after a while, options traders will come to a sobering realisation...
that in a long run, if options premiums are always fairly priced, then the options trader should result in breaking even in all his options trades (exclude commission fees)....but only theoretically, because in reality Options premiums are almost always skewed to the disadvantage of the retail options traders...
to cement this phenomenon convincingly across, let's use the SPX options position (see link) to explain...
recall that theoretically, it has a 70% chance of winning that $100. conversely, it has a 30% chance of losing $400. in other words, if one establishes such conceptually equivalent options positions over 100 months, one can expect to win 70 times and lose 30 times. in $$ terms, one can expect to win 70 x $100 = $7000 and expect to lose 30 x $400 = $12,000
the net result is that the Options trader loses money...
but why does this happen?
there can be many reasons for this....
let me postulate just one reason here (actually, i can't think of any more than one reason...wahahaha)...please feel free to share your thoughts...
a) Mispricing of and especially of OTM options due to inflated Implied Volatility (ie artificially skewed IV by market makers)
so, then why would anyone entertain the thought of trading options, if indeed retail options traders are constantly disadvantaged? the answer is in knowing when to trade options and when to stay away.... and i dare say that the key lies in spotting mispriced options premiums...known otherwise as "the edge"..
without having a meaningful edge, very few options traders can last too long in the market place...
Sunday, September 27, 2009
Low Risk - Premium Generating Option Proposition on SPX
Basic Assumptions
Capital Base = $5K
Each position will NOT risk more than $500 of maximum losses
Target Rate of Return of Capital = 2% of Total Capital Investment
(means, making $100 for $5K total capital)
Given current SPX level of ~1045, we opine that index will not make a sudden and large downward movement, even though we are not sure if SPX will rally from current level. All that we are "predicting" is that SPX will not drop below 1005 by Oct09 expiration...Incidentally, given current VIX, we have some ~75% chance that SPX will remain above 1005 come Oct09 expiration...
Our Trade Position
1 x Short SPX Oct 1005/1000 Put vertical spread
Max Profit = Premium Received = $100 (excluding commission fees)
Max Loss = $400 (this is below our $500 losses we are prepared to accept)
Risk/Reward Ratio = $400/$100 = 4:1
Probability of Success = ~70% (it would have been better if this was closer or better than 75% given the risk/reward ratio). The inference here is that the market makers are under pricing the option premiums, and understandably because VIX has stayed comparatively low for some months now. Another inference is that there are insufficient Put buyers to drive SPX Puts higher in premium... This is an important judgement for traders who look into option chains for clues on directional bias of SPX index.
Possible Consequences of this Trade
Win $100 or 2% monthly or 24% annualized profits on Total Capital
or
Lose $400 or 8% of Total Capital, which is rather acceptable for most people
[u]
Will One Become a Millionaire using this Strategy?[/u]
Yes...over a long time....but it makes sense because this is a relatively low risk proposition...and so, it is realistic to expect only moderate compensation...
My Question
Does this look like a good trade? Does this look like a plausible strategy to achieve 24% annual income to you?
Capital Base = $5K
Each position will NOT risk more than $500 of maximum losses
Target Rate of Return of Capital = 2% of Total Capital Investment
(means, making $100 for $5K total capital)
Given current SPX level of ~1045, we opine that index will not make a sudden and large downward movement, even though we are not sure if SPX will rally from current level. All that we are "predicting" is that SPX will not drop below 1005 by Oct09 expiration...Incidentally, given current VIX, we have some ~75% chance that SPX will remain above 1005 come Oct09 expiration...
Our Trade Position
1 x Short SPX Oct 1005/1000 Put vertical spread
Max Profit = Premium Received = $100 (excluding commission fees)
Max Loss = $400 (this is below our $500 losses we are prepared to accept)
Risk/Reward Ratio = $400/$100 = 4:1
Probability of Success = ~70% (it would have been better if this was closer or better than 75% given the risk/reward ratio). The inference here is that the market makers are under pricing the option premiums, and understandably because VIX has stayed comparatively low for some months now. Another inference is that there are insufficient Put buyers to drive SPX Puts higher in premium... This is an important judgement for traders who look into option chains for clues on directional bias of SPX index.
Possible Consequences of this Trade
Win $100 or 2% monthly or 24% annualized profits on Total Capital
or
Lose $400 or 8% of Total Capital, which is rather acceptable for most people
[u]
Will One Become a Millionaire using this Strategy?[/u]
Yes...over a long time....but it makes sense because this is a relatively low risk proposition...and so, it is realistic to expect only moderate compensation...
My Question
Does this look like a good trade? Does this look like a plausible strategy to achieve 24% annual income to you?
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