Wednesday, 17 May 2017

Follow up on Coiled Spring Experiment and Final Blog Post (New Blog Coming)

It's been a long while since I last posted. My regular profession as a Chartered Professional Accountant resulted in my being inundated during tax season (in Canada this runs from basically, end of February through end of April) with very little time to opine on anything. But there's been lots of time to think since my last post.

I wanted to debrief my last couple of posts on options trading with a number of irrefutable observational truths in no particular order:
  • Option trading at the best of times is a frustrating endeavour, enough to drive a participant absolutely nuts. 
  • Options are not assets, they are decaying derivative instruments. If a participant does not realize this up front, he/she has no business participating. How best to understand the concept of price change and decay? Start with understanding theoretical greeks. Theta measures time decay. Delta measures sensitivity to changes in the price of the underlying instrument.
  • The more time there is to expiry, the more expensive the time value component of the option price is. As time lapses, time value decays, and the closer to expiry, the faster the decay.
  • Options are priced by professionals, using professional models (Black Scholes, etc.). On top of theoretical pricing is the bid/offer spread. A market maker will use a combination of theoretical model output + the bid/offer spread to make a market. The more liquid the underlying, the more liquid the option will be, and vice versa. So, not only are participants up against a decaying derivative instrument, they are up against professional market makers who set the option spread on any given day. They are also up against their own particular biases. 
  • Not only do participants have to be right in terms of strike price and time to expiry, they have to be right about direction, all while not getting juiced on the spread. All of this begs the question, why bother in the first place?
  • It is not uncommon (in my experience) for market makers to price the tails surrounding a price range at greater than the near term volatility range (on the offer anyway). For example, say a stock is trading at $50, and the near term at-the-money straddle (i.e., the $50 call + put) is pricing in between a 5 & 10% move. This would make the premium of both strikes between $1.45-$2.50 each, and depending on how liquid the underlying is, the market maker could vary the bid offer spread according to his/her discretion. For example, he/she could make a market with a $.05 spread (i.e., $2.45/$2.50) or a $.50 spread (i.e., $2/$2.50). The $.50 spread is an invitation to lose money. The market maker can then set the range of prices in the chain up/down accordingly. For example, at say +/-10% x $50, he/she could set the $45 put at $0/$.50, and the $55 call at $0/$.50. I ask again, why bother?
So why am I going into all of this detail?

Well, firstly, the Coiled Spring Experiment was a cute idea, but it was stupid. So I identified a bunch of charts with triangles. Who cares. Is this research? No. On top of that, I suggested buying strangles midway between the expected break-out range. What does this particular trade setup achieve? It really achieves one thing, an almost certain transfer of wealth in terms of premium paid for the strangle between the participant and the option writer.

Secondly, while the strangles were a novel idea back in January, and while one leg of the strangle did appreciate noticeably in the direction of whatever breakout occurred, the other leg depreciated noticeably once direction was established, and if my call on the mid-point of the breakout range was too distant or the premium paid for both legs ended up being more than the intrinsic value of the winning leg by expiry (i.e., for a call, IV = stock price - strike price, and for a put, IV = strike price - stock price), then the overall experiment was a losing proposition. As theta burn kicked in during mid-March, the winning leg started to decay feverishly. At least if I was long the underlying in the direction of the move, I'd be right on direction with no time limit, and no decay, and I'd earn dividends while I waited.

Thirdly, none of this is a good use of time or effort. Looking back at the above, I believe that the Coiled Spring Experiment was an exercise in first level thinking, something along the lines of, "hey, there's a triangle, it's going to resolve and I'm going to be able to take money from a derivatives desk who's only job is to professionally set the odds (by the second) by paying up for premium six months out".

Sounds dumb in hindsight doesn't it? Where is the research to substantiate risking capital above and beyond observing a chart pattern?

Fourthly, as I mentioned above in my irrefutable observational truths list, I've observed (experientially) that the tails around a volatility range are often over-priced. This negates the ability to buy tails cheap, and I believe that the best way to make money in options is to pay nothing, and therefore lose nothing. This really means paying nothing for the tails, so in the event of a abnormal standard deviation move, the tails get valuable. But market makers are not stupid, and they don't easily get picked off, which explains why the tails often appear overpriced relative to the near term volatility range.

In the context of the $50 stock above,  it wouldn't surprise me at all to see the $50 calls, $52.50 calls, and the $55 calls priced as follows (assuming 25% implied volatility and assuming a $.50 spread):

$50, $.95/$1.45
$52.50,  $.05/$.55
$55, $0/$.50

There's no way to buy cheap options in this case.

So in the order of final debriefing:

  • Options are a losing proposition from the outset, so why bother?
  • If a participant wants to trade options, the best way to participate is to buy tails for cheap with a lot of time left for the underlying to do whatever it's going to do. BUT, in my observational experience, tails don't often get cheap due to market makers setting wide bid/offer spreads. And the longer the time to expiry, the more expensive the tails get due to wide spreads. The best way to participate is to be the market maker yourself and just have silly bids in between the existing spread and hope they get hit, and the likelihood here is that the bid will just sit there and not get hit, which begs the original question, why bother?
  • If a participant is lucky enough to have a silly tail bid filled with enough time to expiry, he/she should look to immediately sell another strike against the premium paid in order to have a spread on for free. Case in point on the $50 stock, if the ATM straddle is pricing in 10% and the bid/offer spread on the $55 calls is $0/.$50, and and the bid/offer spread on the $45 puts is $0/$.60, have silly bids in for $.05 on both legs. If either of the bids happen to get filled, look to sell the $60 calls, same expiry, for $.05, or look to sell the $40 puts for $.05. This way, the participant has either the $5 call or the $5 put spread on for free. I believe this is the only way to successfully trade this stuff. Have enough premium on that if it erodes to zero, you don't care, and if you just happen to get lucky enough for the underlying to blow through your short strike before expiry, you paid nothing and you make something.
  • There's a hidden element of psychology embedded in this entire discussion, and that is, what does your own read of a chart tell you about your own psychology and biases, and what does it tell you about other participants' psychologies and biases'. If I see a triangle, you can bet other participants see a triangle, and participants will either try to front-run the resolution or wait for resolution either in the underlying or in the options. Going back to my original post, I identified a set up in Abbott Labs that hadn't resolved yet in January 2017. The May 2017 $44/$38 strangle was priced at $2.35 in January with the stock at $40, the May $44C was priced at $1.01, and the May $38 put was priced at $1.34. Abbott broke up, but moved nowhere near midway between the $13 breakout range I originally identified in January. My bias was to overlay my expectations on resolution vs. what price actually did, and my model paid too much for the privilege of trying to participate. In theory, a $13 range/move suggested a +/- 30% move in the underlying, and here's where the gut check comes in: what research was done to support a +/- 30% move beyond observing a nice looking chart pattern? NONE. How likely are +/- 30% moves without some fundamental change in the operating business?
I close off with the following final observation:

If there's no research tied to allocation of capital, don't bother. And if a participant wants to bother for the fun of it, don't EVER overpay for the privilege.

On the subject of a new blog

I'm going to start a new blog which does not have Stable, or Dividend, or Portfolio in the title. As I progress in terms of experience (what fools endearingly refer to as their mistakes over time), I want to write closer to home on a range of financial topics which may include or exclude any or all of the above aspects of my previous blog.

I'm thinking of either two titles:

1) Confessions of a retail muppet 

2) Diary of a retail muppet 

I will try and get this set up in the next few weeks.

Thanks all for reading.

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