Essential Lessons- Option Income Strategies are Dangerous to your Financial HealthBy Richard Wiegand, founder of ProActInvest.netThis blog post is an excerpt from the Essential Lessons of Investing SeriesLesson 15 Why Options Income Strategies are Dangerous to Your Financial HealthWhoever named these derivative instruments “options” had a cruel sense of humor. Theyfeel a lot more like shackles… - any options trader The so-called option gurus make it seem like a no-brainer. "8-10% per month consistent incomeselling time," "Laugh all the way to the bank with couch potato option selling strategies," etc.,etc. Yet many experienced traders would argue that option selling strategies are dangerous toyour financial health. For traders and swing to intermediate-term trading system developers witha competitive model, its actually far better to be an option buyer than an option seller. This blogpost will attempt to explain why.A little personal backgroundWhen I was much younger, I returned from Paris to co-manage an emerging markets bondportfolio with a hedge fund in New York and learned many lessons simply by keeping my eyesand ears open. This hedge fund was run by ex-Salomon Brothers directors and equity traders.They were really good at managing stock portfolios –generating in excess of 30% average annualreturns. One of the things that struck me most was that the hedge fund completely avoidedoptions trading almost completely – no directional or “delta” plays, no time decay or ”theta”plays – not even option hedging strategies like protective puts or collars.At first, I thought that this was because they were kind of old school and needed to hire somefresh blood in order to get up to speed on the greeks. But over the years, I began to realize whythe New York hedge fund that I worked for many moons ago firmly decided to avoid complexoptions strategies. The Paris-based hedge fund that I worked for also cut back on options incometrading because those accounts were going nowhere. The head options trader at the Paris hedgefund sat just across from me – he was well-educated and had superior quantitative-analyticalskills. He liked to put on calendar spreads – where he essentially tried to buy implied volatility(IV) when it was cheap and sell it when IV was rich. Since the accounts that he managed wereessentially going nowhere, he was asked to stop. In all my years in the industry, I have yet tomeet someone who has consistently made money with option income strategies over a prolongedperiod of time (say over a 7-10 year period).I began to think to myself, “heck, I’m a pretty experienced trader and model developer guy.Imagine what all those option newbies must be going through as they embark on the treacherousroad of options income trading!” I realized that I simply had to get the word out about howdangerous options income trading is.
What exactly are option income or option selling strategies? Briefly said, option incomestrategies are designed to take advantage of the time decay of options by collecting (andhopefully keeping) the premium sold. Theta is the options greek that has to do with the decay oftime value as you approach expiration. The time decay of options is a mathematical certainty,and the rate of decay increases exponentially as you approach the expiration date. It is said that70% of all options contracts expire worthless. So everyone should be an options seller (orwriter), right?Wed all be pretty stinking rich if this were the case. In practice, theres tremendous skill,experience, capital and psychological fortitude required to manage the risk of an options sellingstrategy. In addition, what many of those sleek options mentoring courses dont tell you is thattheres a huge difference between the probability of keeping premium at expiration, versus theprobably of touching a stop level during the life of the option.Some of the most popular option income (or selling) strategies include:credit income spreads : bull puts, bear calls, iron condors, butterflies, covered calls (or covered writes), and naked call/put selling. Credit spreads entail buying a call (put) and selling another call (put) simultaneously for a net credit (taking in more premium than paying out). debit income spreads: calendars, diagonals and double diagonals. Debit spreads entail buying acall (put) and selling another call (put) simultaneously for a net debit (taking in less premiumthan paying out).What all these income options strategies have in common (probably best seen graphically), isthat they all try to build some sort of a roof-top over the underlying price movement in an effortto contain the price action. In return for a supposedly high probability range of limited income(about 6.7% of the margin requirement), you are subject to the potential for some pretty
precipitous losses at the wings (anywhere from -12% to -100% of the margin requirement). Thislop-sided potential for losses at the wings is typical of option income strategies and is whatmakes them so dangerous. As an example, the iron condor (as shown below) is designed to profitfrom prices staying inside the price range of the two short strikes (the short 118 put and the short130 call). In this example, the 118-130 range is the roof-top that is typical of options incomestrategies.These strikes were selected based on the 68% probability range at expiration. Doesnt the ironcondor strategy vaguely remind you of the normal distribution bell curve? It should. High probabilitytrades are supposedly what attract option income traders, because the expectation is that prices
will stay inside the +/- 1 standard deviation range with 68% probability. Many options tradersoverlook this to mean that theres a 68% probability that the price action will not penetrate the118-130 (short strikes) range during the life of these 1 month options. However, the probabilitythat prices will not penetrate the roof-top range during the life of the options is actually31%, not 68%! There is a big difference between where prices will be at expiration vs. duringthe life of the option. If you factor in the probability of penetrating the inside strikes during thelife of the options, together with slippage and commissions, you end up with a negative expectedreturn! Using the expected return formula: % Winning trades x Avg Win + % Losing trades xAvg Loss, for the typical iron condor we have 31% x 6.7% + 69% x (-13%) = -6.89%, and thisis before slippage and the cost of adjustments! Many inexperienced options come to the optionincome strategy waterhole because they expect a high probability (limited profit) trade -consistent, couch-potato income, remember? - but in fact theyre getting low probability limitedincome plus the potential for catastrophic losses at the wings.I will not go into the pay-off diagrams for all the other option income strategies, but the messageis basically the same: with option income strategies there is the illusion of a high probability pay-off in return for a limited income stream and big-time trouble when prices penetrate the wings(the is, when prices go outside either +/-1 standard deviation). But what about the mathematicalcertainty of time decay - dont most options expire worthless? Yes, but virtually every optionstrader knows this. Other than extreme market sell-offs (when implied volatility gets pumped),there is less time value to sell than you think. Analogously, with so many term-life insurancecarriers out there competing for policies, term life insurance underwriters are most likelyassuming greater risk than they should - because the premiums are so ridiculously low. The sameholds true for option writers on financial contracts.I would argue that if you believe you have a competitive directional model of some kind,more money can be made by doing the reverse - by buying options (especially deep in-the-money and/or longer dated calls/puts). If option sellers arent getting paid enough for the riskthey assume, then option buyers are getting a bargain more often than not. Another reason is thatthe farther out in time you go (3, 6 month options, even LEAPs), the greater uncertainty there is.No one on this planet knows about the future and where prices will end up - and this is more sothe case the farther out in time you go. This is how leveraged trend followers generate profits.Instead of capping you profits with some sort of income spread trade - consider keeping thingssimple: follow the trend and let your profits run using longer-dated in-the-money long callsor long puts.There are some highly experienced option income traders who are masterful at adjusting theiriron condors, butterflies, calendars, etc. before and when prices fall off the deep end. But thesefolks are extremely rare. Chances are, these are ex-option-market-makers with a keenunderstanding of the greeks - particularly, of delta and gamma hedging. Yet all the optionsadjustment skills in the world cant address the issue of violent overnight gaps, for example.Gaps make price action containment (as all option income strategies try to do) virtuallyunfeasible. For most of us directional folks trading through a broker, its better to work at honingyour risk management and directional modeling and/or trend-following abilities instead.
To recap, here are some of the key reasons why complex options income strategies (especiallythose with multiple legs), should be avoided:1. Options are illiquid instruments. As derivative instruments, the total equity options marketin terms of volume traded in the U.S. (as measured by the Options Industry Council) representsless than half of 1% of the total volume for the Russell 3000 (R3K represents 98% of theinvestable universe of stocks). (This figure makes you chuckle when you hear market sentimentanalysts poring over put/call ratios when you consider just how small the options market is as apercentage of the entire stock market). Liquidity basically refers to how easy it is to enter or exitpositions – in terms of not having to pay fora) Exorbitantly wide bid-ask spreads (the wider the spread in % terms of the bid-ask midpoint,the more punishing the cost of slippage in terms of trade execution is)b) Moving markets/ slippage – this can be a big problem with illiquid securities like optionsbecause sizable orders will literally push prices in the direction of the order – resulting in terriblefill pricesc) Options exchange margin requirements – that is, how much cash you have to maintain inthe account to cover options positions that you wrote (or sold). These can freeze you into holdingpositions until you raise sufficient cash so that you can unwind the legs of a spread, for example.Imagine being in this situation when the market is moving furiously against you – you want toget out by selling the “painful” leg of an options spread trade – but you can’t! You have to getout your surgical gloves and piece by piece unwind the legs of the position. This can be anightmare to say the least especially for option income newbies.2.Commissions on options trades are about $5/contract. If you put on a 10 x 10 vertical spread(like a bullput or bear call), that will cost you $100. If the market goes against you directionally, you’ll haveto pay another $100 to unwind the position. That’s 2% of a $10,000 options account just forentry and exit costs.Oh, and let’s not forget about the slippage for the illiquidity points made above. That’ll cost youanother 2.5% round trip. Add this all up and you’re down 5% right from the get-go.3. Options are rapidly decaying instruments. As we said earlier, the time value of all optionsdecays exponentially the closer you get to expiration - unless implied volatility (the risk of theunderlying stock or index) increases. Because time decay is perilous to buyers of puts and calls,only traders with exceptional directional market timing skills (greater than 55% accuracy) shouldconsider buying options for bullish or bearish plays. To minimize the impact of time decay,directional players should consider deep in-the-money calls and puts. A very simple conceptindeed.Long option strategies do have one important thing going for them: they cap downside risk. Butthis sense of security is short-lived when you consider how much you pay (a form of insurance,
really) for limiting downside risk. Remember that the total cost of buying protection includesnot only the premium but also the slippage and commission. So if your directional skills are notexceptional (greater than 55%), long option strategies can also turn into a losing proposition. also proposition4. Options are leveraged instruments and the leverage factor is not constant. This means thatunless youre super careful,being mindful of the greeks (particularly gamma and delta), yourposition can explode in your face. This is particularly true for options selling strategies when theunderlying market has moved a great deal.As mentioned earlier, the issue of probability of touching vs. probability at expiration isprevalent with all option selling strategies. Whenever you create a roof over the price action (ascan be clearly seen in the case of the iron condor discussed earlier), youre essentially trying tocontain the price movement in some way in order to keep the net premium sold. Covered callsare also option selling strategies (long stock plus short call=short put), that try to contain the lingprice action above a certain pain threshold. Covered calls are apopular way to generate income but present unlimited downside risk in bear markets. Needlessto say, option selling strategies that try to contain the direction of the market in some way areextremely dangerous in view of truly unexpected market volatility like we had during the FlashCrash of May 6, 2010 when Dow Jones Industrial Average gyrated by more than a 1000 pointswing on an intra-day basis. Or how about when the market gaps up or down in a big way? Good dayluck trying to "contain" the price action under these circulstances!It makes no sense to me to put on complex, cumbersome, and expensive options strate strategies thatgenerate limited % yield (or income) and either do not work most of the time or leave youexposed to significant downside risk!
Despite all the hype about 70% of all options expiring worthless at expiration, as weve seen,what really matters is the risk that you assume during the life of the options strategy. Theoptions brokerage firms should really be advertising that you have less than a 50% chance ofkeeping the premium whenever you sell options - and that is before factoring in the exorbitantslippage and commission costs. Blackjack at the casinos offers better odds.Sophisticated options income strategies are extremely sexy. For anyone who is quantitative,loves charts, statistics and probability - options present an endless world of speculation. Optionsbrokerage firms lure you in with state of the art trading execution and analytical platforms - withall the greeks (delta, gamma, theta, vega), pay-off simulations, probability analysis, impliedvolatility - all in real time with split-second execution.There are literally thousands of variations or views you can have by combining multiple legswith even or uneven weightings, across a wide range of strikes and expiration months. Optionstraders are not two-dimensional - heaven forbid, thats for brutes - typically they are threedimensional - incorporating not only price and time but also volatility into their views. In thissense, options trading attracts some of the most brilliant minds. Yet in the world of speculation,brilliance can be at war with risk management- intellectual arrogance coupled with the use ofleveraged derivative instruments has proven itself to be a recipe for disaster. In light of this,every investor should read the epilogue of Roger Lowensteins When Genius Failed: The Riseand Fall of Long-term Capital Management at least once a year.Many options traders wont admit to this, but I feel that one of the chief reasons people tradeoptions (instead of the traditional, two-dimensional boring stocks and ETFs, or i-t-m calls/putse.g.), is that they simply cant take losing trades. There are many options mentoring sites outthere whose key selling point is "never having to take a losing trade," or "how to turn a losingtrade into a winning trade." The magic word here is adjustment. "Well show you how to adjustyour options positions so you almost never have to take a loss." What they forget to tell you isthat theres an opportunity cost of trying to salvage losing trades. Sure, you can restructure yourlosing iron condor or calendar trade in an attempt to get back to break-even - but doing so willtake at least another three weeks. Youve simply tied up your capital that could have been usedmore productively on another potentially profitable trade idea. And, once again, after you factorin the cost of slippage and commissions for removing and adding legs ("rolling up and out" or"doing the jujitsu" - to use popular phrases among adjusters), youre lucky to get back to break-even at best.Options trading opens a Pandoras box of temptations. By presenting thousands of variations andstrategies on thousands of markets, it is tempting to want to experiment in uncharted territory(from the perspective of the options trader, that is). This often leads to over-trading, which leadsto more slippage and commissions.In sum, when it comes to options income trading, the odds are stacked against you. When youfactor in the lack of liquidity, the potential of being frozen into losing positions due to marginrequirements, exorbitant cost of slippage and commissions, the opportunity cost of adjustinglosing trades, not to mention the the huge temptation of trying new and aggressive ideas - itbehooves the majority of traders and investors to simply stay away from these complex
strategies.. You can save literally thousands of dollars in tutorials and trading losses byavoiding complex options income strategies. If you really must try out these strategies, Irecommend that you trade real money (paper trading is useless because it does not factor in allreal-world challenges, variables and emotional considerations), but that you trade extremelysmall size. Prove that you can turn a $5,000 account into at least double that in 3 years usingoptions. If you cant, then you shouldnt be trading options for income at all. You would bebetter off focusing on honing your directional modeling or subscribing to a solid market timingmethodology combined with sensible risk management for a portfolio of ETFs, stocks or in-the-money long option strategies. These should do nicely instead - and youll have a lot lessheadaches.ReferencesIf you should care to explore options concepts in greater detail, two well-written books that youshould have on your shelf are:For more articles and insights on trading and investing, please visit www.ProActInvest.net