BUY or SELL Options - Vote

[Robertral]

RogerM - All I was saying is that when I write an option I delta hedge it. Not sure I should have added it into this discussion, but as the topic of writing calls came up I thought I'd mention it.

 

[johnk49]

Guys - I think that this is the first time in the history of T2W that we have had a heated discussion on an options subject. Allelulia - This is progress! But can we please keep it civil.

I'm not certain that delta hedging is relevant to a covered call position. Delta hedging is more often used in a situation where there are multiple short positions to keep delta at or close to zero. I am open to persuasion here, but it'll need to be clearly put (pun blatently intended).

I've drawn a pay-off diagram of that compares a covered call and a short put.

Position (A) is a stock at 50 and a call with a strike of 50 sold for 1. If the price stays at 50, then the call expires worthless, the premium taken is retained and there is a profit of 1.

Position (B) is a short put with a strike price of 50, sold for a premium of 1. If the price of the stock at expiry is 50, then the put expires worthless, and the premium of 1 is all profit.

Superimposing (A) onto (B) shows that they are both the same.

With the covered call, if price tanks to 20, then there is a loss of 30 on the shares, but the call option expires worthless so the premium of 1 can be offset against teh loss and the net position is a loss of 29.

With the short put, if price tanks to 20, then the seller of the put will have the shares "put" upon him at 50 and he will only be able to sell them in the market at 20, leading to an immediate loss of 30, although he will still have the premium of 1 to offset against this, leaving a net loss of 29 (as shown in Red - the same as the covered call(Blue).

Now the psychological position between the 2 positions may be different in that the covered call holder doesn't need to take any action other than to cry gently into his beer - he has, after all, already paid 50 for the shares and is nursing his loss. The short put writer, however, will have to stump up the 50 upon expiry in the full knowledge that the shares he is acquiring for 50 are only worth 20 in the market. Of course if he doesn't have 50, then he has more than a psychological problem, and given the temptation to be over-geared, this may have led to regarding naked puts as more risky. But provided that you always have the funds (in this case - 50) set aside to buy the shares if price falls below 50, then the 2 positions are the same.

Has that helped or merely poured petrol on the flames?

BTW - the Charles Cottle free e-book is first class, and I shall add it to the reading list in the Options Trading Guide. Thanks for reminding me of this one Johnk49.

Yes RogerM,that is perfectly correct!

The point is,when you sell a naked call your potential loss is unlimited!Why?Because theoretically a stock could go to any price! On the other hand selling a naked put the stock can only go to zero,which is the risk when you buy any stock!In fact,the risk could be less!For instance,you buy a thousand shares of stock at $20 if the company goes bankrupt you lose $20,000 if,on the other hand you sell a naked put for $2000 and the company goes bankrupt you lose $18,000!!

Please don't think that I am recommending everyone to start selling naked puts,all I am saying is keep a sense of proportion,selling naked puts can be a great way to get top class stocks at a discount!

For instance you really fancy IBM but you don't want to pay the current price of $100 per share,so you wait until the price drops to say $95 then you sell a put at the 95 strike for perhaps $2,if the stock rises you get to keep the $2!If the stock falls you get the stock at discount.Some people will argue that the stock could go to zero,well if IBM goes to zero we are all in trouble no matter what we have bought or sold!!!!


Keep the thoughts coming and I am sure we can make lots of money selling premium!!

 

[cassiopeia]

In terms of profit potential

A written put is equivalent to combining bought stock and written call.

Moreover

A bought call is equavalent to combining bought stock and bought put
A written call is equivalent to combining sold stock and a written put
A bought put is equivalent to combing sold stock and a bought call

re 'Traded options' - a private investors guide, by Peter Temple

I think the confusion arises due to the practical v theoretical differences. Before expiry in some so called 'equivalent cases' one could be forced into a transaction in one case and not in another. ie in the case of having a written put one could be forced to buy stock, whilst in the case of a written call one could be forced to sell the stock. This may affect profits for the individual position relative to what would have happened at expiry. Of course this only applies to American style options.

So prior to expiry the two positions cannot be said to be totally equivalent in all respects. Whether this really matters in terms of profits over the long run is more debatable.

 

[Robertral]

When you guys write an option how do YOU personally hedge it? What technique do you use?

 

[RogerM]

Robertral - personally, when doing a covered call I tend not to hedge. I just treat it as a way of extracting more income from a share I already hold, which is consolidating, but which I don't want to sell, or to fund the purchase of a put under the price to protect it - for instance whilst away on holiday. If I want to initiate a hedged position, I feel you might as well miss out the long stock part and just put on a vertical call spread (sell 1 x 100 call , buy 1 x 95 call ).

 

[volatileN]

So you're effectively pair trading.

But are the pairs options for different underlying instruments or more often for the same, but with different strike/expiry?

Hi,

It is like pairs trading the implied volatilities of different expiries for the same underlying. Sometimes the strike also varies, if I see a wide discrepancy between the 25 delta and the 45 delta relative to its historic average then trade the straddles and hedge out any delta as time/spot move.

 

[RogerM]

RogM - how do you do that (if it's not a trading secret of course!). Sell expensive means deep in-the-money far month (I'm guessing). But how can you 'cover' these with cheaper (out-of-the-money, near month???) options?

TheBramble - my apologies - I've not yet responded to your request for more info.

Actually you do the exact reverse of what you have suggested! Expensive doesn't mean how much the premium is, but what you are paying (or receiving) for "time" which is normally a function of Implied Volatility (IV).

Time decay accelerates as you approach expiry, so you pay/receive more for a "week of time" close to expiry than you do 2 or 3 months out. So ideally you want to sell an option with high IV in the near month and buy an option with low IV in a far month.

Take the US stock SEPR as an example. Today you could sell the March 22.5 calls for 6.3 with an IV of 99.6% (very close to the 12 month high for IV on this stock) and buy the July 30 calls for 4.2 with an IV of 69%, which is very close to the average for the last 12 months. This means that you could sell 2 x March 22.5 calls and use the premium collected to buy the 3 x July 30 calls. If SEPR pulls back to 22.5 then the 2 x Mar calls will expire worthless and you'll be left with the 3 x Jul calls for free. If Price rises then the Mar calls will expire in the money (ITM), but the greater number of Jul 30 calls will partially offset this. Perfection would be for SEPR to pull back to 22.5 for expiry in March so that they expire worthless, and then rocket away whilst you still hold the free July 30 calls. But that's just a pipe-dream.

In the meantime, if the stock tanks, both options expire worthless, but as the longs were paid for by the short premium, I breakeven (less dealing costs).

In the diagram below, the worst that can happen would be for the stock to rise to 30, and then stagnate there until expiry in July and for me to sit there and do nothing about it, in which case the July calls expire worthless as well and I lose 15! In practice this is a trade for the March expiry and I'll review it then. This is shown by the pink line, which provided IV doesn't collapse, barely drops below the zero line at any point. This is a trade where I can sleep at night because whatever happens I'm unlikely to get burned badly. This is why I say that options can be lower risk than trading shares directly.

Many traders will sell premium in a front month (maybe a short iron butterfly ( sell 1x100 call, sell 1x 100 put, buy 1 x 95 call, buy 1 x 105 put)) and use the premium to buy cheaper options (i.e. with a lower IV) in the far month.

HTH.

 

[bonsai]

Robert

in order to hedge an option,just cover with a future.

 

[Robertral]

Robert

in order to hedge an option,just cover with a future.

You mean keep the number of futures fixed for a changing underlying price, i.e dDelta/dS = 0 ????????

 

[bonsai]

why would you do that ?

sort out an arrangement that suits you.

but if you are going to write naked then you need cover which you can execute quickly or some spare underpants.

assuming you get the direction right.

hedging is the easy bit.
legging out is another matter.

 

[ubi]

If you don't know anything about synthetics, or even call-put parity you really shouldn't touch options.

 

[fildi101]

When you guys write an option how do YOU personally hedge it? What technique do you use?

I write both calls and puts, so one partially hedges the other. I occasionally hedge by buying/selling the underlying to cover.Sometimes I use stops if I'm not going to be in front of my screen. In the event of very low volatilty whilst I'm in a short options postition, I might buy the next strike out to form a credit spread.

mainly though I "hedge" through very conservative money mangement.. If the market makes a wild swing, I fade it by selling more options into the volatility spike.

As a rule.. keep it simple. Cut losses. Plan ahead. and above all... don't get greedy.

btw.. John49 is right.. short put = stock plus short call.

you can hedge both in the same way by selling the stock.

 

[sachuc]

I read about this strategy in newspaper[a long 2700put 3000call laid off with short 3200call and short2500put (a combi of bull spread and bear spread)this debit strategy how does it work what is it called when do losses start and when max gains when should this strategy be used and adjustment should be made how does it differ from iron condor which is credit sinflow
Sachuc

 

[slik]

mainly though I "hedge" through very conservative money mangement.. If the market makes a wild swing, I fade it by selling more options into the volatility spike.

As a rule.. keep it simple. Cut losses. Plan ahead. and above all... don't get greedy.

btw.. John49 is right.. short put = stock plus short call.

you can hedge both in the same way by selling the stock.

Agreed, you always have an exit plan and a stop but to sell vol into a vol spike is dangerous and not for the faint hearted. Imagine selling equity puts in the last 18 months? Dow trades down to 8800 from 9300, short 8500 puts, damm, better sell the 8300 puts at a good premium and a vol spike, the thing shanks through 7800 in 2 days- then what, vol probably bid to the stratosphere. What do you do?

absolutely nothing because you have already blown up and the clearers have already gone to market and liquidated your position.