Bloomberg Option Blooper

There are no end of erroneous statements regarding options that appear in financial publications. Today I'm going to pick on an article in Bloomberg, because I just happened to do something I don't often do... and that is read Bloomberg. (Nothing worse about Bloomberg than other Wall Street Cheerleaders, I don't often read much of any of them).

This is what they had to say:

Oil Options Hit Highs as Verleger Predicts 44% Plunge

Sept. 21 (Bloomberg) -- Oil traders are paying more than ever in the options market to protect against a plunge in crude prices.

Oil options are something I follow pretty closely, so fearing a volatility spike that I had missed, I immediately pulled up $OVX (The VIX of oil options)

Hmmmmm IV near recent lows, no spike there. What could our B'berg author be on about here. Reading further:

The gap between prices of options betting on a decline and those that would profit from a rise in oil widened to a record 10 percentage points, according to five years of data compiled by Banc of America Securities-Merrill Lynch...

...Options granting the right to sell, or put, oil in December below current prices have a so-called implied volatility of 54.3 percent, compared with 43.3 percent for the equivalent options to buy, or call, data from the New York Mercantile Exchange show.

What's this? The arbitrage opportunity of the century? As I pulled up the option chain for December crude, I was multitasking and transferring every cent of spare cash in my trading account for mountains of reversal margin. Alas, I was disappointed as both ATM calls and puts were priced equally in terms of volatility.

What the f*** were they on about?

The subtle clue is what I have retrospectively bolded in the above quote. The author was comparing the IV of WOTM puts to WOTM calls. This is nothing more than a downside price skew. Skew is common in all sorts of markets; in fact it would be a little unusual for a market not to have some degree of skew to one side or another.

It's true that event sensitive commodities usually have skew to the upside and therefore skew to the downside in oil is noteworthy. The hypothesis that oil probably will experience some downside pressure is a fair one. But I wish they would call a spade a spade rather than dishing out erroneous bullshit on on options like this article has. Options are confusing enough for the neophyte, without inaccuracies from supposedly authoritative sources.

Give yourself an uppercut Bloomberg.

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.

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?

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

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

Original Content Sigma Options

++++++++++

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.

Naked Puts - A Horror Story

Original Content Sigma Options

++++++++++

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

Goodbye USD!

0.5% is a very fucking lousy decision.

I'll let the real economists mull over than one, while ignoring the capitol hill sycophants.

So WTF Exactly, is Going On?

Is the Gold upage a harbinger of more uncertain times? What the fuck is going on? B-52s flying around with nukes by "mistake", Russian bomber fleets flying with Jet fighters in puruit?

Holy Crap!!

US B-52 in nuclear cargo blunder

The US Air Force has launched an investigation after a B-52 bomber flew across the US last week mistakenly loaded with nuclear-armed missiles.

It follows reports in the Army Times that five missiles were unaccounted for during the three-hour flight from North Dakota to Louisiana. FULL STORY.

... and then:

U.K., Norway Send Jets to Intercept Russian Aircraft (Update2)

By Robin Stringer and Sebastian Alison

Sept. 6 (Bloomberg) -- Four U.K. Royal Air Force Tornado jets were launched to intercept eight Russian strategic bombers, the British Ministry of Defence said. Two aircraft from the Norwegian air force also trailed Russia's planes.

The RAF Tornado F3 jet fighters were scrambled early today to intercept the Soviet-era Russian bombers ``which had not entered U.K. airspace,'' the ministry said in an e-mailed statement. The ministry didn't elaborate on how close the RAF aircraft got to the Russian planes. FULL STORY

This is a rather apocalyptic development and could explain gold why gold is getting of its arse and doing something. Renewed Cold war tensions anyone?

Still some ways to go before gold looks like a new trend, but it's been worth paying attention over the last few days.

Eyes wide open for a couple of reasons here.

Nike Straddle - Just Do It?

Todays posts have reminded me of an interesting situation a poster over on EliteTrader has gotten himself into. What reminded me was the confluence of Wallstrip's latest topic, i.e. Nike (NKE) and Adams post on vega which I posted about below.

Here is what a trader did on the 20th Dec as reported in ET:

Just bought NKE Jan 100 straddle for debit of 5.82. Option prices seem relatively cheep (sic) considering its right before earnings announcement. Any ideas on how it might play out? All comments are welcome!

To which one of the experienced hands replied:

Learning exercise.

Go to www.ivolatility.com and enter NKE in the ticker symbol location. Then look at the chart for historical IMPLIED VOLATILITY. Then compare where the IV is today for NKE compared to where it has been a few weeks ago.

To cut to the chase, current IV is at 25% or so. Last month it was at 16%. The high for the year is 28% last December (presumably before earnings) and the low is just under 16%.

So you are buying a straddle when IV is near historical highs.

In December of last year, IV crashed from its high of 28% or so to about 18%.

So what does this all mean. High IV means premiums are higher in value relatively. When earnings are released IV crushes. So your straddle will most likely go from an IV of 25% to somewhere below 20%. If you are not sure what that means, plug your straddle in an option calculator and change the IV from 25% to 19% and see what happens to the value of your straddle. It will drop sharply.

So before putting any money into a straddle you should study volatility and the effect it has on option prices.

Basically with respect to volatility you are buying high and gonna sell low after the news. So you need a real nice stock move to overcome the volatility crush AND time decay that will start creeping in...

...and that is exactly how it played out.

The poor guy bought the straddle on the 20th for $5.82 with the underlying at ~$100.00. Today with the underlying still ~$100.00 the straddle is worth about $3.60.

What happened? Implied volatility crush; which often happens once earnings are released... and if the stock doesn't move, or it doesn't move *enough, the trader gets smacked on long gamma positions (bought option positions like straddles).

This is what is termed "vega risk", the possibility that implied volatility will drop on your bought options (or rise on your short options) and cost you money, independent of any stock price movement.

The flip side of the coin is that it can also work in your favour. The trick is in understanding it as a risk when entering positions.

Reasons To Not Chase Big CC Premium - RE - REVISITED

The latest Big IV stock the Buy/Writers have been chasing premium on is Telik Inc (TELK) with IV 's in excess of 200% on the table. I've batted on about these Buy/Write strategies ad infinitum to anyone prepared to listen (and a great number who weren't lol) down here in the antipodes for years now.

I stress though, there are other ways to play these huge IV's, but Buy/Write is the silliest way in my opinion. Why? Because of the uncovered downside risk.

This last few days has been a treasure trove of examples of this and these have been trades that have been discussed extensively on various trading fora during the last month. First (NUVO), then (NFLD) and now we have (TELK), which released news today. (Hat tip to Adam Warner)

The picture says more than words ever could:


That's three train wrecks in the space of 8 days and it's quite possible that readers of those forums I mentioed could have traded all three. OMG!!!

Reasons To Not Chase Big CC Premium - REVISITED

With Northfield Labs (NFLD) near month implied volatilities at in excess of 200%, Buy-writers have been all over it like a rash, chasing the huge premiums available.

One thing folks forget who chase this type of trade is the risk inherent in this strategy, that's why the IV's are so high.

Well guess what? Northfield (NFLD) is down some 50% in after hours due to some bad news via last nights conference call... and this is IN ADDITION to the 20% whackage during the day.

Now, imagine if a trader had been in (NUVO) and (NFLD) covered calls! That would be two big losses in one week.

Ouch!

{edit} Just wanted to put up a chart of the fun... NFLD 15min including after hours session.

Reasons To NOT Chase Big CC Premium

I often see posts on the various forums about folks chasing extreme IV to write Covered Calls.

This is often not a very good idea. Why? Well despite being able to collect huge premiums, there is a huge amount of risk.

Check out this one:



It's Nuvelo Inc (NUVO) and this was a disaster for those chasing big premium.

Sometimes I'll have a go at these and play the IV crush when the announcement comes out, BUT with limited risk strategies.

CC's are Russian Roulette in this circumstance... trying to snatch a bone from a pit bull. A bad idea.