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"Sheer terror" is typical of the emotive language that is often used
when anyone even mentions selling options. Those stupid enough to pursue
the argument are silenced by references to the Black Swan effect, fat
tails and how Victor Niederhoffer lost his fortune. Another mantra is
"limited returns and unlimited risk". Oh, and the unspeakable horror of
the option being "exercised", spoken to rhyme with "exorcised".
Maybe we need find the source of these dark warnings. Perhaps those
large institutions that write option contracts? Write, as in "write an
insurance policy". The language is designed to confuse, so that it
appears to be some complicated contract drawn up by a team of lawyers
rather than what it really is - selling options, and it's as simple as
selling a futures contract and even simpler than short selling a stock.
Why don't they want individual traders trespassing on their turf?
Because it's highly profitable, that's why. Option trading has often
been likened to gambling, and to a large extent this is true, but in
this game the option buyers are the suckers and the "writers" own the
casino. In fact they own a casino where they even get to choose which
bets to accept.
Maybe we also need to look at some facts behind the spook stories. Black
Swans and fat tails refer to the fact that market price movements are
not normally distributed. Catastrophic events occur more often than they
"should". This is true for all markets - stocks, bonds, commodities,
whatever. Somehow the fallacy prevails that these catastrophies are more
harmful to option sellers than any other trader. My own trading has
proved that in fact the opposite is true.
I have traded options for the last six years. More specifically I sell
out-of-the-money options on US futures. I calculate what I call
odds-to-miss, which is the probability of expiring worthless based on
the statistical volatility, and take trades where this figure is higher
than 70%. My stats indicate that 61% actually do expire worthless (i.e.
I get to keep the whole premium). Of the remaining 39%, a further 12%
are still profitable because the difference between the strike and
futures price at expiry is less than the option premium. That leaves 27%
losses with the dreaded unlimited risk, right? Not at all. I put a
futures stop at the strike+premium and that takes care of another 22%
where I (normally) just lose my brokerage, and the remaining 5% where I
lose the premium + another 60% (I can explain all the details in a
private email). So what's the downside? Well it's back to our
catastrophic events, and specifically those that cause a gap through my
stop. And so, finally, to my point which is that although those events
still hurt like crazy, they don't hurt any more than for the futures
trader trading the same commodity. And here's the thing I AM ONLY
EXPOSED TO THOSE EVENTS IN ABOUT 39% OF MY TRADES COMPARED TO HIS 100%.
The numbers are probably different for stock options, but the same
principle holds.
Unlike stock traders I can also cut down my exposure to catastrophies by
for instance never selling puts on stock indexes and never selling calls
on coffee - again I can explain the details in a private email - I will
send my OptionScan booklet to anyone who asks. It details exactly how my
trading system works as well as slaying some more dragons, everything
from Black Swans to Black Scholes. It also explains why I will happily
send out my calculations every day for free.
John R Pretorius
johnpretorius@xxxxxxxxxxxxx
-----Original Message-----
From: DH [mailto:catapult@xxxxxxxxxxxxxxxxxx]
Sent: 06 July 2006 04:30
To: Omega List
Subject: Re: Implied Volatility for Futures Contracts
Simple test, would your hedging strategy have protected you from being
short puts on 9/11 when the market was closed for a couple of weeks?
Would you already have had your protection in place if you'd shorted
puts the day before the crash/market-closure, considering that Sept
hedges would have expired worthless after the closure? If so, I'd say
you've covered your risk pretty well.
> I would like to declare the "selling of deep-out-of-the-money options"
> a strictly a game of skills and understanding of statistical
> properties of market returns etc. If you follow
> my recipe than there is NO 1% of "sheer terror". All cases of
"extreme" market
> conditions
> (that bankrupt gamblers like Victor N.) are handled with "business as
usual"
> attitude.
>
> So, you don't need any luck (but you need badly a math knowledge of
> markets), and there is no fear involved in market extremes ("fat tail"
> events), just a simple hedging invoked
> with a proper timing.
>
--
Dennis
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