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Options Not So Risky!

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wayneL

VIVA LA LIBERTAD, CARAJO!
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It is often stated that options are high risk investments, and it is true that options in the hands of a certifiable idiot, can cause deleterious damage to said idiots account. However in actual fact, options are no more risky than stocks.

People believe they are risky because of a fundamental misunderstanding of what an option actually does. An option merely transfers risk from one trader to another in exchange for risk in another form.

Lets consider the six possible one legged positions that a trader can undertake.

Long stock
Long Put
Short Call

Short Stock
Long Call
Short Put

Lets assume that all the option strikes are the same and ATM and traded at fair value. If all six positions are initiated at the same time (ignoring cost of carry and brokerage) by one trader there would be no possible profit or loss.

Said another way, if six separate traders each entered one of the above positions, each trader would either end up with either a profit or a loss, of varying magnitutes. However, if the profit or loss of all six traders were added together, the result would be 0, NO MATTER WHAT THE STOCK PRICE DOES.

Now in reality, the contest risk (spread + commish) would ensure a slight loss overall.

So what we can see here is that options have not introduced any additional risk whatsoever (apart from additional brokerage perhaps)

More to come……
 
It is not by accident that I have separated the 6 positions into two groups. The first group:

Long stock
Long Put
Short Call

…If traded concurrently, also will always add up to zero, no matter what the underlying does. As a matter of fact, the above three positions, when traded together is called a locked position, because no profit or loss is possible from the point the trade is placed. This particular locked trade is called a “conversion”, and is the most likely position you friendly market maker will be in if you are on the other side of one of the other option positions.

Also, if we take any two components of a conversion, it will be the synthetic opposite the remaining component.

For example if we take the long stock and the short call and put them together, what do we have? Well we have a covered call, but we also have a synthetic short put… which is the exact opposite of the remaining component, the long put. Put a short put and a long put together and they cancel each other out… SHAZAM! A locked position.

Likewise;

Long Stock + Long Put = Synthetic Long Call
Locked by the Short Call

Long Put + Short Call = Synthetic Short Stock
Locked by Long Stock

The exact Same scenario applies to the second group, only in reverse. Those three as one position is known as a “reversal”. That is , short stock + long call + short put

More….
 
So where am I going with this? It is to demonstrate that options are NOT more risky than stocks, they are not LESS risky than stocks, and that they merely transfer risk from one aspect to another, and one trader to another.

Lets look an extreme example to illustrate. Lets say we have a stock trading at 30 dollars and the options are trading at 25% volatility (with sixty days till expiry). We have six traders who each enter 100 shares (or one contract) on one of the above positions. (we are excluding cost of carry for the sake of simplicity)

Trader 1 buys 100 x stock @ $30
Trader 2 shorts 100 x stock @ $30
Trader 3 long 1 x 30call - @ $1.20 * 100
Trader 4 writes 1 x 30call - @ $1.20 * 100
Trader 5 buys 1 x 30put - @ $1.20 * 100
Trader 6 writes 1 x 30put - @ $1.20 * 100

OK! Disaster! The stock gaps down to $5.00 overnight due to bad news. Lets tally up the winners and losers in order, biggest winner, down to biggest loser.

Trader 2 (short stock) makes $2,500
Trader 5 (long put) makes $2,380
Trader 4 (short call) makes $120
Trader 3 (long call) loses $120
Trader 6 (short put) loses $2,380
Trader 1 (long stock) loses $2,500

Two things to notice here:

1/ The stock positions lost the most and made the most.
2/ The Profit and loss of all positions add up to zero

So in this particular instance the long stock ended up being the most risky position of all. It lost more than all of the option positions.

More….
 
So am I trying to say that stock is the riskiest position? No, not at all.

I am merely saying that long stock has the most downside risk.

Other positions have risk in other areas. By removing risk in one area, you will be taking on risk in another area. The decision the trader must make is whether that trade off, of one type of risk for another, is both acceptable and/or advantageous according to your precise view of the stocks potential movements within a given time frame. (even if your view is precisely imprecise)

By buying a call (or synthetic equivalent thereof), you are removing a great deal of downside risk. However it comes at a price, you must pay a premium and the potential upside is reduced absolutely by that amount of premium at expiry. There is also time risk; the stock must make it move before the expiry date.

…and so on down through the strategies, trading one risk for another.

All of these risks are quantified by the outputs of the various option pricing models, and are known as the greeks. It is the greeks that tell you where these risks are, and how much.

The important thing to remember, and the intent of this thread, is to dispel the myth of options being "risky".

Any questions are welcome.

Cheers
 
The only thorn in the side of this argument is liquidity (contest risk as you call it?), which I don't think can be dismissed (and you've of course mentioned it as well in the first post but glossed over it).

It means you aren't guaranteed to get the 'theoretical price', all you get is a spread unless its a highly liquid options series - this unfortunately typically means no more than a couple of months out and pretty close to the money.

But if you trade in underlying stock you do get the liquidity and don't have to worry about this.

This is a concern if taking large options positions - similar to the concerns someone would have taking large positions in an illiquid stock. If you want to get out in a hurry you will pay a price - maybe a big price.

Are there any strategies for dealing with contest risk (assuming I've understood this term correctly)? Also has this cost been quantified?
 
Cuttlefish,

You've brought up some interesting points


Firstly, I am not advocating the trading of options over stocks, just trying to help people understand them better. If people want to trade them or not trade them, let that be from a position of understanding, and not heresay, misinformation and half truths.

However this liquidity risk is real, and one must assess any instrument as to the suitability to their trading style. If the trading style is entering for short term speculation and exiting on some type of stop, then stay right away from illiquid series. Exactly the same, as you say, for illiquid stocks.

But contrary to popular opinion, this is not the only use of options. If you want to trade this way, then stick with those series you've mentioned above.

But regarding this liquidity issue; this only applies in VERY small option markets like OZ. US options have masses of liquidity right out away from the money and right out in the back months. If people insist on trading illiquid markets, then it will be a problem

cuttlefish said:
This is a concern if taking large options positions - similar to the concerns someone would have taking large positions in an illiquid stock. If you want to get out in a hurry you will pay a price - maybe a big price.
Click to expand...

"Large Option Positions": This is a very important point. People tend to over use leverage when presented with the opportunity. I've seen people who wouldn't dream of taking a 1000 delta position in a stock, happily take on 5000-10000 deltas in an option position... absolute friggin' insanity.

This is in actual fact where the great bulk of additional contest risk is incured in option positions. people are taking on enourmous position sizes... way way too big for their account size... and this is precisely where option traders crash and burn.

Instead of merely transfering risk, they are assuming whopping great gobs of additional risk as well... deta risk, vega risk, theta risk and contest risk. This is almost always underestimated by noob (and not so noob) traders, because they don't understand the greeks (read haven't bothered to learn them) and how they quantify risk.

Contest risk is only slightly larger in an option position of equivalent underlying size, than on the underlying itself.

cuttlefish said:
Are there any strategies for dealing with contest risk (assuming I've understood this term correctly)? Also has this cost been quantified?
Click to expand...

Well I think I've answered that indirectly. Determine your position delta, and don't violate sound money management principles.... and don't trade illiquid series if your trade management includes the use of emergency exits.

Cheers
 
thanks for the reply. I guess something I've found in my experimenting with options is that the reality is that contest risk (or the cost of the spread) is real - you might be able to negate it on one side of the trade (e.g. only enter when you're not paying it - effectively means only entering when you're buying from another trader rather than an MM) but you can't guarantee it on exit. (and yes you can increase your chances of not paying it on either side if you pick a liquid option).

To me in the illiquid Australian market this limits the variety of choices available in using options - almost to short term trading rather than taking longer term positions. I'm still experimenting at using long ATM calls (or near atm calls) for long term investing types of positions but am aware that I'm paying a contest premium when doing it, and also don't have the ease of exit I would with a long term position by directly buying the stock - so if I need/want to exit in a hurry I might have to give away a fair bit of theta and delta (and if it wasn't for the arbitrage traders I'd be giving away a lot more.).

For this reason I'm not that confident about using them to synthesise the equivalent of a large investment in the underlying.

I guess the other way of doing it is to use reasonably deep ITM's to synthesise the long position in which case there isn't as much theta and vega built into the price - but to some extent that defeats the purpose - it would be possible to achieve similar by directly buying more of the underlying using margin and I'd probably pay less carry cost overall.

I know I can also short puts to take long term positions, but I'm talking about low volatility stocks and my understanding so far is it is probably better to short options when you think volatility is going to reduce and long them when you think it will rise.

I'm at the very early stages of learning this stuff, so finding it interesting to talk and think about it and also by trying it am learning a lot that you can't learn via the reading etc.

I've found a lot of the comments on here helpful, particularly discussions on the greeks etc. in the options mentoring thread, and am pretty sure they've resulted in an increased success rate so far.
 

Well you've got a pretty damned good grasp of the concepts if you are in the early stages. Good stuff.

A couple of comments on long term positions and ATM vs ITM.

Remember, there is always a trade off of risk.

ATM: Theta and Vega is maximum when atm the money, and also gamma is reduced the further out in time you go. Therefore you must be careful "when" you put the trade on in terms of the stocks Implied Volatility cycle.

Even low IV stocks cycle from relative lows to relative highs. The lower quartile in the IV range is the time to put this on.

ITM: Reduces the above considerations markedly, but once again there is a trade off. You will have more absolute downside risk.

In comparing it to a margined stock position, once again, trade offs. You effectively have NO downside protection in this position if the stock is subject to a large gap down.

The decision comes in when you decide "where" you would prefer your risk to be. If you consider there is little downside risk because of excellent fundamentals, and not expecting any real volatility, then unquestionably the best position is straight stock.

But if your outlook varies from that, then an option strategy could suit.

Also, there is the flexibility to metamorphosise the long term position for short term advantage, using options. This can be achieved whether the underlying position is stock or a long term call. As your view evolves, transfer risk to where you want it to be.

Cheers
 

hi Wayne
Glad to see another good thread on options!

here's my question: sometimes you can find arbitage opportunities in conversion, box spread and reversion etc.....

1) how does that happen? because of a mistake made by MMs?

2) how would you capture such a risk-free opportunity? sitting in front of your computer all day and search? or you set up your software in some way so that you'll get a pop-up window when the opportunity presents itself?

thanks
 
Hissho, while you are waiting for Wayne to reply, I will add that there is usually a reason apparent mispricings and an upcoming dividend is the most usual one.
 
Wayne,

Thanks again for the reply.

wayneL said:
Even low IV stocks cycle from relative lows to relative highs. The lower quartile in the IV range is the time to put this on.
Click to expand...

thanks - useful advice.

In comparing it to a margined stock position, once again, trade offs. You effectively have NO downside protection in this position if the stock is subject to a large gap down.
Click to expand...

I think thats a good point as well - and a valid counterpoint to the liquidity argument in favour of direct stock.
 

Hi Hissho

Margaret is spot on there, make sure to account for the dividend in apparent persistant arb opportunities. (A big factor in Oz options)

Notwithstanding, these arb opps do exist. However they are "usually" closed pretty quicksmart by the instos. I heard of one Japanese firm who specialises in arbitration, recently spending USD28 MILLION uprading their computer system.. ie the speed at finding these opportunities. The gain in speed achieved? 1 SECOND!

So in reality, for the retail trader, by the time you investigate to see if this a true arbitrage, its gone!

It's not really realistic to go looking for them and even if you do find them, margin rules + cost of carry + commish may destroy the profit for us retail traders. Those locked positions are still useful though in determining whether a strategy is fairly priced, sometimes they will show up some vol skew that might be worth a few cents more doing a spread one way over the other, even if the arb is not viable, so still worth looking at.

Also look at the opposite lock/synthetics for an advantage in this regard.

Cheers
 
OK, So I've bsically demonstrated that options do not introduce risk, but merely transfer risk.

But unquestionably, people crash and burn, sometimes spectacularly, trading options, and this is where this perception of high risk comes from.

Basically the question is; if options are so safe, how do so many people blow up?

Here's one way:

Quite some time ago I posed a question to the board; I asked how, given the present condition, would people trade this particular stock I mentioned, that was trading at $26.76.

Anyway, someone sent me a PM and said "write 100 $25 puts, it will never get that low"

Anyway the puts were selling for $1.20, so that strategy would have initially collected $12,000.

Can you guess what happened next?

To avoid unnecessary anticipation, I submit exhibit A, the stock in question:

more...
 

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Anyone who actually wrote 100 $25put option contracts would be staring a ~$175,000 loss in the face.

Now I will point out right here that anyone who bought 10,000 shares at the same time would have lost even MORE. But I submit that the same person who sold the 100 contracts, would NEVER have bought 10,000 shares because of the risk!!

Can you see where I'm going with this? Can you see the shear lunacy of what this person suggested? This is precisely what people do every day with options.

By not understanding the greeks people expose themselves to absolutely insane levels of risk.

And that ain't all! But I won't bore with more stories, I'm sure you get the gist.

Cheers
 
<Makes mental note> Must remember not to do that...
 
Blimey and crikey! A drop like that is one of the reason options were invented - to protect you against financial ruin.

A few others that that chart reminds me of are HIH Insurance, Pasminco, NAB (about 2 years ago), Enron, Repco, hmm anymore?

I'd like to get some opinions on writing a covered call on RMBS. It has been one of the highest yielding calls in recent weeks (or longer I guess) as it has extreme volitility. An ideal collar candidate? Would you consider it?
 
Hopeful said:
I'd like to get some opinions on writing a covered call on RMBS. It has been one of the highest yielding calls in recent weeks (or longer I guess) as it has extreme volitility. An ideal collar candidate? Would you consider it?
Click to expand...

Below is RMBS, with the arrows pointing to the spots where you would have written calls, expiry from the previous cycle having been the previous friday; since April.

The September expiry is the only one where you would have made a profit. The previous 4 months would have been a blood-bath. You would have written the 12.50 call for sept and had them called... the current price being $17.50

Selecting stocks to do CCs based solely on high IV is a loser!!!!

Cheers
 

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Hopeful said:
I'd like to get some opinions on writing a covered call on RMBS. It has been one of the highest yielding calls in recent weeks (or longer I guess) as it has extreme volitility. An ideal collar candidate? Would you consider it?
Click to expand...

Just noticed it was collars you are suggesting and not CC's (Jumped to conclusions when I saw the extreme vol)

1/ IV is not really relevant at expiry of a collar unless the written call is ITM and the put OTM.

2/ A collar is a synthetic vertical spread. Why chew up capital buying stock when you can use a pure option strategy for much cheaper (and keep the bulk of your capital earning interest) You also have much more versatility... for instance you can do a bear vertical much easier without the long stock, which would have been nicely profitable in the above chart

3/ A collar is NOT a safe CC. It is a synthetic vertical and your greeks will be different.

That said, on a high IV stock such as RMBS, a vertical spread is quite a sensible choice in that it does much to neutralise some of the unsavoury negative aspects of high IV when picking direction.

Cheers
 
Thanks for the reply, WayneL. One would be foolish to do bullish strategies in a bear market. But as it appears that RMBS may have found a bottom.

I haven't traded Options yet, but working up to it - still got lot's to read. But I would have liked to write a RMBS naked call on the 15th of Sept (my indicators told me it would likely fall from there) for about $1.30. I would now be looking to buy the stock to cover and a protective put as well.

What are your top income earning strategies? A little bird tells me that these are one person's top four:

1.BWB
2.Collars
3.Gamma Scalping
4.Time spreads

I only know what a collar is though... (must read more must read more).
 
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