Hi, I know some people that make their money by every month writing out of the money calls and puts on an equity index. The intention is to make profit on the decay of the time premium. It is supposed to be a market neutral strategy. As long as the priceswings of the underlying equity index are not too much, the position is more or less neutral and when big market moves happen they just roll their positions to different strikes (taking some loss of course). They claim that although they sometimes lose money in extreme markets, they are profitable in the long run. I have difficulties believing this, since this would imply imo that these options are not correctly priced. I think all they are doing is distributing the chances of profit and loss in a different way (i.e. big chance of small profit almost every month and a small chance of catastrophic loss once in a while, but eventually a zero-sum game). Is there any reason to believe that this kind of strategy can really be profitable in the long run and if so, what is the fundamental reason for that? Thanks!
here we go again... the real question is; are options priced for zero sum or not? trade your opinion.
Well, that is a good question. These same people claim that the option prices are skewed in favour of the option writer because the majority of the option buyers are supposed to be n00b retail investors and the majority of the writers are professionals. However, even if this is true I would expect these professionals to compete for this 'free' money until the point that the possibility disappears... Is there a reason to assume that options are NOT priced for zero sum?
I think that's about right. In reality though it's not a zero-sum game because in reality you either get caught in a truly catastrophic loss or you don't. Trouble is, one-in-a-lifetime catastrophes seem to happen with some frequency. I knew guys in grains who got Chernobylized in 1986. At a Memorial Day barbecue I talked with a live cattle options trader who got wiped out by mad cow disease a few years ago. And of course, the crash of '87 - something that should only happen once every 300,000 years or so. So will you be one of the lucky ones who gets away with selling premium big time, or not? At the end of the day it's a roll of the dice. As someone said here recently, "Do you feel lucky, punk? Well do you?" Personally I don't feel that lucky. I'm not willing to risk my entire financial well-being on a roll of the dice.
But you can certainly limit the risk. The reward will vary. Ther are various hedging strategies, starting with collar to slingshot ...
Im a noob., but im VERY interested in writing out of the money options because dont the VAST majority of options expire worthless? Something like 85%? Seems like all that money has to go somewhere. As long as you hedge your self I think it can work. Im in the process of trying it with fake money.
Let's say 90% of all options expire worthless. Who guarantees that in a given month the settlement price of the remaining 10% of the contracts that expire in the money don't more than make up for the premium that changed hands for all contracts? It's a game of expectancy, not probability. Expectancy = (% of Winners * Average Winner) - (% of Losers * Average Loser) Knowing that the majority of contracts expire worthless says nothing about the average value of a contract that expires in the money.
I understand what you're saying, but if you hedge yourself so you dont necessarily make as much on the 90% that expire worthless, but you dont lose on the 10% that do end up in the money, wouldn't that work?
The cost of the hedge will be proportional to the amount of risk you lay off. There is no free lunch.