A bet or no bet?

Recently, I caught up with an old market acquaintance who was always interested in selling options. Even I have been an options trader for a large part of my career, so we gel well. One reason why writing options is so popular is the fact that one take position in deep OTM strikes where there is say 99% possibility of the underlying to not reach. Surprisingly, he had made some short bets on options (sold OTM options), however, it turned sour during the sharp upmove in November and recently as well. The volatility had been hurting his trades offlate. While discussing with him on what went wrong I explained to him that by selling options he did not make a bet, he had to take a bet.

Options trading does not have a linear pay off like futures.  In futures, if you long an underlying and if the price goes up then you make money to the extent of upmove and the counter party losses that much, so you are “making a bet”.  This may be a gamble, speculation or a well-researched or informed trade.

In case of long options also if the direction is correct you get the intrinsic value atleast, but in case of short options if you are correct you get the premium only but if you are wrong you lose atleast the intrinsic value, so you are on the receiving side, thus “taking a bet”.

Being on the receiving side, i.e. limited gain and unlimited (theoretically) loss potential + payer of margins, the options writer needed to be far more cautious and skilled than option buyers.

While there is a popular notion that buying of options is “wasting asset” and 90% of the time option buyers tend to lose money, my focus is on rest 10% of the times. If in that 10% of the time they make as much money as they have lost in 90% of the time, that means in one surge of volatility they will make as much money as an option writers has toiled all year to make. In my experience as well, there are 1 or 2 months during the year when option writers get slaughtered due to sharp and unexpected volatility.  So, if you guard yourself well against those couple of months you will end making extremely good money at the end of the year.

Few factors that one needs to take care while creating and managing Short options position are:

• Take Small Positions. Never overleverage. This will make you panic, not think right and make mistakes. Keep your returns expectation realistic.
• Stock are much more volatile than the index, so be double sure when writing options on stocks.

• Keep your eyes on Greeks. The extent of risk you have on your short options position can be know from the Greeks. The extent of short gamma and short Vega are the most crucial indicators. Higher the short gamma and Vega greater the risk one is carrying in the position.

• Follow the implied volatilities carefully. This is the most important part of the position. If one goes wrong on the volatility estimate, inspite of being right on the direction, can lose money.
  Implied volatility on liquid options tend to stay in a range. If it moves out of the range on higher side, suddenly the premiums seem expanded and juicy enough to lure one into option writing. But, the implied volatility has not moved up without any reason. It is indicating something unusual in offing. So that’s the time to turn on the amber signal.

• Time is your best friend. The theta or time decay or extrinsic value of the option written by you is your benefit. So obviously while gains keep coming to you in the form of correct view on direction and volatility. A large gain comes from time decay. As each day passes with a flattish action on the underlying, you gain theta. The time decay is nonlinear in nature, while it is slow early on it falls very steeply towards the expiry. The theta of an option with shorter duration is higher as compared to that of one with longer duration also has a direct relation with volatility. Few pointers on theta:

• For ATM option Theta increases as an option goes closer to expiry
• For OTM & ITM option Theta decreases as an option is approaching expiry
• When IV decreases Theta will be lower, especially when it is approaching expiry
• When IV increases Theta will be higher, this is because time value part of more volatile stock is higher & therefore have more to lose per day as time passes

• Use Stop Losses.
• Exit positions which make you uncomfortable: Never hold a short options position which you are not convinced or comfortable about.
• Be sure of your defense, i.e. repair strategy. How to cover a short options position by a hedge or an offsetting position should be extremely clear. So, when the position moves against you, the damage is minimal.

Net – net, option writing or “taking a bet” is for the agile and well researched market participant. Making money on it is a function of strong discipline, consistent and well tested methodology and a clear strategy.

So good luck on the “bets you take”.

Happy Trading!!!

Cheers.