Conciousness vs Heuristics

In my previous post I discussed the competency scale used across a number of fields. The Ducster took issue with the term "unconscious".

From sigmaoptions, this post appeared discussing mental competencies. In a first part response, I’ll look at the Greeks component. In the second, I’ll consider the actual neurological pathways involved, and why in this example, unconscious is a misnomer.

While knowing what the term is getting at, I agree it is a misnomer; in the field of options trading anyway.

He suggests that the advanced options trader is in fact utilizing some form of heuristic reasoning rather than being "unconcious". That's probably more accurate, but it sure messes with the poetry of the "unconscious incompetent => unconscious competent" hypothesis.

So how to rejig it to incorporate "heuristic"? I can't think of anything that flows and describes the progression of competency nearly so well.

Suggestions welcome.

Options and the Unconscious Competent

In other technical fields, I often heard of experts speak of the phases of skill progression from novice to expert, invariably stated as having four phases as below:

1. Unconscious Incompetent
2. Conscious Incompetent
3. Conscious Competent
4. Unconscious Competent

It's a fancy way of saying that you progress from an idiot, to knowing what you're doing without thinking. The unconscious competent is that individual that acts and reacts from second nature without having to think first. A kung fu master has hundreds of complicated techniques as his disposal that are second nature, due to thousands upon thousands of hours of practice. A master tradesman can be thinking about the hot looking woman that just walked past while he works; he is creating his work without thinking about it.

(N.B. I use the male gender generically and of course include females in this discussion)

Options trading is of course no different and it is the aim of any non-delusional individual to progress to the Unconscious Competent stage; just knowing what to do at any point, quickly, without an over reliance on software, calculators and suchlike.

The unconscious competent can have been in such a state for so long, that he no longer realizes what knowledge he is actually using.

An illustration of this point came up on a discussion forum recently. The question was asked, can you be successful without regard to the Greeks? Various points of view were put forth, but the one that interested me was from an ex-institutional trader with decades of high level experience. He thought that Greeks were not necessary for simple directional strategies.

I questioned whether he in fact had a mental map of option pricing that was so ingrained, that perhaps had a "picture" of the Greeks that he used without thinking about it, even with simple strategies. At first he didn't think so, but later reversed that opinion and agreed.

That man is an unconscious competent. Options trading is just second nature, to the point that he doesn't even have to think about it. This is the state all will aspire to and achieve given the correct knowledge/education. This is actually easier said than done as there is soooo much erroneous information and truly worthless (and very bloomin' expensive) options education programs out there.

Getting to the Conscious Competent stage for a retail trader is harder than many imagine, that is, getting the correct grounding in options theory and pricing. So many crash and burn from being taught BS.

Every options education program, whether in book form or CD/Internet course needs to be marketed in order to attract clients; and the trainers will require remuneration for their efforts.

But how does the options neophyte sort the good from the bad and the truly ugly?

Even good programs will indulge in a certain level of hype. This is the reality of marketing, "warts and all" reality just won't sell well. But on the other hand, what seems to good to be true, probably is. This is the sort of thing I have bagging out recently, the total BS claims and totally erroneous and inaccurate, even mischievously outrageous claims.

I guess it boils down to avoiding the worst of the hype and being somewhat skeptical, perhaps even cynical when evaluating a potential information vendor.

Be careful out there. Marketers are master psychologists (unconscious competents) and work on your base emotions rather than your intellect. Some of the worst programs are the most absolutely taleted marketers, because they appeal to those most powerful of financial market emotions, fear and greed.

American vs Euro Double Take

As I trawl around the options universe I see many statements from the erroneous to the downright dishonest. Occasionally there are statements from ersatz options "experts" that even make me do a double take, so stunning are they in their cretinous ignorance.

Behold the latest example, from someone selling information, producing videos etc:

American vs. European style options:

American style options such as OEX or SPY can be traded anytime. European style options can not be closed until their expiration date. I prefer to trade American style options since I can buy and sell them out when I want.

LMAO

Of course European style options can be traded into and out of, anytime, just as American style options can. Jesus! We ALL know that one don't we? (For the newbies reading this, American or European style refers to when options can be exercised, not whether they can be closed out or not.)

Further down the page, we are served up this little beauty, in big bold type:

Turn $1000 into $124,000 in One Year!!!

Where do I sign?

VIX Options Weirdness

I don't trade VIX options, but I've shown some pretty wacky disparities between call and put IVs. I thought there had to be an explanation, because it just wasn't credible that such huge differences weren't arbed away.

Dean Mouscher has the answer in a 16 minute video on the subject.

If you are trading these, or might at some point in the future, this is a must view.

Probability is Probably Improbable

The Ducster has brought an interesting theme in the whole probability/expectancy conundrum that has been bouncing around the blogosphere of late:

Probabilities, or frequencies that are calculated via Black-Scholes, Binominal Tree or even the more esoteric methodology of GARCH, all essentially utilise a Gaussian distribution of stock prices in their volatility calculations.

This as the old saw notes, generally works well, until it doesn’t. <<Read>>

Essentially, probabilities are calculated by one or another model using a sample past data. This is a problem. As we know, in real life, stock market distributions do not really adhere to distribution assumptions of the various models - Black Scholes, Binomial Tree et al. There are models that are allegedly better, but not in common use. More particularly, the data sample used, or even volatility projections implied by option price may bear no relation to future volatility as it is realized. Also, statistical probabilities change as events unfold.

Two days can change the statistical landscape the trader has used to place a trade altogether.

The whole problem with using a model is... well, it's just a model...

...and models fail.

So when option traders make assumptions about probabilities and take risks based on them, it is really treading on thin ice. It's a guess. It may be an educated guess, but a guess nonetheless.

Ergo, option traders should question how probable the probability is.

"It'll never happen", happens with enough frequency to weed out model arrogance.

Survivors of 8 sigma events are those wise enough to mistrust "probabilities" and religiously cover their ass.

Probability Is Only Part Of The Puzzle

Over the last couple of weeks I've been concentrating on option trading myths and nonsense, in particular the myth of 90% of options expiring worthless, but only alluding to the second part of the puzzle. That second part of the puzzle is mathematical expectancy.

As Dean from www.masteroptions.com pointed out in a comment on my previous post:

The debate over what percentage of options expires out of the money misses the point. Even if it were true that 90% of options expired worthless it would mean nothing. There's also the matter of how much you make on your winners vs how much you lose on your losers.

Never a truer word said. Probability of win is irrelevant on its own.

The expectancy equation has two parts, 1) probability of win and 2) win size vs loss size. One way of expressing this mathematically is with this equation:

Expectancy = ((1 + reward/risk ratio) * win/loss ratio)-1

One way to have a look at this principle in practice is to wander down to the casino and play a little roulette. It is a wonderful way to understand this principle, because at the roulette wheel, it does not matter one iota with what probability we play, the negative expectancy cannot be overcome. On a 00 wheel the negative expectancy is -5.26%.

We can create a ~90% probability, but that won't help us a jot. A chip placed on 34 numbers gives us a ~89.5% probability of winning paying 36/34, but it's still a losing strategy in the long run. Let's look at the maths:

Expectancy = ((1 + reward/risk ratio) * win/loss ratio)-1

= ((1 +2/34) *34/38)-1

= -0.0526

= -5.26%

Likewise, an option strategy with a theoretically 90% probability, whether an actual statistical probability, or an erroneous probability, doesn't make the trader profitable in the long run. We are all aware of the snatching pennies from in front of a steam roller analogy.

If you make $1,000 90% of the time and lose $10,000 10% of the time, you're down a hole. In fact, you lose $1,000 every ten trades on average.

F### that!

High probability trades are nice in theory, but a trader still has to develop a positive mathematical edge. So our "90% of options expire worthless so sell options" pseudo-gurus actually make two major misrepresentations; that 90% options expire worthless and that this automatically confers profitability.

Mathematics outs in the end.

90% Of Options Expire Worthless

In the previous post, the quoted "guru" stated unequivocally that 90% of options expire worthless, wit the implication that option sellers have an edge over buyers... actually it's often explicitly stated.

According to the Chicago Board Options Exchange, typically only about 30% of options expire worthless in each monthly cycle. Only about 10% of options are exercised during each monthly cycle, usually in the final week before expiration. In fact, over 60% of all options are traded out in the marketplace. This means that buyers sell their options in the market, and writers buy their positions back to close.

So we see that the "90% of options expire worthless myth" is... a myth.

The fact it that there is no inherent edge in buying or selling options at point of inception, if they are correctly priced. It can be determined in retrospect, but the problem is that we cannot see into the future. There is no way of knowing whether the option premium is cheap or expensive, because we don't know what the underlying is going to do.

I like being nett short premium, because I am better at managing those positions for more consistent profit, but it does not mean being nett long premium is wrong. Each has it's own set of management implications.

Horses for courses.

Credit Spread Nonsense

In keeping with my current fetish for trying to bust a few nonsensical myths and mistruths with premium collection strategies, I guess I've turned my attention to credit spreads.

Look! Credit spreads are a good strategy, one good strategy, one of any number of good strategies. I use them when I think they are the right strategy to use. What makes me lose the will to live is the bullshit that emanates from ersatz experts and course spruikers.

N.B. I have nothing against education courses at all. There are a few good ones I'll never criticize, but they are outnumbered by some truly odious and dangerous programs inflicted on innocent neophyte option traders... usually at vast expense.

To subject (sent via email so unable to attribute) of my ire today, which resulted in a distinctly forehead shaped dent in my desk, behold:

The beauty of option trading is that it opens up a lot of alternative ways building wealth from the stock market. Recent events have shown that the "buy-and-hold" approach to stock trading carries substantial risk. With a volatile market, a safe "in-and-out" approach is much more desirable. Of all the option trading strategies available, trading credit spreads is by far the safest and simplest method. It has a risk profile significantly lower than stock trading, and it offers much better profit than any type of stock trading strategy around.

Selling credit spreads takes advantage of the fact that the value of any option declines as the expiry date of the option approaches. It does this particularly fast during the last 30 days of the life of the option. It has been said that 90% of option buyers lose their money. This means that those who sold the options to those unfortunate buyers win 90% of the time!

What are the advantages of credit spread trading?

• It is short term - trades are typically less than 30 days in duration, and take advantage of short term trends in the market;
• It is low risk - trades have a better than 90% of success - always! You know exactly what the risk, return and profit will be before you enter a trade - there is no guess work.
• Profit is up front - a trader gets his profit immediately, and only needs to protect that profit for a short period;
• Market fluctuations are mostly irrelevant. The market can continue its trend, stagnate, or even turn against you to a certain extent, and your profit is completely safe and untouchable.
• Simple technical analysis - other options trading strategies (and stock trading) require intense fundamental and technical analysis, significant understanding of the market, and the ability to "beat the news". Selling Credit spreads needs a very simple trend analysis procedure, which should not take longer than 10 minutes a day, and the ability to plan for upcoming events such as earnings reports.
• Time spent in monitoring the trade is very low;
• Profits range between 5% and 20% per month, depending on how actively the spreads are traded. Compounded, this leads to significant growth in a profile. Starting with $1,000 and gaining a steady but sure 15% per month, you can get your first million dollars in four years, without deductions for ulcer treatment.

What do you need in order to start building wealth by selling credit spreads?
you need an account with an options trading broker such as Thinkorswim or OptionsXpress.
you need a minimum balance of $1,000, in order to cover margin requirements for selling credit spreads.
you need to be able to identify a trend in the market and in your chosen stock.
you need to be able to look ahead for predictable events such as earning reports and dividend payments.
you need about 15 minutes per week.
...and that's it!
You do not need nuclear physics degree in fundamental and technical analysis; you do not need to spend hours pouring over graphs and indicators; you do not need to go bald, get an ulcer or a heart condition; and you definitely do not need to pander to your obsessive compulsion to constantly monitor your trade, making fiddly adjustments on the way!

Selling credit spreads is an excellent method for those who are committed to a safe, steady approach to building wealth.

I sell credit spreads every month, and even when a very few trades have gone against me, I still build an average 15-20% growth on my portfolio each month.

Hallelujah! The Holy Grail found! Gold, Frankincense and Myrrh for all! If your still with me, indulge me in a point by point fisking:

The beauty of option trading is that it opens up a lot of alternative ways building wealth from the stock market.

A good start for the writer here, this is exactly the reason we option traders trade options rather than the underlying stocks. Unfortunately, it's all downhill from here.

Recent events have shown that the "buy-and-hold" approach to stock trading carries substantial risk.

Well, yes, but wait for the rest.

With a volatile market, a safe "in-and-out" approach is much more desirable.

Why is it more desirable? It might be for the author and it might be for me, but it might be the antithesis of what is desirable for somebody else, depending on innumerable factors.

Of all the option trading strategies available, trading credit spreads is by far the safest and simplest method.

How so? Simplest? So a two legged strategy is simpler than a simple bought option? Safest? How does he/she quantify safe? Considering that one can put their entire capital at risk in one trade, with some probabilty of a maximum loss, I violently disagree. Most strategies are safe if used safely, i.e. with proper position sizing. All strategies, including credit spreads, are unsafe if used with too much size/leverage.

It has a risk profile significantly lower than stock trading, and it offers much better profit than any type of stock trading strategy around.

This is about the point where my forehead first hit my desk with some velocity. Without going into mathematics and payoff diagrams, this is a truly pukeworthy statement. Much better profit? Credit spreads offer a "different" risk/reward/probability profile which may be better in certain circumstances but not others. Stock going sideways? Sure, give me a credit spread or related strategy. Stock about to go to the moon? I'll take the stock, or perhaps some call options thanks.

Selling credit spreads takes advantage of the fact that the value of any option declines as the expiry date of the option approaches. It does this particularly fast during the last 30 days of the life of the option.

This person has obviously never heard of delta/gamma. True, extrinsic value, in simplistic terms, declines, but what about intrinsic value? I want to ask this person if he/she thinks the value of the put option he/she just sold is going to be worth less if $10 in the money at expiry.

It has been said that 90% of option buyers lose their money. This means that those who sold the options to those unfortunate buyers win 90% of the time!

Just disingenuous bullshit. Even the standard myth only says 80%. The truth is somewhat different and more complex. For another post maybe.

It is short term - trades are typically less than 30 days in duration, and take advantage of short term trends in the market;

Yes short term, but the preceding statement says this person is trading OTM credit spreads. If I want to trade short term trends, I'll pick an entirely different strategy. OTM Credit spreads are best for non-trends or slow trends. If you're trying to trade a trend and still want a vertical spread, go an ATM debit spread.

It is low risk - trades have a better than 90% of success - always! You know exactly what the risk, return and profit will be before you enter a trade - there is no guess work.

Well I don't know about low risk, there is a higher probability, but also a very low reward compared to the outright risk. Again that's OK, if it suits your view. But a credit spread constructed with 90% theoretical probability is going to be extremely skinny on the nett credit. As far as "always", a truly risible statement.

Profit is up front - a trader gets his profit immediately, and only needs to protect that profit for a short period;

Oh brother!! The old credit is better than a debit fallacy. I wonder if this person ever tried to spend that up front profit? I wonder if he/she ever looked at their margin statement. I think these are best constructed as credit spread, but for completely different reasons than the up front credit. The credit is *irrelevent*. It is the positive theta one is trying to trade here while hoping not to get crunched by the other greeks. Positive theta, AKA premium collection, can still be acheived with an initial debit.

Market fluctuations are mostly irrelevant. The market can continue its trend, stagnate, or even turn against you to a certain extent, and your profit is completely safe and untouchable.

This one is kind of half true. Provided that the underlying doesn't close ITM on the sold option, you keep the credit. In the intervening period however, you can be deep in a hole if the stock is moving against you. The profit is most certainly not safe as you are then in a position of hope. An exit or adjustment is going to cost.

Simple technical analysis - other options trading strategies (and stock trading) require intense fundamental and technical analysis, significant understanding of the market, and the ability to "beat the news". Selling Credit spreads needs a very simple trend analysis procedure, which should not take longer than 10 minutes a day, and the ability to plan for upcoming events such as earnings reports.

What can I say.... this is just nonsense. A simple approach may work, indeed it does. But a simple laissez faire TA approach is not going to give you 90% probability spreads.

Profits range between 5% and 20% per month, depending on how actively the spreads are traded. Compounded, this leads to significant growth in a profile. Starting with $1,000 and gaining a steady but sure 15% per month, you can get your first million dollars in four years, without deductions for ulcer treatment.

[sigh] The BS just doesn't stop! I'm weary, I've had enough of this. Maybe I'll continue this once I've recovered from concussion

The Second Apocalypse?

There is an email doing the rounds in London at the moment purportedly written by the MD of a major bank. Excerpts were posted on The Financial Times Aphaville blog - Here is copy and paste of the excerpts... very bearish:

US Housing

It lead us into this recession & it will likely lead us out. -This asset class is the collateral spine of household & bank B/S. It remains a sine qua non for the mkt. Unfortunately, foreclosure filings are +18% yoy (May), the mort delinquiency rate (9.12%) is a record, prime defaults have just doubled (yoy) to 2.9%, new and existing home sales are still barely off their Jan lows (you’d need to see a 50% increase from here to be consistent with flat gdp), unsold inventory is still at 10.2 mths (even without shadow inventory from banks & Securitised Mort Trusts), 30% of mort are in negative equity & rising, -18.1% hse prices is still ugly….

US Consumer

Too much debt, not enough credit. -Declines in the housing & equity mkts have removed c$14tr from his net worth (Fed) at a time when he’s 3x the leverage of 20 yrs ago & carrying $13.5tr of debt. That process of de-leveraging is just starting. Delinquencies on Home Loans just hit 3.5% (ABI), a number that will grow in tandem with unemployment & US Personal bankruptcies (ABI) were +35% last seen. Look at the recent & salutary examples of the banks and Japan’s lost decade to remind us just how painful & prolonged the de-leveraging process can be.

The savings rate just hit 6.9%. It has reverted to 10% in prev deep downturns. That cld be exacerbated by a baby boomer generation who in previous recessions cld get credit & had a higher propensity to spend (in their 30’s) but who now can’t get credit & have a greater propensity to save (as they’re now in their 50’s).

The latest non-farm number (-472,000) wasn’t just worse than expectations, but was worse than the very worst print seen in either of the ‘80-’82, ‘90-’01 or ‘01-’02 downturns. Initial Jobless yesterday were better, but Continuing claims were worse (& a record high). Unemployment (beware the lagging mantra) is relevant because this is a credit related crisis & unemployment’s continued rise to & thru 10% (The Congressional budget is based on 8.1% ‘09) will generate more delinquencies & foreclosures. Moreover, the “leading” indicator components of the non-farm report-Hours worked (still at a record low & with a 70% correlation to GDP) & Temporary Hires (-37/-) are still showing falling leaves rather than green shoots.

Credit cards (the lender of last resort) are seeing record charge offs (Moody’s:-10.6% vs 9.9% in Apr) & cc outstandings are falling at a 20% annualised rate with consumer credit contracting by over $50bn since Lehman hit the tape. Remember, the consumer is just starting, not just ending his de-leveraging process.

US Insiders

A vote of No confidence. -51% of CEO’s (Business Roundtable) expect lower capex (the inventory replenishment is now a given for the mkt) & 49% expect lower payrolls going fwd. -Directors sold $2.9bn of stock in June (Trimtabs). The Sell/Buy ratio is a monster 10x, so the green shoot callers might be selling it, but the Corp insiders aren’t buying it.

US Dividends

70% of US equity rtns since 1900 (LBS) have been generated by dividends. -In Q2 just 233 S&P names raised their divi (a record low) & 250 names actually cut (2nd worst ever reading).

US Valuation

Valuations are not at a level that discounts any ongoing negative news. -Mkt bottomed (666) on 11.7x. The ave of of the last 11 bear mkts (where over 70% have seen a lower bottom) has been 9.9x (Haver) & there’s nothing ave about this recession. -Going all the way back to 1929 (NDR) and we find that PE multiple expansion has averaged 10% in the first 3 mths & 22% in the first 6 mths of recovery. We just clocked up 40%! With the “P” already there we need the “e” to catch up real fast to validate this rally.

US Technicals & Volume

Better to wear out than rust up? -Dow has broken its 8300 Head & Shoulders neckline support & 200 day move ave (FTSE has broken its 4295 Triple Top neckline, 200 day & failed to breach its channel top). Dow theory (DJT has failed to validate the main index highs) is also firmly in the bear camp. S&P has been clinging on by its fingernails but the breach below its 200 @ 887 & a subsequent fall below major support @ 875 wld frighten lots of rabbits.

-Ave daily vol has contracted by 30% on the S&P & c 50% on the Dow over the last 3 mths (Trimtabs). -Bear mkt bottoms (19 going back to the war) have typically been associated with steady eddy rallies on good vol (Hussman). The 4 episodes that were the exception & saw rel light vol also only rallied modestly. We’ve just belted the biggest rally since the Depression on thin vol with just slightly less depressing news….which reminds me of the Sage of Omaha’s axiom that “you can’t make a baby in a day by making 9 women pregnant”.

Light trading vol (compounded by higher vol on recent down days vs lower vol on recent up days), and a diminished response to “positive” news imply that we don’t need to see strong selling pressure to roll us over some more. Just buyer’s fatigue. And we need to beat (a 62% beat rate in Q1) not just meet consensus eps forecasts for Q2.

US Issuance

Today’s problem or tomorrow’s promise? May clocked up $64bn & June was similar. The prev record issuance was $38bn. There have only been 12 mths since ‘98 that Corp issuance has exceeded $30bn & the ave rtn of the S&P over the nxt qtr was btwn -4% to -7% (Trimtabs)

US Quotes (recent)

Moody’s:-”US housing wont hit bottom until 2010″.

Hayashi (Jpn Economy Minister) “The US economy has yet to hit bottom”.

S&P:- “CMBS credit deterioration is just beginning” ($400bn of commercial property re-sets to y/e). I think this space is armed & dangerous.

IMF:-”The retrenching of the US consumer is a huge adjustment that the whole global economy is going to have to absorb”.

Buffett (who’s a bull remember) “I had a cataract op on my eye recently & I still can’t see any green shoots”.

Moody’s:-”US housing wont hit bottom until 2010″. Hayashi (Jpn Economy Minister) “The US economy has yet to hit bottom”. S&P:- “CMBS credit deterioration is just beginning” ($400bn of commercial property re-sets to y/e). I think this space is armed & dangerous. IMF:-”The retrenching of the US consumer is a huge adjustment that the whole global economy is going to have to absorb”. Buffett (who’s a bull remember) “I had a cataract op on my eye recently & I still can’t see any green shoots”.

US/China

Our knight in shining armour. But… -The US is 25% of global gdp & China is 8%. -6% Chinese gdp grth (which we’re all now excited about) is actually still consistent with an ongoing global recession. -For every 1% that the US consumer shrinks, the Chinese consumer needs to expand by 6%. -Jpn shipments to China dropped -29.7% in May (-25.9% in Apr). -1/3rd of China’s gdp are exports (47% for Asia)….& those mkts are still contracting. People are talking up de-coupling again, despite the fact that that particular chocolate teapot got melted before.

And finally

California, Russian banks, CMBS, Sovereign risk (Baltic states), Swine Flu….

Naked Puts Ad Nauseam

OK, clearly I have a bee in my bonnet about naked puts at the moment. As we have discussed in the preceding days, a naked put is equivalent to a covered call, vis a vis, a covered call is a synthetic naked put.

The main problem seems to be with the thinking, the psychology around this strategy. Over the weekend, once again I listened to trader friends referring with great fear and loathing about the risks of naked puts, yet waxing lyrical about the virtue covered calls.

It makes me want to smash my head against a wall... actually I wanted to smash their head against a wall, but I would have possibly lost their friendship in doing so. So I imbibed in that favourite English pastime of drinking to excess instead. A tactic which ensures a change of topic to fast cars, football and loose women. Genius... but I digress.

So now I'm back into the mire of markets, economies and managing option positions, I'll preach into the electronic ether, instead of at my friends.

Dean posted a comment below which referred to a thread on the Motley Fool's discussion board. In it was what I thought was a very useful thinking exercise when considering naked puts (and by synthetic implication, covered calls) and once again, it involves synthetics. (Hat Tip BeautifulPlumage)

We know that we can create a synthetic long stock position with options, by buying a call and selling a corresponding put, so we can look at any stock position as having a long call and short put embedded within it.

We can then analyze the naked put option as a long stock position with the short call stripped out leaving only the short put. A covered call can be looked at precisely the same way, as you have long stock with the long call component stripped out, buy writing (selling) the call leaving only the short put, albeit synthetically.

Why would an investor/trader do this?

By implication, the investor is dodging the cost of buying unlimited upside (the call option premium) and electing to collect the premium available in the short put. He is implying that he doesn't believe the stock is going to appreciate in value more than the strike price, plus what the put option premium is going to deliver in the time to expiry. If he does believe the stock is going higher than that point, he is short changing himself.

He also (by implication) doesn't believe the stock is going to fall by more than the strike price plus premium collected, otherwise just stay out, or use a different strategy. However if the stock does fall past this point, at least the loss is less than long stock.

It is a bet that the stock price is going to stay in a range.

Obviously, the put premium has to be adequate recompense for the risk taken, measured against the probability of such moves occurring in the time frame.

There is no new information there and this is all pretty obvious stuff for those with a good grasp of synthetics, but I thought it was an interesting way of looking at these two strategies, and a good way for people whose thinking has been confused by definitive statements that aren't consistent with reality.

Once again, there are various reasons people want to trade the naked put and it's synthetic equivalent (covered call) which may or may not be optimum for their purposes and there are other strategies from which to select. I'm not promoting this as a good or a bad thing. It's just an exercise in understanding.

The VXV

It's the CBOE S&P 500 Three-Month Volatility Index. It is from the same family as VIX, but whereas the VIX looks at the implied volatilities of SP500 options of 30 days duration (according to a formula), the VXV looks at the three month picture.

Bill Luby of Vix & More has a good article in Barrons that details how we can use it:

As a result of its elevated profile, the VIX is now followed by a wider variety of investors than at any time in the history of the index. But while the VIX is an important tool, investors -- including those who do not trade options -- would be well-served to look past the VIX for a more nuanced understanding of volatility and its implications for their portfolios.

A case in point is the little-known VXV, whose formal name is the CBOE S&P 500 Three-Month Volatility Index. The VIX calculates implied volatility in S&P 500 index options for merely the next 30 days, but VXV uses a 93-day time window. The different time horizons have some important implications.

You can read the rest of the article HERE.

Where For Art Thou, GS?

"They" let me down yesterday. I will certainly have to brush up on my soothsaying skills I guess.

The employment numbers and the market reaction (a 2 standard deviation move down) must raise the specter of a continuation of the bear market. Most of the credible experts (those that predicted the whole mess in the first place) are incredulous at the up move since March and believe the market should be much lower.

I agree. So when where will the market be manipulated next?

For me, I couldn't give a crap, just don't get there too fast so I can hedge my deltas. VIX ticked up a couple of %, a solid, but not fearful move, so I'm not worried about fast markets... yet, but I don't think we've seen the last of fast down markets.

Disclaimer: I'm delta neutral on the indices.

I'm Buying

OK now that I'm in full conspiracy theory mode, my prediction for today is that GS and MS will have a busy day in the SP pits.

A comment in response to Marketwatch's pre-non farm payrolls numbers:

MarketWatch - why do you pass on this gobbledegook? You guys know as well as all of us that the U.S. government "statistics" are about as dependable as a 2 dollar watch.

...and there are dozens along the same lines.

The payroll numbers will be dreadful, but folk will suspect the government is lying and things are actually much worse (Noooo - who'd believe that?). Folks will realise the bobbleheads optimism is totally misplaced and flog all their stocks the market will open sharply down.

GS & MS will start buying with their ears pinned back for some mysterious account, the market will finish green, Goldilocks will make another cameo appearance, folks will be conned into believing all is well and a return to the upward grind will ensue.

Disclaimer: I'm short gamma on the indices with a little upside skew.

OK I've let my cynicism out for a run, back to normal programming shortly.

Update: As expected, the #s were woeful, now all I need for soothsayer status is for the SP500 to be green by day's end.

Market Manipulated! Levin Lets The Cat Out Of The Bag!

Original Content Sigma Options

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Via ZeroHedge, here is a jawdropping video where Larry Levin let's the cat out of the bag about gu'mint manipulation.

"Larry Levin is a professional futures trader. He has been in and around the S&P 500 futures pit at the largest futures exchange in the world; the Chicago Mercantile Exchange (CME), for almost 20 years.

Larry has been trading his own account or company's proprietary accounts since 1993, trading an average of 2500-3000 E-mini S&P futures contracts a day."

The meaty bit starts at about 2 minutes in.

Covered Calls and Naked Puts - Same Only Different

Original Content Sigma Options

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We all know that naked puts and covered calls are synthetically equivalent... well I hope we all know by now, and we know that a buy write IS a covered call.

My thesis today is that they all may be quite different, not in risk profile, but in the psychology these strategies are a subject of.

Firstly the difference between a covered call and a buy write. Of course there is no official difference, it's long stock and short a call no matter which name you use, but I think there is a difference of inception, the nomenclature different according to the goal of the trader. I think of a buy write as when a stock is bought with the call written at the same time. A covered call I think of as a call written over stock already owned, perhaps for some considerable length of time.

A buy write is entered as a trade to collect the premium (Here I am speaking of general practice, not my practice) and the buy writer is hoping that the stock goes up and is called away. Of course a written put can be used instead, but there are a few reason why the trader doesn't use the naked put. He may have done one of "those" courses. He may not know about synthetic equivalency. His muppet of a broker may not allow him to trade naked puts. This is the sort of trader that scans for high IVs looking for maximum premium (for better or for worse), but he usually doesn't want to keep the stock.

The covered call trader on the other hand, already owns the stock. He probably doesn't want his stock called away, particularly if he has a low cost base and doesn't want a capital gains tax event. As such he is probably writing the call to partially hedge and/or derive some extra income from the premium. His stock is going sideways or perhaps on what he hopes is a short term decline. If the call goes in the money, he is more likely to trade out of the call rather than have his stock assigned.

Please note that these are personal definitions and may not reflects other's thinking.

The naked put trader generally has one of two goals. He either want to just collect premium, so is like our buy writer, or he is writing puts he hopes will end up in the money and wants to be assigned the stock. This second type of naked put trader is more akin, but slightly different to our covered call trader. He is used the puts as part of an overall investment strategy and not really a trader.

All of the above traders may select different strikes and expiries depending on what his ultimate goal is.

So yes, all have the identical payoff diagram when the strike price and expiry are the same, but there are different reasons and psychology that dictate different approaches within the same group of strategies.