Anyone here trade options?

[utrecht]

Yes, I used a constant 1.5%. I believe that's a conservative number based on my experiences real time. The VIX is relatively high right now so obviously the premiums are higher. The last 2 weeks since the craziness started I got 2.05% and 1.88% which is 37% and 25% higher premiums than my avg number respectively.

Personally I prefer when the volatility is lower. I collect less money in premiums but there's a better chance that I will keep the entire amount.

I don't think this will be the case, but if my assumed 1.5% avg premium turns out to be too high, then obviously my back test numbers will be no good.

 

[FIRE'd@51]

Yes, I used a constant 1.5%. I believe that's a conservative number based on my experiences real time. The VIX is relatively high right now so obviously the premiums are higher. The last 2 weeks since the craziness started I got 2.05% and 1.88% which is 37% and 25% higher premiums than my avg number respectively.

Personally I prefer when the volatility is lower. I collect less money in premiums but there's a better chance that I will keep the entire amount.

I don't think this will be the case, but if my assumed 1.5% avg premium turns out to be too high, then obviously my back test numbers will be no good.

Assuming the puts are at-the-money (is that correct?) a 1.5% premium using Black-Scholes yields an implied volatility of nearly 27%. This is higher than the highest value of the VIX over that time period , and considerably more than the average VIX over that time period.

 

[clifp]

Heres the formula I use:

Assume that I sell one SPY put. I receive $2 in premium and the stock price is 120.
If the put expires worthless I make $200. If I was forced to buy the stock it would cost me $12000 so I divide $200 by the $12000 I was theorectically tying up. So my return is 1.67%. This is similar to buying 100 shares of SPY for $120 for a total of $12000 and then selling it for a $200 profit.

Technically I never have to put up the $12000 because I buy the put back before it expires if its not going to expire worthless and Im not technically tying up a full $12000, but thats the only formula I can come up with for return.

I have been writing calls and puts for quite some time. The doubling of the VIX last week had me write many times my normal one or two a month.

I try and look at the annualized return. I believe the correct formula for a cash secured put is premium/(strike-premium) * 365/days to expiration + cash*MM return. The second term is near zero and can be ignored although it didn't use to be. About 25% of one of my IRA is now fully committed to cash secured puts.

In the case of puts written against margins, I am not sure how to calculate the return. I'm like utrecht with margin rates so high, I'd never use margins so it doesn't seem appropriate to treat it the same as cash secured puts. On the other hand ERD50 is right it isn't exactly free money, something that would be very obvious if the market crashed.

Finally, one difference is I write options on individual stocks rather than indexes. As a general rule I only write puts at stocks I am happy to own at specific price. However, the other reason was I found that if I wanted to have exposure to 120K worth of puts that I was better off writing puts on 3 or 4 big names stocks than SPY despite the higher transaction cost.

However, when I just looked at the premium for SPY I realize this is no longer the case at least for at the money options. People are desperate for insurance I am happy to write contracts at for the right premium.

So my question to ERD and Utrecht is do you guys actually own SPY? The reason I ask is that SPY has the highest expense ratio of the ETFs because the structure is oldest. I own SCHB, and VB (large cap) and VTI but no SPY. If I wrote a call on SPY would that be considered a covered call? I am guessing not.

 

[ERD50]

About 25% of one of my IRA is now fully committed to cash secured puts.

I was doing this, and one day I got frightened.

If I own stock, fund, or ETF and something wonky goes on at my broker, they just hold the paper records for me, and I should be fine. I still own the stock, fund, or ETF.

But when the put is cash-secured, I ended up having a lot of cash sitting in the account. I started to get worried about the level of FDIC, XYZZ insurance. It scared me to think that I'm in 'risky' equities, but might lose a big chunk of money that was sitting in 'safe cash'. Maybe paranoia on my part, but with the problems in banking and other financials, I was concerned. I've switched to doing covered calls (synthetic equivalents IIRC), so most of the account is in equities (plus I earn divs).

So my question to ERD and Utrecht is do you guys actually own SPY? The reason I ask is that SPY has the highest expense ratio of the ETFs because the structure is oldest. I own SCHB, and VB (large cap) and VTI but no SPY. If I wrote a call on SPY would that be considered a covered call? I am guessing not.

Yes, I own SPY and sell covered calls against it. I occasionally buy a call, depending upon my gut feel and testosterone levels.

However, the other reason was I found that if I wanted to have exposure to 120K worth of puts that I was better off writing puts on 3 or 4 big names stocks than SPY despite the higher transaction cost.

However, when I just looked at the premium for SPY I realize this is no longer the case at least for at the money options. People are desperate for insurance I am happy to write contracts at for the right premium.

I used to do ~ 10 stocks rather than SPY. It seemed to make sense mathematically (something about the sum of the variance of ten stocks versus the sum of the variance of 500 stocks, but I had wine with dinner, so that's as far as I'll go). It seemed to work, for a while... then it just seemed getting hit by one mis-behaving stock here and there was driving the averages down. Maybe that would regress (progress?) to the mean after a while, but I didn't want to see my profits dwindle away. It's also a lot more work to trade 10 stocks than one index.

Plus with the liquidity of SPY options, I'm more open to a market order, which saves a few bucks. Spreads are pretty low, and though I usually do a limit, sometimes it goes the wrong way, I back up and reset my limit and would have been better off with a market order. Probably averages out.

-ERD50

 

[utrecht]

Assuming the puts are at-the-money (is that correct?) a 1.5% premium using Black-Scholes yields an implied volatility of nearly 27%. This is higher than the highest value of the VIX over that time period , and considerably more than the average VIX over that time period.

The puts are slightly in the money. I dont know enough about implied volatility to comment on that so I wont. What I do know is the amount of premium Ive been getting the past 14 weeks and the amount I got in paper trades before that.

VIX was ~25 at the end of July which is about the avg isn't it?. I got 1.52% the last week of July.
VIX was 32 the first week of August. I got 2.04% (I said 1.88% earlier but was looking at the wrong number).

As I said, I dont know that much about implied volatility or calculating options prices or a lot of that technical stuff which is why I asked the original question about how realistic my back test is. I'm using real life prices that I'm seeing in real time.

Are the premiums I just quoted out of whack according to whatever formula you are using?

 

[utrecht]

So my question to ERD and Utrecht is do you guys actually own SPY? The reason I ask is that SPY has the highest expense ratio of the ETFs because the structure is oldest. I own SCHB, and VB (large cap) and VTI but no SPY. If I wrote a call on SPY would that be considered a covered call? I am guessing not.

If you owned SPY and wrote a call against it, it would be considered a covered call just like any other stock. Since you said you dont own SPY if you write a call its an uncovered call which is a whole different animal. I own VTI, not SPY, but my strategy has nothing to do with writing covered calls or wanting to own the stock. Having said that, I realize that selling naked puts and writing covered calls has the same risk / reward profile.

 

[utrecht]

I try and look at the annualized return. I believe the correct formula for a cash secured put is premium/(strike-premium) * 365/days to expiration + cash*MM return. The second term is near zero and can be ignored although it didn't use to be.

Is this a formula to calculate the return of an option trade if all goes well to compare it to other possible trades? Your formula doesn't take into account what actually happened. I was talking about a formula for the actual return after the position is closed.

 

[FIRE'd@51]

The puts are slightly in the money. I dont know enough about implied volatility to comment on that so I wont. What I do know is the amount of premium Ive been getting the past 14 weeks and the amount I got in paper trades before that.

VIX was ~25 at the end of July which is about the avg isn't it?. I got 1.52% the last week of July.
VIX was 32 the first week of August. I got 2.04% (I said 1.88% earlier but was looking at the wrong number).

As I said, I dont know that much about implied volatility or calculating options prices or a lot of that technical stuff which is why I asked the original question about how realistic my back test is. I'm using real life prices that I'm seeing in real time.

Are the premiums I just quoted out of whack according to whatever formula you are using?

I think the put premiums you are using in your back-test may be too high.

The average VIX is more like 15% - 20% over the long-term, not 25%. If you look at the data in my link in post #27 in chart form, you can see that the average VIX over the Sep 2010 - Feb 2011 time period looks like it was about 20%, or maybe a little less. At a 20% volatility, a one week at-the-money put on SPY would have a premium of about 1.12%. This would be (1.12 / 1.5 ) = 75% of the constant premium you used in your back-test. So I would estimate that the total return over the time period in question would be closer to 0.75 x 15.1% = 11.3%. Furthermore, adding back the dividend of about 1% to the index, it seems that the put-writing strategy would have underperformed the S&P 500 by about 9 percentage points.

 

[utrecht]

You could very well be right. I would expect there to be a fairly big under performance in a market that is shooting straight up. However, even if I use your figures, going back to 2005, the weekly puts based on my research would still return 15% to the SP500's 1.7%. It will be interesting to see how this works out in real time over the next few months.

 

[Leon44]

When I write puts I also give myself some downside protection. Are you writing puts at the money? I like to have at least a 5% cushion even if I give up some premium.

Lately I have been buying quality dividend paying stocks and writing calls on them. Almost using this method as a substite for bonds....

 

[Nords]

About 25% of one of my IRA is now fully committed to cash secured puts.

I've been wondering about the taxation of that. You're not paying taxes on the income now, and if it's a Roth then you'll never pay taxes. Does it mean that after age 59.5 we could write calls & puts on our Roth IRAs for tax-free income?

Finally, one difference is I write options on individual stocks rather than indexes. As a general rule I only write puts at stocks I am happy to own at specific price.

I might be done selling calls for a few months, but these days I'm mightily tempted to sell Berkshire Hathaway puts. However I'm pretty sure that the day after I do so, Ajit Jain will get run over by a bus.

How do you handle the "bad news" put, especially if it's a surprise dividend cut? Do you shrug your shoulders and hope that the stock's fundamentals recover from the (hopefully temporary) drop in price? Or do you immediately sell to lock in a known loss?

 

[clifp]

Is this a formula to calculate the return of an option trade if all goes well to compare it to other possible trades? Your formula doesn't take into account what actually happened. I was talking about a formula for the actual return after the position is closed.

Yes this was the formula for calculating the APR for writing an option that expired worthless.

 

[clifp]

I've been wondering about the taxation of that. You're not paying taxes on the income now, and if it's a Roth then you'll never pay taxes. Does it mean that after age 59.5 we could write calls & puts on our Roth IRAs for tax-free income?


I might be done selling calls for a few months, but these days I'm mightily tempted to sell Berkshire Hathaway puts. However I'm pretty sure that the day after I do so, Ajit Jain will get run over by a bus.

How do you handle the "bad news" put, especially if it's a surprise dividend cut? Do you shrug your shoulders and hope that the stock's fundamentals recover from the (hopefully temporary) drop in price? Or do you immediately sell to lock in a known loss?

I hadn't thought about it with respect to my Roth which is still pretty small. However, it certainly seems like option trading and along with bonds and REIT are the right things to hold in a IRA. (Now that I've finished my 2008 capital losses I'm going to have to be much smarter/more discipline about have the right asset in the right accounts.)

For the most part I only write puts where I am happy to own the company despite any bad news at the strike price. So for instance if back the truck up level for Berkshire is 60, and my $60 put gets exercise, cause Charlie, Warren, and Ajit are killed aboard Netjet plane which crashes into a Burlington Train hauling toxic chemicals I'll simply grit my teeth and hold.

On the other hand during the crisis the dividend cuts made several banks stocks unattractive so I simply either sold the stock out right or closed out the short put position at a loss.

 

[utrecht]

I dont think you can sell naked options in an IRA can you?

 

[Nords]

Thanks. Looks like I can complicate my asset allocation more easily than ever before...

 

[utrecht]

OK, I went back and recalculated. Instead of using a static 1.5% option premium, I adjusted the option premium up or down depending on the VIX. I didn't calculate the VIX for every single week. I used the avg VIX for the year to do each years calculations. VIX ranged from an avg of ~34 in 2008 to ~12.5 in 2006.

My 14 weeks real time returns stay the same because the data is real and not an amateur attempt at back testing.

Real time 14 weeks
SP500............-12%
Weekly puts...+1.3%

2011 YTD
SP500............-5.2%
Weekly puts....+15.0%

2005-Present
SP500.............+1.7%
Weekly Puts.....+16.5%


The most amazing thing to me is that once I adjusted for the VIX, this method actually came out in the black in 2008. Even though the Sp500 was -37%, the weekly puts returned +14.7%. As mentioned earlier the strategy definately under performs in a very strong market.

 

[kyounge1956]

Here are two articles I came across recently, about option collars.
Risk Management through Costless Collars and Equity Collars as an Alternative to Asset Allocation.

 

[clifp]

Here are two articles I came across recently, about option collars.
Risk Management through Costless Collars and Equity Collars as an Alternative to Asset Allocation.

Interesting article unfortunately as the 2010 article points out, a strategy which was perfectly valid in 2007 during the bull market is no longer close to being achievable today.

For instance. SPY is at 116.44 a 20% out of the money call is 140. Writing that call out for Jan 2013 (1.4 years out) would earn ~$3.20. Using that 3.20 to buy a put would let us buy some 70 and few 75 put also in Jan 2013 lets say on average $72, this means the market would have to fall 38% for your puts to kick in. Even if you use the expected $3 of dividends between now an Jan 2014 to buy puts you could only purchase puts at average price of ~$88 this means your maximum loss is 24%. So the insurance is very expensive TSANTFL.

By the way I was looking at purchasing puts back in early July when VIX was in the 16 and 17 range. SPY puts were much cheaper and I did notice that is was possible to have a riskless collar although the spread was around 10% downside protection for 12% upside. In hindsight it would have been great move.

 

[kyounge1956]

Here are two articles I came across recently, about option collars.
Risk Management through Costless Collars and Equity Collars as an Alternative to Asset Allocation.

Interesting article unfortunately as the 2010 article points out, a strategy which was perfectly valid in 2007 during the bull market is no longer close to being achievable today.

For instance. SPY is at 116.44 a 20% out of the money call is 140. Writing that call out for Jan 2013 (1.4 years out) would earn ~$3.20. Using that 3.20 to buy a put would let us buy some 70 and few 75 put also in Jan 2013 lets say on average $72, this means the market would have to fall 38% for your puts to kick in. Even if you use the expected $3 of dividends between now an Jan 2014 to buy puts you could only purchase puts at average price of ~$88 this means your maximum loss is 24%. So the insurance is very expensive TSANTFL.

In the article they looked at it the other way around—they held the maximum allowable loss to 10%, and found that with put and call prices where they were at the time you'd have had to sell calls with a strike only about 5% higher than the index price at time of purchase. Either way you look at it, it's an expensive strategy when the market is nervous.

By the way I was looking at purchasing puts back in early July when VIX was in the 16 and 17 range. SPY puts were much cheaper and I did notice that is was possible to have a riskless collar although the spread was around 10% downside protection for 12% upside. In hindsight it would have been great move.

There was another article about option collars on Morningstar today. For the example they actually managed to find a collar with the puts costing less than the call premium, so there was a profit from the options alone, never mind what the stock did. I wonder how long they had to look to find that one!

 

[clifp]

In the article they looked at it the other way around—they held the maximum allowable loss to 10%, and found that with put and call prices where they were at the time you'd have had to sell calls with a strike only about 5% higher than the index price at time of purchase. Either way you look at it, it's an expensive strategy when the market is nervous.

There was another article about option collars on Morningstar today. For the example they actually managed to find a collar with the puts costing less than the call premium, so there was a profit from the options alone, never mind what the stock did. I wonder how long they had to look to find that one!

Actually the real trick is to find a stock that you can buy for $44 and then goes up to $325 a few years later. Do that consistently and you won't have to worry about pensions, withdrawal strategies, LYBM, or even finding dates on Saturday night;

I just checked the options on Mastercard ~10% ($355) out of the money call for Jan 2012 earns 20.60 buying a 10% put ($295) cost $22.80 a fine strategy if you want protect a 600% return... but not great for the rest of us.

 

[ERD50]

For the example they actually managed to find a collar with the puts costing less than the call premium, so there was a profit from the options alone, never mind what the stock did. I wonder how long they had to look to find that one!

And did it exist long enough to actually place and execute the two orders? I'd be surprised. That's free money. It seems I may have seen something like that a time or two, but it's gone in a flash, and I bet the two 'righted' themselves and no one got that deal.

-ERD50

 

[FIRE'd@51]

And did it exist long enough to actually place and execute the two orders? I'd be surprised. That's free money. It seems I may have seen something like that a time or two, but it's gone in a flash, and I bet the two 'righted' themselves and no one got that deal.

It's not free money. If you did the collar alone (not owning the underlying stock), you could lose money if the stock price rose above the call strike by more than the amount of net premium.

 

[ERD50]

It's not free money. If you did the collar alone (not owning the underlying stock), you could lose money if the stock price rose above the call strike by more than the amount of net premium.

You're right. I shouldn't post on options before the second cup has been absorbed I guess I was thinking call/put at the same strike. Even holding the stock, you would be exposed to a downdraft between the two strikes.

And thinking about this a bit longer...

There was another article about option collars on Morningstar today. For the example they actually managed to find a collar with the puts costing less than the call premium, so there was a profit from the options alone, never mind what the stock did. I wonder how long they had to look to find that one!

There is nothing unusual at all - you can almost always form a collar and take a credit. But the call strike will be closer in than the put strike. You'll trade away more upside than you gain in downside protection.


-ERD50

 

[kyounge1956]

(snip) There is nothing unusual at all - you can almost always form a collar and take a credit. But the call strike will be closer in than the put strike. You'll trade away more upside than you gain in downside protection.

-ERD50

That might be a worthwhile trade-off for fraidy-cat investors like me. So would you say the current conditions described in the 2010 article are pretty unusual? At then-current put & call prices, protecting from losses beyond 10% required the investor to forego all but about 5% of potential gains.

I am also still trying to wrap my brain around this statement from the earlier article:

There is an additional possibility. It can generally be assumed that investors have some expectation about the average return. However, given the uncertainty, they have no idea what the next year will bring. That would depend on the stage of the business cycle. In a down cycle, you have a floor of –10% in any one year. In an up cycle, you have a 20% ceiling. Suppose the actual return next year is 20% (up cycle/bull). You have now overperformed the expected return by 11% (20% – 9%). The collar can now be set at +19/–9. As the business (up cycle) continues, you can continue to book the overperformance to future years by narrowing the collar. In this way, you can reduce the volatility around the expected return. You could advocate similar management styles if the move (collar) coincided with the beginning of a down cycle.

I think the expected return of 9% refers to the mean annual return of either the collar strategy or the mixed stock/bond portfolio used for comparisons in the article. What I haven't grasped yet is the relation if any between the amount of overperformance this year and the amount the collar can be narrowed next year. Nor do I get what a "similar management style" would be in a down market.

ISTM too there is an element of timing involved in this which is not mentioned in either article. Suppose after you get your collar all set up, we get a period of high market volatility like this last month or so. Down 5% today, back up the same tomorrow, and down even further the day after that. How do you decide whether/when to exercise your put option? If you do exercise the put, wouldn't you also want to close out the call option, lest the underlying make a sudden spike upwards and someone exercise the call, forcing you to buy said underlying at a higher price than they will pay you for it? Then you are sitting there collarless until you buy some more options and maybe the market takes a dive before you get the collar re-set. Maybe the collar would work better with European-style options, so timing of exercise is not an issue.

Lastly I want to understand how a collar would be formed using cash-settled index options. I think FIRE'd@51's comment will throw some light on that but there's no time to ponder it now, alas. Off to w@rk I must go.

 

[utrecht]

Anyone here think the market is going to gap down at the open due to the hurricane? I'm going to violate the rules for my options trading this weekend only and open a new position Monday after the opening instead of today before the close. The market gapped down 3.5% on Monday after hurricane Ike hit Galvaston in 2008, although I have no idea what else was going on that weekend.