options Archives - Bankers Anonymous

September 19, 2024September 19, 2024

Ask an Ex-Banker: One Day Options Trading

Hey Michael!

I wanted to fill you in on something I have been playing with recently.

In February I used my margin account to buy 100 shares of ETF QQQ. [Ed note: This ETF tracks the tech-heavy Nasdaq 100 index.] Then immediately I sold a 1-day call at the next dollar value up and a 1-day put at the next dollar down price. If forced to buy, I immediately turn around and sell a 1-day call at what I think is a reasonable price. If all my shares were “called away”, I would simply sell puts. I have made $14,784 (cash, not paper profits) in just over 6 months without using a penny of my own money. This total includes capital gains/losses, put premiums, call premiums, and margin interest charged. I understand that if I had just bought and held the original 100 shares, I would have made $6,200 profit on paper. That pales when compared with what I have done. And also, I don’t research or try to outsmart anything. It takes about 3 minutes a day and is pretty mindless.

Obviously, it has been a wonderful market for 6 months, and I’m not suggesting you write about this for the general public. I just thought you might find it interesting and would welcome your thoughts. Even in a down market, it would create an income stream of about $100 a day in cash (even with paper losses) to pay bills etc.

If I ever got overloaded with too much QQQ due to exercised puts (i set my limit at 300 shares or about $135,000 on margin), I would stop selling puts.

I would love to see an article about my basic investing strategy of using put and call ladders on strong ETFs to force me to sell at high prices and buy at low, while creating an income stream and boosting yields.

Gerard van den Dries, San Antonio, TX

Thanks for staying in touch Gerard, and for your most recent idea, writing about short-dated options. I am particularly grateful because since early 2023 1-day option trading – also known as 0dte (short for “zero days to expiration”) – has dramatically surged among retail traders. Whereas short-dated options were only about 20 percent of options trading volume until 2022, it now makes up 45 to 50 percent of the options trading on stocks. Regulators have taken notice, and frankly they are worried. The former SEC Chairman Jay Clayton has called “0dte options” gambling, and thinks they should not be allowed.

To briefly review options terms: When you sell a 1-day put, that means your broker has the right to sell you that ETF, which they only do if it drops in value over that day. When you sell a 1-day call, that means your broker has the right to buy the ETF from you, which they only do if it goes up in value over that day.

0Day-to-expiry Options trading has soared, as % of all options trading

I have lots of thoughts on options-trading as a strategy, a business I used to be involved in on the brokerage side as an institutional bond salesman.

Before I get into my actual reaction, it’s worth acknowledging the advantages you cite:

1. You are only spending 3 minutes a day on it and not doing any research, which implies many could use this same strategy to profit.

2. Your investment returns have been well over twice what they would have been if you just bought and held the same ETF.

3. You have created a system by which, because of the forced buying and selling, you will automatically buy low and sell high, which is highly enviable.

4. Finally, you are using borrowed money, so you don’t have to put up money in advance, an attractive feature as well.

Ok, on to my views of this as a strategy, both for you in particular and for the people who are participating in this massive surge in 0dte trading we’ve witnessed in recent years.

Your experience has been very positive and profitable. But in no way would I endorse this.

Risk Profile

I think the risk you are taking when you sell options has the profile of an insurance company. That is to say, you take in small premiums most days, earning the steady income you like. Then, every once in a while, a big move happens and you have the potential to lose big.

This works in the insurance industry best (and is ultimately survivable only) with unlimited funds relative to the size of the bets.

A sudden downward move, or multiple down days, could leave you owning a lot of QQQ with losses on your ownership. It is good that you have a limited size of QQQ beyond which you wouldn’t purchase more or write additional put options. Investment returns will also be magnified, for good and evil, when you buy on margin.

A structural problem of you earning premiums like an insurance company is that your broker is buying the insurance from you. They have the computing power to price this attractively for them, over the long run. You should not assume they are mispricing the insurance they are buying from you.

I’m not saying you should never do this. Based on our previous conversations, I know you have a very conservative approach to spending, and you’ve very likely accumulated sufficient investment capital that allows you to take a gamble. I would just say emphatically that this is a gamble, in a way that boring old buy-and-hold can feel like a gamble in the short run but in the long run is an investment. With options trading, there is no long run. It’s only a series of short-run gambles. I believe that in the long run and on average, options trading like this will not lead to gains. The primary winner will be the firm that bought insurance from you.

I acknowledge that has not been your experience so my advice doesn’t match up with your observed profits.

Market environment

I fear that this strategy works well in particular market environments, and not others. The ideal environment for covered-options selling is steady and upward trending. Which is mostly what we’ve had in 2024.

The first two days of August however started with the Nasdaq 100 down about 5 percent. It’s that kind of action, especially if it continues, which can lead someone to get wrecked.

We generally won’t know when we’ve shifted from one phase (steady and upward trending) to the other phase (volatile and downward trending) until it’s already happened to us.

Options trading in general

As a general rule, I can’t endorse retail – meaning non-professional – options trading.

Certain options strategies, like selling uncovered calls, have unlimited losses as a possibility. You have limited your risk there by owning the underlying QQQ before you sell a call, which is good. Other options strategies, like selling puts, also have nearly 100% loss-of-principal possibilities. You limit your risk there by keeping your bet sized appropriately. Purchasing calls and puts that expire worthless also have the possibility of 100% loss of investment. Unlike buy and hold investing, options trading is always a short-term and zero-sum gamble.

Short-term gambles can be fun. I play poker with the neighborhood dads. I even periodically make a pilgrimage to Las Vegas to lose sums larger than I can efficiently lose to the neighborhood dads. But I distinguish my fun gambles from good investment strategies.

From other conversations we have had, and since you personally limit the size of your gambles, I think you will be fine. I just would not recommend this as a general strategy for most people to pursue.

A version of this ran in the San Antonio Express News and Houston Chronicle.

Please see related post

Options Trading 101

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September 3, 2014September 4, 2014

Options Part III – Delta Hedging

Please see related posts

Options Trading Part I – NFW Edition

Options Trading Part II – The Currency of Options Trading

For the next little bit I’ll use a specific made-up example, of a fictional pet insurance company[1] with ticker symbol PAWS.[2]

Let’s say PAWS shares trade at $100 per share, and I am planning to sell 1,000 3-month puts struck at $90 for $2.70. I bank $2,700 (1,000 shares x $2.70), and I give the put buyer the option to sell me 1,000 shares at $90 a piece at any time in the next 3 months. [For a definition of what a put is, I recommend starting here. and then read here.]

As a retail investor, I’m hoping the shares stay roughly where they are, and certainly above $90 per share for the next 3 months. If they drop below $90/share, I am forced to buy them at a price above the market.

Without getting into heavy math, we can see intuitively why an option on a stock would be more valuable, or cost more, for a more volatile stock. If you have a 3 month option on a stock, and the stock moves only slightly during those three months, the owner of the option will have no opportunity to profit. The more dramatically the stock moves during those three months, the more the owner of the option may profit.

Perhaps not intuitive at first glance, however, is the idea that an options trader (the pro, not you and me) cares almost exclusively about the volatility of the stock – the frequency and magnitude of price changes during the time period of his option – and not about the price direction of a stock, up or down.

An options trader trades “volatility” for a living rather than stocks, and the value of all calls and puts in an option trader’s portfolio fluctuates with the rise and fall of volatility, rather than the price of stocks.

In practice, that means that if the trader owns an option, he hopes (or can be said to have ‘bet’) that the stock becomes more volatile. Conversely, if he has sold an option, he hopes (or can be said to have ‘bet’) that the stock becomes less volatile over the time horizon of the option.

In practice the professional options trader – or “vol trader” as he or she may be known – has a portfolio which is net long or net short volatility. And just importantly, in most cases the vol trader will seek to be “flat” or neutral with respect to the underlying stock, or stock market, or whichever market he or she[3] trades.

Hedging market exposure to the stock in order to isolate volatility exposure

Do you want to go deeper down the options trading rabbit hole with me? Why not? Let’s hum a few more bars of the volatility tune to learn about what options traders actually do for a living.

When an options trader buys my 1,000 puts on PAWS struck at $90 per share he typically will want to leave his portfolio exposed to volatility, but not exposed to the underlying stock. After all, he’s a ‘Vol trader,’ with a view to the historical, present, and future value of volatility, but typically without any particular responsibility for a view on the historical, present and future price of the underlying stock. But initially, at least, he’s a little bit exposed to the price of the stock.

At the moment he begins to own my puts – with the right to sell me some 1,000 PAWS shares at $90 – he becomes ‘long’ volatility but slightly ‘short’ some notional amount of PAWS shares.

The notional ‘short’ PAWS shares needs some explanation. You see, he’s slightly short PAWS shares despite the fact that he hasn’t sold any yet.

Even though he hasn’t sold me any, there is some non-zero probability that he will end up selling me PAWS shares 3 months from now, so he has a contingent future short exposure to the stock, the contingency being that PAWS shares drop below $90 per share.

This positive probability of selling shares in the next 3 months makes the vol trader somewhat exposed to the direction of the market. And, generally speaking, a vol trader doesn’t want to be exposed to the direction of the market.

Notional market exposure and “the Delta”

Let’s assume the vol trader knows – and in fact he would know based on the measure of the historical volatility of PAWS shares – that there’s a 20% probability that PAWS stock goes below $90 in the next 3 months. That makes the options trader 20% “short” 1,000 shares of PAWS, on a probability-weighted basis.

In the options trading world this notional market exposure is known as the ‘Delta.’

The delta is used in practice to calculate how the options trader can hedge his market exposure to PAWS shares, which he doesn’t want. With a 20% short position on 1,000 shares, the right thing for the options trader to do is to purchase 200 shares of PAWS (20% of 1,000) at the market price of $100 per share.

This purchase – assuming he’s calculated the delta correctly – leaves him ‘market neutral’ with respect to the future price of PAWS but ‘long’ volatility with respect to future fluctuations – in either direction – in PAWS stock.

He’s long puts on 1,000 shares, and he’s also long enough shares to cover – on a probability-weighted basis – the expect amount of shares he may sell.

Now he’s good. And ready.

Trading the delta

The interesting part for an options trader begins as soon as he’s isolated his exposed to volatility only, so next I’ll describe good scenarios for the options trader.

Let’s assume PAWS drops the next day to $90 per share.

paws_insurance — My fictional pet insurance company

For the next part I’m mostly going to ignore the option seller’s situation (my situation) however because – as noted earlier – no retail investor should be doing this.[4]

Our options trader, who is long the 1,000 puts and long 200 PAWS shares as a hedge, now has a great opportunity based on the market’s dramatic move downward. The delta of a $90 put with the market at $90 per share will be roughly 50%, meaning the trader is now 30% under-exposed to the underlying stock.

The delta changes, remember, because it reflects the probability-weighted exposure for an options trader to the stock market price over the remaining three months. Once the stock has dropped to $90, we can assume that there’s roughly a 50-50 chance that these puts will be exercised – meaning a 50-50 chance the trader will sell 1,000 shares to the put seller at $90, three months from now.

Our vol trader can, and should, purchase an additional 300 shares of PAWS to remain ‘market neutral’ to PAWS shares.

Once he buys 300 shares to add to his original 200 shares, he owns 500 shares total, and he owns 1,000 puts on PAWs with a Delta of 50. Once again, he’s good and ready.

He’s long volatility, but neutral to PAWS, exactly how a ‘vol’ trader should be.

The next day, PAWS rockets back upwards to a price of $100 per share.

Then what happens?

The original put seller (still me, I guess?) lets out a big sigh of relief that his puts are back ‘out of the money.’[5]

Interestingly, however, our options trader is also made happy by the quick move. He couldn’t care less that the puts he owns might expire unexercised, because he cares instead that the volatility of the stock has spiked.

Why is volatility so good for him?

The delta of the PAWS shares at $100 shifts back in this example to something close to 20%, leaving the trader ‘long’ PAWS shares by about 300 shares. The options trader, in order to shift back to ‘neutral’ on the PAWS stock, gets to sell 300 shares at $100.

This part is kind of cool, if you’re an options trader long ‘vol’ on PAWS.

In the course of two trading sessions, our options trades has bought 300 shares at $90 and sold 300 shares at $100, pocketing the riskless difference of $3,000. [300 shares x $10 price move.]

An options trader who is ‘long’ volatility will always have the happy circumstance of buying low and selling high in the course of ‘delta-hedging’ his exposure to the underlying stock.[6]

If PAWS shares go up again, to $110, his delta shrinks further and he will sell some of his original 200-share delta hedge at an even higher price. If PAWS shares drop, he will buy low at the new low share price to hedge his delta. All the while remaining ‘market neutral.’

The more the shares move over the course of the next three months the more the vol trader delta hedges profitably. Wash, Rinse, Repeat.

On the other hand if PAWS never moves over the three month period in our example, our options trader loses the money he spent on the premium.

That, in super-simplified form, is how options trading works.

The retail investor speculating in options rarely delta hedges or even understands how to calculate volatility, putting him at an extraordinary disadvantage with this type of speculating.

You can still get lucky with a leveraged long or short position, and everybody knows it is better to be lucky than good.

But again, I would only wish this type of retail speculating on my worst enemy.

Please see related posts:

Options Trading Part I – NFW Edition

Options Trading Part II – The Currency of Options Trading

[1] Here’s how I imagine pet insurance working: You pay $10/month to PAWS, and in return little Fifi gets medical costs covered up to a certain amount, plus some lump sum ($10K?) to compensate you in case Fifi goes missing or gets hit by a truck. I’m making this business up but I’m certain many dog owners would be willing to buy this type of insurance.

[2] I learned after I wrote this that there is an actual penny stock with ticker symbol PAWS and I’d recommend getting involved with that penny stock even less than I would recommend selling puts. Run away!

[3] Apologies in advance, I’m going to go all gender-specific in my pronouns for the rest of the post so I don’t have to keep adding “or she” to every clause. This is just to say that I’m sorry about this and I hope to make it up to you some day.

[4] But understand that the option seller (me in this example) begins to wet his pants because losses start quickly from here.

[5] Importantly, he has time to step away from his day-trading desk to change his pants.

[6] Of course this cuts both ways – an options trader who is ‘short’ volatility will be in the uncomfortable delta-hedging position of buying high and selling low if the underlying stock makes volatile moves over the life of the option.

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August 30, 2014September 3, 2014

Options Trading Part II – The ‘Currency’ of Options

Please see related introductory Post: Options Trading Part I – NFW Edition

normal_curve — Options trading begins with assumptions about future volatility based on past price volatility of the instrument

How Wall Street thinks about options trading

Non-professionals who engage in options typically do not understand the ‘currency’ in which they’re trading.

By ‘currency’, I don’t mean option-users remain unaware of their US dollars.

I mean that professional options traders use a mathematical valuation called ‘volatility’ which your average retail[1] options speculator does not even consider.

What is volatility?

Volatility – not the price of the stock or the price of the option – determines the value of an option. Volatility measures the underlying value of an option. Volatility also is how an options trader comes up with the price of an option in dollars.

In math terms, volatility is expressed as a single number describing the frequency and magnitude of price changes over any given amount of time.

The mathematics of volatility – the single comparable number that describes the frequency and magnitude of price changes over any year – involve assuming a standard model for the distribution of prices. Some traders may use a ‘normal’ bell curve distribution of probable prices, but others can use ‘non-normal’ probability curves in sophisticated options trading.

Technically, the “annual volatility” of a stock is the standard deviation of yearly logarithmic returns on that stock.

A high ‘volatility’ number means the stock price spends significant periods of time outside of your ‘normal’ expected distribution. If the stock price lands on the outside ‘tails’ of a normal bell curve, the ‘vol’ number will be high. If the stock price trades within the high-probability tight band of a bell curve, the ‘vol’ number will be low.

If you buy or sell an option with a high ‘vol,’ the premium, or cost, of the option will be high, to reflect the expectation that the stock prices over time will land on the ‘tails’ of a normal bell curve. If you buy or sell an option with a low ‘vol,’ the premium or cost of the option will be low, reflecting its expected narrow trading band.

Did I lose you yet? That’s fine. You only need to remember one thing.

The important thing to remember is that if you don’t know how to calculate the mathematics of volatility then you have no idea what you are buying and selling when it comes to options. I’m fairly certain the author of the “sell puts!” newsletter did not explain the mathematics of ‘vol’ trading[2] to his audience.

Please see related Posts:

Option Trading Part I – NFW edition

Options Trading Part III – Delta hedging options from a trader’s perspective

[1] By ‘retail’ in this post I mean non-institutional investors. I mean: you and me.

[2] Come to think of it, trading options without understanding vol leaves you as blind as an individual who purchases stocks based on the ‘price’ of the stock, without modeling the underlying future cashflows of the company. Now wait, that would describe 99% of all individual stock investors. Hmmmmmm. What does that say about whether most of us should buy individual stocks? Let me think about that…

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August 29, 2014September 3, 2014

Options Trading Part I – NFW Edition

This is a highly speculative trade, not an investment, so run away, retail investor!

A friend in the finance-writing space sent me a query not long ago about the idea of “selling puts” as an appropriate and lucrative investment activity.

Following my swift reply of “NFW[1],” she asked for an explanation. After all, a friend of hers had been writing a regular ‘investment newsletter’ describing all the clever money he made writing puts on stocks. The newsletter-writer described a ‘win-win,’ in which either the put seller pockets the option-premium, or manages to purchase stocks at a discount to current prices.

Selling puts, I should explain, involves giving your counterpart the option, for a limited amount of time (between one and three months, typically) of selling you shares at a set price. A ‘put seller’ often picks a price lower than current prices.

For giving someone else this option, the put-seller pockets some money, known as the option premium.

How about an example?

XYZ stock sells for $50 in the market today.

I sell 3-month puts, let’s say 1,000 of them, with a ‘strike price’ at $40. That gives the put-buyer the right to sell me up to 1,000 shares of XYZ at $40 anytime for the next 3 months. For that privilege the put-buyer pays me – I’ll make this number up – $3 per put. In this example, I pocket $3,000 in premium ($3 x 1,000 puts).

In my most optimistic moments, I can tell myself that I ‘win’ if I just pocket $3,000, and I also ‘win’ if the shares of XYZ drop and I end up buying up to 1,000 shares at a 20% discount to the current market price.

Run away

However, I’m here to tell you to run, not walk, away from put selling. Do not try this at home, for a few reasons.

I’ll list them in increasing order of importance.

First, options trading for non-institutional investors (you and me) are always speculative trades, not investments, because they are short-term in nature. “Investing” means that your time horizon spans more than 5 years, disqualifying all but the most exotic options, none of which are available to you and me.

Second, options for retail investors – because they are slightly exotic and opaque – involve costs that make them inappropriate for non-professionals, trading in small sizes.

Third – Most importantly for this particular ‘newsletter advisor’:

You’re telling individual investors to sell puts? Are you f-ing kidding me?

Put-selling-sucks — NB: Whoever wrote this is a moron

This is the kind of bull-market nonsense that only people who have been in the market for about 3 minutes would fall for.

Do you know that phrase “bending over to pick up nickels before the oncoming bulldozer?

That’s you, when you sell puts.

You make a little bit of money this week, you make a little bit of money next month, you collect a few more nickels for a couple of months, and then BAM! You are dead.

And you never even saw that bulldozer before you became part of the asphalt. Because the market will always, always (ALWAYS!) punish put sellers.

It’s a rule written down somewhere that they only show you AFTER your investment portfolio has been taken out on a white sheet and dumped into a shallow grave.

Put sellers are like the lone teenager in the horror movie who says “Did you guys hear that noise? I’m just going to check that out with my dim flashlight, by myself. You guys stay here.”

put-selling-is-a-horror-cliche — Put selling always ends up as a horror movie cliche

I do not believe that markets have anthropomorphic personalities, or particularly recognizable patterns, or act as sentient beings, except in this one instance: put sellers always get killed. It’s just a rule.

Put-selling as a ‘synthetic long’ in the market

Prior to getting killed as a slaughter-house put-seller, you should understand that selling a portfolio of puts acts as a proxy for being long, or bullishly exposed, to a stock or set of stocks. Provided the stock goes sideways or up, put-selling provides a nice stream of income based on the non-exercised put options.

In addition, like many other derivatives, options give investors ‘leverage,’ by exposing an investor’s portfolio to larger movements in markets than would be otherwise available through regular stock purchasing.

Because put-selling resembles a synthetic long and leveraged position in the market, put sellers may briefly (all too briefly!) fool themselves into believing they’ve stumbled upon a neat and uniquely profitable way to ‘play’ the market. I think this is what the put-seller newsletter pushed, wittingly or not, on its audience. As long as the market basically goes up, put-selling appears even more profitable than buying ordinary stocks.

Then, as I mentioned, you’re financially wiped out. Because leverage goes both ways, and put sellers always get smushed.

Ok, now that I’ve told you my strongly held opinion of this guy’s newsletter garbage, I will spend the next two posts teaching interested folks a bit more about the options market.

Please see subsequent related posts:

Options Trading Part II – The “Currency” is Vol, not $

Options Trading Part III – Delta-hedging options from a Trader’s Perspective

[1] That stands for “No Flipping Way”

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