If you are buying options - you will consistently lose money. Both time and risk premia overpricing go against you. If you don't make the mark within the time period (and market dynamics are notoriously hard to predict) - you will lose 100%. Breaking even often requires a large 5-7% move in your favour - and that just doesn't happen often enough - especially in the one month buy-to-mark time frame that most options trade at. Nassim Taleb does this - he probably makes more money selling pretty books and giving fancy talks.
If you are selling options - you will consistently make fat stacks until you blow up (since you're the counterparty of the above buyers). You can push naked index puts or calls all you want, and make an absolute fucking killing. I'm not kidding. You could easily pull $10-200K a month in profit, depending on how much of a baller you think you are, and how much capital you have backing your risk-taking ass (talking individual traders here).
But this money isn't without insane risks, have no doubt - you are playing with an armed thermonuclear warhead. If all the market correlations go to one and you're the last guy holding the bag containing other people's vol - you will get decimated. LTCM did this for 3 years - blew up year 4 - lost $5 billion in one month. LTCM principals went on and started a bunch of similar firms - finance is apparently very forgiving of failure - it shouldn't be. Most of those funds went thermonuclear back during the 2007 GFC.
If you do a mixed strategy - you'll end up with mixed results - because you're just mixing the above. No option strategy outside of market making consistently makes money (computational traders making markets and taking hedged spreads).
It's exactly like insurance. Insurance buyers pay up, but they never want to actually use it (unless they are committing fraud/market manipulation), and are happy to burn that cash to protect themselves. Insurance sellers are happy to sell, but their industry is commodity, and the only way they make money is by investing the float they have on hand between cash inflows (buyer premiums today) and cash outflows (buyers claiming a year later).
Problem is shares aren't like physical goods - they aren't bound by physical laws and hence do not follow the normal distribution. Share prices can go to infinity and hit zero all over the course of a day - their just bits of data in a db somewhere in Jersey. Car crashes, geographically separated houses and diversified mega-cat risk don't do that - often :D.
If you put in a costless collar on a stock you already own, you cap both your upside and your downside relatively cheaply (this is how Mark Cuban survived the dot-com crash with $2 billion in Yahoo! stock).
Outside of those few lessons - unless you are pushing statistical liquidity or selling millions of options per day - stay the fuck away from them. Individual investors should either go passive index or if they know an industry inside and out value-growth.
Everybody else should either be supply liquidity (HFT - not too profitable anymore) or pushing relative stat arb (RenTech/Shaw's + hundreds of PhDs). Individuals should not try to compete in this area - at all. Just like you don't try to build your own car, cruise ship, 747, iPhone or tank, you shouldn't try and trade against stat. arb/HFT guys without the mental or financial backing to hold your own shit.
Value-growth/passive works because the market comes to you - hat in hand saying - here take my money please. Stat. arb/HFT also works, but it's much harder, because you have to go to the market and make sure that it isn't you that is saying - here take my money, please.
To be fair, if you can sanely use options on the buy-side (as insurance or call income, as opposed to buying lottery tickets) you can also sanely use them on the sell-side too. The problem is, you need deep pockets to do so on the sell side, since you need to be able to buy the stock without breaking a sweat. Specifically, the sane way to use options on the sell side is to use them as a way to commit to a price you believe is (or technically, will be) fair, regardless of what the market says on the matter at that time. (Yes, this presumes you believe EMH is bullshit.) If they expire, you make a decent income. If you're assigned, you're content purchasing the stock at that price, regardless of the market price. (Or, if you're not due to some underlying change in the fundamentals, you can occasionally roll the contract forward. You should have probably done this before assignment day otherwise you are fooling yourself.)
Of course this leads back to your main point being unchanged: only experts are going to have confidence in knowing what a "fair" price is for a business, so selling options (or using them in general) should be left to such experts.
The problem with people, markets and efficiency: They see markets and go - wow - that's pretty fucking good, my prices just went down, I got better service and it's harder for others to make money now so things must be priced competitively.
Problem is they go to far. As soon as they state that you can't make money in markets - they've just crossed into stupid territory. If that were true - the world would be efficient and no one would ever make any money, because everything would be priced correctly.
What is with people separating stocks from businesses. If you work at a business, you are by definition stating that the market you work in is not efficient and hence EMH is bullshit. It's like massive cognitive dissonance - stocks are completely separate in people's minds from the shit that actually gets done - it's insane. It's just like religion. I mean you can happily see someone flying in a plane and the next second they'll be telling you how god exists and how science is bad. YOUR IN A FUCKING PLANE! Your life depends on science and engineering and they state that you are wrong.
Markets are what I'd call "better than central" planning efficient. They are better than central planning - for example you are a young programmer - how will a government bureaucrat know that you should go start an app company - it's better if people figure out what to do themselves, because they know themselves the best and can on average pick careers more correctly than a "sorting hat". But they are still pretty crappy because people make shitty choices all the time.
I agree with all your points - sell-side is a great money maker for people who know their shit. Buffett is one example. He runs $60 billion in insurance float, with nearly $24 running reinsurance and mega-cat risk. He makes a lot of money. But unless you have the financial reserves to back up your claims - don't even bother.
Buy insurance if you wish to hedge yourself - otherwise - stay the hell away.
Yeah it's all about how much capital you have. People selling "cheap" options whose underlyings are worth 10x more than their entire net worth are playing with fire. Options should always be bought or sold as a proxy for the underlying, not thought of as standalone priced securities, IMHO. I think this is the mental trap that most people fall into when they get screwed by options -- they are seen as just another symbol on their trading platform with a price they can buy and sell. However, they have wildly different dynamics since they are, literally, derivatives.
This is a good post with things to think about. The key variables of option pricing--but in particular Vol--are not understood by most people. The second order effects people fail to grasp. A simple, classic example: volatility smile.
The <valuation> of an option is <in general> distinct from "payout" and not simple linear math. [1]
The statement's point is pedagogical - you don't risk more by buying an option than you pay up front. It's also true - if someone were to offer you free options, you couldn't lose money by accepting them.
This is distinctly different from, say, a future or a forward, which is an agreement with no money exchanged upfront (other than commissions and margin requirements).
Hi there. I buy options all the time. I make lots of money doing it. You only need a 1 to 2% change in price to make decent money when working with options[1]. I don't know why you quote 5-7% as that's just not true. Even if it was Stocks regularly move by that amount on a weekly basis. I know it may not be much to some, but I made over 50k doing one or two options purchases per month last year ( 2011, 25k base investment). I had to stop this year due to me needing to liquidate my portfolio to free up some cash, but what your saying is verifiably false.
1. As of 13 November 2012 GOOG dropped by ~1% a $650 put options rose in price by $1.70 had you owned just one contract you would have made $170 your outlay for that would have been $1180 a one day gain of ~15% even subtracting the trading fee of $10.00 to buy and $10.00 to sell you made $150 for a $1180 outlay or 12% in one day on one stock. This particular transaction is very risky as there is no hedge against a decrease in the put price. You can do that, but it will take more time to explain then I have right now. My napkin math tells me you could have placed a less risky trade and make a cool $100 on a 1% change with a 1K investment (i.e. 10%) on one day with minimal risk (risk is if stock isn't volatile enough or trailing stops are set wrong) .
You're playing with nuclear weapons. If you stand to make $10K profit, you're exposing yourself to a much more massive downside.
Being extremely careful will only prolong the inevitable crunch. You're betting on a 1% hike that might be a 5% drop because some idiot in a bus ran over someone important. That 5% drop could clean you out.
If you're betting on sure things, which means you're cheating somehow, then options are your best bet. Hey, if it works for you, you've got a good racket going, but most people will be absolutely destroyed.
Here is the quick and dirty recipe for making money off volatility.
Buy a put and a call option for the same strike price. On both options place a trailing stop at a fixed point ( <- that's where skill / statistical analysis comes in ) After one of those two orders execute cancel the second order and place a new trailing stop at a lower value to prevent additional loss.
If the stock goes up you sell the put and ride the call until the price drops or you liquidate.
If the stock falls you sell the call and ride the put.
Your risk is total to the loss in time value of the option for the duration of your trade , and is capped at a maximum of the sum total of the two trailing limits on your initial purchase. If you would like me to run the numbers for it please give me a security and I can even tell you where to set your puts ( I have computer programs I use to calculate reasonable stops , and execute this particular strategy )
So basically you can lose everything you put in. This is a slot-machine strategy. It's a load of crap.
Anything bought on margin or of a derivative nature is like this. You can bust out hard.
The thing with buying an actual security is a 5% drop is only a 5% drop in value, whereas in an option a 5% drop could translate to a gigantic liability.
trailing stops limit your risk to a percentage of your initial investment. Its the same thing as with purchasing a stock. That investment can also lose all its value overnight. Its less likely to happen ( less risk ) and its also less likely to really increase much ( less reward ). All options do is scale up the risk/reward.
It's extremely rare that a security loses all of its value in a short period of time. In the last twenty years I can think of only a few occasions where it's happened that quickly, and it's almost always front-page news.
Options, on the other hand, are constantly declining to zero value. It's how they work. If you end up out of the money at the end of the day, you bust out on that bet.
Nobody is arguing about the long side of options being "oh god run for the hills nuclear weapons dangerous", they are arguing that about the short side (or certain complicated strategies that are long-short.) The long side is just a suckers bet, but it's a relatively low risk one. You buy a $1000 call -- most of the time you lose the $1000. Sometimes you break even. Rarely you make a little money. Once in a blue moon you 2 or 3x your money. (These are the instances you remember and hence you keep buying calls.) In the long run, you lose money (academic studies have shown this.)
Where you can really get screwed is going (naked) short. Lets say you shorted a "modest" $1000 worth of out-of-the-money GOOG options today with a 8% spread from strike. The $600 Dec 22nd puts right now cost $2.80, so you'd sell 4 contracts for $1120. 8% is plenty of cushion, right? As long as GOOG's price doesn't go down more than 8% before expiration, you'd have $1120 in your pocket. That's a huge drop and highly unlikely. An easy $1120, right? It worked last month and the month before, so why not this time?
But oops, lets say just like last time GOOG's earnings leak early because someone fat fingered an email or something, and the stock took an instant 12% haircut. That extra 4% below your strike price just cost you approximately $24 per share. You had 4 contracts, so your options were against 400 shares. You just lost $24 * 400 shares = $9600 in order to make an "easy" $1,120.
Now, consider the fact that many people are going to be looking to make more than $1,000 a month when trading options. More like $5,000-$10,000. Guess what -- if the market systematically crashes by 10% over a few days because Ben Bernanke sneezed during a speech you could be in the hole for hundreds of thousands of dollars depending on what positions you've taken.
Also, if you were to buy closer to-the-expiration options (say, ones expiring next week as opposed to next month), the per-contract costs go down by approx a factor of 10, so you have to sell 10x more contracts in order to get the same gain. But guess what, if your luck is particularly bad and something goes horribly wrong, you can multiply your losses above by a factor of 10. (Yes, Virginia, with options it is possible, nay, easy to have a 10,000% loss in a few minutes on a bad day.)
That's how you can get fucked. You keep selling short puts on positions you can't really cover comfortably, and rake in the dough. And then on one sunny otherwise uneventful autumn afternoon something weird happens, and Vegas, er, I mean, Wall Street, takes it all back, and much more.
Great comment gfodor. I like to think of it like this.
Buying options is like gambling at a casino. Statistically you will just keep losing money because the house always wins - they have the edge - unless you play a game like poker with a bunch of suckers - where the casino still takes a nice chunk of your change.
Selling options is like being a casino without the ability to know what the statistics of the underlying distributions or their payoffs are. Nor do you have the ability to kick a guy out if he wins too big and too often. It's a casino without the control. And a casino without control - is a casino that goes bankrupt.
So your saying if you don't manage your risk you will lost a lot of money ? Thats goes without saying which is why its called risk. The purchase I talked about exposed me to my purchase price in risk. In reality the risk was less since _everyone_ for every stock purchase should always set trailing stops to limit risk. In my theoretical trade of purchasing a put option on GOOG you are exposed to a maximum of you outlay in risk ( no ballooning risk ) and if like you should you set a trailing stop you further limit your risk to a small subset of the initial outlay.
Also to further prove that your wrong. The SEC has rules in place requiring that investors are not allowed to have to mush risk in their portfolio. Had you done what you jsut claimed and did a naked short on GOOG with no protection you would have been required to either pony up a large cash reserve ( protecting your broker from the liability ). Most responsible brokerages won't even allow your trade to go through unless again you have a large enough portfolio to absorb any reasonable risk.
This by the way is only using options for speculation. They have lots of other useful purposes and you haven't even discussed things like covered calls and using options as insurgence against volatility.
It doesn't seem that your read my comment since my entire point is that you seem to be acting like the buy-side of options is the 'nuclear weapons' the OP is warning people about. The buy side of options is perfectly "safe" since it is only really leveraged on the upside. It's the sell side that is a concern and requires extreme caution since it is leveraged on the downside. I'm not sure what you are claiming I am "wrong" about since nothing I said in my previous post was an opinion but simply explaining facts around the risk factors involved to make sure readers of this thread don't mix up the buy side and sell side of options and their associated risks.
You can get naked put option permission at many brokerages once you have done some trading. Also your point about stops is irrelevant: the way you get burned by short options isn't from a stock price slowly grazing down past your stop, it's when the value of the company objectively changes by 5-10% overnight or instantly intra-day due to some event or disclosure. The rarity of this situation is the very reason that the risk in short options is easy to ignore since you are selling insurance against tail risks and usually don't have to pay up to the buyer. (Covered calls can be viewed as 'income for the price of potential gains' or 'insurance for short sellers' depending on how you want to view it. The same argument applies on both types of options.)
Don't lie - the vast majority of options expire worthless. Your argument is like saying: "Oh if you buy that piece of shit penny stock and it goes up 1 penny - you'll double your money - no cash down!". Sounds an awful lot like a scam to me.
There are no free lunches. Anyone who say's otherwise - is lying.
expiring doesn't have a thing to do with it. I bought and sold the security on the same day. Also most don't expire worthless, about half expire worthless the other half expire with marketable value
Factor in time decay and rapidly falling risk value and you'll see my point about being worthless. The intrinsic value of options is almost always an order of magnitude less than what you pay for it (at the money - most liquid). Being worth 10% what you pay for something is not marketable value.
Verifiably false. Look at the November 17th $600 Call option for GOOG today. Its selling for $59.40 it has an intrinsic value of 59.05 and a time value of $0.35. In this case the time value is two orders of magnitude _less_ then the intrinsic value. That's just one example to prove my point. Your whole concept of options is bad, and you should feel bad
I said at the money not deep in the money genius. That call is almost a stock. Most options are traded at the money and most of the money is made there too. My statement is true.
So if you buy a option that by definition has _only_ time value, then by definition it will have very little intrinsic value. However contrary to your assertion most options are not traded there As of today (14 November 2012) on GOOG the at the money had the highest number of contracts traded at it ( ~350 at 660 ), but the total number of GOOG contracts traded was ~1100 so at the money was not even half of the contracts traded. I will leave these two links here one is to the google finance page so you can have a clue about what your trying to debate the second is to the definition of majority since you don't seem to know it
Haha, yea that's actually was one of the most concise and accurate summaries of options I've seen, though unlike the OP, some of the terminology would be lost on a layman.
Do yourself a favor and don't. From his post I would assume he has been burnt by options in the past and may not have the best insight into them or the possibilities they open up.
If you are buying options - you will consistently lose money. Both time and risk premia overpricing go against you. If you don't make the mark within the time period (and market dynamics are notoriously hard to predict) - you will lose 100%. Breaking even often requires a large 5-7% move in your favour - and that just doesn't happen often enough - especially in the one month buy-to-mark time frame that most options trade at. Nassim Taleb does this - he probably makes more money selling pretty books and giving fancy talks.
If you are selling options - you will consistently make fat stacks until you blow up (since you're the counterparty of the above buyers). You can push naked index puts or calls all you want, and make an absolute fucking killing. I'm not kidding. You could easily pull $10-200K a month in profit, depending on how much of a baller you think you are, and how much capital you have backing your risk-taking ass (talking individual traders here).
But this money isn't without insane risks, have no doubt - you are playing with an armed thermonuclear warhead. If all the market correlations go to one and you're the last guy holding the bag containing other people's vol - you will get decimated. LTCM did this for 3 years - blew up year 4 - lost $5 billion in one month. LTCM principals went on and started a bunch of similar firms - finance is apparently very forgiving of failure - it shouldn't be. Most of those funds went thermonuclear back during the 2007 GFC.
If you do a mixed strategy - you'll end up with mixed results - because you're just mixing the above. No option strategy outside of market making consistently makes money (computational traders making markets and taking hedged spreads).
It's exactly like insurance. Insurance buyers pay up, but they never want to actually use it (unless they are committing fraud/market manipulation), and are happy to burn that cash to protect themselves. Insurance sellers are happy to sell, but their industry is commodity, and the only way they make money is by investing the float they have on hand between cash inflows (buyer premiums today) and cash outflows (buyers claiming a year later).
Problem is shares aren't like physical goods - they aren't bound by physical laws and hence do not follow the normal distribution. Share prices can go to infinity and hit zero all over the course of a day - their just bits of data in a db somewhere in Jersey. Car crashes, geographically separated houses and diversified mega-cat risk don't do that - often :D.
If you put in a costless collar on a stock you already own, you cap both your upside and your downside relatively cheaply (this is how Mark Cuban survived the dot-com crash with $2 billion in Yahoo! stock).
Outside of those few lessons - unless you are pushing statistical liquidity or selling millions of options per day - stay the fuck away from them. Individual investors should either go passive index or if they know an industry inside and out value-growth.
Everybody else should either be supply liquidity (HFT - not too profitable anymore) or pushing relative stat arb (RenTech/Shaw's + hundreds of PhDs). Individuals should not try to compete in this area - at all. Just like you don't try to build your own car, cruise ship, 747, iPhone or tank, you shouldn't try and trade against stat. arb/HFT guys without the mental or financial backing to hold your own shit.
Value-growth/passive works because the market comes to you - hat in hand saying - here take my money please. Stat. arb/HFT also works, but it's much harder, because you have to go to the market and make sure that it isn't you that is saying - here take my money, please.