Archive for the ‘Options’ Category

Before you short the market with options…

Sunday, September 6th, 2009

After reading our previous article (Time to short stocks in the NYSE?), one of our readers asked us a very practical question on using options to successfully trade the market. For those who are thinking of making their wealth with options, please read and understand what we wrote to this reader:

But one thing you have to bear in mind: learning about the technical aspects of options (e.g. delta, gamma, theta, delta-neutral, options strategy) is the easy part. We have quite a few good book recommendations that can teach you the technical aspects of options very well. The difficult part is to be a good trader. Even if you are an options expert, you will still make plenty of losses if you are a bad trader. On the other hand, if you are a good trader, you can still make good money with the most basic options strategies.

Options is just a tool. A bad trader who uses a powerful tool will lose money regardless of how well he/she understand about the tool. A good trader, coupled with a strong basic understanding of the tool, can make good money.

Options trading is a very vast field of study (for example, the topic of volatility in itself can cover a thick volume). Therefore, this is something that we cannot cover in just one article. For this article, we will give a little preparatory background about options before going into something more practical. For those who are totally uninitiated to options, please read Introducing options as insurance and How not to use options first before continuing.

For budding options trader, the thing to remember about options is: statistically, around 80% of options expire worthless.

  • Therefore, buying options (whether call or put) is likely to result in loss.

BUT…

  • But the other 20% of options (that are not worthless when they expire) have the potential to yield fantastic profits.

Therefore, buying options allows you to profit from Black Swans. If you have not already, please read Failure to understand Black Swan leads to fallacious thinking. Put it simply, even though you are more likely to lose money buying options, you will make lots of money should you win the unlikely-to-win (based on statistical probability) bets.

  • Conversely, if you write options, they are likely to result in profits.

BUT…

  • But on the other 20% of options (that are not worthless when they expire) expose you to a contingent liability that can result in substantial loss.

Therefore, writing options makes you vulnerable to Black Swans. Put it simply, even though you are likely to make a nice income writing options, you are exposing yourselves to contingent liabilities that can result in substantial losses (if you are not hedged).

In options trading lingo, buying options gives you positive gamma while writing options gives you negative gamma. If you have no idea what “gamma” is, forget about it because it is a specialised jargon used in the options universe. If your options position have positive gamma, you will benefit in sudden increase in volatility. On the other hand, negative gamma positions will benefit from little volatility in the market.

When options traders construct an options position, they are using a combination of buying and writing options to adjust between the positive and negative gamma according to their tolerance for risk and their conviction of the market.

In the current market, if you believe that there’s a likelihood of sudden unexpected increase in volatility, your options position should have positive gamma (e.g. from simple buying of put options to the more complex put ratio backspread). Positions with negative gamma are vulnerable (e.g. writing put options in the belief that a nice gradual up-trend will continue) to sudden increase in volatility. To explain this in more detail, let us give you a few examples:

  1. If you buy out-of-money put options, you are likely to lose 100% of your money, based on statistical probability. But if the market suddenly crashes, you will make many times the return on your capital.
  2. If you write out-of-money call options, you are likely to make a little money most of the time. If the market crashes or rises a little, you will profit a little. But if the market rises significantly (e.g. a stock that receives a takeover bid), you will likely to suffer heavy losses.
  3. If you buy out-of-money call options, you will suffer limited loss should the market crashes. But if the market sky-rocket suddenly (e.g. if the Fed announces that they will drop freshly printed US$100 trillion from the sky via helicopters), you will make big money.
  4. If you write out-of-money put options, you will make a little money if the market rises or falls a little. But if the market crashes, you can lose a lot of money.

That’s all for today on options. If you do not understand what we are talking about, don’t worry. Options traders live in a different planet from the rest of the world.

One final note: in a recent interview, Marc Faber said that he believes that the market will make a big move in the next 10 to 14 days.

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Posted in Investor Education, Options | 10 Comments »

How to implement an asymmetric payoff strategy: Part 2- Using options

Thursday, August 16th, 2007
In our previous article, How to implement an asymmetric payoff strategy: Part 1- stop loss, the wrong way, we talked about using a wrong way to implement an asymmetric payoff strategy. Today, we will talk about the proper way to do so.

 Our preferred method of profiting from a possible stock market crash (see How to take advantage of an impending crash- Part 4: asymmetric payoff) is to use derivatives called options. Contrary to common misperception, options are inherently not ?risky? and ?dangerous.? When used properly, options can in fact reduce your risks significantly. It is the misuse of options that can result in severe loss, which probably give it such a bad reputation in the first place (see our articles on options here).

Also, options are arguably the most complex topic in finance, which could explain why they have the feel of mystic and danger to those who are uninitiated. Understanding options involves knowing options pricing theory, which uses complex mathematical formulas and algorithms that involves the Bell curve (see How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud). Thus, we cannot go too much into any detail about options for today’s article. We can, however, point you to the right direction.

The great thing about using options is that with specific combinations of short (sell) and long (buy) puts and calls, you can profit from all kinds of market conditions (bullish, bearish or neutral, volatile, stable, trending, trendless, etc). For example, there are options strategies for taking advantage of extremely stable (and boring) markets. There are also strategies for taking advantage of highly volatile markets when you have no conviction on the direction of the market.

For the very specific purpose of profiting from a possible stock market crash, a suitable options strategy would be the Put Backspread. The profit/loss pay-off diagram for this strategy is this:

Put Backspread

As you can see, with such a strategy, you maximum loss is if the stock price remains stagnant at $90 by the time the options expire. If you are wrong about the direction of the stock price (i.e. stock price shoot up suddenly), you still can make a profit. But if you are right about the stock price crash, your profit can be unlimited.

There are much more about options that what we mention here. If you want to learn more about options, there are some books that we recommend here.


Posted in Investor Education, Options | 12 Comments »

Introducing options as insurance

Friday, January 12th, 2007

In our previous article (How not to use options), we mentioned about options. Today, for those of you who are uninitiated to the world of options, we will give you a quick introduction. For more in-depth information about options, we recommend the books in the ?Derivatives? section in Recommended Books.

First, let us have a brief introduction on options. When you buy a call option of a stock, you are purchasing the right (but not the obligation) to buy the stock at a specific price (the exercise price in the option?s contract) on and before the option?s expiry date. Correspondingly, when you buy a put option, you are purchasing the right to sell the stock at the exercise price. Technically, when you buy a call (put) option, you are said to be entering a long call (put) option position, or simply ?long? a call (put) option.

The interesting thing about options is that you can also ?create? them for sale. When you sell a call option of a stock, you may be obliged to sell the stock at a specific price if the buyer of the option chooses to exercise his/her right to buy from you. Correspondingly, when you sell a put option, you may be obliged to purchase the stock from the buyer of the option. Technically, when you sell a call (put) option, you are said to be entering a short call (put) option position, or simply ?short? a call (put) option.

When you initiate an option purchase or sale, you are said to ?open? an option position. To ?close? an option position, you enter an opposite option transaction?sell back the purchased option or purchase back the sold option.

A good way to understand options is to see them as akin to insurance. When you enter a long call (put) option position, you are in effect purchasing ?insurance? against the rise (fall) of the underlying stock price. When you enter a short call (put) option position, you are in effect underwriting ?insurance? for the rise (fall) of the underlying stock price. So, option trading is a game of probability?the same way insurance companies are in the business of pricing probability of events for profit. Therefore, as in the insurance business, the option trader has to accurately ascertain the price of probabilities accurately in order to profit.

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Posted in Investor Education, Options | No Comments »

How not to use options

Friday, January 5th, 2007

Many people have the impression that options are ?risky? because they expire after a cut-off date. Though this impression is understandable, it indicates a misunderstanding on the use of options. As a result, options are often misused, resulting in losses?that is where its bad reputation comes from.

To elaborate on how options are misused, we first look at how people trade stocks. It is easy to understand how to profit from stock trading?buy low and sell high if you believe that the stock price will rise. If you believe that the stock price will fall, you can short-sell?borrow stocks at high price, sell and then buy back the stocks at lower price later to return the loaned stocks. In other words, to profit from stock trading, you only have to get the direction of the stock movement right (though not exactly so for short-selling, but the idea is there).

Now, when you extend this idea to options trading, it becomes a recipe for losing money. Since options have expiry dates after which it becomes worthless, getting the direction right is not enough?you have to get the speed of the stock movement right as well. Since it is hard enough to get the stock?s direction right, let alone its speed, using options as if it is a proxy for stocks will result in increase likelihood of suffering losses. Also, options prices also depend on other variables in addition to the direction of its underlying stocks (the stock that the options derive from). In real life trading , it means that in some cases, it is possible for an option?s price to fall even though the underlying stock price remained unchanged.

Thus, if you are intending to trade options the way you trade stocks, we urge you to think twice. To trade in options, you need a paradigm shift from your understanding of conventional stock trading. We will touch more on that later. For more information on how to trade options safely, we recommend the books in the Derivatives section of Recommend Books.

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Posted in Investor Education, Options | 5 Comments »