Growing pains

I'm new to this forum and a novice options trader. I can contribute by documenting my painful series of mistakes as I bungle and fumble while learning to walk. This is stale news to the old pros here, but should be helpful to over eager novices like myself.

BUNGLE 1 - Over Scalping Gamma Scalping
I read about gamma scalping and it sounded too easy. Instead of doing paper trades, I like to put real money on the table as I'm too eager. You can google pages that describe gamma scalping. However, they don't tell the whole story unless you have a good options trading book and you bothered reading it. In hindsight, after reading Cottle, I now understand my cardinal sin.

The scenario is as follows. You have a straddle that is slightly profitable when the price has risen slightly ie. you have generated some delta. The idea is that you can short some underlying such that you become delta neutral again. Sounds easy, I thought. I then worked out how many deltas I had generated and sold the equivalent number of stocks to be delta neutral. So far, so good.

The price started going up. I tried to liquidate my entire position as I could have exited profitably. But the market maker (MM) from hell refused to bite. His best offer was going to take a huge chunk of my profit. "To hell with the MM. I'll just scalp more gammas", I foolishly thought. So, I shorted even more underlyings.

This went on for 3 days. Suddenly, the underlying price exploded even higher. My calls were going for parity. I thought I surely can get out now as the MM can't screw me any further. I was letting my calls go for zero extrinsic value. To my horror, I could not close my position with a decent profit at all. "Where's all the gamma scalping theory gone to?", as the thought raced through my mind and I panicked.

I'm stuck. I can't exit with a decent profit. Why?

My options bible (which arrived after I got myself in this mess) provided the enlightenment. When you short your underlying, you are effectively reducing your calls and increasing your puts. If you keep scalping more gammas as the price goes up, you will end up being the equivalent of having less and less calls and more and more puts in your straddle. Pictorially, imagine your straddle tilting to the right. The saturation point is when your equivalent position is zero calls and all puts. You have converted your straddle into pure OTM puts. Worthless puts !!!!!

That's what happened to yours truly. From a 5 put/5 call straddle, I ended up with the equivalent of 9.5 put/0.5 call straddle.

Novice lessons learnt:
1. Gamma scalping is more that just shorting shares when price goes up. There is a limit and you should be aware of that limit ie. don't scalp till kingdom come.
2. Understand what synthetic equivalence means. I mean, really, really understand it. It is vital to understand that your straddle has morphed into a pure OTM put.
3. Gamma scalping should be used to reduce/compensate for your rotting theta. It should not be used to make money.
4. MMs should be hung up to dry and have their testicles fed to flesh eating monkeys .

It hurt. It really hurt. It still hurts. I walked away with crumbs when I could have had the whole cake. But it was worth it. I learnt more than any $3000 course could have told me. It only cost me my pride and my cake.

Next episode: Why I gamma scalped in the first place.

I have since learnt that gamma scalping should be mainly used for compensating your losses due to time decay, and not for generating profits. Of course I did not know that then. Despite that, I really stumbled into this strategy not by intention but as a consequence of another problem.

BUNGLE 2 - Not all option markets are liquid
When reading books about options, you do not question certain assumptions. I had this naive notion that the market will always be there. I have read that market makers (MM) are there to be the buyer when you want to sell, and be the seller when you want to buy. In exchange, they will quote you a low bid price and high ask price, much like a money changer. I also believed that there was some sort of market regulator that will ensure that the MM will always take your trade. In other words, I can buy or sell whenever I wish.

My straddle from hell taught me that this is not always true. My original intention was to profit from a very imminent rights issue of XYZ. You could smell the greed in the air. I wanted a piece of the action too. I decided to buy an OTM bull call to take advantage of the expected price surge as punters stampeded over each other to get in before trading halt.

I put an order in for my bull call spread at the start of day. I offered to pay quite a bit above fair value because MMs had to eat. I watched the price surge before my eyes in the first hour of trading. To my disappointment, there was no MM to take my trade. I watched my potential bull call spread triple in value in an hour, as it slipped further and further away from my reach.

I decided then to abandon the bull call and initiate a straddle instead. Both the put and call were ATM and therefore liquidity should not be an issue. I was correct as the straddle was sold to me just slightly above the mid price. The next day, a trading halt was announced. XYZ announced a rights issue. Bingo! I had a punt each way with my straddle. So I thought I had a good chance to exit the straddle profitably.

After trading halt was lifted a few days later, the options market for XYZ appeared dead, like the last 1/2 hour of trading after the underlying has stopped trading. There were not continuous quotes from the MM. I was not alarmed because I knew that the ASX was adjusting the contract size and strike price to reflect the adjusted value of the underlying due to the rights issue. I assumed that the MM will not act until the adjustments were made.

The underlying price surged after trading halt. I know that my straddle was profitable but did not know the exact amount because the adjust strike and contract price were still unknown. I waited patiently for the ASX announcement of the adjusted option strikes.

On the morning after the options adjustments were made known, I quickly put in a sell order to liquidate my straddle which was fat with profits. To my horror, the MM was not quoting/trading. Not just my trade, but everybody else's trade. The MM was not quoting or trading until about 11.30am. I had thought that MMs had some sort of obligation to buy and sell during market hours. But I have since found that this MM in particular, starts his trading day at random.

This time, I watched by profits dwindle to zero between 10 am to 11 am. Where was the MM when I needed him? Did he have a late night out? Was he dropping his precious darlings off to school? Was he in the toilet farewelling last night's beef vindaloo? I can only speculate. But my losses were real .

By the time he started quoting again, it was 11.30am and I lost my profits a second time. That was why I resorted to gamma scalping as a consolation prize. As stated in my previous post, it went pear shaped very quickly.

Novice lessons learnt:
1. There is no guarantee that the MM will be there when the market opens.
2. Corporate actions sometime result in the options market being in limbo.
3. If you must trade ETOs, pick the most liquid one.
4. I now understand why the pros here prefer to trade index options.
5. Bottom line is that you have no control over market hours and liquidity. You are at the mercy of the MM.

Well done Fox, you are on the right track.

Re liquidity: Aussie options are notoriously illiquid and the MMs notoriously reticent to play fair. If you can stand the night shift, check out US options. Astonishingly, American MMs are far more eager to deal with you, for a number of reasons.

Re gamma scalping: This can be used for profit with some changes in philosophy and technique, but the setup must be "right". Perhaps I'll start a thread on this one day. But trading gamma on the Oz market? As you have learned - fuggedit.

Welcome to the derivatives forum, you have obviously put some time into learning.

Cheers

Hi Fox,

Thanks for sharing,

Yeah i've been squeezed by MQG series a few times, the dumbest was a fat finger error buy to open instead of a sell to open, i didn't reverse the trade because i didn't want to pay up and now i'm left with some lottery tickets.

XJO options are definitely the go if you plan to stick to the aussie market, the only oddity is the deep ITM's sometimes tend to trade below parity due to the fact there's no tradable underlying instrument but to me it's not really a big deal, sometimes it's worked to my advantage (i've only noticed this on front months).

You may have already figured it out but if you're long a WTFITM call, shorting the underlying (if possible) and exercising could be a more attractive method of closing the position.

wayneL said:

Well done Fox, you are on the right track.

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Coming from the master morpher himself, that means a lot to me. Thank you.

wayneL said:

If you can stand the night shift, check out US options.

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Like most before me, that seems to be the inevitable path.

wayneL said:

Re gamma scalping: This can be used for profit with some changes in philosophy and technique, but the setup must be "right". Perhaps I'll start a thread on this one day.

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I for one and I'm sure everyone else in this forum, is waiting with bated breath.

wayneL said:

Welcome to the derivatives forum, you have obviously put some time into learning.

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Thank you again. I have put in the hours and will need to put in a lot more. I have taken your advice to learn the greeks, dissection, synthetic equivalence etc. Your posts here have inspired me. Every line you have written here has been laden with truth, value and mystery. I think I speak for all, in saying that you have been most generous.

cutz said:

XJO options are definitely the go if you plan to stick to the aussie market,

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Thanks Cutz. That was going to be my next plan of action. I recall your previous post where you mentioned that the IB code is AP. I'll find out Monday when I can log it to TWS again.

cutz said:

You may have already figured it out but if you're long a WTFITM call, shorting the underlying (if possible) and exercising could be a more attractive method of closing the position.

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Actual I have not figured it out. Thanks for the tip. I'm sure all newbies will appreciate this. I did read from OTTHR that closing out using the equivalent trade that gives you a better spread is the way to go. But I have not thought about the actual trade itself. So, thanks again.

Great post, Fox.

At the end of the day, all the options theory in the world doesn't help with the Aus options market. I too have lost profits purely to fees and slippage because I chose to do my learning and experimenting during daylight hours here in Aus. Also influenced by the fact I had been trading the SPI and ASX shares for a few years prior to learning options and felt I had some understanding of the Aus market generally.

However, below is approx what I paid in fees from the day I entered my first options trade in March 2003 to January 2008 when I stopped trading the Aus market for a while.

Aus options brokerage: $32,800
Aus options ACH fees: $5,025
ASX data fees (Iress, Bourse, etc): $11,640

Now, that doesn't include GST as we are registered & we get that back. Otherwise that would add about another $5000 of costs.

Slippage is another demon. During those five years, I traded roughly 5000 option contracts (eg a bull call of 5 = 10 contracts). So, on the assumption of approx 5000 contracts - lets assume 1c slippage. 5000 x 1c = $50. Multiply that $50 by 1000 SPC = $50,000. That's a whopping $10,000 average per year for every 1c of slippage. What if it is more - say 2c or 3c.... It's is an extremely underestimated cost which tends to fly under the radar for new option traders. It did for me for quite a while.

Now, if IB had been available for Aus options trading, those broker and ACH fees would have been roughly less than half. The fees quoted above were initially $75 minimum - then I changed brokers and got them down to $40 min. and then later to $26. So, if adjusting only one or two, the minimum fee had to be paid. And it would have been better to experiment with new strategies with only one or two contacts rather than go bigger to try and average out the fees. But then IB have their issues - they had negative pricing for Aus options when I started with them (it's finally fixed now) - but a very confusing IB spread description cost me another $3k. Some MM would have had a party with that one. Also, IB only give one level of market depth for options - that makes slippage very risk and very likely negates any benefit of fees.

Sadly, I haven't been able handle the night hours to trade the US due to a family situation which eventually took up most of my time (and still does). Even if I had the time, I would be very reluctant to go back to Aus option trading due to the above.

I ended up narrowing my trading down to BHP and the 4 banks - but even with BHP the MMs are very choosy when they decide to quote. The only helpful thing is other retail traders which sometimes make it possible to get a better price - but it takes a bit of skill and not showing your hand too much! And one can't rely on other retail traders popping up to take the other side, so it's pretty risky.

Maybe there should be an options action group to try and fix the issues of slippage and choosy quoting that goes on, but I think the fat cats like their easy cream too much. I don't object to MMs needing to make some money along the way, but I do object to being ripped off.

So, take care with the Aus options market. I often liken it to being a small fish in a pond full of large sharks.

sails said:

Great post, Fox.

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Thank you. I can only contribute my bungles at the moment. And there's plenty of it .

sails said:

That's a whopping $10,000 average per year for every 1c of slippage.

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This is often overlooked by novices. When I realized it myself, I felt anger and then followed by resignation.

sails said:

Also, IB only give one level of market depth for options - that makes slippage very risk and very likely negates any benefit of fees.

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Had not thought about that. I will need to think about this more.

sails said:

I ended up narrowing my trading down to BHP and the 4 banks

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I initiated my first single contract butterfly on Friday with CBA. I managed to get the order filled at $0.007 above my assumed fair price. ie. $7 going to the pocket of the MM. The problem was that order price increments were in $0.005. When I offered $0.002, the MM did not bite. He took the next one.

sails said:

... but I think the fat cats like their easy cream too much. I don't object to MMs needing to make some money along the way, but I do object to being ripped off.

So, take care with the Aus options market. I often liken it to being a small fish in a pond full of large sharks.

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Yes, MMs are a law unto themselves. We live in a world where stealing 1c over thousands of times is not a crime, but stealing a loaf of bread can lead to a prison sentence. The banks, the government and MMs do it with impunity.

My sentiments exactly to all of the above post and like many others have given Oz options the flick last year (hopefully never to return). Zero sum, negative sum gets thrown around alot, rightfully so. If you trade Oz think it should be more like beyond negative & then some.

Fox, well done for sharing. I'm sure it will help many who visit retain some of their hard earned before getting fleeced, as you know theres no quick & easy way to the riches and that anything worth doing is usually going to be difficult, options trading is no exception. You seem like a quick learner, unfortunatly I'm not & endured some consistent punishment courtesy of the MMs. Im glad I did as hard lessons taught are the ones best learnt.

Grinder said:

Im glad I did as hard lessons taught are the ones best learnt.

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I'm with you on this. All the reading and paper trading cannot replicate the feeling the sting of your own mistake. In my folly with gamma scalping, I "felt" the loss gamma first hand. My appreciation of the greeks (gamma at least) doubled overnight. Gamma is no longer theoretical but practical to me now.

Fox said:

I'm with you on this. All the reading and paper trading cannot replicate the feeling the sting of your own mistake. In my folly with gamma scalping, I "felt" the loss gamma first hand. My appreciation of the greeks (gamma at least) doubled overnight. Gamma is no longer theoretical but practical to me now.

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This is so true. Studying the greeks is initially quite daunting and mind bending. I'm not a quant either, so I know how hard it was - but I also remember how rewarding it was when the lights came on! Then to see them in action and understand the factors that are driving the option price is absolutely the cream on the cake.

Just noticed this on the ASX site: http://www.asx.com.au/products/pdf/notices/2009/Clm10709.pdf
ACH fees are to increase from $1.02 to $1.30 (exclusive of GST) as from 1st September, 2009:

Continues to confirm my belief that they really don't want customers - just newbies to suck dry...

sails said:

ACH fees are to increase from $1.02 to $1.30 (exclusive of GST) as from 1st September, 2009

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A whopping 27.5% increase?!

SCUM!

sails said:

Just noticed this on the ASX site: http://www.asx.com.au/products/pdf/notices/2009/Clm10709.pdf
ACH fees are to increase from $1.02 to $1.30 (exclusive of GST) as from 1st September, 2009:

Continues to confirm my belief that they really don't want customers - just newbies to suck dry...

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Yeah pretty disappointing,

I guess they must be upping their fees in preparation for when they finally split the contracts, well that's my theory anyway.

Glad they haven't touched the index options (yet).

BUNGLE 3 - Limited Perspective Of Options

I spent many years searching for the holy grail of option trading systems. I wanted to believe that there is a particular spread, or entry/exit system etc, that will give me a positive mathematical expectation a.k.a the edge. Then I would simply blindly follow the the "system" and over time, the edge will manifest itself.

I now believe that while such systems may exist, they have their limitations. These include:
1. If you do find an edge, and the edge is small, you will need to make thousands of trades over years to realise the profits. Profits will not be consistent ie. you can't rely on it as a regular income. For those who can churn the required large number of trades with the edge on their side (like our dreaded MMs), then this will work.
2. If your edge is too small, the costs eg. bid/ask spread and commissions, will overwhelm your edge and you will be a net loser, or break even at best in the long term. I think the term used in this forum is "contest risk". Please correct me if I'm wrong regarding the meaning of contest risk. These systems will be for the big boys with favourable conditions that you can never match.

Now comes the good news. This forum has given me a new perspective on options trading. The clues and hints are everywhere, but only if you awaken to them. A knife analogy will be helpful here. Options are like knives. They come in all varieties: butter knife, carving knife, hunting knife, meat cleaver etc. Trying to find a mindless blackbox system is like trying to use a butter knife for cutting meat, spreading jam, killing a freshwater croc and shaving. No such single knife exists that will do all that. It is better to find the right knife to do the right job.

This perspective is simple in hindsight but eye opening if you were previously blind to it. The active forum members have shared this idea for a long time now. For novices, the jargons and options theory seem daunting and therefore may drown out this powerful idea. I humbly admit that I was unaware of this simple idea before finding this forum.

The holy grail is neither black nor white. It is neither left nor right, near nor far. It always lies hidden somewhere in between. Until you change your perspective, you will not be able to dissect the beast and find the treasure hidden in between.

The secret is to short WOTM options

I think the idea of finding the one and only option strategy is largely fed by option educators. In my case, I felt that the educators would bait by stating the next expensive course would teach a certain secret strategy... lol.

I would then spend hours searching and sifting through option forums worldwide to try and discover this secret strategy without paying the overpriced fees. And by doing that, I got some pretty good education in options along the way and became quite proficient at testing other people's ideas in the likes of the Hoadley software. I also learned, as you have just pointed out, that there are many tools available in the option tool box to suit different conditions.

At the end of the day, we are simply trading puts and calls while attempting to manage the greeks that control them.

mazzatelli said:

The secret is to short WOTM options

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lol Mazza - that's a bit boring...

What about the seagull - never did find out exactly what that was, except I got the impression it has something to do with the look of the risk graph.

And the Tarzan Loves Jane strategy (I think that's what it was called). I never learned it either, but got the impression it was something along the lines of a double ratioed calendar...

sails said:

And the Tarzan Loves Jane strategy (I think that's what it was called). I never learned it either, but got the impression it was something along the lines of a double ratioed calendar...

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So naughty M...
Does one put these on naked? :casanova: or with limited risk for added protection?

EDIT: I just saw the responses on Optionetics, choked on my coffee

mazzatelli said:

So naughty M...
Does one put these on naked? :casanova: or with limited risk for added protection?

EDIT: I just saw the responses on Optionetics, choked on my coffee

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What - on the optionetics forum? Haven't checked back in there for months!

Not naughty at all - just telling it like it was..