What strategy works like selling DOTM naked call?

Discussion in 'Options' started by a529612, Nov 23, 2006.

  1. Is there any strategy that works like selling DOTM naked call but with better profit potential and defined risk? I want to make a bet that the underlying will never hit the "fantasy" DOTM strike by expiration, e.g. GOOG Dec 600. Thanks!
  2. You want a defined risk strategy that will make more profit than an unlimited risk strategy? If that were possible, do you think anyone would take an unlimited risk position?

    Do you have an opinion about where GOOG will be by Dec expiration? If so, a butterfly at that strike will make pretty good, defined risk, money.

    Alternatively, buy a bear spread at 600. (Short 600 call, long 6x0 call). The more risk you're willing to take (i.e. the spread between the short and long calls), the more money you'll make if you're right.
  3. That is one thing that always annoyed me about options books and the like. Everything sounds great in theory and on paper. But the reality is something different.

    Lets take the DOTM number you bring up. you think this magical number of GOOG not hitting $600 by the expiration of Dec. Thats cool. The spread right now on those calls is bid .20 by ask .30

    since you would be selling, you would be taking out the bid at .20, possibly .25 in between at best. But for you to make any money you would need to sell at least 20 contracts which would yield you premium of $400

    now to cover this, would be hard, because the ask on the $630 or $640 is showing .15, which would basically eliminate your premium credit. but just for giggles, lets say you could buy the $630 & still yield a .10 credit on the spread. the margin requirment for this would be $60K with a potential $200 profit. if you just sell it outright naked, for one, you will need minimum capital of $100K + in most retail accounts & remember, you are short 20 contracts which are the equivalent of 2000 GOOG shares -- if GOOG takes off, those calls would easily crush you. is this kind of exposure really worth $400??

    Just be careful and make sure the risk/reward makes econimical sense and is practical.
  4. This is where people get hurt in these strategies. "Making it worth your while" is always the beginning of the end when people sell options. Your goal to survive as a trader for the long term should be "live to fight another day".

    You also need to take probabilities into account when computing the risk/reward. These 600 calls probably have a 99.5% probability of expiring worthless. So, you have 5 chances in 1000 of losing money. Those are pretty good odds.

    You're passing up on a winning bet. If you win, you make $20. If you lose, you'll lose $1000. You have 995/1000 chances of winning. If you make this bet 1000 times, you'll win $19,900 and lose $5000. That's not bad.

    All of this assumes you can properly compute the probabilities of you winning. Intelligent models that you believe in are key.

    In any case, it's not a bad bet just because the risk/reward is too high (1000/20). Absent probabilities, people will always buy DOTM options ("you mean I can bet $20 and win $1000 if I'm right! Wow!" When in fact, that's a losing bet in the long term).
  5. jj90


    I think the better question is the choice of model and how well it accomodates the trading strat to fat tails. Pure probabilities are nice, but IMO statistical outcomes are quite different from reality.
  6. Thats good but one must also consider the distribution of the outcomes. What if you hit 2 losses in close proximity of one another? Now you are doing the next 100 trades trying to merely break even. Even if one has the psychological makeup to come back from such a draw, the opportunity cost could be too high. Compare that to the other side of the bet, that person is now 100 bets ahead. You cant define a bet as a winning bet until you have factored in the distro of outcomes and not just the risk/reward and probability of expiring OTM. Sure, fat tails may not occur as often but they certainly have and could. How does one know for sure?
  7. Probability *is* the distribution of the outcomes. Both you and jj90 have an implicit mistrust of a probability model as "not including fat tails". Lognormal distributions are just one model of probability.

    Probability is all that matters in trading. If you can pick a chart pattern or technical indicator set that skews the probabilities in your favor (and enough to overcome the house bias of spreads & commissions), you will be a successful trader. If not, you will lose--maybe not today, but in the long term.

    Long OTM calls are expensive for a reason--most people want to buy them because they think it's a "good deal". Were humans better able to compute the odds, this bet would be even--if there's a 99.5% chance of winning, the bet would be win $5 or lose $1000. In that case, it simply doesn't matter which side of the bet you take--the market maker would happily either buy or sell calls at that spread. Throw in some vigorish, and you've got a market.

    However, people are inclined to buy OTM calls rather than sell them, driving their price up.

    Think of it this way: casinos are happy to let you play a slot machine where you bet $1 but can win $1M. Yes, they may lose the very first two bets that are placed, but they know that they'll make it up in the long run. As long as the odds are better than 1M:1, and they can survive an unexpected run of improbable outcomes, they'll let you gamble all day long.

    People get into trouble by selling options at a size that makes it "worth their while". They then can't survive the "fat tail".

    All of this is predicated on having a probability model you believe in. If you cannot compute the odds, you have no idea if you're taking the right side of the bet. In this particular case, the market thinks the probability of those 600 calls expiring ITM is 4x higher than a lognormal distribution does. Maybe the market has a better model. Maybe people are so happy to take a low probability bet that the price is driven up. The answer is almost certainly "both".
  9. The only thing I can think of is an Iron Condor, both OTM Call and Put Credit Spreads at the same time. Your risk is defined and the profit might be better than just a DOTM Naked Call.

    Just have to figure out how far OTM to go.
  10. jj90


    FA, it's my understanding that you are assuming this off a keep trade intact until expiration or at least to the sold option is worth a nickel. How would the model then compensate with adjustments to the position? I would think that would change the prob parameters, maybe not for the better. And rally has already mentioned the drawdown issue.
    #10     Nov 24, 2006