Anyone here trade options?

[clifp]

This is what I have been trying to say throughout this thread. The source of any long-term alpha is solely the result of the puts being overpriced. Without this systematic overpricing, selling naked puts would theoretically be expected to underperform a B&H over the long-term because the put seller does not participate in the upside (right side) of the underlying stock's probability distribution in excess of the put premium, while fully participating in the downside (minus the put premium). When you say "these puts are more expensive than they are worth", you are implicitly saying that the implied volatility (and, hence premium) of the puts you sell is greater than the subsequent experienced volatility (the stock's probability distribution is narrower than what you paid for). I attempted to calculate the magnitude of this effect in posts number 91 and 94, and came up with the result that, for weekly puts, this alpha is about 2.9% annually (before commissions) per one percentage point of excess implied volatility.

I went back and reread post 91 and 94 and I finally understand what you are saying. (Hey I got a D the first time I took Differential Equations and boundary value problem ) Yes and I agree the actually volatility is significantly lower than implied volatility of the options which is why the strategy is working so far. 3% Alpha is pretty nice.

My rational is that unlike 9/11 or the Fall of 2008, there really hasn't been any fundamental changes to the market that justify the crazy daily swings we have been seeing. The market is just very nervous and people are expecting/fearful that it will crash or in some cases take off. It is hardly news or unexpected that Europe will be (not) dealing with debt problem, and partisan gridlock will prevent any progress on the US deficit reduction. Yet the VIX at over 30 is predicting some major movement, when the most likely result is a muddling through on both sides of the Atlantic.

 

[utrecht]

Someone double check my math here because this doesn't seem right.

I had to make a trade earlier than I normally would've have because I am out of town on vacation and everyone wanted to go to the beach.

I bought back the weekly 122 put for 4.58 and then sold next week's 117 put for 1.94. Normally I would've waited and ended up selling the 116. My original cost was 2.37. Since I spent 4.58 and collected 1.94 today. That adds 2.64 to my cost basis making my total cost basis 5.01. I could close the trade right now for 5.14. That's whats throwing me off. It doesn't seem like I should have a profit.

Basically I have a SPY 122/117 calendar put spread which I paid 5.01 for and is worth 5.14? Something seems amiss.

 

[ERD50]

Someone double check my math here because this doesn't seem right.

I had to make a trade earlier than I normally would've have because I am out of town on vacation and everyone wanted to go to the beach.

I bought back the weekly 122 put for 4.58 and then sold next week's 117 put for 1.94. Normally I would've waited and ended up selling the 116. My original cost was 2.37. Since I spent 4.58 and collected 1.94 today. That adds 2.64 to my cost basis making my total cost basis 5.01. I could close the trade right now for 5.14. That's whats throwing me off. It doesn't seem like I should have a profit.

Basically I have a SPY 122/117 calendar put spread which I paid 5.01 for and is worth 5.14? Something seems amiss.

I'm not sure why you are surprised the position would be showing a profit at this time?

Your original position was:

I sold 10 Nov25 Weekly 122 Puts for 2.07 each
I bought 10 Dec 122 Puts for 4.44 each.
Total debit of 2.37.

The way I see it - since you paid (went long) more for the further out monthly Put than you received in credit for the other Put (obviously, since they are the same strike the further out one will have a higher price), the over-all position is weighted to the 'long' side on the Put. Since Puts go up in value as the underlying drops, and SPY has dropped from ~ 122 to ~ 116 in this time, I would expect the value to increase.

Does that make sense?

-ERD50

 

[FIRE'd@51]

Someone double check my math here because this doesn't seem right.

I had to make a trade earlier than I normally would've have because I am out of town on vacation and everyone wanted to go to the beach.

I bought back the weekly 122 put for 4.58 and then sold next week's 117 put for 1.94. Normally I would've waited and ended up selling the 116. My original cost was 2.37. Since I spent 4.58 and collected 1.94 today. That adds 2.64 to my cost basis making my total cost basis 5.01. I could close the trade right now for 5.14. That's whats throwing me off. It doesn't seem like I should have a profit.

Basically I have a SPY 122/117 calendar put spread which I paid 5.01 for and is worth 5.14? Something seems amiss.

Your math seems right to me.

I think your original estimate that the long 122 puts would only be worth 5.70 with SPY at 118 may have been too low (did you take into account the dividend?). Additionally, the VIX increased 2.5 percentage points over the past week, so your long 122 puts held their time premium better than you anticipated.

 

[utrecht]

I used the options calculator at CBOE when I quoted prices for the options if SPY finished the week at 118. The calculator showed that the trade would be profitable with SPY ending the week anywhere from 119.25 to 124.75. This is what I'm talking about when I say that options don't act in real life as they seem like they should on paper.

 

[FIRE'd@51]

I used the options calculator at CBOE when I quoted prices for the options if SPY finished the week at 118. The calculator showed that the trade would be profitable with SPY ending the week anywhere from 119.25 to 124.75. This is what I'm talking about when I say that options don't act in real life as they seem like they should on paper.

What inputs did you (or they) use for volatility and dividends until expiration?

 

[utrecht]

Those fields are already filled in. The volatility number was whatever the VIX was at that time (around 32). I don't remember what the dividend number was but i assume it was correct.

According to the calculator now, the trade will remain profitable if SPY ends the week anywhere under about 119.5.

 

[FIRE'd@51]

If you mean this option calculator it gives me a put price of 6.42 (not 5.70) for a 32% volatility if I use a strike of 122 and an SPY price of 118 and 21 days until expiration.

 

[utrecht]

OK, then assuming I looked at the calculator incorrectly when I posted last week, this trade would've been profitable ( according to the calculator) at the end of the first week if SPY ended the week anywhere from 117.75 - 125.85. According to the probability calculator at OptionsHouse, there is a 62% chance of SPY moving those percentages in one week. So if these two calculators are correct, you could make this trade the first week of every option cycle and expect to make money long term without regard to the state of the market.

Now, we already saw in real time that SPY ended at 116.34 ( a good chunk below the 117.75 predicted by the calculator) and the trade is still profitable so obviously the calculators are estimates and dont take into account other variables that occur in real life.

 

[FIRE'd@51]

Now, we already saw in real time that SPY ended at 116.34 ( a good chunk below the 117.75 predicted by the calculator) and the trade is still profitable so obviously the calculators are estimates and dont take into account other variables that occur in real life.

I would say it somewhat differently. One of the inputs to the calculator changed over the past week - i.e., the VIX increased by 2.5 percentage points, reflecting increasing options premiums, all else equal. Had the VIX stayed the same (or decreased) the trade would show an unrealized loss at an SPY of 116.34. It's sort of like trying to predict what the price of a Treasury bond will be next week. There is nothing wrong with the model that the price equals the present value of the future coupon payments. It's just that the rate used to discount those coupons is itself a random variable.

 

[utrecht]

Except that if SPY drops from 122 to 116.34 or 4.6% in one week, then you can be sure the VIX is going up. Its a virtual certainty but the calculator doesn't use that info.

 

[FIRE'd@51]

Except that if SPY drops from 122 to 116.34 or 4.6% in one week, then you can be sure the VIX is going up. Its a virtual certainty but the calculator doesn't use that info.

Not necessarily. Even in a world with a truly constant volatility of 30%, there is about a 13% chance that SPY will drop at least 4.6% in a week - about the same probability as flipping three heads in a row with an "honest" coin.

In any case, the calculator gives a numerical sensitivity to changes in an input variable (e.g. the volatility) for traders who wish to try to hedge against those changes, or at least better understand the risks they are facing.

 

[utrecht]

Well, I learned one thing. This calendar spread doesnt like getting whipsawed.

 

[ERD50]

Well, I learned one thing. This calendar spread doesnt like getting whipsawed.

Yes, but the people on the other side of your trade LOVE it!

I'm hoping SPY settles down near $123 or lower by Friday close, or my calls will cap my gains this week.

-ERD50

 

[Lsbcal]

Has anything changed in options since Peter Lynch said not to do them?

See One Up On Wall Street, copyright 1989, page 278. An introductory excerpt from his discussion:

There's no point describing how futures and options really work, because (1) it requires long and tedious exposition, after which you'd still be confused, (2) knowing more about them might get you interested in buying some, and (3) I don't understand futures and options myself.

I think he knew more then he admitted.

P.S. I own a bunch of SPY. Based on longish term trading that has "seemed" to work since the 1930's. But too boring for the Wall St crowd. I mention this because I'm fine with taking timing risks if they make money.

 

[FIRE'd@51]

Well, I learned one thing. This calendar spread doesnt like getting whipsawed.

This is not intended to be a criticism because I know you were on vacation and probably couldn't do a thorough analysis. A lot of times I roll the short ITM put keeping the strike the same. IOW, with the VIX increasing last Friday, you probably could have rolled the 122 weekly put out another week at the same 122 strike and taken in 0.30 - 0.40 in time premium, which would have reduced your cost to 1.97 - 2.07 and not exposed you to the whipsaw, yet still left you with two more chances to own the 12/17 put for free.

 

[utrecht]

Yes, I think that would've been a better move. It would've changed the whole idea of making a mechanical trade though. This trade still may get a chance to recover though. We went from WAY oversold to WAY overbought very quickly and my guess is the market finishes the week lower than where it is now.

 

[FIRE'd@51]

I'm curious which weekly puts you sold today in your calendar trade. I would have sold the 122's for about 85 cents. Even though you could get more premium by selling the 124 or 125 strike, you would be exposing yourself to a downside whipsaw to 122.

 

[utrecht]

I did sell the 122's and you were right, I should've sold the 122s last week as well. When I first thought about making a trade like this, the idea was to just stay with the same strike and sell weekly puts 3 times against the one monthly put that I was long (there is no point and making a 4th weekly trade if I'm using the same strike). I got confused and made a trade that wasn't what I intended to do.

If I had made the trade that I had intended to make in the first place, right now I would have the following:

Long Dec 122 Puts....Worth 1.73
Short Dec9 Weekly puts...Worth 0.87

Original cost of the trade was 2.37 and I would've sold last weeks 122's for ~.35 and this weeks 122s for .85

Total cost basis 1.17 and the spread is worth 0.86 right now.

 

[utrecht]

I did sell the 122's and you were right, I should've sold the 122s last week as well. When I first thought about making a trade like this, the idea was to just stay with the same strike and sell weekly puts 3 times against the one monthly put that I was long (there is no point and making a 4th weekly trade if I'm using the same strike). I got confused and made a trade that wasn't what I intended to do.

If I had made the trade that I had intended to make in the first place, right now I would have the following:

Long Dec 122 Puts....Worth 1.73
Short Dec9 Weekly puts...Worth 0.87

Original cost of the trade was 2.37 and I would've sold last weeks 122's for ~.35 and this weeks 122s for .85

Total cost basis 1.17 and the spread is worth 0.86 right now.

Hang on a second. I misread what Fire'd@51 wrote when he said I could've (should've) rolled out the 122s last week for .30-.40 in premium.

I now realize that he meant .30-.40 on top of what it cost me to buy back the current weeks 122's (option calculator shows it to be more like .60). meaning that the total trade would've looked like this:

Week 1
Bought Dec 122's for 4.44
Sold Nov25 Weekly for 2.07. Cost basis 2.37

Week 2
Bought back Nov25 Weekly122 for 4.58 and sold Dec2 weekly122 for ~5.15. Cost basis 1.80

Week 3
Dec2 Weekly 122 expires worthless. Sold Dec9 Weekly 122 for 0.85. Cost basis is 0.95

Position is currently worth 0.86.

 

[utrecht]

Closed out this trade yesterday. I lost money because I screwed the trade up, but here is the trade when done correctly.

As of last week the cost basis was 0.95. The weekly expired worthless and the monthly (with one week left) sold for 1.14 for a total profit of 0.19.

 

[FIRE'd@51]

This has been an interesting thread. Thanks, utrecht, for sharing your thoughts, research, and trades with us.

Here is a relevant article from the Personal Finance section of today's WSJ:


Options for Nervous Investors

By JACK HOUGH

Stocks have generated more worry than gains this year—and for more than a decade. Yet slim yields on bonds and savings give stockholders little enticement to sell.

The result for many investors is an unlovely combination of high fear and low reward.

There is one way to steady a stock portfolio without unloading shares, however: an options strategy known as "covered calls." The idea is to collect extra income now in exchange for giving up potential gains later.

Research suggests investors who use covered calls can turn the risk-reward trade-off in their favor by using a strategy based on stock indexes rather than individual stocks.

First, some terminology. Calls are option contracts that can give buyers an inexpensive bet that a stock will rise above a specified "strike price" before a specified date. A call "writer" collects the price of the bet (the "premium"), but might have to deliver the shares if the stock tops the strike price. He's "covered" if he already owns the shares.

"Puts," by contrast, offer buyers protection against a stock decline. Put writers collect a premium—but, like insurers, writers might have to pay if disaster strikes.

Depending on the strategy, calls can be used to reduce risk (covered call-writing) or to add staggering amounts of risk ("naked" call-writing), so brokers issue options-trading permission only selectively.

Call writers should have no advantage over call buyers. "If you write a call on your IBM shares, you reduce both risk and potential return, one for one," says Bob Whaley, a Vanderbilt University professor who in 1993 developed the Chicago Board Options Exchange Market Volatility Index, or VIX, which tracks investor expectations for market volatility.

Indeed, mutual funds that used options for either speculation or hedging from July 2003 to June 2007 showed no sign of market-beating returns after adjusting for risk, according to a working paper by Gjergji Cici, an assistant professor at the College of William and Mary. He says there is limited research on the subject because the historical data are "a mess."

One type of option might offer more opportunity than others, however. Some researchers say a quirk related to index options, like those written against the Standard & Poor's 500-stock index, offers investors a way to reduce risk without giving up much in return.

At least nine research papers since 1990, from academia and Wall Street, have shown that index options are often overpriced—an opportunity for those who sell them.

In the options world, contract prices are directly related to the volatility of the underlying securities. That is how the VIX works: An investor who knows the prices others are paying for options on the S&P 500 can calculate the volatility those investors expect.

With individual stocks, this "implied volatility" tends to match pretty closely with actual volatility over long time periods. That suggests neither buyers or sellers have a predictable price advantage.

But the VIX overestimates the broad S&P 500's future volatility more than 80% of the time, according to Josh Parker, president of asset manager Gargoyle Investment Advisor.

There is a good reason. Institutional investors have ravenous demand for index puts, since they offer cheap protection against a market crash, Mr. Parker says. All that buying pushes index put prices higher—and call prices, too, because the two move in tandem. That suggests an investor who writes index options is getting a better price than one who buys, on average.

In 2001, Vanderbilt's Mr. Whaley developed an index to exploit the high price of index options. It is called the CBOE S&P 500 BuyWrite Index, or BXM, and it simulates owning the S&P 500 and writing covered calls each month. "It aims for stock-like returns but bond-like volatility," says CBOE vice president Matt Moran.

Over 10 years through November, the BXM returned 4.2% a year, versus 2.9% for the S&P 500. Over 20 years, which counts the go-go 1990s, its lead is narrower: 8.4% versus 8.3%. During both periods its volatility was significantly lower than that of the S&P 500.

Investors can buy into the BXM index through the PowerShares S&P 500 BuyWrite Portfolio, an exchange-traded fund, or the iPath CBOE S&P 500 BuyWrite Index, an exchange-traded note. Both were launched in 2007, so real-world return histories are limited. Also, both cost $75 a year per $10,000 invested, plus trading commissions. That is enough to more than offset the 20-year outperformance of the index, which suggests investors should view these as volatility reducers, not return boosters. (CBOE has other BuyWrite indexes that aren't yet tracked by ETFs.)

Such funds perform best when stocks are flat, says Ilya Figelman, an analyst with AllianceBernstein. Investors shouldn't overestimate the safety they confer, since they only slightly outperform during a crash, he says.

Then again, an investor who can't take risk shouldn't be in the stock market in the first place, Mr. Figelman says.

—Jack Hough is a columnist at SmartMoney.com.

 

[utrecht]

Wow, some smart guy and I agree on something!

 

[clifp]

Ah you just beat me in posting that great article. My headline was going to be "Utrecht you are a genius" LOL

When I looked at my YTD performance I was struck by the difference in performance of my taxable accounts around 7% vs 2.7% for IRA. The portfolio composition is different MLPs in my taxable account, more bonds (which did well this year) in the IRA. But I own a mix of individual dividend stocks, and various index funds in both accounts. However, the big difference was that I wrote close to 300 contracts in my taxable account and only a few dozen in my IRA.

Now obviously a flat year for stocks with high volatility in last 6 months of the year has been the ideal time to write calls and puts. Still the returns for the roughly 25% of my taxable portfolio (i.e. the margin allocated) which I've been writing options has been outstanding.

The thing I learned form Utrecht is that despite my inclination to write options on individual issues you are actually much better off writing options on the indexes because the are over priced relative to the true volatility of the market.
I suspect that index calls are also overpriced and so the short strangle trade has been a good one, Utrecht it is something you might want to consider looking into.

The question I'd like to discuss is assuming Utrecht's back testing and 9 research papers are correct and index options are mispriced is why are they mispriced and are likely to remain so?

My hypothesis is that are structural reasons relating that causes a greater demand for index options than supply and hence they are overpriced.

The biggest problem with option writing is it is tax inefficient so I'm going to be restructuring my portfolio so that I'm going buy 1000 SPY and maintain a cash equity position in my IRA so that I can write 10 SPY at the money calls (they have to be covered in an IRA) and 10 SPY Puts each week.
I am going to be ret

 

[clifp]

Why are index options overpriced.

This is just a working hypothesis please feel free to shoot holes in it, especially you folks who have actually worked on wall street.

If index options are overpriced then logically this is because the demand for them exceeds the supply. This caused me to start to wonder well why is this the case.

When I thought about money managers who write index calls the only group that seem to do this on a regular basis is managera of buy write funds like those discussed in the article. In my experience these funds tend to be close end funds, like ETV and ETJ with assets in the 500 million and 1 billion ranges.

On the demand side there are insurance companies which issue investment like Equity Index Annuities. As Brewer explained these investment typically consist of zero coupon bond and call options on indexes. My guess is that there is more money invested in insurance products than in the Buy-Write funds.

Actively managed funds and hedge funds are probably other large suppliers and consumers of index options. I have no idea if on net they tend to write or buy more options.

Finally we come to individual investors. I feel pretty confident that individual investor are more likely to purchase call options than write them.
So while Utrecht trades have been impressive to this group, if he is at cocktail party, telling people that I risked $125,000 to make $1500 this week, sounds a lot less impressive than the guy on the other side of the trade who can brag that he bought $1500 weekly option that is now worth $10,000 (While neglecting to mention that for the last 8 weeks it expired worthless).

Moving to the market for put options. I am hard pressed to figure out what institutions are systemic writers of put options. I know that Warren Buffett has written them especially long term ones. In contrast, it is easy to see why there would be a demand for put options. Money managers for pension funds and such I am sure often want to purchase puts in order lock in their profits for a period of time. Their objectives are typical doing well enough that the client does not fire them, not trying to maximize returns. Likewise I individual investors who are bearish would be purchasers of puts, as well as folks buying portfolio insurance.

Now mind you this pretty much pure speculation.