Today's Options Forum makeup question was submitted last Thursday just before the lights went out:
Steve, I was sort of surprised to read this in last week's column:
"It seems the big bet is that nothing happens over the next two weeks and traders just sit on their hands waiting. Currently, the prospects of owning a decaying option or exposing yourself to unlimited risk are equally unappealing."
Aren't low volatility and restricted trading range considered ideal for certain strategies (short strangles, selling an out-of-the-money call and put)? Or do the pros regard such methods just for amateurs? Thanks, -- RHR
While the blackout ultimately amounted to little more than another day of time decay -- volume was low, the volatility index barely budged and the indices ended fractionally higher -- I'm sure many option traders saw a spike in their blood pressure and lost a few pounds sweating out Friday's opening. Remember, the first reaction was to send
futures down 20 points, or more than 2%.
Strategies such as short strangles, straddles or naked option selling are most certainly used by professionals or full-time traders, but they watch the position and typically look to buy options when volatility is low and sell when it's high. But since they carry unlimited risk, most part-time or longer-term individual investors (I don't like the term "amateur," since it connotes doing something for no pay or profit and that ain't the game we play here) should be careful about establishing net-short option positions.
My caution regarding premium selling as an ongoing strategy (you may collect nine times out of 10, but that loss is usually a doozy and can put you out of business) comes from two places: personal experience and my preference to err on the side of caution when dispensing advice to a broad audience.
This doesn't mean that selling premium is
; in fact, I'm a huge proponent of letting time work in your favor. It's one of the few immutable and predictable pieces that can be plugged into an options' pricing formula; no matter what else happens, time will pass. I've recommended selling premium in all forms, from
naked calls and
puts to calendar spreads; even a
short strangle has its time and place.
However, I don't like selling premium if the only thing I'm looking at is the clock. You should have at least one other theme for initiating the position, whether it be overwriting to generate income, put selling to reduce the purchase price or an outright volatility play.
Strangles and straddles are first and foremost volatility trades, not calendar positions. While we may be stuck in a range, that doesn't mean the risk and its relative reward for selling premium are attractive. I don't think volatilities will be dropping much further, given its already low level. This by no means minimizes the impact of time decay, (I gave the example of the
put price declining nearly 50% in just 12 days) but as I said in the last
, I think we'll see an increase after Labor Day, and this should provide those long premium a good wind at their back.
As a reminder, keep in mind that you should always factor in an unexpected worst-case scenario when establishing a position.
Here are a couple anecdotes from my personal files that may illustrate this last point:
In 1989, with Russia as the biggest importer of U.S. grain and Mikhail Gorbachev making nice to Reagan, there seemed to be a floor on soybean prices during the quiet winter months. So, it seemed safe and sensible to sell some deep out-of-the-money puts with two weeks remaining. But the day after I shorted them bean puts, they opened down the maximum limit for the day. Why? Because Gorbachev was missing. Rumors of a kidnap roiled the market as trade agreements cobbled together in Reagan's last days seemed ready to unravel. Two days later, Gorby revealed he was alive, fishing in the Black Sea on a family vacation. Beans prices catapulted back up, but not before I was forced to take a loss.
In April 1992, some brilliant city employee drilled a hole into a water main pipe under the Chicago River (this is a man-made river that diverts Lake Michigan and defines the downtown loop). The result was a huge flood, since the lake was essentially running into the city. All the exchanges were closed for three days while the city bailed itself out.
That flood also occurred on a Wednesday in the middle of an expiration week that also included the first of the seasonal planting reports being released that Thursday -- bets had been placed and volatility was running high in the days leading up to the flood. Following the report, the cash markets gyrated wildly immediately. On reflection, the report proved to be relatively benign and futures prices opened the following Monday mostly unchanged. This proved to be a dream scenario for those short premium; time was literally dialed into fast-forward mode -- trading ceased but the clocked ticked.
But this seems a slim reed on which to a hang a position.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to