwear before the bottom got put in. I think IV is often too cheap during panics.

Selling naked puts in a crash is only worthwhile if you can time the bottom with some precision. But if you can do that, it makes far more sense to go long the outright, or long some calls (depending how big the bounce back will be, and how high the IV).

For a directional player, selling puts is for calm markets where you wouldn't mind being long at somewhat lower prices, but aren't desperate to get long at today's prices. For example, if you are steadily accumulating an investment position; or if you are playing a trading range. Even then, I would argue that having a lower strike put is always a good idea as a disaster hedge. Selling naked puts just sucks as a directional trading strategy IMO.

It is a fallacy to think if you don't want to buy something, you must want to sell it. That assumes it is rational to take risk for a tiny edge. On the contrary, uncertainty in the markets is so great that you should demand a gigantic, fat, elephant-sized edge before you even think about putting on a position. You are not a market-maker with obligations to quote.

 

[atticus]

Quote from Ghost of Cutten:

Why would you be able to out-market make a market maker?

The upstairs trader isn't beholding to flow. He can take liquidity as often as he likes, and gets near MMer haircut in a PM account. Stick to liquid stuff and the spreads are insignificant.

 

[atticus]

Quote from Ghost of Cutten:

You are not a market-maker with obligations to quote.

Which makes Daal's argument to gamma-trade. Of course it has really nothing to do with MMing. He would still be taking liquidity with every adjustment.

Daal, we need to drop the "MMing" connotation. But yes, it's "better" to gamma-trade upstairs as a taker of liquidity, IMO.

 

[Daal]

Quote from Ghost of Cutten:

The problem here is what if the short spends 18 months steadily grinding lower? You could lose a fortune as each month the price drifts down enough to hit you on the ATM puts but not enough to put the OTM puts into the green.

This just seems like another classic example of someone thinking they can magically create 'free money' in options by fiddling around with spreads. Generally this is not true - whatever you gain in one scenario, you give up in another. With back spreads, you can be right on direction and do even worse if the stock falls gradually than if the stock soars massively - how is that aligned with your expectation (that the stock will fall?).

Rule of thumb: if a trading position is such that you could be totally right and yet lose money, it's not a good position.

There is no getting around the risk of being short. Either you pay a hefty premium to cap that risk via puts, or you accept the risk by being naked short. Any attempt to lower the market price of being bearish, for example by trying to 'finance' the puts, comes at a cost of losing more money if some other scenario occurs. Backspreads can cause you to lose big if the stock drifts steadily down. Writing call spreads causes you to lose moderately if the stock drifts up. There's no free lunch.

However, I would say that writing call spreads seems a much more rational way to 'finance' puts than doing back spreads. In reality they don't 'finance' anything, they just alter the structure of your payouts under different scenarios. Being long some OTM puts, and short some call spreads, means you make more if it goes down a lot (your expected scenario), lose less or zero if it goes down a bit (2nd most likely scenario if you are right), and lose more if it goes up (least likely scenario if you are right). That looks like a superior structure to back spreads, where your biggest loss comes in your 2nd most likely scenario of a mild decline.

Finally, if the stock is really going to collapse, why do you want to be short a put? Just load the boat on OTM puts and finance them the conventional way - by paying for the premium! Why put on a spread that will reduce your profit - or even hand you a loss - if you are right?

I certainly wasn't trying imply that the strategy would fit any scenario nor it would be a free lunch. It can however make a lot of sense for some stocks
Take DMND, this stock is either headed for bankruptcy or its going to come back big time. I don't expect it to stay where it is, as a result a put backspread can make sense(the calls might be too expensive to be bought)

Another benefit is something that Nassim Taleb talked about, its a really difficult strategy to implement one that losses money almost every day with a chance to make all that back in one day. Its not the most emotionally easy thing do to. So if you combine these 2 things, 1-The strategy fits the stock likely future distribution 2-Its easier to trade by a human, it makes it superior to just buy OTM puts

The 2nd benefit can help with mistakes in terms of missing signals due its smaller human appeal

 

[Daal]

Quote from Ghost of Cutten:

Why would you be able to out-market make a market maker? Stick to your edge, picking stocks that are going to blow up in 1-3 years. Then bet as purely as you can on that happening. Don't bet on other shit you know little about, like trading volatility, or short-term swings, or market-making options.

The best bearish bets I made were when I had a lot of conviction, and either bought a lot of long-dated (1-2 year LEAP) puts and held them through thick and thin; or when I had some kind of timing edge and caught a big downswing with 1-3 month puts. I can't remember ever doing good, let alone making home runs, trying to finesse with option spreads or any fancy stuff.

I never did much options trading other on outright directionals but its quite possible that it can help my trading. Its about self-improvement

 

[Daal]

Quote from Ghost of Cutten:

Questionable. Ask how shorting puts 1 or 2 days before the bottom (i.e. near perfect timing) in October 87, or Q4 2008, would have done. You would have soiled your underwear before the bottom got put in. I think IV is often too cheap during panics.

Selling naked puts in a crash is only worthwhile if you can time the bottom with some precision. But if you can do that, it makes far more sense to go long the outright, or long some calls (depending how big the bounce back will be, and how high the IV).

For a directional player, selling puts is for calm markets where you wouldn't mind being long at somewhat lower prices, but aren't desperate to get long at today's prices. For example, if you are steadily accumulating an investment position; or if you are playing a trading range. Even then, I would argue that having a lower strike put is always a good idea as a disaster hedge. Selling naked puts just sucks as a directional trading strategy IMO.

It is a fallacy to think if you don't want to buy something, you must want to sell it. That assumes it is rational to take risk for a tiny edge. On the contrary, uncertainty in the markets is so great that you should demand a gigantic, fat, elephant-sized edge before you even think about putting on a position. You are not a market-maker with obligations to quote.

Shorting the puts during a panic can make sense when they are hedged by a even lower strike put. If one assumes that IV is mean reverting(And I believe history shows that quite clearly), making this kind of bet probably has higher expectation than outright long in the underlying
Why?
Because its like playing 2 edges at the same time(oversold in the underlying, selling overpriced insurance plus buying less overpriced insurance that it was sold, I'm using the term overpriced in terms of expectation for someone with no margin req, its not overpriced for you because of margin req but thats why you bought it. The buying takes the margin issues aways so they become overpriced after the purchase)

Of course, this must be made in a small position so there is virtually no chance you get auto-liquidated(Risk can be but further by devoting a separate account for this, specially if through an LLC)

Yes, it can be a fallacy not to sell something that you wouldn't buy if the edge is small but a lot of the time I see that happens its not a fallacy at all

 

[Daal]

With regards to the fat tails in 87 scenarios, that is yet another reason to short the ATM puts and buy the the OTM put. In those crashes usually there is a bounce or a mega collapse. Its rare that the price stays where it is, so there is an edge there