Spreads vs naked

dagnyt · Jan 8, 2009

Quote from chrismontez:

When I started this post I was just pointing out that in reviewing MY trading history..
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Yes, you made an innocent observation and it took on a life of its own.

Mark

dagnyt · Jan 8, 2009

Quote from taowave:

If you are a directional trader who employs stops,than the same $ stop should be employed with option positions
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Stops with options are much more complicated.

Would you want to be stopped out of a position because IV changed and that resulted in a loss? I would hope not.

And getting out of option positions 'at the market' is absolutely a money-losing proposition.

Mark

u21c3f6 · Jan 8, 2009

Quote from chrismontez:

"What is your conclusion from what you wrote above?"

I've had this discussion on ET with traders who are much more knowledgeable than I am and who think I am wrong. But in my simpleton view, if I know I can win 4 out of 5 times by selling options, and I have the resources to offset any short position the same way MM's do ( buying the underlying on short calls, selling the underlying on short puts) seller's win over the long haul.
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I was trying to address this in my post at the top of page 6 in this thread. For this discussion I would like to focus on just the option and forget about adding hedging techniques at this time. For the option, the seller will "win" more times but at a fixed or lower rate. The buyer will "win" less times but at a higher average rate. The end result is that there is no inherit advantage to being a seller or buyer. The expected return will be about the same for both.

The key to solving this for me is to find set-ups and or situations that will give you a statistical expected return that will cover spread, commissions and desired return (edge). I want to clarify what I mean by this last sentence but I will use wagering on horses to convey my meaning as this is how I see it.

I'm going to backtrack for a moment to address the more wins concept discussed earlier. If I told you I have two systems of wagering on the horses, one that has a winning wager 1 out of 2 wagers and one that has a winning wager 1 out of 3 races, which would you say is better? Depends on what your criteria is. If your criteria is to cash as many tickets as you can, then the first system is better. However, if your criteria is the one that has the greatest expected return, then you need to know what is the average return for each system. If system 1 returns on average $3.60 for every $2 wagered, you would make two wagers, $4, to collect $3.60 for a loss on 10% for every dollar wagered. If system two returns on average $6.60 for every $2 wagered, you would make three wagers, $6, to collect $6.60 for a gain of 10% for every dollar wagered.

Now the application of the above to my point. If using system 2 I collected the win on the first wager, it does not mean that my expected return is 230%, I know somewhere along the way I will lose two other wagers to bring my expected return back in line with the true expectation of 10%. IMO this is the mistake that I see when FOTM options are touted as a "conservative" strategy. They don't allow or plan for the returning to the real expected return because the strategy gives them many more wins. The problem is of course that those many small wins can be totally wiped out and then some by the very few large losses.

I hope that is clear. Please note that this is how I approach and view things. This is not to say that there are not any other successful approaches that are different. I know that there are many other successful approaches. This is just the approach that I use. I analyze a problem this way (whether it be stock market, options, horse-racing, sports betting, jai alai, casino etc):

1. If I make totally random "wagers", what is the expected return?
2. If a negative expected return, what factors make up the negative return?
3. Once the factors are determined, analyze each factor to determine if the negative effect can be minimized or eliminated.
4. Test to ensure that that the expected return is positive before use.

There is still plenty to cover but I'll stop here for now.

taowave · Jan 8, 2009

There really isnt a difference in a "continuously" traded framework.Most traders by and large do not apply position sizing algos and MM to option trading.They are under a false pretense that the leverage factor/limited risk should dictate a different approach to trading...i.e SHOOTING...Hence,they choose not to make a business out of it..

If one decides that the proper posion size is 1000 shares of XYZ stock,why in the world would you select a different delta for LONG option position??

Its irrelavant that an option is a leveraged instrument.I could leverage a stock position with margin,I could do swaps.Does that mean I should position size differently a long swap position vs cash?Should I now risk more than 2% of equity on any given position??

You ae wrong about spreads vs naked option positions

If you were deltal long 50,000 shares of AAPL by being naked Long options,what amount ov verticals would you sell to hedge yourself???

Thats right,the delta amount.....Anything else is a punt,and hopefully you are a good kicker

Quote from dagnyt:

I don't believe that's a winning strategy over the long-term.

There's quite a difference in results when buying options vs. buying stocks. One reason for buying options is the leverage. It's not necessary to buy 1000 deltas. By buying options, the trader invests less money and

1) decreases the probability of success

2) increases the potential return on investment

c) limits losses - despite the fact that losses occur much more often

When deciding to buy an option spread, the idea is to hedge - reduce risk. I agree with your opinion that owing a spread is not an automatic decision and that IV, among other factors, must be considered. But, <i>once the decision is made</i> to buy spreads instead of individual options, there is no need to increase the size to provide an equal delta position. That's just poor strategy, IMHO.

Once you decide to take a position via options, there is an appropriate number to buy. Just because you hedge that purchase by doing a spread does not mean you increase the quantity. In fact, it's right (IMHO) to trade the same number of contracts. That provides a true hedge: less risk, less reward; higher probability of earning a profit.

Mark
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dagnyt · Jan 8, 2009

Quote from u21c3f6:

The problem is of course that those many small wins can be totally wiped out and then some by the very few large losses.
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Well stated.

That is the point.
The main point.
The only point.

If you take those occasional large losses, your chance of doing well over the longer term is dismal.

My initial method of choice for preventing devastating losses is sell spreads, rather than naked options.

Regardless of how you choose your positions, it is essential to manage risk. That means taking some losses that would have turned into winners, but it also means there will be NO large, portfolio-killing losses.

Mark

dagnyt · Jan 8, 2009

Quote from taowave:

If one decides that the proper position size is 1000 shares of XYZ stock,why in the world would you select a different delta for LONG option position??

Because options are not stocks.

Because the purpose of buying options is not to own a position that is exactly equivalent to owning stock.

Because options provide leverage - and that means reduced risk.

If you buy 1000 deltas worth of calls, at what point do you sell out those extra deltas so that you are again long only 1000? Do you you sell 10 shares when long 1010? Do you wait until it's 1100? You may begin with 1000 delta, but you no longer own that number when the stock price changes -even by a couple of pennies.

And what if the stock declines and you now own fewer than 1000 delta? Do you buy more and increase risk? You clearly would not trade any more stock because that position remains at 1000 delta. Would you be forced to buy more options to get back to 1000?

Again: because options are not stock and they must be treated and traded differently.

I could leverage a stock position with margin,I could do swaps.Does that mean I should position size differently a long swap position vs cash?Should I now risk more than 2% of equity on any given position??

I don't see the relevance of this. You buy 1000 shares of stock because that's what you want to own. Whether you pay cash or use margin does not matter. You own 1000 shares of stock and own the risk and rewards that go with owning the shares.

Buying options gives you far different risk/reward parameters. Options are not stocks, and NO, you should not risk more than 2% (if that's your number) on any one position.

You are wrong about spreads vs naked option positions

If you were delta long 50,000 shares of AAPL by being naked Long options,what amount of verticals would you sell to hedge yourself???

I would 'create' verticals by selling an equal number of CONTRACTS at a suitable, higher strike price. That maintains a long delta position. It creates a spread position that's a partial hedge. It reduces risk, as a hedge is supposed to do.

Thats right,the delta amount.....Anything else is a punt,and hopefully you are a good kicker [

That is nonsense.

You seem to believe it's okay to buy 50,000 delta to go long, but if I want to hedge, I am 'punting.'

I choose to sell the call that completes the vertical because it suits my needs. It has the right properties, and that's a mix of IV, delta, theta etc.

My hedged position now consists of somewhere between 500 and perhaps 1000 call spreads. To me, that's better than owning 50,000 delta. I much prefer the vertical spread to being naked long. I have reduced my downside market risk, as well as my upside profit potential. But my theta and vega risk are significantly reduced.

You don't like the hedged position and you seem to believe that it would be best to but a lot of extra spreads just to get back to 50,000 delta.

That is not a workable strategy. Nor is it the best way to take advantage of the special properties of options.

Mark
The Rookies Guide to Options
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taowave · Jan 8, 2009

Mark,if the purpose of buying options is not to own a position,or should we say REPLICATE a position that is equivalant to owning the stock,then what exactly are you suggesting???

Are ytou saying since an option has a reduced risk,you should load up???Or are you saying due to the fact that it is a leveraged position you should have a much smaller delta.You need to pick one....

As for debating when to sell the residual deltas,thats kind of "odd" coming from your point of view.You need to tell us what delta amount of options one should purchase,as you have clearly indicated that its not the equivalant share amount.

I will add that the residual amount of delta should be adjusted relative to gamma,and I trade with vol adj pos size ,MM with hard stops as well as a time stop.

Options should not be traded differently than stocks unless one is a 100% discretionary trader who is fully willing to take calculated bets and risk X% of capital....Dont get me wrong,there is absolutely nothing wrong with that approach,but IMHO it still comes down to Deltas or risking x percent of capital.How else can one decide to buy stock vs # of spreads vs # of naked options??

FYI,buying soon to expire options with large gamm is a different topic

taowave · Jan 8, 2009

Mark,much of our differences stem from your view on point #5..I dont agree with your view

You do not seem to look at option delta's when comapring spreads vs naked options.I think that is a mistake as your P&L will make a very large distinction on a daly accounting basis.

You simply should not equate a naked option with a .5 delta with an option spread of .25 delta...It really has nothing to do with "reduced risk",gambling and higher profits.

It seems to me that you look at everything on a terminal expiration diagram....

Long Naked options

Quote from dagnyt:

1) I must make this point for anyone reading this post: he is referring to buying naked options, NOT selling them.

5) Spreads are used to reduce risk. If you don't like reduced risk, if you prefer to gamble and seek higher profits, then go ahead and buy options. Just understand the difference.

Mark
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dagnyt · Jan 8, 2009

Quote from taowave:

Mark,if the purpose of buying options is not to own a position,or should we say REPLICATE a position that is equivalant to owning the stock,then what exactly are you suggesting???

I see your problem.

Owning an option position is NOT an attempt to replicate a stock position.

If you want to REPLICATE, then you must use an equivalent. That means instead of buying 1000 shares, you buy 10 calls and sell 10 puts (same strike and expiration). That's replication. Anything else is NOT replication.

One trades options differently than one trades stocks. They have different properties and they are different.

Are you saying since an option has a reduced risk,you should load up???Or are you saying due to the fact that it is a leveraged position you should have a much smaller delta.You need to pick one....

"Load up?" Of course not.

You have a choice. You buy an option and have unlimited profit potential. Or, you buy a spread with reduced profit potential and reduced risk. That's all there is. Less money to make. Less to lose when wrong. But, the spread also provides less theta risk and less vega exposure.

You do NOT load up. You do not increase size to make the number of dollars invested the same. You would choose the spread to take less risk. That's all.

I am saying nothing about reduced delta. You may buy as many deltas as you like. But if you want to take advantage of the properties of options, you buy the number of deltas that are appropriate and then hedge the position by re-selling some of those deltas by selling a different option.

There is more to an option position than its delta.

As for debating when to sell the residual deltas, thats kind of "odd" coming from your point of view.You need to tell us what delta amount of options one should purchase,as you have clearly indicated that its not the equivalant share amount.

Are you kidding? Let's keep this simple. You are the one who wants to buy an EQUIVALENT number of shares, not me. You are the one who wants to own 1000 deltas. Not me. If I buy an option, I choose the option - and the delta is one of the considerations that makes me choose a specific option - that's it. I buy the calls and then decide what to do with them.

But you want EQUIVALENCE. You want 1000 delta. So I ask, what do you do when the gamma results in your being long 1037 delta? Do you keep them or do you sell the extra 37 delta? It's the right question to ask - if you truly want to own the equivalent position, that means 1000 deltas ,b>all the time</b>.

I will add that the residual amount of delta should be adjusted relative to gamma,and I trade with vol adj pos size ,MM with hard stops as well as a time stop.[]B]

Ok. then you are saying that your position does vary from 1000 delta and that you are NOT REPLICATING the stock position. Do you understand that you are NOT replicating; not trading an equivalent position - or do you still not get it?

Options should not be traded differently than stocks unless one is a 100% discretionary trader who is fully willing to take calculated bets and risk X% of capital....Dont get me wrong,there is absolutely nothing wrong with that approach,but IMHO it still comes down to Deltas or risking x percent of capital.How else can one decide to buy stock vs # of spreads vs # of naked options??

NOT TRUE. Options are different from stocks. Stocks do not have theta. Stock prices do not change when IV changes. Stocks do not have delta.

Stocks are not options.

FYI,buying soon to expire options with large gamma is a different topic

FYI. No kidding?

You do not seem to look at option delta's when comapring spreads vs naked options.I think that is a mistake as your P&L will make a very large distinction on a daly accounting basis.

Of course deltas count. Of course I look at them. But if I am buying options, I know how many dollars I want to place at risk. I then CHOOSE an option that suits my needs. And that includes considering delta.

When I trade a spread, I do not look at the delta. If I were buying a spread, I would choose the option to buy based on the above paragraph - and then complete the spread by choosing an appropriate option to sell.

I am trying to make money from the spread and once I have chosen the best option to buy and the best option to sell, the delta is not my primary concern.

Let me state this also. I never pick direction by buying options. I only trade spreads. And I trade spreads near to delta neutral (iron condors).

You simply should not equate a naked option with a .5 delta with an option spread of .25 delta...It really has nothing to do with "reduced risk",gambling and higher profits.

I do not equate them. You do by insisting on owning an equal number of deltas.

The 'reduced risk' is the part you don't get. My risk is reduced because I own the same number of long options - at a reduced cost, i.e., a reduction in the money I can lose on the position And yes, it also means lower potential profits.

It seems to me that you look at everything on a terminal expiration diagram....

Where in the world would you get that idea? I believe holding positions through expiration is insanity.

Question: How long have you been trading options?

Mark
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taowave · Jan 8, 2009

Mark,the real problem is,and I do not mean any disrespectbut it certainly appears you are not a directional trader,nor do you think like one.You have a floor traders mentality,and that is why we are speaking different languages

As an "iron condor" trader,I now understand where you are coming from.Its a much different world.

How do I know this??

I too was a market maker on an options exchange,but for 15 years I was the head trader of equity derivatives and emerging market derivatives at a major investment bank.I later ran a fund and cashed my chips in 2006.

With that said,I have had the good fortune of meeting, and working(trading against as well as covering) with some of the largest "directional traders" at various hedge funds,and I promise you they do not look at things the way you do..Not even close......