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