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Old 07-04-2007, 10:12 AM   #41
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I think a lot of speculators are drawn to buying calls.
Let me repeat my question for this case: Who do you believe is selling what those speculators are buying?

Let me suggest reading this thread and, in particular, this post. The post contains a simple example of how option sellers convince themselves they're making money on every trade yet somehow end up with less money. I assure you it's not an uncommon belief, especially among covered call writers.
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Old 07-04-2007, 12:04 PM   #42
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Let me suggest reading this thread and, in particular, this post.
Interesting posts. Nice, clear example (two $10 stocks, one goes to $5, one goes to $15), and I agree, many option sellers would think they 'won' over the stock buyer and they would be wrong. But I'm not sure you can extrapolate that example to an entire portfolio (and maybe you did not intend to).

You are absolutely correct that you only get a (relatively) high % premium on a (relatively) highly volatile stock. Some option sellers don't want to believe this fact and think they can get a high premium on a 'safe' stock. With few exceptions, they would be wrong.

But, the distribution of stock movement is roughly a bell curve. Very many of the highly volatile stocks that I have sold options against moved very little during the option period (as one would expect from a bell curve), and of course, others moved a moderate amount and others pushed the tails.

When you throw in a bunch of stocks with high implied volatility (and premiums to match), and see that a good number of those stocks trade within a more narrow range, your example falls apart a bit. Though, it is still a very good example to make your point, I just don't think you can apply it so directly to an entire real-world portfolio of option selling.


Quote:
... how option sellers convince themselves they're making money on every trade yet somehow end up with less money. I assure you it's not an uncommon belief, especially among covered call writers.
You are preaching to the choir there. I'm with you on that. I engaged in a long, long 'discussion' on that very topic on this forum. I do however, think there are fundamental reasons why one could make a little bit of extra risk-adjusted return. In practice, the difference may be too small to really benefit from, I think it depends on market conditions - if the market is over-estimating volatility, option sellers benefit. Can one tell when volatility is 'over-priced'? That sounds to me like trying to determine when a stock is 'over-priced', I'm skeptical.

Quote:
Let me repeat my question for this case: Who do you believe is selling what those speculators are buying?
My analogy is that call buyers are like gamblers, put buyers are like insurance buyers. Both should realize that they are going to lose money on average, but they pay a premium to play 'the game', one in the hopes of a big gain, one in the hopes of hedging a large risk. The casinos, ins co's, and the option sellers collect this premium, and if they could not make a reasonable risk-adjusted profit, would not offer the product.

I tend to think that options are priced this way by the market, the sellers need to be rewarded for their risk, or they go home. But, they can't make a 'killing' at it, or the players wouldn't play, and the market would quickly adjust to any 'excess' profits anyway, with more sellers coming forward to cash in. I am *not* convinced that an individual with a limited number of positions in a portfolio can expect to cash in on that - a few outliers (which can only hurt, not help, the option seller) might easily wipe out the benefits.

So 'who' is selling? Those that think they can make enough in premiums to provide a higher risk-adjusted return compared with an outright buy. That doesn't mean they are right adit/add: The option sellers also need to have the capital to back their sales (option buyers only need to come up with the premium), and need to be of the mindset to take a smaller, potentially more consistent return, versus a big win. I think that puts them in the minority, and supply/demand might be in their favor.

A much shorter version of all this : There is no free lunch.

-ERD50
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Old 07-04-2007, 05:00 PM   #43
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I have a friend that used to do "computer work" for an option trading company. This was over 15 years ago and it was a small company. Although it was a small company, they had spent hundreds of thousands of dollars on computers with "direct feeds" from the "exchanges" and a "seat" on those exchanges (to eliminate brokerage fees).

They traded options so fast that 5 minutes of downtime during the trading day could cause them to lose "$1M".

They had complicated algorithms that ran all night on their computers telling them what trades should be made.

These guys made money !
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Old 07-04-2007, 05:06 PM   #44
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Yes, if one stock goes to $5 and one goes to $15, the stock buyer does beter than the put seller, but if they both stay at $10, the put seller does better. We could post examples all day long where one or the other does better.
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Old 07-04-2007, 05:09 PM   #45
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Interesting posts.
...
My analogy is that call buyers are like gamblers ...
Confession time.

I have gambled (bought calls), and to date, I'm ahead. It is very "addictive" to make 100-200% profit in a matter of weeks.

Of course I lost 100% on 1 transaction in less than a week.

If you treat options like going to the casino and NEVER BET MORE THAN YOU CAN AFFORD TO LOSE, you can have fun and maybe make a buck or not lose too many !
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Old 07-05-2007, 07:27 AM   #46
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I think a lot of speculators are drawn to buying calls. They see the possibility of huge percentage gains through leverage, and are willing to pay the premium for that opportunity.

But, in order to make a profit, not only does that speculator need to be correct in the direction of the underlying stock, but also the time frame. And the directional move needs to exceed the premium.

So, I think it is tough to make money on average buying calls. Certainly you can find the opportunities, I have done it on occasion, brewer has, but I suspect there are plenty of losers in the game.

If you sell options, you trade the possibility of large returns for the consistent premium, but you still hold the downside risk ( a bit less if you sell at a strike below the current stock price). I'm not convinced that is always a good trade-off, but it sure seems to be under the proper market conditions.

-ERD50
I do a few things to try to get the odds more on my side. First, I generally keep my positions small and my total options exposure modest (1 to 2% of my portfolio). It is easier to stay unemotional when dealing with small sums, and the losses that occur will be negligible overall. Second, I am generally ruthless about taking profits with options. I am a patient shareholder and willing to wait for years to see an investment bear fruit. One does not have the luxury of time with ptions, so positions that turn a profit are liquidated pretty quickly. Third, I tend to buy options on stocks that I already own and know a great deal about. Often an options trade for me is an effort to take advantage of short term weakness in something I have confidence over the long term. Fourth, I try to buy options that trade cheap to their intrinsic (black-scholes) value.
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Old 07-05-2007, 08:38 AM   #47
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I do a few things to try to get the odds more on my side. First, I generally keep my positions small and my total options exposure modest (1 to 2% of my portfolio).
Good points. I find that many people think of buying calls as 'low risk' as they control, say, $100 of stock with a $10 investment. They think along the lines of 'you could lose $50 on a big drop, a call buyer only loses $10'. However, they are much more likely to lose 100% of their investment than is the stock buyer. So, if they invest a lot, they will lose a lot. It's just plain old (dangerous) leverage.

Quote:
Often an options trade for me is an effort to take advantage of short term weakness in something I have confidence over the long term.
I have bought calls under those conditions also. I just don't do enough research or have enough confidence in my intuition/analysis to do it very often.


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Fourth, I try to buy options that trade cheap to their intrinsic (black-scholes) value.
I was under the impression that there are computer models running near real time on all these things, and that any drift from the Black-Scholes value gets scooped up lickity-split? IIRC, the one 'subjective' aspect of the B-S model (maybe they should have given Scholes top billing?) is the implied volatility? So, if you think the market has the IV wrong, then you have a potential buy opp, is that it?

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Old 07-05-2007, 10:47 AM   #48
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I was under the impression that there are computer models running near real time on all these things, and that any drift from the Black-Scholes value gets scooped up lickity-split? IIRC, the one 'subjective' aspect of the B-S model (maybe they should have given Scholes top billing?) is the implied volatility? So, if you think the market has the IV wrong, then you have a potential buy opp, is that it?

-ERD50
Depends.

Volatility is the main thing open to debate, and really the only one that matters.

I see three types of equities that appear to have mispriced options:

1) Companies nobody cares about, especially those that have issued warrants that trade on exchanges
2) Companies that pay out big, fat dividends. Considering the volatility of the underlying, EGLE and DSX options are consistently cheap.
3) Companies that are extremely heavily shorted. In these cases, puts tend to be very expensive and calls very cheap. This happens because people who would like to be short but cannot get a borrow on the shares sell the calls and buy the puts to create a synthetic short.
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Old 07-05-2007, 11:40 AM   #49
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So, if you think the market has the IV wrong, then you have a potential buy opp, is that it?
Volatility traders (i.e. those who choose to sell/buy options because they think the implied volatility is too high/too low) typically set up positions that are neutral with respect to stock movements (they are betting on volatility, not direction). Essentially the initial position would be (or look like) an at-the-money straddle, and as the stock price moves around, they buy or short stock to keep the hedge ratio zero. If they sell/buy volatility and the realized volatility is lower/higher than the implied volatility, they make money. However, being short volatility (i.e. a seller of options) is a game where one can blow oneself up, since gap moves can really hurt. This is what happened to a lot of volatility traders (as well as the dynamic portfolio insurers) in 1987.

Someone who has a view on a stock really doesn't care that much about whether the option is "fairly-priced" or not - he primarily wants the leverage. In other words, you can make a lot of money buying overpriced calls on stocks that go up a lot, or lose money on cheap calls on stocks that don't go up.
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Old 07-05-2007, 11:46 AM   #50
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Someone who has a view on a stock really doesn't care that much about whether the option is "fairly-priced" or not - he primarily wants the leverage. In other words, you can make a lot of money buying overpriced calls on stocks that go up a lot, or lose money on cheap calls on stocks that don't go up.
Sort of. I guess I will usually buy when I have a view on the underlying, but I pay attention to the pricing of the options vs. the intrinsic. If the options are priced too high, its harder to make money on the trade.
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Old 07-15-2007, 03:05 PM   #51
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There are studies on covered call writing. It's often not as profitable as holding the stock outright. The market trends up, but not in a uniform manner.

Benesh and Compton,
HISTORICAL RETURN DISTRIBUTIONS FOR CALLS, PUTS, AND COVERED CALLS

Read the study yourself, but I found this interesting:

"Thus, on average, covered calls produced lower mean HPRs [Holding Period Returns] than those of the underlying stocks."

"Covered calls represent a conservative strategy aimed at generating some extra income and downside protection in return for giving up some of the upside potential on the stock. In other words, covered calls should exhibit less variability in returns than do the underlying stocks.

The empirical evidence confirms this relationship as the standard deviation of the HPRs for CCs are 5.8 percent for the ITM sample, 8.7 percent for the ATM sample, and 11.8 percent for the OTM sample, versus approximately
15 percent for the underlying stocks in each case. A comparison of the minimum and maximum returns for the CCs versus the underlying stocks also reveals a smaller range for the HPRs of CCs. However, much of the reduction in the range is due to the reduction of maximum returns as opposed to higher minimum returns."

www.studyfinance.com/jfsd/pdffiles/v13n1/benesh.pdf


But we're all above average here.
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Old 07-15-2007, 03:37 PM   #52
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A very interesting study thanks for pointing it out. I find it unforunate that study covers a period off only 4 years 1986-1989 which while in includes the crash of Oct 1987 still was a very good period for stocks. I also find it interesting that study wasn't published until 2000!

I longer study of the use of covered calls say overa 20 or 30 years and including various withdrawal levels e.g. 4-6% would be much more interesting.
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Old 07-17-2007, 06:14 AM   #53
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To: Easter 99. Simon, I would be more than happy to answer your specific inquiries. Please post your questions on this forum. Thank you.

PS- PLEASE do not take my strategies & thoughts as appropriate for you or anyone else for that matter. Just read that it takes 10 years to develop a personal trading approach. It's taken me A LOT longer. Please tread very carefully! The old saying is very true "never mistake a bull mkt for brains" Best of luck!!!
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Old 07-17-2007, 08:00 AM   #54
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With the generous endorsement of fmhealth to share his trading experience to all of us, I would be more than happy to post my private message earlier to him in here:

"Hi Dear fmhealth,

Sorry for bothering you by sending this mail. I just came across your posts recently and convinced that you are an experienced options trader and the one I would like to talk to.

I have a few questions in my mind, which I cannot figure out by myself and would like to have your private mentoring if you don’t mind spending some time to help me.

Let me introduce myself here:

I am 40, male, living in Hong Kong, having two kids, started trading stock options in US market 5 months ago (also using Schwab’s Street Smart Pro platform). Before that, I have 14 years experience of trading real stocks in HK market and US market.

According to my short time experience, selling naked puts & covered calls (which I mostly do) made a lucrative business. I treated it as a business since I found out that it consistently provide me with 4% monthly return on my US$1.2M portfolio (now run up to 1.5M+) when deploying buying power margin.

Originally, I think even with 1% monthly return, such cash flow created from receiving premiums would sufficiently cover my family’s expenses plus asset growth (to overcome inflation); I could therefore consider ER by the end of 2008 (after acquiring full equity of my home, now worth 1.5M).

You know, my wife and I always have the goal in our life to be free, independence, able to spend more time with the kids, doing whatever we like affordable, (LBOM of course) etc. These strong desires drive us to save as hard as we can and even to decide to forfeit our current handsome incomes (say 200K pa vs our spending 60K pa).

I know I have flare and zeal in trading (although most people don’t recognized this is a proper mean to make a living). I am also a natural learner, so I can pick up something new very quickly, like accounting, financial, economical issues, etc, by reading books, despite my profession is an Architect.



What I am not sure is: If I commit myself full time into the option trading business after 2008, would I be able to survive in long run, judge from your valuable experience?

I can trade very conservatively (think I need only 1% pm), but what I cannot avoid is a sudden downturn of the market. How do you deal with this? What is your view?

Thank You.


Simon"


PS: fm, I fully understand the old saying you quoted. Don' forget I have been there and through the famous Asian Financial Crisis & Tech Bubble.
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Old 07-29-2007, 10:19 AM   #55
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Hi Easter. Well the past two weeks have shown you the "Dark side" of PUT selling. After a magnificent & very profitable first half of the year, I've given back a great deal of my profits.

This past week alone I've been stopped out of 16 positions, all for losses, some very significant. Does it bother me , NO (well maybe a little!). It's simply the way this game is played. That's why I would NOT recommend this strategy to you or anyone else that needed the proceeds of these trades to cover their fixed expenses. Simply too difficult to sustain a monthly P&L that is reasonable for most of us.

If, you feel that on a yearly basis you can augment your your income by selling PUTS, that's a tactic that can make a lot of sense & money. But you MUST be willing to either continually take relatively small losses or acquire stock at a lower price for this to work.

I'm trading GOOG now. Sold the Dec 380s for $2.40 with a stop at @3.60. A wonderful (I hope) premium for a strike that is, as I write this 130 points away. This is NOT a recommendation. I simply like the risk/reward ratio on this one.

Best of luck & remember this is a evolutionary not revolutionary process. It takes years upon years to develop a strategy that works for you & even then must constantly be monitored & course-corrected!
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Old 07-30-2007, 02:41 AM   #56
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Crazy Week

Hi fm, Nice to hear from you again and thank you for passing on of your wisdoms.

Wow, the last week was a crazy week. Here is my damage report:

1) I finished on July 21 expiry date with a ‘regular profit’ of 4% (on margin);

2) On Jul 24-25, when things seemed taste bad then I started selling more covered & naked OTM calls (21 nos. total; I think that would serve a hedging purpose); while keeping the puts; ;

3) On the pm session of Jul 25 to Jul 26, big lots of INTC (stock) were sold on profit taking and for capital preservation; temporary shorting of JWN, TEX & X stocks (to protect the puts; all closed out later with small profit). When I saw the board market didn’t turnaround, I closed out bad put positions and underlying stocks like crazy (14 nos.) and started profiting from the calls (not too much gains tough);

4) On Jul 27, I was sitting with mostly the short calls; Felt exhausted and waited for the upcoming signals from the market;

5) On Jul 28, counting chips, the whole month's profit of July was almost wiped out in just a few days;


Loss positions closed: ATI, TIE, NUE (stock), CLF, COH, JWN, MO, TEX (puts);

Calls selling that saved me from going negative: AA, ATI, CLF, FCX, INTC, MRK, MTW, X;

* * *

You see, you and I were expecting something like this to happen (but didn’t know when); So far, I am glad to have confined my losses and gone slightly positive by the end of the month; Looking back, if I were not staying in the game closely watching and managed my trades by doing hedging, I would have no doubt suffered huge loss.


Hope we can keep in touch. Good luck and good trading.
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Old 07-30-2007, 08:33 AM   #57
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I'm trading GOOG now. Sold the Dec 380s for $2.40 with a stop at @3.60. A wonderful (I hope) premium for a strike that is, as I write this 130 points away. This is NOT a recommendation. I simply like the risk/reward ratio on this one.
fmhealth - interesting. I'm trying to understand your GOOG position risk/reward. I 'play' these puts quite a bit differently than your example (near term, put strike a bit below current stock price).

In the most likely event, those puts expire worthless, and you collect the full $2.40. But, is that a reasonable return? You had to keep $380 tied up in order to sell that put (in case it gets put to you @ 380). So, I calculate the potential return as 2.40/380 = 0.63% return over 5 months ~ 1.5% return annualized. It seems to me you would be better off in a money market? Do you anticipate liquidating this far in advance of DEC? It seems it would take quite a drop to move that deep put very much in the near term, but I haven't done the math.

I realize that with your stop, you would never actually take ownership of the stock, but the money is still tied up. So how is is this a good return?

-ERD50
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Old 08-03-2007, 12:28 PM   #58
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he could make that exact same trade with Google by selling a naked put (as oppossed to buying Google stack and selling a covered call). The profit / loss is virtually the same but there is no money tied up by buying the stock. You only have to tie up potential margin buying power.
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Old 08-03-2007, 02:41 PM   #59
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he could make that exact same trade with Google by selling a naked put (as oppossed to buying Google stack and selling a covered call). The profit / loss is virtually the same but there is no money tied up by buying the stock. You only have to tie up potential margin buying power.
But it is still tied up. IOW, that money could be doing other work for you. And if you sell the put with margin to cover, the piper may come to you with a bill one day. Even with a stop, if it plummets overnight, someone could put the stock on you first thing AM.

-ERD50
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Old 08-03-2007, 05:45 PM   #60
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You guys eating at the trough now that option premia have gone through the roof? Or getting whipsawed?
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