Coughing Up For Gold Options

The recurring theme in stock index options over the last few months has been the chronic overvaluation as measured by implied volatility over the eventual realized volatility. Theoretically, this has been an excellent time for index option writers, except that the indexes have been running a long way from their mean. Any sellers writing fairly close to the money (like moi :-0) have been as busy as a one armed taxi driver with crabs, making adjustments.

We've had to work pretty hard for our money.

Index options haven't been the only ones in more or less chronic overvaluation. Gold options have been in a similar situation. I like the futures and their options, but the gold ETF, GLD and its options pretty much mirror the futs.

Check out the IV/HV chart for the last six months.

Even ignoring the IV spike earlier this month, those buying options have been paying well over the odds. Writing options here seems the no brainer. I liked the idea of selling premium with some long delta with a couple of different ideas leading into September, due to the pretty reliable seasonal tendency. That's worked out pretty well, but who's game to write unhedged on the call side in this market?

Not this little black duck!

Runaway gold markets don't happen that often, but the bulls can go berserk if *something* happens. Nevertheless, there is a bit of short gamma fun to be had here in this market... just cap the risk IMO.

Synthetic Equivalence - What It Ain't.

I've posted a bit on synthetic equivalence a few time in recent months, both here on the blog and on some message boards. Some people have a few trouble with this concept even when proven mathematically, so thought I would talk a bit on what it is and what it isn't.

For what it is, I'll leave the explaining to Charles Cottle, from The Hidden Reality:

There is the raw (actual)position consisting of the exact options that contribute to an overall strategy. For every raw position there are a number of alternative positions called synthetic positions (synthetics). A synthetic position has the same risk profile as its raw position and achieves the same objectives.

What that means is that the risk profile of an option strategy can be duplicated via different combinations of options and/or stocks. A few examples:

A covered call is a synthetic naked short put
A married put is a synthetic long call
A collar is a synthetic vertical spread

There are dozens of combinations that can duplicate the risk profile of different combinations.

The problem seems to be that some people feel that the positions must me identical in every respect to be synthetically equivalent. The most common objection is that of different capital/margin requirements. - that if one position needed more money to trade than the other, they can't be synthetically equivalent.

One fellow didn't feel that a long call/short corresponding put wasn't synthetically equivalent to long stock, because he could get the option combo on margin, whereas the stock required the full investment of the value of the stock. That *may* be true for some traders. But it is certainly not true for others due to different margin rules, haircuts or whatever.

The logical extrapolation of that logic would be that stock bought on margin is not the same as stock bought for cash.

In any case, capital/margin requirements are not relevant to synthetic equivalence. What is relevant, it the risk profile... the payoff diagram adjusted for cost of carry and dividends if necessary.

Capital/Margin is not considered when looking at synthetic equivalence.

Covered Calls - Naked Puts Redux

About a month ago, I was opining opining that though covered calls and naked puts are synthetic equivalents, there may be valid structural or psychological reasons why a trader might use one over the other.

It might not surprise many that I am impressed by my own profundity in that discussion ;). *Some* other arguments on the merits of one over the other leave me underwhelmed however, most particularly when those arguments are chockers full of non-sequiturs, half truths and plain old BS. These of course are all over the place in Option Land, but I'll pick on a recent article published by an option book vendor.

In the article, the author recognised the synthetic equivalency of covered calls and naked puts (rare), but argues the superiority of CCs based on a load of old cobblers, to wit:

Here are the reasons I prefer covered call writing to naked put selling:

1- Many brokerages want the assurance to know that you have the ability to purchase the shares you are obligated to buy when selling the put. Therefore, they will require you to have an adequate amount of cash in your account to cover such an event. You will then have sold a cash-secured put and set aside the same amount of cash as the CC seller.

I don't see this as a disadvantage at all if the goal is conservative premium collection. As the author acknowledges, capital usage is the same. Therefore, there is no valid reason on this point to prefer covered calls.

2- The seller of a covered call captures all dividends distributed by the underlying corporation, the put seller does not. We’re not talking about a huge windfall here, but the cash is better in our pockets than someone else’s.

Just plain incorrect. Option pricing takes into account any pending dividend and option pricing cum-dividend and ex-dividend account for them. If you have a covered call position, the call premium will be cheaper to the tune of the dividend amount. You get the dividend via the stock, but you lose it via less call premium. I have an article on the effects of dividends for further information.

3- Selling covered calls allows the investor more flexibility. The most profit a naked put seller can generate is the premium on the option sale. A covered call writer can profit from the option premium PLUS additional share appreciation if an out-of-the-money strike is sold. That choice is available to the covered call writer but not to the naked put seller.

There is still no difference in payoff. If an OTM call is written, the *corresponding* ITM naked put can also be written, again with the same payoff diagram as the OTM covered call. Synthetic equivalence is maintained no matter what the strike price.

4- Early assignment is not an issue for CC writers because the option premium is not affected and possible additional upside appreciation is incorporated into your profits if an O-T-M strike was sold. For naked put sellers, early assignment could be a disaster. Imagine a stock gapping down, and the stock “put” to us at the $30 strike. The stock is plummeting and heading for the teens! The put seller wants to sell the stock before it loses more ground but perhaps the shares haven’t even hit his account yet. He may have to wait until the next day to sell the shares. One way of getting around this issue is to sell the shares short (selling before actually owning them). The problem with this solution is that average... investors will have a difficult time getting “shorting privileges” from their brokerage firm and may lack the sophistication necessary to manage such situations. Besides, who needs the headaches?

There are a couple of points here:

a) It's true that the naked put might be assigned early if there is zero extrinsic value, however the short put will have a delta of +1, or very close to it, and will be trading like the stock anyway. This will put the trader in a position of a substantial open loss for sure, but the author neglects to inform the reader that the covered call will be in the identical position of a large open loss. Once again, the positions will be the same.

b) The suggested response of shorting stock is incorrect for the stated goal of exiting the position, as you don't know if and/or when you will be assigned. You may just be flipping your deltas and have an open synthetic short call. That's not what the author intended. There is no law that says you have to hold the put till expiry or assignment. The best response if you want to exit the trade before possibly being assigned is just buy back the written put.

5- Those interested in option investing in tax sheltered accounts, will have an easier time establishing such accounts using covered call writing than any other form of options trading.

This isn't my field, but I am led to believe that cash covered naked puts are permissable in such tax sheltered accounts.

If people really want to trade covered calls over naked puts, fine, there may be valid reasons as I stated in my earlier article. No skin off my nose, but let's not justify it with misinformation and bullshit.

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.

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.

Put Spreads - How to Blow Yourself Up In One Easy Lesson

Original Content Sigma Options

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My last few posts have been concentrating of naked puts, the main point I've been trying to get across is that they no more risky than anything else, less so, in fact. But we've seen that they can indeed be a weapon of mass wealth destruction if the trader uses inappropriate levels of leverage.

See:

Naked Puts - Myths & Truths

Naked Puts - An Addendum

Naked Puts - A Horror Story

A suggestion that came up as a safer alternative for a straight out premium collection trade is the bull put spread. In principle, I agreed with the suggestion, but with a few caveats.

1. Proper money management/position sizing is used.
2. Reward versus risk is commensurate with the probability of win/loss.
3. Be careful of correlation with multiple positions.

Even though the bull put spread is perceived as a safer strategy than naked puts, it is not necessarily so, if our old friend leverage is used inappropriately. I would argue that bull put spreads may even be more dangerous than naked puts, depending on the margin requirements of individual jurisdictions and brokerages.

There was an option "education" firm (and I use that term very loosely) in Australia promoting bull put spreads as a panacea for wealth building. The chap even gave it a new name... his name - The ######### Strategy (I have no wish to publicize this rubbish) - how's that for marketing nonsense?

I don't have a challenge with bull puts, 'cept that they aren't appropriate at all times. To borrow a point from Ecclesiastes 3, there is a time for every strategy. The most odious feature of our ersatz options guru is the money management and position sizing algorithm whereby most, if not all of the trader's capital is put at risk in the market. This is spread across four or more positions, but the dearth of tradeable options on the Australian market means there is a very high degree of correlation in optionable stocks.

Every boat rises with the tide, as neophyte bull put traders thought that the Holy Grail had been found at last. That is until the arrival of last year's bear market. Those slow to react, in denial or too green to know what to do next were completely wiped out.

Once again, the fault is not the strategy, the fault is leverage... and fighting the tape.

Naked Puts - A Horror Story

Original Content Sigma Options

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My last couple of posts have been concentrating on removing some of the misconceptions and erroneous assertations regarding the risk of naked puts. I hope I have been carefull enought to stress that you can crank up your risk to unreasonable levels with naked puts. (the same is true of many derivatives).

To illustrate this point, I'm using an example from 2005, because it involved someone I knew.

Background: I had posted up a chart of Elan (ELN:NYSE) in February 2006, on a trading forum I frequent. The stock had been going sideways for two or three months and was trading at ~$27.00. I wanted to get a sense of what folks thought was a good option strategy and generate a bit of options discussion.

Amongst the various replies, one chap said:

Trader: Sell 100 $22.50 puts for about $2000 credit.

Me: That's potentially 10,000 deltas if the stock gets smacked down hard and goes DITM.

Trader: It'll never get there.

The rest as they say, is history.

That's about $143,000 down the pan in one night.

It is important to note that the massive loss is nothing whatever to do with naked puts per se. An equivalent size covered call position would have similar losses, as would a CFD position of similar face value, even more in fact.

The loss was a conequence of "leverage".

I don't know whether the chap took the trade or not, but he was conspicious by his absense on that particular forum from then on. :-(

See:

Naked Puts - Myths and Truths

Naked Puts - An Addendum

Naked Puts - An Addendum

Firstly something a little off topic. It has come to my attention that some media sites have been linking my content onto their sites without my knowledge. I don't mind, it's a bit flattering to be honest, but they haven't extended me the courtesy of attributing the content with a link to this blog such as every blogger does when quoting content. I have no desire to start threatening legal action, so I'll just be putting an embedded link at the top of my posts from now on.

Original Content Sigma Options

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Yesterday I posted up some views on "Naked Puts - Myths And Truths", to which Mark Wolfinger from the excellent Options For Rookies blog, replied in the comments with some very good points I wanted to cover in a new post:

It's not 'being comfortable with the risks' that is the prime consideration.

What is important is for the trader to understand that there is an alternative strategy. Then the alternatives can be compared, and an intelligent choice can be made.

I strongly agree with Mark here. I find it a tad irksome the preponderance of options courses (that charge a rather enormous fee usually) that promote a single strategy as the key to options riches, be it covered calls (the usual) to put spreads, condors whatever. All are really great strategies for a particular market and/or volatility conditions. But no strategy is a catch all, to be applied without considering that there may be a better strategy for the moment.

I prefer selling put spreads. For me, the reduction in potential loss is well worth the reduced profit potential. That's my comfort zone, and each trader should find his/her own.

I have the same feeling in most cases, particularly with individual stocks. As I trade commodity options as well, for me it is not always so. But on stocks I just want to collect premium on, I don't want to be naked at all and also prefer a put spread.

I've moved into the camp that believes that naked put selling is ONLY for investors who want to buy shares as an investment. Traders would do better to use positions that are less risky. That's my opinion - it's not a demand that others agree.

Yes, as I mentioned in the previous post, you have to be prepared to end up with the stock if you trade naked puts. Unless you are happy to be holding the shares for some longer term objective, there are safer alternatives, as mentioned.

My only caveat comes with commodity options. Depending on the situation, based on seasonals, statistical studies, favourable IV etc., I'm quite happy to write naked for a straight out trade. Stuart Johnston covers this very well in his book Trading Options To Win. A great read if folks are into commodity options.

That in no way takes away the validity of Mark's comments however.

The fact that selling puts is less risky than buying stocks, doesn't mean it's a strategy without substantial risk.

Very true. However, if naked puts are risky, it then has to be accepted that long stock of equivalent position size is even more risky. The risk in both can be mitigated, save for humungous gaps.

Also as we know, there are legions of traders who do nothing but trade covered calls with no intention of holding stock long term, yet regard naked puts as the spawn of Satan. My objective was to skewer that misapprehension, arming folks with the knowledge to make more rational decisions. We know the covered call is synthetically equivalent to the naked put and once novice traders get their head around that, it presents them with one of two realisations

1. Folks happy with the risk of covered calls may feel equally happy to trade naked puts of the same face value.
2. Folks realise that covered calls are far more risky than the muppet that sold them a course has told them. I've even seen it claimed that covered calls carry zero risk. :-P

I hope I was careful enough to stress that one can increase their risk of ruin substantially with naked puts by trading too many contracts.

One more point. I don't dislike the idea of naked put selling. In fact, it's one of three strategies that I believe is suitable for rookies. But once the investor has some hands-on trading experience, I suggest moving on to the safer put spread.

I think that's good advice. The caveat being that people can still crash and burn with put spreads. There were a whole host of them I know of in Australia, the followers of one particular "guru" who promoted put spreads as a investing panacea, encouraging people to essentially have their entire capital as risk in correlated underlying stocks. The recent market crash machine gunned those poor folks to pieces.

Option people tend not to talk about money management very much (even specifically disregarded by some "gurus"), and this is paramount with any strategy, no matter how safe it is perceived to be. I think we option people make the mistake thinking that folks have some sort of position sizing algorithm in place. Often they don't and ruin may only be a market swing away with the majority of strategies if the leverage is cranked up enough.

My main point remains, don't be frightened of naked puts, they have their place in the option armoury.

There's plenty there for novices to think about, two slightly differing perspectives but not really that far away from each other.

Naked Puts - Myths and Truths

Naked puts, no strategy is subject to more warnings from ersatz options experts and umm.... educators. Even some very good options people regurgitate some thoroughly dubious statements regarding naked puts. These generally encompass some sort of exhortation to not trade naked puts couched in such beauties as:

1. Naked puts are extremely risky.
2. Naked puts have unlimited risk.
3. Don't ever trade naked puts.
4. Naked puts cause diabetes and heart disease.

OK, I might have exaggerated a bit on the last point, but that is the general tone. All are nonsense without some qualifying conditions. Before I go on, I will point out that naked puts can be very risky if they are traded in a highly risky fashion, and we'll get into that in a moment.

Let's look at this with a bit of basic mathematics.

Naked Puts Are Extremely Risky

Believe it or not, naked puts are less risky than the underlying stock.

Let's take the example of Trader A buying 100 of XYZ common stock @ $50.00 (total outlay $5,000), and Trader B writing a contract of near month naked $50 puts and receiving $2.50 premium ($250 net premium received).

We are not looking at the upside on the stock here, although it should be recognised that the upside is capped at premium received for the option writer, we are looking specifically at risk alone.

At expiry, the put writer pockets the $250 premium no matter what happens to the stock. So if the stock closes @ $50 at option expiry, the option writer is $250 ahead of the stock owner whether assigned or not. Looks like the put writer is a winner in that instance.

What if the stock goes down though?

If the stock goes down, the put writer will likely be assigned and forced to pay $50 for stock that may be worth considerable less. Oh Yeah that's risky! But guess what, the stock buyer is holding stock, bought at $50, that is worth considerable less too. However the put writer has received $250 premium which he keeps, providing a cushion not available to the stock owner.

For example, if the stock is at $40 at option expiry, the stock owner will be down $1,000 at that point in time. Likewise, the put writer will have been assigned the stock @ $50, now worth $40; also a $1,000 loss. But the writer received that $250 premium which means the actual loss is $750.

What seems more risky to you $1,000 loss or $750 loss? The truth is that unless the stock is above $52.50 (in this example) the naked sold put will always be ahead of the stock.

There is another way of looking at this. Lots of folks trade naked puts all the time without ever giving it a second thought, they just trade them synthetically without ever realizing it. Enter the covered call. I have so many people argue with me that a covered call is not the same as a naked put, it's ridiculous. But the mathematics do not lie, a covered call IS a (synthetic) naked put.

Therefore it doesn't make a whole lot of sense to warn about naked puts when folks are completely at ease being long the stock, or long the stock and selling calls over it.

Most of the objections I encounter to this comparison do something like this = "Yeah but, my stop loss will take me out of the stock trade long before it gets to $40". Excuse me? Why is there this presumtion that because a person trades options, they do not have the brains to protect their capital? Options traders can use stop losses too, but it is more likely that they have another strategy in mind e.g. owning the shares or mitigation by adjustment or spreading off.

There are a couple of caveats to the above.

1/ All the above presumes an equal position size. In other words, if we're comparing naked puts to stock, it has to involve the same number, i.e. 100 stock compared to 1 standard option contract (or 1000 in some countries).

2/ Because of the possibilty of assignment, either at expiry or before, you need to have cash in your account to cover the purchase. Furthermore, you have to not mind winding up with the shares and/or have a plan on what to do once the shares are in your account.

There are some traders, through lack of caution or lack of knowledge, or perhaps just a bigger risk profile, who will write huge size out of the money puts, tens or perhaps hundred of contracts in order to collect premium with what they percieve as high probability. The problem is that a black swan event can (and eventually will) blow up those traders spectacularly.

It's proverbially snatching pennies in from in front of a steam roller. If the steam roller catches you, you get squashed. This may be what our option experts try to warn against, but it should be qualified with the actual maths.

Naked puts have unlimited risk

This is my favourite. The word "unlimited" means without limit, infinite. But do naked puts have unlimited risk?

What is the lowest a stock can go? It's zero isn't it? Can a stock go below zero? No, it can't. Therefore we know the maximum loss don't we?

Using the above example, our maximum loss on the naked put is $4,750, that is a $5,000 loss on the stock, less our $250 premium.

Is that unlimited? No!

Is risk unlimited? No! That's just silly.

A better term is "indeterminate risk".

Don't ever trade naked puts

OK don't, seriously! Not unless you are comfortable with the risk/reward profile. But don't not trade them because somebody regurgitated something he heard and never thought about. But if you trade covered calls, there is no reason why you shouldn't trade naked puts instead if you don't already own the stock.

And you shouldn't be afraid to trade them if you know, and are comfotable with the risks.