Selling Naked Calls?

I will say it again.You have to pick your spots!

There are no golded rules or guarantees.

One thing I always hear is how options market-makers are afraid of being picked off by inside information. But isn't it usually the laws against insider trading that bust market-makers?


Meaning, any piece of information becomes a fact slowly. Company X is thinking of buying a smaller company in another geographic region. Company X is looking at Companies Y and Z. Company X is in talks with Company Y. Company Y is receptive to Price N, etc.


And any piece of information normally spreads gradually from person to person. Jack has a zit. Jack has a rash. Cindy says Jack dated a girl with Herpes. Liz, Jack's neighbor, whom nobody knows, saw Jack buying herpes cream at the store. Sally sees other girls avoiding Jack, and wonders if they know something she doesn't, etc., pretty soon jack can't get a date in this state.


Meaning, if people were allowed to trade on inside information, so stock prices moved gradually, market-makers wouldn't wake up in the morning to find their stock had jumped 40 points, and their life is over! I hate the SEC, and this Reg FD only makes it worse!


Any agreeers, disagreers?


eLROY

Buying many out of the money calls and selling the more expensive near the money calls is a fantastic way to make money "if" you are convinced about the direction of the market and looking for

a rapid move. For instance(I am not recommending this but I am watching on a daily basis)the coffee

options.If the market seems to have stalled and I can put on some " ratio backspreads" they could be very profitable.

About the bid and offers or spreads in options quotes.The bond market is extremely liquid and if you can call the floor direct it is not uncommon to get a "choice" quote where the bid and offer are the same.

The profitability of options depends on their moneyness and maturity in addition to the asset. Do you include options only on individual equities? What about indices? What about commodities or options on futures? How do we weight all these options? Over what period?


Importantly, options are usually hedged. Since the market has generally risen, call options have tended to appreciate. This is particularly obvious in the case of in-the-money LEAPS. But they may have appreciated less than an equally-risky stock portfolio. So a better issue is the profitability of at-the-money straddles.

I'm not entirely sure about equity markets, but with regard to interest rate markets, selling at the money option straddles has on average made money. I suspect this is also true for out of the money and equity options as well. There are a few theories that i know of regarding this matter. Essentially, the idea is that because the option seller is selling insurance and therefore has a skewed risk profile, they need to be compensated by a risk premium. Also since volatility is greater on crashes than rallies, options straddles are more likely to pay off when the market is selling off, making it a negative beta instrument.


Of course, the fact that selling option straddles are positive EV does not make it a good play as your downside potential is much greater than upside... hence the risk premium required. Also, margins will further distort this.

One of the many interesting things Javelin points out is how you may get a positive EV from someone buying an option when that counter-party is also getting a positive EV.


Meaning, you are a seller and he is a buyer at the same price, and yet you both make money!?


He makes money because, somehow, the combined portfolio of his equities and his bond options becomes more valuable. You make money because, well, you make money - he gives you a piece of the action for being there.


But it is important to notice that a guy who writes bond straddles for a living might not be a natural counter-party, but rather a middleman. Meaning, he cannot hold them until expiration, and make money in the long run, he has to find a natural counter-party. Why? For one thing, he may have the same equity exposure - and the same volatility averseness - as the guy buying the straddle.


In other words, if you are the equity guy buying the long bond straddle, you have to ask yourself why is this option under-priced? Everyone owns stocks or something! What kind of freak, be it a collection agent, or someone in a high tax bracket, would consider this price expensive?


Okay, I ran a little thin there...


Other interesting things to recall are 1) the impact of interest rates on the pricing of things which create positive and negative cashflows at different points along the time axis, and 2) the pricing of volatility as a cost, whereby a 50/50 chance of .50 or $1.50 is worth less than $1.00.


leroy

If you read my post more carefully, you'll notice that i claim that option straddle sellers get positive EV... NOT option buyers. Of course as options are zero sum, option buyers get negative EV

Javelin,


I must confess to being baffled. You are the one who gave "reasons" why some sucker would pay "too much" for straddles. Your reasons, essentially, were that he is not a sucker!


For instance, if he owns stocks and you don't, then he can hedge and diversify his stock portfolio by betting on an increase in implied volatility in bonds. Or, maybe he is just more risk-averse than you, meaning for you a 50/50 shot at 1.50 vs. .50 is worth .99, for him it's only worth .98!


The simplest proof I can give that options are not a zero-sum game is that, if they were, the most successful options and futures traders would have bankrolls no bigger than the most successful poker players. But for some reason, the suckers are willing to manufacture billionaires in futures?


I don't think so. They suckers are getting something out of it. If you care to explore this further, here are some 2+2 posts dealing with this concept:


http://www.twoplustwo.com/cgi-bin/ne....pl/read/29310


http://www.twoplustwo.com/cgi-bin/ne....pl/read/29226


http://www.twoplustwo.com/cgi-bin/ne....pl/read/29310


http://www.twoplustwo.com/cgi-bin/ne....pl/read/29184


I think this stuff is important to understand, or at least interesting, since it is how most people on Earth make money!


eLROY

Ok, i see whats going on. When i refer to options as being zero sum, i'm talking in cash terms... of course in utility terms they are not zero sum.


Second, i never claimed that you would be a sucker to buy options when their EV is negative... thats my whole point... that option sellers get a positive EV but that this is to be expected and a fair risk premium.