Sorry, meant that the 90C skew will flatten as it approaches atm, not the smile itself. I'd imagine >slope on the deep otm calls.
Are you referring to the new book THE COMPLETE GUIDE TO OPTION SELLING? I read it at B&N for about fifteen minutes a few weeks ago. I was thoroughly UNIMPRESSED. Cordier and his co-author--both brokers--give little attention to volatility and to risk. Their article in this month's FUTURES (I get it free--I didn't pay for it) was full of errors. Sadly, there are few really good books that focus on option writing. Come to think of it, I cannot think of any.
Hi Maverick74, Thanks for all your great posts but I really do not agree or understand what you said about how you can make an adjustment that change your expectancy? Your expectancy is determined at the time the trade is put on. What you do subsequent to that is another trade, eventhough it is part of your "intended" legs. If you are using some superior forecasting tools or charting techniques to try to time the market and get a better entry for different legs, then that edge is derived from your directional model, not an inherent edge in the way you executed your trades. Can you explain a bit more about what you mean? Sorry, if I have missed something as I am quite new to options.
LoosenUp, one thing you need to understand about options, is that most professional options traders don't just put on a position. They build them. I spend weeks building my positions. I look at each of my positions as a whole position, not the individual trades that compose that position. Like I have pointed out before, each trade on it's own, has negative expectancy, but as a combined position, it can be morphed into a positive expectancy trade. I really could care less about each of the legs. At the end of the month I care about my position as a whole and my p&l. Let's look at another example. Let's take a trade that riskarb is actually attempting to do on his journal thread. He is selling the ATM combo on a stock and looking to offset with the purchase of the wings 7 to 10 days down the road. His goal is to try to capture as close to a full 5 pt credit as possible. So let's say he sells the Sep ATM combo in EBAY for 3.70. Now the 42.5/47.5 wings are trading around 1.95. He is going to wait on the purchase of the wings to try to get them cheaper. Maybe he thinks volty will continue to drop and perhaps 10 days from now he can purchase the wing combo for 1.20. He now has a net credit of 2.50 in the trade. What is his risk? He has none! His risk is the difference between the 2 strikes minus the credit. So 2.50 minus 2.50 is 0! He now has a risk free trade. And his expectancy is certainly positive. If he ran a simulation on his trade going forward from that date to exp 1000 times and summed the results and divided by the number of trial runs, he would get a positive expected return. This trade certainly has a positive expectancy. Now I know what you are saying. But he took risk when he sold the first ATM combo. Of course he did. All option traders take risk when they are building the positions. There is no way around that. The idea is to be able to offset as much of that risk over the course of that trade as possible and create a positive expectancy trade. Neither the sale of the ATM combo nor the purchase of the wings carried a positive expectancy on their own. But combined, in this example, they turned into a risk free trade with the upside of 2 1/2 pts! Not a bad trade. All successful option traders try to build their positions towards a positive expectancy. This is why I keep saying over and over that to be successful, you need to be a good trader. You can't just slap on a fly or a condor and sit back and watch. At some point, a trader has to trade. There is no escaping this. But the beauty of options, is you can create all sorts of combinations and permutations that offset risk with each additional trade and increase your upside! That is why we trade options. Not to blindly sell juice and count our theta! It just doesn't work that way. I hope this example cleared a few things up for you.
Interesting, I'm on the exact opposite side. The point of zero expectancy is that the losers HAVE to be huge. But if the losers are curtailed then positive expectancy is created. You raise an interesting point though, if the predetermined exit is time based your point is completely valid. I'm actually referring to options prices or market levels. Discontinuity would be the major evil at this point. I also tend to think options are not priced inefficiently and more accurately the buyers as a whole are over paying.
Mav, we disagree on a few points but I really enjoy your posts. In your example the atm was sold with the opinion that the market would not move too far too soon before the wings were added. This would probably be what riskarb meant when he said edge bleeds into the trade in his journal. If you were to run the simulation 1000 or so times as you mentioned, clearly the result would be a positive expectancy or edge as the complete position is essentially riskless. But, what if the trade simulation was run from the origin of the trade when the atm was sold. Then x days later the wings were added. There would at the least have to be a positive opinion that the trade would have positive expectancy I would think. Would riskarb sell the atm's in the first place if he did not think there was an edge?
first the expectancy that the losers have to be huge is a relative concept. you'd have to be selling 10 delta options consistently for this to be the case. remember that we're looking at probable returns as a distribution. you could have one catastrophic loss or a bunch of little one cent losses. secondly, a stop loss does not negate the negative expectancy. you can never be sure that by cutting your losers early you aren't eliminating trades that would have ultimately been winners. i believe that the zero-exectancy holds in this scenario as well. i know that you meant a price trigger for the stop. i just used the time example to make the concept simple. if you used a price stop instead, the principle still holds. no matter where you exit a trade if there has been no intervening adjustment or spreading that alters your net expectancy, you are essentially adding two negative expectancy trades together. two minuses added together in this case do not make a positive. if you are saying that you don't think prices are efficient, you are mistaken. if this were true, there would be limitless arbitrage opportunities. i've heard a variety of this type of claim before and none of them holds much credence. one common misconception is that the volatility skew or "smile" is somehow an indicator of inefficiency. people claim that the skew violates the premises of the BS pricing model. OTM put strikes frequently have higher IV than OTM calls. so the logic runs that one should buy the high strikes and sell the low strikes. but there is no reason why the skew isn't an accurate reflection of probabilities. i use this example. assume a stock where there are only two sets of investor opinion. 50% believe the stock is worth $48 and 50% believe the stock is worth $50. efficiency would therefore place the fair value of this stock at $49 (.5*48+.5*50 = 49). now what would be the IV of a 45 strike option in this scenario? obviously pretty close to zero since the market is in a very tight consensus. the volatility smile would even possibly turn into a frown in this case. now assume that new information causes market participants to alter their opinions on the value of the stock. now 90% believe the stock is worth $50 but a small minority, 10%, believe the stock is only worth $40. the efficient price on the stock does not change; it is still $49 (.9*50+.1*40 = 49). but what happens to that 45 strike option now. suddenly there is a lot more interest in owning this strike because there is a much wider range of opinion on the stock. the result would be a typical smirk-type skewwhere the puts would now be inflated due to the higher probability of their being in the money. the stock price is just the tip of the iceberg in terms of the aggregation of opinions about value. the skew tells a more granular picture of probabilities at discrete prices. would you consider the put buyers overpaying in this case?
I'll let him answer but my guess is he would sell the ATM combo knowing there is negative edge in the trade. He, like me, acknowledges there is negative edge in all trades when they start out, but he is attempting to morph the trade into something that will carry some positive edge at some point in the future. He may be dead wrong. Maybe EBAY gaps down 20 pts tomorrow. This is the risk of this business. We are not teaching 3rd grade public school here. I think we can all agree that somewhere, a risk has to be taken. However, a good trader will find ways to offset this risk going forward and improve the risk/reward ratio over time. Again, I'll let him respond to your question as I don't want to put words in his mouth.
Maverick makes a good point that I never thought of before. So it goes back to the question "Can you TRADE options for a living?" What's our conclusion here?