Options for Rookies

Your Trades and People who Take the Other Side of the Trade

SS writes: Mark,

There is always going to be counter-party to each contract one buys or sells.

1) Yes there is always a counter-party.  If you buy, someone must sell it to you.

Let’s assume a scenario, based on earnings, in which 'everyone' agrees it's likely that the share price will move higher.

Clearly, any active trader (a large hedge fund for instance) is not likely to take a short view based on this news, and let’s say the open interest on the available put contracts confirms this. Sure enough, the stock goes through the roof. Yet, somehow, individual traders who were long were able to take on somebody as counter-parties for their positions.

2) I disagree.  It's not 'clear' to me that 'any active trader' will not take a short position. Why would you believe that's true?

Just because the majority anticipate good news and a boost in the stock's price, that does not mean it will happen.  There are plenty of contrarian traders who do exactly as you suggest they won't:  Some will go short in anticipation that whatever the news, the market will react as if the news is disappointing.

But most hedge funds (to use your example) prefer not to take market risk.  The earn their profits by remaining neutral to as many risk factors (the Greeks) as possible - and that certainly includes not being exposed to delta or gamma risk when earnings news is about to be announced.

3) The open interest on the short  put confirms NOTHING.  Anyone can hold a short position by selling naked calls or call spreads.  In addition, a synthetic put position can be created by buying calls and simultaneously shorting stock.  The open interest of the puts is meaningless.  Too many people mistakenly assume that a huge call open interest signifies that the call buyers are bullish.  In order to hide his/her intentions, the call buyer may be creating synthetic puts by selling 100 shares of stock for each call purchased. 

Don't forget that 'neutral' traders can buy calls and by selling 50 shares of stock for each call purchased, create a synthetic long straddle position.  The bottom line:  Unless you know how the calls were hedged, you have no idea if the call (or put) buyer is bullish.  Don't assume anything.

The only way I can understand the individual profiting is if they extracted their profits from the very long-term view of other traders-- such as hedge funds-- who purchased put options with the expectation that their positions would be worth more after a significant period of time...

Is this correct? If so, it wouldn’t necessarily be true that the counter-party to your trades is intentionally taking the opposite side of your view at the moment you purchased your contracts. It may just be that you were able to profit in that short window of opportunity because their position was worth less at the moment you bought them.

4) Investors who bought calls - and who are making a lot of money in your scenario - bought those calls from someone else - the counter-party. But, they do not 'extract' their profits from anyone.  As soon as the trade is made, the counter-party is separated from the customer with whom the trade was made.

You are implying that the counter-party loses as much as the call buyer gains.  Why?  Just because you, the buyer, choose to hold the options 'naked long' and make no attempt to hedge the position, that doesn't mean that your counter-party has done the same.

If that counter-party is a 'hedge fund' or any large, active trader, there is virtually zero chance that the trade was not hedged as quickly as possible.  You, the public investor, may be willing to gamble that the news will be good and purchase options based on that hope.  But I assure you that no professional trader does the same.  They hedge any and all risk.  They earn their profits by selling options to you - at a price that's higher than they are worth.  They don't care if you make a fortune on the trade.  Their task - and they are very efficient -  is to buy other options and/or stock to construct a position with almost no risk.  They lock in an 'edge' by selling overpriced options to you, and hedge by buying options that are nearer to fair value.

On this trade, you 'win' because you make a lot of money.  But the counter-party also profits.  This is not creating money out of nothing.  Some people sold options, closing a position to lock in a profit (or loss).  Others sold stock at a price they were willing to accept, and the buyers of that stock made money.  Those who chose to sell naked calls or call spreads, lost money.  But that has nothing to do with you and your counter-party.   This is not magic and money does not appear out of nowhere.  But it does not necessarily mean that others lost an amount equal to the gains.  Others may have simply sold early and someone else made money the early sellers could have earned.

None of this has any long-term implications.  You buy calls, they sell calls.  Then they eliminate risk.  Then the people who sell options to your counter-party, hedge their trades with yet another counter-party.  Someone winds up with risk - but only if that trader elects not to hedge.

This is not an 'I win; you lose' situation.  I don't know what you are trying to say in the last paragraph.

What Other Bloggers Are Saying About Volatility

Bill Luby at VIXandMore is an excellent source for information regarding VIX (the CBOE Volatility Index) and how traders can incorporate VIX, and related vehicles, into their trading.

He says: "I generally use the VIX as a speculative vehicle rather than a hedging tool, but lately I have received several questions about how one might go about hedging a portfolio with the VIX." 

Bill then offers the following conclusion from a recent study:

"the results of this study suggest that, dollar-for-dollar, VIX calls could have provided a more efficient means of diversification than provided by SPX puts."

An interesting result, and I confess that I have not read this lengthy paper.  Expect more from Bill on this topic.

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Adam Warner at Daily Options Report offers frequent comments regarding VIX and volatility in general. He served the investing public well by spreading the word that trading the triple weighted ETFs is a losing proposition for the investor, and that these vehicles are designed for day traders only.

This is merely a random sample of his quality discussions about various aspects of volatility.

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Jared at CondorOptions also takes the time to write about volatility.  If you are interested in more than the basics, here's one example of a more advanced discussion.

If you like to look at charts and data, his volatility tracker is not to be missed.  He writes about iron condors, giving you an opportunity to see how and when his perspective differs from mine.

I suggest subscribing to the RSS feeds from these blogs.  It will provide a bunch of good reading.

Elite Trader Forum

Mea Culpa.  As pointed out by Wayne of Sigma Options, I erred.  His comment is below and this post was updated Jun 9, 12:40 PM.

Elite Trader attracts a variety of posters to their forums.  Some are rookies, some are very experienced, some are professional traders, and unfortunately there are always those who try to spoil things for everyone else. But it is a worthwhile place to visit.

Here's a recent question that resulted in a bit of difficulty for the person who asked the question:

"Selling ITM strangles is equivalent to selling OTM strangles with the same strike prices: True or Not?  Why?"

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Here's my attempt to solve the problem.  I thought it may be of interest to readers of this blog.


Example:  Assume SPX is 900

ITM strangle:
  

Sell SPX Jan 850 call;   Sell SPX  Jan 950 put

OTM strangle:

Sell SPX Jan 950 call;   Sell SPX Jan 850 Put

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You are having a problem comparing these positions. Try this:

Consider the difference between the two strangles. To do that,subtract one strangle from the other.  For example, Add the legs from the ITM strangle and subtract the legs from the OTM strangle,

Take the four legs from both strangles.
Add them to make a single position.

Theat position is now a long box.

Long Jan 850 Call
Short Jan 950 Call

Long Jan 950 Put
Short Jan 850 Put

A box is a riskless (ok, there is pin risk) position that varies very slightly in price as time passes (or interest rates change) by the cost of carrying the position to expiration.

Next, break that box into a call spread and a put spread, instead of two strangles.  That gives you the SPX Jan 850/950 call spread and the SPX Jan 850/950 put spread.

It's easy to see that at expiration, no matter what the price of the underlying, the call spread plus put spread equals the distance between the strikes, or 100 in this example. Thus, the price of the box is constant.

If the value of the box is constant, that means the difference between the two strangles is also constant  the value of the box because that difference is a box spread.

Sell either strangle - and the P/L must be identical.  Why? Because the difference between the strangles remains constant.  So if one strangle loses $5,000 then the other must also lose $5,000.

This assumes you collect the value of the box as the extra premium when selling the ITM strangle.  In other words, you should collect almost $10,000 extra (fair value is $10,000 less interest through expiration) when selling the ITM strangle when compared with the OTM strangle. When expiration arrives and you are assigned one or two exercise notices on your short options, you will repay that extra $10,000 if you sold the ITM strangle.

Why a Single Trading Strategy is Insanity

I'm returning to one of my recurring themes today because I found a great blog post by The Pragmatic Capitalist:

"Nassim Taleb is the analyst community’s biggest critic.  He recently said: “We have to build a society that doesn’t depend on forecasts by idiotic economists.”  This goes back to our flawed system of thinking.  Too many investors have been suckered into the belief that one investment approach is the best way to invest.   Can you imagine if an Army General had ONE battle plan?   Every war is different and requires a unique battle plan.  Economic cycles aren’t so different [from wars].  Each cycle is different and each cycle is going to reward different assets in different ways.  But investors have been schooled to believe that you can apply one school of thought or one investment approach to each cycle...

The same can be said of buy and hold for many small investors.  Unfortunately, we’ve discovered over the last 10 years that buy and hold isn’t always applicable.    All economic cycles are unique and asset responses to each will vary widely.  Investors need to learn that a multi-strategy, flexible approach is the best approach."

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I believe the above quotation sums it up nicely.  Buy and hold was good advice as the markets soared from the end of the depression through 2000 - with some notable pauses along the way.  But for analysts to claim that the markets are bound to hit new recovery highs anytime in the foreseeable future are simply pie-in-the-sky wishes - as far as I'm concerned.  We can never know - in advance - which is going to be the best strategy going forward.  Thus, prudence, conservatism and insurance are essential for long-term success.  Why is that so difficult to understand? 

Investors should continue to invest - but only when their portfolios are insured against a disaster.  Without insurance it's just another form of gambling.  And if that insurance limits the upside, what's so terrible about that.  Isn't it better to be sure you have a next egg when you need it - even if it turns out to be a smaller next egg than it might have been had you not bought insurance - as opposed to being in need and not having the wherewithal to retire at all, let alone retiring comfortably?

Why don't financial journalists jump on this bandwagon?  Why don't all financial planners and advisors see the merits of sacrificing some upsdie for a guarantee of no more heavy losses?  I know it's not that simple.  Even if everone were suddenly to decide that owning collars for all investments was a very sound, intelligent idea (which I believe it is), who's going to make all those option trades for the masses of individuals who need to make them?  that's the biggest hurdle. Educating people on how to protect their assets.

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"Golden Cross" or Crash. Is Either In Store for the Market?

As usual, the market provides a variety of signals, allowing investors to hop onto a bandwagon, believing that know what's in store for the stock markets of the world.

Recently, the NASDAQ gave a bullish signal, known as the Golden Cross (when the 50 Day Moving Averages crossed the 200 Day Moving Average to the upside) which is supposed to be a bullish sign.  You can read more about that formation in several places.

On the other hand, there are those who compare today's market with that of the Depression era in which a large market decline was followed by a substantial rally - only to sink to new lows. I don't want to publicize this opinion, but one prognosticator is looking for the Dow Jones Industrial Average to move below 3,000.

We know they can't all be correct, but the bulls and bears can go merrily on their way, each with 'evidence' to support his/her dreams.  The message I take from this is that it's possible that one of these views will prevail, but because I have no idea which is more likely (ok, I have an opinion, but will not wager on it's coming true), so it just encourages me to trade with a neutral bias,  However, I plan to continue to own enough insurance so that if we do see a significant rally or debacle, I'll survive in good shape.  I have no plan to bet on a long shot and thus, will not load up on cheap, OTM options - hoping for a miracle.  I'll settle for being prepared to prevent such a miracle (or nightmare) from demolishing my account.

How will you position yourself?