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Old 01-07-2002, 04:07 AM
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Default Selling Naked Calls?



In a thread below, Wild Bill says that there is positive EV in selling naked calls. I have heard this from others as well. The claim is that this "good play" is avoided by most people because of the risk involved. I think some believe that calls are generally overpriced because people like to go for jackpot scores. I have no idea whether this theory is correct or not but I am sceptical for a few reasons. One of course is the spread, which is very high on low priced, out of the money options. Also I would think that the price is kept down by those who are writing covered calls. They are hedging. And in all gambling that I know of, hedgers are taking the worst of it in return for reducing volatility. If so, the option can't be a pos EV sell. Add that to the fact that there are experts out there with big money who can easily afford the risks on both sides. Doesn't it stand to reason that they will drive down the price of an overpriced option?


Obviously if it is true that selling naked options is a bad play it would be because of the rare calamity that would befall the naked seller. But because of its rarity, meaning that the great majority of naked sales show a profit, might it not be that this widespread belief that selling naked options is positive EV, is in fact wrong? I believe we have readers out there who KNOW the right answer to this question and I hope they tell us.
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Old 01-07-2002, 10:13 AM
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Default readers who \"KNOW\" the right answer



I suspect nobody "knows" the right answer in the sense in which you mean it. The reason is it is impossible to arrive at a generalized assumption without, instead, choosing a specific strategy.


If you were, at 10:00 on Monday morning, to hit the bid in every US exchange-traded call in which there was a published bid, and do only the size at the inside bid, would you expect to make money - even ignoring the "cost" of volatility - if you held them to expiration? I don't think so.


But, on the other hand, I certainly could not guess! And any prolonged study of the problem performed by actually selling calls pursuant to the strategy, would at first drive down their price, and then increase the apparent utility for calls - so that calls would likely be overpriced the month the study ended!


There have been numerous academic studies as to the generalized pricing of options - and many people who "know" one thing or the other as a result - but they are all hogwash. It's like trying to attribute the residual of why men earn more than women "with the same education."


Men and women with college degrees, the men earn more. But wait, men are more likely to also have masters degrees. Men and women who have masters degrees, men earn more. But wait, men are more likley to have masters in econometrics or chemistry, women in sociology.


Men and women who both have degrees in econometrics, there is still a residual difference. To what do we attribute it? And can we then extrapolate this to men and women who both have only bachelors in psychology?


So, in calls, if we choose anything apart from the strategy I proposed, you are left wondering, is it something about our strategy, or something inherent in calls themselves? Plus, another concept you miss is asymmetric utility, which I addressed briefly in the following post:


http://www.twoplustwo.com/cgi-bin/ne...s.pl/read/1627


When I go to the grocery store, I find that toilet paper is almost always selling way too cheap, and so I buy some every time! But if I were to do a study which suggested that toilet paper is too cheap, and the grocery store should raise the price to where I would be indifferent to doing without it or finding a substitute, I would not escape the ridicule that the answerer of your equally-silly question will escape.


Is it possible to make a profit in the options market? Yes, and nor is it a zero-sum game. Are calls, in general overpriced? Well that depends on whether you - as an individual - in general, have no use for calls.


Are there individual suckers who, in specific instances, probably pay more than they should for calls? Yes. If there were a simple, or academic-texture strategy, for selling a diversified portfolio of calls, would entire companies evolve to take advantage of it, as they did in the 1980's? Yes.


I honestly believe that, when I worked as a runner serving an options pit - and most order flow was in contracts on the move - that a big part of my job - upon which the very fate of the exchange rested - was moving just slowly enough that 50% of the paper orders I carried were stale by the time they arrived at the pit.


Then, upon my delivering a customer limit offer below the "fair" bid for instance, competing market-makers would all bid higher than where the customer "would have been willing" to do business. But few of them would bid at a price were they could not make money, at least those who did wouldn't last for very long. What is their replacement rate?


All economic profits are the result of asymmetric friction. If there are a million firms with fixed overhead invested in plant and equipment to sell calls, and then the sucker call-buyers dry up, and I can turn buyer rather than seller faster than anybody else, I win. Or, if they can all either buy or sell, but are in business to do one or the other, I can kick back and pick and choose - and pick them off.


Or something...


Point is, simple answers make suckers.


eLROY
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Old 01-07-2002, 10:48 AM
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Default Re: readers who \"KNOW\" the right answer



My goodness. Where did all that come from? I was just wondering whether selling a general category of naked options, such as out of the money calls, (getting no special price break) has shown a long run profit. Just like I might have asked whether betting every bowl game dog has. It was not a theoretical question and certainly had nothing to do with utility or other investment alternatives. When I said some of our readers might know the answer I didn't mean they would because they are smart. Rather I assumed that someone has historically checked out this system on paper, published the results, and that the results were read by someone on this forum who could tell us about them.
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Old 01-07-2002, 11:13 AM
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Default Re: readers who \"KNOW\" the right answer



I find this thread amusing.I and many of my friends have long term(over 15 years) winning records trading options.Most of us do not use any fixed system. Sometimes we sell naked options!

You seem to be looking for that magic "black

box" system.Forget about it!FridayI made a recommendation in the bond options.No analysis

was needed.I said I had bot feb 98 puts in the bonds and sold feb 97 puts in the bonds.For each 98 put I sold 2 97s.I did this at 12 credit and said they were still a sale at 5 credit.This is a delta long trade and the bond market was down on friday and yet this trade still made money.Think about it.A computer would have told you with the market settling 10 ticks lower on friday this trade should have lost money..but it picked up a few ticks.As a matter of fact the 98 put was down 1 tick and the 97 puts were down 2 ticks!the trade settled at 2 credit from the previous days 5 credit.
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  #5  
Old 01-07-2002, 11:15 AM
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Default that\'s just my point



1) It may not be impossible to check out this system on paper, but that hasn't stopped almost every academic or paper study of the problem from being misleading if not worthless. Paper studies of options are notorious for their very "paperness," much more so than bowl games. Not only are there more execution complications, but there are more people doing studies!


2) I am very touchy about the idea that, by "curve-fitting" a strategy - finding a set of inputs which would have yielded a theoretical profit in the past (and choosing from a sufficiently large pool of candidate inputs that such a strategy will certainly be found) - suggests anything about the price of options, or about the future profitability of the strategy, or even answers your question!


So, if you want the simple answer to your question, yes, in the early 90's I did your study using 12 years of Wall Street Journals which I bought from a guy in Hayward CA, so that I could figure in news stories to see if they helped advertise the jackpot illusion. I had recently finished writing a "complex expectations" options-pricing program for Windows and, to my surprise, it seemed to suggest that most options were over-priced! So I was curious was it garbage-in-garbage-out, or could I make a profit, so I did the study.


The study confirmed that a study will often show that calls are over-priced. And what I'm telling you is that anybody who answers your question is silly!


But I'm also taking it a step further. The correct thing to study is not the behavior of options prices, but the behavior of people who perform studies, and who in turn create options prices with their transactions!


There have been many academics who came to Wall Street armed with studies. Milken used Braddock Hickman's "Corporate Bond Quality and Investor Experience, 1900-1950" - as a sales tool if nothing else - and made a fortune. David Askin used his own studies of experience with difficult-to-price mortage-backed securities and got killed.


I guess the bottom line is that the stock market is an out-of-control knowledge-production machine. Charts are like Rorschach charts, you can see in them whatever you want, and then write the word KNOW in capital letters.


And I can't stand to watch people learn nonsense!


It irritates me if someone writes an article in a newspaper advising investors to always use limit orders, or someone writes a post saying you can make money selling calls, or if someone says you can buy and hold stocks and you will make money!


In reality, stock-market knowledge is generally wrong as soon as it is produced. So if I simply say, "look what people have learned to do and do the opposite" I will also be misleading. The question is, how fast do people evolve to do one thing and, once they have, how long will they continue losing money before the opportunity vanishes?


leroy


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Old 01-07-2002, 11:29 AM
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Default Re: that\'s just my point



You are correct sir! Also when you sell a naked option you should have a sense of what you will do if you are wrong and when you will do it.This is not always possible however and I have a good example.Last year the price of natural gas ran up from 4 units till over 9 units in a short time.

California was having brown outs and there was talk of storms in the Atlantic near the gas fields.The "analysts" were calling for MUCH

higher prices.I looked at the 20.00 unit call that expired in approx 5 weeks.They were trading for 1,800.00 each.I sold a few and waited to see

what the futures were going to do.A week later

the futures were trading at 10 units and yet those same options were offered at 150.00 each!

There was no way to hedge the options I sold effectively.They were lotto tickets.They had priced in the end of the world!I just thought they were a sale and it takes a lot for me to just sell options naked.
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  #7  
Old 01-07-2002, 11:29 AM
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Default a significant difference



Usign Bayes theorem we can show that, even though people who win in poker or sports betting are infinitely more likely to bet or play again than people who lose, that there are so many people gambling on the weekend and earning a paycheck during the week, that survival rates don't substantially change the texture of sports betting or poker. Or if they do, at least the texture change operates slowly and steadily in one direction over a period of years, rather than being complex or cyclical.


In most stock-market situations, the current pool of players is not mostly newcomers, but a large percentage of people who have survived previous or recent rounds. Add to that the different nature of a football bet where your bets don't affect the skill of the players, and the stock market where the bets actually change the supply and demand and cause the outcome, and you find there is almost nothing more dangerous than stock-market "knowledge!"


So that is why I came back at your question with an incomprehensible gobbledygook. Because that is what people are in for if they start down that path.


eLROY



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  #8  
Old 01-07-2002, 11:41 AM
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Default *NM* Sell S&P *NM*




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  #9  
Old 01-07-2002, 11:46 AM
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Default a study should always show calls over-priced?



Call sellers need only get killed once every century to invalidate a 90-year study.


Any arbitrarily short study of options prices will show that those who bought options didn't get paid, and those who sold them did.


As you increase the length of the study, the number of times option buyers get paid, and the number of time sellers get killed, rises. This is true, even if only slightly so, at any sub-infinite length study, no?


Meaning any study, given that it does not extend from the beginning of time to the end, is more likely to exclude periods when call buyers got paid than when call sellers did. So what it shows, at its most sensitive, is a function of the length of the study. Am I wrong?


For a real-world example, I think biotech-stock options were jackpot-priced all thoughout the 1980's. Then Clinton came along with his health-care thing, and anybody short bio-tech puts got absolutely wrecked. But by that time, the bear-side jackpot players had gone broke and turned over many times.


eLROY
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  #10  
Old 01-07-2002, 11:48 AM
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Default Re: Selling Naked Calls?



>The claim is that this "good play" is avoided by most people because of >the risk involved.


It's also avoided by most people because, unless you're a Market Maker on an Exchange, the margins are high.


But it's still not a good play as you will soon see.


> I think some believe that calls are generally overpriced because people >like to go for jackpot scores. I have no idea whether this theory is correct >or not but I am sceptical for a few reasons.


This was true in the early days.


Nowadays, when a low price option is very overpriced, it could well be because, say, Morgan Stanley or Goldman Sachs, or one of their huge customers, might have a bit more information than you.


So, we are left with the anomaly that, many times the goofier the price of a low price option, the worse the sale is.


>One of course is the spread, which is very high on low priced, out of the >money options.


The Bid/Ask is much narrower these days.


>Also I would think that the price is kept down by those who are writing >covered calls. They are hedging. And in all gambling that I know of, >hedgers are taking the worst of it in return for reducing volatility.


Sometimes the hedgers make a low price option even more expensive. When they're worried that the SEC or an Option Exchange might suspect that they traded on inside info, they need plausible deniability.


They get this by coming up with a plan that requires some lopsided spread which involves buying a lot more of the cheap options than they sell of the expensive ones.


>Obviously if it is true that selling naked options is a bad play it would be >because of the rare calamity that would befall the naked seller.


Calamity is an understatement.


It's very, very sad.


I can still remember the faces of all of these people.


At least ten Market Makers who committed suicide because they went broke selling naked options.


At least five ex multi-millionaires Market Makers who are now broke. They originally made all their money by selling naked options.


One Market Maker and one retail broker who most would judge to be almost insane. e.g. one of them walks around the city going from McDonalds to McDonalds eating Big Macs. Again, it was selling naked options that did it.


> But because of its rarity, meaning that the great majority of naked sales >show a profit, might it not be that this widespread belief that selling >naked options is positive EV, is in fact wrong?


Sklansky's got it right.



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