One of my trading strategies is a delta-hedged vol strategy. I have had good results this month, up 1% by selling just roughly 2-5 contracts a week on a portfolio margined account. I reason that this strategy is working in this kind of low vol market melt up environment but my concern is of course about these tail events and "blowups." I'm only doing 1 contract per name but the contracts are on some big names trading at $>400. What are the reasons that option traders blow up? Are they over-leveraged on a small acct? How much do you stand to lose on a single contract if a big event happens (could be to the stock or overall market)? I keep my deltas in a [-30,30] band, gamma is in a range of [-12,-6], vol -8, theta 60 per contract.
Read about Vic Niederhoffer....he was successful for quite a while. He NEVER capped his short options positions....which was usually short puts. Why not use credit spreads instead ? Answer: He was greedy...he wanted that entire premium. He eventually blew up, and one of the reasons was he was not diversified....at all. Being diversified with individual stocks does help.....except in the case of a black swan event where everything moves in the same direction. Thus, credit spreads do limit your exposure compared to naked short option positions....but they do reduce your profits as well. That's the trade-off....naturally....risk vs. reward.
Add some insurance. When the tail risk hits, there is no rolling down or out strategy that will help you. You will find a years worth of profits gone before you can blink. The problem I have seen is that we have had "once in a lifetime" events pretty frequently over the past decade. If you have software that allows you to backtest, put on one of your positions and run it through some of the events we have had. I was sitting at my desk during the flash crash with neg gamma and watched $2 sold options go to $30 before the quotes stopped updating and I wasn't sure how much I was losing. I was "smart enough" to have contingent orders in to buy me "insurance" as we dropped. These executed insurance trades were what I ended up losing the most on. Volatility has been low and everyone is talking about the "death of volatility". That is a sign to me of possibly rough seas ahead and you don't want to be caught short options, especially options that are priced at this current volatility.
I think it'd be really helpful if someone can give examples of minor and major "blowups." What is a blowup in dollar amounts & %'s? For me a blowup (position blowing up in my face) is a tail event, a 2+ annualized std move where I lose more than a few grand on a single contract cap it at 4-5. Anything less I assume is the cost of doing business. Now do you mean blowup to be a career ender? In that case we're talking lifetime events. Relative example: Even if PCLN drops 100 points that is a 10k loss per contract, very unpleasant, but if its extremely rare, I can take it and that's not going to put me out of business. Now just say hypothetically PCLN gets bought out and jumps 700 points in a day with zero warning that's another thing. I still won't be out of business, but I'll seriously think about deactivating this strategy. Since these events don't happen very often its hard for lesser experienced traders to understand these events and historical quotes on options is hard to get. What is the example of a blowup? How much do you lose per contract? How much were hedged? What are the details of the trade?
If you're selling naked calls you might use historical takeover premiums as a guide. You can find the research or do your own, but as a starting point, you should be able to handle an immediate 15-25% pop in the underlying. Not all that different from a super-duper positive earnings surprise, at least for smaller cap firms. I don't know if you'll find a precise definition for blow-up. In general terms it's the type of event that knocks you out of the market. You have to stop trading until you've saved enough money (that you earn elsewhere) to re-fund your account. Or maybe it hurts so much that you give up altogether. Alternatively, if you used to be good and still show promise, perhaps you can raise fresh capital from forgiving investors.
do a simple stress test.... Most likely event if you have multiple positions on, even if they are 'hedged'. Move prices down by 5-10-15-20-25-35% and mark volatility up. If that blows your account there is your answer. Forget about the 1,2,3,95 standard deviation BS, because it will be irrelevant if something occurs and you have a bunch of positions together moving against you. Even if the market is only down 25% in a day, many stocks might fall 30-40%. ...and while they might be rare - they are certainly less rare than many think and it only takes one. Your broker will likely liquidate you if you dont have enough margin, and will not give you enough chance to deposit more margin.....again another risk. Stress test yourself and dont rely on anyone elses history or stories. The answer is yours to work out what a blow up consists of.
And don't forget that it's not the 25% one day move that can kill you. 5 5% moves in a row can do a lot of damage to a 20 vol stock. Everytime I've found myself caught in a short vol quagmire it's the latter example. Vol clusters so if you are down 5%, you have to make choice, hedge and potentially lose on the 5% rebound or don't hedge and lose double if it sells off 5%. Plus you are losing on vega at the same time because the market knows there will be another 5% move.
I reduce positions if my theta exceeds 1% of notional. Even if I am up substantially. I have exceeded that number many times, but only for a short period. You're running too much risk, IMO.