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kbluck
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One common technique sometimes seen portrayed in hard science-fiction is subvocalization. Basically, your brain thinks about speaking, your body starts to go through the motions of forming speech, but no actual detectable noise comes out. The general idea in the fiction seems to be that the computer doesn't directly attempt to transcribe the sounds of the speech as such; instead, it reads the muscle twitches or nervous impulses or brainwaves or something to determine what you were trying to say. At least it'll be quieter down at the local Starbucks.
There's always the dividend arbitrage. SPY and DIA often hook the careless spread seller looking to hold through expiration since their ex-dates are usually on expiration Friday. So close and yet so far...
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When evaluating these results, do keep in mind the "Above-Average effect", aka the "Lake Wobegon effect". This is the tendency of individuals to believe they are "better than average" at any given skill they wish to imagine that they possess. It has been well demonstrated that the less competence an individual actually possesses, the more likely they are to believe that they are much more competent than they really are, precisely because they are too incompetent to recognize their own incompetence. Conversely, the highly competent tend to underestimate their own competence compared to others. This is known as the "False Consensus effect", an unwarranted assumption that one’s peers are performing at least as well as oneself. Interesting study on the subject: http://www.apa.org/journals/features/psp7761121.pdf In other words, just because somebody doesn't *think* they're a rookie doesn't mean they aren't.
Toggle Commented Jul 30, 2009 on Initial Poll Results at Options for Rookies
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I emphatically second Mark's admonition to avoid selling the American-style but cash-settled OEX options. Never again will I sell OEX, whether naked or as part of a spread. Been there, done that, taken it in the shorts.
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On a tangentially related note, for traders who like to adjust their IC wings outward when one is threatened, buying a butterfly is often a convenient way of doing so. Of course, this is a debit trade, but if you're comfortable with the cost and the resulting position it's a nice little trick to know about. As an illustration for the audience, suppose you have an IC at strikes 400/420/580/600. You might have a trading rule that if the market price touches 580, you will buy a butterfly to roll the call wing out. In this case, buying a 580/600/620 call butterfly will leave you net an IC at 400/420/600/620. Naturally, the same thing could be done to roll down the put wing.
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Kudos for continuing to beat the equivalence drum. Traders don't really understand options until they understand equivalent positions. As an additional caution associated with short straddles, some holy grail seekers may also independently come up with the elaboration we talked about previously: the notion of flipping the covering underlying as the market moves through the strike. Be short the underlying if the market price drops below the strike and be long if it goes above it, repeat until expiration. Theoretically, this makes the short straddle completely bulletproof, as whichever side eventually expires in the money will be covered with stock bought or sold at the strike. But, as we agreed, this method doesn't really work well in practice because it requires inhuman 24/7 vigilance to avoid getting caught by big intraday moves or overnight gaps. Even if you manage to avoid missing any moves, you usually end up getting killed anyway by slippage and transaction costs incurred every time the price passes through the strike. Never mind the potential complications of the uptick rule. Basically, it only works if the stock refrains from crossing your strike very often, and if it moves through decisively when it does. But what usually happens in the market is that at some point during the cycle the price will linger around the strike, crossing back and forth dozens of times intraday, churning you into a huge loss.
Toggle Commented Jun 3, 2009 on Covered Straddles at Options for Rookies
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I think the important point for your readers to understand is that the OCC will guarantee all owners of option contracts shall receive a fair settlement per the terms of their contract, regardless of the stock's ultimate fate. And conversely, that the OCC will ensure option sellers perform their obligations even if the stock vaporizes. Most traders pay no attention to the OCC, but none of us would be in this business without their attention to detail.
Toggle Commented May 30, 2009 on Bankruptcy and Options at Options for Rookies
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Article VI, Section 19 (p. 84) 'Shortage of Underlying Securities' is probably also applicable.
Toggle Commented May 30, 2009 on Bankruptcy and Options at Options for Rookies
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p. 74, 'Adjustments for Stock Option Contracts'. However, I think it only applies when a stock issue quits trading altogether, as in a merger, liquidation, or dissolution. I would expect that as long as the stock continues trading OTC, however cheaply, the normal settlement will apply.
Toggle Commented May 30, 2009 on Bankruptcy and Options at Options for Rookies
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> if and when I can verify that the options are cash settled. OCC bylaws and rules: http://www.optionsclearing.com/publications/bylaws/bylaws.jsp In the bylaws, I believe the relevant section for adjusting stock option contracts to cash exercise due to corporate actions affecting the underlying stock is Article VI, Section 11A. Also, according to OCC Rule 807, in such cases the expiration date will ordinarily be accelerated as well.
Toggle Commented May 30, 2009 on Bankruptcy and Options at Options for Rookies
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Just to be sure I understand you; if one is uncomfortably short a 530/540 call spread, as I understand it you are saying one could buy back the short 530 call and offset the cost somewhat by selling additional further OTM verticals. In your narrative above, when you said "the 530 call will be at least 40 points ITM," did you mean the now-naked long 540 call? Or are you suggesting to actually go net long the 530 call?
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I see your point. Even synthetics don't work right. Looking back to 11/21/08, when the RVX closed at about 80, doing a synthetic short -Dec80C/+Dec80P carried a debit of 9 points. It seems curious to me, as I would think that your 'its the RVX on expiration day' comment would apply equally well to any Euro index option like, say, RUT. I guess it illustrates just how strong is the expectation of mean reversion for volatility. On a side note, I just noticed the 'binary' options on SPX and VIX. I guess those let you trade pure market direction without regard to volatility? Ugh. I'd better quit for the day before I sprain my brain. Thanks for the link; that looks like a really interesting blog. And thanks for taking the time to entertain my wild ideas. You're a very patient man.
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I just looked at CBOE and both VIX and RVX are European cash-settled based on an SOQ of the actual volatility index. http://www.cboe.com/Products/indexopts/rvx_spec.aspx If they are not based on futures underlyings after all, does that change your view much about their correlation? I'll have to do some back-testing to see how well they would have hedged against some of my past positions' vega. I sort of wonder if it wouldn't also offer some de facto gamma protection on the assumption that fast market moves will be accompanied by volatility spikes. I guess this will be my little research project during slow markets.
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D'oh! I screwed up the margin math. It's <$500 at risk total, not per lot.
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Excellent points. The futures factoring in mean reversion and thus not tracking the spot is a real problem with this idea.
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You are of course right about the long call hedge; I shouldn't have called the short stock "unhedged". But that assumes you're allowed the choice of holding the short stock until a time of your own choosing. I would imagine that most of your audience has RegT margin rules, since portfolio margin doesn't kick in until at least 100k for most brokers, even sophisticated brokers like ToS or IB. I could be wrong, but I believe RegT rules are quite inflexible on the issue of stock margin, option hedges notwithstanding. Brokers have to toe the line. Let's imagine a not unlikely scenario: some small trader with a $10k account. Perhaps he's trading a 5-lot 1-strike wide DIA IC with let's say $500 at risk per lot after credit. That's about $2,500 in net margin for the position, perhaps aggressive but not outlandishly so if its money he can afford to lose. But if assigned, suddenly being short 500 shares of DIA worth $40k is a RegT margin call that may be liquidated at an unfavorable price on open. Not devastating, but certainly more than he needed to lose if he'd been on the ball and closed out his call leg the prior day. Just one more thing beginners (or inattentive veterans!) need to keep in mind when they decide to hold into expiration. A corollary moral here is: don't trade instruments you don't understand, and for stocks or ETFs that includes knowing the next ex-dividend date.
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Re IC vega: I've been toying with the idea of neutralizing vega using long calls on the underlying volatility index; for a RUT IC, for example, I would buy OTM RVX calls with deltas equal to the short RUT vega. Any comments?
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As you point out here, the main reason so many think that options are "too risky" is because they are conflating margin risk with option risk. Selling naked puts isn't risky as such; selling the maximum quantity of naked puts your broker's margin rules will allow, well beyond the amount of stock you could afford to buy if assigned, now *that's* risky. But the poor naked put gets blamed when the real sin is overtrading. If only more IRA trustees would allow naked puts. That's got to be the best possible place to start trading them, since the cash-secured rules make it far more difficult to overtrade. It's especially exasperating when the same IRA trustee that says cash-secured naked puts are too risky to allow *do* allow vertical put spreads as you describe here, which offer the capability to completely zero out a lifetime of savings with a single trade.
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I'm sure you know this, but you didn't mention that it can get even worse for the equity iron condor trader than merely not collecting a dividend. Iron condor traders are often short calls when ex-dividend comes around, and usually have no long position in the underlying. If those calls should be exercised, you will suddenly be short the underlying. Now, not only are you at risk from having an unhedged short stock position, and very possibly facing a margin call, but because you are short that stock as of ex-dividend you actually *owe* a dividend payment which must eventually be paid by you in cash. Highly unpleasant. Another good reason to trade index options.
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> It's one thing to pay 20% or more of a car's value for > insurance, but it's another to do that for an investment > portfolio. I'm not sure 2/20 hedge fund and front-load mutual fund investors aren't pretty close to doing exactly that already over the life of their investment. ;-) Never mind the cost of those expensive managers on average underperforming the broad market.
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Perhaps what is needed is a bit of marketing and repackaging. I wonder if one could market to retail buy-and-hold investors a "portfolio insurance policy", keeping options out of the discussion entirely. The policy would explicitly state "premium", "deductible" and "benefits" in terms of some broad market metric, just like any insurance policy. It would be quoted individually for any given client's portfolio at some point in time and over some explicit timeframe, again just like other forms of insurance. The firm offering the insurance, naturally would actually implement their own "reinsurance" using option trades, but the clients would not have to think in terms of options. I suppose it could also be offered to finanical advisors, who as you have noted are reluctant to recommend options to their clients but I'm sure are quite comfortable with products like term life insurance. This would be "term market insurance."
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I apologize if you felt I was "dumbing down" on your account. I was actually thinking of the many traders with stock-trading backgrounds in your audience who might relate better to stocks than futures. After all, the whole point of the article was to introduce index options to those who might more naturally gravitate to equities. We are in total agreement that this strategy, while appearing riskless in theory, is in practice very risky and extremely difficult to pull off successfully. It's offered only as an intellectual curiosity. I don't personally trade it, although I have papertraded it in the past as a possible program trade. I eventually concluded the slippage risk was just too high. I think it's relevant to your audience in the sense that rookies often get suckered in by strategies that look good on paper, but practical limitations of real-world execution end up killing them. I'll never forget the day I was rudely introduced to the reality of dividend risk the hard way, despite holding a "risk-free" box spread.
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It's not gamma scalping. The delta is neutralized with regard to expiration, not the current market. The position is *always* held to expiration. Since we are only looking at the expiration curve, there is (theoretically) no gamma risk. Let's use an equity example so we can talk shares instead of deltas. For example, if you sell a 5-lot IWM straddle, you'd be long or short 500 IWM shares at all times; long 500 if IWM is above your strike, short 500 if below. Maintain the position until expiration. At expiration, the ITM side will be assigned (barring a pin), and your hedging stock position is neutralized to zero by the assignment. For example, if IWM is above your strike at expiration, you should be long 500, your short calls will be assigned and you'll be forced to sell 500 at the strike, but you (theoretically) bought the stock at the strike, so you net out zero both cash and stock. You keep the original premium credit from selling the straddle as your profit. For anybody who actually wants to try this, though, I can't emphasize enough that you have to stay on top of the market 24 hours a day, and slippage is very likely to kill you even if you have a robot to help you.
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One of your points in favor of IWM was the small dollar size. You might mention that there exists a 1/10 mini index option for RUT, RMN. For SPX, there is XSP. NDX has MNX. DJX is already size-equivalent to DIA. This allows small traders to try out index options without exceeding their risk comfort levels; they're also useful for buying insurance for small lot size spreads of the full-size options. The spreads are typically much worse than the ETFs, though.
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Just as a thought exercise, consider the idea of writing a short straddle ATM. Now, delta neutralize the expiration curve by being long futures when the underlying is above your strike and short futures when it's below until expiration. Theoretically, this is a risk-free trade; no matter where the market finishes, your futures will offset your ITM side's losses, the OTM side expires worthless, and you'll get to keep the premium. You could also do it with any related strategy such as an IC, where you go long or short only when one of your short legs goes ITM. Of course, in reality it's not risk-free. There is always slippage and transaction costs every time the futures have to flip. If the market wanders back and forth across your strike a lot, you can very quickly start losing money from the slippage. There's also some correlation risk, pin risk if you're not cash-settled, and the technique is very high maintenance. But if a trader thinks they have a talent for picking strikes where the market is not likely to linger or thrash, it could be a profitable technique.
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