A Challenge For You...

Discussion in 'Options' started by magic423, Jun 12, 2010.

  1. magic423


    Are options a "bad bet" long term?

    My math indicates they are and I'm truly hoping someone can meet the challenge and PROVE me wrong.

    Long term performance can be evaluated in terms of trade return on investment expectation. Here is how trade ROI expectation is calculated:

    Expected profit/loss ($$$) per trade divided by investment amount

    Let me provide an example to clearly explain the problem I am finding with option positions. I'll use a real life example of selling a SPY Iron Condor (using 2 pt spreads). The trade quote info comes from the Thinkorswim platform 6/12/10.

    Relevant Data:
    The position - SPY Jul 10 (expiration about 5 wks) sell 114 call, buy 116 call, sell 104 put, buy 102 put
    Credit received: .89 or $89 for the 100 shares per 1 contract
    Probability of expiring at break even or above: 45.52%
    Commission to enter trade: $11.80
    Profit Potential: $77.20 (credit received minus entry commissions)
    Risk/Margin/Investment: $122.80 ($111 margin requirement + entry commissions)

    Ok, that's the position and the data. To see if this (or any) trade is a good bet (profitable long term), one must determine how one would do if the trade were made many, many times. If this trade were made 100 times, one would expect to win the profit potential 45.52 out of the 100 times...

    45.52 x $77.20 = $3,514.14 total winnings

    And one would lose their investment of $122.80 54.48 times out of the 100 times (100 - 45.52).

    54.48 x $122.80 = $6,690.14 total losses

    So if this trade were made 100 times, what would be the total EXPECTED PROFIT/LOSS....

    - $6,690.14
    - $3,176 total expected loss

    Which provides an expected profit/loss per trade of -$31.76 (total loss divided by the number of trade, in this case 100).

    This per trade profit/loss is then divided by the investment of each trade ($122.80) to determine the per trade expected return on investment.

    -$31.76 divided by $122.80 = -25.86% !!!!

    And therein lies the problem. Every credit spread or option position I evaluate produces a NEGATIVE expectation. And that means the position is a bad bet because it will lose money long term.

    Closing a position early doesn't solve the problem, it only makes it more complicated to calculate and even compounds the problem.

    So here's my challenge...

    Where am I wrong? What am I missing? The only way to make money long term is to engage in trades with a positive (not negative) expectation. If there are no option trades with a positive expectation (and I've yet to find one), how does one overcome the negative expectation and make a trade positive??

    With all due respect, I'm NOT looking for personal opinions or one's personal trade experiences. If you can't quantify it down to a definable trading situation that can be objectively evaluated, then one can't duplicate it for future benefit. It is all about numbers. It is about gaining an edge (positive expectation) and then profiting from it.

    I would greatly appreciate any quality input.
  2. You are wrong in many ways...

    1) The most obvious thing is that you describe a case where you have no view whatsoever on the market. Yet options are a very useful tool to express an opinion on direction and/or volatility. Ex: calendars, 1 by 2 spreads, risk reversals, vertical spreads. But you do need to have a thesis...

    2) Adjustments can and will be made on a position if you want to be successful in the long run.

    3) Your example is a bad example IMO. You can read dagnyt, he is the condor man around here but personally I NEVER sell call spreads, the risk/reward makes no mathematical sense.

    If you want positive E(X) you need to change your approach with put spreads. SPY options are for sissies, go on the cash settled SPX or XEO. You need to take a look at the weekly options. They come out every friday with 8 days of life. You can easily find positive E(X) with deep OTM puts. They decay so quickly that they make it possible. I did that for a couple of years although I would not recommend it. Have you heard of the expression: picking up nickles in front of the bulldozer? Well thats what it is.

    I've learned with experience that a good E(X) is not the main factor, if you trade based on it, you will loose no matter what the odds say. You need to have a thesis, there are no ways around it.
  3. magic423


    I appreciate the reply and this may be a good discussion, but you're wrong on your points. Let me address each issue:

    1) An Iron Condor is a credit spread and one does not want direction. Additionally, option plays with a directional bias still produce a negative expectation, so either way they all appear to be bad bets. Volatility and the Greeks only apply to options if and when one exits the position early. And as I stated, early action only complicates the evaluation and does NOT solve the problem... you still end up with a negative expectation.

    2) Adjusting only increases the negative expectation due to the increased cost of the adjustment. As I said, you still end up with a negative expectation... one even greater than had no adjustment been made.

    3) My example is just that... an example. But it illustrates the problem with every option strategy I have evaluated. If you have a strategy that provides a positive expectation, please provide all the details!!!!

    You said, "I've learned with experience that a good E(X) is not the main factor, if you trade based on it, you will loose no matter what the odds say."...

    Without it you can't win in the long run. You can talk about personal experience all day long, like the player that won at the craps table for 10 straight hours... but sooner or later the odds and probability WILL kick in... they always do and always will.

    If you claim that some factor will overcome the inherent negative expectation of an option, please provide a detailed explanation of how that is accomplished.

    If you claim that I need to just create some direction preference, then the problem is only made worse. I have a 50% - 50% odds of guess right today and wrong tomorrow. How does that help me overcome the negative expectation?

    Give this problem some serious thought because we're putting real money at risk and often taking bets against odds that would make Las Vegas drool with envy.
  4. magic,

    First of all, it seems you are trying to claim options are worthless by showing 1 example. That makes no sense. As far as your example goes, if that has a negative expectation, flip it. Who says everything has to be a long iron condor - if instead you bought the closer options and sold the further ones, the expectation in your example would be better.

    Personally, I don't put too much into the "this has a 41.23% chance of happening" type of stuff anyways - what were the odds in Aug 87 of that level crash in Nov - I bet it was .001% or something. I have seen studies where they have shown option sellers not paid anywhere near enough for the worst-case potential for example. If someone saw XYZ was at $100 and was only 1% chance to fall below $80 by expiration, then they don't buy it, now it falls to $55 - the buyer makes big and the seller gets hammered. Of course, it can happen the other way around as well. If there is only a 1% chance of something happening and it happens, then really it was 100%.

    I think heiasafari is basically correct as well. Also, if someone had a trade that was simple and clear and always had a + expectation, do you really think they would want to just post it here for everyone to see?

    Also, as far as expectations go, I can have positive expectations on a trade and not be able to clearly show it or have others even agree with it. For example, I did a trade with CLF basically live on ET (I showed what I had done at the end of the day as I was at work when I placed the trade, so it wasn't live, but I showed the trade before knowing the outcome).

    Here is the thread:


    I had a positive expectation for that trade, and it worked. I'm not saying it was 100% lock or anything. You can see in my comments my reasons for figuring it was a good trade. Others may not have thought it would work - I have/had no way to prove that though x many of the trade that y many would work for $z dollars or anything. So what? BTW, I did the same sort of trade semi-live again later on ET and it was profitable again. Again, other people would never do that trade because it is a debit and they make money on credit spreads - great, the market has to have buyers and sellers to work.

    I can find this type of trade that works for me quite often - others it might not work for as it's not exciting enough, or maybe they adjust too much, or they don't completely understand IV or whatever.

    My point is that I have a positive expectation when I lay down a trade like that, but I can't quantify it nor do I ever plan to try nail down the exact expectations.

  5. magic,

    One more thing you really have to look into and understand if you don't yet is IV and the extreme role it can play, especially around earnings.

    live_vol has many good posts that show the general idea here. I don't normally play these so often, but the idea is this:

    Let's say XYZ is a big tech co. that is worth $80/share. They have earnings coming after the market close and everyone is excited to see how their last product has been - some are bullish, some are bearish. Straddles with 3 days left are worth $1000 - pretend the current IV is 50% (up from 30% a month ago). You do a quick look at past earnings and realize that even though there is often hype, the stock doesn't usually move much on earnings and of course IV often gets crushed.

    You might sell the straddle - after earnings, the stock moves the next morning to $83.50, IV is crushed, and you close out the straddle for $375. Now this might be viewed as a positive expectation just from the fact that maybe the stock didn't move much 5 of the last 6 earnings plays. You would have to do research to see if you did that many, many times what the results would be - no one is just going to come here and give all the details.

    On the other hand, one could do the opposite trade of going long Vega as earnings approach. In one book I have, a couple of examples show where for example a straddle would hold even or even gain somewhat despite the stock not moving (he was using real numbers) because IV was rising into earnings. So, there was very little or no loss for days when the stock didn't move, but then a large move in the stock resulted in a nice gain. (One of the examples was an Apple Strangle).

    One of my main points is that there are 1000s of ways to trade and most people won't ever even agree on the best way even if someone came here and showed all the details of a working strategy anyways!

  6. magic423


    Thanks for your input. I have to disagree with you however. Please understand, I'm not trying to be argumentative, but this is a serious business (huge business) involving big money and almost every aspect of this business is broken down and defined by numbers. Smart people are not going to invest millions of dollars on hunches, a few past experiences, etc.

    If you can't define HOW you have an edge AND be able to clearly DEDUCE THE AMOUNT OF EDGE you have, then you're simply gambling. You may be lucky, some gamblers are. You may have contrived all sorts of justifications to convince yourself that your method is profitable, but in the end if you can't define your edge then you really have none.

    As far as your trade, I can confidently state that you did not have a positive expectation. I have evaluated almost any type of option position you can imagine, credit spread, debit spreads, etc. and the result is the same... a negative expectation.

    I have the gut feeling that somehow, someway there is a positive expectation out there (besides the bookies that get commis on the deals). Here's the thing... the positive E(x) IS the money we want to make. That's where the profit is. And you can't confidently make it until you can find it. I sincerely hope that someone really understands what my point in this thread is all about and has the answer.

    Heiasafari and you say I'm looking at this wrong, but you can't explain exactly why that is so. You can't explain how your trading method gains a consistent, long term advantage. Sorry guys, but I think my approach is correct and the question I'm raising is probably the most important one in this business.
  7. Here is the problem, you seem defensive, and not open to what others say, so discussion here seems fruitless. Just the responses from others that you are basing your arguments on examples blow you out of the water from a statistical, mathematic and logical viewpoint

    So the question you raise is probably very naive.
  8. magic423


    I don't think I'm defensive and sorry if you take it that way. I am simply responding. One person says to find a reason to pick a direction, so I point out that without something concrete (numbers) to validate and test the selection method the procedure is little more than guessing. I'm told to make adjustments, but I've already evaluated that strategy. Adjusting, even if the cost seems small, is actually expensive when the everything (including $2.95 transaction fee per option contract) is added in. The result is simply a new negative expectation position in a different price location. I'm then told by another person that he believes he has positive expectation on his trades, but can't provide example evidence or proof of such. Maybe he does, but maybe he doesn't. I doubt it since I have yet to find a positive EX position, but I simply pointed out that without a way to pinpoint and prove positive expectation situations, you can't devise a trade method or confidently repeat those trades in the future.

    My point is that the long term success of every business depends upon that business' profit expectation (casinos operate on a profit expectation of less than 2%!). It is illogical to think that option trading would be any different.

    I went to considerable length in my initial post to explain how profit/loss expectation is calculated so everyone can apply it and prove or disprove their trade methodology. I used a valid quote and provided the source of the data. I supported every element of my position. I'm very open to any idea or suggestion. I want to find a EX+ and I'm hopeful that some are out there. Proving it is the key. Without proof, it is only hopeful speculation, even if supported by substantial personal experience.

    Without the mathematical support, one can't really know whether they are playing poker or craps.
  9. jamesbp


    If you are seeking mathematical proof, you are going to be disappointed and probably unsuitable to option trading, as the markets are really a study of behavioural science and don't really obey 'cast iron' rules ... but wish you best of luck in your search.

  10. ...ok, you proved it, (with some bs software from tos). now what?
    it has been "proven" humming birds cant fly, yet they are buzzing about my back yard.
    every thing in life is a derivative (option), (including you and me), we know how it ends, just not when, dont need no stinkn math proof.
    while you are looking for your proof that it wont work, others are making money, (and more derivatives), play the game with joy while you can.

    use your math skills for your own and societys enrichment, not some bogus proof of the end game.

    read cottle (risk doctor) and look at sheridans videos.

    as you are talking poker or craps, you might also check this out:
    Susquehanna, the poker-friendly options trading firm

    #10     Jun 12, 2010