Cost of insurance using options

Discussion in 'Options' started by Neutral, Dec 13, 2011.

  1. Neutral

    Neutral

    Assuming efficient markets, one cannot make money from buying/selling options without an edge about the direction of the underlying, so it seems to me that the long-term cost of insuring a security about which the owner has no edge or opinion is zero. But wouldn't this allow a "noise trader" to purchase a protective option and wait out the adverse moves (as opposed to getting stopped out) and take profits when the underlying moves in the "right" direction? And then repeat the process. The fact that the option was purchased as protection shouldn't make the option itself to be more or less likely to be profitable over the long run, and its average cost should converge to zero. I feel that this is the equivalent of a "perpetual motion machine", and should not be possible. What am I missing?
     
  2. 1) Options decay. Protection costs.

    2) When wrong and UL drops, you lose UL value down to strike plus decay. Huge drop and you lose entire cost of protection as well.

    To succeed, you'll still need some degree of timing and selection. More rights than wrongs or larger wins than many smaller lsoses. Whatever. A bull (or bear) stretch doesn't hurt either :)
     
  3. Neutral

    Neutral

    But on average, over many many trades the time decay would be cancelled by the option moving into the money and showing a profit (when UL is losing money)
    And when the UL moves the wrong way you just wait because the option is largely cancelling further loss, and buy a new option if the original expires in the money. And do this until UL turns around. Of course better do this with an index, which is exceedingly unlikely to go to zero and stay there;-)
    Anyway, thanks for your reply but I still don't see what I am missing. If buying options as protection must cost money in the long run, then option sellers should make money like the "house" as a statistically assured thing, but I am pretty sure it cannot be true; the market would eliminate the "sure thing". I guess when you take profit in the UL the option must have a smaller but nonzero loss which wouldn't average to zero, but there is still the problem of being able wait forever to turn a profit in the UL while buying options that average to zero profit/loss until it's time to take profit in th UL. It must be impossible but ...
     
  4. For example, stock is 52 and 50 put costs $2. Stock drops to $45 and 50p is now $5. Net loss of $4 at expiration.

    Now you buy a 45p for $2.50 and short term, the stock must rise about $5 to break even (recovering the $4 plus offsetting about $1 of 45p premium loss from the rise). If at expiration, the stock must be $51.50 to break even. Suppose instead, the UL kept dropping. Wash, rinse, repeat. At $40 you cash the 45p and buy the next month's 40p for $2.25. Now you have as much as $8.75 to recover to break even. Feeling good about waiting for the UL to recover?

    Or perhaps we can look at it another way. Your long stock plus long put position is equivalent to owning a long call. In your opening post, you stated "that one cannot make money from buying/selling options without an edge about the direction of the underlying". But that's jsut what you're doing, just synsthetically. Care to rethink the concept?
     
  5. I received the following via E-mail tonight. I can't believe the (disguised) crap that people try to sell:

    http://www.radioactivetrading.com/the_sketch.pdf
     
  6. Why do all that work? why not just buy the call option instead?
     
  7. heech

    heech

    Neutral is completely right. In the big picture view, options are fairly priced. Therefore, there is no loss in expected value from buying options as "insurance" for limitin losses.

    And yes, if you believe you have positive expectancy when it comes to picking direction, then this doesn't hurt your expected gains while limiting losses. And yes, you can achieve the same by buying a call.
     
  8. That's the point. Buying deep ITM puts to protect long stock is the equivalent of buying a long call. And then selling a shorter term call against that position after the UL runs up is no more than legging into a diagonal spread.

    You don't have to be a rocket scientist to make money with options when the UL cooperates. It's what you do when the UL moves against you that separates the men from the boys,
     
  9. MBC

    MBC

    I have always heard this "equivalent".

    Fact or reality is that more people have reason to own underlying and want a hedge, so they use options. Rather you are talking about bets on options themselves....


    ?

    Thanks
     
  10. Equivalent means having similar or identical effects. Being equal. That applies to certain option strategies.

    In this topic, buying stock and simultaneously hedging with a long put gives you the same risk graph buying the same strike/month call.

    Another popular misconception is that selling naked puts is very dangerous whereas doing covered calls is not. They too are equivalent. As are collared stock and vertical spreads.

    To verify this, simply plot a risk graph of each and it will become apparent.
     
    #10     Dec 17, 2011