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What is this option selling hedge fund's edge??
- Thread starter short&naked
- Start date
selling fairly priced options generates positive alpha because the standard way to calculate alpha only calculates risk by looking at the standard deviation of returns (i.e. it doesn't take into consideration skewness or higher moments).
Say you can make a rather outsize return every year from selling index options like 40% per year. Letâs also say you are smart and donât compound the returns for safety, and assume a starting risk capital (and this obviously has to be true risk capital that you can afford to lose) of 100k.
That means you make 40k per year, and if you live a non income tax state then your max section 1256 tax rate is a blended 23% which leaves you with an after tax gain of 30,800 per year.
At some point in your career of always being short options, day after day, month after month, year after year, you will undoubtedly suffer a max loss. That means credit spread traders lose 100% of their account, and naked players could lose even more. If we guess that 5 years in you have this loss and your account is blown out then you have to come up with another 100k to start again. 5 years times 30,800 is 154,000 in profits but you just lost 100k in your blowup so now you made 54k in profits over 5 years. That is an average return of 10.8% after tax. While many a pension fund would love that and even some hedge funds would be happy with it, considering that your risk is losing everything in the account on an event that no one can efficiently plan for, predict, or hedge against that return is nothing special.
But what if you go 10 years without blowing out, or you get lucky and only have 40 or 50% drawdowns? Ok, but what if you have two blowout events in the same year? You are betting with odds that no one can properly quantify.
You can also use enough capital to hold on and roll through most all events that would blowout the average account, like 40,000 per one ES option contract. But then your return is again nothing to get too excited about compared to other trading strategies.
You have to understand that it is possible to make above average returns with selling options, but it quite literally takes luck to succeed in the long run, and you only have a hope of succeeding if you are a professional trader doing all the right things. This is not a sit back and not pay attention strategy, it takes time and effort. That time and effort of a successful professional trader might be more efficiently used elsewhere.
That means you make 40k per year, and if you live a non income tax state then your max section 1256 tax rate is a blended 23% which leaves you with an after tax gain of 30,800 per year.
At some point in your career of always being short options, day after day, month after month, year after year, you will undoubtedly suffer a max loss. That means credit spread traders lose 100% of their account, and naked players could lose even more. If we guess that 5 years in you have this loss and your account is blown out then you have to come up with another 100k to start again. 5 years times 30,800 is 154,000 in profits but you just lost 100k in your blowup so now you made 54k in profits over 5 years. That is an average return of 10.8% after tax. While many a pension fund would love that and even some hedge funds would be happy with it, considering that your risk is losing everything in the account on an event that no one can efficiently plan for, predict, or hedge against that return is nothing special.
But what if you go 10 years without blowing out, or you get lucky and only have 40 or 50% drawdowns? Ok, but what if you have two blowout events in the same year? You are betting with odds that no one can properly quantify.
You can also use enough capital to hold on and roll through most all events that would blowout the average account, like 40,000 per one ES option contract. But then your return is again nothing to get too excited about compared to other trading strategies.
You have to understand that it is possible to make above average returns with selling options, but it quite literally takes luck to succeed in the long run, and you only have a hope of succeeding if you are a professional trader doing all the right things. This is not a sit back and not pay attention strategy, it takes time and effort. That time and effort of a successful professional trader might be more efficiently used elsewhere.
I have been doing Strangles/Straddles for quite some time (SPY and IWM)
#1 Risk Management is key.
#2 You really need to be well capitalized, it is a capital intensive operation.
#3 There are times when you will see some big drawdowns, but that is to be expected. Weather the storm and don't panic. When you go cruising on the Sailboat, you will have to go through some rough waters as part of the process.
#4 Patience is key.
#5 Never borrow more than 10% against total assets, and when doing so insure your position against margin calls worst case scenario (plan for black swan events all the time)
#1 Risk Management is key.
#2 You really need to be well capitalized, it is a capital intensive operation.
#3 There are times when you will see some big drawdowns, but that is to be expected. Weather the storm and don't panic. When you go cruising on the Sailboat, you will have to go through some rough waters as part of the process.
#4 Patience is key.
#5 Never borrow more than 10% against total assets, and when doing so insure your position against margin calls worst case scenario (plan for black swan events all the time)
Don't be too cavalier about selling naked options - use only a very small amount relative to your portfolio if you decide to do so. I'm not talking about cash-secured puts, but more speculative trades like short straddles and strangles on index options. Trading large volumes requires protection, and even with bound positions like condors, look at what you would be risking if the market goes against you 5% or 10% before you even get a chance to adjust.
Quote from KINGOFSHORTS:
I have been doing Strangles/Straddles for quite some time (SPY and IWM)
#1 Risk Management is key.
#2 You really need to be well capitalized, it is a capital intensive operation.
#3 There are times when you will see some big drawdowns, but that is to be expected. Weather the storm and don't panic. When you go cruising on the Sailboat, you will have to go through some rough waters as part of the process.
#4 Patience is key.
#5 Never borrow more than 10% against total assets, and when doing so insure your position against margin calls worst case scenario (plan for black swan events all the time)
What is your risk management strategy? I am seriously thinking about doing this. So far my risk management consists of trailing stops (cut your losses short and let your winners run), and far OTM long strangles (basically a double diagonal, black swan event).
I am open to any other risk management ideas.
"...but it quite literally takes luck to succeed in the long run..."
All your points are valid & things to consider.
But, show me any trading strategy or approach that isn't at the mercy of the above statement. Trading or any business pursuit for that matter is bound to this above statement. It's all about timing. I know of a former bank trader in FX options that made a mint over the years being short premium w/ the huge house, cars, etc etc. Then left the business in 2005. She had a great run and was out of the business when the shit hit the fan in 2008. Sometimes it's just all about luck.
How do you know that you won't hit a home run over the years trading w/ that "100K acct" and then your trading skill/market knowledge will evolve to where you begin to seek out other trading opportunities elsewhere in other markets w/ other approaches as they arise? Maybe the profits you book in selling premium set you up to capitalize on the next opportunity. Trading and life are not that static & linear. You never know what upside the future holds until you try.
Just to play the devil's advocate, take the other side of the short premium trade. Another poster cited Taleb's long premium only fund that did the exact complete 180 deg opposite of what we're discussing here & he closed his fund. Once again it's all timing. He didn't get that tail event or enough of those tail events that would have given him & his investor's their pay off. Once again it's all luck. No guarantees in this life or in this game, but just markets that present opportunities everyday. Opportunities that are our job to advantage.
You make & strike while the iron is hot.
Once again valid points on your part.
All your points are valid & things to consider.
But, show me any trading strategy or approach that isn't at the mercy of the above statement. Trading or any business pursuit for that matter is bound to this above statement. It's all about timing. I know of a former bank trader in FX options that made a mint over the years being short premium w/ the huge house, cars, etc etc. Then left the business in 2005. She had a great run and was out of the business when the shit hit the fan in 2008. Sometimes it's just all about luck.
How do you know that you won't hit a home run over the years trading w/ that "100K acct" and then your trading skill/market knowledge will evolve to where you begin to seek out other trading opportunities elsewhere in other markets w/ other approaches as they arise? Maybe the profits you book in selling premium set you up to capitalize on the next opportunity. Trading and life are not that static & linear. You never know what upside the future holds until you try.
Just to play the devil's advocate, take the other side of the short premium trade. Another poster cited Taleb's long premium only fund that did the exact complete 180 deg opposite of what we're discussing here & he closed his fund. Once again it's all timing. He didn't get that tail event or enough of those tail events that would have given him & his investor's their pay off. Once again it's all luck. No guarantees in this life or in this game, but just markets that present opportunities everyday. Opportunities that are our job to advantage.
You make & strike while the iron is hot.
Once again valid points on your part.