Why people trade options
Sep. 18th, 2024 03:37 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
ny_quantНачало здесь и тут.
There are two major reasons but the subject of these mini-series is neither.
1. To benefit from correct predictions of the future via speculation and leverage
Let’s assume that I have developed a point of view that stock XYZ will more likely go up to $120 from the current $100 within the next year than down. I could decide to invest all my $10,000 in buying 100 shares of XYZ with the plan to sell if the price hits $120, my target price, or $90 where I will cut the losses. With this plan in mind, I stand to gain up to 20% or lose up to 10%. If my view on probability distribution is correct then the former is more likely than the latter so I can expect (I mean statistical expectation) to make some money. But both upside and downside are rather modest.
BTW. In trading, YOU MUST ALWAYS THINK ABOUT PROBABILITY DISTRIBUTION. In other words, you should always think about what can go wrong.
Alternatively, I can return to example 1 from earlier and buy an option with the strike $105 and maturity 1 year. By doing so I am expressing a very strong view that XYZ will trade above $105 plus the premium that I will have to pay to the seller with higher probability than it won’t. If XYZ is another proxy for S&P 500 then such an option could cost about $5, so my capital buys 20 contracts (100 shares each). If I am wrong and XYZ never trades above $105 then, alas, I lost all 100% of my capital.
But if it actually hits $120 let’s e.g. 3 months before maturity, I can follow the plan and sell the option. I could exercise my options and realize a $15 profit for each (120-105), so my total will be $30,000 = 2000*15. Hallelujah! I just tripled my money! However, exercising a call option before maturity is rarely a good idea. It is better to sell it b/c the market price will be above the exercise profit $15. Why? Because there is 3 months of life left in the option and the stock could continue going up, so the market price in this case would be around $17.5, so my capital after I sell sell options will be $35,000 so I made 250% profit on the trade!
Thus, my range of outcomes is [-100%,+250%] if I trade OTM call options vs [-10%,+20%] if I trade stocks. That’s called leverage. Potential of making 250% on a trade is very exciting, of course, but you should focus on the possibility to lose everything. This style of trading is not much different than playing roulette in a casino. DON’T GAMBLE.
2. To protect from unfavorable future market moves, aka hedging.
Let’s say I already own 100 shares of NVDA and I am really afraid that it could lose up to half the value within a year. I could live with the 10% loss but not more. I could buy a put struck 10% below the current price, about 100 at current prices. This will cost me about 10% of my capital if maturity is a year. Thus, I won’t lose more than 20% even if NVDA goes bankrupt and crashes to zero. In other words, by buying this put I chopped off left tail of the probability distribution. This is very similar to buying insurance on your real property. This is a legit use of options but it’s very expensive. (You usually overpay for options, especially puts. No, it’s not the reason to start selling them.) Therefore, I don’t recommend it. If you think that probability that price will go down is uncomfortably large, just sell it.
With this, I think I am done with preliminaries.
Update. I thank![[livejournal.com profile]](https://www.dreamwidth.org/img/external/lj-userinfo.gif)
mi_b for pointing to the error in the original text.
There are two major reasons but the subject of these mini-series is neither.
1. To benefit from correct predictions of the future via speculation and leverage
Let’s assume that I have developed a point of view that stock XYZ will more likely go up to $120 from the current $100 within the next year than down. I could decide to invest all my $10,000 in buying 100 shares of XYZ with the plan to sell if the price hits $120, my target price, or $90 where I will cut the losses. With this plan in mind, I stand to gain up to 20% or lose up to 10%. If my view on probability distribution is correct then the former is more likely than the latter so I can expect (I mean statistical expectation) to make some money. But both upside and downside are rather modest.
BTW. In trading, YOU MUST ALWAYS THINK ABOUT PROBABILITY DISTRIBUTION. In other words, you should always think about what can go wrong.
Alternatively, I can return to example 1 from earlier and buy an option with the strike $105 and maturity 1 year. By doing so I am expressing a very strong view that XYZ will trade above $105 plus the premium that I will have to pay to the seller with higher probability than it won’t. If XYZ is another proxy for S&P 500 then such an option could cost about $5, so my capital buys 20 contracts (100 shares each). If I am wrong and XYZ never trades above $105 then, alas, I lost all 100% of my capital.
But if it actually hits $120 let’s e.g. 3 months before maturity, I can follow the plan and sell the option. I could exercise my options and realize a $15 profit for each (120-105), so my total will be $30,000 = 2000*15. Hallelujah! I just tripled my money! However, exercising a call option before maturity is rarely a good idea. It is better to sell it b/c the market price will be above the exercise profit $15. Why? Because there is 3 months of life left in the option and the stock could continue going up, so the market price in this case would be around $17.5, so my capital after I sell sell options will be $35,000 so I made 250% profit on the trade!
Thus, my range of outcomes is [-100%,+250%] if I trade OTM call options vs [-10%,+20%] if I trade stocks. That’s called leverage. Potential of making 250% on a trade is very exciting, of course, but you should focus on the possibility to lose everything. This style of trading is not much different than playing roulette in a casino. DON’T GAMBLE.
2. To protect from unfavorable future market moves, aka hedging.
Let’s say I already own 100 shares of NVDA and I am really afraid that it could lose up to half the value within a year. I could live with the 10% loss but not more. I could buy a put struck 10% below the current price, about 100 at current prices. This will cost me about 10% of my capital if maturity is a year. Thus, I won’t lose more than 20% even if NVDA goes bankrupt and crashes to zero. In other words, by buying this put I chopped off left tail of the probability distribution. This is very similar to buying insurance on your real property. This is a legit use of options but it’s very expensive. (You usually overpay for options, especially puts. No, it’s not the reason to start selling them.) Therefore, I don’t recommend it. If you think that probability that price will go down is uncomfortably large, just sell it.
With this, I think I am done with preliminaries.
Update. I thank
mi_b for pointing to the error in the original text.
![[identity profile]](https://www.dreamwidth.org/img/silk/identity/openid.png){kind=small}
no subject
Date: 2024-09-19 03:26 pm (UTC)long stock is part of your protective put strategy, of course. I guess, that is my bold statement — "one have to think in terms of overall portfolio"
I know, people recommend covered calls, protective puts, vertical spreads instead of. in some cases, virtually equivalent option writing. but that's, first, not justified — retail used "unlimited risk" thing, they do own stocks and short-sell stocks. there is nothing special for retail having tail risk.
second — for pretty much 90% of stocks/etfs, synthetic positions (e.g. anything with two legs — vertical spreads) mean that one has to cross bid-ask spread 4 times. *that* is something that is really expensive, and I have point of reference here.
but from my point, most important that guys who trade covered calls really think they know what they are doing and they are *conservative* (while in reality they are *not*).
no subject
Date: 2024-09-19 09:51 pm (UTC)Finally, we can agree on something.
Owning stocks -> limited risks which is not always the same as small but, for a reasonable portfolio, closer to 20% than to 50% over say 1 year horizon. Short-selling -> unlimited risk, a different kind of tail. Those who engage it deserve their fate.
There is nothing synthetic in vertical spreads and, of course, if you have 2 legs, you have to cross spreads at most twice. For liquid underlyings (SPY), it is actually less than that: I am often able to execute at the mid. And spreads for liquid underlyings are very narrow, sometimes a couple of cents only and in all cases a very small %age of mid.
Define conservative. For me, it is reducing the dispersion of the expected returns. So, writing the calls against existing long stock position is conservative. Even if you find a counter-example (I can't think of any), typically it still is.
no subject
Date: 2024-09-19 10:07 pm (UTC)how do you exit your vertical spreads? you box them? you sell them before expiration?, or you have cool Monday after-expiration-morning?
For me, it is reducing the dispersion of the expected returns. So, writing the calls against existing long stock position is conservative. Even if you find a counter-example (I can't think of any), typically it still is.
so, selling your existing stock, and writing naked put instead is even more conservative ? ok, buy also 5c otm put, and call it "spread".
no subject
Date: 2024-09-19 11:56 pm (UTC)Even more conservative would be selling all your stocks and investing in Treasuries. But conservatism is not the only thing I am after.
So what is your definition?
no subject
Date: 2024-09-21 01:34 am (UTC)> So what is your definition?
sort of a scale, where "conservative" is almost totally linear position (with deep in the money option positions) on index funds, and then with growth of bid-ask spread, legs, complexity of managing (ways to build/exit/babysit your position), larger gamma and vega, and how your trade depends on that.
like, if one tries as retail investor to do delta-hedging, it is close to insanity, from my point of view.
also, if I have to think in terms of returns distribution for my trade — that's "not conservative" for me, I am retail, I am not very at that. but spreads on SPX is more or less ok for me, and more conservative than atm call on NVDA.
spreads on NVDA — no, no. I think it is a way to sponsor options market making desks. I suck, and loose money at bid-ask spread, time slippage to buy second leg, and exiting (do that in reverse). I tried boxing — it feels very odd, and annoying.
FOMO trades also (like otm calls for that NVDA, in case it is suddenly goes up a lot) are fine, but I treat them as a casino, with very small capital invested in any time).
no subject
Date: 2024-09-21 04:38 pm (UTC)So, 25% ITM call with e.g. 1 year maturity is a conservative position for you? OK then ...
> time slippage to buy second leg
There is no time slippage. Both legs are executed as a single structure at the same time. You can custom-build any multi-legged structure and execute all legs simultaneously. Some are pre-set for the users, like iron butterfly.
no subject
Date: 2024-09-21 10:16 pm (UTC)yep. nothing wrong with it. e.g. 4 BOXX + 400 SPY call ($184) SPY is 568 now
i would assume 4 BOXX would return $20, and SPY would pay $14 dividends, so the whole thing costs like 60-70bps, and I would do PMCC on it, recovering most of that.
opposite to whatever amount of SPY iron condors and butterflies you could buy on that whole amount, and for some reason consider "conservative".
There is no time slippage. Both legs are executed as a single structure at the same time. You can custom-build any multi-legged structure and execute all legs simultaneously. Some are pre-set for the users, like iron butterfly.
I told you like 5 times already. this relatively works for ~20-30 names (SPY, QQQ, bunch of other etfs, and few stocks). for others — e.g https://www.barchart.com/etfs-funds/quotes/XRT/options?expiration=2024-11-15-m (https://www.barchart.com/etfs-funds/quotes/XRT/options?expiration=2024-11-15-m) , atm call is bid 0.79 and ask 5.45, if you'd use your fidelity strategy "simultaneous" thing — you are %$ed from start, being deep in red pnl.
I suspect that your "conservative" also implies that you, probably, have something like 1mln long equity portfolio, and trade options with max +-pnl of 1% of that total portfolio, right? You don't invest 30% of your capital entirely in SPX straddles, right?
no subject
Date: 2024-09-22 12:07 am (UTC)> I told you like 5 times already.
I don't recall but it doesn't matter. You can repeat it 10,000 times and it's not going change the facts. There is no time slippage on the spread trade. This is the same for very liquid names and illiquid just the same. The width of bid-ask spread is a separate issue. Crossing the wide bid-ask spread for illiquid names is a dumb idea, whether it's a naked option or a spread or whatever.
Wrong, but it doesn't matter.
no subject
Date: 2024-09-22 12:34 am (UTC)> ОК, it's your money. If/when SPY drops by 30% you'll find out what's wrong with that.
i am not sure you are reading whatever i commenting here, with multiple legs position management, and with "futures" margin requirements, that have nothing to do with futures.
I am ok, if you don't want to engage the point, let's stop and agree to disagree.