Saturday, October 02, 2010

The main virtue of buying options

I realized that I have omitted the most obvious virtue of trading options instead of stocks in my last post: the much more attractive reward-risk ratio for options.

Suppose your stock strategy generated a buy signal. You can either buy the stock now, or you can buy an ATM call. If you buy the stock, you are of course benefiting from 100% of the upside potential of the stock price movement, but you are similarly exposed to 100% of the downside risk. Indeed you can lose the entire market value of the stock. If you buy the call, you will benefit from > 50% of the upside potential of the stock price, assuming that your holding period is so short that the time value will not dissipate much. As the stock price rises, so does your delta. (It increases from 0.5 to 1.) But what about the downside risk? All you can lose is the option premium, usually << 50% of the market value of the stock.

In other words, while one may be tempted to hedge a large stock position with stock index futures, there is no need to hedge an equivalent call option position. This should simplify your strategy implementation and reduce risk management costs (i.e. the probable loss on your short futures position).

Given that I am a short-term trader anyway, I can't figure out why I have been trading stocks instead of options all these years! (Aside from the caveats detailed in the previous post.)

22 comments:

techtrade89 said...

In theory options are great, in practice I have been quite unhappy. I know you mentioned some of this in your post(s), but my experience has been: (i) the bid ask spread can be ridiculously high; (ii) the time value can sneak up on you and eat away at you - you not only have to be right as to direction you have to be right re timing and (iii) without market orders, it is harder to know if you would have been filled in backtesting, and you can lose trades that don't get filled in practice. Maybe this is just me and options are great, but I am waiting for a lot more liquidity before I can rely on them.

DW said...

While the leverage offered can be quite attractive I agree w/techtrade89 regarding bid ask spread and the point on decay sneaking up on you. Additionally you have the uncertainty about vol. It's very frustrating for example to be long calls, have the market move in your direction but the call decline in value do to a fall in volatility. They can be great tools but there are many pitfalls.

John G. Black said...

BE EXTREMELY CAREFUL!!!

The leverage in options is fantastic, both ways. A lot of factors have to work in your favor to turn a profit.

Ernie Chan said...

techtrade89,
Agreed. That's why I only trade OEX component stocks (narrower bid-ask), and hold at most a couple of days.

I also didn't backtest the options strategy, but I do backtest the underlying stock strategy.
Ernie

rara avis said...

For small return and holding times, options are really like underlying + leverage. For longer holding times, and larger returns, what convexity buys you is eaten away by time decay and slippage. There is of course use for options for directional bets (e.g., the big sale of long-term put by Berkshire), for risk management, and volatility trading. But even for liquid assets, I would not treat them as substitutes for the underlying. This is especially true on short positions.

liskers said...

On top of the issues that have already been mentioned in other posts, I would like to add that when using options you will have to take in account the implied volatility skew. You might select the right stock entry point, the right strike and the right maturity but it just so happens that the option that you have selected is trading at a very high implied volatity that is not supported by the realized volatity of the underlying during the holding period of the position.

I have been trading options for 20 years and I would not use them to implement a systematic investment strategies as too many endogenous factors might have an impact on returns.

I think that options are a fanstastic tool to enhance returns of existing portfolios through systematic buy-wright programs or targeted premium selling. They can be deployed tactically to establish specific entry and exit points and of course to hedge existing positions. They are also suitable for some RV trades.

In principle I tend to be a seller rather than a buyer of premium and even when I buy it, I rarely establish outright positions. I tend to use spreads/combos.

My 2 cts...

Anonymous said...

I was going to go off and say just how short sighted this post was but liskers seems to have covered it.

Main point is that the spot might not move but vol can blow out or collapses and change the value of your option value pretty significantly!

Options are a vol bet.

Ernie Chan said...

liskers and anon:
These are all good points. But I believe they are mainly relevant if you intend to hold options overnight. I have not seen the implied vol of options change too much intraday, and as I am a day trader, the substitution of stocks with call options seems so far to be quite promising in live trading.
Ernie

Puzzled said...

Hi,

sharing my point of view, I tried back-testing options on the GLD/GDX pair for the last month. On stock, the calculated sharpe-ratio was ~6.5. When using at-the-money options, the sharpe ratio decreased to ~3.5, and had a recent catastrophic loss. Using 10% of stock price in-the-money options, the sharpe ratio got to ~4.2, still with a recent significant loss. I might try 20% in the money options, but then going for SSF might be actually a better bet with that investment, since, if I understand correctly, SSF count as part of the equity with loan, while options do not.

Does this make any sense?

Ernie Chan said...

Hi Puzzled,
What caused your catastrophic loss in option value, but not in the stock value? Is it due to a sudden change in volatility?

For SSF, your margin deposit certainly counts as equity. But if you use the maximum leverage already, then it will not have any remaining loan value. For options, the equity is the current market value of the option, and it is true that it will not have any remaining loan value since one is not allowed to use leverage on options.
Ernie

Puzzled said...

Hi Ernie,

I could not perform a rigorous analysis, as IB do not provide historical implied volatility, and I do not have yet a module to calculate it locally (anybody aware of an open source java library to calculate implied volatility?).

But, from checking a single trade sample, it seems that there was a drop of around 1/2 the value of implied volatility, both in the call and the put options. Also, the rate of losing trades was doubled in options compared to stock for particular date, and the losses were much more significant.

Is there a way to neutralize implied volatility, maybe by means of some spread?

Ernie Chan said...

Hi Puzzled,
If you are using options to implement pair trading, you can indeed neutralize implied vol change by buying a call on the long side, and shorting a call on the short side. However, in this case you will lose some use of leverage on the short side.
Ernie

volatile smile said...

Well the better reward-risk ratio should be completely priced out by the bank, if they're doing it right.

Unknown said...

One huge disadvantage of option trading on an intra-day basis is the slippage caused by the bid/ask. This isn't so bad on super liquid options like the SPY; where the b/a spreads are 0.01.

Neutralizing vega with a call/put spread will definitely increase this slippage.

If you want your option to behave closer to what the stock is, buy a strike deeper in the money. The margin you'll tie up will be larger, but the delta will be higher, and changes in IV will have less impact.

Doing this on the short side by buying a put will do the same, but your combined position will now have twice the vega risk (if you're long 2 options, a deflation in IV will hurt you).

IV tends to vary wildly weeks before and just after earnings (for companies)... I'd think if you're automating a trading system using options that this would have to be dealt with in the logic somehow.

Ernie, I'm curious have you been trading multi-leg option spreads, and if so are you using limit or market orders? When I was a newb I got burned pretty hard with fills using market orders on option spreads.

Unknown said...

Another thing to note: IV tends (not always of course) to increase when the stock is going down, decrease when going up.

If you're looking for additional strength on your trade, go short puts for your long side, and long puts on the short side.

Using calls exclusively has the reverse affect, being that you have an IV cushion if you're wrong.

Ernie Chan said...

Jeremy,
Thanks for the good discussion. I currently only use options for intraday directional trading, not for spreads. I also use mostly limit orders, for the reason you pointed out.
Ernie

Unknown said...

Hi Ernie,

I'm curious, if you happened to find a decent data source for historical intra-day option prices... I found that was my biggest problem was finding a reasonable source for this. Without historical intra-day data, I was not able to backtest using options and it was one of the main reason's why I abandoned the effort.

Ernie Chan said...

Hi Jeremy,
tickdata.com has just started providing such data.

Maybe our readers know of another good quality source?
Ernie

Glyphard said...

@Jeremy and Ernie

check out nanex.com they have years of tick by tick data for options.(full OPRA feed).
Their live data is pricey, but historical data is much cheaper. Several API's (Java, C/C++, .Net, etc...)

No, I don't work for them, or own stock :-)

Ernie Chan said...

Thanks for the tip, Glyphard!
Ernie

Anonymous said...

To add to the list, I get my intraday (1min, 15min) option data from Livevol. Easy to use, and comes with IV data and an IV index of their making, which is nice. I find some occasional bad data (missing quotes, inversions, etc) but nothing i couldnt deal with. The customer service however is poor: they are unwilling to help, and do not have any code available to get you started faster. Ernie, this is an awesome blog, thank you for doing this.

Ernie Chan said...

Thanks for this info, anon!