The Cash C.O.W. (Conservative Option Writing)

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Carley Garner

24 May, 2005

in Options

Imagine how much money you could have made had you sold every option that you have ever purchased?  While many traders boast of huge profits attained from a singe long option play, these stories are rare in comparison to those in which traders have lost some, or all, of the premium paid for an option.

In a sense, option buyers are throwing good money after bad in hunt of that one big market move that could return extraordinary profits. Given the fact that markets spend most of their time trading in a range, it is easy to see why few traders experience the abnormal returns that drew them to the markets in the first place.

A less exciting, but more fundamentally sound approach would be to attempt to profit from markets that are trading in a range.  The most efficient means of taking advantage of a “quiet” market is to strangle the current range by selling calls above technical resistance and puts beneath support levels. 

The logic of a short option strategy, such as a strangle, is similar to that of insurance companies. Insurers collect premium on policies with the expectation of future payouts. By knowing the probability of a claim, they can calculate their expected return for assuming the risk of the policyholder. They are confident that over time they will profit despite their obligation to pay claims. 

By nature, options are a depreciating asset.  Just as a new car buyer will find that the value of their purchase diminishes once the automobile is driven off of the seller’s lot, an option buyer will find that the time value of their long option erodes with every passing minute. 

It should be obvious by now that selling options provides traders with an advantage over buyers.  After all, a seller of a call option can profit in a declining market environment as well as a market that is trading sideways.  In fact, it is possible for a seller of a call to also profit during times of increasing prices given that the market does so at a slow enough pace.  A buyer can only profit on a call option if a market rallies over a specific price in a specific time limit. 

Nonetheless, traders continue to be lured into long option strategies. This is likely due to the fact that purchasing an option provides traders with unlimited profit potential and the risk is limited to the premium paid.  The peril in this type of approach, as mentioned before, lies in the fact that although one’s losses are limited it is likely that an option buyer will lose some or all of the value of the option. 

The exposure to unlimited losses by option writers is merely theoretical.  In theory a market could go up forever, but it isn’t likely.  Additionally, while most markets can’t go to zero (equities excluded), they can drop significantly.  However, due to the leverage and risk involved it is imperative to have adjustment strategies in place before a position is executed.

Quick Refresher
An option premium is the actual market price of a particular option at a particular time. Thus it is necessary to understand the fundamentals to option pricing before implementing a short option strategy.  The exact price that buyers and sellers are willing to accept at any given time is based on two major factors, intrinsic and extrinsic value. 

Simply put, intrinsic value refers to whether or not an option is in the money and to what degree.   For example, the intrinsic value of a call is the amount of premium by which the underlying market price is above the strike price (also known as exercise price).   Accordingly, a put option is said to have intrinsic value once the market price dips below the strike price.  An option with intrinsic value is ideal for an option holder, but creates an undesirable situation for an option writer.  If a short option expires in the money, the writer will be assigned a corresponding position in the underlying market.  In the case of a short call, the seller will be short the underlying from the stated strike price. Conversely, a trader with a short put will be assigned a long position from the strike price.  It is often in the best interest of the option writer to offset a position prior to expiration in the case of an in the money option.

The extrinsic value of an option is a combination of several factors including the strike price relative to the underlying price, market volatility, time to expiration, and demand for that particular option.  The goal of an option seller is to profit from the erosion of intrinsic value.  Times of increased volatility provide ideal circumstances for option sellers because option premiums are inflated.  Similarly, it is helpful to understand that the depreciation of extrinsic value tends to accelerate during the last 30 of an option’s life creating an ideal scenario for option selling.

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Good comments DP -- My trade parameters and assumptions are based on normal distributions and do not take into account extreme valuations and/or large market kurtosis. This is why I write options on the SPX only -- it has massive liquidity and long option chains. The SPX is a tracking index that includes 500 large and diverse US Corporations and is not subject to the same extreme movements (gaps) as single stocks and other smaller indexes. However, the SPX is still subject to down gaps and so your point is well taken and very valid; the biggest risk would be a total Black Swan event which may or may not cause the SPX to open below my stop loss or strike price depending on the severity of the event and how far away the underlying is to my stop loss and strike. I always have a stop loss in the market and place it right after my trade. Over the past year I have placed trades as far out as 3 standard diviations and I can't deny there isn't risk here, but there's risks in every form of trading and speculation. Once again, thanks DP for your comments -- they should be considered before selling options.

Apr 25, 2009

Member (8 posts)

Lance P.;737362
. . .
-- 2 times when volatility is low; 3 times when volatility is high (yes, the risk-reward ratio is not that good; however, your probability of winning at 1.5 - 2. std. div. away should be approximately 90%).

Depends on the degree of kurtosis in the market.
Lance P.;737362
If the market threatens your positions prior to being stopped out you can buy back to close the contracts that are the closest to the underlining and sell (rollout) more contracts further down the option chain or add onto your further away contracts previously sold.

Which is the standard way of hedging . . . this'll work fine in discreet markets but what'll f*ck you up totally is when the market gaps down.
Under this situation your margin requirement increases semi-exponentially and is impossible to fund by rolling down and back.

Apr 24, 2009

Member (1373 posts)

raysor;732846
I started writing OTM FTSE call options in May 2008.
A friend of mine who had a degree in Mathematical trading had been running the system for the previous 2 years and was up about £300000. He had just fully qualified as a chartered accountant and had just quit his job (in risk management!) to concentrate on trading for a living and maybe to start it as a business (maybe a hedge fund). He was also running sveral accounts for other people. It was suggested I use yhe same system in a small way to get the feel of it and to help him commercialise it.
Basically you tried to establish how the index would move and then write options the other way (is that right?). I started writing a few OTM calls thinking the market was going down (hah hah). I had capital of £2000 and made two months of £200 each. For some unknown reason as the market came down I switched tack to writing OTM puts. My mate suggested I could carry on taking £100-£200 a month or start raising the stakes. In my mind I thought of changing tack to writing calls, but for some reason stuck with the puts.Probably because it wasn't easy to close them and the fact that it gets tricky to hedge puts and calls at the same time (comments?)
Probably got positions of 20 contracts and started hedging with futures. All jolly good fun.Making good moning on the future (Selling ) Then things started getting a bit hairy with the markets falling. My capital requirement was soon about £4000 and needing more and I realised on a worst case scenario I would run out of funding at the rate things were going and on the worst, worst case could see a loss of £15000 (if the FTSE wnet to zero- not possibele, but in times like those you begin to think the unthinkable-I think it's called self preservation).
I telephoned my mate for a bit od advice and he was "otherwise engaged". Or more precisely pulling his hair out when he wasn't on the 'phone trading. He probably had about 400 options open, maybe more and trying to run about 6 accounts.
I made a decision to 1. not panic. and 2. gradually unwind the positions. Net result about £1500 total loss. Not bad for lesson in "how to trade options".
My friend was contemplating re-mortgaging his house to bolster his capital/margin but in the end decided to close everything down. I suspect he lost 2 years of trading and more, but apparently if he had had the nerve to run it he would have cleaned up.
He was running programs to calculate his risk and hedges and also running empirical (is that right?) to establish whether the positions had performed in accordance with the previous forecasts. If you see what I mean.
The lessons I suppose are to only have positions, hedged or otherwise, well, well below your available capital.
But, I suppose, that's how the credit crunch all started.
Beginners note: You don't often read about people losing money- it's just not macho!


That's a good option war story Raysor -- I've had a few like that myself. I sell SPX Index options every month 4 - 8 weeks from expiration. When the overall market is in an upmove-bull phase -- starting 8 weeks out -- I wait for a market reaction to sell on strong down days (when volatility spikes) or at the end of a short correction down and I will continue to sell over a 10 day window period (reverse the proecdure when the overall market is in a down move). I will usually sell 1.5 to 2.00 standard diviations away from the current price of the SPX. Also, I will sell at multiple strike prices (4 strikes) with 25 points of separation. Depending on the current volatility I will place a "stop loss" (sometimes on a "limit") 2 - 3 times my collected premium -- Example: $200.00 per contract collected premium, place stop loss at $400.00 to 600.00 per contarct -- 2 times when volatility is low; 3 times when volatility is high (yes, the risk-reward ratio is not that good; however, your probability of winning at 1.5 - 2. std. div. away should be approximately 90%). If the market threatens your positions prior to being stopped out you can buy back to close the contracts that are the closest to the underlining and sell (rollout) more contracts further down the option chain or add onto your further away contracts previously sold. Other methods of hedging by way of buying put contracts in front of your position(s) or selling future contracts or creating a "Strangle" when possible or you can use the Greek "Delta" technique or a violation on technical indicator of the underlining. For money management , I limit my total collected premiums to no more than 5% of my trading capital. Example: for $100,000(US) capital limit collected premiums to $5,000 dollars. So using the 3 x's maximum loss calculation from above actual loss would be: $15,000 less collected premiums of $5,000 = $10,000 loss -- not including transaction fees.

Apr 22, 2009

Member (8 posts)

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