Saturday, November 10, 2012

Directional Trading With Options Pt2

Part 1 HERE.

In part one of this article, I stated that IF long option buys have any chance of outperforming straight out stock trading, it is the the "swing trading" time frame or momentum plays, generally moves that last 3 - 20 trading days. This is my opinion based on my experience and is not to say that one cannot be successful in other time frames, but let's just say my goal in option trading is outperforming stock trading over the long term; In other time frames, I doubt that the additional contest risk (extra brokerage and bid ask/spread in the notionally larger position size) and theta risk can be overcome by the advantages of gamma over the long term.

I m quite happy to stand to be corrected on this and I haven't done a scholarly thesis on this, but this matches the consensus of many other experienced option traders.

Firstly, lets look at the advantages and disadvantages of options versus stocks as I see it, always working with the assumption that an equal number of deltas is used, as described in Part 1

Stocks have the advantage of being very simple to trade. You buy x number of stocks and that is the number of deltas you have, you can calculate the exact profit or loss that is possible from a given move. For example if you want to acquire 500 deltas of x stock, you simply buy 500 shares, if your stock goes up $1 you have made $500, if your stock goes down $1, you lose $500 - easy.

However to acquire 500 deltas in x's options, some qualitative decisions must first be made. Obviously those deltas are positive so we are looking at calls, but am I going ITM, ATM, OTM? What delta is the option I want to buy - and why? If the delta of the option is .33 we're going to need 15 contracts to get our 500 deltas. Fine, but what expiry? How far out to we want to buy - and why?

How will these decisions affect the outcome of the trade.

Stop Loss
There is an advantage in a long option position that the absolute maximum risk is known, that is the cost of the options. Stock traders will protest that a stop loss order can be placed on a stock position, however that does not protect the trader in the event of a large gap. If the stock gaps down 50% overnight, there is no stop loss in the world that will save you. In addition, once the stop loss order is triggered, you are out of the trade; and how often have you been stopped out only to see the stock immediately bounce higher?

Although the maximum loss of the option position may or may not equate to the calculated loss of a stopped out stock position, a maximum loss on the option position does not necessitate the exit of the trade. If that stock bounces back hard, you may still be in the money.

Another advantage for the long option trader is gamma. This is the Greek that measures the change in delta as the stock price moves. If you are long the above calls, all things being equal, the position will increase in deltas as the stock goes up. So if that puppy is going in your favour, you have some automatic pyramiding of the position, and the higher it goes, the longer you get.

Likewise, if the position goes against you, deltas will decrease getting you less and less long as the stock moves down. The stock position never changes its delta however.

This is good news, the more gamma you have, the more accentuated this affect. There is a flip side to gamma though, which is...

Countering the positive effect of gamma, is theta (or time decay). Every day that you are in a long option position, you are losing time value on your option. Actually it is more complicated than that; the time value will vary in relation to the option's moneyness and volatility, but as a general principle it is true, an option devalues as time goes by.

Theta has a direct relationship to gamma, so the more gamma you have, so too the more theta you will have.

This is the prime reason I believe swing trading/momentum plays are the spot where long options may have an advantage over stocks; providing one makes intelligent choices regarding strike and expiry. You can acquire sufficient gamma to give you a real boost if you get on a strong move, yet not suffering to any great extent from the effects of theta.

Vega measures the effect of changes in volatility on the price of the option. Stocks don't have vega, so not a consideration. Whether vega is an advantage or disadvantage to a long option position is... well, it can be either and is not something to be ignored.

If you punt on some calls at what you think is the bottom of a big swoon at very high IVs, you will suffer some degree of premium sag if it starts moving your way, particularly if you buy OTM options and your position gets toward being at the money. You were right and you may be in profit, but it will be like having left the handbrake on.

It is possible to be right on the direction and still lose.

On the other hand, volatility tends to increase on down moves. Buying puts at low IVs can be spectacularly profitable if you catch a high volatility down move, because of vega.

These Greeks are all something to be considered when selecting strikes and expiries, or even whether to select a long option at all in a given situation, which goes back to the first point - Complexity.

These points I have only really touched on and there are deeper considerations to these Greeks, such as when and where their effect is greatest.

Part Three coming soon.

Sunday, September 16, 2012

Directional Trading With Options Pt1

There are several philosophies used in options trading; premium collection, volatility trading etc. But the one I want to focus on for a while is straight out directional trading.

Yet again there are several means to trade directionally, from straight out option buys, to vertical spreads, to just about any other spread you can think of.

All require some consideration of direction, volatility and magnitude (yes there is a difference) of the anticipated move, and hence the effect of the Greeks... or rather a quantification of risk and reward via the Greeks.

The simplest way to trade direction with options of course, is straight out option buys, but once more the decision to buy an option is more complicated than straight out stock. We are faced with dozens of alternatives in the form of strike, expiry and quantity of options relative to an equivalent stock position. Though we may attempt to ignore them, the Greeks will still quantify risk and reward.

Some options educators recommend long dated, deep In The Money options as a stock replacement strategy, with delta greater 0.7, yet some others recommend short dated, way Out of The Money options in some hope to hit the occasional home run.

I think it's kind of futile to make such blanket statements without knowing what it is the trader is trying to do. There are various styles of directional traders, from long term strategic traders, trend traders, swing traders and day traders. The trader's goal in taking a trade is going to be important in what strike or expiry he or she selects... or indeed whether an option has an advantage over the underlying; there is no point in complicating a trade for no advantage.

The successful stock trader will have a risk management and position sizing regime in place, so for any trade, a position size will be calculated. In option lingo terms, we can describe this as the number of deltas. As the share delta is 1.0, the number of shares will be the number of deltas exposure in the trade. If a long position size is calculated as 1000 shares, we have 1000 deltas exposure.

If we are considering replacing stock with options, that is also how we should view our directional exposure, by the number of deltas. For example, if we bought ATM options with a delta of 0.5, we would need 20 contracts to make up the equivalent 1000 deltas of exposure. DITM options with a delta of 0.7 would need 14 contracts to approximate the 1000 deltas and OTM options with a delta of 0.25 would require 40 contracts to do the same.

It is the with other Greeks where things get interesting and how we can define whether there is anything to gain... or lose from option buys. A stock position is not affected by these Greeks, so we know absolutely our profit or loss from a given move. However options are non-linear and profit or loss parameters exist a in a more chaotic system. We can know profit or loss within a range,with a given move in the underlying, but the randomness of volatility changes and time in the trade make the absolute results more variable.

An examination of each type of trading is beyond the scope of this article and it is my belief that if long options have potential to outperform stock trading, it is in the swing trading time frame or momentum plays, trades of 3 - 20 days duration.

That's the time frame I want to look at.

Part 2 HERE

Sunday, June 17, 2012

A Look At Covered Calls - 6 Months In

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.


Although I haven't posted in a while and didn't update May results, I have been recording the hypothetical trades in real time. It is now six cycles with a bull phase and bear phase included. This has been fortuitous as it has been handy to show largely what I have been wanting to demonstrate about covered calls.

Going back to my original motivation for this simulation, it was to expose the nonsense of the ubiquitous advertising line that one could make 4-8% income every month from this strategy.

This simulation is not the perfect example of how everyone would trade covered calls, but by now shows the problems inherent in the strategy as a systematic income generation machine.

I should point out that I am not against covered calls in the slightest. I use them (or the pure version of the strategy, the short put) frequently when I want that particular risk profile. I have some long term holdings that I sometimes write calls over when I think it is appropriate, but never systematically every cycle.

The fact of covered calls is that they are optimally profitable when the stock moves sideways. They under perform their underlying market in strong up-trends and outperform their underlying market (though may still make losses) in down-trends. Over the long term they reduce volatility, but depending on the greater trend there is no guarantee that they will be outperform the underlying.

I do not believe picking and choosing tickers (systematically) works any better than picking and choosing underlying stocks in a trading system.

Several 'educators' try to rework the numbers by altering the moneyness of the options, most frequently by writing deep in the money. This increases probability of profit, which feels good to the investor who enjoys large numbers of wins, but dramatically reduces the maximum profit. It also dramatically increases the size of the (abeit fewer) losses as a proportion to the typical win.

It changes the nature of the equity curve, but not the ultimate expectancy. It's a bit like a martingale system. it feels like you have found the holy grail for a while, until you get run over by the proverbial steam roller.

OK lets look at the graphs of the individual stocks I am using along with the total list of trades with the last two month's trades beneath the screen split.

As at close of trading June 15 2012:

Goldman Sachs

After six months trading, an impressive run up, an equally impressive swoon, we are essentially back where we started with both the underlying and the covered call strategy. All we have managed to achieve is to reduce volatility.

But this is a classic illustration of how CCs under perform the underlying in up-trends and outperforms the underlying in down and sideways trends. 

National Oilwell Varco

NOV has not been that dissimilar to GS, excepting that the CC strategy has managed to augment our equity by 5.5% over the six months. That's not a bad result for a buy an hold investor, but a far cry from the 4-8% per month as claimed by the seminar clowns.

Freeport McMoran

FCX represents the most significant out-performance of the three stocks selected at ~7.5%, but really has only trimmed the nearly 9% loss on the underlying to 1%. If you are invested in FCX on a buy and hold basis, that is a significant achievement... and that 7.5% is cash you can use for a festive dinner with friends and family, or reinvest if you prefer, but still nothing like the "buy my $3,000 covered call course" promoters claim.

Yes some of the returns in individual months were 4-8%, but mostly at the cost of even greater returns from the underlying. In other words investors trying to pick uptrends to write covered calls would have been better off just buying the underlying.

However, there is still good times to write calls in up-trends. One can dust off their crystal ball and write calls  a bit out of the money at points where the underlying is overbought and likely to retrace or consolidate in the time frame selected (time til expiry).

As shown, they also partially hedge in downtrends. But the best use of covered calls is if you can see into the future and pick when your stock is going to go sideways.

Overall, a useful strategy for investors, but sub-optimal for shorter term traders.

Saturday, April 21, 2012

A Look At Covered Calls - Cycle 4 Round Up

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.


I have now wrapped up cycle 4 of the covered call simulation and the results get more interesting, but not unexpected on my part. The motivation for this sim is the representation of easy money available through trading covered call. Although this is not a perfect example, it is generally representative of the ebb and flow of trading this strategy.

I've tried to represent an augmented version of CC trading, via rolling at times within the cycle, to pick up more premium if possible. Most times this works, but sometimes it screws up at we shall see below with FCX.

Let's start of with GS:

The stock is off 10% (relative to starting price in Dec 2011) and the cycle's movement is shown by the red box.

I was able to roll the calls dow, collect most of the original premium, plus the additional premium as it expired OTM. A 6.4% cash profit from the option premium. This is set against the 10% fall. Although the covered call outperformed buy an hold in this cycle, the covered calls still made an overall loss. Buy and hold over the four cycles is still outperforming covered calls at this stage.

FCX was the screw up for the month from a trading perspective. The stock is down just ~2.5% for the cycle:

This is CC manna; write calls get sideways movement collect the premium and buy a holiday to the Bahamas on the proceeds at the end of the cycle. But when this whipped down to around $36, I traded the April $40 calls for $36 calls (Which I neglected to record on the blog. Like GS above, it would have worked well if it lingered down there, but it didn't. It whipped back up again causing a loss when closing out ITM on the second lot of short calls.

C'est la vie.

Cash profit for the cycle 0.65%, less the loss on the stock and we are again behind a bit. Nevertheless, the covered call strategy is in front of the stock over the four months by an eyelash.

Lastly, NOV was down ~9% over the cycle:

I rolled this twice and closed the third lot as it was slightly ITM, getting nice chunks of premium from each resulting in ~5.6% cash profit. But like GS, the dumpage of the stock caused an overall loss for the cycle. Like GS, the covered calls are making gains on buy and hold, but after four months, buy and hold is still a few lengths in front.

The overriding point at this stage is that in a non-margined account, there is still no net cash income from the covered calls. That would be disconcerting for someone sold the dream of reliable cash income from covered call trading.

Wednesday, April 18, 2012

Accuracy Of Market Estimates of Volatility

In a couple of recent posts viz, Is It Better To Buy Or Sell Options? and Buy/Sell Musings & Volatility, I've been looking at the trader's bias of being a either a buyer or seller of options, or at least being nett short or long gamma.

The conclusion I have reached, for whatever that is worth, is that the decision generically boils down to volatility. That is to say that the trader must examine the volatility priced into the option, AKA implied volatility, and decide whether the price is at, over, or under the odds; or in option parlance, whether the option is fair value, over, or undervalued.

Some writers suggest a comparison to historical volatility, but I wrote in Buy/Sell Musings & Volatility that I thought that was naive and an inappropriate way of determining relative value. Implied volatility looks forward; it is the collective markets guestimate of the volatility it thinks will be realized in the future, in other words the market's view of correct value for that option. It is not definitive, cannot be definitive, because we don't know what will happen in the future.

Historical volatility is definitive however because it measures actual prices traded in the market place over a set of past data of the analyst's choosing. This can be any period, but most commonly over the preceding 20 or 30 days of data. For the purposes of this article I am going to use 20 day historical volatility as this represents the approximate number of trading days in one month.

The VIX is an index of near term implied volatility on S&P 500 options and is quoted according to a formula, to smooth out implications of impending expiry etc. Details and method of calculation are available from the CBOE at this LINK. Essentially it is recording implied volatility one month henceforth.

As I have stressed up til now, it looks at past data, whereas implied volatility looks forward and what happens in the next 20 trading days may be vastly different to what happened on the last 20 trading days, volatility wise. It does have it's uses however. It allows the analyst to examine the 'normal' range of actual volatility for an underlying instrument, how it's cycles, what has been its upper and lower boundaries under various market conditions etc.

Historic volatility has a further use. We can use it to measure how accurately the market forecast one month volatility by looking at the actual volatility realized in on month's time, via the historical volatility calculation.

Let's have a look at the S&P500 using VIX as proxy for implied volatility available at a given date and realized volatility one month later.

Click To Enlarge
As we can see in the above graphic, on the 1st of Feb the market overestimated volatility substantially, therefore we can say that on that date and with the benefit of hindsight, we would have been better to have been a seller of options, all other considerations aside.

Manipulating the historical volatility plot backwards by one month makes it easier to analyze by lining up the implied volatility with the volatility realized in one month later.

Click To Enlarge
In the data that we can see in this graphic, the market collectively forecast volatility correctly, finally, in about the third week of March. So we can say, again with the benefit of hindsight, that S&P500 options at that point were fair value, though it is only today, one month later, that we can say that.

The displaced historical volatility plot gives us the opportunity to view the implied volatility at any point in the past and also in toto, to see how well the market forecasts volatility over the long term. The graphic below shows, on SPX options at least, that the market tends to over estimate forward volatility chronically.

Click To Enlarge
That is it overestimates future volatility until it doesn't. Sellers at market tops get taken to the woodshed.

This evokes the 'picking up pennies in front of a steamroller' cliche for put sellers and synthetic equivalents (buy/write traders) and bull put traders. Put buyers who successfully pick tops score a big time try/touchdown/<or goal scoring nomenclature appropriate for your country> with the vega bomb that blew up in the seller's face. (With apologies for mixing metaphors there)

As intimated in the preceding paragraph, of course being short or long options is not the only consideration. Delta, gamma and theta also cohort the make the trade; or wreck it as the case may be. In markets swoons put buyers will be celebrating with festive dinners, Dom Perignon and Cuban cigars while quite obviously call buyers will be drowning their sorrows with rough red, despite being on the correct side of the buy/sell divide.

The overriding point here however is that market estimations of volatility aren't very accurate and I believe an edge can be obtained by being a better forecaster of volatility and I believe such analysis can help traders make better option trading decisions and not be stuck in a permanent buy or sell paradigm.

Sunday, April 15, 2012

Buy/Sell Musings & Volatility

In a recent post I was discussing the question of whether it is generally better to be a buyer or seller of options. My conclusion was that theoretically there is no inherent advantage in either buying or selling, if options are priced correctly; it depends on the situation.

The oft repeated mantra out there in options land is to sell when options are overpriced and to buy when underpriced. Wise advice, but of course the sixty four thousand dollar question is - when is an option overpriced and when is it underpriced?

Of course if you know your option theory, you'll know the great variable in option pricing is volatility, all other inputs being known definitively.

We can measure the volatility of the underlying by looking back over a set number of days and applying a formula to determine the statistical volatility over that time frame. This is also definitive, but unfortunately may bear no relation to the volatility realized over the same number of days henceforth.

This is the volatility option traders want to know, future volatility. As it lies in the future, it cannot be known. Therefore the market collectively makes a forecast of future volatility and prices options accordingly, hence the measure derived by a little bit of algebra, 'implied volatility'.

Some folks suggest comparing implied volatility to statistical volatility to determine over or under valuation. I say that's naive. As discussed, statistical volatility looks backward, but implied volatility looks forward and as I've already pointed out, the volatility realized going forward can be markedly different to the preceding period.

What the individual trader must therefore do, is to make a call on future volatility and decide whether options are fairly valued or not, according to his or her own projections. Statistical volatility may be a tool that can be used in this analysis, but ultimately he who guesses best, wins.

Of course there are other dynamics at play depending on the specific strategy which may sink or save any one position, but good forecasters of volatility have a huge edge.

In the next post, I want to have a look at how accurately 'the market' forecasts volatility.

Tuesday, April 10, 2012

A Look At Covered Calls - April 11 Update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.


Just as this market was getting so complacent (relatively) that I was starting to doze off a bit, it throws in a half decent swoon, startling me from my daydreams. Now I find that the stocks I follow... and the index itself at levels of time and price support, I find myself pondering upon some adjustments.

As my covered call stock sell off, the extrinsic value of the call options have reduced, my positive theta is now relatively less, and the positions have built up some extra deltas. I can buy them back at a profit and re-sell ATM again to pick up more premium or leave them to expire .

If indeed the market does get some support here and we get a bounce going into expiry, those extra deltas are going to help the overall position. On the other hand if the market steps of into the abyss, they're going to hurt.

Writing new calls ATM will bring in more extrinsic, reduce delta and will partially hedge downside. On the other hand it opens the risk of taking it once again on the intrinsic value of those short calls if the market bounces.

This introduces a new question: Does the systematic covered call writer want to be an analyst as well, or just write premium at points where he can get it most. If I hark back to the original idea of this, it was to show a hypothetical portfolio to collect premium. .

Well as it's a hypothetical account, it doesn't matter much and the idea is to see different scenarios in real time, so I did record some adjustments earlier.

With GS trading at 116.13 I bought back the April 125 call for 56c and sold the April 15 for $3.40

I also adjust the NOV position; with the underlying at $78.33 I bought back April 80 call for 57c and sold the April 77.50 for $1.32.

Thursday, March 29, 2012

80% Percent of Options Expire Worthless?

It comes in several flavours, sometimes stated as 80%, 90%, or whatever. It is the maxim that most options expire worthless. It is repeated so often out there in the marketplace, it is taken as a given and used as a justification to be a nett seller of options and/or promote option selling @education". It is repeated, as a mantra, by some of the most well known folks in optionland. There is only one problem, it's bullshit.

I like being a nett seller of options too, but the reason has nothing to do with the statistic of how many options expire worthless. As I sated in my previous post, it rather depends what strike one sells that dictates the probability of an option expiring out of the money. I like selling options for mostly psychological reasons; what I do has evolved mostly because of my personality direction picking prowess (poor) and how I like to trade.

Let's look at the actual figures according to the Chicago Board Options Exchange:

About 10% of options are exercised during each cycle. That means the other 90% must expire worthless, right?

Wrong! In fact over 60% of all options are traded out in the marketplace before expiry. These could be in, out or at the money.

That leaves approximately 30% of options expire that expire worthless in each monthly cycle.

Can anything be gleaned from this regarding being a buyer or seller? Absolutely not, there are so many different  strikes, strategies and combinations which are not given in this statistic that further analysis is impossible.

Monday, March 26, 2012

Is It Better To Buy Or Sell Options?

This is the question perpetually asked by retail option traders, often having been tainted by BS from some hyped up moron on a stage. I guess the question in their mind is over the long term,whether the negative theta of long options is too costly to be overcome by the long gamma and therefore it is better to sell options and take the other side of the equation.

In this simplest form it ignores volatility and presupposes that one should 'always' be either a seller or a buyer.

Professionals rightly point out that if options are correctly priced, there is no long term advantage in either buying or selling options. In my experience as a retail trader of some length of time, I am quite prepared to accept that as broadly true.

However, most retail traders, seem to fall on the side of selling options, or rather being nett short premium and short gamma at inception at least. Certainly a short gamma strategy where the short strike(s) are somewhat out of the money will have a higher than 50% win rate, which makes it 'feel' like it's a better way to go. However the win rate is irrelevant if the relatively fewer but higher losses, outweigh the more numerous but smaller wins.

Sometimes it can take neophyte option traders some time and a bend at the end of the trend to realize this.

Perhaps the most absurd reason I have seen is the claim that "80% of all options expire worthless", so it is much better to sell than to buy. Apart from this being at worst complete bollocks and at best a misrepresentation, it is irrelevant as discussed above. The actual figures I will detail in another post, but let's put our thinking caps on here.

Supposing XYZ is trading at $50 and I sell a $40 put, is there an 80% chance of the put expiring worthless? That's entirely possible, but what if I sold the call instead? Is there also an 80% chance of the call expiring worthless?

 Of course not.

What if I sell the ATM $50 put or call? There would be about a 50% chance wouldn't there? I could belabour this point further, but you get the point that chance of expiring worthless is dependent on several factors.

The question of whether to be a buyer or seller, if the question is couched in terms of always being a buyer or a seller, is the wrong question in my view. It is often asked because neophytes fall in love with a particular strategy and try to impose it onto every market condition. An example of this are the traders that have been sold a course on bull put spreads or covered calls and try to trade that strategy at all times. Real life invariably teaches these people that these strategies, though perfectly good strategies when appropriate, do not fit every market condition.

The question I want to ask is - What is the best strategy right now, at this point in time, for this particular market?

Before that can be answered, one must have a view of direction, volatility and the possible magnitude of changes in these. An understanding of how it might be if it blows up in your face is also essential.

Therefore the answer to the question posed is - it depends.

Saturday, March 24, 2012

NOV Adustment

Just an adjustment I recorded on the covered call project; last Thursday with NOV trading at $78.93, I bought back the April 85 call for $0.61 and wrote the April 80 call for $2.21.

Monday, March 19, 2012

A Look At Covered Calls - Cycle 3 Round Up

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.


We are starting to get some interesting results from the covered call project as not all of the stocks are continuing to go vertical.

I've slightly changed the format of the spreadsheet and added a chart; Last week my hard disk started splitting atoms and nuked itself, so decided to reconstruct them this way. It should give a better longer term view as we go along.

Goldman Sachs is the one stock from the three continuing to rocket northward so the story here is a repeat of the last two cycles. That is, the covered call is making money, but less than if we just held the stock, the short call losing on intrinsic value.

Last Friday at $122.19 GS was well in the money so to avoid assignment I bought back the call at the ask for $7.16 and wrote the April $125 call for $3.05

We're 18% up, but with 14% cash losses on the short calls we'd be grimacing if we had a non margin account. Yes we've made 6% per month which seems to validate the seminar cretins on the face of it, but deeper analysis reveals a different picture.

When a stock is on a strong uptrend, the covered call effectively halves (give or take) returns and gobbles up spare cash.

From FCX we get a totally different picture this cycle. The stock has retraced much of the gain seen in the first cycle. We made some nice cash from the calls. After rolling the nearly worthless Mar 44 down to the 40 and the forty expiring worthless, we made nearly six and a half percent. But the cash gains over the last two cycles have only paid for the losses on the first cycle and we've lost money on the stock. Overall the covered call strategy is level pegging with buy and hold at just over four percent. I wrote the April $40 call for $1.20.

Still no nett cash in hand profit after three cycles.

The covered call strategy has reduced volatility but still no cash in hand.

NOV has been in the sweet spot for this cycle as far as the covered call strategy is concerned, i.e. write the call, stock goes sideways, call expires worthless, pocket the premium and have a festive dinner with family and friends... seminar cretin nirvana with four percent cash in hand return this cycle. This is the situation the covered call is best for long term holders of stock.

If only you could predict that. But if you could predict that accurately, bugger the covered call, you'd cash up the stock, mortgage the house, the business, sell your first born male child and plonk on as many short strangles as they'd let you have and retire rich

Additionally, if I was trying to flog a bullshit course on covered calls, I would cherry pick this months results as an 'example' of how to get rich with covered calls.

Over the three cycles thus far the picture of course is different, still down eleven odd percent on the cash position and still behind on buy and hold, even though we are up nineteen percent overall.

We will need a few more sideways months to make this look good. I wrote the April $85 call for $1.71.

Overall a pretty good month for the project as readers can see what happens when the stock is not going straight up.

Wednesday, March 7, 2012

Day Trading Options - Contest Risk

This is a follow on from the previous post Options and Day Trading.

Firstly, let me define what I mean by contest risk, as it is not a term that is generally used in retail trader land. It is simple the cost of playing the game, in other words, the cost of commission plus the bid/ask spread.

It can be simply quantified by asking the question - what would be my loss if I entered and exited straight away and there was no movement in the underlying. So if the bid/ask spread on a stock was two cents you would lose that two cents in the trade, plus commission. If commission is one cent a share, the total contest risk is four cents a share, or $4.00 per hundred shares traded.

In the aforementioned interchange with my profane friend, he cherry picked a profitable trade where he purportedly made a $3,000 odd profit. Nice when looked at in isolation. But lets dig a bit further:

He told us he traded 27 x 1000 share contracts (the contract size in Australia at the time) = 27,000 shares of underlying, with a delta of approx 0.5 giving a total number of 13,500 deltas.

 The bid ask spread is typically about 5 - 8 cents... lets say 5 cents to be generous. That is 27,000 x $0.05 = $1,350 This means that if the share did not move and he exited, it would have resulted in a $1,350 loss PLUS commission.

It also means that the underlying has to move > 10 cents just to break even (remember our 0.5 delta) That's a massive impost to overcome in a daytrading system. Now compare that to Shares or CFDs, where to gain the same 13500 deltas, we only need 13500 shares with a spread of typically 1 cent.

That's $135 plus commission contest risk. In this instance the options are 10 TIMES more expensive to trade in terms of contest risk. Daytrading sytems, if positively expectant, are not greatly so, because you never get huge outliers. They rely on trade frequency to make money.

Maybe Bill is a good enough trader to overcome 10x contest risk, maybe not, but are the people he teaches?

I know I'm not a good enough day trader to overcome that sort of contest risk over the long term and I would bet London to a brick and Mombasa to a melon that very very few retail traders can overcome this either.

I have had the gamma argument thrown at me which if it moves enough can help, but countering this is theta, which depending on time til expiry and time of day can work against you. Over the great bulk of trades, it's line ball on those arguments in my opinion.

An important point is that our friend operates on the Australian stock exchange where there is much less liquidity and wider spreads than most US tickers. On the American exchanges there are options with much skinnier bid/ask spreads and if feels they must day trade options, that's where I would be looking...

...but for me, I'll just trade the underlying when I'm day trading.

Monday, March 5, 2012

Day Trading and Options

I am a fan of Day Trading. At various times in my trading career I have day traded as my primary means of income... paying for the groceries, the mortgage and the lease on the Por..... errr, I mean the Toyota.

To quote Ernie Chan from his 'QuantitativeTrading' blog:
Which brings me to day-trading. In the popular press, day-trading has been given a bad-name. Everyone seems to think that those people who sit in sordid offices buying and selling stocks every minute and never holding over-night positions are no better than gamblers. And we all know how gamblers end up, right? Let me tell you a little secret: in my years working for hedge funds and prop-trading groups in investment banks, I have seen all kinds of trading strategies. In 100% of the cases, traders who have achieved spectacularly high Sharpe ratio (like 6 or higher), with minimal drawdown, are day-traders.
I'm also a fan of options for a number of reasons; they are my vehicle of choice for trading and augmenting my long term stock holdings.

So what about combining day trading and options? Buying puts and calls in place of stocks or CFDs?

Ummmmm..... no.

I had and interesting exchange with a cretin from Australia by the name of Bill Stacy, who sells a course to ostensibly noooobie traders purportedly training them to earn "a few grand a week" day trading options on the Australian Stock Exchange with a $20,000 bank.

Questioned about the size of delta and contest risk with what he was teaching, the conversation deteriorated into one of those comedic threads you find on internet fora with name calling and the whole shebang. Well, it was amusing until Bill hightailed it off into the sunset.

So over the next few posts I want to have a look at day trading options, whether it's a good idea or not.

A Look At Covered Calls March 5 Update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).


A couple of our sold calls have very little extrinsic value left after some downward movement in the stocks, so time to roll down and pick up some more extrinsic.

With FCX trading at 40.01, I bought back the March 44 calls for 15c and sold the March 40 calls for $1.20.

With NOV trading at $79.52, I bought back the March 85 calls for 27c and sold the March 80 for $1.52.

No action on GS.

A Look At Covered Calls - Feb Cycle Catchup

Geez I've been bloody slack at updating this blog. With my business plus looking at properties I've been as busy as a one armed taxi driver with crabs and writing bullshit in the Interwebs has taken a back seat.

Anyways time to catch up on how my covered call project is doing so I'm harking back to February expiry here to detail the trades I recorded at that time. Firstly my normal lead in:

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

GS First

The Friday before expiry GS was trading above our 115 strike so with GS at 115.49 I closed out the 115 call so there was no risk of assignment. I am making the assumption that these are long term holdings and that we don't want assignment, which will precipitate a capital gains tax event. I paid 91c on the ask and lo! We actually made some cash profit on the call.

So with GS our CC strategy has under-performed in the first two cycles by greater than 10% which is to be expected as the stock was still basically on a rip. It was the sideways movement after the last roll where we ended getting some cash from the short put.

I wrote the March 115 for $3.95


This one expired slightly out of the money with the stock at $44.09, pay dirt as far as income from short calls is concerned and with no rolls during the cycle, pretty simple, we got a buck fifty two and put it straight in the bank.

By virtue of the underlying going sideways all month, ending a buck or so down and getting reasonable premium for the call, the FCX CC strategy has done quite well this month, trimming back about half of the under-performance against just holding stock. Which of course means the CC has outperformed this month. This shows the best use of covered calls in a portfolio, when the stock is going sideways.

If only we knew that in advance.... :-P

I wrote the March 44 for $1.31


For some reason I can't remember, I closed this one out on the Thursday before expiry with the stock in the money at $84.07, the loss of intrinsic value eating up the gain from extrinsic value, plus a bit; thus taking yet another loss on the short calls. Our under-performance on NOV has been worst of all with the stock increasing at a strong clip over the two months I've been doing this simulation at -15%

We're still 15.4% up, but just holding stock we would have been up 30%. Worse still, if we are not operating on a margin account, we would have received no income from this and in fact would have taken away from our cash position. 

The seminar cretins didn't tell you that did they.

I wrote the March 85 for $2.57

Sunday, February 5, 2012

A Look At Covered Calls - Groundhog Day

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).


Groundhog Day - Well that's what it seems like, closing out short calls pre-expiry for a loss and rolling up to gather up a little more extrinsic value. The adjustments are increasing our profit from the covered call strategy, but not enough to keep pace with the rise in the stock.

Essentially we are taking it where the sun don't shine on the intrinsic value of the short options as our stocks relentlessly rise.

I didn't have time to update live again, but on Friday I recorded a couple of adjustments.

GS continues to rise in essentially a straight line since inception of the strategy, so once again to tweak the collection of extrinsic vale, I rolled from the Feb $110 calls to the Feb $115. Once again, we lose on the intrinsic value, but collect the bulk of extrinsic ahead of time and writing closer to the money for some more extrinsic.

Here's the state of play:

NOV presented the same opportunity so we rolled from the Feb $75 to the Feb $82.5

No action necessary on FCX

Saturday, January 28, 2012

A Look At Covered Calls - GS On A Tear

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).


I have another adjustment for GS placed on the Friday 27th. Essentially Goldman is on a tear and rocketed up the the next strike,trading at . This means we can pick up some more extrinsic at $111.81.

The 105 call we wrote at $4.45 I bought back for $7.85 once again taking a hit on intrinsic value of the option, even though we've made some on the extrinsic. Chalk up another situation where we would have been better off with just the stock (so far).

I've noshed up a spreadsheet to keep track:

No action on NOV or FCX

Saturday, January 21, 2012

A Look At Covered Calls - The End Of The First Cycle

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).


I've been very busy with my non-trading business and haven't had the time to post here as I would have liked, but I did record some adjustments in the intervening time.

But anyway, we've now come to the end of the first cycle of this project and good news, we've made a profit. I'll get to the bad news later.


FCX continued to surge higher and with the shares at around $42 I rolled the Jan39, taking a loss of $2.63, out to Jan42 and collecting $1.40 in premium. On Jan 11 we also got a $0.25 dividend which we must add to the results.

Last Thursday I closed out the January calls (as I wasn't going to be around Friday and do not want to be assigned) for $2.30, taking another loss on the short calls of 90c. Underlying was trading at $44.51.

Overall on our FCX covered call strategy we've made ~10.5%, an awesome result until we look a bit deeper.

  • Had we have just held the shares, we would be 19.9% up! So the covered call strategy has cost us 9.4% at this point in time.
  • We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
  • We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

GS continued to surge higher and with the shares at around $100 I rolled the Jan95, taking a loss of $2.97, out to Jan100 and collecting $2.73 in premium. 

Last Thursday I closed out the January calls for $6.25, taking another loss on the short calls of $3.52. Underlying was trading at $106.55

Overall on our GS covered call strategy we've made ~8.9%, another awesome result until again we look a bit deeper.

  • Had we have just held the shares, we would be 15.2% up! So the covered call strategy has cost us 6.3% at this point in time.
  • We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
  • We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

Last Thursday I closed out the January calls for $5.50, taking a loss on the short calls of $3.14. Underlying was trading at $75.36

Overall on our NOV covered call strategy we've made ~8.2%, yet another awesome result until once again we look a bit deeper.

Same situation as the other two:

  • Had we have just held the shares, we would be 16.9% up! So the covered call strategy has cost us 8.7% at this point in time.
  • We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
  • We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.
These are the Feb calls I wrote for the next cycle:
  • FCX Feb12 45 call for $1.52
  • GS Feb12 105 call for $4.45
  • NOV Feb12 75 call for $3.25
Still early days, but what we can glean from this first cycle is that covered calls cost you potential profits in strong uptrends and though still profitable, do not give you any cash income. You could just let the options expire in the money and be assigned in which case you would realize the extrinsic value of the options, but you would only realize cash from the stock to the value of the strike price.

Any way you look at it, the covered calls have cost us money so far.

Monday, January 9, 2012

We're Not All About Covered Calls

By the way, for those who have followed me over from my previous blog and any new readers that have found me, it might seem we're all about covered calls here. We're not.

There's lots more stuff to come.

A Look At Covered Calls - Jan 9 update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).


FCX has been lingering around the $39 mark for a few days now. The Jan $37 calls have about 30c of extrinsic, whereas the ATM $39 Jan calls have around $1.00 of extrinsic.

The question is whether to pick up another 70c of extrinsic while losing the $2.00 of intrinsic hedge we have at the moment. I say stuff it, let's do it, we're all about premium collection here and damn the downside risk. :-P

I'm buying back the $37 calls at the offer of $2.52, a loss of 20c, and selling the Jan $39 for $1.17 with FCX trading at $39.21. So we're $1.89 to the good with the covered calls while just holding the stock would have us $2.09 in profit at this stage.

No action on NOV and GS.

Sunday, January 8, 2012

Covered Call Are Naked Puts - The Proof

In my previous post I made the assertion that a covered call IS a naked put, synthetically. In this post I'll prove that with an example.

Firstly, it is important to know that every call option has a relationship with it's corresponding (same strike and expiry) put option as proven by and equation called the put/call parity equation. For your information, this equation goes like this: call price - corresponding put price = stock price - strike price + interest - dividend (if any).

It is not merely theoretical and we know this exists in the real traded market, because any anomalies in this relationship would be closed by arbitrageurs quicker than you can say 'Jack Robinson'. If for example call prices were too expensive compared to the corresponding put, arbitrageurs would sell the call, buy the put and buy the stock in equal proportions in a position called a conversion. This would guarantee a risk free profit. In reality, this is not achievable by a retail trader, so we can trust that option prices are in line with each other.

But I digress...

Let's suppose on Dec 15 2001 Tom the Trader wanted to collect some premium and had the view that GS would stay roughly where it is at around $92.50 or trickle up a bit until mid January 2012, so he sells 3 $90 Jan put contracts at $4.10, a face value of $27,000 (the amount Tom would have to cough up for the shares if assigned) and collecting $1230 in premium... a 'dangerous' naked put position.

If GS is above $90 as the January expiry date, Tom keeps his $1230 and pockets a tidy > 4% on the face value of the contracts (or > 12% on initial margin if you prefer looking at things that way {I don't}).

But what of the risk? What if Goldman has finally been caught out with one of its dirty deeds and the price collapses down to $70.00 by expiry? Well Tom could always cut his losses and exit before expiry, just like any trader can, but let's suppose Tom is a deer in the headlights and freezes?

Well Tom will most certainly be assigned the stock and will have paid face value for the stock, less the premium collected; a total of $25,770 for stock now worth $21,000. A loss of $4,770.

Ouch! Risky!

On the same day in Dec Tony the Trader thought it would be a great idea to do a covered call on GS, so buys 300 stock at $92.48 and sells 3 calls at $6.65. He pays $27,774 for the stock and collects $1,995 in call premium, bringing the cost base down to 25,779. Notice anything about similar about the put scenario yet?

If the stock closes anywhere at $90 or above at expiry, Tony will most certainly be assigned and will be paid $90 for the shares, collecting $27,000 ( a loss of $774) but will keep the $1995 call premium. This is an overall profit of $1,221.

But once again, what are the risks? Using our $70 at expiry scenario as we did with Tom's naked puts, Tony would be left holding stock now worth $21,000. He's lost $6,774 on the shares, but keeps the $1,995 call premium; an overall loss of  $4,779

Ouch! Risky also!

In each scenario the profit or loss of both traders is only $9 different to each other and this is accounted for by the interest accounted for in the option pricing model.

Pick any number at expiry and the profit or loss of these two scenarios will always be only $9 apart. Once interest for holding stock is accounted for, the result is the same. Because they are the same.

A covered call IS a (synthetic) naked put.

Thursday, January 5, 2012

Covered Calls - The Naked Truth

Seeing as I have kicked off this blog by following a hypothetical portfolio of covered calls, I thought I'd have a bit of fun with a thought exercise. This is something every option professional knows, but many option noobies have a bit of trouble with.

We all know what a covered call is, long the stock and short calls in equal proportion. For example, if we Own or buy 100 of XYZ stock, we write 1 call contract.

Covered calls are variously promoted as a conservative option strategy, almost risk-less, easy monthly income and a host of other soothing adjectives and superlatives.

On the other hand, naked short puts are often castigated as being highly risky, having unlimited risk, dangerous, gambling and perhaps even having the potential to give you heart disease and herpes.

The overarching message is covered calls - good, naked puts - bad. Most covered call traders are quite comfortable with the strategy... initially at least. These same traders probably reach for their crucifix and don a string of garlic immediately naked puts are mentioned.

Unless you are au fait with option synthetics, you might be wondering why I'm talking about this.

It's because a covered call IS a naked put. Or more accurately, a covered call is a synthetic naked put. They have the same risks, same reward, same payoff diagram. If you are trading covered calls, you are ipso facto trading naked puts.

The only caveat to that is that the the strikes and expiry must be corresponding. So if you have a covered call with a $95 strike and March 2012 expiry, you in fact have a naked short march 2012 $95 put.

Need proof? I'll go through the maths in a later post.

Wednesday, January 4, 2012

A Look At Covered Calls Jan 4 2012 Update

So here we are on Jan 5 on our first covered call cycle, with a couple of weeks to expiry. I'm updating today because a couple of these positions now have very little extrinsic value left and could be rolled up to pick up a bit more extrinsic.

As to the P/L situation, I took the snapshot of the market a little earlier and this is how we stand:


The stock is trading at 95.51, up 2.2% since inception last month

I rolled the option and got $5.95, a profit of $0.70 a further 0.75%, combined profit  of 2.95% so far. So for GS we are at this stage just a little bit further ahead with the covered call strategy.

I've gone and written the Jan12 95 call for $2.93


The stock is trading at 39.75, up 7.1% since inception last month

However our Jan12 37 call is $3.35 at the offer, an open loss of  $1.03 (not worth rolling this one) and 2.8%. For the strategy we are up $4.3%

Yes, around that magic 4% profit mark at the moment, but lo! We would be better off just holding the stock at the point.


The stock is trading at 70.49, up 9.4% since inception last month

I rolled the option and got $5.90, a loss of $2.45 which is 3.8%, combined profit  of 5.6% so far. So for NOV we are at this stage behind with the covered call strategy, even though on the face of it we are above the 4% per month thing

I've gone and written the Jan12 70 call for $2.36

I stress that at only a couple of weeks into this, these results are fairly meaningless and only worthy of reporting because of the adjustments. As we get a few months into this, it will get a lot more interesting.