Am I overlooking the risk?

[trader0303]

I've been doing a very simple options strategy for a few months and have had success, and it seems too "low risk" that I must be overlooking something.

I sell a call above the stock price, and sell a put below stock price betting that the stock will stay in the range, and both will expire worthless.

I manage it by if the stock reaches my call price I buy the stock, and sell it if it goes back into my "range" . Inversely if it falls to my put price I short the stock, and cover my short when it rises back above my put price.

So, even if it goes out of my range, my risk is covered. I do this when I have the cash in the account to cover buying or shorting the stock to manage position. What am I missing besides overnight gaps?

 

[Shakone]

What if it gaps outside the range, and you can't buy at the end of the range? This could be very costly.

What if it hits the range and you buy, then it comes back down and you sell, then it hits the range again and you buy, then it comes down again....

What edge do you think is there in what you do?

 

[trader0303]

What if it gaps outside the range, and you can't buy at the end of the range? This could be very costly.

What if it hits the range and you buy, then it comes back down and you sell, then it hits the range again and you buy, then it comes down again....

What edge do you think is there in what you do?

Well the edge is that I hope I'm picking a range with some very strong support and resistance, and picking a stock that seems to be ranging.

I get a "buffer" for my trading losses in the scenario you speak of where it repeatedly enters and exits the range by the premium I collect from selling the options.

Also, holding any equity overnight exposes you to the risk you mention. Do you never hold an equity overnight without a protective option?

 

[daveyc]

Selling strangles can work for a while but you probably can figure out why this trade can get out of control and do some damage to your account. Try to factor in volatility, if your stock is at 50 and your selling the 55 call for $1 and your 50 put for $1.50, what do you think will happen to that put you sold if you have a down move with an increase in volatility? Your put might cost you $4 to close and even if you shorted the stock at the perfect moment, you could then see a reaction to the upside and lose with the stock as well. So, you can surely see the dangers in this strategy. Try to put this trade on a risk graph and see what the risk really is and also factor into the strategy an increase in volatility.

 

[JSO]

Managing risk for credit spreads options must be managed before even entering the trade. Know what is the reward vs risk profile first and the probability for the trade getting into ATM or worst ITM. Adjustment is also another important method of managing risk during the life of the trade that can determined your winning ratio.

 

[chroniclenyc]

I think all beginners who first get into selling options come up with this strategy. Like already mentioned the biggest risks are that the price blows right through your strike price (slippage/gaps) and second and more importantly it will bounce around your strike price causing you continuously buy high and sell low (with the momentum of the price movement against you). The question then becomes is that loss worse than your premium? It is really a crap-shoot, but I have never seen anyone actually do a backtest or analysis on it.

I am just curious is your strategy to hedge immediately when it crosses the price or end-of-day, etc?

 

[Dommo]

As a rough and ready benchmark, I suggest you look at VIX over the period you've been selling options. If it's been a few months, then VIX has fallen to low levels over that period (ie this was a favourable time to be selling equity options). If VIX/vol rose, it could be an entirely different story (depending on the particular stock of course). If you're a retail trader, I think selling options is very risky.

 

[Dommo]

Of course it's possible to risk manage short options, but at a retail level, I think the transaction costs make it prohibitive.

 

[JSO]

A good entry for writing options is when VIX is high and that's is when you will get good premiums from the options due to it's high Implied Volatility (IV). With good premiums, you can afford to write far OTM options to futher minimise your risk. Look around for a good broker that provides low cost like $5.50 per round-trip position (i.e open and close position). In fact, you can save half the cost when you let our OTM options expires worthless.

 

[stabart]

Obviously, this strategy is akin to delta hedging at zero implied volatility and it will not work for two reasons - mean reversion (going back and fourth around the strike will cost you dearly) and gaps (if the underlying blows through that strike before you can hedge).

An interesting question would be - if you look at some high frequency data, could you find a strategy along these lines that actually has a reasonable sharpe? My sense is yes, especially in the last few days before the expiration cycle and on fairly illiquid stocks.

 

[bezzer11]

Yah, the risks are pretty much described above. Since you are concerned with risks, I think that it might be wise to do this with indices or ETFs since you dont have to work about any sort of buy outs, M&A etc. One merger or deal signed by a company could put you seriously within red. I almost got screwed with BKS about a month ago.

Another thing that might help if you picked a stock where you had a good idea of fundamentals and have been watching closely to see what it does at support/resistance levels. If it teeters a lot at those levels maybe wait and see instead of buying and selling every time it dips. Maybe set a stop order slightly above resistance levels (in case of call option).