Selling short or buying puts

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1

I have never used options and don’t personally know anyone who has, so I would greatly appreciate some advice. I am considering either selling stocks short or buying puts during the next recession (most of my money is in retirement accounts and is thus ineligible but I have some that I can use for this) and would like to develop a strategy in advance. Here are my questions:

  1. How would I simulate such a strategy in Portfolio123, including margin costs?

  2. What are the advantages/disadvantages of selling short versus buying puts?

  3. What are the liquidity requirements for placing short trades or buying puts? I assume they’d be far stricter than for going long?

  4. I have an ultra-low-beta strategy for remaining long during a recession. Would you advise me not to bother selling short with that in place, and simply rely on my long-only strategy?

  5. Are there any good articles or books about this that you’d recommend?

If anyone wants to share personal experiences, I’d love to hear some.

2

I was a derivatives broker a few years ago and have some options experience. Depending on the brokerage firm you use, self-directed retirement accounts allow buying puts.

  1. I’ve never tried to simulate in P123, so will leave that to someone more experienced with the platform.

  2. I’d recommend defining exactly what you are trying to do with a short position. Are you trying to hedge your portfolio? Be opportunistic and overweight the account short? Protect from a crash (tail risk)? If its hedging that can be done easily with a short equity position. If its the latter 2 then options probably make more sense so you aren’t tying up too much capital.

  3. A Reg T account requires 50% on a short equity position. Portfolio margin accounts have more flexibility. Buying puts requires 100% of the premium for Reg T. Again, portfolio margin is more flexible. Retirement accounts you can’t short equity and will require 100% on any long options.

  4. In my experience, making money shorting is incredibly hard, even in a recession. Reducing long exposure easier.

  5. Option Volatility & Pricing by Sheldon Natenberg is the gold standard for professional option trading books. Also, although not an option trading book I got a lot out of Black Swan by Nassim Taleb.

Last piece of humble advice: before you do anything with options its really important to understand how they are priced. Implied volatility can make or break you.

3

I would recommend steadyoptions.com. I’ve been a member there for some time and I’ve made far more than it’s cost me.

If you follow their anchor trades for a while, you’ll see a good hedging model in action, assuming that’s all you’re interested in.

Personally, I think defensive long strategies are more realistic than short or hedged models and it’s where my focus has been lately.

4

My 5 cents…maybe 4…

I think you should use what makes more sense based on market conditions. For instance, insanely low implied volatility means time value of options are cheap. You’ll need to work the numbers out on a case by case basis but if you give up 2% of your overall capital in puts - your upside is only reduced by 2%. And if the market goes nuts in a bad way - volatility will increase making your put options more valuable based on that alone. This means you likely won’t need as many put contracts as you would in a high IV market to get the same coverage.

But when markets go down by 20% or more - buying puts may no longer make as much sense. When IV is high the options become more expensive.

I believe that short positions should be reserved only if you really think you have short alpha or if you are trying to make a neutral product where your short side has a high inverse correlation to your long side to kill volatility. But using shorts simply as insurance…risky in my opinion. Options, especially when they are cheap makes more sense to me.

5

Hi Yuval,
I design and operate automated options trading systems for a hedge fund for many years, so I have lots of knowledge and experiance with options.
My best advice is: don’t trade options!
If you do, you are on the oposite side of very sofisticated systems, so your expected profit is very negative, more negative the more you trade and more negative than other forms of trading (including short selling).

That said, I can try to answer some of your questions:

  1. I’m not aware of a way to test opions trading in Portfolio123. Does the database include historical options prices? (You can’t imply option prices just from index levels, there are some other major factors affecting prices).
  2. Selling short is simply like reducing position (Beta). Buying puts is like buying insurance (every put “insures” a specified quantity of stocks, indexes, etc): you pay a premium and if the index goes under a specified level (the “strike price”) at a specified time (Expiration), you get compensated, more so as the index goes lower. If the index doesn’t go below the strike price, you lose the premium paid. Of course you can trade this “insurance” at all times. It’s market price reflects the expected value at expiration (sum of probabilities * values). So as time goes by, value usualy decreases and as volatility goes up, value increases.
    So with shorting it’s relatively easy to profit (just a down move), but risk is unlimited (as a hedge, you give up any profit from up moves). With long insurance puts (strike price below current index level) profitting usualy requires a large and/or fast down move, but risk is limited, and you still profit from an up market (after losing the insurance premium).
  3. With an ultra low beta I see no good reason to bother with short exposure.
  4. A good theoretical knowledge is necessary for trading options. I also recomend Natenberg’s book.

But remember: even if you have perfect theoretical knowledge of options, the market is complicated, fast and sofisticated. So as it’s a zero sum game, your expectancy is (very) negative!

6

Options should be traded before the predicted event happened, not after.

You may consider selling calls on your stocks (covered call strategy).

You will collect premium if your stocks do not advanced in price above the strike.
This strategy decreases your portfolio beta.
This is good strategy when you think that market will be relatively flat next year.

7

I want to thank everyone who responded. You guys are the best–it’s so helpful to hear from you, and you’ve given me a lot of material to think about. After reading this all I’ll likely take Yoram’s advice and just put this idea to bed.

  • Yuval
8

How, option is zero sum game ?

One of my friend bought call option for 2 months to expiry; he sold the call option with 50+% gain within few days to few weeks; he is not holding the option for more than a month,
He told, after 4 weeks; if the option is not work out; he will take the loss; loss will be less than 50% if sold within a month;

He made 400% return, last year 2017. He has only few years investment experience; It seems he learned option trading from another friend not from book or website.
his account is small; last year was good one; so he don’t know about risk or bear market;

He trade option with NVDA, MU, JPM, CHW. only trading top performing stocks, sector and industry.
He told; just 1 strategy instead of buy stocks; he is buying call option (long same as buy). as he will make small pct in stocks even he is correct in stock picking; he choose option to grow his money faster.

Thanks
Kumar

9

I have experience of trading in options via my IB account, for me the only broker is IB for trading in options, all strategies, low margins, low comms,strategy testing etc,

stay anyway from any option in futures, high margins, overpriced and mostly illquid, wide spreads, the aforementioned does not apply to the most liquid indexes in the USA and Europe,

longer term stock options or leaps are undervalued, the reason for this mispricing is simply because of the time period of leaps, very difficult to predict where the price of AAPL shall be one year from now !!,

I actually discovered this via a book from the 1990,s, whereby the author over many years to augment the retirement plan, sold put options on his portfolio, thereafter I have investment in a similar fashion, I shall be showing more size in this strategy 2018,

goto bighcharts.com and lookup AAPL then the options series, scroll to the long dated option series 2019 etc, these leaps trade like the stock, one caveat only the most liquid and biggest stocks in the US are good for this strategy

the title of the book is, “Using Options To Buy Stocks - Build Wealth With Little Risk And No Capital”, very good book, I would only disagree with one item in the title, that is it does take a certain amount of capital, i.e to buy the stocks,

finally you should either only day trade options, see APPL( at the money options, and most option series open a few seconds or more later than the underlying, therefore you have an opportunity to see the momentum and move accordingly ), or invest in leaps, with over eight months to expiry,

I have tried and have never been successful trading in options with few days or a few weeks to expiry, just too much noise and fuzz for the logic of intellect to decide what to buy and sell.

10

Kumar,
A zero sum game is one in which the sum of profit for all players is zero. When you buy a put or call option, who do you buy it from? You buy from someone who sold it short (it’s called writing an option). In essence the writer creates the option. The sum of profit of buyer and seller is zero.
For any long position there is a short position. The sum of positions of all options is zero, and so is the profit (In fact it’s zero less commissions).
So if there are positive expectancy profit players in the market (the sofisticated, computerized, hedge funds, etc), their profit is possible only from the negative expectancy players.
Your friend experienced a “positive noise event” :slight_smile: The more he will trade, the less noise will affect his outcome…

11

yorma,

My best advice is: don’t trade options!

even, i have heard from wallstreet professional with decades of experience the same; don’t trade options!.

Please, help to clarify; we have high probability trading system; using fundamental, technical, maket timing, and picks stocks which is intended manually.
and have high probability 67% success rate with 2:1 win loss ratio.
in out of sample even it become 50% success rate with 1.5:1 win loss ratio; still the system is profitable.
what i have heard; the small profit in stock investing make big profit in buying call option; option have flexibility can sell before few weeks before expiry.

in out of sample, using my trading system and seasonal filters; i made 30+% in 2017.
My question is why i can not replicate large cap sp500 stocks stock pick success in buying call option with 3 to 4 months expiry (instead of buy long few shares).
instead of getting 30% return avg return; i can get more 100+% return.

I have well spent last 4 years with SP500 trading system; i am also good with analyzing trading systems manually. (I have learned CANSLIM and TA from few long term AAII investors, value investing from Mgerstein virtual class). I have some edge.
Please, let me know; the option is still zero sum game for me ?

Thanks
Kumar

SP500 High probability system - whether suitable for option.png
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12

Yorama was right, most people do not understand options.

Please, do not watch tastytrade and listen people who make money by trading options.
Rather I recommend objective literature :“Volatility Trading” by Euan Sinclair and his blog : http://taltoncm.blogspot.com/

13

ahha,

i have friends who holds stocks for multiple years and getting 30%-40% avg return. their strategy, buy AAPL, JPM, GS industry leaders at multi-year low.
even though, energy industry in multi year beark market, VLO and MPC made 100+% return in last 2 years.

Macy’s, Kohls 40+% up from 1st Nov 2017 from multi-year low;

Please, help to clarify
why the stock picking alone can’t help in buy call option strategy.

Thanks
Kumar

14

Zero sum game example:
t0 : AAPL stock at $100, buy call $150 with expiry at t1 (one year), delta 0.25 and price $10, imp. volatility 10%
t1(a) : AAPL stock at $160, you have right to buy AAPL at $150, you exercise the option by sending $150 to the seller and receiving 1 AAPL stock which is traded now at $160, you immediately sell AAPL stock and realize $10 profit. The seller had to buy 1 AAPL stock at $160, and receive from you only $150. Zero Sum game minus commission.

Why it is probably impossible to replicate the equity strategy with options ?
Because P123 does not provide options prices. At the end you compare implied volatility (IV) (embedded in option price) to future realized volatility. If IV is lower than realized one, you make profit on call options.
So if AAPL IV is 10% (at price $10) and the price will go up more , you make profit of $10 x multiplier.

Currently AAPL call at the money, strike $175 is traded at IV 24% ($15). This means that to make any profit on AAPL, the stock should go up more than $15.

By the way I would pay a lot if P123 would introduce option prices and allow to backtest such strategies!

15

Ahha & Yorma,

Buying call option contract (same as opening/buying long position) with 2 months expiry.
we also sell the call option contract before expiry any time; without any restriction. (same as closing /selling long position).

I don’t know this option flexibility sell any time is you are aware of;

Please, help to validate this safe option strategy screen for small account.

my friend showed these screens and explained. (he don’t know theta, gama, time decay). He only know these screens.
he made 400% in 2017, without prior investment experience.
I did not believe, he showed his Etrade account statement.
he encouraged me as i can be sure success in option buy call option 2 months expiry strategy.
but, i told him option is risky; he replied all the option are not same; his option strategy buy call with 2 months expiry is far better than investing in stocks;

===========================
successful safe option trading rules;
He will not wait 2 months to option to expiry;
he will set limit order to sell if there is 50% profit; it will fill within fews day to few weeks if it profitable.
after a month; he will start sell the loosing position;
he will sell all the position before week of expiry. he said; his losses will be limited 50%.

believe, his option trading rules may make a difference.

How buying call option (same as buying stocks) for 2 months expiry time is profitable.

  1. Less risk while stock draw down to 40% ($100), the investment will loose $4000
    $500 can buy call option with 1 contract will control $10,000 of investment,
    loosing the $500 entire investment. it is far less than $4000.

  2. 5X profit when stock gained $3 (10%), option gained (50%) of the investments.

In University of Texas, Dallas (UTD), Jindal business school teaches option; this strategy as safe option strategy for small account.

if we trade 20 stocks in SP500 diversified in all sector with 2 months expiry option. $500 trade on each position.

after 2 months 50% winners and 50% looser; can we get 5X profits for winners than loosers ?

Thanks
Kumar

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2. 5X profit on winning.jpg
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16

hi Kumar,
I think what’s missing in your share example is what if stock doesn’t move or move just a little bit. Then your option expires and your stock value stays the same. So you need to no only predict stock’s price move but also its volatility in your example in order to make profit.

Best,
Terry

17

gs3,

Please, check my high probability screen shots;
at avg; 120 days; 22% gain and 10% loss;
out of 10 stocks; 3 stocks gained 22%, 3 stocks losses 10% and 4 stocks move little bit; closer to -5% to +5%
still i can’t be profitable ?

here, i am dealing with 10 stocks buying call option strategy for 4 months to expiry. here, i have flexibility to sell the option position with 50% gain any day and can close the loosing position before expiry.

Thank you
Kumar

18

Kumar,
My recomendation to not trade options, assumes “normal” prediction capabilities (ie low to none).
If you realy have such a big edge, and the stocks you pick usualy move fast and a lot in your favour, you can indeed profit more from options.
But that edge is a necessary condition. In options it’s not enough to be right about the direction of the stock/market, you should also be right about valueing the option (mainly estimating future volatility), and about timing (if the move is in your favour, but slow, you still might lose money).

19

Yes, absolutely. For example, here’s a backtest of Kumar’s long call strategy in AAPL over the last 5 years:

50% profit target, 120 DTE at various deltas:

It did well, but the success of that came from picking AAPL as a winner 5 years ago and then applying leverage in the form of option delta.

I’ve had some success taking signals from P123 (that’s my “edge”) and using them to trade directional options positions. Personally I prefer the defined risk of selling a put spread (or buying a call spread) over straight long calls. Time decay (theta) has to be dealt with somehow or it will hurt.

20

Yuvaltaylor,

I wanted to add one more post on this. I have traded options off and on over the past 10 years. There are a lot of ways to trade options, but I think as a form of insurance to protect you against the next down market – that’s where options will come through for you. Here is a quick example.

Lets say you have $500,000 invested and you are going to start to draw on it. Your rate of return has averaged around 10% annually. You want to draw 4% and use 2% as insurance and let the rest stay in the portfolio as an inflation fighter.

You buy puts in the SPY which expire Jan 2018 with a strike of $222. You buy 20 of these contracts. They are worth $514 each. So you outlay $10,280. This represents roughly 2% of your capital and you cannot lose more than that with these put options.

I am using the CBOE options calculator for all these numbers. Assume 6 months go by. The SPY has risen to $300. Then a market shock, something happens and it retreats back to todays price. Do you have $4,600 remaining due to lost time value? No. Now fear is higher and the volatility factored into the price also went up. The contract had an implied volatility of 20% but now it spiked to 35% and each contract is worth $822 or $16,440. You lost time, the index is the same price but your options kept their value since volatility spiked. So this type of insurance makes sense when implied volatility is low.

Let’s say that the market tanked and the SPY went down to $186 (30% drop from today’s price). You are down $150,000 in your long portfolio. There are only 60 days to expiration for your put contracts. But because of the market shock – implied volatility is 50%. Your contracts are worth $80,000.

You will need to experiment to get the right mix of coverage and such for your portfolio. You will likely also want to roll your options kind of like a stop-loss. Using options in this way should never make you money. Assume you are giving up 2% every year to protect your portfolio. But due to the long bull run and cheap price of options – is it worth it? I say so. Assume we get another 5 years of a bull market. So you give up 10% of your portfolio but you make 40% and net 30%. Was that worth it for the peace of mind? And when the market tanks you protect a good chunk or maybe all of your losses – was it worth giving up that capital?