jimmyjazz: That's certainly a fair question. What the hell is it I am doing? You are right. The options I deal with ARE pretty fairly priced. But there is some space for profit. When I sell puts I play the roll of an insurance company. If I buy a house I can't risk having the house burn down and take the entire loss of the cost of the house... so I buy home owner's insurance. The company selling me home owners insurance (e.g. State Farm) computes the probability of my house burning down (or having another catastrophic event) and sells me insurance with a policy premium it computes. If the insurance company insures a lot of people, on the average it computes it's premiums so that the large number of people who's houses don't burn down will pay for the few people whose houses do burn down... plus a little profit for the insurance company. That's all there is to it. If I buy a stock, and am a careful investor, I will buy puts to protect my investment. Same thing. All insurance companies hedge their bets in several ways. 1. reinsurance is the most important way. http://www.investopedia.com/ask/answers/08/reinsurance.asp There are companies that you have never heard of who specialize in selling reinsurance to insurance companies. e.g. Munich Re https://en.wikipedia.org/wiki/Munich_Re 2. risk spreading. e.g. Your home owners policy does not cover floods. http://www.iii.org/article/does-my-homeowners-insurance-cover-flooding If I were an insurance company and I insured a lot of houses in a flood plain a flood would wipe me out. A Federal agency (FEMA) provides me with flood insurance via a federal program, totally separate from my home owners insurance. Even with these protections an insurance company will need to have adequate financial resources to cover random periods of high numbers of claims. So do I. 3. Other things... When I do a credit spread I am selling insurance (the short put) and 'laying off' the majority of the risk to someone else (my reinsurer) via the long put. It's up to me to evaluate the risk, price the short premium and lay off the majority of the risk to someone else... my re-insurer... and to properly price the premium. If I can't get an adequate premium I can't afford to sell the insurance. It's by selling insurance for inadequate premium that people can't make a go of it. The main task in my business is to evaluate the risk, price it, and then lay off the majority of the risk to someone else. A 'good deal' for me is to sell overpriced puts and buy underpriced puts. Rarely happens. Recently I had a claim. I sold puts to people who were betting on the Pfizer/Allergan merger. http://www.reuters.com/article/us-allergan-m-a-pfizer-idUSKCN0X3188 That's called paying a claim. I am lucky I had re-insurance or my losses would have been staggering. http://stockcharts.com/h-sc/ui?s=AGN In evaluating the risk I need to carefully examine the company whose stock I am insuring and get a reasonable premium for insuring that risk. Success in this business is completely dependent on the correct evaluation and pricing of that risk. Like an insurance company I can go long periods of time collecting premium and accumulating money... and then BOOM. I have to pay a claim. If I am good at what I do I will have saved up enough premiums to pay the claim with out a problem. In order to sell insurance I need to have money to pay the claim. (and, by the way, that money can't be idle or I will never make a go of it) If I have foolishly sold insurance to high risk situations with inadequate premiums I will quickly go bankrupt. If I have inadequate funds to insure my book of outstanding liabilities I also risk disaster. People don't realize it but current low interest rates are a real problem for me (and for insurance companies). It used to be that I could put my cash into the money market and earn enough interest on that cash to help with my overall P/L. This is no longer the case. Now if I keep cash on hand, with money market rates less than 1% and treasury rates at 3% or so my cash does not earn enough while waiting for a claim to help pay for anything. So in order to keep on an even keel I have to search the market for SAFE opportunities to put cash to work. Money Market Substitutes. The problem is that 'safe' can be a matter of perception and you can be fooled. Skill in doing this is essential to conducting a profitable insurance company. One other word on risk diversification. I need to hold a 'risk diverse' portfolio so that single industry disasters, for example, don't entirely wipe me out. I keep my exposure to financials to a minimum for example. Health care is good but you have to keep your eye on federal health care policy and it's prospects. Diverse industrials would seem good but there are execution risks (e.g. GE). At any one time I hold between 20 and 40 spreads. I review those spreads (and the companies involved) daily. I will bail out of a position at the first sign of trouble. I make 10-20% annualized on this portfolio and have done so for about 10 years. If you try to work this business with a quick profit short term day trader mind set you will get killed... probably sooner rather than later.
Nice post. Would you say that your profit largely lies in your ability to find spreads that the market has not priced appropriately?
Jimmyjazz: Let me add one other issue. On some occasions you will find that the market has 'unfairly' priced a stock because of news events and you find your spread threatened. In such a situation you will see that you have made money on the long put and lost money on the short put. The whole phenomenon may be a complete chimera (i.e. a myth). In such situations a skillful trader can (usually just before expiration) take his profit on the long put, allow himself to be put the stock and then sell calls on the stock until called. To do this you must be very skillful in valuing the stock AND have the capital to buy the stock.
well.. you could conceive of a scan that would find 'mispriced' options. I don't think it would work. The scan would have to be able to read the Wall Street Journal and Barron's but it might be a starting place. Mostly I first look for companies that are making projections that are believable (good projections for long positions and bad projections for short positions) and then look to see if the options market is pricing a spread I can live with. For me company earnings projections and company prospects are the starting point not options pricing. Like Warren Buffett I am primarily valuing the company and its immediate future.