Post by papasloth on Feb 23, 2011 17:32:29 GMT -5
Dino asked a question in personal messaging that might be of general interest. I'm going to quote him, in part, without permission, along with my response:
Being short options is "scary." You have limited upside and UNLIMITED DOWNSIDE!!!11!!!ELEVENTY-ONE! OMG! Seriously though, you can lose several multiples of the premium you are collecting when the trade turns against you. It's really easy to collect, say, $10,000 in premium and then lose $20K or $30K in the next month moving into options expiration. That just never happens when you are long options. It's the difference between buying insurance and selling insurance. When you buy insurance, you feel all safe and protected, and you know nothing bad will happen to you. When you sell insurance, you know you will have to cover some claims, but you try to sell enough policies at a high enough premium that you still make a profit. And, generally, insurance is a good business to be in (but just look at AIG, Ambac and MBIA for some counter examples).
Selling options is probably not more dangerous than shorting 3X ETFs -- but I sell call options on 3X bear ETFs, and that can be REALLY scary sometimes. But, you have a lot of things working in your favor, including both decay in the ETF, and theta in the option.
Certainly, adding to the short can be a good thing to do. Rolling the short over to a future month at a better strike is also a good thing to do. I haven't had a lot of luck with getting out of a position when it's running away from you, though, because with options the damage is usually done already before you can get out. It's easy for the option premium to double or quadruple literally overnight, or within a day or two. By then, the damage is already done and your best bet is to prepare to roll the option over when expiration comes around. I've done this successfully several times. Sometimes it takes a month or two before you break even, but if you've chosen the stock wisely, they do eventually.
What you'll see on theta (TP) is that most of the decay in options price is weighted toward expiration day. It's really an avalanche. You can see that by looking at the monthly prices for different strikes. There's very little difference between a year out and six months out, compared to the difference between this month and next month. That's why it's better to get as close to options expiration day before rolling over your options as possible, because you've benefitted from the maximum amount of theta on the expiring options but you haven't sacrificed very much theta on the next month's options. This makes it possible to "work off" a loss over time by selling short term options.
I thought it would be good to illustrate this point with an actual example from my trading history last year. I have a good example at hand, selling puts against HPQ. First, the setup:
This started on 8/10/2010. At that time, HP's CEO was involved in a rumored sex scandal with an HP contractor, and had just been fired by the board. HPQ had fallen from around 47-48 to around 42-43. Meanwhile, HP's earnings were still strong, and my opinion was that the selloff was overdone. I decided to sell some naked puts against HP stock. I wanted to take a small position in case the selloff continued, so, on 8/10/10, I sold 40 HPQ Aug 42 puts at 0.55/sh, netting 2159.97 after commission. Aug expiration was on 8/21 (Saturday).
The selloff did continue, and by Friday before options expiration, HPQ was down to 39.85. That means my puts, which I shorted for 0.55/sh were now worth 2.15/sh. Ouch. I still liked the position, so I decided to roll it over until September. On Aug 20th, I bought to cover my 40 contracts for 2.35/sh for a total including commission of 9439.99. At that point, I am down around 7300 on a trade where the maximum upside was 2159.97. At the same time (actually, 1 minute before I bought to cover) I sold 40 HPQ Sep. 42 puts for 2.86/sh, netting 11,399.81 after commission. Note that due do decay in the Aug options price, I was able to get the same strike price one month later while collecting an additional $2K.
On 8/24, there was an additional leg down on HPQ to 38.39/sh. It looked to me like the stock was finally bottoming out. At that point, I shorted an additional 40 HPQ Sep 38 puts for 1.01/sh, netting 3999.94. At this point, true value on my Sep 42 puts was $3.61/sh, around 7 times the original 0.55/sh entry price.
The stock recovered a bit, and started to form a double bottom. On 9/13, the stock was at 38.28, and I decided to add some Oct 38 puts. I sold 40 HPQ Oct 38 puts for 1.24/sh, netting 4929.91.
On 9/15, with options expiration rolling around on 9/18, I decided to roll my Sep 42 puts over to a more favorable strike at the same premium. At that point, I bought to cover my 40 Sep 42 puts for 2.36/sh, for 9470.00 total, and sold 95 Oct 39 puts at 0.99/sh netting 9323.60.
On 9/20, my Sep 38 puts expired out of the money, netting me 3999.94.
On 10/18, my Oct 39 puts expired out of the money, netting me 9323.60. Also on 10/18, my Oct 38 puts expired out of the money, netting me 4929.91.
At that point, I was completely out of my HPQ position. The total for all trades, after the dust cleared, was
2159.97+11399.81-9439.99+3999.94+4929.91-9470.00+9323.60=$12,903.24 net profit.
So, points to consider:
1). I was right about the movement of HPQ, but my timing was off.
2). Theta decay in options price allowed me to roll over the short positions to correct for my timing.
3). Starting with a small position allowed me to add to the position later on.
4). Before all the dust cleared, I had several times my initial investment at risk. If I had started out large, I could have lost my ass on this position.
5). Having multiple smaller positions in different stocks "smooths things out." If I had everything invested in this one position, and my timing was off, I could easily have busted out before the stock came back. Definitely, DON'T put all your eggs in one basket. Practically speaking, though, I find it difficult to have more that three or four positions active at the same time, and give them all the mental mind share they require. YMMV.
Why wouldn't more people trade this way? I know there's the risk of being naked, but this could also be much better than shorting a 3x bear etf. And as you said in your thread, you don't have to be precise in the entry as long as your pretty good at picking the direction as the tp works for you. I guess you just have to be careful to either a.) add to the short when needed or b.) get out if it's running away from you.
Being short options is "scary." You have limited upside and UNLIMITED DOWNSIDE!!!11!!!ELEVENTY-ONE! OMG! Seriously though, you can lose several multiples of the premium you are collecting when the trade turns against you. It's really easy to collect, say, $10,000 in premium and then lose $20K or $30K in the next month moving into options expiration. That just never happens when you are long options. It's the difference between buying insurance and selling insurance. When you buy insurance, you feel all safe and protected, and you know nothing bad will happen to you. When you sell insurance, you know you will have to cover some claims, but you try to sell enough policies at a high enough premium that you still make a profit. And, generally, insurance is a good business to be in (but just look at AIG, Ambac and MBIA for some counter examples).
Selling options is probably not more dangerous than shorting 3X ETFs -- but I sell call options on 3X bear ETFs, and that can be REALLY scary sometimes. But, you have a lot of things working in your favor, including both decay in the ETF, and theta in the option.
Certainly, adding to the short can be a good thing to do. Rolling the short over to a future month at a better strike is also a good thing to do. I haven't had a lot of luck with getting out of a position when it's running away from you, though, because with options the damage is usually done already before you can get out. It's easy for the option premium to double or quadruple literally overnight, or within a day or two. By then, the damage is already done and your best bet is to prepare to roll the option over when expiration comes around. I've done this successfully several times. Sometimes it takes a month or two before you break even, but if you've chosen the stock wisely, they do eventually.
What you'll see on theta (TP) is that most of the decay in options price is weighted toward expiration day. It's really an avalanche. You can see that by looking at the monthly prices for different strikes. There's very little difference between a year out and six months out, compared to the difference between this month and next month. That's why it's better to get as close to options expiration day before rolling over your options as possible, because you've benefitted from the maximum amount of theta on the expiring options but you haven't sacrificed very much theta on the next month's options. This makes it possible to "work off" a loss over time by selling short term options.
I thought it would be good to illustrate this point with an actual example from my trading history last year. I have a good example at hand, selling puts against HPQ. First, the setup:
This started on 8/10/2010. At that time, HP's CEO was involved in a rumored sex scandal with an HP contractor, and had just been fired by the board. HPQ had fallen from around 47-48 to around 42-43. Meanwhile, HP's earnings were still strong, and my opinion was that the selloff was overdone. I decided to sell some naked puts against HP stock. I wanted to take a small position in case the selloff continued, so, on 8/10/10, I sold 40 HPQ Aug 42 puts at 0.55/sh, netting 2159.97 after commission. Aug expiration was on 8/21 (Saturday).
The selloff did continue, and by Friday before options expiration, HPQ was down to 39.85. That means my puts, which I shorted for 0.55/sh were now worth 2.15/sh. Ouch. I still liked the position, so I decided to roll it over until September. On Aug 20th, I bought to cover my 40 contracts for 2.35/sh for a total including commission of 9439.99. At that point, I am down around 7300 on a trade where the maximum upside was 2159.97. At the same time (actually, 1 minute before I bought to cover) I sold 40 HPQ Sep. 42 puts for 2.86/sh, netting 11,399.81 after commission. Note that due do decay in the Aug options price, I was able to get the same strike price one month later while collecting an additional $2K.
On 8/24, there was an additional leg down on HPQ to 38.39/sh. It looked to me like the stock was finally bottoming out. At that point, I shorted an additional 40 HPQ Sep 38 puts for 1.01/sh, netting 3999.94. At this point, true value on my Sep 42 puts was $3.61/sh, around 7 times the original 0.55/sh entry price.
The stock recovered a bit, and started to form a double bottom. On 9/13, the stock was at 38.28, and I decided to add some Oct 38 puts. I sold 40 HPQ Oct 38 puts for 1.24/sh, netting 4929.91.
On 9/15, with options expiration rolling around on 9/18, I decided to roll my Sep 42 puts over to a more favorable strike at the same premium. At that point, I bought to cover my 40 Sep 42 puts for 2.36/sh, for 9470.00 total, and sold 95 Oct 39 puts at 0.99/sh netting 9323.60.
On 9/20, my Sep 38 puts expired out of the money, netting me 3999.94.
On 10/18, my Oct 39 puts expired out of the money, netting me 9323.60. Also on 10/18, my Oct 38 puts expired out of the money, netting me 4929.91.
At that point, I was completely out of my HPQ position. The total for all trades, after the dust cleared, was
2159.97+11399.81-9439.99+3999.94+4929.91-9470.00+9323.60=$12,903.24 net profit.
So, points to consider:
1). I was right about the movement of HPQ, but my timing was off.
2). Theta decay in options price allowed me to roll over the short positions to correct for my timing.
3). Starting with a small position allowed me to add to the position later on.
4). Before all the dust cleared, I had several times my initial investment at risk. If I had started out large, I could have lost my ass on this position.
5). Having multiple smaller positions in different stocks "smooths things out." If I had everything invested in this one position, and my timing was off, I could easily have busted out before the stock came back. Definitely, DON'T put all your eggs in one basket. Practically speaking, though, I find it difficult to have more that three or four positions active at the same time, and give them all the mental mind share they require. YMMV.